Production, Cost, and the Perfect Competition Model: every key term you need (+ practice quiz)

More AP Microeconomics guides

• Supply and Demand
• Imperfect Competition
• Factor Markets
• Market Failure and the Role of Government

Production Function

The relationship between the quantity of inputs a firm uses and the quantity of output it produces.

Short Run

The period during which at least one input (usually capital or plant size) is fixed.

Long Run

The period long enough for a firm to vary all inputs, including plant size, and for firms to enter or exit an industry.

Marginal Product of Labor (MPL)

The additional output produced by hiring one more worker: ΔQ ÷ ΔL.

Law of Diminishing Marginal Returns

As more of a variable input is added to fixed inputs, the marginal product of the variable input eventually falls.

Fixed Costs (FC)

Costs that do not vary with output in the short run, such as rent and insurance; they must be paid even at zero output.

Variable Costs (VC)

Costs that change with the level of output, such as raw materials and hourly labor.

Total Cost (TC)

Fixed costs plus variable costs at each output level: TC = FC + VC.

Marginal Cost (MC)

The additional cost of producing one more unit: ΔTC ÷ ΔQ; it eventually rises because of diminishing marginal returns.

Average Fixed Cost (AFC)

Fixed cost per unit, FC ÷ Q; always falls as output rises (spreading the overhead).

Average Variable Cost (AVC)

Variable cost per unit, VC ÷ Q; typically U-shaped.

Average Total Cost (ATC)

Total cost per unit, TC ÷ Q, equal to AFC + AVC; U-shaped in the short run.

MC and Average Cost Relationship

Marginal cost intersects both AVC and ATC at their minimum points: when MC is below an average it pulls it down, when above it pulls it up.

Economies of Scale

Falling long-run average total cost as a firm increases its scale of production, often from specialization or bulk buying.

Diseconomies of Scale

Rising long-run average total cost at very large scales, often from coordination and management problems.

Constant Returns to Scale

The flat range of the long-run ATC curve where increasing scale leaves average cost unchanged.

Explicit Costs

Direct out-of-pocket payments for resources, such as wages, rent, and materials.

Implicit Costs

The opportunity costs of using resources the owner already possesses, such as forgone salary and forgone interest.

Accounting Profit

Total revenue minus explicit costs only.

Economic Profit

Total revenue minus all costs, both explicit and implicit; can be negative even when accounting profit is positive.

Normal Profit

Zero economic profit: revenue just covers all explicit and implicit costs, so the owner earns exactly what the next-best alternative would pay.

Total Revenue (TR)

Price times quantity sold: TR = P × Q.

Marginal Revenue (MR)

The additional revenue from selling one more unit: ΔTR ÷ ΔQ; equals price for a perfectly competitive firm.

Profit-Maximization Rule

All firms maximize profit (or minimize loss) by producing the quantity where MR = MC.

Perfect Competition

Market structure with many small firms, identical (homogeneous) products, perfect information, and free entry and exit.

Price Taker

A firm that must accept the market price; its individual demand curve is perfectly elastic (horizontal) at that price.

P = MR = D = AR (perfect competition)

For a perfectly competitive firm, price, marginal revenue, demand, and average revenue coincide as one horizontal line.

Shutdown Rule

In the short run a firm should shut down if price falls below minimum AVC; between AVC and ATC it operates at a loss smaller than fixed costs.

Short-Run Supply Curve (firm)

The portion of the firm's MC curve above minimum average variable cost.

Break-Even Point

The output where price equals minimum ATC; the firm earns zero economic profit.

Entry and Exit (long run)

Short-run profits attract entry, shifting market supply right and eroding profit; losses cause exit until remaining firms break even.

Long-Run Equilibrium (perfect competition)

Firms produce where P = MR = MC = minimum ATC, earning zero economic profit with both productive and allocative efficiency.

Productive Efficiency

Producing at the lowest possible average total cost (P = minimum ATC).

Allocative Efficiency

Producing the quantity society values most, where P = MC: the value of the last unit equals its resource cost.

Constant-Cost Industry

An industry whose input prices do not change with industry size, giving a horizontal long-run supply curve.

Increasing-Cost Industry

An industry where expansion bids up input prices, giving an upward-sloping long-run supply curve.