Introduction to Product, Cost, Revenue, Profit Theory (Theory of the Firm Basics)

total product (TP) : total output produced by FoPs in a given time period.

average product (AP) : the output per unit of variable factor. TP/V = AP

marginal product (MP) : the extra output from using an additional variable factor. ∆TP/∆V = MP

fixed costs (FC) : costs a firm must pay regardless of output. A firm could produce absolutely nothing and still face fixed costs, and this is the definition of the short-run in microeconomics. These are things such as rent, insurance payments, depreciation, etc.

variable costs (VC) : costs that depend on the level of production

total cost (TC) : variable costs plus fixed costs - TC = FC + VC

average total cost (AC) : total cost divided by units of output. TC/Q = ATC

marginal cost (MC) : the cost of producing one extra unit of output. ∆TC/∆Q = MC

short-run cost curves : cost curves used in the short run (AFC, AVC, ATC, MC).  MC cuts AVC and ATC at their minimums.

long-run cost curves : defined as the period of time in which all factors of production are variable, the long run features cost curves in this time period (i.e. economies of scale).

economies of scale : occur when an increase in a firm's scale of production leads to lower average costs per unit produced (graph - downward-sloping LRAC curve as quantity increases).

diseconomies of scale : occur when an increase in a firm's scale of production leads to a higher average cost per units produced (graph - upward-sloping LRAC curve as quantity increases beyond economies of scale).

returns to scale: if output (y) increases by the same amount, we have constant returns to scale; if output increases by less than the proportional change, we have decreasing returns to scale; if output increases by more than the proportion, we have increasing returns to scale.

law of diminishing returns: MP eventually falls as variable factors are added to fixed factors and MP falls (i.e. Kebab shop in the Swiss mountain village of Leysin)

total revenue (TR) : price times quantity; total amount firm receives in sales.

average revenue (AR) : the revenue gained from selling one unit; equal to price. TR/Q

marginal revenue (MR) : the extra revenue a firm takes in when increasing output by one extra unit. ∆TR/∆Q = MR

normal profit : occurs when all costs are covered including the entrepreneur’s OC; anything above is considered abnormal profit, anything below is a loss.

profit maximization (MR = MC) : occurs when marginal revenue, the revenue gained from producing one extra unit of output, equals the marginal cost of producing that unit.

shut-down price(P ≤ AVC): occurs if marginal revenue is equal to or below average variable cost at the profit-maximizing output.

break-even price (P = ATC) : the point at which cost or expenses and revenue are equal, the firm has “broken even”.