Lecture2 Posting

Lecture 2:
Production, costs and supply
Reading: NW Ch.7 & 8

Online Quiz 1 – week 3
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BUSS1040 - Lecture 2 2
Introduction
• Now we focus on how firms operate.
o We want to describe firm behaviour with a view on understanding firm and market
supply
1. we examine the ideas of short and long run for a firm's production
process;
o In the short run the firm has at least one fixed input of production, whereas in the
long run all inputs can be adjusted if the firm wishes to.
2. we analyse the relationship between a firm's inputs and its outputs –
that is, its production function.
3. we examine how a firm's output is related to its costs in the short run
and in the long run.
o There is a one-to-one relation between production and costs
BUSS1040 - lecture 2 3
Economic profit versus accounting profit
• We assume that firms aim to maximise profits, where
profit = Economic profit

• Economic profit may differ from accounting profit
• Accounting profits are revenues minus all explicit costs
• Economic profits are revenues minus total opportunity cost
4
BUSS1040 - lecture 2
Economic profit
Total revenue – the amount a firm receives for the sale of its output
Total cost – the amount a firm pays to buy the inputs of production + forgone opportunities
= total opportunity cost of producing goods/services
o Opportunity costs include
 explicit costs (that are not sunk)
= direct payments for inputs or factors of production
 implicit costs (value of foregone opportunities)
e.g. forgone wages, interest earnings
Profit – total revenue minus total costs
π = TR – TC
Example: Helen uses $300 000 of savings, interest rate at 5 % Thus Helen gives up $15 000 per year in
interest
Not an explicit cost – but it is an opportunity cost while she is running the firm, so needs to be
included in costs (and measures of economic profit).
Zero economic profit – revenues just cover opportunity costs
Economic profit versus accounting profit
How an economist How an accountant
views a firm views a firm
Economic
profit
Accounting
profit
Implicit
opp.
Revenue costs Revenue
Explicit Explicit
costs costs
Economic Profit – Example
Tom recently opened a restaurant.
This requires Tom to (temporarily) give up a job working as a lecturer at the university that pays $20 000 a year.
The restaurant is located in a house he inherited from his grandmother, of which he is the sole owner. The house would
otherwise be rented out at a price of $30,000 a year.
This year, the restaurant has revenue of $200 000, personnel costs of $50 000 and costs of food inputs of $20 000. What is
Tom’s economic profit of running his restaurant this year?
(a) $80 000
(b) $90 000
(c) $110 000
(d) $130 000
(e) None of the above
7
• Answer: (a) $80,000
• Explanation: Economic profit = Total revenue – Explicit costs – Implicit
costs
• Here, revenue = $200,000
• Explicit costs = $50,000 (personnel costs) + $20,000 (food inputs) =
$70,000
• Implicit costs = $20,000 (forgone wages) + $30,000 (forgone rental
income) = $50,000
• Therefore, Economic profit = $200,000 - $70,000 - $50,000 = $80,000
RMIT University©4/08/2022 8
The short run and long run
• What is a firm?
• A firm, using the available technology, converts inputs – labour, machinery
(often called capital), natural resources (typically called land) – into output
that is sold in the marketplace.
o Typically, a firm will require more than one input to produce its final output.
• We define the short run and the long run of a firm in relation to
whether or not any of the factors of production (inputs) are fixed
o An input is ‘fixed’ if it cannot be changed regardless of the output produced
The Short and long run
• The short run is the period of time during which at least one of the
factors of production is fixed
o for example, the size of a factory might not be able to be changed.
• In the long run, all factors of production are variable (that is, not
fixed).
o Therefore, in when the firm's lease of the factory ends, the firm is free to
decide whether or not to renew the lease for that factory.
• The short run and the long run is not defined in relation to a set
period of time, but rather in relation to how long it takes for all of a
firm's inputs to become variable – this will differ between industries.
Production
• A firm requires inputs or factors of production (labour, capital, land,
etc.) in order to produce its final output (i.e. goods or services).
• A production function shows the relationship between quantity of
inputs used and the (maximum) quantity of output produced, given
the state of technology.
Example of a production function
• Jonathan owns a factory that makes umbrellas.
• Assume the factory size cannot be changed – that is, we are in the
short run.
• Jonathan chooses how many workers to use
o with one worker, he can make 60 umbrellas; with two workers, 110 umbrellas;
three workers, 150 umbrellas; four workers, 180 umbrellas.
• The relationship between inputs (number of workers) and output
(number of umbrellas) is the production function.
• Often a production function is represented using an equation.
o For example, q=f(L) where q is the level of output and L the amount of labour.
Example of a production function
Typical production function
𝑞
𝑓(𝐿)
Marginal product
• The marginal product (MP) is the change in output when one more
input is used.
• In the umbrella example above:
o Hiring one worker (rather than having no workers at all) allows 60 umbrellas
to be made rather than 0 – the MP of the first worker is 60.
o If Jonathan has one worker and hires one additional worker, output increases
from 60 to 110 – the MP of the second worker is 110 - 60 = 50.
o If Jonathan has three workers and hires one additional worker, is output will
increase from 150 to 180; the MP of the fourth worker is 30 umbrellas.
• MP is the slope of the production function.
Diminishing MP
• MP of an input changes as we increase the use of that input.
• If the MP becomes progressively smaller, this is called diminishing
marginal product.
o In the example above concerning Jonathan's umbrellas, the marginal products
of the second, third and fourth workers respectively are 50, 40 and 30,
indicating diminishing marginal product;
o that is, each additional worker contributes less to output than the worker
before.
Diminishing MP
• Diminishing MP is very common
o In the short run there is a fixed input of some kind which creates a capacity
constraint;
o this will mean that each additional worker will contribute to output less and
less than those hired before.
• Crucially, diminishing MP is a short-run concept

