Theory of the Firm/ Production

Theory of production deals with Quantitative relationship between inputs(labour and capital) and
outputs.
Production: it means transforming/ converting inputs into output. In the economic sense, the
process by which resources ( men, material , time , etc.) are transformed into different service or
useful commodity.
Input & Output: Inputs are any goods or services that go into the process of production and outputs
are goods and services that come out of production process.
Inputs are classified as Fixed & Variable Inputs: fixed inputs are inelastic in short run and variable
inputs are elastic in short run( where the inputs are fixed or inelastic). In the long run the supply of
inputs is elastic. Very long run , which refers to a period in which technology of production is
subject to change or may be improved. The technological advancements results in larger output from
a given quantity of inputs per unit of time.
Types of Costs
1. Fixed Costs(TFC)/ Supplementary costs/ overhead : They are constant and does not change with
output; expenses incurred on fixed factors like
● Salaries of permanent staff
● Depreciation
● Insurance premium
● Expenses related to land or repairs

2. Variable Cost (TVC)/ Prime costs/ special cost: They change with the level of output. E.g.
● Cost of labor
● Cost of raw material
● Running expenses like fuel, electricity etc.

3. Semi Variable costs (SVC): some element of it is fixed and other varies with the level of
production, Like:
● Telephone bill
● Electricity bill

4. Opportunity costs: it is defined in the terms of sacrifice of output of another good, which could
have been produced by the same resources used in the production of first good.
5. Marginal costs(MC): the addition to the total cost on account of producing 1 additional unit of
product
6. Average costs(AC): the total cost when divided by the total units produced gives AC.
7. Total Cost: the sum of fixed and variable costs is known as total cost.
 QTY TFC TVC(TC- TC AFC AVC ATC MC
TFC)

1 50 5 55 50 5 55 -

2 50 8 58 25 4 29 3

3 50 10.5 60.5 16.67 3.5 20.1 2.5

4 50 13 63 12.5 3.25 15.75 2.5

5 50 15 65 10 3 13 2

6 50 18 68 8.33 3 11.33 3

7 50 22.75 72.75 7.14 3.24 10.39 4.7

8 50 28 78 6.25 3.5 9.75 5.25

The Concept of Profit Maximization

In the theory of the consumer, we assumed that consumers act to maximize their utility. The
equivalent assumption in the theory of the firm is that firms act to maximize their profits. Profit is
defined as total revenue minus total cost.
Π = TR – TC
(We use Π to stand for profit because we use P for something else: price.)
Total revenue simply means the total amount of money that the firm receives from sales of its
product or other sources.
Total cost means the cost of all factors of production. But – and this is crucial – we have to think in
terms of opportunity cost, not just explicit monetary payments. If the owner of the business also
works there, we must include the value of his time. If the firm owns machines or land, we must
include the payments those factors could have earned if the firm had chosen to rent them out instead
of using them.
If only explicit monetary costs are considered, we get accounting profit. But to find economic
profit, we need to take into account the opportunity cost, implicit or explicit of all resources
employed.
Just as the consumer faced constraints (income and prices), the firm also faces constraints, but of a
somewhat different form. The main constraints faced by the firm are:
• technology
• the prices of factors of production, and
• The demand for its product.
 The assumption of profit maximization is frequently used in microeconomics because it predicts
business behavior reasonably accurately and avoids unnecessary analytical complications. For
smaller firms managed by their owners, profit is likely to dominate almost all decisions. In larger
firms, however, managers who make day-to-day decisions usually have little contact with the owners
(i.e. the stockholders). In any case, firms that do not come close to maximizing profit are not likely
to survive. Firms that do survive in competitive industries make long-run profit maximization one of
their highest priorities.
Profit (Π) = TR – TC , will be maximum only when, foll. 2 condition are fulfilled:
1. Necessary condition( first order condition)- MR=MC
2. Secondary condition ( supplementary condition)- first order condition must be satisfied under the
stipulation that MR is decreasing and MC is increasing

P1
Cost MC
P2 MR

Q1 Q2 Output (Q)
revenue (TR)= f(Q), Q is qty sold
cost (TC)=f(Q), Q is Qty produced
Profit (Π) = f(Q)TR – f(Q)TC
Slope of MR<Slope of MC
It implies that MC must have a steeper slope than MR or MC must intersect MR from below.
Mathematically, the MC is first derivative of TC. The Mc is the slope of TC curve. The MC curve is
U shaped

