The UK’s European university

Economics for Accounting

ECON3007
Autumn Term
7. Theory of the firm: Production and Costs I
 Aims and reading

• Aims
• Why do firms exist?
• Understand types of costs of production
• Differentiate costs in the short run and the long run
• Discuss economies of scale

• Reading
• Gillespie, Chapters 10 and 11

Page 2
 Why do firms exist?

Costs in the short run

Costs in the long run

Page 3
 Why do firms exist?

Page 4
 Why do firms exist?

• The main reason for firms to exist is to reduce costs!

• Ronald Coase (“The Nature of the Firm”,1937) offered
this economic explanation

(1910-2013)

Page 5
 Why do firms exist?

• The article argues that firms emerge because they are

better equipped to deal with the transaction costs -the costs
of entering into and executing contracts and managing
organizations- inherent in production and exchange than
individuals

• He was awarded the Nobel Memorial Prize in Economic

Sciences in 1991

Page 6
 Why do firms exist?

Costs in the short run

Costs in the long run

Page 7
 Costs in the short run

• Managers will aim to achieve the lowest possible cost

per unit for any given level of output

• This involves getting the most efficient combination of

resources

• Their ability to do this varies from the short run to the

long run. In the short run there will be more constraints
than in the long run

Page 8
 Costs in the short run

• The short run in economics is the period of time

during which there is at least one factor of
production fixed

Page 9
 Costs in the short run

• Fixed costs (FC) are the costs that the firm incurs
regardless of the level of production
• Example: interest on a loan

• Variable costs (VC) are any other production costs –

the largest is labour-, they increase with the level of
production
• Example: costs of materials

• Total cost (TC) is the sum of FC and VC

Page 10
 Costs in the short run
100 Output FC
(Y) (£)

80 0 12
1 12
2 12
60
Costs

3 12
4 12
40 5 12
6 12
7 12
20
FC
0
0 1 2 3 4 5 6 7 8

Page 11
Output
 Costs in the short run
100
Output FC VC TC
(Y) (£) (£)
0 12
VC
0
80 1 12 10
2 12 16
3 12 21
60 4 12
Costs

28
5 12 40
6 12 60
40
7 12 91

20
FC
0
0 1 2 3 4 5 6 7 8

Page 12
Output
 Costs in the short run

• Marginal cost (MC)

• It is the extra cost of producing one more unit
∆
MC =
∆
• It follows directly from the law of diminishing returns (the
extra output will decrease as more units of a variable
factor are added to fixed factors)
• The marginal cost of labour (MCL) per unit of output is
the obverse of the MPL i.e. if there are diminishing
returns to labour, the marginal cost of labour will rise

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 Costs in the short run

• Marginal product is the extra output of an extra

employee

Page 14
 Costs in the short run

Page 15
 Costs in the short run

Page 16
 Costs in the short run

• Average costs
• Average cost (AC) is cost per unit of output

AC = = AFC + AVC
Example: if it costs a firm £2,000 to produce 100 units of a product, the
AC would be £20 for each unit (£2,000/100)

• Average fixed cost (AFC) falls with the level of output

• Average variable cost (AVC) is total variable cost per
unit of output

Page 17
 Costs in the short run
MC AC

AVC
Supply
curve in the
Costs(£)

SR → along
MC>AVC

x
AFC
0
Output (Y )
Page 18
 Costs in the short run

Page 19
 Costs in the short run

• The marginal cost curve cuts the average cost

curve at its minimum point
• If the marginal cost is lower than the average cost, the
average cost is decreasing
• If the marginal cost is higher than the average cost,
the average cost is increasing
• If the marginal cost is equal to the average cost, the
average cost does not change
• If the market price is less than the average variable
cost, the firm will prefer to produce nothing (shutdown
condition)

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 Why do firms exist?

Costs in the short run

Costs in the long run

Page 21
 Costs in the long run

• In the long run all factors of production are variable

• This means that mangers are able to change all their

resources to find the optimal combinations

Page 22
 Costs in the long run

• Technical efficiency means that a production process

uses as few inputs as possible to produce a given level
of output

• Economically efficient refers to the method that produces

a given level of output at the lowest possible cost.

• The most important determinants of what is economically

efficient it the long run are economies and diseconomies
of scale

Page 23
 Costs in the long run

LRAC shows
the lowest
possible cost
per unit for any
level of output
when all
factors of
production are
variable

Page 24
 Costs in the long run

• Internal economies of scale: lower unit cost as a result

of a larger size factory
• Technical economies

• Indivisibilities

• Volume

• Specialization and division of labour

• Purchasing economies

• Managerial economies

• Financial economies

Page 25
 Costs in the long run

• Internal diseconomies of scale if a firms expands too

much, then it may find that the average costs rise
• Motivation issues

• Management problems

Page 26
 Costs in the long run

Returns to scale

• Increasing returns to scale occur when an

increase in all of the factors of production leads
to a more-than-proportionate increase in output,
leading to decreases in the average costs

Page 27
 Costs in the long run

• Decreasing returns to scale occur when an

increase in all the factors of production leads to a
less-than-proportionate increase in output. This
leads to an increase in average costs.

• Constant returns to scale occur when an increase

in all of the factors of production leads to a
proportionate increase in output. Average costs
stay constant.

Page 28
 Costs in the short run

Constant
Economies of scale Diseconomies of scale
returns to
Costs per unit (£)

scale

ATC
Minimum
efficient
scale (MES)

0
Quantity
Page 29
 What have we learnt?

• Justification for firms’ existence

• Concepts of total, fixed, variable and average marginal

cost and their relations

• Shape of the LRAC

• Economies of scale in production

Page 30