Theory of Production and

Costs
1. We move from behavior of consumers to
behavior of producers
2. Firms use economic resources to produce
goods & services
3. Firms make monetary payments to
resource owners (ex. Workers)
4. These payments together with opportunity
costs of own resources make up the firms
costs of production

Theory of Production and

Costs
We will look at:
1.
Economic Costs and profits
2.
Short-run
Production
Costs
Relationships
3.
Long-run
Production
Costs
Relationships

and
and

Introduction
Every economy consists of thousands of firms
that produce the goods and services that we
enjoy everyday
Some firms are large they employ thousands of workers
Have large numbers of shareholders who share in the
firms profits

Other firms are small

They employ a few number of people (1-100)
Owned by one man/ one family (sole proprietorship)
or few people (partnership)

Introduction
Recall the law of supply-firms will supply more
goods when the price of the goods rise
Hence the supply curve slopes upwards

We use the supply curve to show the firms

production decisions
The behaviour of the firm is summarised by the
supply curve
Question: what curve summarises the behaviour of the
consumer?

Market forces of Demand and

Supply
Supply and demand are the two words
that economists use most often.
Supply and demand are the forces that
make market economies work.
Modern microeconomics is about supply,
demand, and market equilibrium

What Are Costs

According to the Law of Supply:
Supply
Firms are willing to produce and sell a greater
quantity of a good when the price of the good
is high.
This results in a supply curve that slopes
upward

What Are Costs

The Firms Objective
To understand the decisions of a firm, we
must understand what it is trying to do
The economic goal of the firm is to maximize
profits

Total Revenue, Total Cost and

Profit
Total Revenue
The amount a firm receives for the sale of its
output.

Total Cost
The market value of the inputs a firm uses in
production. (The amount that a firm pays to
buy inputs)
What are the inputs in a firm that makes
cookies?

Total Revenue, Total Cost and

Profit
Profit is the firms total revenue minus its total
cost.

Profit = Total revenue - Total cost

Total Revenue is easy to compute:

it is the quantity of output the firm

produces times the price at which it sells
its output.

Total Cost is more difficult to measure

Costs as Opportunity cost

Recall that the cost of something is what
you give up to get it.
Opportunity cost of an item refers to all
those things that must be foregone to
acquire the item
When the economist talks of a firms cost
of production, they include all the
opportunity costs of making its output of
goods and services

Costs as Opportunity Costs

A firms cost of production includes all the opportunity
costs of making its output of goods and services.
Consider the cookie case: Paying P100 to buy flour is an
opportunity cost because we can no longer use the P100
to buy something else.
Explicit and Implicit Costs
A firms cost of production include explicit costs and implicit
costs.
Explicit costs are input costs that require a direct outlay of money by
the firm, e.g. salaries it pays to workers, cost of raw materials
Implicit costs are input costs that do not require an outlay of money
by the firm-e.g. my computer skills, my driving skills etc.

Economic Profit Vs Accounting

Profit
Economists measure a firms economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
Accountants measure the accounting profit as
the firms total revenue minus only the firms
explicit costs.
When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

Accounting profit & Economic Profit

A firm has incurred the following costs:
Purchase of raw materials
P62,350
Wages & Salaries
32,150
Electricity & Telephone
13,520
Firm uses its borehole for water
cost of water consumption is 6500
Transporting charges
5400
(the firm used its vehicle)
The firm used its own factory building,
whose rent amount
- 36,700
The value of the firms owners managerial abilities but no
manager is employed
52,000
Total Revenue of the firm
- 275,750
13
Calculate Accounting profit and economic profit.

Production
The total amount of output produced by a
firm is a function of the levels of input
usage by the firm
The Production Function
The production function shows the
relationship between quantity of inputs used
to make a good and the quantity of output of
that good.

Short-run production
relationships
S.R. is a period too brief for a firm to alter its
plant capacity
We look at the relationship between
(variable) inputs and output, i.e., laboroutput relationship given a fixed plant
capacity
First we define some terms
Total product is the total quantity of a particular
good produced

Total Product

Total Product Curve

Average Product (AP)

AP or labor productivity is output per unit of labor
AP = TP / amount of input
Quantity
of labor TPP
0
5
10
15
20
25
30
35
40
45

0
50
120
180
220
250
270
275
275
270

APP
10
12
12
11
10
9
7.86
6.88
6

Marginal product (MP)

the additional output that results from the
use of an additional unit of a variable
input, holding other inputs constant
measured as the ratio of the change in
output (TP) to the change in the quantity
of labor (or other input) used
MP=TP/L

Computation of AP and MP
Computation
Quantity
of labor

TP

0
5
10
15
20
25
30
35
40
45

0
50
120
180
220
250
270
275
275
270

AP
10
12
12
11
10
9
7.86
6.88
6

MP
10
14
12
8
6
4
1
0
-1

Marginal Product
Note that the MP is positive when an
increase in labor results in an increase in
output; a negative MP occurs when output
falls when additional labor is used.

Law of diminishing returns

As the level of a variable input rises in a
production process in which other inputs are
fixed, output ultimately increases by
progressively smaller increments.
This is also known as the law of diminishing
marginal product- 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.

Shape of MP and AP curves

Relationship between MP and TP

MP rises when TP increases at an
increasing rate, and declines when TP
increases at a decreasing rate.
MP is negative if TP declines when labor
use rises

Relationship of AP and MP

Relationship between AP and MP

AP rises when MP > AP
AP falls when MP < AP
AP is at a maximum when MP = AP

From Production to Costs

The relationship between the quantity a
firm can produce and its costs determines
pricing decisions.
The total-cost curve shows this
relationship graphically

Short Run vs Long run

Short run
Long run a period of time long enough to
enable producers to change the quantities
of all the resources they employ
Short run costs:
fixed costs costs that do not vary with the
level of output. Fixed costs are the same at all
levels of output (even when output equals
zero).
variable costs costs that vary with the level of
output (= 0 when output is zero)

Cost curves
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC

Short run Vs Long run

Total Fixed Cost

Total Variable cost

TC, TVC, TFC

Average costs
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

Average Fixed Cost

Average fixed cost (AFC) = TFC / Q

Average variable cost

Average variable cost (AVC) = TVC / Q

Average total cost

Average total cost (ATC) = TC / Q
ATC = AFC + AVC (since TFC + TVC =
TC)

Marginal cost
Marginal Cost
Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
Marginal cost helps answer the following
question:
How much does it cost to produce an additional
unit of output?

Marginal cost

( c h a n g e in to ta l c o s t) T C
MC

( c h a n g e in q u a n tity ) