The Theory of the Firm: Production and Cost

Ephesians 5: 1-7

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Follow God’s example, therefore, as dearly loved children 2 and walk in the way of love, just as Christ loved us and gave himself up for us as a fragrant offering and sacrifice to God. 3 But among you there must not be even a hint of sexual immorality, or of any kind of impurity, or of greed, because these are improper for God’s holy people. 4 Nor should there be obscenity, foolish talk or coarse joking, which are out of place, but rather thanksgiving. 5 For of this you can be sure: No immoral, impure or greedy person—such a person is an idolater—has any inheritance in the kingdom of Christ and of God. 6 Let no one deceive you with empty words, for because of such things God’s wrath comes on those who are disobedient. 7 Therefore do not be partners with them.

What Is A Firm?

 A firm is an organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand. Most firms exist to make a profit.  Production is not limited to firms.

Production  Production is the process by which inputs are combined. and turned into outputs. transformed. .

individual firms are price-takers. This means that firms have no control over price. Price is determined by the interaction of market supply and demand. .Competitive Firms are Price Takers  In a perfectly competitive market.

the quantity demanded of that firm’s output will drop to zero.45. d. Each firm faces a perfectly elastic demand curve.Demand Facing a Single Firm in a Perfectly Competitive Market  If a representative firm in a perfectly competitive market rises the price of its output above $2. .

The Behavior of Profit-Maximizing Firms  The three decisions that all firms must make include: 1. How much output to supply 2. How much of each input to demand . Which production technology to use 3.

The Theory of the Firm .

The Production Process  Production technology refers to the quantitative relationship between inputs and outputs.  A labor-intensive technology relies heavily on human labor instead of capital. .  A capital-intensive technology relies heavily on capital instead of human labor.

Production Function .

.The Production Function  The production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. It shows units of total product as a function of units of inputs.

L. Land (L) and Labour (La) used .Production Function  Mathematical representation of the relationship:  Q = f (K. La)  Output (Q) is dependent upon the amount of capital (K).

machinery and equipment not used for its own sake but for the contribution it makes to production • Price paid for capital = Interest .Production Function  States the relationship between inputs and outputs  Inputs – the factors of production classified as: • Land – all natural resources of the earth – not just ‘terra firma’! • Price paid to acquire land = Rent • Labour – all physical and mental human effort involved in production • Price paid to labour = Wages • Capital – buildings.

Production Function Inputs Land Labour Capital Process Product or service generated – value added Output .

Analysis of Production Function: Short Run  In the short run at least one factor fixed in supply but all other factors capable of being changed  Reflects ways in which firms respond to changes in output (demand)  Can increase or decrease output using more or less of some factors but some likely to be easier to change than others  Increase in total capacity only possible in the long run .

and 2. The firm is operating under a fixed scale (fixed factor) of production. Firms can neither enter nor exit an industry. .Short-Run Versus Long-Run Decisions  The short run is a period of time for which two conditions hold: 1.

In this example. . land is the fixed factor which cannot be altered in the short run.Analysis of Production Function: Short Run In times of rising sales (demand) firms can increase labour and capital but only up to a certain level – they will be limited by the amount of space.

Analysis of Production Function: Short Run If demand slows down. land is the factor which stays fixed. . the firm can reduce its variable factors – in this example it reduces its labour and capital but again.

. land is the factor which stays fixed. it reduces its labour and capital but again. the firm can reduce its variable factors – in this example.Analysis of Production Function: Short Run If demand slows down.

and new firms can enter and existing firms can exit the industry. Firms can increase or decrease scale of operation. .Short-Run Versus Long-Run Decisions  The long run is a period of time for which there are no fixed factors of production.

for a market stall holder. the firm is able to increase its total capacity – not just short term capacity • Associated with a change in the scale of production • The period of time varies according to the firm and the industry • In electricity supply. the time taken to build new capacity could be many years. the ‘long run’ could be as little as a few weeks or months! .Analysing the Production Function: Long Run  The long run is defined as the period of time taken to vary all factors of production • By doing this.

the firm can change all its factors of production thus increasing its total capacity. In this example it has doubled its capacity. .Analysis of Production Function: Long Run In the long run.

