1. What is the relationship between costs and output in the short run?

Let's use a typical business, Joe's Gourmet Hamburgers, as an example. Joe has a small restaurant that makes and sells gourmet-quality hamburgers. It seems pretty obvious that Joe's costs will go up as Joe's output goes up; when Joe wants to produce more hamburgers, he has to hire more workers and buy more hamburger meat, rolls, lettuce, and so on.

In addition to this simple relationship, there are other relationships between costs and output that apply to most firms in the short run. The short run is a period of time just short enough that at least one input can be changed. Joe can quickly hire and train workers, or buy more hamburger meat, but it would take him several months to build a new restaurant. The short run is the time period when Joe can't change the restaurant or its equipment (grill, french fryers, etc.), but he can change the number of people who work for him.

As Joe thinks about making more hamburgers every hour by adding more workers to the restaurant, total costs will at first increase only slowly. The first few workers Joe hires have lots of room to work and lots of equipment to use, so they can work very efficiently. But as Joe tries to keep making more hamburgers, eventually there will be too many people trying to use the fixed amount of equipment. They'll get in each others' way and not be able to work as efficiently. Total costs will be increasing at a faster and faster rate.

2. What is the law of diminishing marginal returns?

The law of diminishing marginal returns is a formal statement of the pattern described above. The law says that in the short run, as the quantity of variable resources are increased, output initially rises rapidly, then more slowly, and eventually may decline. One implication of this pattern is that the average total cost (ATC) curve is U-shaped. Average total cost is the cost of each output unit calculated by the equation TC/Q.

For Joe's Gourmet Hamburgers, as the number of hamburgers produced per hour increases from zero, at first the cost per hamburger (ATC) decreases. This happens while the increasing number of workers are able to use the equipment more efficiently. But as Joe keeps adding more workers to make more hamburgers per hour, eventually the ATC will start to increase. This increase happens when there becomes too many workers to use the equipment efficiently. The low point on the ATC curve comes when there are just the right number of workers in Joe's restaurant to use the equipment as efficiently as possible.

3. What do the owners of firms want the firm to do?

The fundamental objective of Joe and Joe's Gourmet Hamburgers, and other business firms and their owners, is to add value. More specifically, they want to add as much value as they can. Added value is the difference between the amount of money the firm receives from selling its product and the costs of all the inputs needed to make the product. Another name for added value is economic profit. The more economic profit Joe's Gourmet Hamburgers makes, the more money Joe gets.

4. What is the difference between economic profit and accounting profit?

Accountants and bookkeepers are primarily concerned with keeping track of money; that's their job. Economists concentrate on resources rather than money. Both accountants and economists count as costs the resources a firm buys. Economists also include the opportunity cost of the owner's equity capital as part of the cost of producing a product.

For example, Joe used a large amount of his savings to buy the building and start up his restaurant. Joe's opportunity cost of his capital investment is the interest he would have received if he had kept the money in his savings account. Economists count these forgone savings as a cost; accountants don't.

Both accountants and economists figure profit as total revenue minus total cost. Since economists include the opportunity cost of the owner's equity capital as part of costs, accounting profit is always larger than economic profit.

When economic profit is zero, economists say that the firm is getting a normal accounting profit. Positive economic profit means that total revenue is more than all opportunity costs. Negative economic profit means that total revenue is less than all opportunity costs.

5. What is the profit-maximizing rule?

Businesses like Joe's Gourmet Hamburgers want to choose the quantity of output to produce where total revenue exceeds total cost by the largest amount. At that point, economic profits are at their maximum value, and Joe gets as much money as possible from his business. Businesses can find that quantity by comparing marginal revenue (MR) and marginal cost (MC) and producing the output quantity where MR = MC.