University of the Western Cape

Department of Economics
ECO151 – Chapter 8 – Background to supply: production and cost
Lecture notes
Part 1 - Slide 1
This week in ECO151 we will discuss Chapter 8. Chapter 8 deals with the background to supply
and studies production and cost.
Slide 2
This week is divided into four parts. This is part 1.
Slide 3
In Chapter 6 we looked at how the demand curve is derived from consumer’s preferences using
the utility approach. The other side of is supply. Supply is derived from firms. The theory of
the firm discusses how firms – not consumers – make decisions. For consumers, the choice is
determined by the prices of the products and their income. The firm considers aspects like
revenue, cost, and profit.
Slide 4
After this chapter, you should be able to:
• define the various revenue, cost and profit concepts.
• distinguish between the total, average and marginal product of a variable input.
• distinguish between total, average and marginal cost.
• explain the relationship between the short-run product and cost curves
• explain the nature of production and costs in the long run.
Slide 5
There are six major types of firms in South Africa. While this is not an exhaustive list, it will
give you an idea of how businesses operate.
1. Individual proprietorships
• Only one owner, no limits on liability.
• An example of this is the corner store or many cell phone repair shops.
2. Partnerships
• Two or more individuals, no limits on liability.
 • An example of this might be a doctors’ office or real estate agents.
3. Companies
• Private companies, with or without limited liability.
• Public companies, with limited liability, stock sold to public to raise funds.
• Many individual proprietorships or partnerships now choose to become a
company for tax purposes.
4. Cooperatives
• Where a certain group comes together with a specific aim.
• The agrimark are cooperatives where they are specifically focused on
agricultural inputs.
5. Public corporations
• Paid for by taxes, determined and owned by government.
• Some of the public corporations in South Africa are ESKOM, DENEL, and
SAA.
6. Franchises
• Specific business model sold to business owners.
• Most fast-food chains are franchises like McDonalds, Burger King, KFC.
Slide 6
We make the assumption that the aim of the firm is to maximise profit. There might be other
objectives for firms, like dominating the market (think Facebook) or having the largest market
share. But if it is not profitable, these objectives become obsolete since it cannot survive long-
term. We also exclude companies like NGOs whose aim is not profit but another cause like
sustainability or community development. We focus on firms with a profit aim here. The
aspects that are important here are profit, revenue and cost.
Slide 7
The following calculations are important here.
• Profit is the surplus of revenue over cost. It is the additional revenue more than total
cost. We use the mathematical symbol pi, 𝜋𝜋 to indicate revenue. And it is the difference
between total revenue TR and total cost.
• 𝜋𝜋 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇
• Total revenue is the total value of sales. It is TR and is the price of the product
multiplied with the quantity sold.
• 𝑇𝑇𝑇𝑇 = 𝑃𝑃 𝑥𝑥 𝑄𝑄 = 𝑃𝑃𝑃𝑃
 • Average revenue is total revenue divided by quantity sold. It is also the price of the
product.
𝑇𝑇𝑇𝑇 𝑃𝑃𝑃𝑃
• 𝐴𝐴𝐴𝐴 = 𝑄𝑄
= 𝑄𝑄

• Marginal revenue is the additional revenue earned by selling an additional unit of the
product. Marginal revenue is the change in total revenue divided by the change in
quantity sold. We use the Greek letter, Delta, Δ as the sign for change in.
Δ𝑇𝑇𝑇𝑇
• 𝑀𝑀𝑀𝑀 = Δ𝑄𝑄

Slide 8
Let’s look at an example. Cowgirlblues is a small company in Cape Town that sells yarn.
Assume one ball of yarn sells for R95. Calculate the total revenue and average cost if they sell
10 balls of yarn. What is the marginal revenue if they can sell two balls at R110?

Slide 9
If we start by calculating total revenue, we know total revenue is equal to the price times the
quantity sold. That means 𝑇𝑇𝑇𝑇 = 𝑃𝑃 × 𝑄𝑄 = 𝑅𝑅95 × 10 = 𝑅𝑅950. The average revenue is 𝐴𝐴𝐴𝐴 =
𝑇𝑇𝑇𝑇 950
𝑄𝑄
= 10
= 𝑅𝑅95. What do you notice of the average revenue if the products sell for the same

amount? It is equal to the price of the products. The marginal revenue if they sell two balls of
yarn at R100 is the change in total revenue divided by the change in quantity. This is equal to
220 divided by 2, or 110.
