Costs of production

In the short run at least one factor is fixed. A firm’s costs split into:

• Fixed costs (FC) — do not vary with output (rent, insurance).
• Variable costs (VC) — rise with output (raw materials, wages).
• Total cost (TC) = FC + VC. Average total cost (ATC) = TC ÷ Q.
• Marginal cost (MC) = the change in total cost from producing one more unit = ΔTC ÷ ΔQ.

Law of diminishing marginal returns: in the short run, adding more of a variable factor to fixed factors eventually raises marginal cost.

Your turn — marginal cost

Revenues

• Total revenue (TR) = price × quantity = P × Q.
• Average revenue (AR) = TR ÷ Q = the price.
• Marginal revenue (MR) = the change in total revenue from selling one more unit = ΔTR ÷ ΔQ.

Economic profit = total revenue − total cost, where total cost includes all opportunity costs (so a firm earning only normal profit makes zero economic profit).

Your turn — economic profit

The profit-maximising rule

A firm maximises profit at the output where marginal cost equals marginal revenue:

At that output the firm may earn:

• Abnormal (supernormal) profit if AR > ATC;
• Normal profit if AR = ATC;
• A loss if AR < ATC.

Where to produce?

Perfect competition

A perfectly competitive market has many small firms, an identical (homogeneous) product, freedom of entry and exit, and perfect information. Each firm is a price taker, so AR = MR = the market price.

• In the short run firms may earn abnormal profit or losses.
• In the long run free entry and exit competes profit away to normal profit.
• Outcome: both productive efficiency (production at minimum ATC) and allocative efficiency (P = MC).

Monopoly

A monopoly is a single seller protected by high barriers to entry. It is a price maker facing a downward-sloping demand curve, so MR lies below AR.

Efficiency: a monopoly is usually allocatively inefficient (P > MC) and can sustain abnormal profit, though it may gain from economies of scale.

Which market structure?

Tap a feature, then tap the market structure it describes.

Monopoly vs competition

Monopolistic competition & oligopoly

• Monopolistic competition — many firms selling differentiated products (branding, quality). Each has some price-setting power but free entry competes profits to normal in the long run.
• Oligopoly — a few large firms dominate. Firms are interdependent, so they watch each other’s decisions. They may compete on price, use non-price competition, or collude (e.g. a cartel) to raise prices.

Game theory: the interdependence of oligopolists is often modelled with payoff matrices such as the prisoner’s dilemma.

Match each term to its definition

Tap a definition on the left, then the term on the right.

The Keynesian multiplier

An injection into the circular flow raises income by more than the initial amount, because part of the extra income is re-spent. At HL the multiplier uses the marginal propensities to withdraw:

Your turn — the multiplier

Your turn — the change in income

Size of the multiplier

Efficiency across market structures

• Productive efficiency — producing at the minimum of the ATC curve (lowest cost per unit).
• Allocative efficiency — producing where P = MC, so the value to consumers of the last unit equals its cost.

Perfect competition achieves both in the long run; monopoly generally achieves neither, though it may gain from economies of scale or fund innovation. This trade-off is central to HL evaluation.

Your turn — average total cost

Productive efficiency

The big ideas to know

You have covered the HL extension essentials. Press Finish to see your score.