Theory of the Firm — Costs, Revenues and Profit (HL)

This higher-level topic opens the "black box" of the firm to explain how production, costs, revenues, and profit determine a firm's output decisions. It provides the foundation for analyzing market structures.

Production in the short and long run

The short run is a period in which at least one factor of production is fixed, usually capital, while others such as labor are variable. The long run is a period in which all factors are variable. In the short run, the law of diminishing marginal returns operates: as successive units of a variable factor are added to a fixed factor, the marginal product of the variable factor eventually falls. This law shapes the firm's short-run cost curves.

Short-run costs

Costs are divided into fixed costs (which do not vary with output, such as rent) and varia