Firm Level Economics Consumer and Producer Behavior Module 3

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Table of Contents
1. Preface
2. Module 3 Firm Level Economics: Consumer and Producer
Behavior
1. Lesson 3-1 The Theory of the Firm
1. Lesson 3-1.1 An Economist's Production Function
2. Lesson 3-1.2 Types of Firms
3. Lesson 3-1.3 Behavior Rule
4. Lesson 3-1.4 Behavior Rule—Part 2
5. Lesson 3-1.5 Law of Diminishing Marginal Returns
2. Lesson 3-2 Cost Theory
1. Lesson 3-2.1 Cost Curves
2. Lesson 3-2.2 Derive Short Run Total Cost Family of
Curves
3. Lesson 3-2.3 Derive Short Run Average Cost Family of
Curves
Curves—Part 2
Curves—Part 3
6. Lesson 3-2.6 The Definition of Marginal Cost
7. Lesson 3-2.7 Derive Shape of the Marginal Cost Curve
- Part 1
- Part 2
- Part 3
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Preface
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made from Module 3 of Professor Larry DeBrock’s Firm Level
Economics Consumer and Producer Behavior on Coursera. The
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Copyright © 2020 by Larry DeBrock
All rights reserved.
Published by the Gies College of Business at the University of Illinois

at Urbana-Champaign, and the Board of Trustees of the University of
Illinois
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Module 3 Firm Level
Economics: Consumer and
Producer Behavior
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Lesson 3-1 The Theory of the Firm
Lesson 3-1.1 An Economist's

Production Function
Media Player for Video
An Economist's Production Function -

Slide 1
This slide contains an image of Professor Larry DeBrock.
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Transcript
Greetings. We're moving into a little more complex part of the

course. Module three looks at the theory of the firm, production, and
costs. As a result of this, we're going to have quite a bit of detailed
graphical analysis as we think about what's happened. This is
production in order, you know—we know firms are going to want to
maximize profits. We haven't really laid those rules out yet, but firms
are going to want to try and make profits, and profits are the
residuals of revenue over and above cost. And the question is,
where do these costs come from? Cost comes from production.
There are no magic elves that come in at night and build your
products for you. If you run a company, you actually have to pay for
inputs, combine those inputs, and make outputs of a certain type that
are attractive to consumers, who will pay cash for them.
We're going to spend a lot of time thinking about what it means to

have costs. We're going to try and move ourselves right down to the
factory floor and think about where these costs come from. We'll use
a local example. You're a big—we have a very, very large
manufacturing facility here in town, Kraft, and they're on the west
side of town. We'll talk a bit about how Kraft incurs costs, as they're
just—they're emblematic—no, they're not emblematic, they're—how
Kraft incurs cost. All manufacturers have to deal with these different
technologies, the hand that nature's dealt them in terms of what's the
technology to produce their product.
Lesson 3-1.2 Types of Firms

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Three types of Firms - Slide 2
Types of Firms
1. Sole Proprietorships—"Single owner"

2. Partnerships—"Group of owners"
3. Corporations—"Independent entities;" owners are shareholders
Transcript
Greetings. Today I want to talk to you a bit about businesses, or

firms, as we call them. What is a firm? Well, a firm is an entity that
puts together inputs of some form. It could be labor, oil, a natural
resource like wood, or talented people. The firm puts those
resources together into something we're going to call a production
function, and out of that action comes outputs.
Outputs are things that firms can sell. Sometimes they're things that
are very concrete, like say, a car or a can of soda. Sometimes
they're less concrete, such as consulting services or something like
that. But that's what businesses do. It’s very important you
understand that businesses also shoulder risk, okay? The business
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will bear risk by putting all these things together and producing a
product and then hoping, with their fingers crossed, that people are
going to buy this product. So that they can make it an ongoing
sustainable business, I guess. They make it, people want it and they
can just keep channeling money back in so that they have more
money to buy more inputs and can sell more outputs.
Today we want to think about business organizations, types of firms

we have. There's lots of different types of firms, but in our case we're
going to take just three general classes. I'm going to write out here
that I want to look at types of firms, and the three types of firms I
want to think about are sole proprietorships, partnerships, and
corporations. So let's take them one at a time.
Sole proprietorship is basically a single owner. A sole proprietorship

is a business that's owned by a person or a family. A single entity.
Think about Larry, you know I'm a university academic and I decide I
need to really supplement my income a little bit, so what I do is I say,
you know what, what I'm going to do is I'm going to go out to Home
Depot and I'm going to buy a chainsaw and I'm going to start Larry's
Tree Trimming Service. I'll take a little ad out in the newspaper and
say, you know, I can trim your trees and I'll just wait. People will call
me; I'll go trim their trees. That's a sole proprietorship. I have to
report that income on schedule C of the tax return. Here in the
United States that would be called a profit or loss from a business.
Now, the second type is partnerships. A partnership is kind of like

what it says, it's a group of owners. A partnership is when different
individuals come together and decide that they're going to work as a
single entity. Imagine I got Larry's Tree Trimming shop and there's
this guy in town named Brian and Brian's got Brian's Landscaping
Business. And I go to Brian and I say, "Hey, Brian, let's team up, your
landscaping, my tree trimming, we can make a little more money,
we'll have partnerships." Brian says, "Sure, we'll do that." Now, what
happens here is that we now have to put in our own money—usually
it's 50/50. Sometimes we'll say, "I tell you what, Brian, since your
business is more successful, you put in 70% and I'll put in 30%; I'm
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only working on weekends after all." You can make that deal out, but
we're going to jointly own this and we're going to split the profits
according to some rule, okay. That's what a partnership is.
Partnerships can be very small, just like Brian and Larry's little
business in Champaign. They can very large, like the big-time
accounting firms that are partnerships with hundreds and hundreds
of partners spread around the world.
The last one is corporations. Corporations are very special.

Corporations are essentially independent entities. A corporation is a
firm that's created. It's an independent entity in and of itself. The
people who own the corporation is something called the owners, are
what we call shareholders. If you look around in your closet, find a
few old dusty paper shares of stocks of IBM, that means you are co-
owner of IBM. Your shares of stock means you're part owner and the
profits that IBM makes will come back to you according to the size of
your stake in the company. If you've only got a hundred shares of
IBM, you're not going to get a lot of those profits, because there's
millions of owners of IBM out there. People all over the planet have
IBM stock. They all get their share, depending on how many of those
shares of stock they have.
Remember, this corporation is an independent entity. In a way, I

could do this too. Instead I could say, Larry's Tree Trimming shop,
what I think I'm going to do is, I'm going to make it Larry's Tree
Trimming Shop, Inc. Larry's Tree Trimming Shop, Inc. means I have
to hire a lawyer, not too expensive these days, and the lawyer here
will incorporate me in the state of Illinois.
In order to do that I have to issue a few shares, simple as maybe just

issuing ten shares. Each share is worth $1000. Okay? And I can say
—or let's say a $100, we'll make it a cheaper business. Each share
is worth $100. Well, that means with 10 shares I have $1000 worth
of equity, okay. I'm going to sell a few of these. Maybe my friend
Brian wants a piece of the action and Brian says, "Oh, I'll take five of
those shares, Larry." He gives me $500 and I say, "I'll take the other
five and put $500 in." We've got the $1000 of equity and we've got
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these ownerships. I want to go out, we do our business and then
people will get the share of the profits according to their share of
ownership. In this little example I made up, Brian gets 50% and I get
50%, because we each own 50% of the stock.
Statistical Abstract of the US - Slide 3
This slide contains a ProQuest webpage with the title Statistical

Abstract of the US 2019 Online Edition
Transcript
Let’s think a little bit about what this looks like, what's the lay of the
land, so to speak. I went out to this great place here called the
Statistical Abstract of the United States. It used to come as a book
every year and data geeks like me, people who—economists who
like data, we used to get a copy of it and it's very big,. It has data on
just about anything you could possibly imagine.
The Statistical Abstract of the United States has lots and lots of data.
It has data across all sorts of areas: labor, products, how many
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churches are there in your town, all these sorts of things. It's got it
longitudinal; it's not just this year, but how about the year before, the
year before, all the way back to, say, the year 1880 or something like
that. They've got tons of data in this thing. This is a screen shot of
the current version of it, which is online. This is the Statistical
Abstract of the United States. If you have access to library privileges
(which, if you're a student at a major university they will have an
account with Pro Quest), you can just log in and take a look at some
of that data. They're going to give us some interesting data here.
Detail (2013 Data from 2019 Volume of

the Statistical Abstract of the US) -
Slide 4
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Detail (2013 Data from 2019 Volume of the Statistical
Abstract of the U.S)—Number (millions)
Sole Proprietorships Partnerships Corporations
24.1 3.5 5.9
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Transcript
What I've done is I put together this little table and it says that this is
the detail of the 2013 data from the 2019 volume of the Statistical
Abstract of the United States. It is the 2019 volume.
Statistical Abstract of the US - Slide 5
This slide contains the same ProQuest webpage presented on Slide

3 - Statistical Abstract of the US.
A ProQuest webpage with the title Statistical Abstract of the US 2019

Online Edition with Current edition (2019) highlighted.
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Transcript
On this page you can see up here it says 2019, but unfortunately,
just because it's 2019 doesn't mean the data is kept up. They're a
little behind in processing their data, putting this together. The
current date they have is 2013.
Detail (2013 Data from 2019 Volume of

the Statistical Abstract of the US) -
Slide 6
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Detail (2013 Data from 2019 Volume of the Statistical Abstract of the
US)
Sole
Partnerships Corporations
Proprietorships
24.1 3.5 5.9

Number
(millions)
71.9% 10.4% 17.6%
1.3 5.1 26.9

Revenue
(trillions US$)
3.9% 15.3% 80.8%
LIMITED
Liability FULL FULL
LIABILITY
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Transcript
You see on this picture that the sole proprietorships, there's a lot of
them. 24 million sole proprietorships. There are three and a half
million partnerships and about six million corporations. Why are
there so many sole proprietorships? Because there are tons of
people out there who make quilts and sell them on Etsy, tons of
people out there who do arts and crafts with fleece and sell them on
eBay. All these people are independent entities. They are
businesses. They're producing a product. They may just be a middle
person who got a shipment of trial cologne and they'll put them up on
eBay and sell these little tri-packs for just a couple bucks—they're
just acting as a way of getting resources out there—but they have to
report that. They're a business. That's sole proprietorship.
Partnerships, we've already talked about those guys.
Let's think about the revenue side. Look at this, this is revenue in
trillions of dollars. You can see that sole proprietorships, while there's
an awful lot of them, they don't make much money. Well, 1.3 trillion is
not bad, but 1.3 trillion over 24 million firms, they're not making very
much money on that basis. Now, some of these are pretty
successful. There are family-owned businesses that have
multimillion-dollar returns. In Champaign, here, there are some long-
standing restaurants that have been from one family over and over
and over and they're wildly successful restaurants. Those people are
making a lot of money, but the people who are selling quilts on Etsy,
not so much. But they're still out there. Partnerships, they make
some money, but look at these guys. Corporations have $26 trillion.
This is just the one year, $27 trillion in one year. And so, what I did
is, I just took a percentage here of those, so you can see of the total
number of firms, 72% are sole proprietorships and 17% are
corporations. But corporations get 80% of all the revenue, and sole
proprietorships not so much. They're usually just small mom and pop
operations. Then you have these partnerships, as I said, some of the
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largest law firms on the planet who will have thousands of lawyers,
those are all partners. They can make a lot of money in these big-
time operations and that's what that shows.
Finally, I want to talk about something else. I want to talk about

