W5 Topic 4.THEORY OF FIRM

TOPIC 4
Theory of the Firm:

Production and
Costs
©2016 Cengage Learning. All Rights Reserved. May not be scanned,

copied or duplicated, or posted to a publicly accessible website, in
whole or in part.
Learning Outcomes
• Explain and calculate Economic and
Accounting Profit
• Explain Production and Costs in the

Short Run
• Explain Production and Costs in the

Long Run
BUSINESS FIRM
● An entity that employs factors of production

(resources) to produce goods and services to
be sold to consumers, other firms, or the
government.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
FIRM’S OBJECTIVE: MAXIMIZING
PROFIT FROM SELLING GOODS
● The difference between total revenue and
total cost.
Profit = Total revenue - Total cost
EXPLICIT AND IMPLICIT COST
 Explicit Cost - A cost incurred when an actual

(monetary) payment is made.
 For instance, the explicit cost of a gallon of

milk is RM1.89.
EXPLICIT AND IMPLICIT COST
 Implicit Cost - A cost that represents the value

of resources used in production for which no
actual (monetary) payment is mad.
 This is incurred as a result of a firm using its
own resources that it owns.
 For example, the implicit cost to the dairy
farmer is the money he could have earned had
he chosen another pursuit say, as a factory
operator earning RM3k per month.
EXPLICIT AND IMPLICIT COST:
EXAMPLE
 Mr Wong currently works as a Manager
earning RM80k a year. He quits his job as a
manager and opens a pizzeria.
 Total revenue a year is RM200k.
 He spent RM2k on plates, RM3k on cheese,
RM20k for rental.
Explicit costs = RM2k + RM3k + RM20K

= RM25K
Implicit costs = RM80K. (forgone)
ACCOUNTING, ECONOMIC AND
NORMAL PROFIT I
 Accounting Profit - The difference between

total revenue and explicit costs.
 Economic Profit - The difference between
total revenue and total cost, including both
explicit and implicit costs. Smaller than
accounting profit.
 Normal Profit - Zero economic profit. A firm
that earns normal profit is earning revenue
equal to its total costs (explicit plus implicit
costs). This is the level of profit necessary to
keep resources employed in that particular
firm.
ACCOUNTING, ECONOMIC AND
NORMAL PROFIT II
Accounting Profit vs. Economic Profit
Example:
• Suppose James is earning RM22,000 a year as
a sales representative for a T-shirt
manufacturer.
• At some point he decides to open a retail store
of his own to sell T-shirts.
• He invests RM20,000 of savings that have been
earning him RM1,000 per year.
• And he decides that his new firm will occupy a
small store that he owns and have been
renting out for RM5,000 per year.
• He hires a clerk to help him in the store,
paying her RM18,000 annually.
Example:
• A year after he opens the store, he totals up
his accounts and finds the following:
RM RM
Total revenue 120,000
Cost of T-shirts 40,000
Clerk’s salary 18,000
Utilities 5,000
Total (explicit) costs 63,000
Accounting profit 57,000
• Accounting profit of RM57,000 generated
ignores the implicit costs and thus overstates
the economic success of his venture.
• Economic profit can be calculated as follows:
RM RM
Forgone interest 1,000
Forgone rent 5,000
Forgone wages 22,000
Total implicit costs 28,000
Economic profit 29,000
POSITIVE ACCOUNTING PROFIT
RM RM
Total revenue 120,000
Cost of T-shirts 40,000
Clerk’s salary 18,000
Utilities 5,000
Total (explicit) costs 63,000
• ZERO ECONOMIC PROFIT
• NORMAL PROFIT
RM RM
Forgone rent 5,000
• POSITIVE ECONOMIC PROFIT
• EXCESS PROFIT
RM RM
Forgone rent 5,000
Accounting Profit Economic Profit
• Accounting Profit
• = TR – EXPLICIT COSTS
• = RM 120,000 – 63,000
• = RM 57,000
Accounting Profit Economic Profit
• Economic Profit
• = TR - EXPLICIT COSTS
-IMPLICIT COST
• = RM 120,000 – 63,000 – 28,000
• = RM 29,000
• OR Economic Profit = AP – IC
• RM 57,000 – 28,000 = RM 29,000
PRODUCTION AND COST:
FIXED AND VARIABLE INPUTS
 Production is a transformation of resources
or inputs into goods and services
 Fixed Input - An input whose quantity
cannot be changed as output changes.
 Variable Input - An input whose quantity
can be changed as output changes.
Production
• A variable
fixed inputinput
is an
is input
an input
whose
whose
quantity
quantity
cannot
can be
changed as output changes in the short run.
• The costs associated with variable
fixed inputs
inputs
areare
fixed
costs. A costs.
variable fixed cost
A variable
doesn’t change
cost changes
as output
as output
changes.
PRODUCTION AND COST:
SHORT AND LONG RUN
 Short Run - A period of time in which some
(at least one) inputs in the production process
are fixed.
 Long Run - A period of time in which all
inputs in the production process can be varied
(no inputs are fixed).
PERIODS OF PRODUCTION, INPUTS,
AND COSTS
PRODUCTION IN THE SHORT RUN
 Suppose two input (resources), labour
(column 1) and capital (column 2), are used to
produce some good (column 3).
MARGINAL PHYSICAL PRODUCT
(MPP)
 Marginal Physical Product (MPP) - The
change in output that results from changing
the variable input by one unit, holding all
other inputs fixed
∆𝑄
𝑀𝑃𝑃=
∆𝐿
AND THE LAW OF DIMINISHING
MARGINAL RETURNS
 In the short run, as additional units of a

