The Firm, Profit, and the Costs of Production Rapid Review for AP Economics

By — McGraw-Hill Professional
Updated on Mar 2, 2011

More in-depth study guides for these concepts can be found at:

The firm: an organization that employs factors of production to produce a good or service that it hopes to profitably sell.

Accounting profit: the difference between total revenue and total explicit costs.

Economic profit: the difference between total revenue and total explicit and implicit costs.

Explicit costs: direct, purchased, out-of-pocket costs paid to resource suppliers outside the firm. Also referred to as accounting costs.

Implicit costs: Indirect, non-purchased, or opportunity costs of resources provided by the entrepreneur. Also called economic costs.

Short Run: a period of time too short to change the size of the plant, but many other, more variable resources can be adjusted to meet demand.

Long Run: a period of time long enough to alter the plant size. New firms can enter the industry and existing firms can liquidate and exit.

Production function: the mechanism for combining production resources, with existing technology, into finished goods and services. Inputs are turned into outputs.

Fixed inputs: production inputs that cannot be changed in the short run. Usually this is the plant size or capital.

Variable inputs: production inputs that the firm can adjust in the short run to meet changes in demand for their output. Often this is labor and/or raw materials.

Total Product of Labor (TPL ): the total quantity, or total output of a good produced at each quantity of labor employed.

Marginal Product of Labor (MPL): the change in total product resulting from a change in the labor input. MPL = ΔTPL/ΔL, or the slope of total product.

Average Product of Labor (APL ): total product divided by labor employed. APL = TPL/L.

Law of Diminishing Marginal Returns: as successive units of a variable resource are added to a fixed resource, beyond some point the marginal product declines.

Total Fixed Costs (TFC ): costs that do not vary with changes in short-run output. They must be paid even when output is zero.

Total Variable Costs (TVC): costs that change with the level of output. If output is zero, so are total variable costs.

Total Cost (TC): the sum of total fixed and total variable costs at each level of output. TC = TVC + TFC.

Marginal Cost (MC ): the additional cost of producing one more unit of output. MC = ΔTC/ΔQ = ΔTVC/ΔQ or the slope of total cost and total variable cost.

Average Fixed Cost (AFC): total fixed cost divided by output. AFC = TFC/Q.

Average Variable Cost (AVC): total variable cost divided by output. AVC = TVC/Q.

Average Total Cost (ATC): total cost divided by output. ATC = TC/Q = AFC + AVC.

Relationship between MPL and MC: if labor is the variable input being paid a fixed wage (w), MC and MPL are inverses of each other. MC = w/(ΔQ/ΔL) = w/MPL.

Relationship between APL and AVC: in the simplified case where labor is the variable input being paid a fixed wage (w), AVC and APL are inverses of each other. AVC = w/(Q/L) = w/APL

Economies of scale: the downward part of the LRAC curve where LRAC falls as plant size increases. This is the result of specialization, lower cost of inputs, or other efficiencies from larger scale.

Constant returns to scale: occurs when LRAC is constant over a variety of plant sizes.

Diseconomies of scale: the upward part of the LRAC curve where LRAC rises as plant size increases. This is usually the result of the increased difficulty of managing larger firms, which results in lost efficiency and rising per unit costs.

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