Total and Marginal Revenue

Total revenue (TR) is the total amount of money the firm collects in sales. Thus,
TR = p*q
if p is the price and q is the quantity the firm sells. Notice that I’m using a small q, because this is
just one firm (Q is reserved for the market as a whole).
 If the firm faces a downward-sloping demand curve, picking a quantity q automatically implies
picking a price p. Why? Because the firm must be operating on the demand curve. Any chosen
price corresponds to a specific quantity that consumers will buy at that price, and any chosen
quantity corresponds to a specific price that will induce consumers to buy the chosen quantity. To
sell more, the firm must lower its price.
Graphically, TR is represented the rectangle created by p and q.
Marginal revenue is the change in total revenue from increasing quantity by one unit. That is, MR =
∆TR/∆q, where the change in q is usually one.
Now, you might think that MR must be equal to the price, p, because that’s how much you get paid
for selling one more unit. But this is not true in general. Why not? Because if you face a
downward-sloping demand curve, you have to lower your price to sell more. So if you increase your
quantity, you’re also lowering your price for all the previous units of the good.
In general, any time a firm lowers its price, there are two effects: the “people buy more units” effect,
and the “people pay less per unit” effect. Which effect is larger determines whether MR is positive
or negative.
elastic demand 1%∆ in price → more than 1%∆ in quantity
“People buy more” outweighs “people pay less”, MR > 0 (above horizontal axis)
⮚ unit elastic demand 1%∆ in price → 1%∆ in quantity
Effects exactly cancel out, MR = 0 (crossing horizontal axis)
⮚ inelastic demand 1%∆ in price → less than 1%∆ in quantity
“People pay less” outweighs “people pay more” , MR < 0 (below horizontal axis)
When the demand curve is a straight line, the MR always has a slope exactly twice that of the
demand curve, so that it crosses the horizontal axis exactly half-way between the origin and the point
where the demand curve does crosses the axis. Why? Because it turns out that a linear demand
curve is always unit elastic exactly half-way down its length, and therefore MR crosses the
horizontal axis at a quantity exactly half-way down the demand curve.

Controversy over Profit Maximization

Arguments against Profit Maximization
1. firms have to have a dichotomy between Ownership & management
2. To achieve profit maximization, firms need to have full knowledge if demand and cost
conditions in both short run and long run. But in reality market is uncertain and price and output
decisions are based on probabilities
3. the equi-marginal principle of MR=MC is mostly absent in the decision making process of the
firms
Defense of Profit Maximization
1. Profit is indispensible for the firm’s survival
2. Achieving other objectives is totally dependent on firm’s ability to make profits.
3. Profit is more reliable measure of firm’s efficiency.

Sales Maximization / Revenue Maximization

Sales maximization is a theoretical objective of a firm which involves selling as many units of a
good or service as possible, without making a loss.
This means sacrificing some short-term profit with a view to achieving a longer term gain. For
example, while seasonal ‘sales’ may result in lower profits, space is created as stocks are cleared,
and more profitable lines can be introduced. Graphically, it means selling at a quantity where AR =
ATC, as shown (at point B.)

Sales maximisation is achieved when: AC= AR or TC=TR. In other words, a business is selling as
much as they can without making a loss.

At the sales maximization output, there are normal profits only and no supernormal profits/loss.

Sales maximisation subject to a profit constraint does not refer to obtaining the maximum sale
volume (which cannot be measured in case of a modern multi-product firm). Rather it refers to
maximisation of total revenue (rupee sales) because if a firm quotes a zero price for its product it can
sell any quantity it likes, but its total revenue will be zero.
Maximum sales revenue need not require very large physical output or sales volume. There is
normally well determined output level which maximises rupee sales. This level is fixed at the output
level at which the price elasticity of demand for the product of the firm is unity i.e., at which
marginal revenue is zero.

This condition is different from the ‘marginal cost equals marginal revenue’ rule of profit
maximisation. But this rule does not take into account the profit constraint. This means that, if at the
revenue maximising level of output the firm does, in fact, earn enough or more than enough profit to
keep its shareholders satisfied, then only it will seek to produce the sales maximising quantity. But if
at this output profits are low, the firm’s output has to be changed to a level which/though it fails to
maximize sales, does satisfy the profit constraint.

