Week 6

Week 6
Firm Behavior and

Theory of Costs
The Objectives of Firms
There are several objectives as to why firms operate businesses and stay in the markets
The objectives depend on the size of the firm and ownership visa-avis management.
Indeed small firms (sole proprietorship) have objectives different from those of large
firms
Also firms run by owners also have objectives different from those run by employed
managers
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Recent models have argued that there are several objectives of firms, particularly
large firms run by employee- managers such as
1. Profit Maximization
2. Sales-revenue maximization
3. Larger market share and
4. Long run survival among others
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Profit Maximization
Traditional microeconomics focuses on the profit motive of business firms, that

the major objectives of firms, small or large, owned-managed or employee-
managed is to maximize profits
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Profit Maximization
In the long run however, such firms will always revert to profit maximization
• A large business firm may decide to reduce the price of its commodities (price
undercutting) when it senses that a competitor intends to join the market to
discourage the competitor since it would fear making losses.
• But soon after the competitor withdraws from joining the market, the incumbent
firm raises the prices in order to maximize profits
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• Also firms that claim to acquire large market share by selling at lower prices
initially to persuade the customers, after establishing themselves in the market
an acquiring loyalty and consumer confidence, they start by raising prices so as
to maximize profits since they by then command a large market share, besides
the consumers are loyal to it
• All in all, profit maximization remains the major goal of the business firm
especially in the long run. We now need to establish the condition for profit
maximization, but first we need to understand the following concepts.
6
• Also firms that claim to acquire large market share by selling at lower prices
initially to persuade the customers, after establishing themselves in the market
an acquiring loyalty and consumer confidence, they start by raising prices so as
to maximize profits since they by then command a large market share, besides
the consumers are loyal to it
• All in all, profit maximization remains the major goal of the business firm
especially in the long run. We now need to establish the condition for profit
maximization, but first we need to understand the following concepts.
7
Profit Maximization
• Profit is made by firms earning more from the sale of goods than the goods
cost to produce.
• A firm’s total profit () is thus the difference between its total sales revenue
(TR) and its total costs of production (TC):
Profits = Total Revenue – Total Cost
= TR-TC
8
Profit Maximization
• Businesses can increase their profitability either by increasing their revenue (by
selling more of their product or adjusting their price) or by reducing their costs of
production.
• Sometimes costs can be outside a company’s control, as can demand. In cases
where there is a combination of falling demand, low prices and rising costs,
losses may become inevitable.
• In order, then, to discover how a firm can maximise its profit, or even get a
sufficient level of profit, we must first consider what determines costs and
revenue by examining production, productivity and costs. As well as revenue, and
then put costs and revenue together to examine profit.
9
Production and Costs
What We Expect to Cover:
 What are Costs?
 How are costs of production measured?
 How do we distinguish between fixed and variable factors of production and
between fixed and variable costs?
 What is the relationship between inputs and outputs in both the short and
long run?
 What is meant by diminishing returns?
 How do costs vary with output in both the short and long run?
 How can a business combine its inputs in the most efficient way? 10
The Meaning of Costs:
• When measuring costs, economists use the concept of opportunity cost.
Opportunity cost is the cost of any activity measured in terms of the sacrifice
made in doing it: To measure a firm’s opportunity cost, we must first discover
what factors of production it has used. Then we must measure the sacrifice
involved in using them.
• To do this it is necessary to put factors into two categories.
 Factors not owned by the firm: explicit costs
 Factors already owned by the firm: implicit costs
11
1. Factors not owned by the firm: explicit costs
• The opportunity cost of those factors not already owned by the firm is simply the
price that the firm has to pay for them. Thus if the firm uses £100 worth of
electricity, the opportunity cost is £100. The firm has sacrificed £100, which
could have been spent on something else.
• These costs are called explicit costs because they involve direct payment of
money by firms.
12
2. Factors already owned by the firm: implicit costs
• When the firm already owns factors (e.g. machinery), it does not, as a rule, have
to pay out money to use them.
• The opportunity costs are thus implicit costs. They are equal to what the factors
could earn for the firm in some alternative use, either within the firm or hired
out to some other firm.
What the firm paid for the machine – its historic cost – is irrelevant. Not using the
machine will not bring that money back. It has been spent. These are sometimes
referred to as sunk costs 13
Production in the Short-Run
The Short-run and Long-run Changes in Production
The cost of producing any level of output depends on the amount of inputs used and
the price that the firm pays for them. Let us first focus on the quantity of inputs
used.
If a firm wants to increase production quickly, it will be able to increase the quantity
of only certain inputs. It can use more raw materials, more fuel, more tools and
possibly more labour (by hiring extra workers or offering overtime to existing
workers). But it will have to make do with its existing buildings and most of its
machinery.
• The distinction we are making here is between fixed factors and variable factors.
A fixed factor is an input that cannot be increased within a given time period
(e.g. buildings). A variable factor is one that can. 14
The Short-run and Long-run Changes in Production
• The distinction between fixed and variable factors allows us to distinguish
between the short run and the long run.
• The short run is a time period during which at least one factor of production is
fixed. This means that, in the short run, output can be increased only by using
more variable factors. The actual length of the short run differs from firm to firm.
It is not a fixed period of time.
• The long run is a time period long enough for all of a firm’s inputs to be varied
15
The Short-run Production
Production in the short run is subject to diminishing returns. You may well have
heard of ‘the law of diminishing returns’: it is one of the most famous of all ‘laws’ of
economics. To illustrate how this law underlies short-run production, let us take the
simplest possible case where there are just two factors: one fixed and one variable.
• Take the case of a farm. Assume the fixed factor is land and the variable factor is
labour. Since the land is fixed in supply, output per period of time can be increased
only by increasing the number of workers employed. But imagine what happens as
more and more workers crowd on to a fixed area of land. The land cannot go on
yielding more and more output indefinitely. After a point, the additions to output
from each extra worker will begin to diminish 16
The Short-run Production: the law of
diminishing returns
The law of diminishing marginal returns.

