7.5 - Types of Cost, Revenue and Profit, Short-Run and Long-Run Production (S)

COURSE: A LEVEL ECONOMICS (9708)
CHAPTER: 7 - The Price System and the Microeconomy
4
TOPIC: 7.5 - Types of cost, revenue and profit, short-run
and long-run production
Last edited:
June 2022
© Dr. Sylvain Hours | econdoctor.com

OUTLINE
 7.5 - Types of cost, revenue and profit, short-run and long-run production
 7.5.1 - Short-run production function
 7.5.2 - Short-run cost function
 7.5.3 - Long-run production function
 7.5.4 - Long-run cost function
 7.5.5 - Relationship between economies of scale and decreasing average costs
 7.5.6 - Internal and external economies of scale
 7.5.7 - Internal and external diseconomies of scale
 7.5.8 - Definition and calculation of revenue: total, average and marginal revenue (TR,
AR, MR)
 7.5.9 - Definition of normal, subnormal and supernormal profit
 7.5.1 - Calculation of supernormal and subnormal profit
PART 1
PRODUCTION IN THE SHORT-RUN

TIME PERIODS R
REMINDERS
 In production theory, we distinguish between the very Short Run, the Short
Run (SR), the Long Run (LR), and the very Long Run.
 Nb: In this course, we will mostly focus on the SR and the LR.
 Simply put, the longer the time period considered, the more flexible the firm.
 In other words, what is fixed (i.e. cannot be changed) in a shorter period of

time becomes variable (i.e. can be changed) in a longer period of time.

TIME PERIODS R
REMINDERS
 In particular, time periods provide information about:
 Whether or not firms can change the quantity of a FoP that they use.
 Whether or not the business environment on which firms have no control (i.e. external
factors) can change (e.g. state of technology, government policy, social customs,
etc.).
 In the VSR, the quantity of all of the FoP used by firms, as well as the
business environment in which firms operate, are fixed.
 In the SR, the quantity of some of the FoP used by firms is variable, the
quantity of at least one of the FoP used by firms is fixed, and their business
environment is fixed.
 To simplify, we usually consider 2 FoP only: labour and capital.

TIME PERIODS R
REMINDERS
 In that case, we assume that the quantity of labour used by firms is variable in
the SR, whereas the quantity of capital used by firms in the SR is fixed.
 In the LR, the quantity of all of the FoP used by firms is variable, and their
business environment is fixed.
 If we only consider 2 FoP, then the quantity of both labour and capital used
by firms is variable in the LR.
 In the very LR, the quantity of all of the FoP used by firms, as well as the
business environment in which firms operate, are variable.
 Question: How long is the SR?

TIME PERIODS: SUMMARY
VSR SR LR VLR
LABOUR FIXED VARIABLE VARIABLE VARIABLE
CAPITAL FIXED FIXED VARIABLE VARIABLE
ENVIRONMENT FIXED FIXED FIXED VARIABLE

ASSUMPTIONS
 There are only 2 FoP: Capital & Labour.
 The firm produces a single good or service.
 We are in the SR so the quantity of labour is

variable, and the quantity of capital is
fixed.
 Labour is homogeneous (i.e. all workers

have the same productivity).

PRODUCTION FUNCTION & TOTAL PHYSICAL
PRODUCT
 A production function is a technical relationship between inputs and outputs,

expressed in physical terms.
 The Total Physical Product (TPP) is the maximum potential output that can be
produced from a given combination of inputs.
 Example: With 10 workers and 5 machines, Seiko can produce a TPP equal to
100 watches.

AVERAGE PHYSICAL PRODUCT OF LABOUR
 The Average Physical Product of Labour (APPL) is the product per worker.
 It is equal to the TPP divided by the number of workers.
APPL = TPP / L
 Example: If LV produces 100 purses with 20 workers, then the APPL is 5 purses.
 The APPL is equal to the slope of the line drawn from the origin to the TPP
curve. (Nb: True for all total-average relationships)

MARGINAL PHYSICAL PRODUCT OF LABOUR
 The Marginal Physical Product of Labour (MPPL) is equal to the change in

TPP resulting from the employment of the last worker.
 Example: If PAUL, a French bakery, produces 100 croissants with 10 workers,

and 120 croissants with 11 workers, then the MPP of the 11th worker is equal to
20 croissants.
 The MPPL is equal to the slope of the TPP curve. (Nb: True for all total-marginal
relationships)
 Therefore, the TPP increases when the MPPL is positive, and vice versa.

TPP, APPL & MPPL
PHYSICAL TPP
PRODUCT
TPP(L1)
MPPL(L1)
QUANTITY
L1 OF LABOUR

TPP, APPL & MPPL
PHYSICAL TPP
PRODUCT
TPP(L1)
APPL(L1)
QUANTITY
L1 OF LABOUR

THE LAW OF DIMINISHING RETURNS
 The Law of diminishing returns states that an increase in the quantity of a
variable factor will eventually lead to a decline in its MPP.
 Nb: This Law is a SR concept, and is also known as the Law of variable
proportions, or the Law of diminishing marginal product.
 In our simplified framework, this Law essentially means that as more workers
are added to a fixed quantity of capital, the MPPL will eventually fall.
 Indeed, beyond a certain threshold, the fixed quantity of capital becomes

over-used (i.e. there are too many workers for the quantity of capital available).

 When this happens, the employment of each additional worker results in a
smaller and smaller increase in TPP.
 In other words, the TPP curve increases at a decreasing rate.
 This is because the employment of each additional worker reduces the average
quantity of capital available to each worker, and therefore reduces labour
productivity.
 In fact, the MPPL may even become negative (i.e. negative returns).
 When this happens, the employment of each additional worker results in a

decrease in TPP.

 Intuition: Even if the firm employs more workers, labour productivity has
decreased so much that overall, the TPP decreases (e.g. « too many cooks in
the kitchen »).
 The MPPL is often assumed to be increasing at first (i.e. increasing returns).
 Intuition: At low levels of employment, labour productivity is likely to be

relatively low because there are not enough workers to divide labour and
specialise.
 In that case, the TPP curve increases at an increasing rate.

RICK’S PIZZA TRUCK
 Rick has recently purchased a pizza truck.
 He works alone, and so he has to complete many different tasks:

 Drive and maintain the truck
 Purchase and prepare the ingredients
 Prepare and cook the pizzas
 Take orders and serve customers
 Wash the dishes
 At the moment, Rick can produce a maximum output of 50 pizzas per day.

