MICRO-ECONOMIC: THEORY AND APPLICATIONS

Chapter 1: An Introduction to Microeconomics

1.1 The Scope of Microeconomic Theory
Macroeconomics – the study of aggregate economic factors
Microeconomics – the study of the behavior of small economic units such as consumers
and firms
Price Theory – Another term for Microeconomics

1.2 The Nature and Role of Theory

1.3 Positive vs. Normative Analysis

Positive Analysis – assessment of expected objective outcomes
Normative Analysis – a nonscientific value judgment

1.4 Market Analysis and Real vs. Nominal Prices

Markets – the interplay of all potential buyers and sellers of a particular commodity or
service
Nominal Price – the absolute price, not adjusted for the changing value of money
Real Price – the nominal price adjusted for the changing value of money

1.5 Basic Assumptions About Market Participants

Goal Oriented Behavior – the behavior of market participants interested in fulfilling their
own, personal goals
Rational Behavior – the behavior of market participants based on a careful, deliberate process
that weighs expected benefits and costs
Scarce Resources – insufficient time, money, or other resources for individuals to satisfy all their
desires

1.6 Opportunity Costs

Explicit Costs – money used in the pursuit of a goal that could otherwise have been spent on an
alternative objective
Implicit Costs – costs associated with the individual’s use of his or her own time
Economic Cost (Opportunity Costs) – the sum of explicit and implicit costs
Accounting Costs – costs reported in companies’ net income statements generated by accountants
Sunk Costs – costs that have already been incurred and are beyond recovery

1.7 Production Possibility Frontier

Production Possibility Frontier (PPF) – a depiction of all the different combinations of goods
that a rational actor with certain personal goals can attain with a fixed amount of resources

Chapter 1 Summary
-Microeconomic theory is the branch of economics that begins with the study of the behavior of
individual economic units, primarily consumers and business firms
-Microeconomics considers how the decisions of individuals and firms are coordinated through
interactions in markets
-Economists make three assumptions about the behavior of market participants: It is goal
oriented, it is rational, and it is constrained by scarce resources
-Because scarce resources, market participants can’t fulfill their desires to the extent they would
like, and choices must therefore be made
-Whenever one alternative is chosen, an opportunity costs is involved
-A production possibility frontier (PPF) allows us to graphically depict the basic assumptions
made by economists about market participants, as well as the concept of opportunity costs

Chapter 2: Supply and Demand

2.1 Demand and Supply Curves
Law of Demand – the economic principle that says, the lower the price of a good, the larger the
quantity consumers wish to purchase
Normal Goods – those goods for which an increase in income leads to greater consumption
Inferior Goods – those goods whose consumption falls when income rises
Complements – two goods that tend to be consumed together, so consumption of both tends to
rise or fall together
Substitutes – goods that can replace one another in consumption
Tastes or Preferences – the feelings of consumers about the desirability of different goods
Movement Along a Demand Curve – a change in quantity demanded that occurs in response to a
change in price, other factors holding constant
Shift of a Demand Curve – a change in demand curve itself that occurs with a change in income,
in the price of a related good, or in tastes and affecting the quantity demanded at each possible
price
Law of Supply – the economic principle that says the higher the price of a good, the larger the
quantity firms want to produce
Movement Along a Supply Curve – a change in quantity supplied that occurs in response to a
change in the good’s selling price, others factors holding constant
Shift of a Supply Curve – a change in the supply curve itself that occurs when the other factors,
besides price, that affect output change

2.2 Determination of Equilibrium Price and Quantity

Equilibrium – a situation in which quantity demanded equals quantity supplied at the prevailing
price
Disequilibrium - a situation in which the quantity demanded and the quantity supplied are not in
balance
Shortage – excess demand for a good
Surplus – excess supply of a good

2.3 Adjustments to Changes in Demand and Supply

2.4 Government Intervention in Markets: Price Controls

Price Ceiling – a legislated maximum price for a good
Price Floor – a legislated minimum price for a good
Rent Control – price ceilings applied to rental housing units
Black Market – an illegal market for a good