When increasing amounts of a variable factor
are used with a given amount of a fixed factor,
there will come a point when each extra unit
of the variable factor will produce less
additional output than the previous unit.
17
The Short-run Production Function
Let us now see how the law of diminishing returns affects total output or total
physical product (TPP).
• The relationship between inputs and output is shown in a production function. In
the simple case of the farm with only two factors – namely, a fixed supply of land
Ln and a variable supply of farm workers (Lb) – the production function would be:
• This states that total physical product (the output of the farm) over a given period
of time is a function of (depends on) the quantity of land and labour employed.
18
The Short-run Production Function
• The production function can also be
expressed in the form of a table or a graph.
Table 9.1 and Figure 9.1 show a
hypothetical production function for a farm
producing wheat.
• The first two columns of Table 9.1 show
how wheat output per year varies as extra
workers are employed on a fixed amount of
land.
19
The Short-run Production Function: Total Product
• With nobody working on the land, output will be zero (point a). As the first farm
workers are taken on, wheat output initially rises more and more rapidly. The
assumption here is that, with only one or two workers, efficiency is low, since the
workers are spread thinly across multiple tasks.
• With more workers, however, they can work as a team, each specialising in one
task and becoming more productive at it, thus using the land more efficiently. In
the top diagram of Figure 9.1, output rises more and more rapidly up to the
employment of the second worker.
• After point b, however, diminishing marginal returns set in: output rises less and
less rapidly, and the TPP curve correspondingly becomes less steeply sloped.
20
When point d is reached, wheat
output is at a maximum: the land
is yielding as much as it can.
Any more workers employed after

that are likely to get in each
other’s way. Thus, beyond point d,
output is likely to fall again: eight
workers produce less than seven
workers.
Figure 9.1. Wheat production per year

