Chapter Outline:

CHAPTER 4 4.1 Production and Firm

4.2 Cost and Profit: Economics and Accounting Concepts

The Production 4.3 The Production Decision

Process of Firms 4.4 The Production Process

4.5 Production Theory

4.6 Short Run Cost Curves and Relationship

4.7 Short Run Revenue and Profit Maximization

4.8 Long Run Cost Curve

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4.1 Production and Firm: 4.2 Cost & Profit:

Economics & Accounting Concepts
• Production: • Explicit Cost:
– Is the process of using the factors of production to – Considered as “normal” cost (or profit)
produce goods and services. – What was paid out (in money)
– In other words, it can be stated as the “transformation – Example: wages or rental
of inputs into outputs”.
– Usually, by firm • Implicit Cost:
– Reflex the opportunity cost
– The 2nd best alternative lost
• Firm: – Example: Owner time/effort or using own building;
– An output producing organization forgone salary, forgone interest.
– Demand production factors from input market
– Maximize profit (rational assumption)
• Accounting Cost = Explicit Cost
• Economic Cost = Explicit Cost + Implicit Cost
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• Accounting Profits: Cost and Profit (Example):

– A firm’s total revenue minus its explicit costs. Simon spends at least 40 hours a week at his place of business. If he
– Formula: closed the bar, he could work for his competitor and earn
= (TR – Accounting Cost) RM30,000 per year. He also owns the building that houses the bar
and could rent it out for RM24,000 per year if he closes his business.
= (TR – Explicit Cost)
The data below provides information on the company’s annual cost
and revenue. Calculate explicit cost, implicit cost, accounting cost,
• Economics Profits: economic cost, accounting profit and economic profit.
– A firm’s total revenue minus its explicit and implicit costs.
– Formula:
= (TR – Economic Cost) Items Cost / Revenue (RM)
= (TR – Explicit Cost – Implicit Cost) Wages 85,000
Interest paid on loans 7,000
Other expenditure for factors of production 67,000
Total revenue 250,000

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 4.4 The Production Process:
4.3 The Production Decision:
Input decision:
• All firms must make several basic decisions to achieve >>How many
Cost decision Selling price
what we as sume to be their primary obje ctive— >>Which types
maximum profits.
Input:
Market price Techniques Prices of inputs Capital
Input:
Labour Output
1. 2. 3.
How much Which production How much of
output to technology each input to Input:
supply to use demand Raw Material Technology

The Three Decisions That All Firms Must Make

q = f (K, L, M…) 
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• Production Function: 4.5 Production Theory:

– Refers to the relationship between inputs and outputs.
– It can be represented in the form of a mathematical equation such • Short run – Period of time which quantities of one
as: Q=f(K,L,M…) or more inputs cannot be changed and firm is
operating under fixed scale, firms can neither
• Marginal Product (MP): enter nor exit an industry.
– Additional output that can be produced by adding one more unit of
a particular input, ceteris paribus. • SR; Variable input + Fixed input
– MP slopping down reflex the law of diminishing marginal returns
– Formula: MP =(∆TP / ∆L) • Long run – Period of time which quantities of all
inputs can be varied (no fixed input). Firms can
• Average Product of labor (AP): change the scale of production
– Average amount produced by each unit of a variable factor (e.g (increase/decrease).
labor)
– Formula: AP = (TP / L) • LR; Variable input only

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A Production Function and Total Cost For Hungry Helen’s Production Function:
Quantity of output
Hungry Helen’s Cookie Factory 20
18
QUANTITY OUTPUT MP AP COST OF COST OF TOTAL 16
OF (TP) FACTORY WORKERS COST
WORKERS 14 TP
0 0 - - $30 $0 $30 12
1 2 2 2 30 10 40
2 5 3 2.5 30 20 50 10
3 9 4 3 30 30 60 8
4 12 3 3 30 40 70
6
5 14 2 2.8 30 50 80
6 15 1 2.5 30 60 90 4
7 15 0 2.1 30 70 100
2
8 14 -1 1.8 30 80 110
0
0 1 2 3 4 5 6 7 8
Number of Workers Hired
11 12