o It relies on the idea that at least one input (like the factory) is fixed.
Production function – Helen’s cakes
Number of Output Marginal

workers (q, cakes per hour) product of labour
0 0
1 50
2 90
3 120
4 140
5 150
Production function – Helen’s cakes
Number of Output Marginal

workers (q, cakes per hour) product of labour
0 0
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
Production function for Helen’s cakes
Production function for Helen’s cakes
Output
140 PF
120
Note how the function
becomes flatter
90
50
No. of workers
Production function
Q of output
Output increases as inputs

Increase, but at a decreasing
Rate (eventually)
This is due to diminishing

Marginal product
Units of labour
Production in the LONG RUN
• Allow all inputs into the production process to be variable.
o In our umbrella manufacturing example, Jonathan can now vary all inputs in
production process; he can choose the factory size as well as the amount of
labour utilized.
• Given all factors of production are variable, we are in the long run.
• We are interested in how the quantity of output changes when we
change the quantity of all of the factors of production.
o production function in the LR: q = f (L,K)
Returns to scale – production in the long run
• Returns to scale refers to how the quantity of output changes when
there is a proportional change in the quantity of all inputs.
o If output increases by the same proportional change, there are constant
returns to scale – if we double the quantity of all the inputs and output also
doubles in quantity.
o If output increases by more than the proportional increase in all inputs, we
have increasing returns to scale.
o If output increases by less than the proportional increase in all inputs, there
are decreasing returns to scale.
• Note, it is possible that a firm has diminishing MP in the short run,

and still has increasing returns to scale in the long run!
SHORT-RUN costs
• A cost function is an equation that links the quantity of output with
its associated production cost.
• For example, TC = f(q), where TC represents total cost and q represents the
quantity of output.
• Example: Helen’s cakes, wage for a worker is $10.
Total cost and output of Helen’s cakes
Number of Total cost Output

workers
0 30 0
1 40 50
2 50 90
3 60 120
4 70 140
5 80 150
Total cost curve of Helen’s cakes
total cost total cost curve
Note how the curve

