Chapter 6: Production and Cost Theory 1. Introduction: Economics Study Guide

ECONOMICS STUDY GUIDE

Chapter 6 – Theory of the firm (Updated: May 2020)
Chapter 6:
Production and Cost theory
1. Introduction
Firms are often the subject of intense interest, in the way they are run, the amount of
output they produce, how they maximize profits and so on. In this chapter, we
examine the theories that drive the firms;; specifically, these will be focused on the
areas of production and cost.
2. Production Theory
In deciding to increase output levels, especially during periods of huge increases in
purchases, such as the Chinese New Year and Christmas, firms may choose to
increase the quantity of factors of production they hire to meet increases production.
The production theory is concerned primarily on two F.O.Ps – capital goods and
labour.
At this point, we differentiate between two periods – the short run and the long run.

Short Run The period where at least one factor of production is held fixed. Firms
are only able to increase the quantity of labour in the short run, as changing the
quantity of capital goods takes more time, such as placing orders for new planes,
buying new machines for clothes factory and so on. For instance, an accounting firm
may be able to hire more accountants in the short run, a factory more workers.

Long Run The period where all factors of production are variable. Firms are able to
increase the quantity of labour and capital in the long run, in order to increase the
quantity of output. This is referred to the planning period as well – a period where
many possibilities are available to the firms.

There is no fixed period corresponding with the short run and long run;; they may
differ from industry to industry. For instance, it may take up to 2 years for an airline
company to procure new planes;; it may only take a week or two for a restaurant to
get three more commercial fryers for use.
Table 1 is shown below to illustrate the possible changes in production of a firm in
the short run.
Labour (units) Capital (units) Total output Marginal output Average
(units) (units) output
(units)
1 5 10 10 10
2 5 22 12 11
3 5 36 14 12
4 5 46 10 11.5
5 5 51 5 10.2

Copyright 2020. Written by Desmond Lim (MSc Financial Economics, SMU) -‐ 1 -‐
2.1 Short Run Production

In the short run, the number of capital units (machinery) is fixed at 5 units. To
increase output, the firms hire more units of labour. The first additional unit of labour
produces 12 extra units of output;; these 12 units are referred to as the marginal
product. Marginal product thus refers to the extra units of output produced by an
additional unit of labour. The total output thus increases to 12 units. Till the third
additional unit of labour, the marginal product was shown to be increasing. This is
because initially, there were too few workers relative to the total physical capital. This
required the staff to multitask and share duties. As more employees were employed,
each employee could specialize and become more adept at their roles, thus realising
higher marginal product. The marginal product thus offers insights into how efficient
a firm is in producing its output;; this information is not offered by the total output
level.

However, at the 4th additional unit of labour, the marginal product started to show
decreases – the extra output produced is 10 units, fewer as compared to the extra
units produced by the 3rd unit of labour. Subsequent additional units of labour
produce fewer and fewer units of output when hired. This trend of decreasing
marginal product is known as the law of diminishing returns.

This may be attributed to overcrowding, in which the ratio of labour to capital goods
becomes less balanced. Effective combinations of factors of production may be
needed to achieve efficient production;; with a fixed F.O.P, this adjustment of ratio will
be disturbed1. Decreases in marginal product would cause the total product (total
output produced thus far) to increase slower. If the marginal product becomes
negative, total output starts to decrease.

Average product is the amount of output produced by each unit of variable input
(worker) on average.
2.2 Graphs of Short Run Production
The graphs of average product, marginal product and total product are shown below.
(Refer to diagram below for the references to the labelling, such as L1, L2 units of
labour and so on)

Total product initially increases at an increasing rate. This occurs when marginal
product was increasing. As marginal product starts to slow down and become
constant, total product starts to increase at a slower rate. It reaches a decreasing
rate after L2 units of labour are hired. After L3 units of labour are hired, the marginal
product is zero. Total product starts to decrease if further units of labour are hired.

