# Production, Costs, and Industry Structure

## Introduction to Production, Costs, and Industry Structure

This chapter is the first of four chapters that explores the theory of the firm. This theory explains how firms behave. What does that mean? Let’s define what we mean by the firm. A firm (or producer or business) combines inputs of labor, capital, land, and raw or finished component materials to produce outputs. If the firm is successful, the outputs are more valuable than the inputs. This activity of production goes beyond manufacturing (i.e., making things). It includes any process or service that creates value, including transportation, distribution, wholesale and retail sales.
Production involves a number of important decisions that define a firm's behavior. These decisions include, but are not limited to:
1. What product or products should the firm produce?
2. How should the firm produce the products (i.e., what production process should the firm use)?
3. How much output should the firm produce?
4. What price should the firm charge for its products?
5. How much labor should the firm employ?
The answers to these questions depend on the production and cost conditions facing each firm. That is the subject of this chapter. The answers also depend on the market structure for the product(s) in question. Market structure is a multidimensional concept that involves how competitive the industry is. We define it by questions such as these:
1. How much market power does each firm in the industry possess?
2. How similar is each firm’s product to the products of other firms in the industry?
3. How difficult is it for new firms to enter the industry?
4. Do firms compete on the basis of price, advertising, or other product differences?
 illustrates the range of different market structures, which we will explore in Perfect Competition, Monopoly, and Monopolistic Competition and Oligopoly.
Let's examine how firms determine their costs and desired profit levels. Then we will discuss the origins of cost, both in the short and long run. Private enterprise, which can be private individual or group business ownership, characterizes the U.S. economy. In the U.S. system, we have the option to organize private businesses as sole proprietorships (one owner), partners (more than one owner), and corporations (legal entitles separate from the owners.
When people think of businesses, often corporate giants like Wal-Mart, Microsoft, or General Motors come to mind. However, firms come
in all sizes, as  shows. The vast majority of American firms have fewer than 20 employees. As of
2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than
half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses.  does
not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.


# Production, Costs, and Industry Structure

## Explicit and Implicit Costs, and Accounting and Economic Profit

Each business, regardless of size or complexity, tries to earn a profit:
Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:
We will see in the following chapters that revenue is a function of the demand for the firm’s products.
Total cost is what the firm pays for producing and selling its products.  Recall that production involves the firm converting inputs to outputs.  Each of those inputs has a cost to the firm.  The sum of all those costs is total cost.  We will learn in this chapter that short run costs are different from long run costs.
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. (See the Work It Out feature for an extended example.)
These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections.

### Key Concepts and Summary

Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.

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### References

2010 U.S. Census. www.census.gov.


# Production, Costs, and Industry Structure

## Production in the Short Run

In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of producing that output.  We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost.  We can answer the former question by looking at the firm’s production function.
Production is the process (or processes) a firm uses to transform inputs (e.g., labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool—to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza?
Economists divide factors of production into several categories:
1. Natural Resources (Land and Raw Materials) - The ingredients for the pizza are raw materials.  These include the flour, yeast, and water for the dough, the tomatoes, herbs, and water for the sauce, the cheese, and the toppings.  If the pizza place uses a wood-burning oven, we would include the wood as a raw material.  If the establishment heats the oven with natural gas, we would count this as a raw material. Don’t forget electricity for lights.  If, instead of pizza, we were looking at an agricultural product, like wheat, we would include the land the farmer used for crops here.
2. Labor – When we talk about production, labor means human effort, both physical and mental.  The pizzaiolo was the primary example of labor here. They need to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven, but they also must know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making.  The business may also have one or more people to work the counter, take orders, and receive payment.
3. Capital – When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, the machines, equipment, and buildings that one uses to produce the product.  In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs).
4. Technology – Technology refers to the process or processes for producing the product.  How does the pizzaiolo combine ingredients to make pizza?  How hot should the oven be?  How long should the pizza cook?  What is the best oven to use?  Gas or wood burning?  Should the restaurant make its own dough, sauce, cheese, toppings, or should it buy them?
5. Entrepreneurship – Production involves many decisions and much knowledge, even for something as simple as pizza.  Who makes those decisions?  Ultimately, it is the entrepreneur, the person who creates the business, whose idea it is to combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur.  Let’s explore these ideas in more detail.
We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs:
The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs?  Production functions are specific to the product.  Different products have different production functions.  The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently.  One pizza restaurant may make its own dough and sauce, while another may buy those pre-made.  A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant.
We can describe inputs as either fixed or variable.
Fixed inputs are those that can’t easily be increased or decreased in a short period of time.  In the pizza example, the building is a fixed input. The restaurant owner signs a lease and is stuck in the building until the lease expires.  Fixed inputs define the firm’s maximum output capacity.  This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e., the maximum quantities of outputs a society can produce at a given time with its available resources.
Variable inputs are those that can easily be increased or decreased in a short period of time.  The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs.  The owner could hire a new person to work the counter pretty quickly as well.
Economists often use a short-hand form for the production function:
where L represents all the variable inputs, and K represents all the fixed inputs.
Economists differentiate between short and long run production.
The short run is the period of time during which at least some factors of production are fixed.  During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building—the owner can’t choose a larger or smaller building.
The long run is the period of time during which all factors are variable.  Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
Let’s explore production in the short run using a specific example: tree cutting (for lumber) with a two-person crosscut saw.
Since by definition capital is fixed in the short run, our production function becomes
This equation simply indicates that since capital is fixed, the amount of output (e.g., trees cut down per day) depends only on the amount of labor employed (e.g., number of lumberjacks working).  We can express this production function numerically as  below shows.
Note that we have introduced some new language.  We also call Output (Q) Total Product (TP), which means the amount of output produced with a given amount of labor and a fixed amount of capital.  In this example, one lumberjack using a two-person saw can cut down four trees in an hour.  Two lumberjacks using a two-person saw can cut down ten trees in an hour.
We should also introduce a critical concept: marginal product.  Marginal product is the additional output of one more worker.  Mathematically, Marginal Product is the change in total product divided by the change in labor:  . In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day.  Why might that be the case?  It’s because of the nature of the capital the workers are using.  A two-person saw works much better with two persons than with one.  Suppose we add a third lumberjack to the story.  What will that person’s marginal product be?  What will that person contribute to the team? Perhaps they can oil the saw's teeth to keep it sawing smoothly or they could bring water to the two people sawing.  What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output.  This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run.  Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice.  Both concepts are examples of the more general concept of diminishing marginal returns.  Why does diminishing marginal productivity occur?  It’s because of fixed capital.  We will see this more clearly when we discuss production in the long run.
We can show these concepts graphically as  and  illustrate.   graphically shows the data from .   shows the more general cases of total product and marginal product curves.

