AF1605 Introduction to Economics

Topic 4: Production and Cost

Lecturer: Chau Tak Wai

School of Accounting and Finance

v Factors of Production

v Short run and long run production

v Product curves

v Cost curves

v Concept of cost and profit

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v A firm is a production unit.
v A firm has to decide the amount of inputs (factors of production) to be
employed.
v Types of input: Land, Labor, Capital

v A firm has to decide the amount of output to be produced.

v Whether a firm has the ability to decide the product price depends on
the type of the market structure.

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v There can be many diverse goals or objectives for firms. (e.g. do good to the
society, produce high quality product, increase market share)

v But some of these goals are just more complex ways of achieving profit
maximization.

v To have a basic theory of a firm’s decision, we assume that the objective of a

firm is to maximize economic profit defined as total revenue minus total
economic cost (max π = TR – TC).

v In particular, a firm would determine its output level, and the amount and
combination of different inputs to produce this level of output that maximize
its profit.

v An implication: Given the target output level, a firm will choose the amount
and combination of different inputs to minimize cost to increase profit.

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v Factors of production are the productive resources used to produce
goods and services.

v Factors of production are grouped into four categories:

v Land
v Labor
v Capital
v Entrepreneurship

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v Land
v Land refers to the natural resources.
v Land includes minerals, water, as well as farmland and forests.

v Labor
v Labor is the work time and work effort that people devote to producing
goods and services.

v Capital
v Capital consists of tools, instruments, machines and items that have
been produced in the past and that businesses now use to produce
goods and services.
v Not include financial capital (e.g., money, stocks and bonds) as they are
not productive resources.

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v Entrepreneurship
v Entrepreneurship is the human resource that organizes labor, land,
and capital, who take the risks of his business decisions.
v Entrepreneurs come up with new ideas about what and how to
produce, make business decisions, and bear the risks that arise from
these decisions.

v Production function: Q = f (input1, input2,…) shows the technological

relationship between amounts of input and level of the output.
v In the following discussions, we simplify and assume that there are
only two inputs: labor and capital.
v The production function becomes Q = f (labor, capital) = f(L, K), i.e.,
the amount of output produced depends on the amount of labor and
capital to be employed.
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v The short run is a time frame in which the quantities of some input factors are
fixed.
v The input/factor that cannot be changed in a short run is known as fixed input /
fixed factor.
v The input/factor that can be adjusted in a short run in known as variable input
/ variable factor.
v In the short run, a firm usually can change the quantity of labor it uses but not
the quantity of capital. Therefore, we assume capital is fixed factor and labor is
variable factor in the discussion below. (But it is not always true!!!)

v The long run is a time frame in which the quantities of all input factors can be
changed.
v In the long run, all factors are variable.

v The distinction between short run and long run does not rest on the length of
time involved.
v It can take a few years to change the plan of a real estate development, but it
can take within a month to start an online store.
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v In short run, to increase output with fixed capital (fixed factor), a
firm must increase the quantity of labor (variable factor) it uses.

v We describe the relationship between output and the quantity of

labor by using three related concepts:

v Total product
v Marginal product
v Average product

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v Total product (TP) is
the total quantity of a
good produced with
given inputs in a given
period of time.

v The figure on the right

shows how the total
product (TP) changes
with labor input, with
the same level of
capital used.

v TP = f(L, K0)

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v Marginal product (MP) is the
change in total product that
results from a one-unit increase in
the quantity of variable factor
employed.
v For a discrete case:
MP(L) = TP(L) – TP(L-1)

v More generally, also applicable in

continuous case, marginal product
of the variable factor, here labor,
can be calculated by:
MP = ∆TP / ∆L

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v Increasing marginal returns occur when
a small number of workers are employed
and arise from increased specialization
and division of labor in the production
process when we employ more labor.

v Decreasing marginal returns arise when

more and more workers use the same
equipment and workspace. As more
workers are employed, the additional
worker becomes less and less productive.

v The law of diminishing returns (or

diminishing marginal product) states
that: As a firm uses more of a variable
input, with a given quantity of fixed
input, the marginal product of the
variable input eventually decreases.
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v Average product (AP) of labor
is the total product per worker
employed.

v APL = TP ÷ Quantity of labor

(APL = TP/L)

v When MP decreases
eventually, AP also decreases
eventually in the short run.
(Why?)

v When MP exceeds AP, AP is

increasing.
v When MP is less than AP, AP is
decreasing.
v When MP equals AP, AP is at
maximum. 13
§ 1. When does law of diminishing returns start to kick in?

§ 2. Can you observe the relationship between average product and

marginal product?
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v To produce more output in the short run, a firm employs more labor,
which means the firm must increase its costs.

v We describe the relationship between output and cost using three

cost concepts:

v Total cost
v Average cost
v Marginal cost

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v A firm’s total cost (TC) is the cost of all the factors of production the
firm uses as a function of output level Q.

v Total cost has two components:

v Total fixed cost (TFC) is the cost of the fixed factor of production
used by a firm as a function of Q.
v Total variable cost (TVC) is the cost of the variable factor of
production used by a firm as a function of Q.

v Total cost is the sum of total fixed cost and total variable cost:
TC(Q) = TFC(Q) + TVC(Q).