 Since no pizza would be produced without him, the MPPL when Rick works on
his own is equal to 50 pizzas.
 Rick then decides to hire his grandson Morty.
 Rick specialises in the tasks he is best at:

 Morty specialises in the tasks he is best at:

 Wash the dishes
 Take orders and serve the ©
customers
Dr. Sylvain Hours | econdoctor.com
 Together, Rick & Morty can now produce a maximum output of 120 pizzas
per day.
 Therefore, the MPPL has increased from 50 to 70 pizzas per day.
 In other words, Rick’s pizza truck benefits from increasing returns.
 This is because specialisation increases labour productivity, the pizza truck

is large enough for two (i.e. capital is not yet over-utilized), and there’s more
than enough work for both of them (i.e. their workforce is fully used).

RICK’ PIZZA TRUCK
 Rick then decides to hire his granddaughter Summer.
 Rick specialises in the task he is best at:

 Morty specialises in the tasks he is best at:

 Wash the dishes
 Summer specialises in the tasks she is best at:

 Take orders and serve the customers

 Together, Rick, Morty & Summer can now produce a maximum output of 180
pizzas per day.
 Therefore, the MPPL has decreased from 70 to 60 pizzas per day.
 That is, the employment of Summer did not increased the total daily output of
pizzas by as much as the employment of Morty did.
 In other words, Rick’s pizza truck starts to experience diminishing returns.

 The employment of Summer allows Rick’s pizza truck to take specialisation one
step further, which could have been expected to increase labour productivity.
 However, the pizza truck is a bit small for three (i.e. capital is becoming over-
utilized).
 Besides, since each individual worker is responsible for fewer tasks, there are
times when they have nothing to do (i.e. their workforce is not fully used).

RICK’ PIZZA TRUCK
 Rick then decides to hire his step son Jerry.
 Rick specialises in the task he is best at:

 Morty specialises in the task he is best at:

 Summer specialises in the tasks she is best at:

 Take orders and serve the customers
 Jerry specialises in the tasks he is best at:

 Wash the dishes
 Together, Rick, Morty, Summer & Jerry can now produce a maximum output
of 200 pizzas per day.
 Therefore, the MPPL has decreased from 60 to 20 pizzas per day.
 That is, the employment of Jerry did not increased the total daily output of
pizzas by as much as the employment of Summer did.
 In other words, Rick’s pizza truck continues to experience diminishing

returns.

 The employment of Jerry allows Rick’s pizza truck to take specialisation even
further, which could have been expected to increase labour productivity, even if
the benefit of additional specialisation is likely to be lower.
 However, the pizza truck is way too small for four, so Rick, Morty, Summer &
Jerry are in each other’s way, resulting in a fall in their productivity (i.e. capital
overutilization is getting worse).
 Besides, since each individual worker is responsible for even fewer tasks, there
are more times when they have nothing to do (i.e. their workforce is even less
fully used).

 At this level of employment, it might actually be more efficient to make two
teams of two workers (e.g. Rick & Morty in Team A ; Summer & Jerry in Team
B) and to get each team to run a different pizza truck.
 This would indeed address the issue of capital overutilization, enable a fuller
use of the workforce, while still enjoying the benefits of a low degree of
specialisation.
 However, we are in the SR, and so the quantity of capital (i.e. the number of
pizza trucks) is fixed.
 That is, Rick cannot purchase another pizza truck, and so the only way for him
to increase his daily output of pizzas is to hire more workers, even if this turns
out to be productively inefficient.
RICK’ PIZZA TRUCK
 Rick then decides to hire his daughter Beth.
 Each family member now completes one single task.
 Rick prepares and cooks the pizzas.
 Morty drives and maintains the truck.
 Summer purchases and prepares the ingredients.
 Jerry wahes the dishes.
 Beth takes orders and serves the customers

 Together, Rick, Morty, Summer, Jerry & Beth can now produce a maximum
output of 160 pizzas per day.
 Therefore, the MPPL has decreased from 20 to - 40 pizzas per day.
 That is, the employment of Beth leads to decrease in the total daily output of
pizzas.
 In other words, Rick’s pizza truck starts to experience negative returns.

 The employment of Beth allows Rick’s pizza truck to achieve a higher degree of
specialisation, but the productivity gains are likely to be small.
 Besides, the pizza truck is overcrowded, so Rick, Morty, Summer, Jerry & Beth
cannot comfortably move around their workplace, resulting in a significant fall
in their productivity (i.e. capital overutilization is getting even worse).
 Moreover, since each individual worker is responsible for one task only,
workers are frequently idle waiting (i.e. low labour utilisation).
 At this level of employment, it would be more efficient to make two of more

teams of workers and to get each team to run a different pizza truck, but we are
in the SR, and so there is one single pizza truck available.

TOTAL MARGINAL
QUANTITY
PHYSICAL PHYSICAL
OF LABOUR
PRODUCT PRODUCT
0 0 -
1 50 50
2 120 70
3 180 60
4 200 20
5 160 -40

PHYSICAL
PRODUCT
70
60
50
20
QUANTITY
1 2 3 4 5 OF LABOUR
-40
MPPL

PHYSICAL
PRODUCT
200
180
160
TPP
120
50
QUANTITY
1 2 3 4 5 OF LABOUR

PHYSICAL
PRODUCT NEGATIVE
RETURNS
QUANTITY
L1 L2 OF LABOUR
INCREASING DIMINISHING
RETURNS RETURNS MPPL

PHYSICAL
PRODUCT
TPP
INCREASING
RETURNS
DIMINISHING NEGATIVE
RETURNS RETURNS
QUANTITY
L1 L2 OF LABOUR

APPL VS MPPL
 If the MPPL is larger than the APPL, then the APPL increases.
MPPL > APPL APPL
 If the MPPL is smaller than the APPL , then the APPL decreases.
MPPL < APPL APPL
 If the MPPL is equal to the APPL , then the APPL is constant.
MPPL = APPL APPL
 It follows that the MPPL curve cuts the APPL curve in its maximum.