### Key Concepts and Summary

Production is the process a firm uses to transform inputs (e.g., labor, capital, raw materials, etc.) into outputs. It is not possible to vary fixed inputs (e.g., capital) in a short period of time.  Thus, in the short run the only way to change output is to change the variable inputs (e.g., labor).  Marginal product is the additional output a firm obtains by employing more labor in production.  At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor.  Mathematically, marginal product is the slope of the total product curve.

### Review Questions


# Production, Costs, and Industry Structure

## Costs in the Short Run

We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm.  The firm’s production function tells us how much output the firm will produce with given amounts of inputs.  However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost.  Let’s move to the second factor we need to determine.
For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production.  From the firm’s perspective, factor payments are costs.  From the owner of each factor’s perspective, factor payments are income.  Factor payments include:
1. Raw materials prices for raw materials
2. Rent for land or buildings
3. Wages and salaries for labor
4. Interest and dividends for the use of financial capital (loans and equity investments)
5. Profit for entrepreneurship.  Profit is the residual, what’s left over from revenues after the firm pays all the other costs.  While it may seem odd to treat profit as a “cost”, it is what entrepreneurs earn for taking the risk of starting a business.  You can see this correspondence between factors of production and factor payments in the inside loop of the circular flow diagram in .
We now have all the information necessary to determine a firm’s costs.
A cost function is a mathematical expression or equation that shows the cost of producing different levels of output.
What we observe is that the cost increases as the firm produces higher quantities of output.  This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire.
What is the origin of these cost figures?  They come from the production function and the factor payments. The discussion of costs in the short run above, Costs in the Short Run, was based on the following production function, which is similar to  except for "widgets" instead of trees.
We can use the information from the production function to determine production costs.  What we need to know is how many workers are required to produce any quantity of output.  If we flip the order of the rows, we “invert” the production function so it shows .
Now focus on the whole number quantities of output.  We’ll eliminate the fractions from the table:
Suppose widget workers receive $10 per hour.  Multiplying the Workers row by $10 (and eliminating the blanks) gives us the cost of producing different levels of output.
This is same cost function with which we began! (shown in )
Now that we have the basic idea of the cost origins and how they are related to production, let’s drill down into the details.

### Average and Marginal Costs

  The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.

We can measure costs in a variety of ways.  Each way provides its own insight into costs.  Sometimes firms need to look at their cost per unit of output, not just their total cost.  There are two ways to measure per unit costs.  The most intuitive way is average cost.  Average cost is the cost on average of producing a given quantity.  We define average cost as total cost divided by the quantity of output produced.
  If producing two widgets costs a total of $44, the average cost per widget is  per widget.   The other way of measuring cost per unit is marginal cost.  If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced.  More formally, marginal cost is the cost of producing one more unit of output.  Mathematically, marginal cost is the change in total cost divided by the change in output: . If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is   We can see the Widget Cost table redrawn below with average and marginal cost added.

Note that the marginal cost of the first unit of output is always the same as total cost.

### Fixed and Variable Costs

We can decompose costs into fixed and variable costs. Fixed costs are the costs of the fixed inputs (e.g., capital). Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs are the costs of the variable inputs (e.g., labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.
Total costs are the sum of fixed plus variable costs. Let's look at another example. Consider the barber shop called “The Clip Joint” in . The data for output and costs are in . The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost: 2 × $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost is: $160 + $160 = $320.
At zero production, the fixed costs of $160 are still present. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two.   graphically shows the relationship between the quantity of output produced and the cost of producing that output. We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs.

You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity which we discussed earlier in the Production in the Short Run section of this chapter, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of  shows.
This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g., water) contributes less to overall production.

