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Table of Contents

  1. Topic pack - Microeconomics - introduction
  2. 1.1 Competitive Markets: Demand and Supply
  3. 1.1 Competitive Markets: Demand and Supply - notes
  4. 1.1 Competitive markets - questions
  5. 1.1 Competitive markets - simulations and activities
  6. 1.2 Elasticities
  7. 1.2 Elasticities - notes
  8. Section 1.2 Elasticities - questions
  9. Section 1.2 Elasticities - simulations and activities
  10. 1.3 Government intervention
  11. 1.3 Government Intervention - notes
  12. 1.3 Government intervention - questions
  13. 1.3 Government intervention - simulations and activities
  14. 1.4 Market failure
  15. 1.4 Market failure - notes
  16. Section 1.4 Market failure - questions
  17. Section 1.4 Market failure - simulations and activities
  18. 1.5 Theory of the firm
  19. 1.5 Theory of the firm - notes (HL only)
    1. Cost theory
    2. Calculating costs
    3. Short-run
    4. Long-run
    5. Internal economies of scale
    6. External economies of scale
    7. Diseconomies of scale
    8. Long run cost curves
    9. The very long run
    10. Revenues
    11. Revenues - notes
    12. Profit
    13. Profit - notes
    14. Combining revenue and cost curves
    15. Profit maximisation - price taker
    16. Profit maximisation - price setter
    17. Alternative aims of firms
    18. Profit, sales and revenue maximisation
    19. Perfect competition
    20. Perfect competition - notes
    21. Short-run to long-run - profits
    22. Short-run to long-run - losses
    23. Shut down price, break-even price
    24. Efficient allocation of resources
    25. Monopoly and oligopoly
    26. Monopoly and oligopoly - introduction
    27. Growth and power
    28. The model of monopoly
    29. Monopoly - profit maximisation
    30. Monopoly equilibrium
    31. Monopoly v. perfect competition
    32. Economic efficiency in perfect competition
    33. Economic efficiency in perfect competition and monopoly
    34. Efficiency and market structure
    35. Monopolistic competition
    36. Monopolistic competition - notes
    37. Monopolistic competition in the short-run
    38. Monopolistic competition in the long run
    39. Oligopoly
    40. Oligopoly - notes
    41. Advertising and branding
    42. Product innovation
    43. Theories of oligopoly - non-collusive
    44. The kinked demand curve theory
    45. Kinked demand curve - change in cost
    46. Cut-price competition (predatory pricing)
    47. Theories of oligopoly - collusive
    48. Forms of collusion
    49. Price discrimination
    50. Equilibrium of the discriminating monopolist
  20. Section 1.5 Theory of the firm - questions
  21. Section 1.5 Theory of the firm - simulations and activities
  22. Print View


It is important to know the difference between the short run and the long run. The law of diminishing returns is a short run law. Economies and diseconomies of scale occur in the long run.


Short run

The short run is the period of time in which at least one factor of production is fixed. Over this time period the firm can only expand production by using more of the variable factor.


Long run

The long run is the period of time when all factor inputs, including capital, can be changed.

You need to remember these as the time period makes a big difference to how the firm can react to changes in circumstances. In the short-run their capacity is fixed and so all they can do is employ more variable factors. They cannot expand the scale or size of the firm. In the long-run though they can. We put the word scale in bold just now because it is important - economies of scale will only arise in the long-run. In the short-run we get diminishing returns to a factor (because the firm can only change the variable factor).

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This theory supports the shape of the marginal and average cost curves. Both of these curves will be u-shaped as eventually diminishing returns will lead to costs increasing. Initially increasing returns mean that both AC and MC will fall, but once diminishing returns set in both curves start to rise again. The MC and AC curves are shown in Figures 2 and 3, although we will return to these in more detail in the next section.


Figure 2 Marginal cost curve


Figure 3 Average cost curve

The marginal cost curve will intersect the average cost curve at its minimum point.

The actual position of the AC curve will vary with a number of factors.

  • Costs of factor inputs (labour, materials, services etc). The cheaper the inputs the lower the average cost will be at any given output.
  • Productivity - productivity can be defined as output per unit input. The more productive the firm, the more output it gets from its inputs and the lower the average cost at any output.

Productivity is measured in a number of ways:

  • Marginal product (MP) - the change in total output resulting from the adding of one extra unit of a variable factor, often labour.
  • Average product (AP) - total output / units of variable factor being used.

The choice of factor inputs will be driven by their costs, productivity and effect on product cost. An efficient firm will make its choices so as to minimise its average cost at the production rate being worked. Look at the following example.



Student Computers make DVD drives. Its average cost curve is shown in figure 4 below.


Figure 4 Average cost curve for Student Computers on 1st May 2002

The following then takes place:

Business rates increase (fixed costs (FC))
Insurance premiums rise (FC)
Wage rates (variable costs (VC)) and salaries (FC) increase

This will change the cost curves. The curve will move upwards due to the increase in fixed costs. The average cost of production at the present output will rise from C1 to C2. Unless something is done about it, the profits will fall.


Figure 5 Average cost curves for Student Computers on date 1

In response to these changes the research and development department introduces new materials that are cheaper to buy than the old ones. They also introduce new working practices and procedures that increase productivity considerably. The savings are shared between the firm and its employees. This all reduces variable costs and the AC curve falls again. Now the production average cost, at C3, is lower than before.


Figure 6 Average cost curves for Student Computers on date 2

The firm has responded to rises in certain costs by taking steps to reduce others.