Theory of Production and

Costs
1. We move from behavior of consumers to
behavior of producers
2. Firms use economic resources to produce
goods & services
3. Firms make monetary payments to
resource owners (ex. Workers)
4. These payments together with opportunity
costs of own resources make up the firms
costs of production
Theory of Production and
We will look at:
Costs
1. Economic Costs and profits
2. Short-run Production Costs and
Relationships
3. Long-run Production Costs and
Relationships
 Introduction
• Every economy consists of thousands of firms
that produce the goods and services that we
enjoy everyday
• Some firms are large-
– they employ thousands of workers
– Have large numbers of shareholders who share in the
firm’s profits
• Other firms are small
– They employ a few number of people (1-100)
– Owned by one man/ one family (sole proprietorship)
or few people (partnership)
 Introduction
• Recall the law of supply-firms will supply more
goods when the price of the goods rise
– Hence the supply curve slopes upwards
• We use the supply curve to show the firm’s
production decisions
– The behaviour of the firm is summarised by the
supply curve
Question: what curve summarises the behaviour of the
consumer?
 Market forces of Demand and
Supply
• Supply and demand are the two words
that economists use most often.
• Supply and demand are the forces that
make market economies work.
• Modern microeconomics is about supply,
demand, and market equilibrium
 What Are Costs
• According to the Law of Supply:
– Firms are willing to produce and sell a greater
quantity of a good when the price of the good
is high.
– This results in a supply curve that slopes
upward
 What Are Costs
• The Firm’s Objective
• To understand the decisions of a firm, we
must understand what it is trying to do
– The economic goal of the firm is to maximize
profits
 Total Revenue, Total Cost and
Profit
• Total Revenue
– The amount a firm receives for the sale of its
output.
• Total Cost
– The market value of the inputs a firm uses in
production. (The amount that a firm pays to
buy inputs)
– What are the inputs in a firm that makes
cookies?
 Total Revenue, Total Cost and
Profit
• Profit is the firm’s total revenue minus its total
cost.

Profit = Total revenue - Total cost

• Total Revenue is easy to compute:
– it is the quantity of output the firm
produces times the price at which it sells
its output.
• Total Cost is more difficult to measure
 Costs as Opportunity cost
• Recall that the cost of something is what
you give up to get it.
• Opportunity cost of an item refers to all
those things that must be foregone to
acquire the item
• When the economist talks of a firm’s cost
of production, they include all the
opportunity costs of making its output of
goods and services
 Costs as Opportunity Costs
• A firm’s cost of production includes all the opportunity
costs of making its output of goods and services.
Consider the cookie case: Paying P100 to buy flour is an
opportunity cost because we can no longer use the P100
to buy something else.
• Explicit and Implicit Costs
– A firm’s cost of production include explicit costs and implicit
costs.
• Explicit costs are input costs that require a direct outlay of money by
the firm, e.g. salaries it pays to workers, cost of raw materials
• Implicit costs are input costs that do not require an outlay of money
by the firm-e.g. my computer skills, my driving skills etc.
 Economic Profit Vs Accounting
Profit
• Economists measure a firm’s economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs.
• When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
– Economic profit is smaller than accounting profit.
 Production
• The total amount of output produced by a
firm is a function of the levels of input
usage by the firm
• The Production Function
– The production function shows the
relationship between quantity of inputs used
to make a good and the quantity of output of
that good.
 Short-run production
relationships
• S.R. is a period too brief for a firm to alter
its plant capacity
• We look at the relationship between
(variable) inputs and output, i.e., labor-
output relationship given a fixed plant
capacity
• First we define some terms
– Total product is the total quantity of a
particular good produced
Total Product
Total Product Curve
 Average Product (AP)
• AP or labor productivity is output per unit of labor
• AP = TP / amount of input
Quantity
of labor TPP APP
0 0 -
5 50 10
10 120 12
15 180 12
20 220 11
25 250 10
30 270 9
35 275 7.86
40 275 6.88
45 270 6
 Marginal product (MP)
• the additional output that results from the
use of an additional unit of a variable
input, holding other inputs constant
• measured as the ratio of the change in
output (TP) to the change in the quantity of
labor (or other input) used
• MP=∆TP/∆L
 Computation of AP and MP
• Computation
Quantity
of labor TP AP MP
0 0 -
10
5 50 10
14
10 120 12
12
15 180 12
8
20 220 11
6
25 250 10
4
30 270 9
1
35 275 7.86
0
40 275 6.88
-1
45 270 6
 Marginal Product
• Note that the MP is positive when an
increase in labor results in an increase in
output; a negative MP occurs when output
falls when additional labor is used.
 Law of diminishing returns
• As the level of a variable input rises in a
production process in which other inputs are
fixed, output ultimately increases by
progressively smaller increments.
• This is also known as the law of diminishing
marginal product- the property whereby the
marginal product of an input declines as the
quantity of the input increases.
• Example: As more and more workers are hired at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.
Shape of MP and AP curves
 Relationship between MP and TP
• MP rises when TP increases at an
increasing rate, and declines when TP
increases at a decreasing rate.
• MP is negative if TP declines when labor
use rises
Relationship of AP and MP
 Relationship between AP and MP