(tonnes) from a particular farm
21
The Short-run Production Function: Average and marginal product
In addition to total physical product, two other important concepts are illustrated
by a production function: namely, average physical product (APP) and marginal
physical product (MPP).
Average physical product: This is output (TPP) per unit of the variable factor (Lb). In
the case of the farm, it is the output of wheat per worker.
APP = TPP/Lb
Marginal physical product: This is the extra output (∆TPP) produced by employing
one more unit of the variable factor, (where the symbol ∆ denotes ‘a change in’).
MPP = ∆TPP/∆Lb
22
In addition to total physical product, two other important concepts are illustrated
by a production function: namely, average physical product (APP) and marginal
physical product (MPP).
Average physical product: This is output (TPP) per unit of the variable factor (Lb). In
the case of the farm, it is the output of wheat per worker.
APP = TPP/Lb
Marginal physical product: This is the extra output (∆TPP) produced by employing
one more unit of the variable factor, (where the symbol ∆ denotes ‘a change in’).
MPP = ∆TPP/∆Lb
23
The figures for APP and MPP are plotted in the lower diagram. We can draw a
number of conclusions from these two diagrams.
 The MPP between two points is equal to the slope of the TPP curve between
those two points. For example, when the number of workers increases from 1 to
2 (∆Lb = 1), TPP rises from 3 to 10 tonnes (∆TPP = 7). MPP is thus 7: the slope of
the line between points g and h.
 MPP rises at first: the slope of the TPP curve gets steeper.
 MPP reaches a maximum at point b. At that point the slope of the TPP curve is at
its steepest.
24
 After point b, diminishing returns set in. MPP falls. TPP becomes less steep.
 APP rises at first. It continues rising as long as the addition
to output from the last worker (MPP) is greater than the average output (APP):
the MPP pulls the APP up. This continues beyond point b. Even though MPP is
now falling,
the APP goes on rising as long as the MPP is still above the APP. Thus APP goes
on rising to point c.
 Beyond point c, MPP is below APP. New workers add less to output than the
average. This pulls the average down: APP falls.
25
 As long as MPP is greater than zero, TPP will go on rising: new workers add to
total output.
 At point d, TPP is at a maximum (its slope is zero). An additional worker will add
nothing to output: MPP is zero.
 Beyond point d, TPP falls. MPP is negative.
26
Costs in the Short-Run
Costs and Inputs
A firm’s costs of production will depend on the factors of production it uses. The
more factors it uses, the greater its costs will be. More precisely, this relationship
depends on two elements.
1. The productivity of the factors. The greater their physical productivity, the
smaller will be the quantity of them that is needed to produce a given level of
output and, hence, the lower will be the cost of that output. In other words,
there is a direct link between TPP, APP and MPP and the costs of production.
27
Costs and Inputs
A firm’s costs of production will depend on the factors of production it uses. The
more factors it uses, the greater its costs will be. More precisely, this relationship
depends on two elements.
2. The price of the factors. The higher their price, the higher will be the costs of
production. In the short run, some factors are fixed in supply. Therefore, the
total costs (TC) of these inputs are fixed and thus do not vary with output.
• Consider a piece of land that a firm rents: the rent it pays will be a fixed cost.
Whether the firm produces a lot or a little, its rent will not change.
• The cost of variable factors, however, does vary with output. The cost of raw
materials is a variable cost. The more that is produced, the more raw materials are
needed and therefore the higher is their total cost. 28
Costs and Inputs
• Consider a piece of land that a firm rents: the rent it pays will be a fixed cost.
Whether the firm produces a lot or a little, its rent will not change.
• The cost of variable factors, however, does vary with output. The cost of raw
materials is a variable cost. The more that is produced, the more raw materials are
needed and therefore the higher is their total cost.
29
Total Costs
The total cost (TC) of production is the
sum of the total variable costs (TVC)
and the total fixed costs (TFC) of
production.
TC = TVC + TFC
In Figure 9.2. They show the total
costs for an imaginary firm for
producing different levels of output
(Q). Let us examine each of the three
cost curves in turn.
30
Total Costs
Total fixed cost (TFC): In our

example, total fixed cost is
assumed to be £12.
Since this does not vary with
output, it is shown by a
horizontal straight line.
31
Total Costs
Total variable cost (TVC): With a
zero output, no variable factors
will be used. Thus TVC = 0. The
TVC curve, therefore, starts from
the origin
Total cost (TC): Since TC = TVC +