2.5 Elasticities
Elasticities – measures the magnitude of the responsiveness of any variables (such as quantity
demanded or supplied) to a change in particular determinants
Price Elasticity of Demand – a measure of how sensitive quantity demanded is to a change in a
product’s price
Elastic – the situation in which price elasticity of demand exceeds 1.0 or unity
Inelastic – the situation in which price elasticity of demand is less that 1.0 or unity
Unit Elastic – the situation in which price elasticity of demand equals 1.0 or unity
Point Elasticity Formula – (∆Qd/Qd) / (∆P/P)
Arc Elasticity Formula - ├ ∆Qd / ( (.5) (Qd1+Qd2) ) ┤When we deal with large changes in
quantity, we should us the arc elasticity formula
*Two general factors seem to have a profound effect on the elasticity of demand for a particular
product. The first, and most important, factor is the availability and closeness of substitutes. The
more substitutes there are for some product and the better the substitutes, the more elastic the
demand for the product will be. The second factor that can be important in determining elasticity
of demand is the time period over which consumers adjust to price changes. The longer the time
period involved, the fuller is the adjustment consumers can make.
Income Elasticity of Demand - (∆Qd/Qd) / (∆I/I) – a measure of how responsive consumption of
some items is to a change in income, assuming the price of the good itself remains unchanged
*Whenever income elasticity is positive, consumption of the good rises with income, so the good
must be normal. Whenever the income elasticity is negative, consumption of the good falls when
income rises, and the good must be inferior.
Cross-Price Elasticity of Demand - (∆Qdx/Qdx) / (∆Py/Py) – a measure of how responsive
consumption of one good is to a change in the price of a related good
*Note that cross-price elasticity will be positive when the goods are substitutes and negative
when the goods are compliments
Price Elasticity of Supply - (∆Qs/Qs) / (∆P/P) – a measure of the responsiveness of the quantity
supplied of a commodity to a change in the commodity’s own price
*If supply is entirely unresponsive to price, the supply curve is vertical and the elasticity of
supply is equal to zero

Chapter 2 Summary
-Most economic issues involve the workings of individual markets
-In the supply-demand model we analyze the behavior of buyers by using the demand curve
-The demand curve shows how much people will purchase at different prices when other factors
that affect purchases are held constant. The demand curve slopes downward, reflecting the law of
demand
-Analysis of the sellers’ side of the market relies on the supply curve, which shows the amount
firms will offer for sale at different prices, other factors being constant. The supply curve
typically slopes upward
-The intersection of the demand and supply curves, reflecting the behavior of buyers and sellers,
identifies the equilibrium price and quantity
-A shift in the supply or demand curve produces a change in the equilibrium price and quantity
-For the market mechanism to operate, price must be free to adjust to any change affecting the
behavior of buyers and sellers in the market. Thus when the government steps in to regulate
prices, the market does not function in the same way
-A government-imposed price ceiling results in a shortage or may lead to diminution in product
quality, nonprice rationing, an incentive for black markets to emerge, administrative costs, and
increased demand for and supply of substitute goods. Sellers are clearly harmed by the imposition
of a price ceiling, and the effect on buyers as a group may not be beneficial
-Elasticities provide a quantitative measure of the magnitude of the responsiveness of quantity
demanded or supplied to a change in some other variable
-The most important elasticity in economics is price elasticity of demand, which measures how
responsive the quantity demanded of a commodity is to a change in the commodity’s own price.
It is measured by the percentage change in quantity demanded divided by the percentage change
in price
-When price elasticity exceeds unity, demand is elastic and a lower price expands purchases so
sharply that expenditure rises
-When price elasticity is less than unity, demand is inelastic, and a lower price leads to a
reduction in total expenditure
-When price elasticity equals unity, demand is unit elastic, and total expenditure is unchanged at a
lower price
-Three important Elasticities are income elasticity of demand, cross-price elasticity of demand,
and price elasticity of supply. They are constructed in a manner analogous to that employed to
construct price elasticity of demand and measure respectively, the responsiveness of quantity
demanded to income, the responsiveness quantity demanded of one good to the price of a related
good, and the responsiveness of the quantity supplied of a commodity to the commodity’s own
price.

Chapter 3: The Theory of Consumer Choice

3.1 Consumer Preferences
Economic “Bads” – commodities of which less is preferred to more over all possible ranges of
consumption
Economic “Goods” – commodities of which more is better than less
Market Baskets – combination of goods
Indifference Curve – a diagram that plots all the market baskets the consumer views as being
equally satisfactory
Indifference Map – a set of indifference curves that shows the consumer’s entire preference
ranking
Marginal Rate of Substitution (MRS) – a measure of the consumer’s willingness to trade one good
for another
Diminishing MRS – a consumer’s willingness to give up less and less of some other good to
obtain still more of the first good
Economic “Neuter” – a case in which the consumer doesn’t care one way or another about a
particular good
Perfect Substitutes – the case where a consumer is willing to substitute one good for another at
some constant rate and remain equally well off
Perfect Compliments – goods that must be consumed in precise combinations in order to provide
a consumer a given level of satisfaction

3.2 The Budget Constraint

Budget Constraint – the way in which a consumer’s income and the prices that must be paid for
various goods limit choices
Budget Line – a line that shows the combination of goods that can be purchased at the specified
prices and assuming that all of the consumer’s income is expended
*Any change in income ore prices will cause a shift in the budget line. A change in income with
constant prices produces a parallel shift in the budget line.