liability. It says here, liability, it's important. Liability is risk. Think
about this. The first one, sole proprietorships says, full. Let's go back
to my story about Larry's Tree Trimming Shop. Larry's Tree Trimming
Shop, I got that chainsaw and a guy calls me up and says, "Hey, I
need you to take this dying tree off my yard. I want to get rid of it,
what are you going to charge?" I give him what my quote is and he
says, "Perfect, come on out here." I go out with my chainsaw, trusty
chainsaw that I got at Home Depot and it's already—and I take that
tree off, but you know what, I'm a pretty good academic, but a not-
very-good woodsmen. It turns out that when I cut that tree down it
falls right down on the guy's house and totals it.
At the same time it lands on his brand new BMW. It's a total of about
$300,000 in damages. How much of that do I have to pay? All of it. I
have full liability on that. I caused that damage. Hopefully I was
smart enough to have bought some insurance to go in, but still, I
have to pay premiums for that. The insurance company is making
me share the risk through making regular payments on premiums.
Partnerships, they're the same thing. Partnerships still have to share
the risk. If Brian and I had joined in our little partnership, where
Brian's Landscaping Service and Larry's Tree Trimming Shop
decided to get together, we're partners, unfortunately for Brian, if I
went out to that guy's stop and dropped that tree down, the
partnership still owes the $300,000 for running the house and car.
But look at the other side. Corporations, it says here at the end,
corporations have what we call limited liability. What's that mean?
Well, it means just what it says. The liability of corporations is limited
to the equity in the company. If I had taken that—remember how I
said I talked about incorporating, I incorporate with 10 shares and
the shares are $100 each, so I got a $1000. Brian gave me 500, I've
got 500 in. I use that to buy a couple chainsaws, so that I have
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different size, a big one and a little trimming one at the side. I got a
little extra money to take out a few nicer ads in the newspaper about
Larry's Tree Trimming Service. I go out to this guy's house and once
again, same thing happens: I drop the tree, it falls on his house,
wrecks his BMW, it's $300,000. But you know what I'm out? The
maximum amount is the equity of the company. The share values of
all the shareholders would go to zero, Brian would be unhappy, Larry
would be unhappy. But you can't get blood from a turnip; that's all I
owe.
At that point they can sue the company, but the company has no
assets. They can't come back to me; that's why I incorporated in the
first place. When you incorporate you take yourself out of the risk
picture. The entity has risk. That's the corporation. Hopefully the
corporation might even buy some insurance if it thinks it's important,
but I don't have to worry about that,. The most I can get wiped out is
the $500. I had five shares. I put $100 for each one. Brian's got five
shares. He put a $100 for each one. That value goes to zero,
because the firm has to give that much to the homeowner. You might
ask the question, why doesn't everybody incorporate? The reason
why everybody doesn't incorporate is because, remember what I
said earlier, corporations are independent entities. Now, I've never
met an independent entity that the government doesn't like to tax.
We have this thing in the United States called a corporate tax. The
corporate tax says that if you make profits of $1000 and you're
Larry's sole proprietorship, you have to pay taxes on the $1000.. But
if you're a corporation and you make $1000, first the government
gets a corporate income tax on that. They take the corporate income
tax off, so instead of $1000 you've got roughly $780 left. Then when
the $780 goes back into the ownership, we get to pay taxes again
too because we have to report that on our income.
Corporations always involve double taxation. The entity gets taxed

first, which means that of those profits that they made, suppose they
made $1000, suppose they made a million dollars, if it was a sole
proprietorship they could keep it all. But if it's a corporation the
government's going to come in and lop off a big chunk at the start
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and then say, "Oh, now you can distribute that to the owners. Oh, by
the way, when you distribute it to the owners they'll have to pay tax
again on that, because that's income that they've earned." That sort
of reason is why you see people decide, I'm not going to incorporate,
I'm just going to go ahead and do my business. If you're just making
quilts to sell on Etsy, there's not a lot of risk in that business. People
will just opt for that. We'll talk more about this when we start turning
our minds towards production. Thanks.
Lesson 3-1.3 Behavior Rule

Theory of the Firm - Slide 7
Behavioral Rule: Maximize Profits
Π=Total Revenue minus Total Cost
Π=TR − TC
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In the above equation, Π is labeled Economic Profit and TC Includes
opportunity cost.
Transcript
Greetings. Today, we want to talk a bit more about what economists

like to refer to as the theory of the firm. In order to think about this,
we're going to talk about behavioral rules. Our behavioral rule is that
firms maximize profits. You know, some people who are interested in
this course or are taking this course are going to say, "Well, Larry, I
work for a non-profit. What do we do?" Well, it turns out non-profits
and profits do the same thing. It's just that a profit maximizing firm
makes money and keeps it. The money belongs to the owners. It
may be that the owners, as you know, are a diverse body of
shareholders out there. We talked about shareholders back in a
previous video. Or it could be that it's just a sole proprietor, an
individual of Larry's Tree Trimming Shop who works and keeps the
money.
Not-for-profits also have the same efficiency issues. They have to

deal with the same technology. It's not that there's a magic
technology for not-for-profits. They have to deal with the same
constraints as for-profit does. It's just what they do. Their goal is not
to distribute the money out to owners. Their goal is to make money
for a common cause. This not-for-profit is to make residuals that we
can use towards helping people who need support for healthcare
issues, or working on environmental issues, or working on childhood
safety issues. All of these sorts of things. There's the NL's, this is
going to be the same. But I'm going to refer to maximizing profits all
the time. And if you do work for a not-for-profit, and you say, "Well, I
guess that doesn't [inaudible]." Yeah, it does. You still want to
maximize the amount of money you make for the cause—for
whatever the good cause is that you're being—that you're working
toward in your non-profit.
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To maximize profits, we know that the firm—we're going to use, for
us, this term. The Greek symbol Pi is going to be profits for us for the
rest of this course. Profits are equal to total revenue minus total cost.
Profits are, "How much money do you bring in net of how much it
costs for you to get there?" How much do you have to pay to make
that product? And then how much—what do we get for it? Then the
difference, that residual, is your profits. We're going to write it in a
little bit simpler form. We're going to say, "Profit is equal to total
revenue minus total cost." From now on, when we see this term,
we're just going to call this TR. When we see this term, we're going
to call this TC. Profits are equal to total revenue minus total cost. It's
important that we start here by laying out a little bit of the rules. This
profit is what we call "economic profit." It's economic profit because
this cost function includes opportunity cost. The distinction is really
important. When you see Pi in this course, it means economic profit.
Accounting Profit - Slide 8
ΠACCY = TR − Total Explicit Costs
Π = TR − Total Explicit Costs − Opportunity Costs
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Transcript
There are other types of profits out there, like accounting profit. We'll
just talk a bit about that for you right now. I'm going to add a page
here. I'm going to say that accounting profit, we'll call ACCY, is equal
to total revenue minus total explicit costs. I'm going to write down the
econ one in a minute, and then I'm going to come back and explain
to you why I am making you go through all these things, why these
things are important. I'm going to write, instead, alternatively, straight
Pi, which is econ profit, because this is an econ course, is equal to
total revenue minus total explicit costs minus opportunity cost.
What's the big difference here? Accounting profit is the revenue you
make minus what your explicit costs are. But to an economist, that's
not enough.
Let me tell you a story. Let's do this little example. It's a thought
example. Imagine you were gainfully employed and had a job that
you enjoyed. You were making about, let's say, $100,000 a year in
this job. All of a sudden, you decide, "You know what? I've got this
idea that I want to open up a hot dog stand. I want to be a hot dog a
street vendor, you know, selling hot dogs on a sidewalk in a major
city. You order yourself a big shiny stainless steel hot dog cart. You
go out on the corner of a busy street. And you start selling hot dogs.
At the end of the year, you hire an accountant. You've got to hire a
very good accountant. We've got good accountants here at the
College of Business. You know, our accountancy program is ranked
number one or number two, depending on which survey you look at.
You get a really good accountant. The accountant goes with a really
sharp pencil and comes back and says, "You know what? It's
amazing, I've taken all of your revenues, I subtracted off all of your
costs, including the parking tickets you got from the police because
you put your hot dog cart in the wrong spot. All of that sort of stuff.
Your total profits are still $78,000. Seventy-eight thousand dollars.
What a deal. I mean, you're a really good vendor." In fact, you would
have to report that on your taxes. Schedule C for your tax form says,
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"profit or loss for my business." And the accountant would have
provided you with a whole list of all your expenses, and a whole list
of all your revenues. And you would write it on a Schedule C. And
there would be a net of $78,000. And that's what you'd have to pay,
because that would be your accounting profit.
But to an economist, he kind of says, "Well, you know what? That's

true. I see those total revenue. And I see the total explicit costs. But
there's also the opportunity cost. You made $78,000, but you also
have to subtract off the fact that you weren't—you could have been
making $100,000 if you stayed your other job. Economists worry a
lot about these opportunity costs. Now, you might say, "Oh, come on,
Larry. What about the fact that you're your own boss?" He certainly
gets a lot of happiness about the fact that he doesn't have to go
punching a time clock and live in a cubicle now. He gets out on the
street selling dogs. Well, we can quibble about that.
In fact, economists can do some statistical estimation to see how

much that's really worth. But the fact of the matter is that economists
want to include this opportunity cost, because it's fundamentally
important to think about where resources flow. Economists like to
say the following. "Imagine you're the boss of a big company. The
accountant walks in, puts the books down for the third quarter, and
says, "Boss, I can't believe it. For the third quarter, we made seven
million dollars. You are a genius. Okay? We made seven million. It's
a tough climate out there, and we made seven million dollars.
Congratulations." And the accountant walks out. The sign they're a
really good manager is the first question that manager asks is, "What
could we have made if we were elsewhere? What if we just
liquidated this company, and started producing Twinkies? What if we
changed this company, and decided to start running cruise ships off
of the coast of Texas?"
Lesson 3-1.4 Behavior Rule—Part 2

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Total Revenue - Slide 9
This slide contains the formula Max Π = TR−TC with an arrow

pointing down to a line graph.
The line graph has an x-axis labeled Q with a point labeled Q0 and a
horizontal axis is labeled P with a point labeled P0. A linear
downward sloped demand curve is drawn. A shaded box is formed
by the points P0, Q0, the midpoint of the demand curve, and the
origin. To the right of the line graph is the equation TR = P × Q.
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Transcript
Greetings. In one of our previous videos, we discussed the fact that

firms want to maximize profits. We talked a little bit about how this
profit—these are the economic profits, so the cost curves include in
there the opportunity cost of what they could be doing in their next
best alternative. That was all in that thing. We had this idea that the
goal of firms is to maximize profits. Profits, we simply wrote as total
revenue minus total cost. We figured out earlier we've got a pretty
good idea of how to do total revenue, because earlier we looked at
what firms might make.
For example, if this is the demand curve, and this was the price that
they sold their product, and this was the quantity, then total revenue
would just be equal to price times quantity. On this graph, price times
quantity, if you multiply those two out, that's like multiplying base
times height. The area of this rectangle would be total revenue.
Good. We've got total revenue. Graphically, we know how to draw
total revenue. Now we've got to do total cost. And we started to think
earlier that total cost comes from where? Oh, yeah, cost comes from
production. You cannot just wish that you have output. You have to
actually go about doing some work to get it. You have to hire inputs.
You have to combine inputs in some systematically efficient manner
to produce outputs. Then sell those to get that revenue. But cost
comes from inputs.
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Market Output - Slide 10
Introduce New Notation
Q denotes Market Output
q denotes Output of an individual firm

