🤑AP Microeconomics Unit 3 – Production, Cost, and the Perfect Competition Model

Key Concepts and Definitions

• Production refers to the process of creating goods or services using inputs (factors of production) such as labor, capital, and raw materials
• Marginal product (MP) measures the additional output produced by adding one more unit of a specific input, holding all other inputs constant
• Average product (AP) calculates the total output divided by the total quantity of a specific input used in production
• Total cost (TC) includes all costs associated with producing a given level of output, consisting of fixed costs and variable costs
• Marginal cost (MC) represents the additional cost incurred by producing one more unit of output
  • Calculated as the change in total cost divided by the change in quantity produced ($\frac{\Delta TC}{\Delta Q}$)
• Average total cost (ATC) measures the total cost per unit of output, found by dividing total cost by the quantity of output produced ($\frac{TC}{Q}$)
• Perfect competition describes a market structure characterized by many small firms, homogeneous products, free entry and exit, perfect information, and price-taking behavior

Production Theory Basics

• Production functions describe the relationship between inputs and outputs in the production process
  • Typically expressed as $Q = f(L, K)$, where Q is output, L is labor, and K is capital
• The law of diminishing marginal returns states that as more units of a variable input are added to a fixed input, the marginal product of the variable input eventually decreases
• Economies of scale occur when long-run average costs decrease as output increases, often due to specialization, bulk purchasing, or more efficient technology
• Diseconomies of scale happen when long-run average costs increase as output expands, usually caused by coordination problems or resource scarcity
• Returns to scale describe how output changes when all inputs are increased proportionally
  • Constant returns to scale: doubling inputs doubles output
  • Increasing returns to scale: doubling inputs more than doubles output
  • Decreasing returns to scale: doubling inputs less than doubles output
• Productivity measures the efficiency of production, calculated as output per unit of input (labor productivity or capital productivity)

Short-Run vs. Long-Run Production

• The short run is a time period in which at least one input is fixed (usually capital), while other inputs (like labor) can vary
• In the long run, all inputs are variable, allowing firms to adjust their scale of production
• Short-run production decisions involve changing variable inputs to optimize output given fixed inputs
  • Firms may hire more workers (labor) to increase production in the short run
• Long-run production decisions focus on choosing the optimal mix of inputs and scale of production
  • Companies can invest in new machinery or technology to expand production capacity
• The short-run average total cost (SRATC) curve is U-shaped due to the law of diminishing marginal returns
• The long-run average total cost (LRATC) curve is U-shaped because of economies and diseconomies of scale
  • The LRATC curve is an envelope of SRATC curves for different plant sizes

Cost Analysis and Types

• Fixed costs (FC) remain constant regardless of the level of output and must be paid even if production is zero (rent, insurance)
• Variable costs (VC) change with the level of output and are incurred only when production takes place (raw materials, labor)
• Average fixed cost (AFC) is calculated by dividing total fixed cost by the quantity of output produced ($\frac{FC}{Q}$)
  • AFC decreases as output increases because fixed costs are spread over more units
• Average variable cost (AVC) is found by dividing total variable cost by the quantity of output produced ($\frac{VC}{Q}$)
  • AVC initially decreases due to increasing marginal returns, then increases due to diminishing marginal returns
• Marginal cost (MC) is the change in total cost (or variable cost) resulting from producing one additional unit of output
• The relationship between marginal cost and average total cost:
  • When MC < ATC, ATC is decreasing
  • When MC > ATC, ATC is increasing
  • When MC = ATC, ATC is at its minimum point

Perfect Competition Model

• In perfect competition, firms are price takers, meaning they have no control over the market price and must accept the prevailing price
• The demand curve faced by a perfectly competitive firm is perfectly elastic (horizontal) at the market price
  • This implies that firms can sell any quantity at the market price but cannot influence the price
• Firms in perfect competition aim to maximize profits by producing the quantity where marginal revenue (MR) equals marginal cost (MC)
  • In perfect competition, MR = Price (P) because each additional unit is sold at the same market price
• The short-run supply curve of a perfectly competitive firm is the portion of its marginal cost curve above the average variable cost curve
• In the long run, firms earn zero economic profits due to free entry and exit
  • Economic profits attract new firms, increasing supply and driving down prices until profits are eliminated
  • Losses cause firms to exit the market, reducing supply and raising prices until losses are eliminated

Market Equilibrium in Perfect Competition

• Market equilibrium occurs when the quantity demanded equals the quantity supplied at a given price
• The market supply curve in perfect competition is the horizontal sum of the individual firms' supply curves (marginal cost curves above AVC)
• Short-run equilibrium is determined by the intersection of the market demand curve and the short-run market supply curve
  • Firms may earn positive, negative, or zero economic profits in the short run
• Long-run equilibrium is achieved when the market demand curve intersects the long-run market supply curve
  • In long-run equilibrium, all firms earn zero economic profits, and price equals minimum average total cost
• Changes in demand or supply lead to shifts in the respective curves, causing the market to move towards a new equilibrium price and quantity
  • An increase in demand shifts the demand curve to the right, leading to a higher equilibrium price and quantity
  • An increase in supply shifts the supply curve to the right, resulting in a lower equilibrium price and higher quantity

Firm Behavior and Decision Making

• In the short run, a perfectly competitive firm should produce if the market price is greater than or equal to its average variable cost (P ≥ AVC)
  • If P < AVC, the firm should shut down to minimize losses
• The firm's short-run supply curve is the portion of its marginal cost curve above the average variable cost curve
• In the long run, a firm should produce if the market price is greater than or equal to its average total cost (P ≥ ATC)
  • If P < ATC, the firm should exit the market to avoid losses
• The shutdown point is the minimum point on the average variable cost curve, representing the price below which the firm should cease production in the short run
• The break-even point is the minimum point on the average total cost curve, indicating the price at which the firm earns zero economic profits
• Firms should compare marginal revenue (price) to marginal cost when deciding how much to produce
  • If MR > MC, the firm should increase production to maximize profits
  • If MR < MC, the firm should decrease production to maximize profits
  • If MR = MC, the firm is maximizing profits and should maintain its current level of output

Real-World Applications and Examples

• Agriculture: Many small farms producing homogeneous products (wheat, corn) with limited control over prices
• Online marketplaces: Platforms like eBay and Etsy have numerous sellers offering similar products, with prices determined by market forces
• Commodity markets: Producers of raw materials (oil, gold) are often price takers due to standardized products and global competition
• Deviations from perfect competition:
  • Product differentiation: Firms may differentiate their products to gain some market power and influence prices (branded clothing)
  • Barriers to entry: Legal, technological, or financial obstacles can limit the number of firms in a market (patents, high startup costs)
• Government intervention: Policies such as price floors, price ceilings, taxes, and subsidies can affect market equilibrium and firm decision-making
  • A price floor above the equilibrium price creates a surplus and may encourage firms to produce more than the equilibrium quantity
  • A price ceiling below the equilibrium price results in a shortage and may cause firms to produce less than the equilibrium quantity
• Efficiency in perfect competition: In the long run, perfectly competitive markets are allocatively and productively efficient
  • Allocative efficiency: Price equals marginal cost, ensuring that resources are allocated to their most valued uses
  • Productive efficiency: Firms produce at the minimum average total cost, minimizing the cost of production