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The Theory of the Firm and the cost of production

Production Function

States the relationship between inputs and outputs or maximum output from various combinations of factors in puts. Inputs the factors of production classified as: Input Description Land All natural resources of the earth. Rent Labour all physical and mental human effort involved in production Wages Capital buildings, machinery and equipment not used for its own sake but for the contribution it makes to production Interest

Price paid to acquire

Mathematical representation of the relationship:

= (, , )
Q - Output K - Capital L - Land La - Labor

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Analysis of Production Function (Short Run and Long run): Short Run In the short run at least one factor fixed in supply but all other factors capable of being changed Reflects ways in which firms respond to changes in output (demand) Can increase or decrease output using more or less of some factors but some likely to be easier to change than others.

Long Run The long run is defined as the period taken to vary all factors of production By doing this, the firm is able to increase its total capacity not just short-term capacity and Associated with a change in the scale of production The period varies according to the firm and the industry In electricity supply, the time taken to build new capacity could be many years; for a market stallholder, the long run could be as little as a few weeks

Marginal Product The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input = Diminishing Marginal Product Diminishing marginal product is 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. In the short run, a production process is characterized by a fixed amount of available land and capital. As more labour is hired, each unit of labour has less capital and land to work with.

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Units of L

Total Product (QL or TPL)

Marginal Product (MPL) 2 4 6 8 6 4 2 0 -2 -4

0 1 2 3 4 5 6 7 8 9 10

0 2 6 12 20 26 30 32 32 30 26

TP Total Product MP Marginal Product AP Average product

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Costs

In buying factor inputs, the firm will incur costs Costs are classified as: Fixed costs (FC) costs that are not related directly to production rent, rates, insurance costs, admin costs. They can change but not in relation to output Variable Costs (VC) costs directly related to variations in output. Raw materials primarily

Total Cost (TC) - the sum of all costs incurred in production = + Average Cost (AC) the cost per unit of output = / Marginal Cost (MC) the cost of one more or one fewer units of production = 1 =

Short run Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factor Long run Increases in capacity can lead to increasing, decreasing or constant returns to scale

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Relationships between Costing and Production

Here I guess that first graph is obvious, in second the increasing increase is due to the increasing increase in the MC as shown in first set of graphs.

Revenue

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Total revenue the total amount received from selling a given output = Average Revenue the average amount received from selling each unit =

Marginal revenue the amount received from selling one extra unit of output = 1

Profit

=
Profits help in the process of directing resources to alternative uses in free markets Relating price to costs helps a firm to assess profitability in production

Normal Profit the minimum amount required to keep a firm in its current line of production Abnormal or Supernormal profit profit made over and above normal profit Abnormal profit may exist in situations where firms have market power Abnormal profits may indicate the existence of welfare losses Could be taxed away without altering resource allocation

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Sub-normal Profit profit below normal profit Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs Cost of exit may be high Sub-normal profit may be temporary (or perceived as such!)

Assumption that firms aim to maximise profit May not always hold true there are other objectives Profit maximising output would be where MC = MR

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The Cost of Production


Profit = Total revenue - Total cost Total Cost includes all of the opportunity costs of production Explicit Costs and Implicit Costs Explicit costs are out-of-pocket expenses, such as labour, raw materials, and rent. Implicit costs are foregone expenses, such as the value of your own time, and the value of your own money (interest earned).

Economic Profit versus Accounting Profit Economic profit is smaller than accounting profit

Question: If a firms total revenue is $80,000, and its explicit and implicit costs are $70,000 and $25,000, respectively, what are its economic and accounting profits? Accounting: 35000, Economics: 10000

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Total and Per Unit Costs Total Variable Cost (TVC) Total Fixed Cost (TFC) Total Cost (TC) Average Variable Cost (AVC) Average Fixed Cost (AFC) Average Total Cost (ATC) Marginal Cost (MC)

Fixed and Variable Costs Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do change as the firm alters the quantity of output produced. Average Costs Average costs can be determined by dividing the firms costs by the quantity of output produced. The average cost is the cost of each typical unit of product. Marginal Cost Marginal cost (MC) measures the amount total cost rises when the firm increases production by one unit. Question: Fill in the missing values Three Important Properties of Cost Curves 1. Marginal cost eventually rises with the quantity of output. [Law of Diminishing Marginal Returns] 2. The average-total-cost curve is U-shaped. 3. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

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The Long-run Average Cost Curve In the long run, all inputs are variable. A firm has enough time to choose the size of its factory, farm, office building, or other capital goods. The firm can choose from many short-run cost curves. The bottom points of the short-run average cost curves make up the long-run average cost curve. Long-run average costs fall as production first rises. This is called economies of scale. When the firm gets too big, long-run average costs rise. This is called diseconomies of scale (DOS).

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Returns to Scale When inputs increase, and production more than proportionately increases, then we speak of increasing returns to scale (associated with economies of scale). Example - Inputs increase by 10%, and production increases by 20%. When inputs increase, and production less than proportionately increases, then we speak of decreasing returns to scale (associated with diseconomies of scale). Example - Inputs increase by 10%, and production increases by 5%. When inputs increase, and production increases by the same percentage, then we speak of constant returns to scale. Example - Inputs increase by 10%, and production increases by 10%.

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