variable input are added to a fixed input, the
marginal physical product of the variable
input may increase at first.
 Eventually, the marginal physical product of
the variable input decreases.
LAW OF DIMINISHING MARGINAL
RETURNS
● Law of Diminishing Marginal Returns - As
ever-larger amounts of a variable input are
combined with fixed inputs, eventually, the
marginal physical product of the variable
input will decline.
LAW OF DIMINISHING MARGINAL
RETURNS
Example:
Agricultural workers (variable input) are added to acres of land
(fixed input).
The workers must clear the land, plant the crop and then harvest the
crop.
In the early stages of adding labour to the land, MPP rises as each
worker has abundant units of fixed input to work with.
But eventually, as we continue to add more workers to the land,
there comes a point where the land is overcrowded with workers.
Workers are stepping around each other, stepping on the crops, etc.
due to these problems., output growth begins to slow.
AND THE LAW OF DIMINISHING
MARGINAL PRODUCTIVITY
The point at
which
marginal
physical
product
decreases is
the point at
which
diminishing
marginal
returns have
set in.
FIXED, VARIABLE, TOTAL AND
MARGINAL COST
 Fixed Costs (FC) - Costs that do not vary with
output; the costs associated with fixed inputs.
 Variable Cost (VC) - Costs that vary with output;
the costs associated with variable inputs.
 Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
 Marginal Cost (MC) - The change in total cost that
results from a change in output: MC = ΔTC/Δ Q.
AND MARGINAL COST I
AND MARGINAL COST II
 The marginal physical product of labor curve

is derived by plotting the data from columns 2
and 4 in the exhibit.
 The marginal cost curve is derived by plotting
the data from columns 3 and 8 in the exhibit.
See next slide.
MPP MC
rises falls
MPP MC
falls rises
Due to the law of

diminishing marginal
returns
RELATIONSHIP BETWEEN COST AND
PRODUCTIVITY
W = Wages (variable cost)
MPP = Marginal Physical Product
MC = Marginal Cost
HOW MPP AFFECTS MC
HOW MPP AFFECTS MC
● What the marginal cost curve looks like

depends on what the marginal physical
product curve looks like.
● If the MPP curve first rises and then (when
law of diminishing marginal returns set in)
falls, it follows that the MC curve must first
fall and then rise.
AVERAGE PRODUCTIVITY
When the press or laypersons use the word productivity,

