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Credit Sprint's Guide to Microeconomics Unit 3: Production, Cost, and the Perfect Competition Model

Firms combine inputs to produce output, and diminishing marginal returns shape their cost curves. Every firm maximizes profit where marginal revenue equals marginal cost. In perfect competition, firms are price takers: they can earn profits or losses in the short run, but entry and exit push economic profit to zero in the long run.

What you need to know

• Diminishing marginal returns: adding more of a variable input to a fixed input eventually lowers marginal product. It's a short-run idea.
• MC crosses AVC and ATC at their minimum points. When MC is below an average, the average falls; above it, the average rises.
• AFC always falls as output rises. The gap between ATC and AVC is AFC.
• Economic profit subtracts implicit (opportunity) costs as well as explicit costs. Zero economic profit is a normal profit.
• Every firm maximizes profit (or minimizes loss) at the quantity where MR = MC.
• A perfectly competitive firm is a price taker: P = MR = D = AR, a horizontal line.
• Short run: produce if P ≥ min AVC; shut down if P < min AVC (the loss would equal fixed cost).
• Long run: profits attract entry (market supply shifts right, price falls); losses cause exit (supply shifts left, price rises) until P = min ATC.
• Long-run equilibrium in perfect competition is allocatively efficient (P = MC) and productively efficient (P = min ATC).
• Economies of scale make long-run ATC fall as the firm grows; diseconomies make it rise.

Formulas

Exam traps

Key terms

• Short run: A period in which at least one input (usually capital) is fixed.
• Long run: A period long enough for every input to be variable and for firms to enter or exit.
• Marginal product: The extra output from one more unit of an input.
• Diminishing marginal returns: As more of a variable input is added to a fixed input, marginal product eventually falls.
• Fixed cost: A cost that doesn't change with output, like rent. Paid even at zero output in the short run.
• Marginal cost: The extra cost of producing one more unit: ΔTC ÷ ΔQ.
• Average total cost: Total cost per unit: TC ÷ Q. U-shaped, with MC crossing it at the minimum.
• Economic profit: Total revenue minus explicit AND implicit costs.
• Normal profit: Zero economic profit. The firm covers all its opportunity costs.
• Price taker: A firm that can't affect the market price. In perfect competition, P = MR = D.
• Shutdown rule: In the short run, shut down if price is below minimum average variable cost.
• Break-even point: The price equal to minimum ATC, where economic profit is zero.
• Economies of scale: Long-run average total cost falls as the firm increases all its inputs.
• Constant-cost industry: An industry whose long-run supply curve is horizontal because input prices don't change as it grows.

Practice questions

Five of the 53 Unit 3 questions in Credit Sprint. Every choice is explained in the app.