N
Implies Q = ∑ qi where N is the total number of firms

i=1
28
Transcript
In this video, we're going to think about where all these curves come
from. Let's introduce new notation. From now on, we're going to use
capital Q. Capital Q denotes market output. It's like the cue we had
on that demand curve when we had demand and supply there. That
was the total of market demand for gasoline or oil, or whatever it is.
We're going to use lowercase q to denote the output of an individual
firm. First of all, why are we doing this? Well, because as we
continue to push our way through this course, we're going to start
realizing that, in fact, in many markets there's more than one
supplier.
When we get to the second module of the second course, which

would be the sixth module of the overall, we're going to talk about
something called "monopolies." A monopoly is a situation when
there's only one firm. In that case, the firm is the market. But in most
markets, there's many people. I mean, there's hundreds of
thousands of farmers in a very active corn market. There's lots and
lots of lots of different producers. You know, there's many, not
thousands, but there's dozens of companies producing mid-sized
automobiles. We know a couple of the big-time players there. The
Honda Accord and the Toyota Camry may be the largest sellers in
that mid-size automobile market.
But there are lots of people selling mid-sized automobiles. There's

going to be situations where we need to have a lower q to talk about
individual players. Then the sum of all their output will be the market.
What we'll do is to say this implies that cap Q is the summation from
i equals 1 to N of the output of each of the i firms. Where in this
case, where N is the total number of firms. We're going to switch
gears. Mostly for the rest of this—for this module three, we're just
going to use lowercase q, because we're going to be talking about
production at an individual firm level. Thinking about the cost curves
for a firm that's in its market trying to make a living.
29
Functional Output Form - Slide 11
Q = f (inputs)
Assume 2 inputs
Labor (L)
Capital (K)
When you insert the two inputs listed above, the resulting formula is
q = f (L, K)
Transcript
We're going to think about production. In order to do that, I'm going

to say that we have this idea that output is some function of inputs.
That functional form, we're going to talk about in a minute. Its f
means it's a functional operator. It's some algebraic, some
polynomial, some complex form that tells us how we can combine
inputs to get outputs. We're going to start by making life relatively
simple for us.
30
We're going to assume that we just have two inputs. And those two
inputs are labor, which we'll call L, and capital. In economics, we use
capital K to denote capital, because C is kind of reserved for costs,
cost function, total cost, marginal cost. All of these sorts of things
use a C there. We use K for this. This implies that output is some
function of these two inputs: labor and capital. In the real world, and
we're going to talk about this in a minute, there could be lots of
inputs. Many, many different inputs. Natural resources,
entrepreneurial cash. All sorts of things could be different resources
that the firm could use. But we're kind of trying to make it as easy as
possible here. We're going to lump them into two categories.
Economists believe that, you know, in this particular model, L for

labor kind of thinks about variable inputs, and K for capital kinds of
thinks about things like brick and mortar. Something you can't
change too quickly. We'll get to talk about that in a minute. What we
want to do is figure out what does this production function look like.
How are we ever going to figure that out? Well, it turns out to figure
out what the production function looks like, we could go out and hire
engineers. That's what engineers are good at. Engineers could say,
"Okay, you want to make this product."
Example: Kraft Plant - Slide 12
31
This slide contains a drawing representing the Kraft factory in
Champaign. To the left of the kraft factory is a parking lot with parked
cars and Kraft workers coming into the factory. On the bottom side of
the factory, there is a loading dock filled with trucks, dropping off
product or inputs. To the right of the Kraft factory, there are trucks
carrying finished goods or outputs.
q = f (L, K)
Transcript
We're going to start with this example, because I said I was going to
use it. Out at the edge of town here is this giant Kraft plant. This
Kraft plant looks like this. It's big. And suppose you got yourself in a
hot air balloon. And you started to take this hot air balloon ride over
this Kraft plant. And you're looking at this Kraft plant. And you're
saying, "You know what? I can see there's a big parking lot out front.
And in this parking lot, people are parking their cars. And they're
walking in. They're workers coming in, carrying their lunchbox, going
into the factory. At the same time, I can see that over on this side
there's a loading dock, where there's big semi-tractors. And they're
dumping off products, inputs.
This Kraft plant is making mayonnaise. They make a lot of stuff at

the Kraft plan. It's huge. They're the number one—in fact, they're the
sole source of Velveeta in North America. They produce half of all of
the macaroni and cheese sold in the United States at this Kraft plant
in Champaign. They also make mayonnaise. We're going to think
about mayonnaise. A simple product. Inputs are coming in. Here at
this loading dock, trucks are coming in, and they're dropping off eggs
and glass jars and crates full of labels to stick on the glass jars, and
all sorts of stuff are going into here. And at the front door, workers
are coming in. So now you, being an economist, you also have a
background in statistics, and you have been gathering data.
32
From your hot air balloon you can count how many workers came in.
You could count how many jars of mayonnaise went in—not jars of—
how many eggs went in, how many glass jars went in. All these sorts
of things go in. And at the same time, at the back, you see—
Bonanza! You see trucks being loaded with final product to head out.
You can count every one of those final products as they're running
them out. That's amazing. It's true that what we're interested in trying
to figure out is what is this functional form of combining inputs to get
outputs. It's true that engineers—an engineering consulting company
could get down there, and get all sorts of data, and work this thing
right out to the right number.
But if you've got good data, statistically you can just replicate the
same thing. You can figure it out with a good statistical program.
You've got good data on all the inputs that went in and all the outputs
that went out, and put them into the right computer program, and
they'll tell you what the functional form was. That's what we want.
We've got to have this—we have to understand a little bit where
these forms come from.
Definition of Short and Long Run -

Slide 13
33
Short Run (SR): The period of time when at least one input is fixed
Long Run (LR): The period of time when all inputs are variable.
q = f (L, K)
In the above equation, L is always variable and K is fixed in SR
Transcript
We have to introduce another definition here. This definition is going

to be crucial for the rest of the course. We're going to talk about
something called the "short run" and the "long run." The short run,
which from now on I'm just going to use SR, okay, is the period of
time—When at least one input—is fixed. The long run—To an
economist, is the period of time when all inputs are variable. The
short run is the period of time when you have something you just
can't change. For us in our production function, where we've got
quantity is some function of labor and capital, we're going to say that
labor is always variable. But capital is fixed in the short run. Capital
is fixed in the short run.
Suppose you're out there at that Kraft plant. You're making

production decisions. All of a sudden, you get a notice from the
people at corporate headquarters that says, "Hey, Fourth of July is
coming up. We've got a big weekend. There's going to be a run on
mayonnaise. We need to increase our mayonnaise production by
about 10, 12 percent each day for the next week." If you're really
going to increase your production, if you're really going to increase
your output, where do you—what's output? Output's over here. If
you're going to increase output of mayonnaise, you've got to
increase inputs. You cannot just wish for more jars of mayonnaise.
You have to change it. Well, what inputs can you change? Well,
capital is what we call brick and mortar. You can't change your
factory in a couple of days.
34
But that day you could definitely change labor. You could put out an
announcement, "We need 15 people to volunteer for overtime—two
hours overtime, because we need to produce a few extra boxes of
mayonnaise every night for the next five nights. Who wants to come
work overtime?" People will make that. You can change labor very
quickly. But you can't change capital that quickly. In our little
paradigm that we're thinking about, some inputs are—you're stuck
with some inputs in what we call the short run. They may be
something as simple and as logical to you as the brick and mortar.
It's very difficult for Kraft. Kraft has got over 100,000 square foot
factory out there. It's true that they could increase production if they
added another 40,000 square feet. But they can't just do that today.
People are going to be making decisions in what we call the short
run, where they have to live with certain inputs that they can't
change anymore.
They can change other inputs. Now, this is an example that is going
to help drive our outcomes as we go through the rest of the course.
There are certain times where firms, whether they're large firms, like
Kraft, or even a small firm, like, say, somebody's selling pizzas on
Green Street in Champaign here on Campustown, they may say,
"I'm not making any money anymore. I've got to get out of here." But
it may be that they have a lease that they can't break for at least 30
days. So they're stuck with that facility for 30 more days. That may
make them a decision that says, "Tough luck, I'm still going to hang a
sign on the door that says we're closed." Or they may say, "Well, I
better keep operating for those 30 days, because at least I'll make
enough money operating to put a little bit towards that lease that I'm
going to have to pay at the end. Whereas if I shut the door now, I just
have to write the whole check out for the lease." We're going to think
long and hard about decisions that come in the short run, when you
have something you can't get out from underneath, versus decisions
that come in the long run, when you have all the freedom to move all
of your variables. Economists like to think of the long run. It's kind of
like a board of director's type of timeframe.
35
The board of Kraft could sit down and make a decision that says,
"Yes, we think we need to enlarge the Champaign facility." They
have the ability in that time period—their time period is big. They
have the ability to say, "Well, we're going to make a change in
capital. We know it won't go online for 22 months. Okay? But we do
want to start changing this process." I want to talk a bit about this
final question for this—in this particular issue. That is, "How long is
the long run?" Is it like three quarters? Is it like a year? What's the
long run? The answer to that question is, "We don't know." It varies
by industry. Think about my little example of Larry's Tree Trimming
Service. Larry's Tree Trimming Service: I go out, I got myself a
chainsaw. That chainsaw is my capital. My labor, I got a chainsaw, I
got the sweat on my brow, I'm out trimming trees. Now, if I wanted to,
I could expand my business, and get a second chainsaw. Maybe a
different type one that would be a little bit longer. How long would it
take for me to change my capital in that business? I don't know, it
takes, what, 30 minutes for me to drive to Home Depot, and get a
larger chainsaw? I have now doubled my plant and equipment. My
capital has gone up very quickly. The long run for Larry's Tree
Trimming Service is pretty quick.
On the other hand, the example that economists love to point out for
the long run that's pretty long is gasoline refineries. It's estimated
that from the time you break ground on a new gasoline refinery to
the time you get your first drop of usable gasoline is about four
years. The long run in that sector is wildly different than the long run
in Larry's little tree trimming service. Every industry is different,
whether you're making bookbinding or putting out 737 maxes, or
whatever it is that you're doing, there's going to be a different
timeframe. But all we need to worry about is those—the decisions
about the long run means that we can change everything. One of
those changes, which is going to be crucial, by changing everything,
it might mean we just want to change it to zero. When can I get out
of this industry? If I don't like where I am right now, I want to move—
get out of there. Well, that's going to be what we call the long run,
the timeframe when you can actually change your brick and mortar.
You find a buyer for that brick and mortar. You find somebody else
36
who wants to set up a warehouse operation or whatever. But you
can get out. Thanks.
Lesson 3-1.5 Law of Diminishing