APPL VS MPPL : EXAMPLE 1
 Coach Dan asks his 20 PE students to do as many push-ups as possible in 10
seconds.
 Altogether, the 20 students did 160 push-ups (i.e. TPP), so on average, each
student did 8 push-ups (i.e. APPL).
 Coach Dan then asks a late 21st student to do the same exercise (i.e. MPPL) .
 If this late student does more than 8 push-ups (i.e. MPPL > APPL), then the
average number of push-ups increases.
 If this late student does exactly 8 push-ups (i.e. MPPL = APPL), then the average
number of push-ups remains the same.
 If this late student does less than 8 push-ups (i.e. MPPL < APPL), then the
average number of push-ups decreases.
APPL VS MPPL : EXAMPLE 2
 Michelle is a high-school student.
 So far, she has obtained the following grades (/20) : 12, 16, 18, 18, 8, 12.
 Therefore, her average grade (i.e. APPL) is 14.
 Michelle then receives an additional grade (i.e. MPPL).
 If she obtains more than 14 (i.e. MPPL > APPL), then her average grade increases.
 If she obtains exactly 14 (i.e. MPPL = APPL), then her average grade remains the
same.
 If she obtains less than 14 (i.e. MPPL < APPL), then her average grade decreases.
TPP, APPL & MPPL
PHYSICAL
PRODUCT
APPL
MPPL
QUANTITY
L1 OF LABOUR

SHORT-RUN COST FUNCTIONS
 In the SR, there are 2 types of costs: fixed costs and variable costs.
 A fixed cost is a cost that does not vary with output.
 A variable cost is a cost that increases with output.
 In our simplified framework, the Total Fixed Cost (TFC) is the total cost of capital
(i.e. the fixed factor), and the Total Variable Cost (TVC) is the total cost of
labour (i.e. the variable factor).
 The Total Cost (TC) is the sum of the TFC and the TVC.
TC = TFC + TVC

SORT-RUN COST CURVES
TC
COST
TVC
TFC
QUANTITY
OF OUTPUT

AVERAGE TOTAL COST
 The Average Total Cost (ATC) is the cost per unit of output.
 It is equal to the TC divided by the quantity of output.
ATC = TC / Q
 Example: If producing 5 ice creams costs $20, then the ATC is equal to $4.
 The ATC is equal to the slope of the line drawn from the origin to the ATC
curve.

MARGINAL COST
 The Marginal Cost (MC) is equal to the change in TC generated by the
production of the last unit of output.
 Example: If producing 5 ice creams costs $20, and producing 6 ice creams
costs $26, then the MC of producing the 6th ice cream is equal to $6.
 The MC is equal to the slope of both the TC and VC curves.

SHORT-RUN COSTS
TC
COST
TC1
MC1
QUANTITY
Q1 OF OUTPUT

SHORT-RUN COSTS
TC
COST
TC1
ATC1 QUANTITY
Q1 OF OUTPUT

AVERAGE FIXED & VARIABLE COST
 The Average Fixed Cost (AFC) is the fixed cost per unit of output.
AFC = TFC / Q
 The Average Variable Cost (AVC) is the variable cost per unit of output.
AVC = TVC / Q
 The ATC is the sum of the AFC and the AVC.
ATC = AFC + AVC

PRACTICE TIME!
Q TC TFC TVC AFC AVC ATC MC

0
1 40
2 85
3 210
4 170 25
5 50

PRODUCT VS COST CURVES
 The MPPL curve and the MC curve have opposite variations.
 That is, if the MPPL rises, then the MC falls, and vice versa.
 Indeed, if the MPPL is low, then the firm needs to hire many extra workers in
order to produce 1 additional unit of output, and so the MC is high.
 On the contrary, if the MPPL is high, then the firm needs to hire few extra
workers in order to produce 1 additional unit of output, and so the MC is low.

 The APPL curve and the AVC curve have opposite variations.
 That is, if the APPL rises, then the AVC falls, and vice versa.
 Indeed, if the APPL is low, then the firm needs to hire many workers to produce
each unit of output, and so the AVC is high.
 On the contrary, if the APPL is high, then the firm needs to hire few workers to
produce each unit of output, and so the AVC is low.

PHYSICAL
PRODUCT
APPL
MPPL
QUANTITY
L1 L2 OF LABOUR
MC
COST AVC
QUANTITY
Q1 Q2 OF OUTPUT
SHORT RUN COST CURVES
 The MC curve cuts the ATC and AVC curves in their minimum.
 The AFC curve is decreasing, because as output increases, the AFC is

spread over more units (i.e. spreading effect).
 Therefore, the gap between the ATC curve and the AVC curve narrows as
output increases.
 The ATC curve reaches its minimum at a larger level of output than the
AVC curve.
 In the SR, the level of output at which the ATC curve reaches its minimum
is known as the Minimum Cost Output (MCO).
 In order to achieve PE in the SR, firms must operate at the MCO.

COST MC
ATC
AVC
AFC QUANTITY
MCO OF OUTPUT

WHY IS THE ATC CURVE U-SHAPED?
 The ATC is the sum of the AFC and the AVC.
 The AFC continuoulsy decreases due to the spreading effect.
 However, the AVC if usually assumed to have a U-shape.
 Simply put, this is because we assume increasing returns at low levels of output,
and diminishing returns at high levels of output.
 At first, the spreading effect (i.e. lower AFC) the increasing returns effect (i.e.
lower AVC) both contribute to reduce the ATC. (STAGE 1)

WHY IS THE ATC CURVE U-SHAPED?
 Then, the firm starts experiencing diminishing returns, but the AVC keeps
going down, because the MC remains smaller than the AVC (i.e. the MPPL
remains greater than the APPL), and so with both the AFC and the AVC going
down, the ATC keeps decreasing. (STAGE 2)
 Next, the AVC starts to rise because the MC is greater than the AVC (i.e. the MPPL
becomes smaller than the APPL), and so the spreading effect (i.e. lower AFC)
and the diminishing returns effect (i.e. higher AVC) work against each other.
 At first, the spreading effect outweighs the diminishing returns effect, so the
ATC decreases. (STAGE 3)
 Then, the spreading effect is outweighed by the diminishing returns effect, so

the ATC increases. (STAGE 4)
STAGE 1
COST MC
ATC
AVC
AFC QUANTITY
OF OUTPUT
STAGE 2
COST MC
ATC
AVC
AFC QUANTITY
OF OUTPUT
STAGE 3
COST MC
ATC
AVC
AFC QUANTITY
OF OUTPUT
STAGE 4
COST MC
ATC
AVC
AFC QUANTITY
OF OUTPUT
PRACTICE TIME!
 Consider the following diagram.
COST
 Questions: What is the…
TC
 …ATC at output B?
 …AVC at output A?
 …AFC at output B? E
D
 …TC at output A?
C TFC
QUANTITY
A B OF OUTPUT

PART 2
PRODUCTION IN THE LONG-RUN

ASSUMPTIONS
 There are only 2 FoP: capital & labour.
 FoP are homogeneous (i.e. all workers and all machines are identical, so they
have the same intrinsic productivity).
 We are in the LR, which implies that firms can change the quantity of capital and
labour that they use, and so they do not incur any fixed cost (i.e. all costs are
variable).
 Firms produce a single good or service.