Slide 10
In economics, we distinguish between two periods of time – short run and long run. The short
run is defined as the period during which at least one of the inputs is fixed. Questions you can
think of in the short term is How easy is it to hire new workers if the firm is profitable? versus
How easy is it to adapt and develop new machines? In the long run, all inputs are variable. It
is important to remember that it is not a calendar time – like days, months or years – but how
adaptable the firm and supply chains can be. It also matters if or how long it takes for
technology changes.
Slide 11
A final question for part 1. Which of the following statements is correct? I’ll give you a couple
of seconds to write down your answer.
Slide 12
The answer is C - The short run is a period of time during which the quantity of at least one
input is fixed and the quantities of the other inputs can be varied.
Part 2 – Slide 13
This is part 2. Part 1 served as introduction to the background of supply looking at production
and cost. We also discussed revenue in part 1. In part 2 we start with costs.
Slide 14
It is important to remember that economists think in terms of opportunity cost. Opportunity
cost is the best alternative sacrificed (or forgone). You can review this from chapter 1. As
economists we therefore look at both explicit and implicit costs. Explicit costs are what
monetary payments are made for. This is related to accounting standards. For example, it costs
R50 to produce a ball of yarn and includes labour, dye, wool, machinery. Implicit costs are not
reflected by the monetary payments but rather reflect the opportunity costs not reflected by
monetary payments. For example, time waiting on an order of undyed wool. The total economic
cost is equal to the sum of the explicit costs and implicit costs and is the opportunity cost of
production.
Slide 15
If Cowgirlblues makes a profit of R1000 a day. They decide to close the business to visit a yarn
festival and pays R3000 for the festival. What is the accounting cost versus the economic cost
of attending the festival?
Slide 16
The accounting cost is only the payment that Cowgirlblues makes to attend the festival and is
R3000. The economic cost, however, includes the lost profit from the store being closed for a
day R1000 and the cost of attending the festival, R3000 (to attend the festival), which equals
R4000. Going forward, remember that we think of economic cost in economics and not the
accounting cost.
Slide 17
Total cost is the total economic cost of producing a certain quantity of output. 𝑇𝑇𝑇𝑇=𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝
𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞×𝑄𝑄. Average cost is total cost divided by quantity sold. 𝐴𝐴𝐴𝐴=𝑇𝑇𝑇𝑇/𝑄𝑄=(𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝
𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞×𝑄𝑄)/𝑄𝑄. And the marginal cost is the additional cost for producing an additional unit
of the product. It is the change in total cost divided by the change in total quantity.
𝑀𝑀𝑀𝑀=ΔT𝐶𝐶/ΔQ
Slide 18
The relationships between total costs, average costs, and marginal costs will become clearer as
we move forward and look at the graph, but a sneek peak here. Total cost increases when
marginal cost increases. Average cost increases when marginal cost is greater than average
cost. Average cost decreases when marginal cost is lower than average cost. Average cost
remains unchanged when marginal cost is equal to average cost.
Slide 19
As we have seen before, the profit is the surplus of revenue over cost or the difference between
total revenue and total cost. Total profit is the difference between total revenue from sales of
the firm’s products and the total explicit costs. Normal profit is the best return that the firm’s
resources could earn elsewhere and forms part of the cost of production. Economic profit is the
difference between total revenue from the sale of the firm’s products and the total explicit and
implicit costs.
Slide 20
We see that the economic profit is always smaller than accounting profit because it also
includes the implicit opportunity costs of production and the explicit costs of accounting.
Accounting profit only considers the explicit costs.
Slide 21
There are three scenarios for a firms profit. One, a firm can make an economic profit if the
revenue exceeds the economic costs. Two, a firm can make a normal profit if the revenue equals
the economic costs. Third, a firm can make an economic loss if the revenue is smaller than the
economic costs.
Slide 22
Going forward, in economics, we consider economic profits like we consider economic costs
and economic profits, and not the accounting profit and costs.
Part 3 – Slide 23
This is part three of four for chapter 8 that looks at the background to supply. In part 1 and 2,
we looked at revenue and costs. Remember we consider the economic cost and profit that
include the implicit and explicit costs. We now turn to production in the short run production
costs.
