Firms and production — common mistakes

Be prepared to draw and label the short-run cost curve diagram accurately. Show AFC falling, and the U-shaped AVC, ATC and MC curves. Ensure your MC curve cuts ATC and AVC at their minimum points. Marks are often lost for inaccurate diagrams.

When drawing cost curves, show MC cutting AVC and AC at their minimum points. Label the shutdown point (P = min AVC) and break-even point (P = min AC) for perfect competition questions.

This is a common point of confusion. 'Diminishing returns' is a short-run concept where at least one factor is fixed. It explains why short-run marginal costs eventually rise. 'Diseconomies of scale' is a long-run concept where all factors are variable. It explains why the long-run average cost curve might eventually rise due to problems associated with being too large, such as poor communication or coordination.

Think of your average test score (ATC) and the score on your next test (MC). If your next test score (marginal) is lower than your average, your average will fall. If your next score is higher than your average, your average will rise. Therefore, the average can only be at its minimum point when the marginal score is exactly equal to the average. The same logic applies to cost curves.

While profit maximisation is the central assumption in traditional neoclassical theory and the one you should use for most exam questions, it is not the only possible objective. Other goals may include revenue maximisation (MR=0), sales maximisation (producing as much as possible without making a loss, where AC=AR), or 'satisficing' – making just enough profit to satisfy shareholders while pursuing other objectives. However, unless the question specifies otherwise, assume profit maximisation.