COST MINIMISATION
 Just like goods and services, FoP can be:
 Substitutes (ATM & bank tellers, assembly lines & workers, cashiers & automated
ordering system, etc.)
 Complements (e.g. carpenters & hammers, trucks & drivers, doctors & X-ray machines,
etc.)
 It what follows, we will assume that FoP are (imperfect) substitutes (i.e. firms can
replace workers by machines, and vice versa).
 In that case, the same level of TPP can be achieved with multiple combinations
of inputs (i.e. production processes of different capital intensities).
 Example: A firm may be able to produce 100 cars with either 500 workers and 10
machines (labour intensive production process), or with 100 machines and 50
workers (capital intensive production process).
 Therefore, for any given level of TPP, firms must determine the input mix which
minimises their TC. © Dr. Sylvain Hours | econdoctor.com
LONG-RUN AVERAGE TOTAL COST
 The Long-Run Average Total Cost (LRATC) curve shows the lowest possible
ATC for any given level of output, when all FoP are variable.
 In other words, the LRATC curve shows the relationship between output and ATC,
when the SR fixed quantity of capital has been chosen optimally for each level of
output.
 The level of output at which the LRATC reaches its minimum is called the Minimum
Efficient Scale (MES).

LONG-RUN AVERAGE TOTAL COST
 In order to be Productively Efficient (PE) in the LR, firms must operate at the MES.
 Remark: According to certain sources, all points that lie on the LRATC are
productively efficiency (i.e. Cost Efficiency + Technical Efficiency)
 For any given level of output, the LRATC curve is tangential to the SRATC curve
associated with the fixed quantity of capital which is optimal when producing this
particular level of output.
 Nb: SRATC curves are not tangential to the LRATC curve at their minimum unless
at the MES.

SRATC VS LRATC
AVERAGE
TOTAL
COST SRATCk1
LRATC
𝑆 𝑅𝐴 𝑇𝐶 𝑘 (𝑞 1)
1
𝐿 𝑅𝐴𝑇𝐶 (𝑞1 )
QUANTITY
𝑞1
SRATC VS LRATC
AVERAGE
TOTAL
COST SRATCk1
LRATC
𝑆 𝑅𝐴 𝑇𝐶 𝑘 (𝑞 2)
1
𝐿 𝑅𝐴𝑇𝐶 (𝑞2 )
QUANTITY
𝑞2
SRATC VS LRATC
AVERAGE
TOTAL
COST SRATCk1
LRATC
QUANTITY
𝑞3
SRATC VS LRATC
AVERAGE
TOTAL
COST
SRATCk1 SRATCk4
SRATCk2 SRATCk3
LRATC
QUANTITY
𝑞1 𝑞2 𝑞3 𝑞4
SRATC VS LRATC
AVERAGE
TOTAL
COST
SRATC1 SRATC3
SRATC2
QUANTITY

SRATC VS LRATC
AVERAGE
TOTAL
COST
LRATC
QUANTITY

SRATC VS LRATC
AVERAGE
TOTAL SRATC1
SRATC6
COST SRATC2 SRATC5
SRATC4
SRATC3
QUANTITY

SRATC VS LRATC
AVERAGE
TOTAL LRATC
COST
QUANTITY

LRATC & LRMC
COSTS
LRMC LRATC
QUANTITY
MES

BEN’S CAR FACTORY
 Ben is an entrepreneur who intends to open car factory.
 Cars are produced by using machines and workers.
 Workers and machines are assumed to be substitutable.
 That is, cars can be produced with either many workers and few machines, or
with many machines and few workers.
 Ben determines that the cost-minimising input mix is 2 workers for 1 machine
so the optimal capital intensity is equal to 1 / 2.

BEN’S CAR FACTORY
 Therefore, it is when hiring workers and machines in this proportion that Ben will
be able to produce any given level of output at minimum ATC.
 Any capital intensity that differs from 1 / 2 is cost-inefficient and will be

associated with a higher ATC.
 Ben carries out a market research and concludes that his car factory needs to
produce 100 cars per day.
 In order to produce this daily output, he hires 100 workers and 50 machines.
 Therefore, the FoP are used in a cost-efficient way so Ben can produce 100
cars per day at minimum ATC.

BEN’S CAR FACTORY
 Let us assume that Ben’s market research is accurate, so his factory actually
needs to produce 100 cars per day?
 In the SR, Ben produces these 100 cars per day with the 100 workers and the 50
machines that he initially hired.
 In that case, the input-mix is cost-efficient, meaning that he produces these 100
cars per day at minimum ATC.
 In the LR, and assuming that Ben’s factory still needs to produce 100 cars per day,
Ben will NOT adjust the input mix because the SR combination of workers and
machines is already cost-efficient.
 Therefore, Ben’s ATC in the SR is equal to its ATC in the LR because the number
of machines that he used in the SR is optimal (i.e. capital is used efficiently).
BEN’S CAR FACTORY
COSTS
SRATC50
LRATC
A
20
NUMBER
100 OF CARS

BEN’S CAR FACTORY
 But what if Ben’s market research turns out to be inaccurate?
 For example, what if the demand for his cars is lower than he expected, so Ben’s
factory only needs to produce 75 cars per day?
 In the SR, Ben cannot change the number of machines that he uses so the only
way to reduce production is to lay off some workers.
 Let’s say he lays off 50 workers, so the capital intensity is now equal to 1.
 In that case, the input-mix is cost-inefficient, meaning that he fails to produce

these 75 cars per day at minimum ATC.

BEN’S CAR FACTORY
Ben will adjust the input-mix in order to restore cost-efficiency.
 For example, Ben may decide to produce the daily output of 75 cars with 80
workers and 40 machines.
 The optimal capital intensity is restored, so Ben produces 75 cars per day at
minimum ATC.
 Overall, Ben’s ATC is higher in the SR than in the LR because the number of
machines that he used in the SR is too large (i.e. capital is under-utilized).
 Indeed, the number of machines that he uses in the SR is optimal to produce 100
cars per day, but he only produces 75 cars per day.
BEN’S CAR FACTORY
COSTS
SRATC40
B
50 SRATC50
LRATC
32
C
A
20
NUMBER
75 100 OF CARS

BEN’S CAR FACTORY
 Let us now consider the opposite case.
 What if the demand for his cars is higher than he expected, so Ben’s factory needs
to produce 125 cars per day?
 In the SR, Ben cannot change the number of machines that he uses so the only
way to reduce production is to hire extra workers.
 Let’s say he hires 50 extra workers, so the capital intensity is now equal to 1 / 3.
 In that case, the input-mix is cost-inefficient, meaning that he fails to produce

these 125 cars per day at minimum ATC.