they are usually referring to average physical product
instead of marginal physical product. To illustrate the
difference, suppose 1 worker can produce 10 units of
output a day and 2 workers can produce 18 units of
output a day. Marginal physical product is 8 units (MPP
of labor = ∆Q/ ∆L). Average physical product, which is
output divided by quantity of labor is equal to 9 Units
LABOR PRODUCTIVITY
● Labor productivity is used in the newspaper

and in government documents, it refers to the
average (physical) productivity of labor on an
hourly basis. By computing the average
productivity of labor for different countries
and noting the annual percentage changes we
can compare labor productivity between and
within countries.
1. If the short run is 6 months, does it follow
that the long run is longer than 6
months? Explain your answer.
SELFTEST
No. The short run and the long run are not lengths of time.
The short run is that period of time when some inputs are
fixed and therefore the firm has fixed costs. The long run is
any period of time when no inputs are fixed (i.e., all inputs
are variable) and thus all costs are variable costs. The short
run can be, say, six months, and the long run can be a much
shorter period of time. In other words, the time period when
there are no fixed inputs can be shorter than the time period
when there are fixed inputs.
AVERAGE FIXED, VARIABLE AND
TOTAL COST
 Average Fixed Cost (AFC) - Total fixed cost
divided by quantity of output: AFC =
TFC / Q.
 Average Variable Cost (AVC) - Total

variable cost divided by quantity of output:
AVC = TVC / Q.
 Average Total Cost (ATC), or Unit Cost -

Total cost divided by quantity of output: ATC
= TC / Q.
TOTAL, AVERAGE & MARGINAL
COSTS I
TOTAL, AVERAGE & MARGINAL
COSTS II
AVERAGE-MARGINAL RULE
● When the marginal magnitude is above the

average magnitude, the average magnitude
rises; when the marginal magnitude is below
the average magnitude, the average
magnitude falls.
Example
• Suppose there are 20 persons in a room and each
person weighs 170 pounds.
• Average weight = 170 pounds [(170 x 20)/20]
• Let an additional (marginal) person enter the
room.
1. Suppose the weight of the marginal person = 275
pounds: new average weights = 175 pounds
{[(170x20) + 275]/21}. When marginal
magnitude > average magnitude : average
magnitude
2. Suppose the weight of the marginal person = 65
pounds: new average weights = 165 pounds
{[(170x20) + 65]/21}. When marginal
magnitude < average magnitude : average
magnitude
AVERAGE AND MARGINAL COST
CURVES
When MC > AVC
(ATC), the AVC (ATC)
curve rises (AVC is
rising);
When MC < AVC
(ATC), the AVC (ATC)
curve falls (AVC is
falling).
The average-marginal
rule does not apply to
the AFC curve, since
marginal costs do not
affect fixed costs
TYING SHORT-RUN PRODUCTION TO
COSTS
What happens in terms of production (MPP rising or falling) affects MC, which in turn
eventually affects AVC and ATC.
SUNK COST
 A cost incurred in the past that cannot be

changed by current decisions and therefore
cannot be recovered.
 Economists advise individuals to ignore sunk
costs.
Sunk Cost
Example:
Jeremy buy a movie ticket, walks into the theater and settles down
to watch the movie. Thirty minutes into the movie, he realizes that
he dislikes the movie.
• Suppose Jeremy says the following to himself as he is watching

the movie:
• ‘I paid to watch this movie, but I really hate it. Should I get up
and walk out or should I stay and watch the movie? I think I’ll
stay and watch the movie because if I leave, I’ll lose the money
I paid for the ticket.’
• The money he paid for the ticket is a sunk cost (the movie
theaters do not give your money back if you dislike the movie).
• The cost was incurred in the past, it cannot be changes and it
cannot be recovered.
• An economist, however, would advise Jeremy to ignore what

has happened in the past and can’t be undone. In other words,
ignore sunk costs (movie ticket).
PRODUCTION AND COSTS IN THE
LONG RUN
 In the short run, there are fixed costs and
variable costs; therefore, total cost is the sum
of the two.
 A period of time in which all inputs in the
production process can be varied (no inputs
are fixed). In the long run, there are no fixed
costs, so variable costs are total costs.
LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
 There are three short-run