Marginal Product and Average Product  Marginal product is the additional output that can be produced by adding one more unit of a specific input. ceteris paribus. a v e r oa gd eu t o t a l u pc tr o d ca p tb r o= fr l t o t a sl uo nf i l t a b o r . m c h a n t go et a i l u n pc tr o d a r g r io n d a u ll ca p tb = o rf c h a n u g n e i t ia s n b o o f r l u s • Average product is the average amount produced by each unit of a variable factor of production.

. the marginal product of the variable input declines.The Law of Diminishing Marginal Returns  The law of diminishing marginal returns states that: When additional units of a variable input are added to fixed inputs.

5 Marginal Product 11.0 15 10 5 0 0 1 2 3 4 5 6 Number of employees 7 .0 12.7 10.0 8.4 7.Production Function for Sandwiches 45 Production Function (1) LABOR UNITS (EMPLOYEES) (2) (3) (4) TOTAL PRODUCT MARGINAL AVERAGE (SANDWICHES PER PRODUCT OF PRODUCT OF HOUR) LABOR LABOR Total product 40 35 30 25 20 15 10 5 0 0 1 2 3 4 5 6 7 Number of employees 0 1 2 3 4 5 6 0 10 25 35 40 42 42 − 10 15 10 5 2 0 − 10.

total product is maximum. and marginal product intersects the horizontal axis. Average. • At point A. . the slope of the total product function is zero. thus. the slope of the total product function is highest. marginal product is highest.Total. • At point C. and Marginal Product  Marginal product is the slope of the total product function.

Average. average product is maximum and equal to marginal product.Total. average product falls to the left and right of point B. and Marginal Product  When a ray drawn from the origin falls tangent to the total product function. . • Then.

Total. marginal product equals average product.  When average product falls.  When average product is maximum. marginal product is less than average product. . average product rises. and Marginal Product  As long as marginal product rises. Average.

Production Functions with Two Variable Factors of Production  In many production processes. • For example. Inputs Required to Produce 100 Diapers Using Alternative Technologies TECHNOLOGY UNITS OF CAPITAL (K) UNITS OF LABOR (L) A B C D E 2 3 4 6 10 10 6 4 3 2 • Given the technologies available. inputs work together and are viewed as complementary. the cost-minimizing choice depends on input prices. increases in capital usage lead to increases in the productivity of labor. .

Production Functions with Two Variable Factors of Production Cost-Minimizing Choice Among Alternative Technologies (100 Diapers) (1) TECHNOLOGY (2) UNITS OF CAPITAL (K) (3) UNITS OF LABOR (4) COST (5) COST WHEN PL = $1 PK WHEN PL = $1 PK = $1 = $1 A B C D E 2 3 4 6 10 10 6 4 3 2 $12 9 8 9 12 $52 33 24 21 20 .

2. . Normal rate of return on capital. Opportunity cost of each factor of production. Total revenue is the amount received from the sale of the product: (q X P)  Total cost (total economic cost) is the total of 1.Profits and Economic Costs   Profit (economic profit) is the difference between total revenue and total cost. Out of pocket costs. and 3.

Normal Rate of Return  The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied. .  For relatively risk-free firms. it should be nearly the same as the interest rate on risk-free government bonds.

000 belts x $10 each) Costs Belts from supplier Labor Cost Normal return/opportunity cost of capital ($20.Calculating Total Revenue.000 2.000 − $ 1.000a There is a loss of $1.10) Total Cost Profit = total revenue − total cost a $20.000 $31.000.000 .10 or 10% $30.000 $15.000 x . and Profit Initial Investment: Market Interest Rate Available: Total Revenue (3.000 14. . Total Cost.