MR = 0 when a firm is maximising its sales revenue and MR will be positive when profits are at a
maximum, i.e., a further increase in output will increase total (sales) revenue. Therefore, if at the
point of maximum profit the firm earns more profit than the required minimum, it will pay the sales-
maximiser to lower his price and increase his sales volume (total output).

Reasons for Sales Maximization Objective

1. Sales is taken as index of performance by many sectors.

2. Sales figures are obtained easily and more frequently to assess the performance of the
management.
3. Salaries and earnings of the managers are closely linked with the sales than profit.
4. Many Personnel problems are easily handled with growth in sales.
5. Profit maximization is difficult to maintain at a longer run and therefore mangers aim more at
sales maximization
6. Sales grow at a higher rate than the rate of market expansion therefore in any competitive
market, sales maximization is a reasonable objective.

Difference between Profit & Sales Maximization

When it comes to business, maximizing sales and profits are two fundamental objectives. Sales
maximization is a business strategy that a company implements when it wants to focus on generating
as much revenue as possible. Profit maximization is the objective of generating as much profit as
possible over time. Sales are the initial steps toward profitability. There are no profits without sales.

Revenue/Sales vs. Profits

A business must choose to focus on maximizing either its revenue or profits, but it typically cannot
do both at the same time. Revenue measures the amount of income a business generates through the
sale of its products or services, while profit measures the income remaining after costs, expenses and
taxes are taken out.
Revenue maximization often involves reducing prices to increase the total number of sales.
Maximizing profits requires a business to sell its products or services at the highest possible profit
margin, by either reducing costs or increasing prices.
 Time Frame and Business Objectives
While profit maximization is always the long-term goal for any for-profit business, sales
maximization is a short-term strategy that businesses implement periodically. People know that
companies are in business to make money, so they can understand why a company would want to
maximize profits.
However, it may be a bit harder to grasp why a company would possibly operate at a loss to increase
revenue.
A company may choose to focus on sales maximization to reduce an excess of inventory, establish
an initial customer base or steal customers from competitors. It is not a sustainable long-term
business strategy because a company eventually needs to be profitable to continue operating.
Instead, it is a means to an end, as companies use it to put themselves in position for long-term
success.
Growth Maximization to Gain Market Share
In business, growth maximization is the fundamental element that ties together sales and profit
maximization. Growth maximization is a business objective that a company focuses on to grow in
size and gain more market share.
A high market share gives companies more pricing power, increased control over industry
advancements, and the ability to create barriers to entry for possible competitors. To increase its
market share, a company resorts to sales maximization, which subsequently, puts it in a position to
focus on profit maximization in the long run.
Implementing the Objectives
While revenue maximization can be accomplished by implementing specific sales initiatives and
goals, profit maximization requires more complex planning and strategies because it involves
simultaneously increasing revenue while decreasing costs.
Sales and marketing employees are typically responsible for increasing sales and growth, while
senior leadership focuses on putting the company in a position to achieve the highest level of
profitability possible.
Risks Involved to Long-Term Profits
While the risks of focusing on profit maximization are small, focusing on sales maximization can put
the potential for long-term profits at risk.
There is no guarantee that an increase in sales correlates to an eventual increase in profits. When
companies sell products at or below costs, they view it as an investment in their customers and bank
on them sticking around for a higher price point down the line.
If this does not happen, the investment becomes lost money that could have been used more
efficiently elsewhere.

Organizational slack
‘Slack includes the potential or actual resources which help any organization successfully adapt to
changes. It also provides a means for the organizations to adopt certain strategies to the external
environments. These resources comprise a surplus of inputs, such as labour and equipment, which
are not functioning at maximum level due to unwise investments in technology know-hows that
could have generated better profits and incomes.
The tendency for bureaucratic organisations to use more resources than are
strictly necessary to perform 
the functions of the organization, with the result that resources are used inefficiently and costs rise.
Furthermore, these slack resources help organizations to waive short-term returns in support of
longer-term profits by generating avenues for chasing current and future competitive prospects. This
is because slack resources can be used in an elective fashion for determining competitive and market
prospects, although some researchers consider these slack resources unnecessary. However, some
organizational slack could be beneficial to the company, wherein a company can develop a financial
cushion that can shield the company against any cash flow deficiency or unexpected losses.

