total revenue: the amount a firm receives for the sale of its output
total cost: the market value of the inputs a firm uses in production, including wages and everything.
profit: total revenue - total cost
explicit costs: input costs that require an outlay of money by the firm
implicit costs: opportunity cost of a firm, such as time, and previous income.
economic profit: total revenue minus total cost, including both explicit and implicit costs
accounting profit: total revenue minus just explicit cost.

Production function: the relationship between quantity of inputs used to make a good and the quantity of output of that good
Marginal product: the increase in output that arises from an additional unit of input
Diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases
Fixed costs: costs that do not change.
Variable costs: costs that increase as quantity of output increase
Average total cost: total cost divided by the quantity
Average fixed cost: fixed cost divided by the quantity
Average variable cost: variable costs divided by the quantity
Marginal cost: increase in total cost that arises from an extra unit of production. It rises as the quantity of output produced, which reflects diminishing marginal product.
Efficient scale: the quantity of output that minimizes average total cost.
Economies of scale: in the long-run average total cost falls as the quantity of output increases
Diseconomies of scale: in the long-run average total cost rises as the quantity of output increases.
Constant returns to scale: in the long-run average total cost stays the same


I. What are costs?
A. All important terms to know
Cost is important concept because in order to maximize profit, we need to consider the firm’s cost. Total cost is cost that the firm pays including wages, factory, and all inputs. Total revenue is how much the firm earns. Profit is total revenue minus total cost. Thus, to maximize profit, the firm should maximize its total revenue and minimize its total cost.
There are two kinds of costs. One is implicit costs and the other is explicit costs. Implicit costs are opportunity costs. You cannot actually see implicit cost because it is like time and foregone opportunity. Explicit costs are one that flows out money. You can actually see them. It is such as current income. Accountants are only worried about explicit costs. They only count explicit costs. Economist, however, count both explicit and implicit costs.

B. Economic profit vs. accounting profit
Economic profit is total revenue minus all the cost (both explicit and implicit costs) Accounting profit is total revenue minus just the explicit costs. Thus, accounting profit would be higher than the economic profit since it does not include implicit costs like economic profit. Here is the diagram

Source: http://images.google.co.kr/imgres?imgurl=http:www.pmcl.com/nedprototype/Images/profit.gif&imgrefurl
This graph shows how economists and accountants view profit. The graph shows that economists' profit is smaller than the accountants' profit because it considers both implicit and explicit costs.

II. Production and costs
A. The production function and total-cost curve
The production function is graph, showing relationship between quantity of inputs and the quantity of output. The production’s slope shows the change in output for each additional input. So, the slope of production function measures the marginal product of a worker. As the number of workers increases, the marginal product declines, and the production function becomes flatter.
Total-cost curve is relationship between quantity of output and total cost. Total cost curve is just like production function except that it is flipped back. For each quantity of output increased, total cost increases. As more quantity of output is produced, total cost rises even more.
The production function gets flatter as production rises, whereas the total cost curve gets steeper as the amount produced rises. This is because the input is limited in the short run. When more people need to use limited input, then each additional worker adds less to the production.

III. The Various Measures of Cost
A. Fixed and Variable Cost
Fixed cost is like its name, fixed and does not change
Variable cost, varies as the output changes.

B. Average and Marginal Cost
There is a huge difference between adding an additional product and making just a product. Making marginal product costs marginal cost and an additional product is called marginal product. You also need to consider average total cost. Average total cost is fixed cost plus variable cost divided by the quantity. Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced Marginal cost tells us the increase in total cost that arises from producing an additional unit of output.

C. Many different cost curves
There are basically two cost curves are important to remember.
First, Marginal cost curve. It rises with the quantity of output produced, which reflects diminishing marginal product. When quantity of output is high, marginal product of out input is very low. It is shown below.
Second, average total cost curve is U-shaped. Average total cost curve is the sum of average fixed cost and average variable cost. Efficient scale is the quantity that minimizes average total cost at the bottom of the curve.
Also it is important to know that marginal cost curve and average total cost curve intersects at the minimal of average total cost curve. When MC < ATC, ATC is constantly decreases. Then at some point MC intersects ATC and ATC is at the minimum. After that MC > ATC, and ATC is constantly increasing.

Source: http://images.google.co.kr/imgres?imgurl=http:
This graph shows important curves. Average total cost curve, which is U-shaped. Marginal cost curve which intersects with average total cost curve at ATC's minimum. Average variable cost rises continually with quantity. Marginal cost also equals Average variable cost at AVC's minimum.

IV. Costs in the short run and long run
A. Difference between short run and long run
You should know that a firm’s cost is fixed in the short run but variable in the long run because you can build new factories and start fresh in the long run, but in the short run, you can’t do anything. ATC is much flatter U-shaped in the long run than in the short run because firms have greater flexibilities.

B. Economies and Diseconomies of Scale
Economies of scale occurs when specialization among workers are prevalent. Long run average total cost falls as quantity of output increases. This is because everyone is better at what they are doing and productivity increases.
Diseconomies of scale occurs due to coordination problems. In any large organization, it gets harder to manages large amount of output. So, average total cost rises in the long-run as quantity of output increases. Constant return in scale is nothing changes in the long-run and everything is constant.

Source: http://images.google.co.kr/imgres?imgurl=http://economicobjectorvism.files.wordpress.com/2007/07/lratc.jpg&imgrefurl
The graph shows economies of scale, diseconomies of scale, and constant. Economies of scale is down-sloping part of large ATC's curve. Constant returns to scale is when the line is straight. When the line goes up again, it has diseconomies of scale. Because fixed costs are variable in the long run, the average total cost curve in the short run differs from the average total cost curve in the long run.

Source: http://www.cartoonstock.com/lowres/mba0781l.jpg


  • Implicit costs are unseen and missed opportunity costs and explicit costs are seen through actual flow of money.
  • Production function and Total cost curve reflect diminishing marginal product which quantity of output or total cost increases for additional output.
  • Marginal cost eventually rises with the quantity of output. The average total cost curve is U shaped because it is the sum of AVC and AFC.
  • The marginal cost curve crosses the average total cost curve at the minimum of ATC. Costs are fixed in the short run, but variable in the long run
  • Economies of scale happens due to specialization and diseconomies of scale happens due to coordination problem.





1. Bob is a teacher in local American public school. His income is $6,000 per year and he couldn’t live with that amount of money and decided to become an engineer. If he becomes an engineer, he would earn $120,000 per year. However, he would have to get more education, pay for tuition in a prestigious college, and go to graduate school again. All this would cost approximately, 200,000.
In the short run, would Bob want to switch being a teacher? Why not? explain using explicit and implicit costs

2. What are the two curves reflecting diminishing marginal product and how do they reflect it?

3. where does marginal cost intersect average total cost
a. at average total cost's minimum
b. at marginal cost's minimum
c. at average total cost's maximum
d. none of them above.


1. Bob would not want to switch being a teacher because his accounting profit would be 120,000 minus 200,000 (just explicit cost ).
and His economic profit would be 120,000 minus (200,000 + 6,000) both his explicit and implicit cost

2. Production function and total cost curve reflect diminishing marginal product bc it gets flatter or steeper as production rises,
which means that its productivity decreases.

3. a