1
See http://www.economicsdiscussion.net/law-‐of-‐diminishing-‐returns/law-‐of-‐diminishing-‐returns-‐
assumptions-‐explanation-‐and-‐causes/6934 for a more extensive discussion.
Note that average and marginal concepts are related in the way below. If the
average height of a group of people are 1.6m, for instance, and an extra person of
height 1.7m (marginal height = 1.7m) joins in, the average height of the group
increases.

Similarly, when marginal product is more than average output, the average output is
increased. When marginal product is lower than average output, it pulls the average
output down.

Marginal product curve thus intersects the average product curve at the maximum
point of the average product curve. This occurs at point B below.

(Diagram taken from Wikipedia)

3. Cost Theory
In examining the cost of production for firms, there are two approaches. We start
with the opportunity cost approach.

When firms produce outputs, they require inputs (factors of production). If firms do
not own the inputs, they have to pay for it. For instance, Singtel hires staff to work at
its branches. It has to pay the staff their wages as Singtel does not own the staff.
This payment, where money actually changes hand, is an explicit cost. It is a cost
reflected in a payment to a factor of production. There is an opportunity cost to
explicit cost, as firms have to give up the use of this amount of money on other
areas, such as on building more factories and so on. If firms own the factors of
production themselves, such as a factory, they may use it without paying further
costs. However, the use of such resources also incurs opportunity cost. For instance,
UOB owns the UOB Plaza at Raffles place area. It may choose to use the building
for its own operations (as office) or rent out to other companies. By using the building
as an office, it cannot rent out;; there will be a loss in potential rental earned by UOB.
This is an implicit cost. It is the cost representing the value of using a resource
not explicitly paid out.

The sum of explicit and implicit cost will be the total cost of production incurred by
the firms, in the form of opportunity cost.

3.1 Total Fixed and Variable Cost
An alternative approach to looking at cost of production is differentiating between
fixed and variable cost. Fixed cost are costs that do not vary with output level.
For instance, the rental cost is the same regardless of output level in a factory.
Variable cos, however, varies with the output level. For instance, more cotton is
needed to produce more clothes. If there is lesser production of clothes, there will be
lesser variable cost incurred to buy cotton. This gives rise to the below:

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡

The total cost of production is the sum of total variable cost and total fixed cost. The
graphs are shown below.

(Diagram taken from Wikipedia)

Since the total fixed cost remains the same regardless of output level, it is shown by
a horizontal curve (line). Total variable cost slopes upwards;; as more is produced, it
increases. However, initially the rise in TVC was at a decreasing rate;; since the
marginal product of labour was increasing, TVC was rising at a slower rate. The
gradient of the TVC curve gets steeper when the marginal output started to
decrease. This was when the law of diminishing marginal returns sets in;; the rate of
increase in TVC was increasing as well.

Total cost (TC) is the sum of TVC and TFC;; it starts at the level of TFC. Without any
production, firms have to at least pay TFC. As more output is produced, TC rises, in
the same way as TVC. TVC and TC curves are parallel;; the distance between them
is TFC, which remains the same throughout.

3.2 Average Fixed and Variable Cost, Marginal Cost
We also examine the costs when it is divided by the total output, giving rise to
average costs. The equation is shown below:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡

The average fixed cost (AFC) decreases as more output is produced. For instance, a
hair salon spends on $10,000 on its rental each month. If it serves 1000 customers
in a month, the AFC is $10. If it serves 10, 000 customers, AFC drops to $1. The
higher the output, the lower the AFC.

Marginal cost refers to the cost of producing the next unit of output. It is
calculated by the change in total cost from an additional unit of production. With
increasing marginal product initially, the cost of producing another unit of output
becomes lesser. For instance, referring to Table 1, we can see that the 1st unit of
labour produces 10 units of output. If the worker is paid a wage of $10 / hour, each
unit of output costs $1. If the 2nd worker who is hired, at the same wage of $10 / hr,
produces 12 units of output, the additional cost of producing each unit will be 83
cents. Marginal cost is decreasing.