### Average Total Cost, Average Variable Cost, Marginal Cost

The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of  duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in .
Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40, or $8 per haircut. Average cost curves are typically U-shaped, as  shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect.
We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80, or $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as  shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. We can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet, as the following Clear it Up feature discusses.
The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.

### Lessons from Alternative Measures of Costs

Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter Choice in a World of Scarcity, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives:
However, note that:
Thus:
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive. If price is below average cost, then profits will be negative.
We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits.

### A Variety of Cost Patterns

The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.

### Key Concepts and Summary

For every input (e.g., labor), there is an associated factor payment (e.g., wages and salaries).  The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment.
In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.
We calculate marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.
We calculate average total cost by taking total cost and dividing by total output at each different level of output.  Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.
We calculate average variable cost by taking variable cost and dividing by the total output at each level of output.  Average variable costs are typically U-shaped.  If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.

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# Production, Costs, and Industry Structure

## Production in the Long Run

In the long run, all factors (including capital) are variable, so our production function is .
Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital.  To start, the firm has just enough business for one typist and one PC to keep busy for a day.  Say that’s five documents.  Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow.  Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents.  However, in the short turn, the firm has fixed capital, i.e. only one PC.  The table below shows the situation:
In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers.  What could the second worker do?  What can they contribute to the firm?  Perhaps they can answer the phone, which is a major impediment to completing the typing assignment.  What about a third worker?  Perhaps the third worker could bring coffee to the first two workers.  You can see both total product and marginal product for the firm above.  Now here’s something to think about: At what point (e.g., after how many workers) does diminishing marginal productivity kick in, and more importantly, why?
In this example, marginal productivity starts to decline after the second worker.  This is because capital is fixed.  The production process for typing works best with one worker and one PC.  If you add more than one typist, you get seriously diminishing marginal productivity.
Consider the long run.  Suppose the firm’s demand increases to 15 documents per day.  What might the firm do to operate more efficiently?  If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as Table 7.12 below shows.
With more capital, the firm can hire three workers before diminishing productivity comes into effect.  More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output.

### Key Concepts and Summary

In the long run, all inputs are variable.  Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run.  Firms can choose the optimal capital stock to produce their desired level of output.

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# Production, Costs, and Industry Structure

## Costs in the Long Run

The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes).
In this context, technology refers to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.

### Choice of Production Technology

A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other.
Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in . The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines.
Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery.  outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery.
Example A shows the firm’s cost calculation when wages are $40 and machines costs are $80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to $55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to $90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as example C shows.
This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.

### Economies of Scale

Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.
 illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is $12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to $4 per alarm clock.
The average cost curve in  may appear similar to the average cost curves we presented earlier in this chapter, although it is downward-sloping rather than U-shaped. However, there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. The short-run average cost curves we presented earlier in this chapter assumed the existence of fixed costs, and only variable costs were allowed to change.
One prominent example of economies of scale occurs in the chemical industry. Chemical plants have many pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the cross-section area of the pipe determines the volume of chemicals that can flow through it. The calculations in  show that a pipe which uses twice as much material to make (as shown by the circumference) can actually carry four times the volume of chemicals because the pipe's cross-section area rises by a factor of four (as the Area column below shows).
A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. However, the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.

### Shapes of Long-Run Average Cost Curves

While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output.  shows how we build the long-run average cost curve from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result.
The shape of the long-run cost curve, in , is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in .
In the middle portion of the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. We call this situation diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.

### The Size and Number of Firms in an Industry

The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size. For example, say that the appliance industry sells one million dishwashers every year at a price of $500 each and the long-run average cost curve for dishwashers is in  (a). In  (a), the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above $500, and the firms would not be able to compete.
We illustrate a more common case in  (b), where the LRAC curve has a flat-bottomed area of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at about the same level of average cost. Given that the market will demand one million dishwashers per year at a price of $500, this market might have as many as 200 producers (that is, one million dishwashers divided by firms making 5,000 each) or as few as 50 producers (one million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. However, firms that produce below 5,000 units or more than 20,000 will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in  (a). However, if the long-run average cost curve has a wide flat bottom like  (b), then firms of a variety of different sizes will be able to compete with each other.
We can interpret the flat section of the long-run average cost curve in  (b) in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5,000 has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20,000. The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,000, while another firm owns four separate manufacturing plants, which each produce a quantity of 5,000. This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm. At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result.
In the examples to this point, the quantity demanded in the market is quite large (one million) compared with the quantity produced at the bottom of the long-run average cost curve (5,000, 10,000 or 20,000). In such a situation, the market is set for competition between many firms. However, what if the bottom of the long-run average cost curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower?
Return to  (a), where the bottom of the long-run average cost curve is at 10,000, but now imagine that the total quantity of dishwashers demanded in the market at that price of $500 is only 30,000. In this situation, the total number of firms in the market would be three. We call a handful of firms in a market an “oligopoly,” and the chapter on Monopolistic Competition and Oligopoly will discuss the range of competitive strategies that can occur when oligopolies compete.
Alternatively, consider a situation, again in the setting of  (a), where the bottom of the long-run average cost curve is 10,000, but total demand for the product is only 5,000. (For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.) In this situation, the market may well end up with a single firm—a monopoly—producing all 5,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 5,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The chapter on Monopoly discusses the situation of a monopoly firm.
Thus, the shape of the long-run average cost curve reveals whether competitors in the market will be different sizes. If the LRAC curve has a single point at the bottom, then the firms in the market will be about the same size, but if the LRAC curve has a flat-bottomed segment of constant returns to scale, then firms in the market may be a variety of different sizes.
The relationship between the quantity at the minimum of the long-run average cost curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC, a few firms will compete. If the quantity demanded in the market is less than the quantity at the minimum of the LRAC, a single-producer monopoly is a likely outcome.

