Some key terms

Costs and • Revenues

– the amount a firm earns by selling goods and
production • Costs
services in a given period

– the expenses incurred in producing goods and

services during the period
• Profits
– the excess of revenues over costs

The production function Short Run v. Long Run

• Short run
• Q = f (x1, x2, x3, …., xn)
– a period of time in which the quantities of some
• Q: quantity of output
resources can be varied while others are fixed
• Xi: factors of production
• Long run
• To simplify:
– a period of time in which the quantities of all
Q = f (K, L) resources utilised by the firm can be varied
K: capital, L: labor

Short run vs. long run Product schedule

L TP MP AP
(workers (sweaters (sweaters per (sweaters per
per day) per day) additional workers)
• Variable inputs: Inputs whose quantity can be workers)
varied in the short run.
a 0 0
• Fixed inputs: Inputs whose quantity cannot be
varied in the short run. b 1 4 4 4.00
c 2 10 6 5.00
• The long-run total cost curve describes the
minimum cost of producing each output level d 3 13 3 4.33
when the firm is free to vary all input levels. e 4 15 2 3.75
f 5 16 1 3.20
g 6 16 0 2.66

1
 Product curves Total product
graphs of the relationships between the quantity Total
product is
of labor employed and total product, marginal
the total
product and average product: output
– Total product (TP) produced
– Average product (AP)
– Marginal product (MP)

Marginal product
Average product
Average
product: total the increase in total
product divided product that results from a
by the quantity one-unit increase in the
of input used. quantity of input used.

APL = Q/ L MPL = Δ Q / ΔL
MPX = ΔQ / ΔX
APX = Q/ X

Marginal Returns
The law of diminishing returns
• Increasing marginal returns: when the
marginal product (MP) of an additional worker As a firm uses more of a variable input, with a
exceeds the MP of the previous worker. given quantity of fixed inputs, the marginal
product of the variable input eventually
• Diminishing marginal returns: when the MP of diminishes.
an additional worker is less than the MP of the
previous worker.

2
 Economic Profit
Economic Costs
and Accounting Profit
• Economic costs are all payments a firm
makes or incomes it provides to resource • Economists include all opportunity costs so all
suppliers input usage is valued
Economic = Total  Opportunity cost
• Include - profit revenue of all inputs
– explicit costs
• involve a direct money outlay to the • Accountants concentrate on explicit money
firm’s input suppliers outlays as measured in the company’s
– implicit costs accounts
• costs where resources are owned by the Accounting = Total  Explicit
firm profit revenue costs

Example: Nam’s Cafe

How an Economist How an Accountant
Views a Firm Views a Firm
Accounting statement of profit:
Economic Sales revenue D385,000,000
profit
less
Accounting
profit Cost of goods sold D220,000,000
Implicit Wages 50,000,000
Revenue costs Revenue
Total Depreciation 15,000,000
opportunity 285,000,000
costs
Explicit Explicit Accounting profit D100,000,000
costs costs

Normal v. economic profit

Example: Nam’s Cafe
Economic statement of profit:
Sales revenue D385,000,000 • Normal profit (zero eco. Profit)
less – the minimum return sufficient to ensure
Cost of goods sold D220,000,000 continuation of the firm
Wages 50,000,000
• Economic profit
Depreciation 15,000,000
– a return above that required to retain all
Nam’s salary 70,000,000
existing inputs in the firm
Interest foregone 10,000,000
Rent foregone 20,000,000 – ‘above-normal’ or ‘pure’ profits
D385,000,000
Economic profit D0

3
 Costs and the economist SHORT RUN COST
• Fixed factor of production
• Sunk cost: A cost that cannot be recovered and – a factor whose input level cannot be varied
that is therefore irrelevant when an economic • Fixed costs
choice is being made – costs that do not vary with output levels
• Example: You pay $6.5 to see a new movie and • Variable costs
find it very boring. The $6.5 is irrelevant to a – costs that do vary with output levels
decision on whether to watch the movie to its • TC = FC + VC
end.

SHORT RUN COST

Labor Output TFC TVC TC MC AFC AVC ATC
(worke (sweate (dollars
rs rs per (dollars per per (dollars per
– Total cost per day day) day) Addition sweater)
– Marginal cost al
sweater)
– Average cost
a 0 0 25 0 25 --- --- ---
b 1 4 25 25 50 6.25 6.25 6.25 12.50
c 2 10 25 50 75 4.17 2.50 5.00 7.50
d 3 13 25 75 100 8.33 1.92 5.77 7.69
e 4 15 25 100 125 12.50 1.67 6.67 8.33
f 5 16 25 125 150 25.00 1.56 7.81 9.38

Total cost
Total cost
• Total cost (TC): the cost of all the productive
resources it uses. Total cost includes the cost of
land, capital and labor.
• Total fixed cost (TFC): the cost of all the firm’s
fixed inputs. Fixed cost is independent of the
output level.
• Total variable cost (TVC): the cost of all the
firm’s variable inputs. Variable cost is a cost
that varies with the output level.
• TC = TFC + TVC

4
 Average cost Average cost
AFC: total fixed cost per unit of output.
The average cost of production is total cost
AVC: total variable cost per unit of output.
divided by the level of output.
ATC: total cost per unit output.
TC = TFC + TVC
TC = TFC + TVC AC

Q Q Q
ATC = AFC + AVC
Output

Average and marginal cost curves Average and marginal cost curves
MC The distance
Cost between ATC
MC cuts both and AVC is AFC,
60
Cost average cost which gets
curves at their
smaller as Q
minimum increases!