average total cost curves
for three different plant
sizes.
 If these are the only plant
sizes, the long-run average
total cost curve is the
heavily shaded, blue
scalloped curve.
ECONOMIES OF SCALE II
The lowest output level at

which average total costs
are minimized.
Exhibit (a):
• There are 3 short-run ATC curves for 3 different
plant sizes. Suppose the manager of a firm wants
to produce output level Q1. Which plant size will he
choose?
He will choose plant size represented by SRATC 1
due to lower unit cost incurred (i.e. Point A) if
compared to plant size represented by SRATC 2.
(Point B).
• How about producing output at Q2?
Choose plant size represented by SRATC3 .(Point C)
• If we were to ask the same question for every
(possible) output level, we would derive the LRATC
curve.
LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
 The long-run average

total cost curve is the
heavily shaded, blue
smooth curve.
 The LRATC curve is not
scalloped because it is
assumed that there are
so many plant sizes that
the LRATC curve touches
each SRATC curve at only
one point.
ECONOMIES OF SCALE I
 Economies of Scale exist when inputs are increased

by some percentage and output increases by a greater
percentage, causing unit costs to fall.
 Constant Returns to Scale exist when inputs are
increased by some percentage and output increases
by an equal percentage, causing unit costs to remain
constant.
 Diseconomies of Scale exist when inputs are
increased by some percentage and output increases
by a smaller percentage, causing unit costs to rise.
 Minimum Efficient Scale - The lowest output level
at which average total costs are minimized.
ECONOMIES OF SCALE II
 Economies of scale → LRATC is falling

 Constant returns to scale → LRATC is
constant
 Diseconomies of scale → LRATC is rising
WHY ECONOMIES OF SCALE?
 Up to a certain point, long-run unit costs of

production fall as a firm grows. There are two main
reasons for this:
 SPECIALISATION
 Growing firms employ a larger number of workers.
 This offer greater opportunities for employees to
specialize and thus increase the efficiency of labour.
 The output increase and the average cost per unit
decrease.
WHY ECONOMIES OF SCALE?
ADVANCE IN TECHNOLOGY
 Growing firms with more resources can take
advantage of highly efficient mass production
techniques and equipment that ordinarily require
large setup costs.
 It is economical only if they can be spread over a
large number of units.
 These machines will produce at maximum capacity
when they are fully utilized.
 As output increase, the average cost per unit
will decrease.
WHY DISECONOMIES OF SCALE?
In very large firms, managers often

find it difficult to coordinate work
activities, communicate their
directives to the right persons in
satisfactory time, and monitor
personnel effectively.
Knowing that these problems exist,

firms will reorganize, divide
operations, hire new managers, and
take other measures to reverse the
diseconomies of scale.
SHIFTS IN COST CURVES
A firm’s cost curves will shift if there is a

change in:
Taxes
Input prices
Technology.

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TOPIC 4

Theory of the Firm:

©2016 Cengage Learning. All Rights Reserved. May not be scanned,

• Explain Production and Costs in the

• Explain Production and Costs in the

● An entity that employs factors of production

 Explicit Cost - A cost incurred when an actual

 For instance, the explicit cost of a gallon of

 Implicit Cost - A cost that represents the value

Explicit costs = RM2k + RM3k + RM20K

Implicit costs = RM80K. (forgone)

 Accounting Profit - The difference between

 In the short run, as additional units of a

 The marginal physical product of labor curve

Due to the law of

● What the marginal cost curve looks like

When the press or laypersons use the word productivity,

● Labor productivity is used in the newspaper

 Average Variable Cost (AVC) - Total

 Average Total Cost (ATC), or Unit Cost -

● When the marginal magnitude is above the

 A cost incurred in the past that cannot be

• Suppose Jeremy says the following to himself as he is watching

• An economist, however, would advise Jeremy to ignore what

 There are three short-run

The lowest output level at

 The long-run average

 Economies of Scale exist when inputs are increased

 Economies of scale → LRATC is falling

 Up to a certain point, long-run unit costs of

In very large firms, managers often

Knowing that these problems exist,

A firm’s cost curves will shift if there is a

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