Part 5

The Theory of
Production and Cost
• Production normally organized in
Firms
• A Firm hires inputs, organizes
production, and sells goods or
services
• A firm is a governance structure that
can range from simple to highly
complex (sole owner to large multi-
nation corporation)
• Firms allocate resources and
coordinate economic activities
internally using commands and
incentive systems
 Why Firms?
• Why is all economic activity
not coordinated through
markets?
• Firms exist because they offer
cost advantages over market
transactions
- Transactions costs
- Monitoring
- Economies of scale or scope
- Economies of team production
 Why Markets?
• Why is all economic activity
not coordinated through
organized firms (or just one
giant firm)?
• Principal-agent and incentive
problems
• Problems of information and
management provide limits to
firm size
 The Firm’s Goals

• The goal of the owners of the

firm is to maximize the return
on their capital investment—to
maximize profit
• Profit is revenue less cost--
defined as opportunity cost
• Explicit and implicit costs
• Normal profit and economic
profit
 The Firm’s Constraints
• Available technology
• Prices of inputs
• Fixed capital in the short run
• Degree of competition in the
output market
• Given these constraints the firm
needs to choose the method of
production and output level that
will maximize profit
• Maximizing profit implies
minimizing the cost of
production
 Output and Cost: Short
Run
• In the short run the firm has a
plant of given size
• The firm can add or subtract
labour and other inputs to vary
output, but cannot alter the size
of the plant
• The fixed plant size affects how
output will change with changes
in the inputs that can be varied
 The Short Run
Production Function
• Total product curve

Output
TP

Inflection point

TP increasing at a
decreasing rate

L’ Labour
TP= Total output as labour (and other variable
inputs) are added to a plant of fixed size
 Short Run Production
Functions
• Other possible shapes
Output
TP

Labour
Output
TP

Labour
 Average and Marginal
Product Curves
TP TP

AP max &
AP = MP
MP max

L
Point of diminishing
AP marginal returns
MP
Point of diminishing
average returns
AP
MP
L
L’ L”
 Diminishing Returns
• When there is a fixed factor
must eventually run into
diminishing marginal returns
• The constraint of the fixed
factor eventually makes it more
and more difficult (costly) to
obtain additional output from
the plant of fixed size
• Law of Diminishing Returns
• Is our world a world of
diminishing returns?
 Short Run Cost
• Our production function
showed output as a function of
the quantity of variable input
(labour) with a given quantity
of a fixed input (capital).
• We need to convert this into a
cost function showing cost as a
function of output
• To do this we assume that the
prices of inputs are given
 Short Run Total Costs

• Total cost is total variable cost plus

total fixed cost
• The total variable cost of a given
level of output is the quantity of
labour it takes to produce that output
(with the fixed level of capital) times
the price of labour
• The total fixed cost is the quantity of
the fixed input times the price of that
input
• Total fixed cost does not vary with
output
 TP and TVC
Q TP

Q’

L
L’
$ TVC
= L x Wage

TVC’
(L’ x W)

Q
Q’
 Total Cost Curves

$ TC

TVC

TFC

Q
Diminishing returns due to the fixed factor
Means that TVC and TC must eventually
Rise at an increasing rate
 Marginal and Average
Costs
• Average total cost is total cost
divided by output
• Average variable cost is total
variable cost divided by output
• Average fixed cost is total fixed
cost divided by output
• ATC = AVC + AFC
• Marginal cost is the additional
cost of an additional unit of
output
• MC = ΔTC/ΔQ
 Marginal and Average
Cost Curves
$

Min ATC
MC
ATC
AVC

Min AVC
AFC
Q
ATC = AVC + AFC
 Marginal and Average
Product and Cost Curves
• As a firm expands output along its
production function the output at
which average product is at its
greatest will be where AVC is at a
minimum
• The output level at which MP is at a
maximum will the output level
where MC is at a minimum
• As MP and AP eventually decline
due to diminishing returns, so MC
and AVC will eventually rise.
 Shifts in Cost Curves

• New Technology
• Costs of inputs
– Fixed inputs
– Variable inputs
• Scale of plant (long run)
 Long Run Cost
• Changes to the scale of the plant
• Each plant size has a TC curve
• Larger plant increases fixed cost
but delays onset of diminishing
returns
• Each plant size has a short run
ATC curve
• Long run average cost curve is the
lower boundary of all short run
ATC curves
• Long run and the least possible
cost of production
 Long Run Cost

$ TC1 TC2

Q1 Q
 Long Run Cost

ATC1 ATC
2
LAC

Q
Q1
Constant returns to scale
 Long Run Average Cost
Generalized case: increasing followed by
decreasing returns to scale

$
ATC3
ATC1 ATC ATC5
2 ATC4

LRATC

Q’ Q* Q
Least cost plant size to produce Q’ is ATC2
Q* is the lowest possible average cost, but
whether this is the firm’s profit maximizing
output will depend on market structure.
 Economies of Scale

• Economies of scale due to

specialization of labour and
capital
• Diseconomies of scale due to
problems of information and
management
• Constant returns to scale
• Minimum efficient scale