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 Stage of Production:
– Increasing Marginal Returns (Stage 1) Law of Diminishing Marginal Return:
• The marginal product (MP) of a variable resource increases as
each additional unit of that resource is employed.
• TP increase at an increasing rate • Definition:
• Reason: Labor can do specialization in their task
– This law explains the behaviour of production
– Diminishing Marginal Returns (Stage 2) functions in the short run, when at least one of the
• As more of a variable resources is added to a given amount of inputs must be fixed.
another resource, marginal product (MP) eventually declines.
• TP increases at a decreasing rate;
• Reason: Labor now becomes less efficient / abundant. – The law of diminishing marginal returns states that as
more of variable inputs is used, while other inputs
– Negative Marginal Returns (Stage 3) are fixed, the marginal product of the variable input
• The marginal product (MP) of a variable resource turn to will eventually declines.
negative as each additional unit of that resource is employed.
• TP decreases
• Reason: As more labors are added, the firms becomes
overcrowded.
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Stages of Production:
TP
Increasing Marginal Returns:

TP
Total Product, TP

 Stage 1 Stage 2 Stage 3

Total Product

Labor
AP, MP
Increasing
Marginal
Average Product, AP, and

Quantity of Labor
Returns
Marginal Product, MP

   AP Average
Labor Product
 MP
Marginal
15 Quantity of Labor Product 16

Decreasing/Diminishing Marginal Returns: Increasing Marginal Returns:

Total Product, TP

Total Product
Total Product

Total Product

Diminishing Negative
Marginal Marginal
Quantity of Labor
Returns
Average Product, AP, and

Average Product, and

Quantity of Labor Returns

Marginal Product, MP

Marginal Product

Average
Average
Product
Product
Marginal
Marginal
Quantity of Labor Product
Quantity of Labor Product 17 18

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 Relationship between TP& MP 4.6 Short Run Cost Curve & Relationship
Ø When MP is increasing, TP will increase at  • Types of costs:
an increasing rate. (stage 1) – Fixed cost (FC)
Ø When MP is decreasing, TP will increase at a 
 Stage 3 • Any cost that does not depend on the firm’s level of
decreasing rate. (stage 2) output.
 Stage 2 Ø When MP is zero, TP is at its maximum
Ø When MP is negative, TP declines. (stage 3)
• Costs that incurred even if the firm is producing nothing.
 Stage 1
• No fixed cost in long run.

– Variable cost (VC)

Relationship between MP& AP
Ø When MP is above AP, AP is increasing
Ø When MP is below AP, AP is decreasing
Ø When MP equals to AP, AP is at maximum.
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• Costs associated with input (e.g. labor)
• Depend on the level of production chosen.
– Total cost (TC)
• Sum of the fixed cost (FC) and variable cost (VC)
• TC = FC + VC
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Fixed Cost: TFC and AFC:

• Types: q TFC (RM) AFC (RM)

– Total Fixed Cost (TFC): 0

1
1000
1000
-
1000
– The total of all costs that do not change with 2 1000 500
3 1000 333
output, even if the output is zero. 4 1000 250
5 1000 200

– Average Fixed Cost (AFC)

– Total fixed cost divided by the number of units
of output or a per-unit measure of fixed costs.
– Formula: Fixed cost FC
AFC
Quantity Q
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Variable Cost: Total cost:

• Types:
– Total Variable Cost (TVC) • Type:
• The total of all costs that vary with output in the short – Average Total Cost (ATC)
run.
• Total cost divided by the number of units of output.
• Formula:
– Average Variable Cost (AVC) TC ATC AFC AVC
ATC
• The variable cost divided by output. q
• Formula: AVC = (TVC / Quantity)

– Marginal Cost (MC)

• Additional cost of producing one more unit of output.
• Reflect the changes in variable costs.
• Formula: (ΔTC / ∆Q)
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 Relationship between TVC, AVC & MC: Short-Run Cost Data:
Ø Total variable cost (TVC) always increases
with output .