When marginal cost is lesser than the average total cost, and lower than it, it is
pulling the ATC curve downwards. Hence ATC is downward sloping initially. MC
curve crosses the ATC curve at the minimum point of ATC curve. Beyond that level
of output, ATC is upward sloping. This is when marginal cost is higher than ATC and
pulling it up.

Average variable cost follows the shape of the ATC curve. However, the gap
between both gets smaller as more output is produced. This is due to the AFC
decreasing as more output is produced. Since the difference between AFC and ATC
is AFC, it gets smaller as more output is produced.

(Diagram taken from Essentials of Economics)

3.3 Product curves and Cost curves
The product curves and cost curves are mirror images of one another. This is
explained in the relationship between production and cost.

Initially, the marginal product was increasing as more units of labour were added.
This means that as more labour are added, each was producing more units of output
than the previous unit of labour. The additional cost of producing the next unit of
output will be lower. Hence marginal cost was falling.

As diminishing returns sets in, additional units of labour would produce lesser output
than the previous unit. This results in the marginal cost of additional output
increasing.
4. Long-Run Production
In the long run, all factors of production are variable. Firms have to consider their
scale of operations – how much output to produce, how many units of factors of
production to hire and so on. This is referred to the planning period as well.

Firms may decide to increase its employment of factors of production. If it doubles its
capital and labour, one of the following may result.

Decreasing returns to scale the percentage increase in output is lower than the
percentage increase in input.

Increasing returns to scale the percentage increase in output is higher than the

Constant returns to scale the percentage increase in output is equal to the

In the long-run all factors of production are variable. It is possible to increase capital
goods and labour;; firms do that, and increase both F.O.P by the same percentage.
This differs from law of diminishing marginal returns, where the capital is held fixed;;
hence the law only operates in the short run period.

4.1 LRAC Curve
As with the short run, in the long-run, production and costs are closely related. With
increasing returns to scale, the firm enjoys economies of scale. This is when the
average cost of producing each unit of output decreases as more are produced. This
may happen due to the reasons below.

Financing economies of scale As firms produce more and grow in size, they are
more credit-worthy to banks. If firms want to borrow money for financing, they may
be able to do so at a lower interest rate, as the banks would deem these bigger firms
to have lower default risks.

Bulk purchases Bigger firms require more raw materials. If they buy more from
suppliers each time, they may obtain bulk discounts, reducing the average cost of
production.

Specialisation Specialised departments may be set up as the firm increases in
size. Workers would be more efficient in their work as they specialise in specific
areas. This raises productivity and lowers the average costs.

Beyond a certain size, or level of output, firms may also experience increases in
average cost, known as diseconomies of scale. This corresponds with the
decreasing returns to scale in production. Diseconomies of scale may happen due to
the following:

Lack of coordination With more departments set up, there may an increasing lack
of coordination between the departments. As there are more lines of communication,
work flow may get slowed down.

Alienation Workers may feel alienated from their work, as they become less
motivated to work on repetitive work. They put in less effort and become less
efficient.

The long-run average cost curve (LRAC) is shown below.



The LRAC is thought to have the same shape as the short-run average cost curve.
Firms initially experience economies of scale, then beyond a certain level of output,
they experience diseconomies of scale. The relationship between the long run and
short run curves are shown and explained below.

(Diagram taken from Tutor2u)

The long run is thought of as the future, when firms have the possibility of producing
at different levels. Since firms aim to maximise profits, they will want to produce at
the lowest point of the AC curve. AC1 to AC4 correspond to four different levels of
output above. The LRAC curve is made up of the different lowest points of the AC
curves. It is a collection of lowest points of the AC curves. Hence LRAC is known as
the envelope curve as well.
5. Revenue
Revenue refers to the amount earned by firms when they sell their goods and
services. At this point, it is essential to differentiate between firms with price setting
ability and those without.

