1. IB
Economics
Econ 2.3
Theory of the Firm (HL only)
Extract from Powerpoint Notes
ISS International School Singapore
Andrew McCarthy ©

2. Diminishing returns for a producer
 The short run is defined
as period of time in
which some resources
used in the production
process are fixed and
cannot be changed.
 In the long run all
factors are variable
including level of
capital employed.

3. Law of Diminishing Marginal Returns
Concepts
 Total product This is the quantity of output produced by a
given number of workers over a given period of time.
Remember the amount of capital (or machines) is fixed.
 Average product This is the quantity of output per unit of
input. In this model, the input is labour. In other words, we
are dealing with the output per worker, on average.
 Marginal product The addition to total output produced by
one extra unit of input (again, labour). It is the extra output
produced at the margin (i.e. by adding a marginal unit of
labour).

4. Law of Diminishing Returns
Example

5. Law of Diminishing Returns
Example

6. Law of increasing costs
 Any situation where the law of diminishing returns operates
so does law of increasing costs.
 To gain an extra unit of output will require a greater increase
in the amount of inputs As a greater number of inputs are
required you will have to pay for them.

7. Diminishing Marginal Returns
Law of Diminishing Costs
 The returns from extra inputs are falling
 The costs of gaining extra output are increasing
Add one more worker | gain less marginal output
Gain extra output | will cost more workers
For each increase in output| the marginal cost will increase

8. Law of increasing costs
Definitions
 Total cost (TC). This is the total cost to the firm of producing a given
number of units. This can be sub-divided. Total cost = total fixed costs
+ total variable costs (or TC = TFC + TVC). A cost is either fixed or
variable. There is no third group. If a cost is not fixed, then, by
definition, it must vary with output.
 Average cost (AC). This is the cost, on average, per unit of output
produced. If a firm made 100 bars of chocolate at a total cost of
£10, then the cost, on average, per bar of chocolate produced, is
10p. So, algebraically: It also follows that average cost = average
fixed cost + average variable cost (AC = AFC + AVC). This is derived
by simply dividing both sides of the total cost equation by Q.
Average cost is often called average total cost so as to distinguish it
from AFC and AVC.
 Marginal cost (MC). This is the additional cost incurred by a firm as a
result of producing one more unit of output. It is the extra cost at the
margin (i.e. by producing the marginal unit of output).

9. Graphing output and costs
COSTS PRODUCT
Data and Graphs and Definitions – sourced from
http://www.s-cool.co.uk/alevel/economics.html

10. Cost Curves
Bob the Builder example
 Total Costs
 To employ Bob to work the firm needs to pay $420
 Every additional worker also cost $420

11. Cost Curves
Bob the Builder example
 Total Product
 When Bob begins laying bricks he adds 70 to the wall
 When a second friend begins the total product increases to 210
bricks. Worker 6 adds less bricks

12. Cost Curves
Bob the Builder example
 Average Costs
 Because Bob is not very productive by himself the cost per brick
is very high at $6
 By adding extra workers the average cost per brick falls due to
increased efficiencies. Division of labour, specialisation etc.

13. Cost Curves
Bob the Builder example
 Marginal Costs
 If Bob’s boss wants to add one more brick to the fence he has to
pay a small amount. This is called the marginal cost.
MC per brick $ = (Total Cost now – Total Cost previous) / Marginal Product
MC (2) = (840 - 420) / 140 = $3 per brick
This is the cost of adding one more brick in dollars, at two workers

14. Cost Curves
Bob the Builder example
 Marginal Costs
 If Bob’s boss wants to add one more brick to the fence he has to
pay a small amount. This is called the marginal cost.
MC per brick $ = (Total Cost now – Total Cost previous) / Marginal Product
MC (2) = (840/420) / 140 = $3 per brick
This is the cost of adding one more brick in dollars, at two workers

15.  Fixed Costs
 The firm where Bob works needs
to pay some costs regardless of
the level of building that is
occurring.
 This are sometimes called sunk
costs
 Bobs firm must pay these fixed
costs.
• General Managers salary
• Lease the digger and crane
• Pay insurance
• Pay for a phone rental
Cost Curves
Bob the Builder example

16.  Average Fixed Costs
 These are calculated by dividing fixed costs by the output
of the firm. If Bobs firm makes two fences the AFC is $60
Cost Curves
Bob the Builder example

17.  Average Variable Costs
 These are the costs that increase as output increases.
 As quantity produced increases ….variable costs increase
 Bills that relate directly to level of output
 Eg. Cost of raw materials, wages, electricity bills, petrol
 Output / Variable Cost = Average Variable Cost

18.  Average Total Costs
 This is the sum of Variable Costs and Fixed Costs
 TC = FC + VC
 ATC = AFC + AVC
 ATC = TC / Output
Cost Curves
Bob the Builder example

19. Cost Curves
Bob the Builder example
 Bringing it all together… what do costs look like?
FC = constant
VC = increases with output
TC = increases with output
AFC = decreases with output
AVC = u shaped
ATC = u shaped
MC = u shaped but very steep at end

20. Cost Curves
Bob the Builder example
 Bringing it all together… what do costs look like?

21. Cost Curves
Bob the Builder example
 Marginal Cost curves… !!
Where does MC cross?
Cuts AVC at minimum
Cuts ATC at minimum
Increasing returns from 0 – 4
mean that MC must fall
Decreasing returns after 4
mean than MC must rise

22. Data and Graphs – sources from Geoff Evans (NZ Economics Textbook)