Determining the Optimal Method of Production Price of output Determines total revenue Production techniques Input prices Determine total cost and optimal method of production Total revenue − Total cost with optimal method =Total profit • The optimal method of production is the method that minimizes cost. .

Costs .

the firm will incur costs  Costs are classified as: • Fixed costs – costs that are not related directly to production – rent. They can change but not in relation to output • Variable Costs – costs directly related to variations in output. admin costs.Costs  In buying factor inputs. Raw materials primarily . rates. insurance costs.

Costs  Total Cost .the sum of all costs incurred in production  TC = FC + VC  Average Cost – the cost per unit of output  AC = TC/Q  Marginal Cost – the cost of one more or one fewer units of production  MC = ∆TC / ∆Q .

Total Variable Cost and Total Fixed Cost TFC Q (units/yr) 38 .TC ($/yr) Example: Short Run Total Cost.

Total Variable Cost and Total Fixed Cost TVC(Q. K0) TFC Q (units/yr) 39 .TC ($/yr) Example: Short Run Total Cost.

K0) TFC Q (units/yr) 40 .TC ($/yr) Example: Short Run Total Cost. K0) TVC(Q. Total Variable Cost and Total Fixed Cost STC(Q.

For this reason.Fixed Costs  Firms have no control over fixed costs in the short run.  Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units of output (q): A T F= C F q C . fixed costs are sometimes called sunk costs.

.000 1. a phenomenon sometimes called spreading overhead.000 1.000 (3) AFC (TFC/q) $ − − 1.Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) q 0 1 2 3 4 5 (2) TFC $1.000 1.000 1.000 500 333 250 200  AFC falls as output rises.000 1.

. PL = $1 TVC = (K x PK) + (L x PL) 1Units of output 2Units of output 3Units of output A B A B A B 4 2 7 4 9 6 4 6 6 10 6 14 $10 (4 x $2) + (4 x $1) = $12 (2 x $2) + (6 x $1) = $18 (7 x $2) + (6 x $1) = $20 $24 (4 x $2) + (10 x $1) = (9 x $2) + (6 x $1) = (6 x $2) + (14 x $1) = $26 B 6 (6 x $2) + (14 x $1) =  The total variable cost curve 14 shows the cost of production using the best available technique at each output level.Derivation of Total Variable Cost Schedule from Technology and Factor Prices PRODUCT USING TECHNIQUE UNITS OF INPUT REQUIRED (PRODUCTION FUNCTION) K L TOTAL VARIABLE COST ASSUMING PK = $2. given current factor prices.

Average variable cost is the average variable cost per unit of all the units being produced. but lags behind.Average Variable Cost  Average variable cost (AVC) is the total variable cost divided by the number of units of output. .  Average variable cost follows marginal cost.  Marginal cost is the cost of one additional unit.

Marginal Cost  Marginal cost (MC) is the increase in total cost that results from producing one more unit of output.  Marginal cost reflects changes in variable costs. M ∆ T C ∆ T F C∆ T V =C = + ∆Q ∆Q ∆Q C .

Derivation of Marginal Cost from Total Variable Cost UNITS OF OUTPUT 0 1 2 3 TOTAL VARIABLE COSTS MARGINAL COSTS ($) ($) 0 10 18 24 0 10 8 6  Marginal cost measures the additional cost of inputs required to produce each successive unit of output. .

The firm has limited capacity to produce output.The Shape of the Marginal Cost Curve in the Short Run  The fact that in the short run every firm is constrained by some fixed input means that: 1. it becomes increasingly costly to produce successively higher levels of output. The firm faces diminishing returns to variable inputs. . and 2.  As a firm approaches that capacity.

The Shape of the Marginal Cost Curve in the Short Run  Marginal costs ultimately increase with output in the short run. .