BEN’S CAR FACTORY
Ben will adjust the input-mix in order to restore cost-efficiency.
 For example, Ben may decide to produce this daily output of 125 cars with 120
workers and 60 machines.
 The optimal capital intensity is restored, so Ben produces these 125 cars per day
at minimum ATC.
 Overall, Ben’s ATC is higher in the SR than in the LR because the number of
machines that he used in the SR is too small (i.e. capital is over-utilized).
 Indeed, the number of machines that he uses in the SR is optimal to produce 100
cars per day, but he produces 125 cars per day.
BEN’S CAR FACTORY
COSTS
SRATC60
SRATC50
D LRATC
35
22
20 E
A
NUMBER
100 125 OF CARS

RETURNS TO SCALE
 The concept of returns to scale describes the LR relationship between a
percentage increase in all inputs, and the resulting percentage increase in
output.
 Let X be the percentage increase in all inputs, and Y be the resulting percentage
increase in output.
 If X > Y, then the firm experiences Decreasing Returns to Scale (DRS).

 A percentage increase in all inputs will bring about a smaller percentage change in output.
 If X = Y, then the firm experiences Constant Returns to Scale (CRS).

 A percentage increase in all inputs will bring about an equal percentage change in output.
 If X < Y, then the firm experiences Increasing Returns to Scale (IRS).

 A percentage increase in all inputs will bring about a larger percentage change in output.
INTERNAL ECONOMIES & DISECONOMIES OF SCALE
 Internal Economies of Scale (IEoS) is a situation where the LRATC decreases
with output.
 Internal Diseconomies of Scale (IDoS) is a situation where the LRATC

increases with output.
 IEoS and IDoS are associated with movements along the LRATC curve.
 Remark: The concept of returns to scale relates a change in inputs to a change

in output, whereas the concepts of IEoS and IDoS relate a change in output to a
change in the per-unit cost of production.

INTERNAL ECONOMIES & DISECONOMIES OF
SCALE
COSTS
LRATC
INTERNAL INTERNAL
ECONOMIES DISECONOMIES
OF SCALE OF SCALE
QUANTITY
MES

CAUSES OF INTERNAL ECONOMIES OF SCALE
 Technical economies: Larger firms are able to use more efficient techniques
of production.
 Technical economies can be the result of:

 The division of labour (i.e. specialisation increases labour productivity)
 The use of specialist capital machinery (e.g. industrial oven, industrial assembly
press, etc.)
 The Law of increased dimensions (e.g. doubling the height and width of a tanker or
building more than doubles increase in its cubic capacity).

CAUSES OF INTERNAL ECONOMIES OF SCALE
 Managerial economies: The employment of specialised staff to supervise
production systems, to manage marketing systems and to oversee human
resources.
 Financial economies: Large firms have access to a wider range of sources of

finance, and on more preferential terms.
 Purchasing economies: Bulk buying of inputs
 Marketing economies: Spreading the fixed cost of advertising over a large level
of output

CAUSES OF INTERNAL DISECONOMIES OF SCALE
 Costly and time-consuming communication
 Duplication of effort
 Geographically dispersed organisation
 Office politics (i.e. management behaviour which is not in the best interest of the
company, but in the personal best interest of the manager)
 Lack of motivation (i.e. workers may feel alienated, isolated and not appreciated)
 Difficulty to coordinate production and to monitor performance

EXTERNAL ECONOMIES & DISECONOMIES OF SCALE
 External Economies of Scale (EEoS) is a situation where the LRATC of all the
firms in an industry decreases as a direct consequence of the growth of that
industry.
 External Diseconomies of Scale (EDoS) is a situation where the LRATC of all

the firms in an industry increases as a direct consequence of the growth of
that industry.

EXTERNAL ECONOMIES & DISECONOMIES OF SCALE
 EEoS and EDoS occur outside a firm but within an industry.
 EEoS and EDoS affect all the firms in an industry regardless of their size.
 EEoS (resp. EDoS) lead to decrease (resp. increase) in LRATC at every level of
output.
 EEoS and EDoS are associated with shifts of the LRATC curve.
 EEoS may be one reason for the trend towards the clustering of businesses in
the same geographical area (e.g. Silicon Valley).

CAUSES OF EXTERNAL ECONOMIES OF SCALE
 Investment in better transport or telecommunication infrastructures
 Development of R&D facilities in local universities
 Relocation of component suppliers and other support businesses
 Availability of a pool of skilled labour

CAUSES OF EXTERNAL DISECONOMIES OF SCALE
 Congestion of transportation infrastructure
 An increase in the price of land & labour, as a result of an increased demand for
inputs.
 A fall in the productivity of land & labour, as a result of higher levels of local
pollution.

EXTERNAL ECONOMIES & DISECONOMIES OF
SCALE
LRATC2
COSTS
EXTERNAL LRATC1
DISECONOMIES
OF SCALE
LRATC3
EXTERNAL
ECONOMIES
OF SCALE
QUANTITY

PART 3
REVENUE CURVES

TOTAL & AVERAGE REVENUE
 The Total Revenue (TR) is the revenue received by a firm from its sales.
 TR is simply equal to price at which each unit is sold, multiplied by the quantity
sold.
TR = P x Q
 Example: If Maria sells 10 bouquets of flowers at a price of $25, then her TR is

equal to $250.
 The Average Revenue (AR) is the revenue received by a firm per unit of
output.
 The AR is equal to the TR divided by the quantity sold.

TOTAL & AVERAGE REVENUE
 It follows that the AR is simply equal to the price at which a firm sells its output.
AR = TR / Q = P
 Example: If Maria sells 10 bouquets of flowers at a price of $25, then her AR is

equal to $25, the price of each bouquet.
 The AR is equal to the slope of the line drawn from the origin to the TR curve.
 Since a demand curve shows the price at which a firm can sell any given level of
output (i.e. the demand price), the AR curve is simply the demand curve.
AR = D

AVERAGE REVENUE & DEMAND CURVE
PRICE
𝑝 1= 𝐴𝑅(𝑞 1)
D = AR
QUANTITY
𝑞1

MARGINAL REVENUE
 The Marginal Revenue (MR) refers to the change in TR generated by the sale
of the last unit of output.
 Example: If Maria receives a TR of $100 when selling 2 bouquets of flowers and

a TR of $140 when selling 3 bouquets, then the MR of the third bouquet is equal
to $40.
 The MR is equal to the slope of the TR curve.
 Therefore, the TR increases when the MR is positive, and vice versa.