Slide 24
Let’s revisit our yarn producer. Cowgirlblues produces yarn from raw wool using machinery,
dyes and labour. Production is the physical transformation of inputs into outputs where outputs
are the products that consumers use. Inputs are the factors of production like labour and capital
and intermediate goods like goods used to make other. It is also important for you to note here
that the same assumptions and conclusions can be made for services.
Slide 25
What are the various inputs and outputs for our yarn company. The output is the yarn balls. For
Cowgirlblues, the inputs from factors of production are labour and machinery, while the dyes
and raw wool are intermediate goods used in the production of yarn.
Slide 26
To simply our real-world observations, we make the following assumptions on production.
1. A firm produces only one product.
2. All units of a given input are identical or homogeneous.
3. The inputs can be used in infinitely divisible amounts.
4. Production function is given and cannot be changed.
5. Prices of product and inputs are given.
6. The firm uses fixed inputs and one variable input.
Review why we make assumptions from Chapter 1’s appendix.
Slide 27
If we continue with our yarn example. We assume that machinery, dyes and raw wool are fixed
inputs. Machinery cannot change easily as it is expensive. Dyes are bought in bulk and not
bought often and does not change over the short run. Raw wools are dependent on farmers and
seasonal production. Labour is the variable input that remains. The company can hire more
workers to produce more. Given that labour is the only variable input, the firm can expand
output only by increasing the quantity of variable inputs or using more labour.
Slide 28
For a given state of technology, there is a relationship between the quantity of inputs and the
maximum output that can be obtained from these inputs. This is relationship is called the
production function. We can distinguish between the long-term production function and the
short-term production function. We first focus on the short-term production function. The
production function depends on the state of technology and the knowledge of the production
function. We present the production function in a table, an algebraic equation or graph.
Slide 29
This slide shows a made-up production schedule for our yarn company, Cowgirlblues. You
should observe that the fixed inputs remain constant. This is the machinery, dyes and wool.
While the labour input changes from zero to ten. The total output increases as labour increases,
but reaches a maximum of 180 before decreasing again. Why do you think this is? Remember
the space of the factory is limited, there are limited machines as well. So if you add a few
workers, the gains will be large, but if you add too many labourers, some might have to wait
for dyes that another labourer is using. Or machines might not be available for the labourers at
the time. And this means that total output decreases after the maximum.
Slide 30
If we draw the graph of total product, this is what it looks like. You see it increases, reaches a
maximum and decreases. We have total product on the y-axis and total labour, that we denote
with N, on the x-axis.
Slide 31
We also need to study the average product is the number of units of output produced per unit
of the variable input or average product is equal to total product divided by labour. Marginal
product of the variable input is the number of additional units of output produced by adding
one additional unit of variable input or it is the change in total product divided by the change
in total variable input, or in this case labour.
Slide 32
In this slide we calculate the average product and marginal product for our made-up production
schedule for Cowgirlblues. The average product is the total product divided by the total labour.
In the first case, it is 30 divided by 1, which is equal to 30. For marginal product, it is the
change in total product, which is 30, divided by the change in total labour, 1. Which is 30. The
second average product is equal to 70 divided by 2, is 35. The second marginal product is the
change is total product, which is 70 minus 30, or 40 divided by 2 – 1. And 40/1 is 40. See if
you can calculate the other average costs and marginal costs for Cowgirlblues.
Slide 33
If we plot the average and marginal products on a graph, we get these two graphs. The marginal
product is the green line and the average product the purple line. As you will see the marginal
product is initially higher than the average product, it reaches a maximum and turns downward
and even negative. The average product is below the marginal product at first, but it also
reaches a maximum and turns downward.
Slide 34
If we combine the total product, average product, and marginal product graphs. You should
notice the following. The marginal product is equal to the maximum of the average product.
This is at 4 labourers. The marginal product is equal to zero, when the total product reaches its
maximum. This is at 8 labourers.
Slide 35
After studying these graphs, we can derive the law of diminishing marginal returns. The law
of diminishing marginal returns states that as more of a variable input is combined with one or
more fixed inputs in a production process, points will eventually be reached where first
marginal product, then the average product, and finally the total product start to decline.
Slide 36
This graph shows you a smoothed version of the graphs for marginal product and average
product. As we discussed before, the marginal product is equal to the maximum of the average
product or where the graphs cross.
