A production function describes how outputs arise from inputs. The marginal product of labor is the additional output produced by employing one more worker, and the law of diminishing marginal returns states that adding more of one input while holding others constant eventually yields smaller increases in output. Economists distinguish between the short run, in which at least one input is fixed, and the long run, in which all inputs can vary. This distinction shapes how firms make decisions in response to changing market conditions.
Costs are divided into fixed costs, which do not vary with output such as rent, and variable costs, which do such as raw materials. Marginal cost is the cost of producing one more unit, while average total cost is total cost divided by quantity and average variable cost is variable cost divided by quantity. The profit maximization rule states that firms should produce where marginal revenue equals marginal cost. The firm's break-even point is where total revenue equals total cost, and the short-run shutdown point is where price falls below average variable cost, at which the firm should temporarily cease production. Economic profit deducts total opportunity cost, including implicit costs, from revenue, while accounting profit deducts only explicit costs. Normal profit corresponds to zero economic profit, where revenue covers all costs including opportunity cost. As firms grow, economies of scale describe cost advantages from increased production, diseconomies of scale describe rising average costs from growing too large, and constant returns to scale describe stable average costs. X-inefficiency arises when a lack of competitive pressure allows costs to drift above the minimum achievable level. Barriers to entry are obstacles preventing new firms from entering a market, while barriers to exit are costs preventing firms from leaving.
Market structures range across a spectrum. Perfect competition features many small firms, identical products, free entry and exit, and perfect information; in the long run, firms earn zero economic profit and the long-run supply curve is horizontal at minimum average total cost once entry and exit adjust output. A monopoly is a market with a single seller of a product without close substitutes, sustained by barriers such as patents, control of resources, or government grants, and a natural monopoly arises when a single firm can serve demand at lower cost than multiple firms, as is common for utilities. Monopolies restrict output below competitive levels, generating deadweight loss. Monopolistic competition features many firms selling differentiated products with relatively easy entry, and in the long run produces zero economic profit but at excess capacity. An oligopoly is dominated by a few firms whose strategic interactions are central to outcomes.