TR, AR & MR
REVENUE TR
TR(Q1)
MR(Q1)
AR(Q1)
QUANTITY
Q1

AVERAGE VS MARGINAL REVENUE
 In the case of a downward sloping demand curve, the MR is smaller than the
AR (i.e. MR < AR).
 This is because the firm must decrease the price of all units in order to sell
each additional unit of output.
 On the one hand, each additional unit sold increases the firm’s TR by an
amount equal to the AR (i.e. the lower price at which the firm now sells its
output).
 One the other hand, each additional unit sold decreases the firm’s TR by an
amount equal to the price decrease multiplied by the quantity initially sold.
 Overall, the change in TR (i.e. the MR) is smaller than the AR.
AVERAGE, MARGINAL AND TOTAL REVENUE
REVENUE
AR(2) = 6
TR(2) = $12
D = AR
QUANTITY
2

REVENUE
AR(2) = 6
AR(3) = 5
TR(3) = $15
D = AR
QUANTITY
2 3

REVENUE
MR(3) = TR(3) - TR(2) = $15 - $12 = $3 < AR(3) = $5

AR(2) = 6
AR(3) = 5
LOSS
IN TR
(-$2)
GAIN
IN TR D = AR
(+$5)
QUANTITY
2 3

REVENUE
AR(3) = 5
AR(4) = 4
TR(4) = $16
D = AR
QUANTITY
3 4

REVENUE
MR(4) = TR(4) - TR(3) = $16 - $15 = $1 < AR(4) = $4
AR(3) = 5
AR(4) = 4
LOSS
IN TR
(-$3) GAIN
IN TR D = AR
(+$4)
QUANTITY
3 4

REVENUE
AR(4) = 4
AR(5) = 3
TR(5) = $15 D = AR
QUANTITY
4 5

REVENUE
MR(5) = TR(5) - TR(4) = $16 - $16 = -$1 < AR(5) = $3
LOSS
IN TR
(-$4)
AR(4) = 4
AR(5) = 3
GAIN
IN TR D = AR
(+$3)
QUANTITY
4 5

REVENUE
6
5
4
3
2
1 D = AR
0 QUANTITY
2 3 4 5
-1
MR

REVENUE
16
15
TR
12
0 QUANTITY
2 3 4 5

AVERAGE & MARGINAL REVENUE: LINEAR
DEMAND
 In the case of a linear demand (i.e. a demand represented by a straight line):
 The AR and MR curves have the same vertical intercept.
 The MR is also linear.
 The MR curve is twice steeper than the AR curve.

AVERAGE & MARGINAL REVENUE: LINEAR DEMAND
REVENUE
𝑎
D = AR
𝟐𝒃 𝒃
QUANTITY
𝑎/2 𝑏 𝑎/𝑏
MR
PED & TOTAL REVENUE
R
REMINDERS
 On the one hand, an increase in price means that each unit sold generates
more revenue (i.e. « the good news »).
 On the other hand, an increase in price means that fewer units are sold (i.e.
« the bad news »).
 Overall, the resulting change in TR depends on the relative size of both

effects.
 Simply put, if the increase in price leads to a small decrease in the quantity
demanded, then TR will rise, and if the increase in price leads to a large
decrease in the quantity demanded, then TR will fall.

PED & TOTAL REVENUE R
REMINDERS
 If demand is price-inelastic, then the increase in price will bring about a less than
proportional decrease in the quantity demanded, and so TR will rise.
TR = P x Q
 If demand is price-elastic, then the increase in price will bring about a more than
proportional decrease in the quantity demanded, and so TR will fall.
TR = P x Q
 If demand is unit-elastic, then the increase in price will bring about an equal
proportional decrease in the quantity demanded, and so TR will remain
constant.
TR = P x Q

REMINDERS
 Let us now consider the case of a decrease in price.
 On the one hand, a decrease in price means that each unit sold generates less
revenue (i.e. « the bad news »).
 On the other hand, a decrease in price means that more units are sold (i.e. « the
good news »).
 Overall, the resulting change in TR depends on the relative size of both

effects.
 Simply put, if the decrease in price leads to a small increase in the quantity
demanded, then TR will fall, and if the decrease in price leads to a large increase
in the quantity demanded, then TR will rise.
REMINDERS
 If demand is price-inelastic, then the decrease in price will bring about a less than
proportional increase in the quantity demanded, and so TR will fall.
TR = P x Q
 If demand is price-elastic, then the decrease in price will bring about a more than
proportional increase in the quantity demanded, and so TR will rise.
TR = P x Q
 If demand is unit-elastic, then the decrease in price will bring about an equal
proportional increase in the quantity demanded, and so TR will remain constant.
TR = P x Q

AVERAGE, MARGINAL & TOTAL REVENUE
REVENUE
|PED|
|P
ED
|>
1 |PED| = 1
|P
ED
|<
1
TR
D = AR |PED| = 0
QUANTITY
MR
PERFECTLY PRICE-ELASTIC DEMAND
 As we shall see, the individual demand curve of a perfectly competitive firm is
perfectly price-elastic at the prevailing market price.
 In that case, the firm does not need to cut the price to sell more output.
 Therefore, each additional unit increases TR by an amount equal to the AR (i.e.

the prevailing market price).
 In other words, the MR is equal to the AR.
MR = AR
 It follows that the TR of a firm facing a perfectly-price elastic demand is linear

and increasing.
REVENUE
10 D = AR
TR(2) = $20
QUANTITY
2

REVENUE
10 D = AR
TR(3) = $30
QUANTITY
2 3

REVENUE
LOSS
IN TR MR(3) = TR(3) - TR(2) = $30 - $20 = $10 = AR(3)
($0)
10 D = AR
GAIN
IN TR
(+$10)
QUANTITY
2 3

REVENUE
TR
𝑝0 D = AR = MR
𝒑𝟎
QUANTITY

PART 4
PROFIT

PROFIT
 Profit () is the difference between Total Revenue (TR) and Total Cost (TC).
= TR - TC
 The definition of TR is straightforward (i.e. TR = P x Q).
 However, TC can be defined in 2 ways depending on the nature of the costs that
are included.
 Indeed, a cost can either be explicit or implicit.

EXPLICIT VS IMPLICIT COSTS
 An Explicit Cost (EC) is a direct payment to the owner of a resource (i.e. rent,
wage, interest, profit).
 Important remark: Depreciation (i.e. the loss in value of an asset due to wear and
tear and/or the passing of time) is considered an EC.
 An Implicit Cost (IC) is an opportunity cost incurred by a producer when using

a resource that it owns.
 In other words, the IC incurred by a producer when using a resource that it

owns is equal to the lost benefit of the next best use of that resource.