3.3 The Consumer’s Choice

MRS cm = Pc / Pm
Marginal Benefit – the value the consumer derives from consuming one more unit of a good
Marginal Cost – the cost of consuming one more unit of a good
Corner Solution – a situation in which a particular good is not consumed at all by an individual
consumer because the value of the first unit of the good is less than the cost
Composite Good – a number of goods treated as a group

3.4 Changes in Income and Consumption Choices

Income-Consumption Curve – the line that joins all the optimal consumption points generated by
varying income

3.5 Are People Selfish

3.6 The Utility Approach to Consumer Choice
Total Utility – assuming that it is measurable, the total satisfaction a consumer receives from a
given level of consumption
Marginal Utility – the amount by which total utility rises when consumption increases by one unit
Diminishing Marginal Utility – the assumption that as more of a given good is consumed, the
marginal utility associated with the consumption of additional units tends to decline, other things
equal

Chapter 3 Summary
-The theory of consumer choice is designed to explain why consumers purchase the goods they
do. The theory emphasizes two factors: the consumer’s preferences over various market baskets
and the consumer’s budget line, which shows the market baskets that can be bought.
-An indifference curve graphically depicts all the combinations of goods considered equally
desirable by the consumer.
-For economic “goods,” the indifference curves are assumed to be downward-sloping, convex,
and nonintersecting
-The slope of an indifference curve measures the marginal rate of substitution (MRS), which is
the willingness of the consumer to trade one good for another
-A budget line shows the combinations of goods a consumer can purchase with given prices for
the good and assuming all the consumer’s income is spent on the good
-The consumer’s income and the market prices of the goods determine the position and slope of
the budget line. The slope of the budget line is equal to the ratio of the prices of the goods and
measures the relative price of one good compared to another
-From among the market baskets the consumer can purchase, we assume the consumer will select
the one that results in the greatest possible level of satisfaction or well-being. Graphically, this
optimal choice is shown by the tangency between the budget line and the indifference curve,
where the consumer’s MRS equals the price ratio
-A change in the consumer’s budget line leads to a change in the market basket selected
-An increase in income when the prices of goods are held constant parallel shifts out the budget
line. This can lead to either an increase or a decrease in the consumption of a good
-When the consumption of a good rises with an increase in income, the good is a normal good
-An inferior good is one for which consumption falls as income increases
-The utility approach to consumer choice does not differ in any significant way from the
indifference curve approach

Chapter 4: Individual and Market Demand

4.1 Price Changes and Consumption Choices
Price-Consumption Curve – a curve that identifies the optimal market basket associated with each
possible price of a good, holding a constant all other determinants of demand

4.2 Income and Substitution Effects of a Price Change

Income Effect – a change in a consumer’s real purchasing power brought about by a change in the
price of a good
Substitution Effect – an incentive to increase consumption of a good whose price falls, at the
expense of other, now relatively more expensive, goods
Excise Tax – a tax on a specific good

4.3 Income and Substitution Effects: Inferior Goods

Giffen Good – the result of an income effect being larger than the substitution effect for an
inferior good, so that the demand curve will have a positive slope
4.4 From Individual to Market Demand

4.5 Consumer Surplus

Consumer Surplus – the net benefit or gain from consuming one market basket instead of another
Total Benefit – the total value a consumer derives from a particular amount of a good and thus the
maximum amount the consumer would be willing to for that amount of the good
Marginal Benefit – the incremental value a consumer derives from consuming an additional unit
of a good and thus the maximum amount the consumer would pay for that additional unit

4.6 Price Elasticity and the Price-Consumption Curve

4.7 Network Effects

Network Effects – the extent to which an individual consumer’s demand for a good is influenced
by other individual purchases
Bandwagon Effect – a positive Network Effect
Snob Effect – a negative Network Effect

4.8 The Basics of Demand Estimation

Regression Analysis (Econometrics) – a statistical method that allows one to estimate, among
other things, the sensitivity of the quantity demanded of a good to determinants such as price and
income
Ordinary Least Squares (OLS) – a technique for estimating the equation that “best fits” the data