Marginal Returns
Production Function - Slide 14
q = f (L, K)
In the above equation, L is variable in SR and K is fixed in SR
37
Transcript
Greetings. Last video we talked a bit about [inaudible] that

economists make about the difference between a short-run and a
long-run. We have a production function. We said output was a
function of inputs. In this particular case, our inputs were labor and
capital. We said that in the short-run capital is fixed. We're going to
put here, capital is fixed in the short run. Labor was variable input.
Variable in the short-run. Remember, the example we were dealing
with was thinking about making mayonnaise at the Kraft plant.
Now, the mayonnaise, I've got two inputs here, labor and capital. We
know, mayonnaise, there's lots of input. There are glass jars. There
are eggs. There's milk. There are all sorts of things that go into
production of mayonnaise besides workers and a factory. But we
have sort of condensed those down and taking all those inputs that
can vary on a daily basis. Things like the number of jars. The amount
of eggs they have. All those such things. And workers. Versus those
that they can't change on a daily basis. Like, for example, brick and
mortar. They can't change the number of assembly lines inside that
plant there are. It's a big plant. There's lots of assembly lines. And
they could add an assembly line, but they can't do it today. They
can't get it done in a week. It takes a while to bring in a new
assembly line. Bolt it down on the floor and make sure it's all
operational. Some inputs can't be changed in the short run. That's
what we're talking about here with this production function.
38
Short Run Production Function (1 of
2) - Slide 15
This slide contains a line graph with an x and y-axis system. The x-
axis is labeled Inputs (L) and the y-axis is labeled q. A generally
upward curve that rounds off at the top is drawn.
q = f (L; K) .
In the above equation, k is fixed in SR
39
Transcript
What I want to do is I want to actually draw a short-run production

function for us. I'm getting a new axis here. On the vertical axis I'm
going to put output. And on the horizontal axis, I'm going to put
inputs. In this case the inputs are L because we've lumped
everything into this thing called labor. Which is a variable input. What
we're interested in thinking about is, what does the production
function look like? The general shape of this production function
looks like this. Production function says quantity is some function of
labor and capital. Notice I used a semicolon there. Which is a typical
mathematical notation to mean that everything to the right of this
semicolon is parametric. It's fixed right now. You can't change it. You
can vary L, okay. If you're running this company, you can vary L all
you want. But in the short run, you can't change K. Remind us that
capital is fixed in the short-run. I should have written this across the
top. We'll just make sure we have it so it's in your notes. This is,
we're looking at short-run production function. That's the exercise
that we're working on right now.
Now, one thing you should note about this curve is that the curve in
the beginning for low input levels, as you increase inputs, look what's
happened to the curve. The curve is actually getting steeper. See
how the curve is getting up? The curve, the slope of the curve is
going up. It's getting steeper as you go out. After some point, which,
if you've had a strong math background, you know there's some
point about right here called an inflection point. After that point, as
you continue to keep adding inputs, this curve is flattening out.
40
2) - Slide 16
This slide contains an x and y-axis system with the x-axis labeled
Inputs (L) and the y-axis labeled q. An upward sloping bell curve is
drawn.
q = f (L; K)
Law of diminishing marginal product: "after some point, extra inputs

will raise output less than previous inputs did."
Transcript
We're going to segment this curve into two parts. This part is the part
where it's growing up. It's getting faster. This part is the part where
it's flattening out. The slope of that curve is beginning to flatten out.
This production function is really a generalized production function.
Let me give you a hint about the idea of where this comes from.
Think about if you have an assembly line.
41
Suppose you're making automobiles. Suppose you're at a big
automobile production facility. They got an assembly line. You have
one worker. Now, bear with me. This is a silly example. But think
about this. Because I want you to think deep and hard about what
happens at low levels of inputs. Low levels of workers into this.
Levels of workers that are way too low and economically a bad idea.
But we want to map those points out because they're possibilities.
Think about that example I [inaudible]. If you have only one worker,
that worker is going to have to jump from the right side of the car to
the left side of the car. From the left side of the car back to the right
side of the car. If you could add a second worker so that one side of
the worker, one worker would only be on the driver side of the car.
The other worker would be on the passenger side of the car. They'd
be a lot more efficient than having to hop back and forth across the
assembly line.
But maybe you should have two workers on each side. One worker
could work on the upper body and one could work on the lower body
of the driver side. On the other side, the passenger side, one could
work on the lower body. One could work on the upper body. In
instances like that you can see these situations where in this curve,
as you add more inputs, outputs are growing at a faster rate than
inputs are growing. That's a good thing for the company. Adding
extra workers is growing output rate that's proportionally faster. But
after some point this goes away.
Economists have a special term to describe this. The law of

diminishing marginal product. After some point, extra inputs will raise
up less than the previous ones did. What's happening on here in
terms of the fundamental geometry is that for these low levels of
inputs, as you add extra inputs, output is proportionally growing
faster than the growth of inputs. But after this thing called an
inflection point, as you keep adding inputs, the extra inputs are
indeed growing output. You know, putting more workers in. Putting
extra workers in will increase inputs and that will increase outputs.
This thing is going up. But it's going up at a slower and slower and
slower rate.
42
Marginal - Slide 17
This slide contains a thought bubble around the words: Economists

use the word marginal to mean change.
Transcript
Throughout the rest of this course and at any other thing you do
read, I'm going to put a little, I'm going to insert a little page here.
Just so we could think about this issue. Another one of these little
thought bubbles. And that is economists use the word "marginal" to
mean "change." If you're comfortable with calculus, marginal is the
derivative of [inaudible]. If we have a cost function, the marginal cost
function is the derivative of the total cost function. If we have a
revenue function, the marginal revenue function is the derivative of
the [inaudible] function. Or if you don't like calculus, it's the slope.
The rate of change, okay. All those things mean the same thing. Just
different levels of technical.
43
2) - Slide 18
This slide contains the same line graph presented in Slide 16 - Short
Run Production Function (2 of 2).
Marginal is highlighted.
An x and y-axis system with the x-axis labeled Inputs (L) and the y-
axis labeled q. An upward sloping bell curve is drawn.
Marginal is highlighted.
q = f (L; K)

44
Transcript
In this case the law of diminishing marginal product says that, while it
may be that as you, increasing labor, you're getting more output out
of that. All we're saying is that the extra output, that change in output
from the tenth worker is less than it was from the ninth worker. That's
all we're saying. That's why this curve begins to flatten out.

2) - Slide 19
This slide contains the same line Graph presented in Slide 16 - Short
q = f (L; K)

45
Law is highlighted.
Transcript
Now, the most important thing about this is the following. This word
right here. This word right here is "law." And law means something
really important to economists. Law means we know of no known
counter example, okay. The law of diminishing marginal product
means it's a law because everybody is subject to it. No production
function, we've never seen a production function for anything.
Whether it's consulting services. Building automobiles. Making
[inaudible] for people who might think, being a barista at a coffee
shop.
We've never seen any counter example yet. And, in fact, if you think
you know of a counter example, get ready. Start polishing up your
Nobel Prize speech. Because you can win a Nobel Prize in
economics if you can actually figure out a counter example to the law
of diminishing marginal product. You won't, okay. There is no known
example of this. It's, this is a short run phenomena. I'm going to
repeat that. It's a short run phenomena. It's due to the fact that we're
fixed, the amount of capital. And then we're just changing the other
input.
Essentially, we're overutilizing the other input relative to this one

input. Engineers would go, don't do that. Change capital and labor.
As if you'd change capital and labor both at 7 percent it will be
optimal. Yes, you're right. That's a long-run thing. But in the short-
run, I'm stuck with my fixed capital. I'm stuck with the brick and
mortar and the assembly lines. I have to change the number of
workers that come in on a daily basis or don't come in on a daily
basis to change my output. Because in the short run, by definition, I
have no ability to change that. That capital is fixed, okay. And given
that it's fixed, the more of this we try to squeeze into that, they're
going to be less and less efficient.
46
Downhill Production Function - Slide
20
axis is labeled L and the y-axis is labeled q. The graph depicts the
portion of the bell curve that shows a steady increase and a slow
decline.
q = f (L; K)
Transcript
Indeed, it turns out that, if we were to somehow extend this picture

farther out, it's actually going to go down. Okay, the production
function will actually start going downhill. Now, that would be a very,
very bad place to be. If you're the manager of the firm and you hire
extra workers. And those extra workers mean you get less output
than before. How can that be? Well, just think about, people would
never do that.
47
But just think about doing this, we're thinking through the theoretical
position here. Think about that Kraft plant on the edge of town. It's a
big plant. But if you try and put 30,000 workers in there, they're going
to be bumping shoulders with each other. You can't get too many
workers in there. No work is going to get done. They're going to be
knocking jars of mayonnaise over and breaking them. Everything will
be in bad situation in that. We could get way out here. But that would
be really, really overusing labor. Remember the production function.
Quantity is some function of labor and a fixed capital. Well, if you've
got a fixed capital there, like these fixed dimensions of the Kraft
plant. You just keep piling workers in there. You're really going to get
yourself in a bad problem.
Short Run Production Function - Slide

21
Run Production Function (2 of 2) with Law highlighted.
48
q = f (L; K)

Transcript
One last thing. It's true that the law of diminishing marginal products
says every firm will be subject to this. But it also says for low levels
of input, you can have some increasing part. It's just eventually the
diminishing part's going to set in.
Diminishing Marginal Return Graph -

Slide 22
axis is labeled Inputs (L) and the y-axis is labeled q. The graph
contains a line with a slow upward curve rounding up at the top.
49
Transcript
It's also the case that you can think of industries where, if this is
output and this is input, L for us, some industries start off from the
get-go with only diminishing marginal returns.
Short Run Production Function - Slide

23
axis labeled q. An upward sloping bell curve is drawn
q = f (L; K)

50
The first portion of the short run production function circled and the
word Law highlighted.
Transcript
They don't have the luxury of experiencing any of this nice range
here where the curve is growing proportionally faster than the inputs
that you're hiring. This is a really wonderful place to be. Because you
keep hiring workers. And for the same extra workers you're getting
for, you know, the extra workers are piling more and more,
proportionally more and more output. This is a really attractive thing.
But you're going to soon get past that over here.
Diminishing Marginal Return Graph -

Slide 24
This slide contains the same line graph presented in Slide 22 -

Diminishing Marginal Return Graph.
51
A line graph with an x and y-axis system. The x-axis is labeled Inputs
(L) and the y-axis is labeled q. The graph contains a line with a slow
upward curve rounding up at the top.
Transcript
Some production functions start out from the very beginning already
in the laws of diminishing marginal returns. There's no increasing
return segment for them to enjoy to start with. Some industries have
a larger one of these. No more graphs. I just want to say something
here. If I were you and I was taking this course for the first time, I'd
be sitting there. I'd say, who's this guy think he is? You want to sit
there and tell me that that, you just draw this general shape and tell
me this is the shape of production for everything? The answer is,
yeah, I am. I realize that the production function for a 737 is going to
look remarkably different scale than the production function of my
tree trimming service. Or the production function of my tax account.
But every single one of those entities, every single one of those
entities is subject to the law of diminishing marginal product.
Because of that, even though the scale may be bigger, the numbers
may be much bigger than my little tree trimming business. They're all
going to have this general shape. It's just like earlier when I just drew
the demand curve as downward sloping and said, I put it here to
work it out. In the real world we might be able to find real numbers
for it.
But in the real world where we generate the real numbers for the
production function, which they do. Economists can estimate these.
Engineers can help them, help us find them. They look just like this.
Sometimes they're on a really grand scale. Sometimes they're very
small. But they all have this same general curvature. Because,
again, they're all subject to this magic word. It's the law of
diminishing marginal product. Technology has dealt us that hand.
Thanks.
52
Lesson 3-2 Cost Theory
Lesson 3-2.1 Cost Curves

Introduction—The Theory of the Firm -

Slide 25
This slide contains an image of Professor Larry DeBrock
53
Transcript
We have just finished the hard work of understanding production

functions. We learned about production functions, and we learned
about the law of diminishing marginal product and these sorts of
things. But now we're going to use that information to get us to the
heart of what we really want, and that is cost theory. Where do costs
come from? We already understand from production that the only
way firms can get output—they want to get output so they can sell it
—is they have to build it. They build it with a production function, and
that production function tells us how many inputs it takes to get the
output.
It would be a great world if firms could just have some sort of magic
production fairy that would just produce all their output overnight,
and they could just sell it. That's not what happens. You think about
the example I've been using about the Kraft plant on the edge of
town here. That Kraft plant makes a lot of mayonnaise. But to make
that mayonnaise, they have to get a lot of eggs. They got to combine
eggs, and glass jars, and fancy labels, and, of course, workers with
their fixed capital. And assembly lines. They put all those people
together and all those items together and they produce jars of
mayonnaise. But those things aren't free. They cost money. What
we're going to do is take our understanding of the production
function. How many inputs does it take to give you a thousand jars of
mayonnaise? Then we're going to have to price out those inputs.
That will give us the cost. Thanks.
Lesson 3-2.2 Derive Short Run Total