IMPLICIT COSTS
 IC of land
 Example: If I use a piece of land that I own to produce potatoes, then I give up the money
that I could have received if I had sold it instead.
 IC of capital
 Example: If I use a wharehouse that I own to store my inventory, then I give up the money
that I could have received if I had rented it instead.
 IC of labour
 Example: If I use my workforce to study in college, then I give up the income that I could
have earned if I had taken a job instead.
 IC of entrepreneurship
 Example: If I use my entrepreneurial skills to run Business A, then I give up the profit that I
could have made by running Business B instead.
ACCOUNTING VS ECONOMIC PROFIT
 The Accounting profit of a firm () is the difference between the TR it receives
from its sales, and the total explicit costs that it incurs.
= TR - EC
 The economic profit of a firm () is the difference between the TR it receives

from its sales, and the total explicit as well as implicit costs that it incurs.
= TR - (EC + IC) = - IC
 A firm’s decision on how much to produce should be based on economic

profit, not accounting profit.
 From now on, unless stated otherwise, the term profit will be used be refer to
economic profit.
NORMAL PROFIT
 Normal profit () is the implicit cost of entrepreneurship.
 Let us call “Gross Economic Profit” (), the profit made by the entrepreneur once
all costs have been subtracted, apart from normal profit.
 Basically, “Gross Economic Profit” is the economic profit left to the

entrepreneur (i.e. what the entrepreneur makes).
 It follows that normal profit is equal to the Gross Economic Profit that the
entrepreneur would have made in its next best alternative business.

NORMAL PROFIT
 If an entrepreneur makes normal profit (i.e. ), then the firm’s economic profit is
zero ().
 An entrepreneur making normal profit earns just enough to carry on with the
business.
 In other words, the entrepreneur would be neither better off nor worse off if
he/she instead decided to run his/her next best alternative business.
 It follows that normal profit can be regarded as the entrepreneur's transfer

earnings, the minimum payment required to keep a FoP in its present use.

ABNORMAL PROFIT
 When an entrepreneur makes more than normal profit (i.e. ), the amount of
Gross Economic Profit above normal profit is known as abnormal profit or
supernormal profit.
 If an entrepreneur makes abnormal profit, then the firm’s economic profit is

strictly positive (i.e. ).
 An entrepreneur making abnormal profit earns more than enough to carry on

with the business.
 In other words, the entrepreneur would be worse off if he/she instead decided to
run his/her next best alternative business.
 It follows the present use of his/her entrepreneurial skills is optimal.

SUBNORMAL PROFIT
 When an entrepreneur makes less than normal profit (i.e. ), the amount of Gross
Economic Profit below normal profit is known as subnormal profit.
 If an entrepreneur makes subnormal profit, then the firm’s economic profit is

strictly negative (i.e. ).
 An entrepreneur making abnormal profit earns less than enough to carry on

with the business.
 In that case, the entrepreneur would be better off if he/she instead decided to run
his/her next best alternative business.
 It follows the present use of his/her entrepreneurial skills is not optimal.

JOE’S FARM
 Consider Joe, a farmer who owns a field and a tractor.
 He can either use these resources to produce wheat or to produce corn.
 If Joe chooses to produce wheat:

 He receives a TR of $12,000.
 He must pay $2,000 in wages to the agricultural workers he hired.
 He must purchase for $2,000 of intermediate goods from other businesses (e.g.
seeds, fertilizers, etc.).

JOE’S FARM
 If Joe chooses to produce corn:
 He receives a TR of $20,000.
 He must pay $5,000 in wages to the agricultural workers he hired.
 He must purchase for $8,000 of intermediate goods from other businesses (e.g.
seeds, fertilizers, etc.).
 In both cases, his tractor loses $1,000 of its value as it wears out and is used up.
 Finally, when Joe uses his field and his tractor to produce either wheat or corn,
he gives up $4,000, the amount that he would have received if he had instead
rented the resources that he owns.

JOE’S FARM
 Joe’s accounting profit when he chooses to produce wheat:
= $12,000 - (2,000 + 2,000 + $1,000) = $7,000
 Joe’s accounting profit when he chooses to produce corn:
= $20,000 - (5,000 + 8,000 + $1,000) = $6,000
 Therefore, an accountant would tell Joe that he should produce wheat rather than
corn (i.e. higher accounting profit), but would regard both activities as
profitable (i.e. both activities generate a positive accounting profit).

JOE’S FARM
 Joe’s Gross economic profit when he chooses to produce wheat:
= - $4,000 = $7,000 - $4,000 = $3,000
 Therefore, Joe makes $3,000 when he chooses to produce wheat.
 Joe’s Gross economic profit when he chooses to produce corn:
= - $4,000 = $6,000 - $4,000 = $2,000
 Therefore, Joe makes $2,000 when he chooses to produce corn.

JOE’S FARM
 If Joe chooses to produce wheat, then his normal profit is equal to $2,000, the
profit that he would have made if he had produced corn instead.
= = $2,000
 If Joe chooses to produce corn, then his normal profit is equal to $3,000, the
profit that he would have made if he had produced wheat instead.
= = $3,000
 Joe’s economic profit when he chooses to produce wheat:
= - = $3,000 - $2,000 = $1,000 > 0

JOE’S FARM
 Joe makes abnormal profit when he chooses to produce wheat (i.e. he makes
$3,000, which is more than the $2,000 of normal profit, so his farm’s economic
profit is positive).
 Joe’s economic profit when he chooses to produce corn:
= - = $2,000 - $3,000 = - $1,000 < 0
 Joe makes subnormal profit when chooses to produce corn (i.e. he makes
$2,000, which is less than the $3,000 of normal profit, so his farm’s economic
profit is negative).
 Therefore, an economist would tell Joe that he should produce wheat rather than
corn (i.e. higher economic profit), and would not regard corn production as a
profitable activity (i.e. negative economic profit).
BREAK EVEN POINT
 A level of output at which TR = TC (or equivalently P = AR = ATC) is known a
Break-Even Point (BEP).
 The demand price of a BEP is known as a break-even price.
 The economic profit of a firm that operates at a BEP is equal to zero (i.e. the
entrepreneur makes normal profit so the firm breaks-even).
 The economic profit of a firm that operates at a level of output such that TR > TC
(or equivalently AR = P > ATC) is strictly positive (i.e. the entrepreneur makes
abnormal profit, and so the firm enjoys an economic profit).
 The economic profit of a firm that operates at a level of output such that TR < TC
(or equivalently AR = P < ATC) is strictly negative (i.e. the entrepreneur makes
subnormal profit, and so the firm incurs an economic loss).