Chapter 4 Summary
-By rotating the budget line confronting a consumer we can determine the market basket the
consumer will select at different prices, while factors such as income, preferences, and the prices
of other goods are held constant. The various price-quantity combinations identified in this way
can be plotted as the consumer’s demand curve
-To determine whether a demand curve must have a negative slope, we separate the effect of a
change in price on quantity demanded into two components, an income effect and substitution
effect
-For a normal good, both income and substitution effects imply greater consumption at a lower
price. Thus the demand curve for a normal good must slope downward
-For an inferior good, the income and substitution effects of a price change operate in opposing
directions. If the income effect is larger, the demand curve will slope upward. However, both
theoretical reasoning and empirical evidence suggest this case is quite rare
-Consumer surplus is a measure of the net benefit a consumer receives from consuming a good. It
is shown graphically by the area between the consumer’s demand curve and the price line
-Consumer surplus can also show the benefit or cost a consumer receives as a result of a change
in the price of the good
-Individual consumer’s demand curves can be aggregated to obtain the market demand
-An individual’s price-consumption curve provides important information about the person’s
elasticity of demand
-An individual consumer’s purchases of a good may be influenced by other individuals’
purchases through network effects
-Three methods allow us to estimate individual’s or market demand curves: experimentation,
surveys, and regression analysis or econometrics

Chapter 5: Using Consumer Choice Theory

5.1 Excise Subsidies, Health Care, and Consumer Welfare
Excise Subsidy – a form of subsidy in which the government pays part of the per-unit price of a
good and allows consumers to purchase as many units as desired at the subsidized price

Lump-Sum Transfer – a form of subsidy in which the government gives the consumer a cash
grant to be spent in any way the recipient wants

Deadweight Loss – a measure of the loss in well-being resulting in this case from the use of an
excise subsidy

5.2 Public Schools and the Voucher Proposal

Voucher Program – a form of subsidy in which parents receive vouchers that can be used to
purchase education at any school they choose

5.3 Paying for Garbage

5.4 The Consumer’s Choice to Save or Borrow

Endowment Point – the consumption mix available to the individual if no saving or borrowing
takes place

5.5 Investor Choice

Expected Return – a summed value of each possible rate of return weighted by its probability

Expected Utility – the summed value of each possible utility weighted by its probability

Risk Averse – a state of preferring a certain return to an uncertain prospect that generates the same
expected return

Risk Neutral – a state of deriving the same utility from a certain return as from an uncertain
prospect generating the same expected return

Risk Loving – a state of deriving less utility from a certain return than from an uncertain prospect
generating the same expected return

Insurance – an arrangement by which the consumer pays a premium in return for the promise that
the insurer will provide compensation for losses due to an accident, illness, fire, and so on

Diversification – investing a given amount of resources in numerous independent projects instead

of a single project in order to minimize exposure to risk

Chapter 5 Summary
-Consumer choice theory can be applied to a wide range of interesting and important policy
questions
-An excise subsidy is a form of subsidy in which the government pays a part of the per-unit price
of a good and allows the consumer to purchase as many units as desired at the subsidized price.
Subsidies can also be made in the form of cash, as a lump-sum transfer. Consumer choice theory
helps us discover that according to their own preferences, consumers will be better off if they
receive cash
-Public schools offer another common form of subsidy in which the government makes a certain
quantity of a good available at no cost, or below the market price. Voucher programs allow parent
to purchase education (with vouchers) at any school they choose. A variety of possible
consequences of a school voucher program can be identified with the tools of consumer choice
theory
-When consumers directly bear the cost of such services as trash collection instead of paying a
fixed annual fee, they have an incentive to cut down on the amount of the service they use,
eliminating what was in effect a subsidy for heavy users of the service. Light users may pay more
however
-A decision to save (or to borrow) is a decision to rearrange consumption between various time
periods. Adaptations of consumer choice theory allow us to examine this decision and to see how
it is affected by changes in earning and in the interest rate
-Consumer choice theory can also be applied to explain what types of financial assets an
individual who is saving for the future should purchase – stocks, Treasury bills, gold, futures, or a
savings account. Indifference curves demonstrate the tradeoffs between expected risk and return.
Utility chords shed light on the way in which insurance operates to reduce individuals’ risk

Chapter 6: Exchange, Efficiency and Prices

6.1 Two-Person Exchange
Economic Efficiency – with regard to exchange, economic efficiency represents a distribution of
goods across consumers in which no one consumer can be made better off without hurting
another consumer