TFC, the TC curve is simply the
TVC curve shifted vertically
upwards by £12.
32
Total Costs
• The shape of the TVC curve follows from the law of diminishing returns. Initially,
before diminishing returns set in, TVC rises less and less rapidly as more variable
factors are added. For example, in the case of a factory with a fixed supply of
machinery, initially as more workers are taken on the workers can do increasingly
specialist tasks and make fuller use of the capital equipment. This corresponds to
the portion of the TPP curve that rises more rapidly
• Then, as output is increased beyond point m in Figure 9.2, diminishing returns
set in. Extra workers (the extra variable factors) produce less and less additional
output, so the additional output they do produce costs more and more in terms
of wage costs. Thus TVC rises more and more rapidly. The TVC curve gets steeper.
33
Average and Marginal Cost
Average cost (AC): is the cost per unit of production.
AC = TC/Q
• Thus, if it costs a firm £2000 to produce 100 units of a product, the average cost
would be £20 for each unit (£2000/100). As with cost, average cost can be
divided into two components, fixed and variable.
• In other words, average cost equals average fixed cost (AFC = TFC/Q) plus
average variable cost (AVC = TVC/Q).
AC = AFC + AVC
34
Average and Marginal Cost
Marginal cost (MC) is the extra cost of producing one more unit: that is, the rise in
total cost per one-unit rise in output. Note that all marginal costs are variable,
since, by definition there can be no extra fixed costs as output rises.
• Given the TFC, TVC and TC for each output, it is possible to derive the AFC, AVC,
AC and MC for each output using the above definitions.
35
Shapes of Average and Marginal Cost
What will be the shapes of the MC, AFC,