PROFIT MAXIMISATION
 In any market structure, profit is maximised at the level of output Q* where
the MR is equal to the MC.
Q* : MC* = MR*
 This condition is known as the optimum output rule.
 In that case, indeed, the difference between TR and TC is the largest.
 Nb: This first-order condition is necessary but not sufficient, and so we need a
second-order condition to ensure that profit is maximised and not minimised.

PROFIT MAXIMISATION
TR / TC TC
TR
QUANTITY
BEP

PROFIT MAXIMISATION
TR / TC TC
TR
MR1 > MC1

𝑇 𝑅1
𝑀 𝑅1
A MARGINAL INCREASE IN
Π1 OUTPUT WILL LEAD TO
AN INCREASE IN PROFIT
𝑇 𝐶1 𝑀 𝐶1
QUANTITY
𝑞1

PROFIT MAXIMISATION
TR / TC TC
TR
𝑇 𝑅2 𝑀 𝑅2
Π2
MR2 < MC2
𝑇 𝐶2
𝑀 𝐶2 A MARGINAL DECREASE
IN OUTPUT WILL LEAD TO
QUANTITY
𝑞2

PROFIT MAXIMISATION
TR / TC TC
TR
∗
𝑇𝑅 ∗
𝑀𝑅 MR* = MC*
∗
Π A MARGINAL CHANGE IN
OUTPUT WILL LEAVE
PROFIT UNCHANGED
∗
𝑇𝐶 ∗
𝑀𝐶
QUANTITY
∗
𝑞
PROFIT MAXIMISATION
MR / MC MC
MR1 > MC1
A MARGINAL INCREASE IN
OUTPUT WILL LEAD TO
𝑀 𝐶1
MR
QUANTITY
𝑞1

PROFIT MAXIMISATION
MR / MC MC
MR2 < MC2
A MARGINAL DECREASE
IN OUTPUT WILL LEAD TO
𝑀 𝐶2
MR
QUANTITY
𝑞2

PROFIT MAXIMISATION
MR / MC MC
MR* = MC*
∗ ∗
𝑀 𝐶 =𝑀 𝑅 A MARGINAL CHANGE IN
OUTPUT WILL LEAVE
PROFIT UNCHANGED
MR
QUANTITY
∗
𝑞
PROFIT MAXIMISATION
TC
TR / TC
TR
∗
𝑇𝑅 𝑀𝑅
∗
∗
Π
∗
𝑇𝐶 𝑀𝐶
∗
QUANTITY
MR / MC MC
∗ ∗
𝑀 𝐶 =𝑀 𝑅
MR
∗
QUANTITY
𝑞
PROFIT MAXIMISATION
COST /
REVENUE MC
ATC
∗
𝑝
∗
𝐴𝑇𝐶
∗ ∗
D = AR
TR*
∗
QUANTITY
𝑞
MR

PROFIT MAXIMISATION
COST /
REVENUE MC
ATC
∗
𝑝
∗
𝐴𝑇𝐶
∗ ∗
D = AR
TC*
∗
QUANTITY
𝑞
MR

PROFIT MAXIMISATION
COST /
REVENUE MC
ATC
∗
𝑝
∗
𝚷∗
𝐴𝑇𝐶
∗ ∗
D = AR
∗
QUANTITY
𝑞
MR

PRACTICE TIME!
 Task: Fill in the following table and compute the profit-maximising level of output.
Q TR MR TC MC MR - MC
0 0 20
1 15 24
2 30 30
3 45 38
4 60 48
5 75 60
6 90 74
7 105 90
8 120 108
9 135 128
10 150 150

7.5 - Types of Cost, Revenue and Profit, Short-Run and Long-Run Production (S)

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COURSE: A LEVEL ECONOMICS (9708)

CHAPTER: 7 - The Price System and the Microeconomy

© Dr. Sylvain Hours | econdoctor.com

PRODUCTION IN THE SHORT-RUN

© Dr. Sylvain Hours | econdoctor.com

 In other words, what is fixed (i.e. cannot be changed) in a shorter period of

© Dr. Sylvain Hours | econdoctor.com

 To simplify, we usually consider 2 FoP only: labour and capital.

 Question: How long is the SR?

LABOUR FIXED VARIABLE VARIABLE VARIABLE

CAPITAL FIXED FIXED VARIABLE VARIABLE

ENVIRONMENT FIXED FIXED FIXED VARIABLE

© Dr. Sylvain Hours | econdoctor.com

 There are only 2 FoP: Capital & Labour.

 The firm produces a single good or service.

 We are in the SR so the quantity of labour is

 Labour is homogeneous (i.e. all workers

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 A production function is a technical relationship between inputs and outputs,

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 It is equal to the TPP divided by the number of workers.

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 The Marginal Physical Product of Labour (MPPL) is equal to the change in

 Example: If PAUL, a French bakery, produces 100 croissants with 10 workers,

© Dr. Sylvain Hours | econdoctor.com

© Dr. Sylvain Hours | econdoctor.com

© Dr. Sylvain Hours | econdoctor.com

 Indeed, beyond a certain threshold, the fixed quantity of capital becomes

© Dr. Sylvain Hours | econdoctor.com

 In other words, the TPP curve increases at a decreasing rate.

 When this happens, the employment of each additional worker results in a

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 The MPPL is often assumed to be increasing at first (i.e. increasing returns).

 Intuition: At low levels of employment, labour productivity is likely to be

 In that case, the TPP curve increases at an increasing rate.

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 He works alone, and so he has to complete many different tasks:

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 Rick then decides to hire his grandson Morty.

 Rick specialises in the tasks he is best at:

 Morty specialises in the tasks he is best at:

 Therefore, the MPPL has increased from 50 to 70 pizzas per day.

 In other words, Rick’s pizza truck benefits from increasing returns.

 This is because specialisation increases labour productivity, the pizza truck

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 Rick specialises in the task he is best at:

 Morty specialises in the tasks he is best at:

 Summer specialises in the tasks she is best at:

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 Therefore, the MPPL has decreased from 70 to 60 pizzas per day.

 In other words, Rick’s pizza truck starts to experience diminishing returns.

© Dr. Sylvain Hours | econdoctor.com

© Dr. Sylvain Hours | econdoctor.com

 Rick specialises in the task he is best at:

 Morty specialises in the task he is best at:

 Summer specialises in the tasks she is best at:

 Jerry specialises in the tasks he is best at:

 Therefore, the MPPL has decreased from 60 to 20 pizzas per day.

 In other words, Rick’s pizza truck continues to experience diminishing

© Dr. Sylvain Hours | econdoctor.com

© Dr. Sylvain Hours | econdoctor.com

 Each family member now completes one single task.

 Rick prepares and cooks the pizzas.