On the production side of the economy, firms combine inputs to produce output, and their decisions hinge on the costs of doing so. Costs come in two forms. Explicit costs are direct monetary outlays such as wages and rent, while implicit costs are the opportunity costs of using owner-supplied resources, such as the salary a business owner gives up by working for themselves. Accounting profit subtracts only explicit costs from total revenue, but economic profit subtracts both explicit and implicit costs: \( \text{Economic profit} = TR - (\text{Explicit} + \text{Implicit costs}) \). A firm earning zero economic profit is doing just as well as it could in its next-best use of its resources; it is earning a normal return.
Costs are also classified by how they respond to output. Fixed costs (FC) do not change with output, such as rent on a building, while variable costs (VC) do change with output, such as raw materials and hourly labor. Total cost is \( TC = FC + VC \). The average total cost is \( ATC = TC / Q = AFC + AVC \), where AFC and AVC are the average fixed and variable costs. Marginal cost (MC) is the additional cost of producing one more unit, \( MC = \Delta TC / \Delta Q \). A key graphical result is that the MC curve intersects the ATC curve at its minimum point: when MC is below ATC, ATC is falling; when MC is above ATC, ATC is rising. Marginal cost is also the foundation of the firm's profit-maximizing rule, namely that a firm maximizes profit where marginal revenue (MR) equals marginal cost, \( MR = MC \).
The shape of cost curves reflects the underlying production technology. In the short run, at least one input is fixed, and the law of diminishing marginal returns says that as more of a variable input is added to a fixed input, the marginal product of that input eventually decreases. The marginal product of labor (MPL) is the additional output from one more unit of labor, \( MPL = \Delta Q / \Delta L \). In the long run, all inputs are variable and firms can enter or exit the market. Economies of scale occur when long-run average total cost falls as output increases, due to specialization, bulk purchasing, or the spreading of fixed costs; diseconomies of scale occur when long-run average total cost rises with output, often because of coordination problems and bureaucracy.