• Below 100 units of output. TVC increases at an increasing rate. TVC increases at a decreasing rate.Graphing Total Variable Costs and Marginal Costs  Total variable costs always increase with output. Beyond 100 units of output. . The marginal cost curve shows how total variable cost changes with single unit increases in total output.

average cost is increasing. • Rising marginal cost intersects average variable cost at the minimum point • At 200 units of output. average cost is declining. and MC = AVC. of AVC. • When marginal cost is above average cost. AVC is minimum. .Relationship Between Average Variable Cost and Marginal Cost  When marginal cost is below average cost.

024 1.000 (6) TC (TVC + TFC) $ 1.018 1.032 1.Short-Run Costs of a Hypothetical Firm (1) q 0 1 2 3 4 5 − − − 500 $ (2) TVC 0 10 18 24 32 42 − − − 8.000 1.000 (7) AFC (TFC/q) $ − 1.4 − − − 16 (5) TFC $ 1.000 1.000 1.010 .010 1.000 1.000 1.000 − − − 1.042 − − − 9.000 (3) MC (∆ TVC) $ − 10 8 6 8 10 − − − 20 (4) AVC (TVC/q) $ − 10 9 8 8 8.000 500 333 250 200 − − − 2 (8) ATC (TC/q or AFC + AVC) $ − 509 341 258 208.4 − − − 18 1.000 1.

T C= T F + CT V C . • Thus.Total Costs  Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. the total cost curve has the same shape as the total variable cost curve. it is simply higher by an amount equal to TFC.

A A T = CA T T= C q C T = F + AC F q + C T q V V C C • Because AFC falls with output. an ever-declining amount is added to AVC. .Average Total Cost  Average total cost (ATC) is total cost divided by the number of units of output (q).

 Marginal cost intersects average total cost and average variable cost curves at their minimum points.  If marginal cost is above average total cost.Relationship Between Average Total Cost and Marginal Cost  If marginal cost is below average total cost. average total cost will decline toward marginal cost. average total cost will increase. .

18 11.27 2.80 9.42 .80 12.56 5.44 9.36 11.09 9.79 12.13 2.66 12.13 9.11 10.67 15.00 3.94 2.24 9.38 9.30 11.17 1.00 16.67 12.50 11.64 29.33 25.30 11.50 5.50 12.Costs of Production Output FC VC TC MC AFC AVC ATC 955 3 4 9 10 16 17 22 23 27 28 50 50 50 50 50 50 50 50 50 50 38 50 100 108 150 157 200 210 255 270 88 100 150 158 200 207 250 260 305 320 — 12 — 8 — 7 — 10 — 15 16.85 1.

Total Cost Curves $400 350 300 250 200 150 100 50 0 TC 956 VC Total cost TC = VC + FC L O M 2 4 6 8 10 20 Quantity of earrings 30 FC .

Per Unit Output Cost Curves $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 MC ATC AVC AFC 2 4 6 8 10 12 14 16 18 20 22 2426 28 30 32 Quantity of earrings Cost .

00 1.00 3.25 1.50 2.00 5.11 1.91 Costs (dollar per day) 10 8 6 4 2 0 AFC 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day) .67 1.00 .43 1.33 2.Cost of Production: An Example Total Average Total Fixed Output Costs (Q/day) (TFC) Fixed Costs (AFC) 16 14 12 0 1 2 3 4 5 6 7 8 9 10 11 10 10 10 10 10 10 10 10 10 10 10 10 ——— 10.

60 2.Cost of Production: An Example Total Variable Costs (TVC) Average Variable Costs (AVC) Total Output (Q/day) 16 14 12 0 1 2 3 4 5 6 7 8 9 10 11 0 5 8 10 11 13 16 20 25 31 38 46 ——— 5.80 4.75 2.00 4.00 3.44 3.67 2.86 3.33 2.13 3.18 Costs (dollar per day) 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day) AVC .

28 4.00 9.00 6.33 4.09 Costs (dollar per day) 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day) ATC .Cost of Production: An Example Average Total Costs (AVC) Total Output (Q/day) Total Costs (TVC) 16 14 12 0 1 2 3 4 5 6 7 8 9 10 11 10 15 18 20 21 23 26 30 35 41 48 56 ——— 15.56 4.80 5.25 4.67 5.60 4.38 4.