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v There are three average cost functions concepts:
v Average fixed cost (AFC(Q)) is total fixed cost per unit of output.
v Average variable cost (AVC(Q)) is total variable cost per unit of output.
v Average total cost (ATC(Q)) is total cost per unit of output.

v TC(Q) = TFC(Q) + TVC(Q)

v TC(Q)/Q = TFC(Q)/Q + TVC(Q)/Q
v ATC(Q) = AFC(Q) + AVC(Q)

v Marginal cost (MC(Q)) is the change in total cost that results from a one-
unit increase in output.

v For a discrete 1-unit change in output: MC = TC(Q) – TC(Q-1)

v More generally, MC = ∆TC / ∆Q

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Note: “Total” can mean
(1) the sum of fixed and variable costs.
(2) ”Total” rather than ”average” and ”marginal”.
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Complete the following table by filling in the empty spaces:

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v Which of the following increase the marginal cost at all quantity levels?

v A. An increase in fixed cost by $10.

v B. An increase in total cost by $10 at all quantity levels.

v C. An increase in average total cost by $10 at all quantity levels.

v D. A decrease in average variable cost by $10 at all quantity levels.

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v Average fixed cost (AFC)
decreases as output increases.
(AFC = TFC/Q)

v The average variable cost curve

(AVC), the average total cost
curve (ATC) and the marginal
cost (MC) curve are U-shaped.
This is due to the law of
diminishing returns.

v Diminishing returns implies MP

eventually decreases. Thus, MC
eventually rises.

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 Δ𝑇𝐶
(Q) 𝑀𝐶 =
Δ𝑄

§ If the wage of workers per day is $500, and the fixed cost is $5000,
calculate the corresponding marginal cost between each level of output.
§ Is MC increasing when MP is decreasing?

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v The marginal cost curve (MC) is U-
shaped and intersects the average
variable cost (AVC) curve and the
average total cost (ATC) curve at
their respective minimum points.

v The increasing MC will eventually

drive up the AVC and ATC. (Why?)

v When MC is less than ATC (AVC),

ATC (AVC) is decreasing.

v When MC is larger than ATC (AVC),

ATC (AVC) is increasing.

v When MC equals ATC (AVC), ATC

(AVC) is at minimum.

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v In the long run, the firm is able to change all inputs, including fixed factors
such as capital (or plant size).
v A short run ATC corresponds to a particular level of capital (fixed) input.
v When a firm uses the smallest plant, its ATC curve is ATC1.
v With successively larger plants, the firm’s ATC curves are ATC2, ATC3, and ATC4.
v In the long run, a firm would choose the capital level (plant size) (level of fixed
input in the short run) that minimizes the total or average cost given the
target long run output level to maximize profit.

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v The long-run average cost (LRAC) curve shows the lowest average cost at each
output level when the firm has sufficient time to adjust all inputs.

v The LRAC curve traces, for each target level of output, the lowest attainable
average total cost among all possible short-run average cost curves for different
level of fixed inputs.
v Thus, the LRAC is the lower envelop of all possible short-run average cost
curves (SRACs).
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v There are economies of scale when the long-run average cost (LRAC)
decreases as output (scale) increases.

v The main sources of increasing returns to scale are as follows:

v Technical economies resulting from the indivisibility of capital like
specialized machinery whose full capacity can be utilized only when
output is large enough.
Another possibility is related to the fact that materials required to make a
container can grow slower than the volume it can contain.
v Managerial economies resulting from better specialization of labor, the
indivisibility of specialized managers and experts such as accountants,
marketing managers, whose full contribution can only be realized for a
large enough output.
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v Marketing economies resulting from more favorable terms of transaction,
such as lower purchase prices of raw materials and higher sales prices of
finished products with a larger level of output.

v Financial economies resulting from better access to financial resources

on more favorable terms (such as the ability to raise funds by issuing
shares in the stock market, issuing bonds in the capital market, and
borrow from banks at lower interest rates) when the scale of the firm is
large enough.

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v When there are constant returns to scale, the long-run average cost
(LRAC) remains constant as output increases.
v Constant returns to scale occur when a firm is able to replicate its existing
production capacity including its management system.

v There are diseconomies of scale when the long-run average cost (LRAC)
increases as output (scale) increases.
v Decreasing returns to scale arise from the difficulty of coordinating and
controlling the enterprise when it becomes too large.
v e.g. harder to monitor employees which lowers productivity, becoming
more bureaucratic
v It may also be due to an increasing cost in expanding to markets further
away from its production base.
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Example: How to find the long-run AC from three different scales of production?