becomes steeper
q of output
A typical short-run total cost function
𝑇𝐶
𝑓(𝑞)
A typical short-run cost curve
• Several points are worth noting:
• When output is zero, total cost is positive
o this is because, in the short run, some factors of production are fixed and
must be paid for.
• The total cost curve rises as output increases
o costs increase when more inputs are required
• The total cost curve rises at an increasing rate
o this captures diminishing MP: as output increases, a greater quantity of inputs
is needed to increase output by the same amount.
Fixed and variable costs
• In the short run, some inputs will be fixed and some inputs will be
variable; as a consequence, a firm will have some fixed costs and
some variable costs.
• Fixed costs (FC) are costs that do not vary with output. When output
is zero, all the costs are fixed costs.
• By contrast, Variable costs (VC) are costs that vary with output. All
costs that are not fixed costs will be variable costs.
VC = TC – FC
• And hence Total costs (TC) consist of fixed and variable costs:
TC = VC + FC
Q of output TC FC VC AFC AVC ATC MC
0 3.00
1 3.30
2 3.80
3 4.50
4 5.40
Average costs
• Average fixed cost (AFC) is fixed cost per unit of output: AFC = FC/q
o Note that the AFC curve is always downward-sloping – why?
• Average variable cost (AVC) is variable cost per unit of output: that is,
AVC = VC/q
o Because of diminishing MP, the AVC curve will eventually be upward-sloping.
• Average total cost (ATC) is total cost per unit of output; ATC = TC/q
o As ATC = AFC + AVC, its shape is affected by both.
o At very low levels of output, ATC is usually the decline in AFC dominates, but
at higher levels of output, it is usually upward sloping because the increasing
AVC dominates.
o Together, this will give the ATC curve a U-shape (i.e. initially decreasing, but
eventually increasing with output).
Marginal cost
• Marginal cost (MC) is the increase in total cost from an extra unit of
output.
• Due to diminishing MP, a typical MC curve will eventually be
increasing in output; MC often has a positive slope.
o In our umbrella example, each worker costs the same to hire but produces
progressively less than the previous hire (diminishing MP).
o The extra cost of producing another unit of output (MC) must go up.
o In the short run diminishing MP implies increasing MC.
0 3.00 3.00 0.00 - - -
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 1.50
4 5.40 3.00 2.40
0 3.00 3.00 0.00 - - -
1 3.30 3.00 0.30 3.00 0.30 3.30 0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
Typical marginal cost curve
MC
Short-run average costs (dollars)
Qty
Typical average cost curves
MC
Short-run average costs (dollars)
ATC
AVC
AFC
Qty
Relationship between ATC, AVC and MC
• The relationship between MC, AVC and ATC is important.
• As a rule, MC passes through the minimum of ATC and AVC.
o Think of a student’s test scores: if the next test score (the marginal score) is
higher than the student’s average, the average rises; if the next test score (the
marginal score) is lower than the average, the average falls.
o The same logic applies to costs: if MC is above ATC, ATC rises; if MC is less
than ATC, ATC is falling; it follows then that MC intersects ATC at the minimum
of ATC.
o The same applies to MC and AVC; MC intersects the minimum of AVC (from
below).
Example: MC = 10, 20, 30, 40, 50, 60, 70. FC = 100
ATC(1) = (100 +10)/1 = 110

ATC(2) = (100+10+20)/2 = 65
ATC(3) = (160)/3 = 53.3
ATC(4) = 50
ATC(5) = 50
ATC (6) = 51.7
ATC (7) = 54.3
When MC below ATC, ATC is falling as q increases
when MC above ATC, ATC is increasing as q increases
Q AVC ATC MC
1 0.30 3.30 0.30
2 0.40 1.90 0.50
3 0.50 1.50 0.70
4 0.60 1.35 0.90
5 0.70 1.30 1.10
6 0.80 1.30 1.30
7 0.90 1.33 1.50
8 1.00 1.38 1.70
9 1.10 1.43 1.90
10 1.20 1.50 2.10
A typical firm’s short-run costs curves
Costs
MC
ATC
AVC
AFC
𝑞
LONG-RUN costs
• In the long run, all inputs are variable.
• As all production factors are variable
o If a firm does not want to produce anything, its costs are zero.
o A firm producing a positive output has more flexibility to adjust all of its
inputs,
o so long-run costs should not be higher than short-run costs (for a given level
of output)
Long-run marginal cost
• Long-run marginal cost (LR MC) is the marginal cost of increasing
output by one unit
o must take into account the fact that all inputs can be varied to achieve this
increase.
• As noted, LR MC will not be more than SR MC.
Long-run average cost
• Given the firm’s extra flexibility in the long run, long-run average cost
can be no greater than short-run average cost.
• As a result of this, the long-run average cost curve will be the lower
envelope of all of the short-run average cost curves. See the following
figure – it illustrates how to derive a long-run average cost curve from
several short-run average cost curves
Long-run Average Cost Curve
For every plant capacity size
there is a short-run ATC curve,
and every ATC has a minimum cost
ATC-5
Unit costs
ATC-1 ATC-4
ATC-3
ATC-2
20 30 40 50 60 Output 45
Long-run Average Cost Curve
The long-run ATC just