Cost of Production: An Example 16 14 12 Costs (dollar per day) 10 8 6 4 2 0 ATC AVC AFC 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day) .

Cost of Production: An Example Costs (dollar per day) Difference between AVC and ATC = AFC ATC ATC AVC AFC TP Output (calculators per day) AVC AFC .

Cost of Production: An Example Costs (dollar per day) ATC = AVC + AFC AFC = ATC .AVC AFC AVC TP Output (calculators per day) ATC AVC .

Short-Run Costs to the Firm  Marginal Cost • The change in total costs due to a one-unit change in production rate change in total cost change in output Marginal costs (MC) = .

Cost of Production: An Example
Total Output (Q/day) Total Variable Costs (TVC) Total Costs (TC) Marginal Cost (MC)

16 14

0 1 2 3 4 5 6 7 8 9 10 11

0 5 8 10 11 13 16 20 25 31 38 46

10 15 18 20 21 23 26 30 35 41 48 56

Costs (dollar per day)

$5 3 2 1 2 3 4 5 6 7 8

12 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day) MC

The Relationship Between Diminishing Marginal Returns and Cost Curves

MC =

∆ TC ∆ Output W MPP

Labor cost assumed constant

MC =

Recall: labor is the variable input

The Relationship Between Diminishing Marginal Returns and Cost Curves

Figure 22-3, Panel (a)

Costs  Short run – Diminishing marginal returns results from adding successive quantities of variable factors to a fixed factor  Long run – Increases in capacity can lead to increasing. decreasing or constant returns to scale .

Revenue .

Revenue  Total revenue – the total amount received from selling a given output  TR = P x Q  Average Revenue – the average amount received from selling each unit  AR = TR / Q  Marginal revenue – the amount received from selling one extra unit of output  MR = dTR/dQ .

T R= P × q • Marginal revenue (MR) is the additional revenue that a firm takes in when it increases output by one additional unit. • In perfect competition. P = MR.Total Revenue (TR) and Marginal Revenue (MR)  Total revenue (TR) is the total amount that a firm takes in from the sale of its output. M ∆ T R P (∆q ) =R = P = ∆q ∆q .

Profit .

Profit  Profit = TR – TC  The reward for enterprise  Profits help in the process of directing resources to alternative uses in free markets  Relating price to costs helps a firm to assess profitability in production .

Profit  Normal Profit – the minimum amount required to keep a firm in its current line of production  Abnormal or Supernormal profit – profit made over and above normal profit • Abnormal profit may exist in situations where firms have market power • Abnormal profits may indicate the existence of welfare losses • Could be taxed away without altering resource allocation .

Profit  Sub-normal Profit – profit below normal profit • Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs • Cost of exit may be high • Sub-normal profit may be temporary (or perceived as such!) .

MR = P.Comparing Costs and Revenues to Maximize Profit  The profit-maximizing level of output for all firms is the output level where MR = MC.  The key idea here is that firms will produce as long as marginal revenue exceeds marginal cost. the profit-maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to short-run marginal cost. .  In perfect competition. therefore.

Profit Analysis for a Simple Firm (1) q 0 1 2 3 4 5 6 (2) TFC $10 10 10 10 10 10 10 (3) TVC $ 0 10 15 20 30 50 80 (4) MC $ − 10 5 5 10 20 30 (5) P = MR $ 15 15 15 15 15 15 15 (6) TR (P x q) $ 0 15 30 45 60 75 90 (7) TC (TFC + TVC) $ 10 20 25 30 40 60 90 (8) PROFIT (TR − TC) $ -10 -5 5 15 20 15 0 .

the marginal cost curve of a perfectly competitive profit-maximizing firm is the firm’s short-run supply curve. the marginal cost curve shows the output level that maximizes profit. . Thus.The Short-Run Supply Curve  At any market price.

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