Short-run AC Short-run AC of Long-run AC

Output, Q Short-run AC of
of small plant medium plant ($)
(units) large plant ($)
($) ($)
10,000 13 18 22
20,000 10 15 18
30,000 9 13 15
40,000 12 11 13
50,000 16 13 12
60,000 20 17 13
70,000 25 21 15

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Example: How to find the long-run AC from three different scales of production?
(Note: it is a discrete case.)

Short-run AC Short-run AC of
Output, Q Short-run AC of Long-run AC
of small plant medium plant
(units) large plant ($) ($)
($) ($)
10,000 13 18 22 13
20,000 10 15 18 10
30,000 9 13 15 9
40,000 12 11 13 11
50,000 16 13 12 12
60,000 20 17 13 13
70,000 25 21 15 15

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v In economics, cost refers to opportunity cost which is defined as the value of the
best alternative forgone.

v A firm’s production cost has two components: Explicit Cost and Implicit Cost.

v Explicit cost: The actual monetary payments a firm makes to its factors of
production and other suppliers.

v Implicit cost: Include (1) the net direct benefit from the best alternative use of the
the firm’s owners’ resources and (2) economic depreciation.

v (1) above also include “normal profit”: the return to entrepreneurship, measured
by the extra return if one uses such efforts to run another business. This is a profit
in the accounting sense. (Note: some scholars uses a different definition.)

v Economic depreciation is the change in the market value of the capital good over a
given period of time.
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v Economic cost
v Takes into account all opportunity costs that include all the implicit
costs and explicit costs that are relevant to the activity under
consideration.
v Accounting cost
v Accounting cost equals explicit costs plus accounting depreciation.
v It does NOT include some implicit costs such as the net direct benefit
from the alternative use of the resources supplied by the firm’s
owners.
v Depreciation method can be different from economic depreciation.
v Accounting depreciation vs Economic Depreciation
v Economic depreciation: opportunity cost of using the capital that it
owns. Measured as the decrease in the market value of the capital
good during the period.
v Accounting depreciation: A fixed rule that divides the expenditure of
the capital goods into its lifespan. (e.g. equal division) 37
v Profit = Total revenue – Total cost

v Accounting profit = Total revenue – Accounting cost

= Total revenue – Explicit cost – Accounting
depreciation

v Economic profit = Total revenue – Economic cost

= Total revenue – Explicit cost – All implicit cost
= Total revenue – Explicit cost – Economic depreciation
– Opportunity cost (net direct benefit from the best
alternative use given up) of resources supplied by
owner

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 (including economic
depreciation)

Opportunity cost of the owner’s

entrepreneurship and financial capital Opportunity cost of capital used and owned by the firm

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v Cost of capital includes depreciation and interest for the fund used to buy the
capital but excludes the purchase expenditure of the capital.
v Depreciation refers to the value of the capital goods that is actually used up in
the production process in the specific period of time.
v However, the purchase expenditure of capital itself is NOT the cost of capital,
because we count the cost as depreciation when the capital goods are actually
used up in the production during the lifespan of the machine.
v The cost is not incurred at the point of purchase since the capital good can be
sold to get back the money.
v Capital goods are usually purchased by the firm before their use on actual
production, and the firm has to pay its cost much earlier, involving an early use
of fund. The firm has to pay the opportunity cost for using the fund earlier (i.e.
interest) . The related interest is part of the cost.
v If there are also explicit costs of maintenance during the period of production,
it should also be counted towards the cost of the capital good.
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v Which of the following is NOT part of the cost of using the mask
producing machine, which can be used for five years, in its first year of
production for a mask production firm?

v A. The machine is bought with $100,000.

v B. The firm needs to fund the purchase of this machine by its own fund,
giving up $5,000 of interest.

v C. Its value decreases by 1/5 (i.e. $20,000) after a year of production.

v D. The regular maintenance cost of the machine is $10,000 a year.

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 Accounting Economic
Total revenue $1,230,000 $1,230,000
Explicit cost:
Rent $240,000 $240,000
Material $280,000 $280,000
Labor cost $360,000 $360,000
Implicit cost:
Accounting depreciation $40,000
Economic depreciation $40,000
David’s foregone income $300,000
David’s foregone interest income ($200,000 × 5%) $10,000
Profit $310,000 $0

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v Even though the owner can earn an accounting profit of $310,000, one can
only earn an economic profit of $0, since some of the implicit costs are
failed to be taken into account in the accounting cost, and thus giving rise
to a higher accounting profit.

v The owner should stay if the economic profit is positive.

v The owner should quit (in the long run) if the economic profit is negative.

v The owner is indifferent between staying and quitting as profit is zero.

(Usually assume the business will stay in this case, but no more others will
enter.)

v Note: zero profit means the firm owners earn as much accounting profit as
their best alternative use of time and money invested. (Why?)
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v Factors of production

v Short run and long run production

v Product curves

v Cost curves

v Concept of cost and profit

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