‘envelops’ all the short-run ATC
curves
Unit costs
Long-run
ATC
Output
46
Economies of scale
• Economies of scale is when long-run average costs decrease with
output.
• Diseconomies of scale is when long-run average costs increase with
output.
• Constant returns to scale is when long-run average costs are constant
as output expands.
Economies of scale
Costs
LRAC
Constant
average costs
Economies Diseconomies
of scale of scale
Returns to Scale and Economies of Scale
• There is a direct relationship between returns to scale and economies of scale
• Economies of scale reflect the relationship between output and costs.
• Recall that returns to scale refers to how the quantity of output changes when there
is a proportional change in the quantity of all inputs.
• The relationship arises as the production function (inputs and outputs) is a mirror
image of the cost function (relationship between costs and output)
Returns to scale & economies of scale
• When a firm experiences increasing returns to scale (increasing inputs
proportionally leads to a more than proportional increase in outputs), it also
experiences ‘economies of scale’ or falling average cost of production.
• When a firm experiences decreasing returns to scale (increasing inputs
proportionally leads to a less than proportional increase in outputs), it also
experiences ‘diseconomies of scale’ or increasing average cost of production.
• When a firm experiences constant returns to scale (increasing inputs proportionally
leads to a proportional increase in outputs), it experiences neither ‘economies or
diseconomies of scale’. That is, average cost of production is constant.
• Typically, we think that a firm has regions where it exhibits each of these.
49
Supply
Introduction
• Now we use costs to derive an individual firm's supply function and
the market supply function.
• We focus on competitive markets, in which there are many buyers
and sellers, such that no individual buyer or seller has the power to
materially affect the price in the market.
• As a consequence, both sellers and buyers in the market are price
takers.
Firm supply
• Firm supply is the quantity of output a firm is willing and able to
supply at a certain price.
o The supply curve traces out all combinations of (i) market price and (ii)
quantities that a firm is willing and able to sell at that price.
• Firm supply curve is drawn by changing the price of output, holding

everything else that is relevant constant (ceteris paribus).
o Examples of factors held constant?
Q: Now how much is a firm willing and able to supply at a given price?
Firm supply
• A firm should sell up until P = MC
Firm supply
• A firm should sell up until P = MC
• The marginal revenue (MR) for each unit that the firm sells is the price, P.
o MR = P (competitive market)
o Remember, a competitive firm is a price taker – it cannot affect market price. This
means price is unchanged, regardless as to how much an individual firm sells.
• First, if a firm supplies a quantity where P > MC for the last unit sold (and
this is true for at least one additional unit), profits rise when increasing its
output by one unit.
o it will increase its profit since the additional revenue from selling that extra unit (P)
outweighs the MC.
• Second, if a firm is producing where P < MC for the last unit made, the firm
can increase profit by not making that last unit
o The extra revenue (P = MR) is less than the extra costs that are incurred.
Firm supply
• Consequently, a firm should sell up until P = MC.
• Now if price P changes – from P1 to P2 in the next figure.
o As price rises, so does the firm’s MR
o it now continues to produce until P = MC for the last unit produced.
o As MC is often increasing, the quantity supplied in the market is higher when
price is higher.
• A movement along the supply curve when output price changes is
called a ‘change in the quantity supplied’
o if output price is increasing it is ‘an increase in the quantity supplied’
o for a decrease in output price ‘a decrease in the quantity supplied’.
Firm supply
𝑃
𝑀𝐶
𝑝2
𝑝1
𝑞
𝑞1 𝑞2
The law of supply
• This means is that a firm's supply curve is given by its MC curve!
• MC curve is upward sloping due to diminishing marginal product.
• This gives a positive relationship between the price of a good and the
quantity of that good supplied:
o Other things being equal (ceteris paribus), the higher the price of a good, the
greater is the quantity supplied.
• This positive relationship is known as the law of supply.
o Note, the law does not always hold, but it often does.
Shifts in supply
• The firm's supply curve is derived by assuming that only the price and
quantity supplied of the product can change.
o We assume that all other relevant factors are held constant (ceteris paribus).
• If any other relevant factors change, the supply curve itself will shift.
o These factors include the cost of inputs, technology and expectations about the
future.
o At any given output price, the quantity supplied changes.
• If there is a change in one of these factors there will be a ‘change in