• AP rises when MP > AP

• AP falls when MP < AP
• AP is at a maximum when MP = AP
 From Production to Costs
• The relationship between the quantity a
firm can produce and its costs determines
pricing decisions.
• The total-cost curve shows this
relationship graphically
 Short Run vs Long run
• Short run
• Long run – a period of time long enough to
enable producers to change the quantities
of all the resources they employ
• Short run costs:
– fixed costs – costs that do not vary with the
level of output. Fixed costs are the same at all
levels of output (even when output equals
zero).
– variable costs – costs that vary with the level
of output (= 0 when output is zero)
 Cost curves
• Total Costs
– Total Fixed Costs (TFC)
– Total Variable Costs (TVC)
– Total Costs (TC)
– TC = TFC + TVC
Short run Vs Long run
Total Fixed Cost
Total Variable cost
TC, TVC, TFC
 Average costs
• Average Costs
– Average Fixed Costs (AFC)
– Average Variable Costs (AVC)
– Average Total Costs (ATC)
– ATC = AFC + AVC
 Average Fixed Cost
• Average fixed cost (AFC) = TFC / Q
 Average variable cost
• Average variable cost (AVC) = TVC / Q
 Average total cost
• Average total cost (ATC) = TC / Q
• ATC = AFC + AVC (since TFC + TVC =
TC)
 Marginal cost
• Marginal Cost
– Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an additional
unit of output?
 Marginal cost

(change in total cost) TC

MC  
(change in quantity) Q
Marginal cost
AFC
AVC, ATC, MC
 MC,AVC, ATC
• MC rises with the quantity of output
• The AC curve is U-shaped
• The MC curve intersects the AVC and ATC at
their respective minimum points
• MC curve reflects the law of DMP
– At low levels of output, few workers are hired, much of
the equipment are unused
– MP of an extra worker is large
– MC of an extra unit produced is small
– At larger outputs, MP is of an extra worker is low, MC
of an extra unit produced is large
 ATC
• ATC=AFC + AVC
• AFC always declines as output rises
because fixed cost is spread over larger
number of units
• AVC rises as output rises because of DMP
• ATC reflects the shape of the AFC and
AVC curves
 LONG RUN cost curves
• For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
– In the short run, some costs are fixed.
– In the long run, fixed costs become variable costs.
• Because many costs are fixed in the short run
but variable in the long run, a firm’s long-run
cost curves differ from its short-run cost curves.
L-R cost curves
 LR cost curves
• In the long run, a firm may choose its level
of capital, and will select a size of firm that
provides the lowest level of ATC.
 Economies and Diseconomies of
Scale
• Economies of scale refer to the property
whereby long-run average total cost falls
as the quantity of output increases.
– Economies of scale – factors that lower
average cost as the size of the firm rises in
the long run
– Sources: specialization and division of labor,
indivisibilities of capital, etc.
 Economies and Diseconomies of
Scale
• Diseconomies of scale refer to the
property whereby long-run average total
cost rises as the quantity of output
increases.
– Diseconomies of scale – factors that raise
average cost as the size of the firm rises in
the long run
– Sources: increased cost of managing and
coordination as firm size rises
 Economies and Diseconomies of
Scale
• Constant returns to scale refers to the
property whereby long-run average total
cost stays the same as the quantity of
output increases
Economies of Scale
 Minimum efficient Scale
• Minimum efficient scale = lowest level of
output at which LRATC is minimized
 Questions
• Given the ff info indicate if the industry
exhibits, Economies of scale or
diseconomies of scale
– A 5% increase in all resources used in
production cause output to increase by 20%
– A 5% increase in all resources used in
production causes output to increase by 2%
• Discuss three sources of economies of
scale
 MES & industry structure
• Economies & diseconomies are important
determinants of industry structure
• An industry where economies of scale are:
– few & diseconomies set in quickly, i.e. MES
occurs at low output levels will be populated by
small firms (size is not an advantage)
– large and diseconomies set in only at very high
levels of output, i.e., MES occurs at high levels of
output will be populated by few large firms
– Continue over an extended range of output, i.e.,
MES at low output and extend to high output
levels, will be populated by firms of different
sizes. Size doesn’t matter in competitiveness
 Summary
• The goal of firms is to maximize profit,
which equals total revenue minus total
cost.
• When analyzing a firm’s behavior, it is
important to include all the opportunity
costs of production.
• Some opportunity costs are explicit while
other opportunity costs are implicit.
 Summary
• A firm’s costs reflect its production process.
• A typical firm’s production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
• A firm’s total costs are divided between fixed
and variable costs. Fixed costs do not change
when the firm alters the quantity of output
produced; variable costs do change as the firm
alters quantity of output produced.
 Summary
• Average total cost is total cost divided by
the quantity of output.
• Marginal cost is the amount by which total
cost would rise if output were increased by
one unit.
• Average cost and marginal cost first fall as
output increases and then rise.
 Summary
• The average-total-cost curve is U-shaped.
• The marginal-cost curve always crosses
the average-total-cost curve at the
minimum of ATC.
• A firm’s costs often depend on the time
horizon being considered.
• In particular, many costs are fixed in the
short run but variable in the long run.