Firms, Production and Costs

Behind Supply of a firm

Theory of firm
 What is a FIRM:

Definition
FIRM is an organisation that
combines and organizes resources
for the purpose of producing goods
and/or services for selling in the
market
 Alternative Goals of a firm
• Profit Maximization
• Value Maximization
• Sales/Revenue maximization (W.Baumol, 1959)
– Adequate rate of profit
• Management utility maximization (Williamson, 1963)
– Principle-agent problem
• Satisficing behavior (Cyert & March)
• Growth
• Long Run Survival
 Relationship to functional areas
• TR = p X q
– P: marketing
– Q: sales
• TC = wl + rK
– L: HR
– K: Finance
2 LEARNING OBJECTIVE

The Short Run and the Long Run

Short run The period of time
during which at least one of the
firm’s inputs is fixed.

Long run A period of time long

enough to allow a firm to vary all of
its inputs, to adopt new technology,
and to increase or decrease the size of
its physical plant.

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 Costs
The Difference between Fixed Costs and Variable Costs

Total cost The cost of all the inputs a

firm uses in production.
Variable costs Costs that change as
output changes.
Fixed costs Costs that remain
constant as output changes.

Total Cost = Fixed Cost + Variable Cost

TC = FC + VC
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 Costs
Implicit versus Explicit Costs

Opportunity cost The highest-valued

alternative that must be given up to engage in
an activity.

Explicit cost A cost that involves spending

money.

Implicit cost A nonmonetary opportunity

cost.

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 Business versus economic profit
• Opportunity cost is the return a firm’s
resources could earn elsewhere in next most
valuable use
• Explicit costs are observable measurable
expenses such as labour, cost of capital
• Implicit costs refer to the value of inputs owned by a firm and
used in its production processes
– are not explicitly observable and fall into two categories
• Opportunity cost of using own capital, implied rental return( depreciation
+ foregone interest)
• Opportunity cost of time and financial resources of firm’s owners, normal
profit
– Represents what owners could have earned if they used their skills in another
activity
• Economic profit considers both explicit and implicit costs
 Costs
11 – 1

Paper $20,000
Wages $48,000
Lease payment for copy machines $10,000
Electricity $6,000
Lease payment for store $24,000
Foregone salary $30,000
Foregone interest $3,000
Economic Depreciation 10000
Total $151,000
 Quick Quiz 1!
• A firm has a total revenue of $ 50 million and uses $ 30
million in labor and materials. Other costs include $ 100,000
in foregone interest, depreciation of $ 20,000, and normal
profit of $ 65,000. What is the economic profit of the firm?
– 19803,000
– 19815,000
– 19856,000
– 20000,000
The Production Function

Production Function The relationship between the

inputs employed by the firm and the maximum output it can
produce with those inputs.
 Production and Costs

A First Look at the Relationship Between Production and Cost

11 – 2
Short-Run Production and Cost at Jill Johnson’s Restaurant\
COST OF TOTAL COST PER
QUANTITY QUANTITY COST OF PIZZA WORKERS COST COPY
OF OF Pizza QUANTITY OVENS (VARIABLE OF (AVERAGE
WORKERS Ovens OF PIZZAS (FIXED COST) COST) COPIES COST)
0 2 0 $800 $0 $800 -
1 2 200 800 650 1450 $7.25
2 2 450 800 1300 2100 4.67
3 2 550 800 1950 2750 5.00
4 2 600 800 2600 3400 5.67
5 2 625 800 3250 4050 6.48
6 2 640 800 3900 4700 7.34

Total Cost: Minimum cost of producing a given level of output

Average total cost Total cost divided by the quantity of output produced.
 The Marginal Product of Labor and the
Average Product of Labor
Marginal product of labor The additional
output a firm produces as a result of hiring one
more worker.