AVC and AC curves? These follow from the
nature of the MPP and APP curves (which
we looked at in section
36
• Marginal cost (MC). The shape of the
MC curve follows directly from the law
of diminishing returns.
• Initially, in Figure 9.3, as more of the
variable factor is used, extra units of
output cost less than previous units.
This means that MC falls.
37
• Beyond a certain level of output,
diminishing returns set in. This is shown
as point x in Figure 9.3. Thereafter MC
rises. Additional units of output cost
more and more to produce, since they
require ever-increasing amounts of the
variable factor.
• Average fixed cost (AFC). This falls
continuously as output rises, since total
fixed costs are being spread over a
greater and greater output.
38
Average variable cost (AVC). The shape of
the AVC curve depends on the shape of
the APP curve.
As the average product of workers rises,
the average labour cost per unit of output
(the AVC) falls: up to point y in Figure 9.3.
Thereafter, as APP falls, AVC must rise.
39
• Average (total) cost (AC). This is simply
the vertical sum of the AFC and AVC
curves. Note that, as AFC falls, the gap
between AVC and AC narrows.
• Although AVC and MC curves are usually
drawn as a U-shape, they are not always
shaped like this.
40
Relationship Between Average and Marginal Cost
This is simply another illustration of the relationship that applies between all
averages and marginals.
1. As long as the cost of additional units of output is less than the average, their
production must pull the average cost down. That is, if MC is less than AC, AC
must be falling.
2. Likewise, if additional units cost more than the average, their production must
drive the average up. That is, if MC is greater than AC, AC must be rising.
3. Therefore, the MC crosses the AC, and also the AVC, at their minimum points
(point z and y respectively in Figure 9.3).
41
Relationship Between TC, TVC, TFC, AC and MC
42
Production in the Long-Run
• In the long run, all factors of production are variable. There is time for the firm to
build a new factory (maybe in a different part of the country), to install new
machines, to use
• different techniques of production and, in general, to combine its inputs in
whatever proportion and quantities it chooses.
• Therefore, when planning for the long run, a firm will have to make a number of
decisions: about the scale of its operations, the location of its operations and the
techniques of production it will use. These decisions will affect the firm’s costs of
production and can be completely irreversible, so it is important to get them
right.
43
The Scale of Production
If a firm were to double all of its inputs – something it could do only in the long run
– would this cause its output to double? Or would output more than double or
less than double? We can distinguish three possible situations.
• Constant returns to scale. This is where a given percentage increase in inputs
leads to the same percentage increase in output.
• Increasing returns to scale. This is where a given percentage increase in inputs
leads to a larger percentage increase in output.
• Decreasing returns to scale. This is where a given percentage increase in inputs
leads to a smaller percentage increase in output.
44
The words ‘to scale’ mean that all
inputs increase by the same
proportion.
Decreasing returns to scale are,
therefore, quite different from
diminishing marginal returns (where
only the variable factor increases).
The differences between marginal
returns to a variable factor and
returns to scale are illustrated in
Table 9.4. 45
In the short run, input 1 is assumed to be fixed in supply (at 3 units). Output can be
increased only by using more of the variable factor (input 2). In the long run,
however, both inputs are variable.
In the short-run situation, diminishing returns can be seen from the fact that output
increases at a decreasing rate (25 to 45 to 60 to 70 to 75) as input 2 is increased.
In the long- run situation, the table illustrates increasing returns to scale. Output
increases at an increasing rate (15 to 35 to 60 to 90 to 125) as both inputs are
increased.
46
Economies of Scale
• The concept of increasing returns to scale is closely linked to that of economies
of scale. A firm experiences economies of scale if costs per unit of output fall as
the scale of production increases. Clearly, if a firm is getting increasing returns to
scale from its factors of production, then, as it produces more, it will be using
smaller and smaller amounts of factors per unit of output.
• Other things being equal, this means that it will be producing at a lower unit
cost.
47
Economies of Scale
• There are a number of reasons why firms are likely to experience economies of
scale. Some are due to increasing returns to scale; some are not.
1. Specialisation and division of labour. In large-scale plants, workers can do more
simple, repetitive jobs. With this specialisation and division of labour, less
training is needed; workers can become highly efficient in their particular job,
especially with long production runs; less time is lost from workers switching
from one operation to another; supervision is easier. Workers and managers
who have specific skills in specific areas can be employed.
48
Economies of Scale
2. Indivisibilities. Some inputs are of a minimum size. They are indivisible. The most
obvious example is machinery. Take the case of a combine harvester. A small-scale
farmer could not make full use of one. They become economical to use, therefore,
only on farms above a certain size. The problem of indivisibilities is made worse
when different machines, each of which is part of the production process, are of a
different size.
49
Economies of Scale
3. The ‘container principle’. Any capital equipment that contains things (blast
furnaces, oil tankers, pipes, vats, etc.) will tend to cost less per unit of output, the
larger its size. This is due to the relationship between a container’s volume and its
surface area. A container’s cost will depend largely on the materials used to build it
and hence roughly on its surface area. Its output will depend largely on its volume.
Large containers have a bigger volume relative to surface area than do small
containers.
50
Economies of Scale
4. Greater efficiency of large machines. Large machines may be more efficient, as
more output can be produced for a given amount of inputs. For example, whether a
machine is large or small, only one worker may be required to operate it. Also, a
large machine may make more efficient use of raw materials.
5. By-products. With production on a large scale, there may be sufficient waste
