Production and Costs

The production function: total, average and marginal product, the law of variable proportions, returns to scale, and short-run costs (TFC, TVC, AFC, AVC, AC, MC).

Key ideas

• In the short run at least one input is fixed; in the long run all inputs can vary.
• Law of variable proportions: adding a variable input to fixed inputs first raises its marginal product, which then falls.
• AP rises while MP is above it and falls once MP is below it, so MP cuts AP at the maximum of AP.
• Returns to scale ask what happens when ALL inputs rise in the same proportion: output rising by more, the same or less gives increasing, constant or decreasing returns.
• Fixed costs (rent, permanent salaries) do not change with output; variable costs (raw materials, daily wages) do.
• AFC falls all the way; AVC, AC and MC are U-shaped, and MC cuts AVC and AC at their minimum points.
• The gap between AC and AVC is AFC, so it narrows as output rises.

Remember

Watch out

• Mixing up diminishing marginal product (one input varied) with decreasing returns to scale (all inputs varied).
• Including TFC when finding MC from TVC, or forgetting that MC is the same from TC or TVC.
• Dividing by the previous output instead of the current one for an average.

Worked example