The Law of Diminishing Returns

Law of diminishing returns The principle

that, at some point, adding more of a variable
input, such as labor, to the same amount of a
fixed input, such as capital, will cause the
marginal product of the variable to decline.
 The Marginal Product of Labor and the
Average Product of Labor

The Law of Diminishing Returns

11 – 3
Marginal and Average Product of
Labor at Jill Johnson’s Copy Store

QUANTITY OF MARGINAL
QUANTITY OF Pizza QUANTITY OF PRODUCT OF
WORKERS Machines PIZZAS LABOR
0 2 0 -
1 2 200 200
2 2 450 250
3 2 550 100
4 2 600 50
5 2 625 25
6 2 640 15
 The Marginal Product of Labor and the
Average Product of Labor
An Example of Marginal and Average Values: College Grades
Marginal and Average GPAs 11 - 3
 Stages of Production
• The relationship between AP & MP is mainly
indicated by three different stages of
production
• Stage I: When MP>AP, AP of labour rises
• Stage II: When MP<AP, AP of labour falls
• Stage III: When MP<0, Negative Returns
 Diagrammatic Representation
TP

TP

O S
t L
AP,MP a
g
e
Stage I Stage III
II

AP
O MP L
 Short-Run Cost Functions
Total Cost = TC = f(Q)
Total Fixed Cost = TFC (Does not change in short
run)
Example: Rent of the building, plant capacity,
Salary of Managers
Total Variable Cost = TVC (Changes with the level
of production output level)
Example: Raw Material Costs, Wages
TC = TFC + TVC
 Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
 The Relationship Between Short-Run
Production and Short-Run Cost

Why Are the Marginal and Average Cost Curves

U-Shaped?
Refer Figure 11 – 4 – Jill Johnson’s production and Costs

Average Variable Cost

AVC = TVC/Q = w/APL

Marginal Cost
TC/Q = TVC/Q = w/MPL
 Definitions on Short Run Costs

SYMBOLS AND
TERM DEFINITION EQUATIONS
Total cost The value of all the inputs used by a firm TC
Fixed cost Costs that remain constant when a firm’s level of
FC
output changes
Variable cost Costs that change when the firm’s level of output
VC
changes
Marginal cost The increase in total cost resulting from producing
MC
another unit of output
Average total cost Total cost divided by the quantity of units produced
ATC

Average fixed cost Fixed cost divided by the quantity of units produced
AFC

Average variable Variable cost divided by the quantity of units

AVC
cost produced
Implicit cost A nonmonetary opportunity cost -
Explicit cost A cost that involves spending money -
 Costs in the Long Run

Economies of Scale
Long-run average cost curve A curve
showing the lowest cost at which the firm is
able to produce a given quantity of output in the
long run, when no inputs are fixed.
Economies of scale Economies of scale
exist when a firm’s long-run average costs fall
as it increases output.
 Costs in the Long Run

Constant returns to scale Constant returns

to scale exist when a firm’s long-run average
costs remain unchanged as it increases output.
Minimum efficient scale The level of output
at which all economies of scale have been
exhausted.
Diseconomies of scale Exist when a firm’s
long-run average costs rise as it increases output.
 Costs in the Long Run
Long-Run Average Total Cost Curves for Bookstores
Refer Figure 11 - 6
The Relationship between
Short-Run Average Cost and
Long-Run Average Cost
 •The Colossal River Rouge: Diseconomies of
Scale at the Ford Motor Company

Is it possible for a factory to be

too big?

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 Sources of Economies of scale
• Cost effective higher output leads to IRS – Cost
effective Technology
• Specialization of labour & inventory economies
causes for IRS
• Firms growing large may lead to DRS as Management
cannot effectively manage it
• Transportation costs become higher leading to DRS
• Attracting more labour paying higher wages - DRS
 Economies of Scale
• Internal Economies arising out of internal sources
when plant size is expanded
• Four types
 Economies in Production
 Economies in Marketing
 Managerial Economies
 Economies in Transport & Storage
• External Economies
 Don’t Confuse Diminishing Returns with Diseconomies of Scale

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Possible Shapes of
the LAC Curve
 Learning Curves
Average Cost of Unit Q = C = aQb
Estimation Form: log C = log a + b Log Q
Minimizing Costs Internationally