Cost Family of Curves
54
Total Cost - Slide 26
The slide contains three formulas as well as the line graph presented
in Slide 9 - Total Revenue
Π = TR − TC
T R = P0 × Q0
q = f (L; K)
There is an arrow pointing from TR in the equation Π = TR − TC to

the line with the label TR = P0 × Q0 and a second arrow pointing
from TC towards the equation q = f (L; K) where K is fixed in the
SR.
The formula Max Π = TR−TC with an arrow pointing down to a line

graph.
55
Transcript
Greetings. We're pushing forward with our trying to understand the

theory of the firm thinking at cost curves, and we understand that the
cost curves come from a very specific outcome. Our fundamental
problem here is that the firm wants to maximize profits. Profits are
the residual of revenues in excess of cost. These are economic
profits, so we've got opportunity costs already built into that. We did
the total revenue side really easily. We understood how to do that
from the days when we had a demand curve. At any price that the
firm might charge and sell this output, then total revenue would just
be equal to that price times that output. If you took q0 times P0,
you're going to get the area of this rectangle, base times height.
We've got great graphical representation of that revenue side, but

the bugaboo here is this. How do we find total cost? We understand
that we find total cost by thinking about production costs come from
production. Firms do not have magic elves that make the output
overnight and they sell it the next day. People have to get up in the
morning and make the donuts. People have to come to work and
build cars. They won't do it for free. You've got to pay them. We
generated something last lecture that was a production function.
That production function said, look. The production function is a
function of labor and capital. Those were our two inputs right now.
The semicolon reminded us that this capital is parametric to the
problem.
In the short run, which is where we are, capital is fixed. You can't
change your brick and mortar today, but you can certainly have
workers stay on and do overtime., We can vary labor anytime, but
that's going to cost us money. We could lay some off, and that would
save a little money, but what we're doing is trying to optimize here on
making this profit maximization decision. What to do is we need to
think about costs, and costs are going to come to us from two
sources.
56
Definition of Total Costs - Slide 27
Total Cost = Fixed Cost + Variable Cost
TC = FC + VC
q = f (L, K)
Transcript
We're going to write this out. Say the definition of total cost is the
sum of fixed cost and variable cost. Definition of total cost is the sum
of fixed cost and variable cost. Fixed cost, which by the way from
now on, this is the last time you're going to see that notation. We're
going to call this fixed cost and we're going to call this variable cost.
It's FC plus VC. What we have to do is we have to figure out how to
graph this. Our previous example where we had the previous page, I
had output was a function of labor and capital is parametric. This
capital, which is fixed, is going to be captured by this fixed cost term.
This labor, which of course is variable in the short run, is going to be
captured by this variable cost term.
57
Fixed Cost - Slide 28
This slide contains an x and y-axis system. the x-axis is labeled q

and the y-axis is labeled $ with a point labeled F0 . There is a straight
line drawn through F0 . The line is labeled FC
Transcript
What we have to do is figure out how to draw a graph of this,. We

need to figure out a draft for this. The way we're going to build this
graph is we're going to build a curve for the fixed cost, and then
we're going to build a curve for the variable cost. Then we're going to
do simple addition because that's all this is: fixed cost plus variable
cost will give us the total cost for the firm. Let's start drawing grass.
The fixed cost is pretty simple. I'm going to put down an axis, and on
this axis, I'm going to measure dollars. On this axis, I'm going to
measure output.
Now, notice, the last couple axes we've been doing when the
production function, we had on the horizontal axis inputs and on the
vertical axis output. We switch that back down around now because
it's important for us to get output down here. We are thinking about
58
how to meld that in with our revenue side later on as we step forward
through this. Fixed cost is pretty simple. There's a certain amount
associated with whatever the cost of capital is, and that's our fixed
cost curve. It's a horizontal line. Simplest of all. Because by
definition, it doesn't change. You can produce zero jars of
mayonnaise, one jar of mayonnaise, ten jars of mayonnaise, or
100,000 jars of mayonnaise, and that craft plant has the same fixed
cost each day. That one was simple.
Variable Cost - Slide 29
This slide contains a blank line graph with an x and y-axis system.
The x-axis is labeled q and the y-axis is labeled $.
Transcript
We're going to get to a little bit harder step. We're going to get to
something called variable cost. We're going to draw another axes
system, and, we'll put, again, consistent with what we did before,
we're going to put output there, and we're going to put [inaudible]
here.
59
This slide contains the same information presented in Slide 26 - Total

Cost.
There is an arrow pointing from TR in the equation Π = TR − TC to

the line with the label TR = P0 × Q0 and a second arrow pointing
from TC towards the equation q = f (L; K) where K is fixed in the
SR.
The formula Max Π = TR−TC with an arrow pointing down to a line

graph.
Π = TR − TC
T R = P0 × Q0
q = f (L; K)
60
Transcript
I just want to remind you why we're doing this because at the
beginning here, notice I said we've already got a revenue side, and
that's nice, but revenue's got, the revenue picture's got quantity on
the horizontal axis and basically dollars and cents on the vertical
axis. We've got to start converting our life to that, too, when we're
thinking about cost.
The Inverse of the Product Function -

Slide 31
This slide contains a line graph with an x and y-axis system within a
thought bubble. The x-axis is labeled L and the y-axis is labeled q. In
the line graph is an "S" shaped curve. The bottom half of the graph is
highlighted in yellow and the second half of the graph is highlighted
in green. The line is labeled with the following equation:
q = f (L; K)
y = f (x)
61
−1
x = f (y)
−1
L = f (q)
Transcript
With variable, when we think about variable, we're thinking about

exactly how much do we have to pay for increasing our production?
In other words, if we increase production, we do, the only way we
can increase production. Fixed cost was easy. It's there no matter
what, but for variable cost, as we increase production, we have to
hire more workers. We cannot just snap our fingers and wish more
jars of mayonnaise. We have to hire more workers to come in. We
have to get more eggs, more glass jars. All of these things pile up.
How do we know about the relationship of that?
Well, what we're going to do is we're going to bring back our old
friend the little thought bubble above the cartoon character's head.
There's this little bubble that pops out of his head and says, "You
know what? I seem to recall that earlier, we looked at something that
looked like this." As we hire inputs, we get outputs according to
what's known as a standard production function, a short range of
increasing returns and then the law of diminishing marginal product
sets in. This is the production function with a fixed capital.
Notice the generalized shape of that. It has this region where it is

increasing, and then it gets to an inflection point. It gets to this region
where it's flattening out. What that means is as it's flattening out,
we're hiring lots and lots of extra workers to get a diminishingly small
growth and output because of the law of diminishing marginal costs.
What we have to do is we have to figure out how does this translate,
and what would be great is if I could somehow have, I had, if I was
really good with this, I would have animation here. I would reach into
this curve, and I would grab the axes and flip them.
62
When you were taking math courses and someone said I want you
to take the inverse, they said, "Well, look. Here's a function y is equal
to f of x." Then, if the instructor said, "I want you to take the inverse
of that," they say, "What's that mean?" You say, "Well, x is equal to
the inverse, f to the minus one, of y." The first one, y is the function
of x says tell me what the amount of x is, and I'll tell you what the y
is. If you invert it, it says tell me how much you want for y, and I can
tell you how many x you need to have. If I could invert this
production function, I would know that for any possible output I want,
now how many jars of mayonnaise do you want? How many jars of
mayonnaise do you want for any possible jar of mayonnaise they
want, I could, by inverting it, know, I could know exactly how many
different workers I need to hire. By inverting that production function,
I can get labor back out. If I flipped it over, I'd now have a curve that
showed me something like this. Bear with me now. We're almost out
of this. Not the most fun.
axis is labeled q and the y-axis is labeled L with an arrow pointing
towards (w) and ($). The graph depicts an S shaped curve that
shows a steady increase followed by a sharp increase.
63
Transcript
I got a function that's got labor on this axis, output on this axis, and it
looks like this. It looks like that. This was the area of increasing
returns which meant that that cost curve, and if I could somehow
translate. This is man hours. These are physical units of labor. But, if
know the wage rate for that, I can scale this up by that scale or
whatever that is, and I've now got dollars and cents. This becomes
my variable cost. By scaling this up, this is actually physical man
hours into that production function. It's all it is. I just inverted it. This
is just the inverse of the production function. But, if I scaled up by the
cost, I now know what the variable cost is for every extra jar of
mayonnaise I want to produce. This tells me how many workers,
which I can translate by their wage rate, I'm actually going to have to
pay for. That means that's my variable cost.
Definition of Total Cost - Slide 33
Total Cost = Fixed Cost + Variable Cost
TC=FC+VC
64
Transcript
Let’s recall where we were. A long time ago, in this lecture, we

wanted to find total cost.
This slide contains the same line graph presented in Slide 28 - Fixed
Cost.
An x and y-axis system. the x-axis is labeled q and the y-axis is

labeled $ with a point labeled F0 . There is a straight line drawn
through F0 . The line is labeled FC
Transcript
I said we're going to do it by finding fixed cost, which you did. That
was easy.
65

Variable Cost.
A line graph with an x and y-axis system. The x-axis is labeled q and
the y-axis is labeled L with an arrow pointing towards (w) and ($).
The graph depicts an S shaped curve that shows a steady increase
followed by a sharp increase.
Transcript
And, we're going to add that to variable cost.
66
Calculating Total Cost - Slide 36
axis is labeled q and the y-axis is labeled $ with a single point
labeled F0 . A horizontal line labeled FC runs parallel to the q axis,
beginning at the point. An "S" shaped dotted line is drawn, indicating
a steady increase, followed by a sharp increase. The line is labeled
VC. A solid S shaped curve labeled TC is drawn parallel to VC. A
small double sided arrow is drawn between VC and TC with the label
FC
Transcript
Let's do that with one final picture. We'll do it by once again putting
an axes system in place, and on this axis, I'm measuring dollars and
cents. On this axis, I'm measuring output. I have some amount of
fixed cost. We drew this fixed cost curve. I'm just replicating it here.
Kind of in the background as a dotted function. Then, we found out
the variable cost function looked something like that. Its general
shape looks like this.
67
If I were to add those two, I would end up having a total cost curve
which has a fixed cost component, and it would just be the vertically
displaced amount of variable cost. Each one of these gaps between
here is by definition or by construction essentially the size of fixed
cost. This is our total cost curve. It has that general shape because
of the law of diminishing marginal product, and that shape is going to
help us to figure out, as we step forward, what marginal cost curves
look like, and that's going to drive home our profit maximizing rule.
Thanks.
Lesson 3-2.3 Derive Short Run