Edgeworth Exchange Box – a diagram for examining the allocation of fixed total quantities of
two goods between two consumers

6.2 Efficiency in the Distribution of Goods

Pareto Optimality – another term for economic efficiency

Contract Curve – in an Edgeworth Exchange Box, a line drawn through all the efficient
distributions

Inefficiency – a distribution of goods in which it is possible, through a change in the distribution,

to benefit one party without harming the other

Equity – the concept of fairness

6.3 Competitive Equilibrium and Efficient Distribution

Price Taker – an individual who cannot affect the prevailing market price

6.4 Price and Nonprice Rationing and Efficiency

Chapter 6 Summary
-Voluntary exchange is mutually beneficial
-The Edgeworth Exchange Box diagram shows that differing marginal rates of substitution
(MRS) imply the possibility of mutually beneficial exchange. The prospect of mutual gain gives
rise to voluntary exchange
-A distribution of goods between consumers is efficient if any change in the distribution will
harm at least one of them. The many distributions that satisfy this definition are shown as points
on the contract curve in the Edgeworth Exchange Box diagram, along which consumers’ MRS
are equal
-Equity is another criterion for evaluating economic arrangements, especially when determining
whether one efficient distribution is to be preferred to another
-The distribution of goods implied by a competitive market equilibrium is efficient. Because each
consumer strives to equate his or her MRS to the same price ratio that confronts other consumers,
consumers’ MRS end up being equal to one another
-Some economic arrangements can lead to an inefficient distribution of goods. The allocation of
water in California across various users coupled with a prohibition of trade in allocated water
supplies is an example

Chapter 7: Production
7.1 Relating Output to Inputs
Factors of Production – inputs or ingredients mixed together by a firm through its technology to
produce output

Production Function – a relationship between inputs and outputs that identifies the maximum
output that can be produced per time period by each specific combination of inputs

Technology Efficient – a condition in which the firm produces the maximum output from any
given combination of labor and capital inputs

7.2 Production When Only One Input is Variable

Fixed Inputs – resources a firm cannot feasibly vary over the time period involved

Total Product – the total output of the firm

Average Product – the total output (or total product) divided by the amount of input used to
produce that output

Marginal Product – the change in total output that results from a one-unit change in the amount
of an input, holding the other quantities of other inputs constant

Law of Diminishing Marginal Returns – a relationship between output and input that holds that as
the amount of some input is increased in equal increments, while technology and other inputs are
held constant, the resulting increments in output will decrease in magnitude

7.3 Production When All Inputs Are Available

Short Run – a period of time in which changing the employment levels of some inputs is
impractical

Long Run – a period of time in which the firm can vary all its inputs

Variable Inputs – all inputs in the Long Run

Isoquant – a curve that shows all the combinations of inputs that, when used in a technologically
efficient way, will produce a certain level of output

Marginal Rate of Technological Substitution (MRTS) – the amount by which one input can be
reduced without changing output when there is a small (unit) increase in the amount of another
input

7.4 Returns to Scale

Constant Return to Scale – a situation in which a proportional increase in all inputs increases
output in the same proportion
Increasing Returns to Scale – a situation in which output increases greater than proportionally to
input use

Decreasing Returns to Scale – a situation in which output increases less than proportionally to
input use

7.5 Empirical Estimation of Production Functions

Cobb-Douglas Function – a production function that does not imply constant marginal products
for inputs

Chapter 7 Summary
-There are two relationships between the quantities of inputs used and the amount of output
produced. In the first, the quantities of some inputs are not changed (fixed inputs), while the
quantities of other inputs (variable inputs) are. This is normally a short-run response, when
varying the quantities of some inputs is not practical
-In the second relationship, the quantities of all inputs can be varied, which is normally the case
when long-run output responses are considered
-With some inputs held fixed, the total product curve shows the relationship between the quantity
of the variable input and output
-The law of diminishing marginal returns holds that beyond some level, the marginal product of
the variable input will decline as more of the input is used. This law implies that total, average
and marginal product curves will have the general shapes as shown is Figure 7.1
-Isoquants depict all combinations of two inputs that will produce a given level of output. They
show the relationship between inputs and output when both inputs can be varied
-A set of isoquants is effectively a graphical representation of the firm’s production function
-Isoquants and indifference curves have the same geometric characteristics
-The marginal rate of technical substitution shows the technological feasibility of trading one
input for another and is equal to the slope of the Isoquant
-Returns to scale refer to the relationship between a proportionate change in all inputs and the
associated change in output. If output increases in greater proportion than input use, production is
said to be subject to increasing returns to scale
-Constant and decreasing returns to scale are defined analogously. In general, increasing returns
to scale are common at low levels of output for a firm, possibly followed by constant returns over
a certain range
-At high levels of output, decreasing returns to scale will exist
-Although it is not without its difficulties, regression analysis offers one means for estimating the
relationship between inputs employed and output