• Foreign Sourcing of Inputs

• New International Economies of Scale
• Immigration of Skilled Labor
• Brain Drain
 Empirical Estimation
Data Collection Issues
• Opportunity Costs Must be Extracted from
Accounting Cost Data
• Costs Must be Apportioned Among
Products
• Costs Must be Matched to Output Over
Time
• Costs Must be Corrected for Inflation
 Empirical Estimation
Functional Form for Short-Run Cost Functions
Theoretical Form Linear Approximation

TVC  aQ  bQ 2  cQ 3 TVC  a  bQ

TVC a
AVC   a  bQ  cQ 2
AVC   b
Q Q

MC  a  2bQ  3cQ 2 MC  b
Empirical Estimation
Theoretical Form Linear Approximation
 Long Run Production Functions
• Long Run – All inputs are variable. Q=f(L,K),
where both L & K are variable factors
• Variable Proportion Production Function –
production functions that allow some
substitution of one input for another to reach an
output target. Variable proportion is possible in
the short run when the variable factor changes
but the fixed factor remains unchanged.
Proportion can also be variable in long run
• Fixed Proportion Production Function- there is
one & only one ratio or mix of factors to produce
a particular input.
 Production in the long run
• Q=F(L,K)
• Important Tool of Analysis – Isoquants
• An Isoquant is a locus of points showing all
possible combinations of the inputs physically
capable of producing a given (fixed) level of
output.
• Each point is technically efficient
• Many combinations of inputs can produce the
same level of output.
 Properties of Isoquants
• Labour, capital, output continuously divisible
• Higher Isoquants show higher output more & more
away from the origin
• Isoquants are negatively sloped and convex to the
origin
• MRTS=Marginal Rate of Technical Substitution –
Absolute value of the slope of the isoquant
• Movement down along the isoquant, MRTS of labour
for Capital given by -∆K/∆L=MPL/MPK
 Economic Region of Production
• Economic region is defined as relevant zone for
producers in the isoquant mapping. It is defined by
the area where isoquants are drawn in such a way
that Marginal Products of both labour and capital are
positive. When productivity becomes negative of
atleast one factor, the producer will not operate in
this non-economic zone.
• Ridge lines separate the economic zone from non-
economic zones. Ridge line is a locus of points on
different isoquants where MP of one of the factors is
zero.
 Optimal Input Combination
• Maximization of output s.t. a cost constraint
• Minimization of cost s.t. an output constraint
• Isocost line = locus of points of equal costs with
different combinations of inputs
• Equation of an isocost line C=wL+rK
• Isocost line is (-)vely sloped line whose slope is –w/r.
• Lower isocost line are more towards the origin, firms
would like to stay at lower isocost lines
 Condition for optimization
• First Order Condition: MRTS =w/r
• Second Order Condition: isoquants must be convex
to the origin

Expansion Path
• It is the locus of points of different equilibrium in the
long run. When the firm wishes to expand in LR, it
does along an Expansion Path.
 Returns to scale
• When factors of production are increased in the long run,
the return will a firm get in terms of output increase is
given by the concept of Returns to scale.
• If the output increases in the same proportion as the
inputs, it is known as constant returns to scale (CRS)
• If the output increases more than proportion of the inputs
increase, it is known as increasing returns to scale (IRS)
• If the output increases less than proportion of the inputs
increase, it is known as decreasing returns to scale (DRS)
 Returns to Scale

Production Function Q = f(L, K)

Q = f(hL, hK)

If  = h, then f has constant returns to scale.

If  > h, then f has increasing returns to scale.
If  < h, then f has decreasing returns to scale.
 Production function explaining returns to
scale
• Q=ALαKβ
• A is the Technology Parameter, α & β are known as
the distribution parameters.
• When α+β=1, Prodn. Fn. follows CRS
• When α+β>1, Prodn. Fn. follows IRS
• When α+β<1, Prodn. Fn. follows DRS
Show each of the above by increasing both labour &
capital by a factor, say t
Empirical Production Functions

Cobb-Douglas Production Function

Q = AKaLb

Estimated Using Natural Logarithms

ln Q = ln A + a ln K + b ln L