Average Cost Family of Curves
axis is labeled q and the y-axis is labeled $ with a point labeled F0 . A
horizontal dotted line runs parallel to the q axis beginning at point F0
68
. The line is labeled FC. An "S" shaped dotted line begins at the
bottom left corner of the line graph and curves up to the right of the
graph, labeled VC. VC is highlighted.
Transcript
Greetings. Last video you looked at the family of total cost curves.
That was very instructive. Just to remind you the total cost curve
looks like, if we just set up an axes system where we have dollars on
the vertical axis and output on the horizontal axis. The total cost
curve had a fixed cost component. That was F sub-zero. It was a
cost that did not change, fixed cost. In the short run that's the cost
associated with capital. Brick and mortar can't be changed on a daily
basis.
If you think about our mayonnaise production out at the Kraft plant
here in town, they have a pile of brick and mortar. Including brick and
mortar big shiny stainless-steel assembly lines. Those things can't
be changed on a daily basis. But the number of workers can. You
also have something here that represents what we call variable cost.
We derive this shape from the production function. This variable cost
curve shows how costs for producing extra jars of mayonnaise. As
you want more jars of mayonnaise, your costs are going to go up.
But not quite at a fast rate. But then all of a sudden, costs are really
going to screaming up because of that law of diminishing marginal
returns.
69
axis is labeled q and the y-axis is labeled $ with a point labeled F0 . A
horizontal dotted line labeled FC begins at point F0 and runs parallel
to the q axis. An "S" shaped dotted line labeled VC. Parallel to VC,
another "S" shaped line is drawn.
Transcript
The two of those together allowed us to put something together that

we called total cost. That was our lecture in the last video. Those are
very helpful curves because we already understand what the total
revenue curve looks like. I could, if I wanted to find the profit
maximization. I got a curve right there, total costs, which I could
subtract from the curve called total revenue. I'd have a profit curve.
But we need to get a little bit deeper into this idea of how to really
analyze profits. We're going to introduce a new tool. We're going to
introduce a curve here. A definition of something. Then we're going
to figure out how to draw it.
70
Definition: Average Total Cost (ATC) -
Slide 39
AT C =
TC
q
"Per unit cost"
TC (F C+V C) FC VC
AT C = = = +
q q q q
In the above equation, FqC is Average Fixed Cost and VC
q
to
Average Variable Cost.
ATC = AFC + AVC
Transcript
The definition is something called average cost. We'll put average

total cost. From now on I'm not going to write it all out. I'm going to
put ATC. Average total cost has a simple definition. It's equal to total
cost divided by output. Total cost divided by output. Basically what
this means is that this is a, the way to think about this in terms of
English, is it's per unit cost.
71
Think about this from our jar of mayonnaise example. Total cost for
the Kraft plant is all the cost associated with producing mayonnaise.
That's its share of the fixed cost. It's the eggs. The glass jars that
they put in. The workers' time. The milk that goes in there. The focus
groups that they had to pay to design the right label that they stick on
the outside that makes it most attractive to the supermarket
customer. All those things are costs that are involved with making
that mayonnaise. If you take all those costs together and put them in
the numerator and divide it by all the production of mayonnaise. We
now have something called per unit cost. We have that share of the
cost that's on the shoulders of each one of those jars of mayonnaise.
That's going to go to be pretty important to us. If that number turns

out to be something like $3.27, and Kraft can only get $3.10 when
they sell it on the market. That's a very bad industry to be in. They're
losing money on each one of those jars of mayonnaise. What they
want to know, is figure out how much is the overall, all costs,
inclusive cost per jar of mayonnaise. Then I want to sell it for a
higher price than that so that I have a little net, the residual. The
profits. Let's do this a little bit, let's break this down into a little bit
more of a useful equation. Average total cost is equal to total cost
divided by output. We know from our previous video that total cost is
two components: Fixed cost plus variable cost divided by output.
72
This slide contains the same line graph presented on Slide 38 - Total
Cost.
the y-axis is labeled $ with a point labeled F0 . A horizontal dotted
line labeled FC begins at point F0 and runs parallel to the q axis. An
"S" shaped dotted line labeled VC. Parallel to VC, another "S"
shaped line is drawn.
Transcript
We know fixed cost is the cost, that horizontal in the previous graph.
That horizontal line doesn't change. That's why it's called fixed cost.
If you produce one jar of mayonnaise, zero jars of mayonnaise or
10,000 jars of mayonnaise. The cost of the brick and mortar is the
same. It's just standing there.
73
Average Total Cost - Slide 41
This slide contains the same information presented in Slide 39 -

Definition: Average Total Cost
AT C =
TC
q
"Per unit cost"
TC (F C+V C) FC VC
AT C = = = +
q q q q
In the above equation, FqC is Average Fixed Cost and VC
q
to
Average Variable Cost.
ATC = AFC + AVC
74
Transcript
We can factor this out a little more and call this fixed cost over
quantity plus variable cost over quantity, okay. And these terms, this
term we call average fixed cost. And this term we call average
variable cost. So average total cost is equal to the sum of average
fixed cost plus average variable cost.
Now, just like we did in the previous video, in the previous video
when we showed that total cost was, sum of fixed cost was variable
cost. And then we graphed total cost by first figuring out what is the
shape of the total of the fixed cost function? And what is the shape of
the variable cost function? Then add the two together. We're going
to, same thing here. So we're going to start by figuring out what's the
graph for this curve look like? And then we're going to figure out the
graph for this curve. And when we add the two, we'll have what we
really want. And that's the average total cost curve. So let's get to
work.

Average Cost Family of Curves—Part
2
75
Average Total Cost Curve - Slide 42
ATC = AFC + AVC
axis is labeled q and the y-axis labeled $. A steady downward curve
is drawn and labeled AFC
FC
AF C =
q
76
Transcript
Where are we? We're still trying to draw this graph for average total
cost curve. Remember, the definition of average total cost is the sum
of average fixed cost plus average variable cost. Let's try and graph
this first term. We'll start by drawing our axes. Now the axes has, on
the vertical axis, dollars and cents, and on the horizontal axis, Q.
The graph I want to draw is the average fixed cost curve. Let's think
about what the form for averaged fixed cost is. Average fixed cost,
by definition, is fixed cost divided by output. Think about that graph.
As I move along the horizontal axis, adding extra units of output,
every time I do that what's happening on this ratio? Well, the
numerator is constant. Fixed cost doesn't move — that's by
definition.
But the denominator is growing. So that whole ratio has to be falling,

correct? And if I asked you to draw that, some of you would say, oh,
Larry, that must be a line that looks like this — and that's wrong.
Because, in fact, it falls in a very specific way and I'm going to show
you the way it looks and then I'm going to tell you why. It's going to
look something like this. This is the average fixed cost. It is indeed
falling. But think about that equation. In that equation, as Q gets
very, very large, what happens to that ratio?
Well, it asymptotically vanishes, but it never really gets to 0. No

matter how big the quantity is in the denominator, there's still this
little fixed cost in the numerator and that ratio can get very, very
small but it is going to, as we say in geometry, this is going to be
asymptotic. It is going to get close but never quite touch. On the
reverse, the same thing. Given our fixed cost in the numerator, if we
were to decrease output, smaller and smaller and smaller, what's
happening to that ratio? It's getting big. And that means that,
asymptotically, for very low output points, this thing is going to start
getting real close to the vertical axis. That's average fixed cost.
77
Average Cost Family of Curves—Part
3
Variable Cost Function - Slide 43
axis is labeled q with points labeled q0 through q6. and the y-axis is
labeled $. The graph depicts a Variable Cost curve: an “S” shaped
curve that rapidly increases, then flattens out before rapidly
increasing again. The variable cost curve concaves downwards for
low output and rises? after the point of inflection at point q6. The
graph demonstrates that Average Variable Cost will take a U shape.
The slope of the line from the original to the Variable cost curve will
get flatter until it reaches q6. As quantity increases the slope of the
variable cost curve will get steeper, implying that AVC will be
decreasing to q6 and continue to increase.
78
VC
Transcript
Remember, we're trying to figure out what does the average total
cost curve look like? Last video, we figured out what this average
fixed cost looks like. Now we're almost home. Now what we have to
do is think about what's the average variable cost curve look like?
This is going to be harder. So, bear with me, concentrate. We can
make this work. Now, first we're going to draw our axis system. Then
we're going to put dollars and cents on the vertical, and output on
the horizontal. We want to figure out what the average variable cost
looks like. We know average variable cost is definitionally variable
cost over output. As I increase my output — for increases in output
what's happening?
Well, one thing, this denominator is getting larger. But also, at the
same time, what's happening in the numerator? Well, it's also getting
larger. You cannot just wish for extra output. If you're going to get
extra output, you have to have extra costs. Your variable costs are
going to be going up, okay? Variable costs can't go down. I mean,
imagine a production function where you went from 6 to 7 and your
costs dropped. Ha, that's not going to happen. Moving from output of
6 to output of 7 requires you to spend more money. The variable cost
is going to be going up too. We've got both the numerator and the
denominator getting larger. The only way we can figure out the ratio
is we have to figure out which one goes proportionally faster. To
make that work, we're going to have to go back to our production
function and think a bit about that production function. Or think about
—about our cost function.
What I want to do here is I want to put one of those—you know, I'm

fond of putting one of these little—you know how in the cartoon
character there's a little bubble. The thought bubble pops up out of
their head and they start thinking about this stuff? I want you to recall
79
what we did with our variable cost function. Our variable cost
function looked like this. Remember? Our variable cost function
looked like this.
Average Variable Cost - Slide 44
ATC = AFC + AVC

VC
AV C =
q
axis is labeled q and the y-axis is labeled $.
Transcript
In this particular lecture, we're asking ourselves to figure out this

ratio. Variable cost divided by output. Well, variable cost divided by
output is pretty easy. Pick any given output point you want. Just pick
an arbitrary output point.
80

Variable Cost Function within a thought bubble.
A line graph with an x and y-axis system. The x-axis is labeled q with
points labeled q0 through q6. and the y-axis is labeled $. The graph
depicts a Variable Cost curve: an “S” shaped curve that rapidly
increases, then flattens out before rapidly increasing again. The
variable cost curve concaves downwards for low output and rises?
after the point of inflection at point q6. The graph demonstrates that
Average Variable Cost will take a U shape. The slope of the line from
the original to the Variable cost curve will get flatter until it reaches
q6. As quantity increases the slope of the variable cost curve will get
steeper, implying that AVC will be decreasing to q6 and continue to
increase.
81
Transcript
I'm going to pick this one. You know, my old joke, "I've got the pen,"
right? I'm picking this one right here. We'll call that q zero. And at q
zero, what is the variable cost? You say, well, I can read that off that
axis, Larry, that graph. This height would be the variable cost at q
zero, and this horizontal distance is q0. If I were to divide that vertical
height, that's the numerator. If I divided that vertical height by this
horizontal length, that's opposite over adjacent. We just know a little
bit of trig or geometry to know that the slope of this line—the slope of
this line—would give us average variable cost. The slope of this line
tells us the ratio of variable cost over output.
Let's try a different one. Let's try this one, q1; q1 gives us a variable
cost of this. The slope of that line has fallen. That means the ratio of
variable cost over output is lower at q1 than it was at q zero. I can do
it again, q2. I can see it falls again. Eventually, I'm going to get to
some point, about right here, we'll call this q sub 6, where this line is
just tangent to this curve. As I keep adding output to q7, now I see
that the slope is starting to rise back up again. So, the slope, the line
from the origin to the curve. For those of you who really like to talk
about math [inaudible], that's called a ray. A straight line from the
origin to the curve. The slope is going to keep increasing.
First of all, for those of you who look at this saying, "What in the heck
is he doing here?" If you don't really understand this because you
forgot that part of analytical geometry, that's okay. I'm never going to
ask you to reproduce this particular construction. But for those of you
who think hard about this thing, you can see that what's actually
happening. As I increased my output, what's happening to this ratio?
Variable cost over quantity, which is essentially the slope of the line
from the origin to the curve. It's falling at low output points and then
starts rising. That means that what we call this—economists call this
—we'll take a look at what it looks like here.
82
U-Shaped Average Cost Curves - Slide
46
axis is labeled q and the y-axis is labeled $. A u-shaped curve
labeled AVC is drawn.
"U-shaped average cost curves"
83
Transcript
The average variable cost is falling at low levels and then rising. This
is what economists refer to, when you read economics papers or
textbooks, they'll talk about U-shaped average cost curve. I'm going
to talk about that a lot, too. Because U-shaped average cost curves
are essentially a creature of that law of diminishing marginal product.
The law of diminishing marginal product, which we did four videos
ago when we looked at the production function. Told us that as you
keep trying to get more—if you keep hiring more and more inputs,
the successive inputs—the extra inputs will give you more output.
But they give you a little bit less output on the margin than the
previous ones did.