Slide 37
A quick question before we move on to part 4. When the marginal product of labour is less
than the average product of labour…
A. the average product of labour is decreasing.
B. total product is increasing at an increasing rate.
C. the marginal product of labour is increasing.
D. the marginal product of labour curve is positively sloped.
E. the firm is experiencing increasing marginal returns.
Slide 38
If the marginal product of labour is less than the average product of labour, we are to the right
of the cross where the graphs are equal. This means the average product has reached a
maximum and is decreasing. This means the answer is A.
Part 4 – Slide 39
This is part 4 of chapter 8. In this part we will look at the short-run cost schedule and briefly at
the long-run.
Slide 40
Remember we refer to economic costs and not just accounting costs. The fixed cost is the cost
that remains constant irrespective of the quantity of output produced. This is because the fixed
inputs remain the same. For Cowgirlblues, this will be the total costs of wool, dye, and
machinery. Variable cost is the cost that changes when total product changes. For
Cowgirlblues, this will mean the cost of the variable input or labour. Let’s assume the
Cowgirlblues machine costs R50000, the dyes R2000 and the wool R20000. Her labour’s
wages are R24000 per worker.
Slide 41
If we place this into our schedule that we had before with the products of Cowgirlblues, we can
calculate the total cost, as well as fixed costs and variable costs. The total fixed cost is the cost
of machinery, R50000, dyes, R2000, and wool at R20000, which is R72000. The variable cost
is equal to the amount of labour times R24000. This means at one labourer R24000 and at 2
labourers R48000. The total costs at zero is only the fixed cost of R72000, while at one labourer
it is equal to R96000 – R72000 plus R24000. See if you can calculate the other values.
Slide 42
We also need to calculate the average costs – fixed, variable and total – as well as the marginal
costs. Average fixed costs is total fixed costs divided by total product. For example, at one
labourer this is equal 72000 divided by 30, which is 2400. The average variable cost is the total
variable costs divided by the total product. At one labourer, this is R24000 divided by 30 which
is 800. Average total cost is equal to total cost divided by total product which is R96000 divided
by 30 which is 3200. The marginal cost is the change in total cost divided by the change in
product. The first marginal cost is therefore equal to 96000-72000 which is 24000 divided by
30 minus zero. This is equal to 600. See if you can calculate all the other values. Also note the
abbreviations for the various functions like the TC is total cost.
Slide 43
This is what the graphs of the various cost functions look like.
Slide 44
We can summarise the relationships between the cost functions as follows: AC lies above AFC
and AVC. MC reaches its minimum before AVC. AVC reaches its minimum before AC. MC
equals AVC at their respective minimum points. Before the minimum, MC lies below AVC
and AC respectively and beyond the minimum MC lies above AVC and AC.
Slide 45
Now we need to look at the relationships between production that we studied in part 2 and costs
from part 3 and 4. I will show you the areas on the graph. We know that marginal product is
equal to the maximum of the average product. We also see that the marginal cost is equal to
the minimum of average variable cost. When marginal product is increasing, marginal cost is
decreasing. But when marginal product is decreasing, marginal variable cost is increasing. The
two are inverse of each other.
Slide 46
Before we move on to the long-run, a quick question. The marginal cost curve intersects the…
A. AC, AVC and AFC curves at their minimum points.
B. AC and AFC curves at their minimum points.
C. AVC and AFC curves at their minimum points.
D. AC and AVC curves at their minimum points.
E. TC and TVC curves at their minimum points.
Slide 47
The answer is D.
Slide 48
Remember that in the long-run, no input is fixed. Therefore, all inputs are variables, and the
input costs are variable as well. This means that the law of diminishing marginal returns does
not hold in the long-run but only in the short-run when there are fixed inputs.
Slide 49
In the long run, we can however consider returns to scale. Returns to scale refers to the long-
run relationship between inputs and output. There are three possible scenarios. First, constant
returns to scale where a percentage increase in puts will give rise to the same percentage
increase in output. Increasing returns to scale is where for a given percentage in inputs, will
lead to a larger percentage increase in output. Decreasing returns to scale is where for a given
percentage input will give to a smaller percentage increase in output. Economies of scale refer
to if costs per unit of output fall as the scale of production increases. Have a look at the graphs
of long run costs.
Slide 50
The aims of the chapter are the listed below. See if you can define the various revenue, cost
and profit concepts; distinguish between the total, average and marginal product of a variable
input; distinguish between total, average and marginal cost; explain the relationship between
the short-run product and cost curves; and explain the nature of production and costs in the
long run.