TOPIC 6: FIRM

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PRODUCTION AND COSTS

WHAT IS A FIRM?

Business firm is an entity that employs factors of
production (resources) to produce goods and
services to be sold to consumers, other firms or
the government.

THE OBJECTIVE OF THE FIRM There are two sides to a business firm: a revenue side (total revenue) and a cost side (total cost). .  π = TR – TC  The firm’s objective is to maximize its profit.  Profit is the difference between total revenue and total cost.

TOTAL REVENUE AND TOTAL COST Total revenue is amount of money the firm receives from the sale of its product.  The opportunity costs of using resources owned by the firm.  Money payments for the use of resources supplied by outsiders. .  Total cost is the costs that the firm incurs for the use of inputs.  Implicit cost: a cost that represents the value of resource used in production for which no actual monetary payment is made.   Explicit cost: a cost incurs when an actual monetary payment is made.

ACCOUNTING PROFIT VERSUS ECONOMIC PROFIT Accounting profit = Total revenue – Accounting costs = Total revenue – Explicit costs  Economic profit = Total revenue – Economic costs = Total revenue – (Explicit costs + Implicit costs)  When economic profit is zero. the firm still earns positive accounting profit which is called normal profit. Normal profit = Zero economic profit  .

 .PRODUCTION Production is a process of transforming inputs into output.  Production function shows the relationship between factors of production and the output of a firm.

 Variable input: input whose quantity employed can be changed as output changes.  Fixed . input: input whose quantity employed cannot be changed as output changes.FIXED AND VARIABLE INPUTS  Inputs are resources or factors of production that are used in a production process.

 Long run is a period of time when all inputs are variable.  In the short run the firm’s plant capacity is fixed. .SHORT RUN AND LONG RUN  Short run is a period of time when there are fixed and variable inputs. The firm can vary its output by using more or less amounts of other resources. The quantities of all resources used in the production process can be varied.  In the long run firm can change its plant.

 Marginal product of labor (MPL) is the additional output the firm can produce when it employs one more unit of labor. APL = Q / L . It is also called labor productivity.SHORT RUN PRODUCTION Total product curve shows the quantity of output that can be produced from different quantities of a variable input.  MPL = ∆Q / ∆L  Average product of labor (APL) is output per unit of labor input.

MARGINAL AND AVERAGE PRODUCT Labor Total Product Marginal Average (L) (Q) Product of Product of Labor (MPL) Labor (APL) 0 0 - - 1 18 18 18 37 19 18.5 7 127 16 18.5 57 20 19 76 19 19 5 94 18 18.77 2 3 4 .12 9 133 -4 14.8 6 111 17 18.TOTAL.14 8 137 10 17.

DIMINISHING AND NEGATIVE MARGINAL RETURNS  Increasing marginal returns  As more units of labor employed. .  Negative marginal returns  As more units of labor employed. the marginal product of labor decreases. the marginal product of labor increases.  Diminishing marginal returns  As more units of labor employed. the marginal product of labor is negative.INCREASING.

 Short run total costs may be divided into total fixed costs and total variable costs.  Total fixed costs are the costs incurred for the use of fixed inputs.SHORT RUN PRODUCTION COSTS  In the short run. . some inputs are fixed and other inputs are variable.  Total variable costs are the costs incurred for the use of variable inputs.

VARIABLE AND TOTAL COSTS  Total fixed costs (TFC): costs that do not vary with the level of output produced.FIXED. TC = TFC + TVC .  Total variable costs (TVC): costs that change with the level of output produced.  Total costs (TC) is the sum of total fixed cost and total variable cost at each level of output.

AVERAGE AND MARGINAL COSTS Average fixed cost (AFC): fixed cost per unit of output. AFC = TFC / Q  Average variable cost (AVC): variable cost per unit of output. AVC = TVC / Q  Average total cost (ATC): total cost per unit of output. MC = ∆TC / ∆Q = ∆TVC / ∆Q . ATC = TC / Q = AFC + AVC   Marginal Cost (MC) is additional cost that the firm incurs when it produces one more unit of output.

SHORT RUN PRODUCTION COSTS .

 When MC is higher than ATC then if Q increases ATC will rise.  When MC is less than AVC then if Q increases AVC will fall.RELATION OF MC TO AVC AND ATC  The MC curve intersects the ATC curves at its minimum point. .  The MC curve intersects the AVC curve at its minimum point.  When MC is higher than AVC then if Q increases AVC will rise.  When MC is less than ATC then if Q increases ATC will fall.

 .  In the long run.  Total cost = Total variable costs  The long run average total cost (LRATC) curve shows the lowest cost per unit at any level of output produced.LONG RUN PRODUCTION COSTS In the long run. there are no fixed costs. a firm can adjust all its resources: all inputs are variable. All costs are variable costs.

LONG RUN AVERAGE TOTAL COSTS .

 Diseconomies of scale: long run average total cost rises as quantity of output increases. CONSTANT ECONOMIES OF SCALE AND DISECONOMIES OF SCALE  The long run average cost curve displays 3 regions:  Economies of scale: long run average total cost falls as quantity of output increases. .  Constant returns to scale: long run average total cost is unchanged as quantity of output increases.  Minimum efficient scale: the lowest output level at which average total cost is minimized.ECONOMIES OF SCALE.

SHIFTS IN COST CURVES  Cost in curves will shift when there is a change  Taxes and subsidies  Input prices  Technology .