products to enable them to make some by-product. For example, a wood mill may
produce sufficient sawdust to make products such as charcoal briquettes or paper.
51
Economies of Scale
6. Multistage production. A large factory may be able to take a product through
several stages in its manufacture. This saves time and cost moving the semi-finished
product from one firm or factory to another. For example, a large cardboard-
manufacturing firm may be able to convert trees or waste paper into cardboard and
then into cardboard boxes in a continuous sequence.
52
Economies of Scale
7. Organisational. With a large firm, individual plants can specialise in particular
functions. There can also be centralised administration of the firms. Often, after a
merger between two firms, savings can be made by rationalising their activities in
this way.
8. Spreading overheads. Some expenditures are economic only when the firm is
large, such as research and development: only a large firm can afford to set up a
research laboratory. This is another example of indivisibilities, only this time at the
level of the firm rather than the plant. The greater the firm’s output, the more
these overhead costs are spread
53
Economies of Scale
9. Financial economies. Large firms can often obtain finance at lower interest rates
than small firms, as they are perceived as having lower default risks or have more
power to negotiate a better deal. Additionally, larger firms may be able to obtain
certain inputs more cheaply by purchasing in bulk. This follows from the concept
of opportunity cost, as the larger a firm’s order, the more likely it is that the supplier
will offer a discount, as the opportunity cost of losing the business is getting higher.
This helps to reduce the cost per unit.
54
Economies of Scale
10. Economies of scope. Often a firm is large because it produces a range of
products. This can result in each individual product being produced more cheaply
than if it was produced in a single-product firm. The reason for these economies of
scope is that various overhead costs and financial and organisational economies can
be shared between the products. For example, a firm such as Apple that produces
mobile phones, tablets, computers, smart watches, etc. can benefit from shared
marketing and distribution costs and the bulk pur- chase of electronic components.
55
Diseconomies of Scale
When firms get beyond a certain size, costs per unit of output may start to increase.
There are several reasons for such diseconomies of scale:
 Management problems of co-ordination may increase as the firm becomes larger
and more complex and as lines of communication get longer. There may be a lack
of personal involvement and oversight by management.
 Workers may feel ‘alienated’ if their jobs are boring and repetitive and if they feel
an insignificant and undervalued small part of a large organisation. Poor
motivation may lead to shoddy work.
56
Diseconomies of Scale
When firms get beyond a certain size, costs per unit of output may start to increase.
There are several reasons for such diseconomies of scale:
 Industrial relations may deteriorate as a result of these factors and also as a
result of the more complex interrelationships between different categories of
worker.
 Production-line processes and the complex interdependencies of mass
production can lead to great disruption if there are hold-ups in any one part of
the firm.
57
Costs in the Long-Run
Production decisions, the firm has much more flexibility. It does not have to operate
with plant and equipment of a fixed size. It can expand the whole scale of its
operations. All its inputs are variable and thus the law of diminishing returns does
not apply. The firm may experience economies of scale or diseconomies of scale or
its average costs may stay constant as it expands the scale of its operations.
• Since there are no fixed factors in the long run, there are no long-run fixed costs.
For example, the firm may rent more land in order to expand its operations. Its
rent bill, therefore, goes up as it expands its output. All costs, then, in the long
run, are variable costs.
58
Long-run Average Cost
Although it is possible to
draw long-run total,
marginal and average cost
curves, we will concentrate
on long-run average cost
(LRAC) curves.
These curves can take
various shapes, but a typical
one is shown in Figure 9.4.
59
Long-run Average Cost curves
It is often assumed that, as a firm expands, initially it will experience economies of
scale and thus face a downward-sloping LRAC curve.
• While it is possible for a firm to experience a continuously decreasing LRAC
curve, in most cases, after a certain point (Q1), all such economies will have been
achieved and thus the curve will flatten out.
• Then, possibly after a period of constant LRAC (between Q1 and Q2), the firm will
get so large that it will start experiencing diseconomies of scale and thus a rising
LRAC. At this stage, production and financial economies begin to be offset by the
managerial problems of running a giant organisation.
60
LRAC curve and the
SRAC curves
Take the case of a firm
that has just one
factory and faces a
short-run average cost
curve illustrated by
SRAC1 in Figure 9.5.
61
LRAC curve and the SRAC curves
• In the long run, it can build more factories or expand its existing facilities. If it
thereby experiences economies of scale (due, say, to savings on administration),
each successive factory will allow it to produce with a new lower SRAC curve. Thus,
with two factories, it will face curve SRAC2; with three factories curve SRAC3, and so
on.
• Each SRAC curve corresponds to a particular amount of the factor that is fixed in the
short run: in this case, the factory.
• From this succession of short-run average cost curves, we can construct a long-run
average cost curve. This is shown in Figure 9.5 and is known as the envelope curve,
since it envelops the short-run curves.
62

Week 6 - Behaviour of A Firm and Short Run Production

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Week 6 - Behaviour of A Firm and Short Run Production

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Firm Behavior and

3. Larger market share and

4. Long run survival among others

Traditional microeconomics focuses on the profit motive of business firms, that

The law of diminishing marginal returns.

Any more workers employed after

Figure 9.1. Wheat production per year

Total fixed cost (TFC): In our

Total cost (TC): Since TC = TVC +

What will be the shapes of the MC, AFC,

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