### Shifting Patterns of Long-Run Average Cost

New developments in production technology can shift the long-run average cost curve in ways that can alter the size distribution of firms in an industry.
For much of the twentieth century, the most common change had been to see alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the long-run average cost curve, the downward-sloping economies of scale portion of the curve stretched over a larger quantity of output.
However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-size tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but did so at a lower average cost than a traditional mid-sized tire plant.
Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state, or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create “winner-take-all” markets where one large company will tend to command a large share of total sales, as Microsoft has done producing of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world, and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers.

### Key Concepts and Summary

A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production.
In the long run, firms can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost.
Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases. Diseconomies of scale refers to a situation where as output increases, average costs also increase.
The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom, so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand in conjunction with the long-run average cost curve determines how many firms will exist in a given industry.
If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the long-run average cost curve, where the cost of production is lowest, the market will have many firms competing. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm.

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# Perfect Competition

## Introduction to Perfect Competition

Most businesses face two realities: no one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Firms that operate in perfectly competitive markets face this reality. In this chapter, you will learn how such firms make decisions about how much to produce, how much profit they make, whether to stay in business or not, and many others. Industries differ from one another in terms of how many sellers there are in a specific market, how easy or difficult it is for a new firm to enter, and the type of products that they sell. Economists refer to this as an industry's market structure. In this chapter, we focus on perfect competition. However, in other chapters we will examine other industry types: Monopoly and Monopolistic Competition and Oligopoly.


# Perfect Competition

## Perfect Competition and Why It Matters

Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, they have to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in December 2021, U.S. corn farmers received an average of $5.47 per bushel. A corn farmer who attempted to sell at $6.00 per bushel would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as we discussed in the chapter on Production, Costs and Industry Structure. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest.
In the long run, positive economic profits will attract competition as other firms enter the market. Economic losses will cause firms to exit the market. Ultimately, perfectly competitive markets will attain long-run equilibrium when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.

### Key Concepts and Summary

A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero.
Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.

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# Perfect Competition

## How Perfectly Competitive Firms Make Output Decisions

A perfectly competitive firm has only one major decision to make—namely, what quantity to produce. To understand this, consider a different way of writing out the basic definition of profit:
Since a perfectly competitive firm must accept the price for its output as determined by the product’s market demand and supply, it cannot choose the price it charges. This is already determined in the profit equation, and so the perfectly competitive firm can sell any number of units at exactly the same price. It implies that the firm faces a perfectly elastic demand curve for its product: buyers are willing to buy any number of units of output from the firm at the market price. When the perfectly competitive firm chooses what quantity to produce, then this quantity—along with the prices prevailing in the market for output and inputs—will determine the firm’s total revenue, total costs, and ultimately, level of profits.

### Determining the Highest Profit by Comparing Total Revenue and Total Cost

A perfectly competitive firm can sell as large a quantity as it wishes, as long as it accepts the prevailing market price. The formula above shows that total revenue depends on the quantity sold and the price charged.  If the firm sells a higher quantity of output, then total revenue will increase. If the market price of the product increases, then total revenue also increases whatever the quantity of output sold. As an example of how a perfectly competitive firm decides what quantity to produce, consider the case of a small farmer who produces raspberries and sells them frozen for $4 per pack. Sales of one pack of raspberries will bring in $4, two packs will be $8, three packs will be $12, and so on. If, for example, the price of frozen raspberries doubles to $8 per pack, then sales of one pack of raspberries will be $8, two packs will be $16, three packs will be $24, and so on.
 shows total revenue and total costs for the raspberry farm; these data also appear in . The horizontal axis shows the quantity of frozen raspberries produced in packs. The vertical axis shows both total revenue and total costs, measured in dollars. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. All these cost curves follow the same characteristics as the curves that we covered in the Production, Costs and Industry Structure chapter.
Based on its total revenue and total cost curves, a perfectly competitive firm like the raspberry farm can calculate the quantity of output that will provide the highest level of profit. At any given quantity, total revenue minus total cost will equal profit. One way to determine the most profitable quantity to produce is to see at what quantity total revenue exceeds total cost by the largest amount.  shows total revenue, total cost and profit using the data from .  The vertical gap between total revenue and total cost is profit, for example, at Q = 60, TR = 240 and TC = 165.  The difference is 75, which is the height of the profit curve at that output level. The firm doesn’t make a profit at every level of output. In this example, total costs will exceed total revenues at output levels from 0 to approximately 30, and so over this range of output, the firm will be making losses. At output levels from 40 to 100, total revenues exceed total costs, so the firm is earning profits. However, at any output greater than 100, total costs again exceed total revenues and the firm is making increasing losses. Total profits appear in the final column of . Maximum profit occurs at an output between 70 and 80, when profit equals $90.
A higher price would mean that total revenue would be higher for every quantity sold. A lower price would mean that total revenue would be lower for every quantity sold. What happens if the price drops low enough so that the total revenue line is completely below the total cost curve; that is, at every level of output, total costs are higher than total revenues? In this instance, the best the firm can do is to suffer losses. However, a profit-maximizing firm will prefer the quantity of output where total revenues come closest to total costs and thus where the losses are smallest.
(Later we will see that sometimes it will make sense for the firm to close, rather than stay in operation producing output.)

