4 the theory of the firm and the cost of production

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

The Theory of the Firm and the cost of production

Production Function

States the relationship between inputs and outputs or maximum output from various combinations of

factors in puts.

Inputs – the factors of production classified as:

Input Land Labour Capital

Description All natural resources of the earth.

all physical and mental human effort involved in production

buildings, machinery and equipment not used for its own sake but for the contribution it makes to production

Price paid to acquire Rent Wages Interest

Mathematical representation of the relationship:

𝑄 = 𝑓 (𝐾, 𝐿, 𝐿𝑎)

Q - Output K - Capital L - Land La - Labor


Analysis of Production Function (Short Run and Long run):

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.

Long Run

The long run is defined as the period taken to vary all factors of production

By doing this, the firm is able to increase its total capacity – not just short-term capacity and

Associated with a change in the scale of production

The period varies according to the firm and the industry

In electricity supply, the time taken to build new capacity could be many years; for a market

stallholder, the ‘long run’ could be as little as a few weeks

Marginal Product

The marginal product of any input in the production process is the increase in output that arises from an

additional unit of that input

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑕𝑦𝑠𝑖𝑐𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑀𝑃𝑃 =𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡

𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑝𝑢𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

Diminishing Marginal Product

Diminishing marginal product is the property whereby the marginal product of an input declines as the

quantity of the input increases.

Example: As more and more workers are hired at a firm, each additional worker contributes less and less

to production because the firm has a limited amount of equipment.

In the short run, a production process is characterized by a fixed amount of available land and capital. As

more labour is hired, each unit of labour has less capital and land to work with.


Units of L Total Product

(QL or TPL)

Marginal Product

(MPL)

0 0 -

1 2 2

2 6 4

3 12 6

4 20 8

5 26 6

6 30 4

7 32 2

8 32 0

9 30 -2

10 26 -4

TP – Total Product

MP – Marginal

Product

AP – Average product


Costs

In buying factor inputs, the firm will incur costs

Costs are classified as:

Fixed costs (FC) – costs that are not related directly to production – rent, rates, insurance costs,

admin costs. They can change but not in relation to output

Variable Costs (VC) – costs directly related to variations in output. Raw materials primarily

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

𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶

𝐴𝐶 = 𝑇𝐶/𝑂𝑢𝑡𝑝𝑢𝑡

𝑀𝐶 = 𝑇𝐶𝑛 – 𝑇𝐶𝑛−1 𝑢𝑛𝑖𝑡𝑠

𝑀𝐶 =𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑢𝑡𝑝𝑢𝑡

Total Cost (TC) - the sum of all costs incurred in production

Average Cost (AC) – the cost per unit of output

Marginal Cost (MC) – the cost of one more or one fewer units of production


Relationships between Costing and Production

Here I guess that first graph is obvious, in second the increasing increase is due to the increasing

increase in the MC as shown in first set of graphs.

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 = 𝑇𝑅𝑛 – 𝑇𝑅𝑛−1 𝑢𝑛𝑖𝑡𝑠

Profit

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 – 𝑇𝐶

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

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


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!)

Assumption that firms aim to maximise profit

May not always hold true – there are other objectives

Profit maximising output would be where MC = MR


The Cost of Production

Profit = Total revenue - Total cost

Total Cost includes all of the opportunity costs of production

Explicit Costs and Implicit Costs

Explicit costs are out-of-pocket expenses, such as labour, raw materials, and rent.

Implicit costs are foregone expenses, such as the value of your own time, and the value of your

own money (interest earned).

Economic Profit versus Accounting Profit

Economic profit is smaller than accounting profit

Question: If a firm’s total revenue is $80,000, and its explicit and implicit costs are $70,000 and $25,000,

respectively, what are its economic and accounting profits?

Accounting: 35000, Economics: 10000


Total and Per Unit Costs

Total Variable Cost (TVC)

Total Fixed Cost (TFC)

Total Cost (TC)

Average Variable Cost (AVC)

Average Fixed Cost (AFC)

Average Total Cost (ATC)

Marginal Cost (MC)

Fixed and Variable Costs

Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are

those costs that do change as the firm alters the quantity of output produced.

Average Costs

Average costs can be determined by dividing the firm’s costs by the quantity of output produced. The

average cost is the cost of each typical unit of product.

Marginal Cost

Marginal cost (MC) measures the amount total cost rises when the firm increases production by one

unit.

Question: Fill in the missing values

Three Important Properties of Cost Curves

1. Marginal cost eventually rises with the quantity of output. [Law of Diminishing Marginal

Returns]

2. The average-total-cost curve is U-shaped.

3. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total

cost.

Question%20TOF.ppsx


The Long-run Average Cost Curve

In the long run, all inputs are variable. A firm has enough time to choose the size of its factory, farm,

office building, or other capital goods. The firm can choose from many short-run cost curves. The

bottom points of the short-run average cost curves make up the long-run average cost curve. Long-run

average costs fall as production first rises. This is called economies of scale. When the firm gets too big,

long-run average costs rise. This is called diseconomies of scale (DOS).


Returns to Scale

When inputs increase, and production more than proportionately increases, then we speak of increasing

returns to scale (associated with economies of scale).

Example - Inputs increase by 10%, and production increases by 20%.

When inputs increase, and production less than proportionately increases, then we speak of decreasing

returns to scale (associated with diseconomies of scale).


When inputs increase, and production increases by the same percentage, then we speak of constant

returns to scale.


Technology

4 the theory of the firm and the cost of production