Variable Cost Function within a thought bubble.
A line graph with an x and y-axis system. The x-axis is labeled q with
points labeled q0 through q6. and the y-axis is labeled $. The graph
depicts a Variable Cost curve: an “S” shaped curve that rapidly
84
increases, then flattens out before rapidly increasing again. The
variable cost curve concaves downwards for low output and rises?
after the point of inflection at point q6. The graph demonstrates that
Average Variable Cost will take a U shape. The slope of the line from
the original to the Variable cost curve will get flatter until it reaches
q6. As quantity increases the slope of the variable cost curve will get
steeper, implying that AVC will be decreasing to q6 and continue to
increase.
Transcript
The result of that is, intuitively you have a variable cost function that
starts to kind of go up and flatten out. Then it just goes screaming
north. Because it's really expensive to keep getting more output,
because you have to jam more and more workers into that factory to
make it work.
U-Shaped Average Variable Cost

Curve - Slide 48
85
This slide contains the same line graph presented in Slide 46 - U-
Shaped Average Variable Cost Curve.
the y-axis is labeled $. A u-shaped curve labeled AVC is drawn.
Transcript
Our average variable cost curve is going to be what we call a U-

shaped cost curve.
Lesson 3-2.6 The Definition of

Marginal Cost
Definition of Marginal Cost - Slide 49
86
Marginal Cost (MC): "The change in TC for any change in output."
"Change in T C"
MC =
dT C
dq
=
"Change in q"
="The slope of TC function."
Transcript
Greetings. Here's the good news. The good news is we're almost
done with our exercises in figuring out cost curves. That's one piece
of good news. The second piece of good news is that this last cost
curve we're going to introduce is actually the most important one. We
saved the best for last. That doesn't mean that it's getting any easier.
But it's really an important cost for what's going to happen for the
rest of this course that, in fact, hopefully for the rest of your life as
you think about reading stories in the newspaper about what this
regulation has done to this firm.
You're going to think a lot about this term, marginal cost. Marginal
cost is the last cost curve we want to think about. Earlier in this
course, when we talked about something called the law of
diminishing marginal product, I pointed out to you that the word
marginal, anytime you see the word marginal, economists use the
word marginal to mean change in. The law of diminishing marginal
product, it was the law of diminishing change in product. In this case,
the marginal cost is the change in cost. We're going to write this out
the marginal cost is the change in total cost for any change in output.
No variables, no jargon in there at all. Let's see what this really looks
like. We can say, oh, by the way, from now on, we're just going to
call this MC. I'm not going to keep writing out marginal cost. MC is
our, is our marginal cost. Marginal cost then formally is equal to the
change in total cost for a change in output. That's the calculus form
is D of TC over D of Q, or D means the derivative of total cost over
the derivative of output. Or if you don't like that, you can put it like,
you can say, I know what that means, Larry, that means a change,
the change in total cost divided by the change in output.
87
What you could also say, if you don't like that too much, it's the slope
of the total cost function. All three of those are correct answers to
what marginal cost means. Remember, economists use the word
marginal to think about change. That's exactly what this term is. Only
it's written in terms of calculus. That's exactly what we did here, just
kind of writing it out in lay terms. Or this is what we know about a
marginal cost is, indeed, the slope of the total cost function. Now, it's
really important to us to understand marginal cost because some of
you probably talk about marginal cost in your businesses, the jobs
you work in. Job sites typically refer to marginal cost as incremental
cost. At times, the Wall Street Journal will jump on some of their
stories between talking about marginal costs in the oil industry to
incremental costs in the oil industry. They are really the same thing.
Incremental cost, they're really talking about how much extra does it
cost me to make one more unit. Think of it that way.
Out there at that craft plant on the edge of town, they've got jars of
mayonnaise that they're making. They're making jars of mayonnaise.
If they want to make one more jar of mayonnaise, they don't have to
change any of their fixed costs. They don't have to change anything
about the assembly lines. All they have to do is, there's some costs
involved, a couple more eggs, because it's usually about two eggs in
a jar of mayonnaise, there's a little milk in there, there's a glass jar,
there's a label, there's some workers' time, and that, the sum of all
those little incremental costs would be called the marginal cost of
that extra jar of output. That's really important to us, because in the
bottom line, when we get into profit maximization, which will be the
next module, when we get into profit maximization, the firm is
thinking about, I know how much it costs to make this, just this extra
jar, I know exactly how much it costs to make it, that's the marginal
cost. I know exactly what people are giving me. That's the marginal
revenue. Where should I stop? What's the right amount to produce?
Thanks.
88
Lesson 3-2.7 Derive Shape of the
Marginal Cost Curve - Part 1
Slope of Total Cost (TC) - Slide 50
MC =
dT C
dq
=(AKA "slope of TC")
axis is labeled q with points labeled q0 through q9 and the y-axis is
labeled $. There are two “S” shaped parallel lines that show a steady
increase, followed by a sharp increase at the inflection point q7 . One
is represented as a dotted line labeled VC and to the right of VC, the
other line is labeled TC
To the right of the line graph, is a smaller line graph with an x and y-
axis system. The x-axis is labeled q and the y-axis is labeled $. A "U"
shaped curve labeled MC. There is line drawn from the line graph
towards "U-shaped MC"
89
Transcript
Greetings, in our last video, we laid out the formal definition of the
marginal cost curve. I gave it a lot of props, I said you know, this is a
really important curve, and it is, it's really an important curve for us,
and so obviously, as we've done when I did the total cost curve, I
figured out how to draw it, and when I showed you the average total
cost curve, I figured out how to draw it and now we're going to figure
out how to draw the marginal cost. Let's recall the definition of the
marginal cost is, the marginal cost is the change in total cost for
change in output, also known as, aka, the slope of the total cost
curve. We're going to have to draw that. Let's start with our axes—I
got dollars on the vertical axis, output on the horizontal axis, and let's
draw our total cost function.
We remember from two videos, three videos, four videos ago, the
total cost function was the sum of a horizontal line that we called
fixed cost, fixed cost at some level, F zero. This curve that we called
variable cost, which is a curve that's always going up but starts to
flatten out earlier and then it starts to scream up as we get into this
region of the law diminishing marginal product. It's getting more and
more expensive for the firm to make more output because each
extra input that it puts in while it's productive, is not quite as
productive as the previous input. Remember, this is not a feature of
the fact that maybe they're just hiring bad workers out of the working
pool, no, it's because the engineers know the underlying polynomial
that is the production function. They know that for the fixed capital,
which is what we got in the short run, the brick and mortar, there's an
optimal amount of the variable input labor.
You can squeeze more out by putting more of that in there, but as
you put more and more of that variable input to the fixed component
of that complex polynomial that was a production function, it's just
not kicking out as much extra output each time. That's the problem,
you're over-utilizing labor relative to the pool of capital. Let's add
these two up. And this gives us our total cost curve. All we have to
90
do now is think about what our definition is. The change in total cost
or change in output, otherwise known as the slope of the total cost
curve, well we could figure that out right now. At low output points,
let's try this output point; q0, at q0 the slope of the total cost function
would be the slope of that line that's tangent to the total cost function
right there.
If we were to increase output to say Q1 the slope of the total cost

function out here is now a little bit flatter. If we increase output a little
bit more out here to Q2 I'm just arbitrarily picking these, you can see
that in fact, the slope of the line that is just tangent to the curve, is
now flatter again. We can continue that process every time it's
getting a little bit flatter, out until you get to some famous point, and
that famous point is referred to as the inflection point. After that
inflection point, as we continue to add more output, oops, that was
kind of a poorly drawn Q, as we continue to add more output, we'll
call this Q7, you can see the slope of the total cost curve is now
starting to get steeper again. We go out here to Q8 and the slope of
the total cost curve at Q8 is getting steeper. Q9 wow, it's really, the
really, marginal cost is pretty high out here, okay. This curve is
getting really steep.
The slope of the total cost function, sorry, the slope of the total cost
function is marginal cost and as you can see, it's always a positive
number, think about that, you can't have negative margin cost. What
a great world that would be. Every time you produce an extra jar of
mayonnaise, your costs go down. That would be a fun world, but
that's not the way the world works. If you're going to produce an
extra jar of mayonnaise, it's going to cost you some extra money.
Marginal cost is going to be a positive number, it's just that the value
of marginal cost is falling over this range. The marginal cost, which is
the slope of this curve, is going down. It's still positive but it's getting,
going down, and then after this inflection point, it's not only still
positive, but now it's starting to scream up. The general shape of
marginal cost curve—is going to be positive; it's going to fall over
one region and go up as we get to higher output. Huh, what's that
91
remind you of? Well of course, that is another in the family of what
we call U-shaped cost curves, it's a U-shaped marginal cost, okay?
We already had U-shaped average cost curves last time, right?
Average total cost and the average variable cost were U-shaped. We
did those in some previous videos and now we see the marginal cost
itself is U-shaped.

U-Shaped Graphs for Marginal Cost

and Average - Slide 51
This slide contains two line graphs each with an x and y-axis system.
Both x-axis' are labeled q and the y-axis' are labeled $. Each line
graph depicts a "U" shaped curved. The line on the left graph is
labeled MC and the graph on the right graph is labeled A. The graph
on the right is contained within a thought bubble.
92
Transcript
Last video we derived that the marginal cost curve was a U-shaped
function. I want to draw just a brief, a brief return to that. We have
here dollars on the vertical axis and quantity on the horizontal axis,
and we discovered that the marginal cost curve was some U-shaped
function that looks like this, and again, how did I know where to draw
that? I don't. It's just a general function, I know it's U-shaped, okay?
Now should it have been farther to the right, should it have been
higher, should it have been lower? I don't know, because I didn't give
you the general, I didn't give you the explicit functional form of the
cost curve.
If we had that, we could know exactly where it goes. Something is

making my head think about something. Ah, you know what?
Another one of these little thought bubbles, hmm, I recall that in fact,
in one of our previous lectures, we discovered that the average cost
curve was itself U-shaped. Since both of these curves have the
same horizontal axis output, both of these curves measure the same
vertical axis, dollars and cents, and they're both U-shaped, I bet you
guess what we have to do next. We have to figure out where do
they, where do they fit relatively. How do these curves come to play
against each other relatively? And this is actually a very important
little piece of understanding.
Let me take a small side track here; if you actually, if you actually
knew calculus and you're not required to know calculus, but if you
knew calculus, you could take a cost curve and you could take the
derivative of that cost curve, and that would be your marginal cost
and you plot that. But you could also take the cost curve, divide it by
output, and then take the, and then you could map out that and that
would be the average cost function. And you could, through calculus,
figure out exactly what the relative size each one of those is on any
given cost function I give you. It wouldn't be a hard exercise at all if
you understood calculus. Right now, we're not doing it in calculus,
we're going to do it in graphs but we're going to do it in graphs that
93
we know we could actually prove if we decided to sit down, roll up
our sleeves, and actually do a proof by calculus. We're not going to
do that, but we could.
I want to start by thinking about making you think about something