### Comparing Marginal Revenue and Marginal Costs

The approach that we described in the previous section, using total revenue and total cost, is not the only approach to determining the profit maximizing level of output.  In this section, we provide an alternative approach which uses marginal revenue and marginal cost.
Firms often do not have the necessary data they need to draw a complete total cost curve for all levels of production. They cannot be sure of what total costs would look like if they, say, doubled production or cut production in half, because they have not tried it. Instead, firms experiment. They produce a slightly greater or lower quantity and observe how it affects profits. In economic terms, this practical approach to maximizing profits means examining how changes in production affect marginal revenue and marginal cost.
 presents the marginal revenue and marginal cost curves based on the total revenue and total cost in . The marginal revenue curve shows the additional revenue gained from selling one more unit. As mentioned before, a firm in perfect competition faces a perfectly elastic demand curve for its product—that is, the firm’s demand curve is a horizontal line drawn at the market price level. This also means that the firm’s marginal revenue curve is the same as the firm’s demand curve: Every time a consumer demands one more unit, the firm sells one more unit and revenue increases by exactly the same amount equal to the market price. In this example, every time the firm sells a pack of frozen raspberries, the firm’s revenue increases by $4.  shows an example of this. This condition only holds for price taking firms in perfect competition where:
The formula for marginal revenue is:
Notice that marginal revenue does not change as the firm produces more output. That is because under perfect competition, the price is determined through the interaction of supply and demand in the market and does not change as the farmer produces more (keeping in mind that, due to the relative small size of each firm, increasing their supply has no impact on the total market supply where price is determined).
Since a perfectly competitive firm is a price taker, it can sell whatever quantity it wishes at the market-determined price. We calculate marginal cost, the cost per additional unit sold, by dividing the change in total cost by the change in quantity. The formula for marginal cost is:
Ordinarily, marginal cost changes as the firm produces a greater quantity.
In the raspberry farm example, in  and , marginal cost at first declines as production increases from 10 to 20 to 30 to 40 packs of raspberries—which represents the area of increasing marginal returns that is not uncommon at low levels of production. At some point, though, marginal costs start to increase, displaying the typical pattern of diminishing marginal returns. If the firm is producing at a quantity where MR > MC, like 40 or 50 packs of raspberries, then it can increase profit by increasing output because the marginal revenue is exceeding the marginal cost. If the firm is producing at a quantity where MC > MR, like 90 or 100 packs, then it can increase profit by reducing output because the reductions in marginal cost will exceed the reductions in marginal revenue. The firm’s profit-maximizing choice of output will occur where MR = MC (or at a choice close to that point).
In this example, the marginal revenue and marginal cost curves cross at a price of $4 and a quantity of 80 produced. If the farmer started out producing at a level of 60, and then experimented with increasing production to 70, marginal revenues from the increase in production would exceed marginal costs—and so profits would rise. The farmer has an incentive to keep producing. At a level of output of 80, marginal cost and marginal revenue are equal so profit doesn’t change. If the farmer then experimented further with increasing production from 80 to 90, he would find that marginal costs from the increase in production are greater than marginal revenues, and so profits would decline.
The profit-maximizing choice for a perfectly competitive firm will occur at the level of output where marginal revenue is equal to marginal cost—that is, where MR = MC. This occurs at Q = 80 in the figure.
Because the marginal revenue received by a perfectly competitive firm is equal to the price P, we can also write the profit-maximizing rule for a perfectly competitive firm as a recommendation to produce at the quantity of output where P = MC.

### Profits and Losses with the Average Cost Curve

Does maximizing profit (producing where MR = MC) imply an actual economic profit? The answer depends on the relationship between price and average total cost, which is the average profit or profit margin. If the market price is higher than the firm's average cost of production for that quantity produced, then the profit margin is positive and the firm will earn profits. Conversely, if the market price is lower than the  average cost of production, the profit margin is negative and the firm will suffer losses. You might think that, in this situation, the firm may want to shut down immediately. Remember, however, that the firm has already paid for fixed costs, such as equipment, so it may continue to produce for a while and incur a loss.  continues the raspberry farm example.  illustrates the three possible scenarios: (a) where price intersects marginal cost at a level above the average cost curve, (b) where price intersects marginal cost at a level equal to the average cost curve, and (c) where price intersects marginal cost at a level below the average cost curve.
First consider a situation where the price is equal to $5 for a pack of frozen raspberries. The rule for a profit-maximizing perfectly competitive firm is to produce the level of output where Price= MR = MC, so the raspberry farmer will produce a quantity of approximately 85, which is labeled as E' in  (a). Remember that the area of a rectangle is equal to its base multiplied by its height. The farm’s total revenue at this price will be shown by the rectangle from the origin over to a quantity of 85 packs (the base) up to point E' (the height), over to the price of $5, and back to the origin. The average cost of producing 80 packs is shown by point C or about $3.50. Total costs will be the quantity of 85 times the average cost of $3.50, which is shown by the area of the rectangle from the origin to a quantity of 90, up to point C, over to the vertical axis and down to the origin. The difference between total revenues and total costs is profits. Thus, profits will be the blue shaded rectangle on top.
We calculate this as:
Or, we can calculate it as:
Now consider  (b), where the price has fallen to $2.75 for a pack of frozen raspberries. Again, the perfectly competitive firm will choose the level of output where Price = MR = MC, but in this case, the quantity produced will be 75. At this price and output level, where the marginal cost curve is crossing the average cost curve, the price the firm receives is exactly equal to its average cost of production. We call this the break even point.