Slack resources can help firms to implement strategies for improving efficiency and profitability and
to prosper in the long run

 Any organizational resources devoted to the satisfaction of claims by managers ofsubunits within th
e business organization in excess of the resources that these subunits need to complete company task
s.Organizations tend to build up a degree of‘organizational slack’, or ‘managerial slack’, where they 
operate in lesscompetitive, oligopolistic markets in the form of excess staffing, etc., and this slack pr
ovides a pool ofemergency resources that the organization can draw upon during bad times. When co
nfronted with a deterioration in theeconomic environment, the organization can exert pressure on sub
units within the organization to trim organizational slackand allow the organization to continue to ac
hieve its main goals. Faced with increasing market competition, the organizationwill increasingly be 
run as a ‘tight ship’ as slack is trimmed until, in the limiting case of Perfect Competition,
organizational slack will be zero and Profit Maximisation becomes the rule.

RETURNS TO SCALE
The law of returns to scale explains the behavior of output in response to the proportionate change in scale. If
increasing the inputs proportionately and simultaneously gives the expansion of the scale of production.
Whenever there is an expansion in output, there are 3 possibilities:

1. The output may increase more than proportionate.: Increasing Returns to Scale
2. The output may increase proportionately.: Constant Returns to Scale
3. The output may increase less than proportionately.: Decreasing/Diminshing Returns to Scale
 Law of Increasing Returns to Scale
Consider 2 inputs only, L(labor), K(Capital)
If the quantities of K and L is doubled and the output because of this , is more than doubled , the
returns to scale is said to be increasing i.e. output increases more than the proportionate increase in
input. This relationship between input and output is known as/ show increasing returns to scale.
The factors behind:
1. Technical and Marginal Indivisibilities:
2. Higher Degree of Specialization:
3. Dimensional Relations:

Inputs
K L Output
1 1 10
2 2 25
3 3 50
4 4 75

Law of Constant Returns to Scale

K L Output
1 1 10
2 2 20
3 3 30
4 4 40

When the output is proportionate to the change in input(increase), it shows constant returns to scale. This is achieved
only when the factors of production are perfectly divisible and technology is such that capital-labor ratio is fixed.

K + L=10Q
2K+2L= 20Q

3K+3L=30Q

Law of Decreasing/ Diminishing Returns to Scale

K L Output
1 1 10
2 2 18
3 3 24
4 4 32

When certain increase in inputs leads to less than proportionate increase in output, the firm experiences
decreasing return to scale.

The most imp factors for this is:

1. Diminishing Return to management i.e. managerial diseconomies.: as the size of firm expands, managerial
efficiency decreases.

2. Exhaustibility of natural resources.

Economies & Diseconomies of Scale

The returns to scale are actually the result of economies or diseconomies of scale. Increasing returns operate
till economies of scale are greater than the diseconomies of scale, and returns to scale decrease when
diseconomies are greater than the economies of scale. When economies and diseconomies are in balance ,
returns to scale are constant.

Economies of scale result in cost saving and diseconomies lead to increase in cost.

Economies of scale
1. Internal/ Real Economies: these economies arise from the expansion of the plant size of the firm and
are internal. They can be
 ● Economies in production: when the firm enjoys technological advantages and/or advantages
from division of labor based on skill
● Economies in Marketing (purchase of inputs): when firm can purchase inputs in bulk and / or
economies in advertising cost , selling through whole sale dealers, utilizing sales force
effectively.
● Economies in Transport and Storage: when firm uses transport and storage in fuller capacity
● Managerial Economies: when the firm enjoys specialization in managerial activities and
mechanization of managerial functions.

2. External/ Pecuniary Economies: these economies appear in the form of money saving on inputs.
● Large scale purchase of raw material
● Large acquisitions of external finance( commercial banks)
● Large scale hiring of transport

Diseconomies of Scale
These are the disadvantages, which arise due to the expansion of production scale and therefore, leads to the
rise in the cost of production.

1. Internal Diseconomies : these are exclusive and internal to the firm i.e. they arise within the firm. Like
everything else, economies of scale too have a limit and when the limit is reached , the diseconomies
begin to outweigh the economies and costs begin to rise.
2. External Diseconomies: these are the disadvantages that arise outside the firm, especially in the inputs
market due to natural constraints like agriculture or extractive industries( diminishing returns takes place
i.e. excessive use of cultivable land causes the land to go barren, pumping out more water for irrigation
reduces the water level, extraction of minerals from the ground exhausts the deposits , excessive fishing
reduces the availability of fishes )
With the increase in demand of factors of production, there comes a stress in the input market and the
discounts or the concessions available on the external financing or bulk purchase of inputs come to an
end.