Price-takers Firms with no ability to set prices on their own. They take the market
price (set by demand and supply) as their own selling price.

Price-makers Firms with ability to set prices on their own. They limit output to sell at
higher prices, and lower prices to sell more units.

As with cost concepts, we differentiate between average revenue, marginal revenue
and total revenue.

Marginal revenue The revenue earned by selling the next unit of a good.

Average revenue The revenue earned on average by selling each unit of a good.
This is the price of the good, due to the following:

𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 =
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑃𝑟𝑖𝑐𝑒 𝑥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = = 𝑃𝑟𝑖𝑐𝑒
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦

5.1 Price taking firm
For a price-taking firm, the revenue curves are shown below.

(Diagram taken from Learn CBSE)
For a price taking firm, it sells each unit at the same price, assuming no changes in
demand and supply in the market. AR = MR, since the revenue from selling the next
unit is the price, which is also the average revenue.

Total revenue curve slopes upwards as the rise in TR is at a uniform rate;; each unit
earns additional revenue by the amount of the price.

5.2 Price Making firm
For a price-Making firm, the revenue curves are shown below.



For a price taking firm, it may set different prices to affect quantity sold. AR = price;;
since the price is shown by the demand curve, the AR curve is also the demand
curve. The MR curve lies below the AR curve in this case. It is explained below.

Suppose a firm can sell 4 units of the good at $4 each. To sell the 5th unit, it has to
reduce its price to $3.50.

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = $3.50 − 50 𝑐𝑒𝑛𝑡𝑠 𝑥 4 𝑢𝑛𝑖𝑡𝑠 = $2

To earn the additional $3.50 from the fifth unit, the firm lowers the price. However,
the previous 4 units are sold at 50 cents cheaper each, resulting in the firm earning
lesser. MR is seen to be lower than the price / AR. Hence MR curve lies below the
AR curve.
6. Profit Maximisation
The firm should produce at the output where MC = MR. If MR > MC, firms earn
profits by selling the next unit of output. However, as they can still continue to earn
more profits, they should not stop while MR > MC.

Conversely, if MC > MR, firms should not sell further, as they would be incurring
further losses. The optimal point would thus be where MC = MR, where profits are
maximised.
7. Alternative Objectives
Firms may pursue other objectives rather than profit maximisation all the time. Some
are discussed below.

Revenue Maximisation Big firms, especially large companies, have the ownership
and management separate. While shareholders may want the management to
pursue profit maximisation to enjoy higher returns to their investments, the directors
may instead want to maximise revenue, if that is their key performance indicator. If
so, the firm would produce at where marginal revenue equals to zero instead. This is
where the next unit of sales yields no more marginal revenue, as it has been
maximised, or exhausted, and thus revenue can grow no more. If firms continue to
produce, MR becomes negative, and the total revenue begins to decrease.

Growth maximization Firms may want to increase the scale of production and
increase the quantity of output they produce. A larger size may allow the firms to
gain more economies of scale, or larger market power in the market. For instance,
the acquisition of Uber by Grab2 allowed the latter to gain a larger market share, thus
having more control over the prices it sets.

Corporate Social responsibility Firms may want to conduct business in a way that
agrees with the public and customers, thus gaining a favourable impression with
them. This may be to reduce externalities by adopting greener technology.
2
See https://www.channelnewsasia.com/news/business/grab-‐uber-‐confirms-‐acquisition-‐of-‐in-‐southeast-‐asia-‐
grabfood-‐10076136.

Chapter 6: Production and Cost Theory 1. Introduction: Economics Study Guide

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 6: Production and Cost Theory 1. Introduction: Economics Study Guide

Uploaded by

Copyright:

Available Formats

ECONOMICS STUDY GUIDE

2.1 Short Run Production

You might also like