The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 75 packs (the base) up to point E (the height), over to the price of $2.75, and back to the origin. The height of the average cost curve at Q = 75, i.e. point E, shows the average cost of producing this quantity. Total costs will be the quantity of 75 times the average cost of $2.75, which is shown by the area of the rectangle from the origin to a quantity of 75, up to point E, over to the vertical axis and down to the origin. It should be clear that the rectangles for total revenue and total cost are the same. Thus, the firm is making zero profit. The calculations are as follows:
Or, we can calculate it as:
In  (c), the market price has fallen still further to $2.00 for a pack of frozen raspberries. At this price, marginal revenue intersects marginal cost at a quantity of 65. The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a quantity of 65 packs (the base) up to point E” (the height), over to the price of $2, and back to the origin. The average cost of producing 65 packs is shown by Point C” or shows the average cost of producing 50 packs is about $2.73. Total costs will be the quantity of 65 times the average cost of $2.73, which the area of the rectangle from the origin to a quantity of 50, up to point C”, over to the vertical axis and down to the origin shows. It should be clear from examining the two rectangles that total revenue is less than total cost. Thus, the firm is losing money and the loss (or negative profit) will be the rose-shaded rectangle.
The calculations are:
Or:
If the market price that perfectly competitive firm receives leads it to produce at a quantity where the price is greater than average cost, the firm will earn profits. If the price the firm receives causes it to produce at a quantity where price equals average cost, which occurs at the minimum point of the AC curve, then the firm earns zero profits. Finally, if the price the firm receives leads it to produce at a quantity where the price is less than average cost, the firm will earn losses.  summarizes this.

### The Shutdown Point

The possibility that a firm may earn losses raises a question: Why can the firm not avoid losses by shutting down and not producing at all? The answer is that shutting down can reduce variable costs to zero, but in the short run, the firm has already paid for fixed costs. As a result, if the firm produces a quantity of zero, it would still make losses because it would still need to pay for its fixed costs. Therefore when a firm is experiencing losses, it must face a question: should it continue producing or should it shut down?
As an example, consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per month. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If the firm shuts down, it must still pay the rent, but it would not need to hire labor.  shows three possible scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any revenues, in which case it faces losses of $10,000 equal to the fixed costs. In the second scenario, the Yoga Center has clients that earn the center revenues of $10,000 for the month, but ultimately experiences losses of $15,000 due to having to hire yoga instructors to cover the classes. In the third scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of $5,000.
In all three cases, the Yoga Center loses money. In all three cases, when the rental contract expires in the long run, assuming revenues do not improve, the firm should exit this business. In the short run, though, the decision varies depending on the level of losses and whether the firm can cover its variable costs. In scenario 1, the center does not have any revenues, so hiring yoga teachers would increase variable costs and losses, so it should shut down and only incur its fixed costs. In scenario 2, the center’s losses are greater because it does not make enough revenue to offset the increased variable costs, so it should shut down immediately and only incur its fixed costs. If price is below the minimum average variable cost, the firm must shut down. In contrast, in scenario 3 the revenue that the center can earn is high enough that the losses diminish when it remains open, so the center should remain open in the short run.
 illustrates the lesson that remaining open requires the price to exceed the firm’s average variable cost. When the firm is operating below the break-even point, where price equals average cost, it is operating at a loss so it faces two options: continue to produce and lose money or shutdown.  Which option is preferable?  The one that loses the least money is the best choice.
At a price of $2.00 per pack, as Figure 8.6 (a) illustrates, if the farm stays in operation it will produce at a level of 65 packs of raspberries, and it will make losses of $47.45 (as explained earlier).  The alternative would be to shut down and lose all the fixed costs of $62.00.  Since losing $47.45 is preferable to losing $62.00, the profit maximizing (or in this case the loss minimizing) choice is to stay in operation.  The key reason is because price is above average variable cost.  This means that at the current price the farm can pay all its variable costs, and have some revenue left over to pay some of the fixed costs.  So the loss represents the part of the fixed costs the farm can’t pay, which is less than the entire fixed costs. However, if the price declined to $1.50 per pack, as  (b) shows, and if the firm applied its rule of producing where P = MR = MC, it would produce a quantity of 60. This price is below average variable cost for this level of output. If the farmer cannot pay workers (the variable costs), then it has to shut down. At this price and output, total revenues would be $90 (quantity of 60 times price of $1.50) and total cost would be $165, for overall losses of $75. If the farm shuts down, it must pay only its fixed costs of $62, so shutting down is preferable to selling at a price of $1.50 per pack.
Looking at , if the price falls below about $1.72, the minimum average variable cost, the firm must shut down.
The intersection of the average variable cost curve and the marginal cost curve, which shows the price below which the firm would lack enough revenue to cover its variable costs, is called the shutdown point. If the perfectly competitive firm faces a market price above the shutdown point, then the firm is at least covering its average variable costs. At a price above the shutdown point, the firm  is also making enough revenue to cover at least a portion of fixed costs, so it should limp ahead even if it is making losses in the short run, since at least those losses will be smaller than if the firm shuts down immediately and incurs a loss equal to total fixed costs. However, if the firm is receiving a price below the price at the shutdown point, then the firm is not even covering its variable costs. In this case, staying open is making the firm’s losses larger, and it should shut down immediately. To summarize, if:

### Short-Run Outcomes for Perfectly Competitive Firms

The average cost and average variable cost curves divide the marginal cost curve into three segments, as  shows. At the market price, which the perfectly competitive firm accepts as given, the profit-maximizing firm chooses the output level where price or marginal revenue, which are the same thing for a perfectly competitive firm, is equal to marginal cost: P = MR = MC.
First consider the upper zone, where prices are above the level where marginal cost (MC) crosses average cost (AC) at the zero profit point. At any price above that level, the firm will earn profits in the short run. If the price falls exactly on the break even point where the MC and AC curves cross, then the firm earns zero profits. If a price falls into the zone between the break even point, where MC crosses AC, and the shutdown point, where MC crosses AVC, the firm will be making losses in the short run—but since the firm is more than covering its variable costs, the losses are smaller than if the firm shut down immediately. Finally, consider a price at or below the shutdown point where MC crosses AVC. At any price like this one, the firm will shut down immediately, because it cannot even cover its variable costs.

### Marginal Cost and the Firm’s Supply Curve

For a perfectly competitive firm, the marginal cost curve is identical to the firm’s supply curve starting from the minimum point on the average variable cost curve. To understand why this perhaps surprising insight holds true, first think about what the supply curve means. A firm checks the market price and then looks at its supply curve to decide what quantity to produce. Now, think about what it means to say that a firm will maximize its profits by producing at the quantity where P = MC. This rule means that the firm checks the market price, and then looks at its marginal cost to determine the quantity to produce—and makes sure that the price is greater than the minimum average variable cost. In other words, the marginal cost curve above the minimum point on the average variable cost curve becomes the firm’s supply curve.
As we discussed in the chapter on Demand and Supply, many of the reasons that supply curves shift relate to underlying changes in costs. For example, a lower price of key inputs or new technologies that reduce production costs cause supply to shift to the right. In contrast, bad weather or added government regulations can add to costs of certain goods in a way that causes supply to shift to the left. We can also interpret these shifts in the firm’s supply curve as shifts of the marginal cost curve. A shift in costs of production that increases marginal costs at all levels of output—and shifts MC upward and to the left—will cause a perfectly competitive firm to produce less at any given market price. Conversely, a shift in costs of production that decreases marginal costs at all levels of output will shift MC downward and to the right and as a result, a competitive firm will choose to expand its level of output at any given price. The following Work It Out feature will walk you through an example.
Step 1. Determine the cost structure for the firm. For a given total fixed costs and variable costs, calculate total cost, average variable cost, average total cost, and marginal cost. Follow the formulas given in the Production, Costs, and Industry Structure chapter. These calculations are in .
Step 2. Determine the market price that the firm receives for its product. Since the firm in perfect competition is a price taker,  the market price is constant. With the given price, calculate total revenue as equal to price multiplied by quantity for all output levels produced. In this example, the given price is $28. You can see that in the second column of .
Step 3. Calculate profits as total cost subtracted from total revenue, as  shows.
Step 4. To find the profit-maximizing output level, look at the Marginal Cost column (at every output level produced), as  shows, and determine where it is equal to the market price. The output level where price equals the marginal cost is the output level that maximizes profits.
Step 5. Once you have determined the profit-maximizing output level (in this case, output quantity 5), you can look at the amount of profits made (in this case, $40).
Step 6. If the firm is making economic losses, the firm needs to determine whether it produces the output level where price equals marginal revenue and equals marginal cost or it shuts down and only incurs its fixed costs.
Step 7. For the output level where marginal revenue is equal to marginal cost, check if the market price is greater than the average variable cost of producing that output level.

In this example, the price of $28 is greater than the AVC ($16.40) of producing 5 units of output, so the firm continues producing.

### Key Concepts and Summary

As a perfectly competitive firm produces a greater quantity of output, its total revenue steadily increases at a constant rate determined by the given market price. Profits will be highest (or losses will be smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be highest where marginal revenue, which is price for a perfectly competitive firm, is equal to marginal cost. If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is making profits. If the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses.
If the market price is equal to average cost at the profit-maximizing level of output, then the firm is making zero profits. We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, the “zero profit point.” If the market price that a perfectly competitive firm faces is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. If the market price that a perfectly competitive firm faces is above average variable cost, but below average cost, then the firm should continue producing in the short run, but exit in the long run. We call the point where the marginal cost curve crosses the average variable cost curve the shutdown point.

