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Production &

Cost

The Short-run Theory of Production

Q=f (L,K)
so far we assumed that supply curves are upward sloping :
that a higher price will encourage firms to supply more . But
how much will firms choose to supply at each price , it
depends on the amount of profits they will make.
Output depend on the amount of resources and how they are used . Different
amount and combination of input will lead to different amount of output
The cost of producing any level of output depends on the amount of inputs or
factors of production used and the price the firm must pay for them

Short-run theory of production


There are two types of factors of production:

Fixed factor: An input that can not be increased in supply within a given time period
(building)

variable factors : An input that can be increased in supply within given time period
(labour)

Long-run production: the period of time long enough for all factors to be
varied

Short-run : the period of time over which at least one factor is fixed

In production we have the law of diminishing (marginal) returns

when one or more factors are held fixed, there will come a point beyond which
the extra output from additional units of the variable factor will diminish.
additional use of a unit of the factor of production will produce less extra
output than the previous unit.

Short-run theory of production


The short-run production function:
relationship b/w inputs and output is shown in a production function
let us now see how the law of diminishing returns affects total output

Total physical product (TPP) total output of a product per period


of time that is obtained from a given amount of inputs

average physical product (APP) in average how much labor does


product

APP = TPP/L

marginal physical product (MPP) how much total product change


when we increase the number of labor

MPP = TPP/L

Wheat production per year from a particular farm (tonnes)

Wheat production per year from a particular farm


d
Tonnes of wheat produced per year

40

TPP
Maximum output

30

Diminishing returns
set in here

20

10

0
0

Number of farm workers

Tonnes of wheat per year

Wheat production per year from a particular farm


40

TPP
30

20

Diminishing returns
set in here

10

0
0

Number of
farm workers (L)

Tonnes of wheat per year

APP
Number of
farm workers (L)

MPP

Wheat production per year from a particular farm


Tonnes of wheat per year

d
40

TPP
30

20

10

0
0

Tonnes of wheat per year

Maximum
output

Number of
farm workers (L)

14

10

Stage
3

Stage
2

Stage
1

12

8
6
4

APP

0
-2

MPP

Number of
farm workers (L)

Stage 1 : before max point of AP : MP > AP


Stage 2 : decreasing AP but still have positive

MP , before MP=0
Stage 3 : decreasing TP and negative MP
adding more labor causes TP to fall
Diminishing Marginal returns start from MP
start decreasing and slop become negative

Background to Supply
Short-run Costs

Short-run costs
Every company is involving by 2 different type of

cost:
Fixed costs : total costs that do not vary with the amount of output
produced

variable costs: total costs that do vary with the amount of output
produced

Total costs: the sum of total fixed costs and total variable costs

total fixed cost (TFC)

total variable cost (TVC)

total cost (TC = TFC + TVC)

Output TFC TVC


(Q)
()
()

100

0
1
2
3
4
5
6
7

80

60

12
12
12
12
12
12
12
12

Total costs for firm X

TC
()

0
10
16
21
28
40
60
91

TC

12
22
28
33
40
52
72
103

TVC

40

20

TFC
0
0

Total costs for firm X


TC

100

TVC
80

Diminishing marginal
returns set in here

60

40

20

TFC
0
0

Short-run costs

Average total cost : total cost ( F+V) per unit of output


AC=TC/Q

Average fixed cost total fixed cost per unit of output AFC=TFC/Q

Average variable cost total variable cost per unit of output


AVC=TVC/Q

Marginal cost (MC) the extra cost of producing one more unit of
output MC=TC/Q

The relationship between the marginal and total cost curves:


as long as new units of output cost less than the average , their production
must pull the average cost down . If MC is less than AC, AC must be falling.
If new unit cost more than the average , their production must drive the
average up. if MC is greater than AC, AC must be rising . MC crosses the AC
at its minimum point
Since all marginal costs are variable , the same relationship holds b/w MC
and AVC

Marginal cost
MC

Costs ()

Diminishing marginal
returns set in here

Output (Q)

Total costs for firm X


TC

100

TVC
80
Bottom of
the MC curve

60

40

20

TFC
0
0

TFC

TVC

TC

MC

AFC

AVC

AC

12

12

12

10

22

10

12

10

22

12

16

28

14

12

21

33

11

12

28

40

10

12

40

52

12

2.4

10.4

12

60

72

20

10

12

Average and marginal costs


MC

AC

Costs ()

AVC

z
y
x
AFC

Output (Q)

Background to Supply
Revenue

Revenue
Defining total, average and marginal revenue
Revenue curves when firms are price takers

(horizontal demand curve)

average revenue (AR=TR/Q)

marginal revenue (MR=TR/Q)

AR, MR ()

Price ()

Deriving a firms AR and MR: price-taking firm


(we are in perfectly competitive market)

D = AR
= MR

Pe

D
O

Q (millions)

(a) The market

Q (hundreds)

(b) The firm

Revenue
Defining total, average and marginal revenue
Revenue curves when firms are price takers

(horizontal demand curve)

average revenue (AR)

marginal revenue (MR)

total revenue (TR)

In perfect competition market, P=AR=MR

Total revenue for a price-taking firm


Quantity Price = AR
(units) = MR ()

6000

0
200
400
600
800
1000
1200

TR ()

5000
4000
3000

5
5
5
5
5
5
5

TR

TR
()
0
1000
2000
3000
4000
5000
6000

2000
1000
0
0

200

400

600

Quantity

800

1000

1200

Revenue
Revenue curves when price varies with output

(downward-sloping demand curve or it is called


imperfect competition)

average revenue (AR)

marginal revenue (MR)

total revenue (TR)

Revenues for a firm facing a


downward-sloping demand curve

AR and MR curves for a firm facing a downward-sloping D curve


Q P =AR
(units) ()
8
1
7
2
6
3
5
4
4
5
3
6
2
7

AR, MR ()

TR MR
() ()
8
6
14
4
18
2
20
0
20
-2
18
-4
14

AR

0
1

-2

-4

MR

Quantity

Q A wine merchant will supply bottles of


Champagne to a wedding at 10 per bottle, but is
willing to offer a 10% discount on the total bill if 50
bottles or more are purchased. What would be the
firms marginal revenue for the 50th bottle?
20%

20%

20%

20%

20%

B.

C.

D.

E.

A. 450
B. 9
C. 1
D. 40
E. 45
A.

Revenue
Revenue curves when price varies with output

(downward-sloping demand curve)

average revenue (AR)

marginal revenue (MR)

total revenue (TR)

TR curve for a firm facing a downward-sloping D curve


20

16

Quantity P = AR
(units)
()

TR ()

12

1
2
3
4
5
6
7

TR

TR
()

8
7
6
5
4
3
2

8
14
18
20
20
18
14

0
0

Quantity