Cost Curve ( short & long run)

TC= f(Q)
A cost function is a symbolic representation of technological relationship between cost and the
output. For the cost analysis, the time frame id long-run or short-run
Change in total cost(TC)/ change in quantity(Q) > 0

TC=TFC+TVC
MC= TC/ Q
AC= (TFC/Q) + TVC
FOR THE SHORT RUN, CHANGE IN TOTAL FIXED COST = 0

TC= a+b*Q

a is constant, = TFC

b is TVC, if, TC= 60+ 10 Q

Output(Q) TFC=60 TVC=10Q TC MC AC(60/Q)+10

1 +1 60 10 70 - 70

2 60 20 80 10 40 (30)

3+1 60 30 90 10 30 (10)

4+1 60 40 100 10 25 (5)

5 60 50 110 10 22 (3)

6 60 60 120 10 20 (2)

7 60 70 130 10 18.5 (1.5)

8 60 80 140 10 17.5 (1)

9 60 90 150 10 16.7 (0.8)

10 60 100 160 10 16 (0.7)

MAKE A GRAPH ON THE BASIS OF ABOVE TABLE, WHERE, OUTPUT(Q) IS IN X-AXIS, COSTS(Y-AXIS)

C TC TVC

TFC

MC

SHORT RUN COST CURVE

Short-Run Cost Relations

Relations among short-run cost categories are shown in Figure. Figure illustrates total cost and total variable cost curves.
The shape of the total cost curve is determined entirely by the total variable cost curve. The slope of the total cost curve
at each output level is identical to the slope of the total variable cost curve. Fixed costs merely shift the total cost curve to
a higher level. This means that marginal costs are independent of fixed cost.

The shape of the total variable cost curve, and hence the shape of the total cost curve, is determined by the productivity
of variable input factors employed. The variable cost curve in Figure increases at a decreasing rate up to output level Q1,
then at an increasing rate.
Assuming constant input prices, this implies that the marginal productivity of variable inputs first increases, then
decreases. Variable input factors exhibit increasing returns in the range from 0 to Q1 units and show diminishing returns
thereafter. This is a typical finding. Fixed the range of increasing productivity and rises thereafter. This imparts the
familiar U-shape to average variable cost and average total cost curves. At first, marginal cost curves also typically
decline rapidly in relation to the average variable cost curve and the average total cost curve.

Near the target output level, the marginal cost curve turns up and intersects each of the AVC and AC short-run curves at
their respective minimum points.

The costs(short run) behaviour is explained ( remembered) as follows:

1. Over the range of output, AFC and AVC fall, AC also falls.
2. When AFC falls but AVC increases, Change in AC is dependent on the rate of change in AFC & AVC.
i. Decrease in AFC > increase in AVC , then AC falls
ii. Decrease in AFC = increase in AVC , then AC is constant
iii. Decrease in AFC < increase in AVC, then AC increases.

3. AC & MC are related :

i. When MC falls, AC follows but decreases at a lower rate than MC.
ii. When MC increases, AC also increases but at a lower rate than MC.
iii. MC curve intersects AC at its minimum. When AC= MC, that is the point of intersection.
LONG RUN TOTAL COST (LTC) CURVE: it is defined as a period in which all the inputs become
variable i.e. the supply of inputs become elastic. Firms have the ability to expand their production
( hiring larger qty of inputs) in the long run it is implied that scale of production will change
whereas in short run it doesn’t.In long run we take into account TC, AC &MC.
LONG RUN = COMPOSITION OF SERIES OF SHORT RUN PRODUCTION i.e., long run cost
is composed of series of short run costs
 Let us assume that the short run costs associated with 1 plant(1) is given as STC 1.Over time the firm
decide to add 2 more plants, plant (2) and plant (3) have corresponding short run costs as STC 2 and
STC3 respectively. LTC (long run Total cost curve) is drawn from the minimum points of STC1,
STC2 and STC3.

LAC (long run Average cost curve) is drawn from the minimum points of SAC 1, SAC2 and SAC3. LAC
curve is also known as “ envelope curve or “planning curve” as it is a guide to the entrepreneur in his
plans to expand the production.