supply’, either:
o ‘an increase in supply’ for shifts of the supply curve to the right (S1 to S2); or
o ‘a decrease in supply’ for shifts of supply to the left (S2 to S1).
Shifts or changes in supply
𝑃
𝑆1
𝑆2
Market supply
• Given that an individual firm's supply curve is given by its MC curve, we can
use this to derive the market supply curve.
• The market supply curve shows the quantity supplied in a market at

different market prices, holding everything else constant.
o Suppose the market price of carrots is $1 and the market consists of 2 suppliers only.
o At this price, Jackson is willing to sell five carrots and Jared is willing to sell eight
carrots. This means that, at $1, the total quantity supplied in the market is 13
carrots. Repeat this for every price to derive the market supply curve.
• Graphically, the market supply curve is the horizontal summation of the

individual supply curves.
o The individual MC curves summed horizontally along the q-axis.
Market supply – two examples of horizontal
summation of individual S curves
𝑃 𝑃
𝑆1 𝑆2 𝑆𝑀 𝑆1 𝑆2 𝑆𝑀
𝑝 𝑝
𝑝̅
𝑄, 𝑞 𝑄, 𝑞
𝑞1 𝑞2 𝑞1 + 𝑞2 𝑞2 𝑞1 𝑞2 𝑞1 + 𝑞2 𝑞2
Market supply
• The law of supply also holds for the market supply curve.
• We also use the term ‘change in the quantity supplied’ to refer to
movements along the market supply curve,
• The term ‘change in supply’ again refers to a shift of the supply curve
itself.
Summary
• Production
• SR vs. LR
• Production function, total product, marginal product
• diminishing MP, returns to scale
• Costs of production
• SR vs. LR
• TC = FC + VC; average costs, marginal cost
• LR average costs and economies of scale
• Firm supply
• Competitive firm produces units until P=MC; supply curve
• Change in quantity supplied vs. change in supply (shift)
• Market supply
BUSS1040 - Lecture 2 63
Next week
• Demand
• Market equilibrium
• Elasticity

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Lecture 2:

Production, costs and supply

Reading: NW Ch.7 & 8

• Schedule enough time to work through the quiz!

profit = Economic profit

• Accounting profits are revenues minus all explicit costs

• Economic profits are revenues minus total opportunity cost

• Crucially, diminishing MP is a short-run concept

Number of Output Marginal

Number of Output Marginal

Output increases as inputs

This is due to diminishing

o production function in the LR: q = f (L,K)

• Note, it is possible that a firm has diminishing MP in the short run,

• Example: Helen’s cakes, wage for a worker is $10.

Number of Total cost Output

total cost total cost curve

Note how the curve

ATC(1) = (100 +10)/1 = 110

When MC below ATC, ATC is falling as q increases

when MC above ATC, ATC is increasing as q increases

The long-run ATC just

• Firm supply curve is drawn by changing the price of output, holding

• If there is a change in one of these factors there will be a ‘change in

• The market supply curve shows the quantity supplied in a market at

• Graphically, the market supply curve is the horizontal summation of the

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