Ø The marginal cost (MC) curve shows how

total variable cost changes.

Ø When MC is below average variable cost,

AVC is declining. When MC is above AVC,
AVC is increasing.

Ø MC intersects AVC at the lowest, or • Both AVC and ATC first decline as output expands, then
minimum, point of AVC. increase (u-shape).
• As more output produced, FC divided by larger quantity,
thus AFC decreases (AFC is downward sloping)
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Productivity and Costs Are Mirror Images:

Figure: Cost Curves for a Typical Firm:
• The shapes of the

Average Product and

Marginal Product
cost curves are
Costs
Note how MC hits both ATC and AVC at their mirror-image
minimum points.
reflections of the
Marginal Cost declines at first and then
$3.00
increases due to diminishing marginal product. corresponding
AFC declines when output increases . productivity curves. AP
2.50 MP
MC Quantity of Labor
2.00 • W he n on e i s MC
1.50 increasing, the other AVC
Costs (dollars)

ATC is decreasing.
AVC
1.00

0.50 • When one is at a

AFC maximum, the other
0 2 4 6 8 10 12 14 is at a minimum.
Quantity of Output Quantity of Output
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4.7 Short Run Revenue & Profit Maximization: – Profit (π):

• Difference between total revenue and total economic
– Total Revenue (TR): cost
• The total amount that a firm takes in from the sale of its • Total economic cost reflects a normal rate of return
output (rate that is just sufficient to keep current investors
• Formula: (TR = P x Q) interested in the industry).
• Formula: (Profit = TR – TC)
– Average total revenue (ATR):
• The amount that a firm received from the sales of each
units of output – Breakeven (π = 0 )
• Formula: (ATR = TR / Q) • TR = normal rate of return/ normal profit

– Marginal revenue (MR):

• Additional revenue that a firm takes in when it increases – Profit maximization:
output by one additional unit • Profit maximization is occur when MC = MR
• Formula: (MR = ∆TR / ∆Q)
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 4.8 Long Run Average Cost Curve:
Table: Cost, Revenues & Profit Calculation
• Economies of Scale:
(1)         (6) (7) (8)
Output (2) (3) (4) (5) TR TC PROFIT – An increase in a firm’s scale of production leads to lower costs
(q) TFC TVC MC P = MR (p*q) (TFC + TVC) (TR – 
(unit) (RM)  (RM) (RM) (RM) (RM) (RM) TC)
per unit produced (ATC falls as output increases).
(RM) – Forces that reduce a firm’s average cost as the scale of operation
0 10 0 - 15 0 10 (10) increases in the LR.
1 10 10 10 15 15 20 (5)
• Diseconomies of Scale:
2 10 15 5 15 30 25 5
– An increase in a firm’s scale of production leads to higher costs
3 10 20 5 15 45 30 15
per unit produced (ATC rises as output increases).
– Forces that may eventually increase a firm’s average cost as the
4 10 35 15 15 60 45 15 scale of operation increases in the LR.
5 10 55 20 15 75 65 10
• Constant Returns to Scale:
6 10 80 25 15 90 90 0
– An increase in a firm’s scale of production has no effect on costs
per unit produced (ATC does not change as output increases).
MC = MR – No gain from specialization.
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Long Run Average Cost Curve: Economies of Scale:

Average
Total Economies of scale may exist because a
Cost
firm can use:
ATC
~efficient capital- use better machines
for production.
10,000 ~l ab o r s p ecia liz a t io n- em p lo y t he
Economies Constant expert.
of returns to

~managerial specialization
scale scale Diseconomies
of
scale

0 1,000 Quantity of
Cars per Day 34
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Diseconomies of Scale: Constant Return to Scale:

Diseconomies of scale may occur as:
The term constant returns
~ a firm finds it increasingly difficult to
means that the quantitative
handle the complexities of large-scale relationship between input and
management. output stays constant, or the
same, when output is
~management coordination problems increased.
The firm’s long-run average cost curve remains
~out of control flat.
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