Chapter 8: The Cost of Production

8.1 The Nature of Cost

8.2 Short-Run Cost of Production

Total Fixed Cost (TFC) – the cost incurred by the firm that does not depend on how much output
it produces

Total Variable Cost (TVC) – the cost incurred by the firm that depends on how much output it
produces

Total Cost (TC) – the sum of total fixed and total variable cost at each output level

Marginal Cost (MC) – the change in total cost that results from a one-unit change in output
Average Fixed Costs (AFC) – total fixed cost divided by the amount of output

Average Variable Cost (AVC) – total variable cost divided by the amount of output

Average Total Cost (ATC) – total cost divided by the amount of output produced

8.3 Short-Run Cost Curves

8.4 Long-Run Cost of Production

Icocost Line – a line that identifies all the combinations of capital and labor that can be purchased
at a given total cost

Golden Rule of Cost Minimization – a rule that says that to minimize cost, the firm should
employ inputs in such a way that the marginal product per dollar spent is equal across all inputs

Expansion Path – a line formed by connecting the points of tangency between isocost lines and
the highest respective attainable isoquants

8.5 Input Price Changes and Cost Curves

Input Substitution Effect – the effect of a change in the price of an input on a firm’s relative use of
the input to produce a given level of output

8.6 Long-Run Cost Curves

Economies of Scale – a situation in which a firm can increase its output more than proportionally
to its total input costs

Diseconomies of Scale – a situation in which a firm’s output increases less that proportionally to
its total input costs

8.7 Importance of Cost Curves to Market Structure

Minimum Efficient Scale – the scale of operations at which average cost per unit reaches a
minimum

8.8 Using Cost Curves: Controlling Pollution

8.9 Economies of Scope

Economies of Scope – a case where it is cheaper for one firm to produce products jointly than it is
for separate firms to produce the same products independently

Diseconomies of Scope – a case where it is cheaper for separate products to be produced

independently than for one firm to produce the same product jointly

8.10 Estimating Cost

New Entrant / Survivor Technique – method for determining the minimum efficient scale of
production in an industry based on investigating the plant sizes either being built or used by firms
in the industry

Chapter 8 Summary
-Cost is ultimately associated with the use of inputs that have alternative uses
-To economists, cost means opportunity cost – sacrificed alternatives when inputs are used to
produce on product rather than some other product
-In the short run, firms cannot change the quantities of some inputs, so output can be altered only
by varying the use of variable inputs
-The law of diminishing marginal returns applies here and dictates short-run cost curves’ shapes
-The short-run marginal cost curve rises beyond the point at which diminishing marginal returns
set in, and it intersects the U-shaped average variable and average total cost curves at their
minimum points
-In the long run, firms can vary all inputs
-The expansion path in an isocost-isoquant diagram shows the least costly combinations of inputs
required to produce various levels of output. It identifies the lowest total cost at which each
output can be produced when all inputs can be varied. The same information is also conveyed by
firms’ long run cost curves
-If input proportions are held constant, returns to scale determine the shape of the firm’s long-run
cost curves. With increasing returns to scale at low output and decreasing returns to scale at high
outputs, the long-run average cost curve will be U-shaped. It shows the lowest per-unit cost at
which each output can be produced
-The level of output at which the long-run average cost curve reaches a minimum depends on
technological conditions and varies across products and firms
-In the more general case, when firms can alter input proportions with output, the shape of their
long-run cost curves will depend on whether output changes are more than proportionate to any
change in total input cost
-Economies of scale are present when a firm’s output increases more than proportionally with a
change in total input cost
-All cost curve for individual firms are drawn on the assumption that input prices are given. A
change in one or more input prices causes the cost curves to shift
-Although economies of scale determine a long-run average cost curve’s shape as a function of a
particular product’s output, firms often produce an array of products
-If it is cheaper for a single firm to produce an array of products than it is for an array of separate
firms to independently produce distinct products, economies of scope apply. There is no
necessary relationship between economies of scale and economies of scope
-A variety of techniques may be relied upon for empirical estimation of cost functions, including
surveys, experimentation, and regression analysis