ATC
MC
ATC
45 AVC
35
30

15

0
0 Q
5 10 15 Q
2727 2828

Marginal cost Average and Marginal Cost- Relationships

Marginal cost: the
increase in total
cost that results  When MC < ATC: ATC falls
from a one-unit
increase in  When MC > ATC: ATC increases
output.
 When MC = ATC: ATC is at its minimum

MC = ΔTC / ΔQ
= ΔTVC / ΔQ
MC = dTC/ dQ

5
 MC and Diminishing marginal returns
MC Cost Curves and Product Curves

Diminishing marginal
returns set in here
Costs (£)

Output (Q)

Principle of production Based on Marginal Product

MPL = MPK (1)
1. Based on Marginal Product PL PK
2. Geometric method and L. PL + K. PK = TC (2)

Geometric method:
Geometric method a. Isoquants

a) Isoquants Isoquants shows the combinations of different

b) Isocosts factors of production producing the same
c) Point of tangency level of output

6
 K Geometric method:
a. Isoquants
• When increasing number of labor, output
increases by:
Q3(90)
ΔQ = ΔL . MPL
Q2(75) • When decreasing amount of capital, output
Q1(55) decreases by:
ΔQ = ΔK . MPK
L

Geometric method: Geometric method:

a. Isoquants a. Isoquants
• Marginal rate of techinical substitution (MRTS
To be sure unchanged quantity of output:
LK) is the amount of capital can be reduced
ΔL . MPL + ΔK . MPK =0 when increasing 1 additional unit of labor to get
- MPL = ΔK = MRTS LK the same quantity of output.
MPK ΔL MRTS LK = ΔK / ΔL
• MRTS LK has minus sign (-) and often
diminishing, on the graph it is the VERY slope of
the isoquant.

The special shapes of the isoquant Geometric method:

b. Isocosts
K K K

TC/PK Isocost: shows the

combinations of factors
1 of production giving the
same cost
L 1 L TC/PLL
Perfect Substitute Perfect
Complement

7
 Geometric method: Geometric method:
b. Isocosts c. Point of tangency

• The equation of the isocost: • The optimal combination point is the tangent
K. PK + L. PL = TC of the isocost and the highest attainable
or: K = TC – PL . L isoquant. At that point, the slope of two
curves are equal:
PK PK
• MPL = PL
• Slope of the isocost: (- PL / PK )
• MPK PK (1)
and L. PL+ K. PK = TC (2)

Geometric method: LONG RUN-

b. Isocosts PRODUCTION AND COSTS
K K • All inputs are variable in the long run
– Therefore, all costs are variable
TC/PK • Concentrate on average costs, not total costs
– How do costs per unit change when all inputs can
Q be varied?
• Economies of scale
– Long run average costs fall as output rises
TC/PLL L • Diseconomies of scale
– Long run average costs rise as output rises

The production function

How To Derive the LRAC Curve
Labor (workers Output (sweaters per day)
per day) Plant 1 Plant 2 Plant 3 Plant
• The LRAC curve shows the lowest unit cost at 4
which each output level can be produced 1 4 10 13 15
when the firm can vary the size of plant 2 10 15 18 21
• The ‘envelope’ curve of all the SAC curves for 3 13 18 22 24
each plant size 4 15 20 24 26
5 16 21 25 27
Number of Knitting 1 2 3 4
Machines

PL = $25 / person / day PK = $25 / machine / day

8
Short-run cost curves and long-run cost Economies of scale (Increasing
curves returns to scale)
Economies of scale – or increasing returns to
scale – occur when long-run average costs
decline as output rises: Increasing
returns to
scale: When
the % increase
in a firm’s
output excess
LAC the % increase
in its inputs
Output

Economies of scale (Increasing returns Disconomies of scale (Decreasing

to scale) returns to scale)
Disconomies of scale – or decreasing returns to
A scale– occur when long-run average costs rise as
K
output rises:
Decreasing returns
LAC
to scale: when the
4
% increase in the
30 firm’s output is less
2 20 than the % increase
10
in its inputs.

0 5 10 L Output

Disconomies of scale (Decreasing

returns to scale) Constant returns to scale
– occur when long-run average costs are
A
constant as output rises:
K
Constant returns
26
to scale: When
the % increase in
a firm’s output is
4
18
equal to the %
LAC increase in its
2
inputs
10

0 5 10 L Output

9
 A typical long-run average cost curve
Constant returns to scale

A Economies Constant Diseconomies LRAC

K 6 of scale costs of scale

Costs
30

20 Constant
increasing Decreasing
returns
2 returns to returns to
to
10 scale scale
scale
0 5 10 15 L O Output

10