here. I'm going to give you a story; suppose you had, suppose you're
in some program in college and at the moment in this program, you
actually have a grade point average of 3.5 and that's your average
grade point. And then at the current course, you actually end up
getting a B. So you get a 3 point for that course. If you get a B from
the marginal course, what's happening to your average? Well, if your
current average is 3.5 and then your marginal performance is 3, it's
going to pull that average down.
If, on the other hand we have a 3-point grade, 3.5 grade point
average, and you get a 4 point, an A, what's going to happen to your
average? It's going to go up. When the marginal is greater than the
average, it pulls the average up. When the marginal is below the
average, it pulls the average down. Think about if you, you know,
think about a sports thing. If you ever go bowling, if your bowling
average is 150, if you're averaging 150 at the bowling lane, and you
roll 180, your average is going to go up. If your average is 150 and
you have a bad day and roll 120, your average is going to go down.
The average curve is going to go down if marginal is below it, the
average curve is going to go up if marginal is above it.
94
Marginal and Average Total Cost
Graph - Slide 52
axis is labeled q with a point labeled qMin ATC. A "U" shaped line
graph labeled ATC is drawn with point qMin ATC at the lowest point of
the line. Another "U" shaped line is drawn to the left of ATC,
intersecting with qMin ATC at the point of inflection with the label MC.
95
Transcript
Now, with our, equipped with logic to figure out what these two
curves look like, I'm going to draw my axes system— and I'm going
to put on there some arbitrary average total cost. It's U-shaped,
nothing wrong with this picture; I didn't do any tricks here. Again, you
could say well why'd you put it there, Larry? I've got the pen. I know
it's U-shaped, I know, I didn't define anything wrong here, I just, it's
just the general position of it. Now I want to ask the question, this
particular region of the average cost function, the average cost
function is going up, correct? If the average cost function is going up,
I'm going to, I'm going to label this point as the output that minimizes
average total cost. That's that output point right there. Everything to
the right of that, average total cost is going up. If average total cost is
going up, what do we know about marginal cost? Marginal cost has
to be bigger than average cost. The only way average cost can go
up is if marginal cost is above it.
On the other hand, what about this region of the cost curve? It's
going down. Now if average total cost is going down, what do we
know about marginal cost? Well it's got to be below it. If your
average is falling, the marginal's got to be below it. You turn that 3
point, for a 3.5 average, if you have a 3.5 grade point average, and
you turn in that 3 point, you're pulling it down. If you got a 3—if your
average is 150 at the bowling lane and you roll 120, it's pulling it
down. The only way that works is if the average, if the marginal cost
curve, which is also U-shaped, goes right through the minimum of
the average total cost curve.
The only way that works is that U-shaped marginal cost curve has to
go right through that minimum. Now, if you decide to go on and get
yourself a PhD in economics, they'll make you prove that through
calculus. And it's a very straightforward proof, you could do it too,
you don't even need to worry about PhD, if you understood calculus,
you could prove it. If I gave you a cost function, and you understood
calculus, you could easily, easily, prove this. But we're not interested
96
in that. My proof to you, I hope, was intuitively quite powerful. The
only way you can pull your average up is if your marginal
performance is stronger, getting your average up. The only, if your
marginal performance is weaker than your average, what's it doing?
It's pulling your average down. Well the only way you can make that
work is if that U-shaped marginal cost curve goes screaming right
through the minimum of the average total cost curve. Thanks.

Relationship of AVC, ATC, MC, and

AFC - Slide 53
This slide contains a line graph on an x and y-axis system. The x-

axis is labeled q with two points labeled qmin AVC and qmin ATC. There
are four “U” shaped curves drawn on the graph with the labels AFC,
ATC, AVC, and MC. MC always intersects ATC at their respective
97
minimum (qmin ATC). AFC and MC intersect at point α which is
indeterminate, as fixed cost and marginal cost are not related. At
point q min AVC, MC and AVC intersect.
Transcript
Greetings, last time we looked at the relationship of marginal cost to

average total cost. We understood both of those are U-shaped, and
we understood that the marginal cost curve has to right through the
minimum of the average total cost curve. But we've got lots of curves
we need to think about, so I'm going to make this, I'm going to make
this really messy for you. I know you're going to appreciate it, but I
told you you wouldn't really like this module, cost theory, but it's
really important.
We got output on horizontal axis, and I want to put on here our

average fixed cost curve, AFC. Remember that curve? It's a
rectangular hyperbole, you don't need to remember that. It's a curve
that asymptotically vanishes as output gets very large. Or as output
gets very small, it asymptotically explodes. And then we had
something called the average variable cost curve. And it looked
something like this. And then we had the sum of those two, and that
was called the average total cost curve. And that looked something
like streets.
Recall we know that that average total cost curve and the average
variable cost curve, are going to asymptotically approach each other
because at extremely high output levels, this curve, the average
fixed cost curve, gets down to infinitesimally small. Never really goes
to zero, but it's going to asymptotically get really close to that axis,
which means these two curves never really touch but they get
remarkably close to each other. And now I have to put the marginal
cost curve on here.
98
The marginal cost curve is itself U-shaped. Where does it go? Well,
I'm not sure where it goes. I know it's U-shaped; I am pretty sure
where it goes given this family. I'm going to label a couple points
before we get started. This point, this is the output that minimizes
average total cost. And by the way, we're going to, as we get farther
on in the course, I mean weeks away yet, but minimizing average
total cost turns out to be a really good thing in terms of evaluating
efficiency properties, it means that you're producing at the cheapest
per unit cost you can possibly get, remember? Average total cost
was defense as per unit cost. If your op production point is right
there, it minimizes the per unit cost. That's a very efficient thing.
Now that doesn't mean you're always going to be there. The profit
maximizing point may be for you to be away from that. I mean it
could, because prices could be so high you're just really producing a
lot and your average cost is going up because at the higher output
levels, at higher output levels, you're just going to experience that,
but it might be optimal for you to do that given the current price, we
don't know yet. That's more of the fun that will come.
This output point, we're going to call Q sub minimum average

variable cost. Finally, we're going to put in blue on here, our marginal
cost curve. You may note that the marginal cost curve itself is U and
it is, it's, marginal is U-shaped, but it goes through the minimum of
average total cost curve, which you, we provide in the previous
video, but it also goes through the minimum of the average variable
cost curve through a proof that is something the same thing we
would do. I'm not going to repeat it here, but you could do the same
intuitive logic of thinking that out, or better yet, if you knew calculus
you could make that proof very quickly, by just taking the total cost
curve, take the derivative, then you have marginal cost and then
take, create an average total cost curve and create an average
variable cost curve, and take what those two look like when they're
minimized and you could see that the two will be equal. The average
marginal cost curve goes through there.
99
I've got to ask a question though. I'm going to label this point alpha.
Now this is, call this point alpha, alpha is where marginal cost hits
average fixed cost, and the question is, where is that point? I've
drawn it, the way I've drawn it, it's at point alpha, what is its
significance? Is there some systematic point where that's supposed
to hit? The answer is no, no, no, and no. There's absolutely nothing
at all associated with this.
Derivative of Fixed Cost - Slide 54
TC = FC + VC
This slide contain an equation within a thought bubble

dT C dF C dV C
MC = = +
dq dq dq
The equation dFdq

C
has been crossed out and an line extending from
the equation and leads to a question mark.
100
Transcript
If you think about this little—we'll come back to this picture. Let's just
think about this little thought bubble. In this thought bubble, we think
about the fact that total cost is equal to fixed cost, plus variable cost.
Marginal cost, which was equal to the derivative of total cost with
respect to output, would be equal to the derivative of fixed cost with
respect to output, plus the derivative of variable cost with respect to
output.
But what is this term? Well this term is nonexistent; it's not defined.
There is no such thing as the derivative of fixed costs. Fixed costs
can never change. By definition, fixed cost is a constant. There is no
such thing as a— so this is not defined. It's a zero, so since fixed
cost and variable cost, that means fixed costs and marginal costs
have absolutely no relationship, none, zero.

AFC (1 of 2) - Slide 55
101
Relationship of AVC, ATC, MC, and AFC with two additional “U”
shaped curves drawn for AFC and ATC, demonstrating a shift to the
right.
A line graph on an x and y-axis system. The x-axis is labeled q with

two points labeled qmin AVC and qmin ATC. There are four “U” shaped
curves drawn on the graph with the labels AFC, ATC, AVC, and MC.
MC always intersects ATC at their respective minimum (qmin ATC).
AFC and MC intersect at point α which is indeterminate, as fixed
cost and marginal cost are not related. At point q min AVC, MC and
AVC intersect.
Transcript
I could go back to this picture. Suppose now something came along

that changed fixed costs? Suppose that there's a giant increase in
fixed costs. The city put a new $10,000 tax on every establishment in
town, regardless of how big or small they are, because they have to
help pay for redoing the streets or something like that. Well if it's a
giant increase in fixed costs, what's going to happen to average fixed
costs? Well, average fixed costs are going to shift out, right? So
average fixed costs might go clear out to here. This would be
average fixed costs under the new world.
Now if average fixed cost shifts out there, what's going to change to
average variable cost? Nothing. Average variable cost has no
relationship to average fixed cost. What's going to happen to
marginal cost? Nothing. Marginal cost has no relationship to fixed
cost, so it has no relationship to average fixed cost. What's going to
happen to average total cost? Well it's going to go up a lot, because
the average total cost is the sum of average fixed cost plus average
variable cost. If this average fixed cost jumps up, even if average
variable cost doesn't move, the new average total cost is going to be
something way out here. It's still going to have its minimum, it's still
102
going to have its minimum on marginal cost curve. But again, all of a
sudden, now marginal costs hits average fixed costs out here, you
know, this is our marginal cost curve and we were asking with that
earlier question is, where is this point, α, where marginal cost hits
average fixed cost.

AFC (2 of 2) - Slide 56

Relationship of AVC, ATC, MC, and AFC
A line graph on an x and y-axis system. The x-axis is labeled q with

two points labeled qmin AVC and qmin ATC. There are four “U” shaped
curves drawn on the graph with the labels AFC, ATC, AVC, and MC.
MC always intersects ATC at their respective minimum (qmin ATC).
AFC and MC intersect at point α which is indeterminate, as fixed
cost and marginal cost are not related. At point q min AVC, MC and
AVC intersect.
103
Transcript
It's irrelevant. It means nothing to any else you would ever do, and
we can't really predict where it is. We could calculate where it is, if
we knew the numbers, but it's irrelevant to us. All that really matters
to us is that in our family of cost curves, our U-shaped average
variable cost and U-shaped average total cost, the marginal cost hits
both of them at their respective minimums. That's all that's key to us.
Thanks.
104

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Lesson 3-1.1 An Economist's

An Economist's Production Function -

This slide contains an image of Professor Larry DeBrock.

Greetings. We're moving into a little more complex part of the

We're going to spend a lot of time thinking about what it means to

Lesson 3-1.2 Types of Firms

1. Sole Proprietorships—"Single owner"

Greetings. Today I want to talk to you a bit about businesses, or

Today we want to think about business organizations, types of firms

Sole proprietorship is basically a single owner. A sole proprietorship

Now, the second type is partnerships. A partnership is kind of like

The last one is corporations. Corporations are very special.

Remember, this corporation is an independent entity. In a way, I

In order to do that I have to issue a few shares, simple as maybe just

Statistical Abstract of the US - Slide 3

This slide contains a ProQuest webpage with the title Statistical

Detail (2013 Data from 2019 Volume of

24.1 3.5 5.9

Statistical Abstract of the US - Slide 5

This slide contains the same ProQuest webpage presented on Slide

A ProQuest webpage with the title Statistical Abstract of the US 2019

Detail (2013 Data from 2019 Volume of

24.1 3.5 5.9

1.3 5.1 26.9

Finally, I want to talk about something else. I want to talk about

Corporations always involve double taxation. The entity gets taxed

Lesson 3-1.3 Behavior Rule

Theory of the Firm - Slide 7

Behavioral Rule: Maximize Profits

Π=Total Revenue minus Total Cost

Greetings. Today, we want to talk a bit more about what economists

Not-for-profits also have the same efficiency issues. They have to

Accounting Profit - Slide 8

ΠACCY = TR − Total Explicit Costs

Π = TR − Total Explicit Costs − Opportunity Costs

But to an economist, he kind of says, "Well, you know what? That's

In fact, economists can do some statistical estimation to see how

Lesson 3-1.4 Behavior Rule—Part 2

This slide contains the formula Max Π = TR−TC with an arrow

Greetings. In one of our previous videos, we discussed the fact that

Introduce New Notation

Q denotes Market Output

q denotes Output of an individual firm

Implies Q = ∑ qi where N is the total number of firms

When we get to the second module of the second course, which

But there are lots of people selling mid-sized automobiles. There's

We're going to think about production. In order to do that, I'm going

Economists believe that, you know, in this particular model, L for

Example: Kraft Plant - Slide 12

This Kraft plant is making mayonnaise. They make a lot of stuff at

Definition of Short and Long Run -

In the above equation, L is always variable and K is fixed in SR

We have to introduce another definition here. This definition is going

Suppose you're out there at that Kraft plant. You're making

Lesson 3-1.5 Law of Diminishing