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# Perfect Competition

## Entry and Exit Decisions in the Long Run

It is impossible to precisely define the line between the short run and the long run with a stopwatch, or even with a calendar. It varies according to the specific business. Therefore, the distinction between the short run and the long run is  more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production.
In a competitive market, profits are a red cape that incites businesses to charge. If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones. New firms may start production, as well. When new firms enter the industry in response to increased industry profits it is called entry.
Losses are the black thundercloud that causes businesses to flee. If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs. But in the long run, firms that are facing losses will cease production altogether. The long-run process of reducing production in response to a sustained pattern of losses is called exit. The following Clear It Up feature discusses where some of these losses might come from, and the reasons why some firms go out of business.

### How Entry and Exit Lead to Zero Profits in the Long Run

No perfectly competitive firm acting alone can affect the market price. However, the combination of many firms entering or exiting the market will affect overall supply in the market. In turn, a shift in supply for the market as a whole will affect the market price. Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit.
To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation. The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC. No firm has the incentive to enter or leave the market. Let’s say that the product’s demand increases, and with that, the market price goes up. The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC.
This will temporarily make the market price rise above the minimum point on the average cost curve, and therefore, the existing firms in the market will now be earning economic profits. However, these economic profits attract other firms to enter the market. Entry of many new firms causes the market supply curve to shift to the right. As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms. As long as there are still profits in the market, entry will continue to shift supply to the right. This will stop whenever the market price is driven down to the zero-profit level, where no firm is earning economic profits.
Short-run losses will fade away by reversing this process. Say that the market is in long-run equilibrium. This time, instead, demand decreases, and with that, the market price starts falling. The existing firms in the industry are now facing a lower price than before, and as it will be below the average cost curve, they will now be making economic losses. Some firms will continue producing where the new P = MR = MC, as long as they are able to cover their average variable costs. Some firms will have to shut down immediately as they will not be able to cover their average variable costs, and will then only incur their fixed costs, minimizing their losses. Exit of many firms causes the market supply curve to shift to the left. As the supply curve shifts to the left, the market price starts rising, and economic losses start to be lower. This process ends whenever the market price rises to the zero-profit level, where the existing firms are no longer losing money and are at zero profits again. Thus, while a perfectly competitive firm can earn profits in the short run, in the long run the process of entry will push down prices until they reach the zero-profit level. Conversely, while a perfectly competitive firm may earn losses in the short run, firms will not continually lose money. In the long run, firms making losses are able to escape from their fixed costs, and their exit from the market will push the price back up to the zero-profit level. In the long run, this process of entry and exit will drive the price in perfectly competitive markets to the zero-profit point at the bottom of the AC curve, where marginal cost crosses average cost.

### The Long-Run Adjustment and Industry Types

Whenever there are expansions in an industry, costs of production for the existing and new firms could either stay the same, increase, or even decrease. Therefore, we can categorize an industry as being (1) a constant-cost industry (as demand increases, the cost of production for firms stays the same), (2) an increasing-cost industry (as demand increases, the cost of production for firms increases), or (3) a decreasing-cost industry (as demand increases the costs of production for the firms decreases).
For a constant-cost industry, whenever there is an increase in market demand and price, then the supply curve shifts to the right with new firms’ entry and stops at the point where the new long-run equilibrium intersects at the same market price as before. This is the case of constant returns to scale, which we discussed earlier in the chapter on Production, Costs, and Industry Structure. However, why will costs remain the same? In this type of industry, the supply curve is very elastic. Firms can easily supply any quantity that consumers demand. In addition, there is a perfectly elastic supply of inputs—firms can easily increase their demand for employees, for example, with no increase to wages. Tying in to our Bring it Home discussion, an increased demand for ethanol in recent years has caused the demand for corn to increase. Consequently, many farmers switched from growing wheat to growing corn. Agricultural markets are generally good examples of constant-cost industries.
For an increasing-cost industry, as the market expands, the old and new firms experience increases in their costs of production, which makes the new zero-profit level intersect at a higher price than before. Here companies may have to deal with limited inputs, such as skilled labor. As the demand for these workers rises, wages rise and this increases the cost of production for all firms. The industry supply curve in this type of industry is more inelastic.
For a decreasing-cost industry, as the market expands, the old and new firms experience lower costs of production, which makes the new zero-profit level intersect at a lower price than before. In this case, the industry and all the firms in it are experiencing falling average total costs. This can be due to an improvement in technology in the entire industry or an increase in the education of employees. High-tech industries may be a good example of a decreasing-cost market.
 (a) presents the case of an adjustment process in a constant-cost industry. Whenever there are output expansions in this type of industry, the long-run outcome implies more output produced at exactly the same original price. Note that supply was able to increase to meet the increased demand. When we join the before and after long-run equilibriums, the resulting line is the long run supply (LRS) curve in perfectly competitive markets. In this case, it is a flat curve.  (b) and  (c) present the cases for an increasing-cost and decreasing-cost industry, respectively. For an increasing-cost industry, the LRS is upward sloping, while for a decreasing-cost industry, the LRS is downward sloping.

### Key Concepts and Summary

In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms cease production altogether. Through the process of entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where the marginal cost curve crosses the AC curve at the minimum of the average cost curve.
The long-run supply curve shows the long-run output supplied by firms in three different types of industries: constant cost, increasing cost, and decreasing cost.

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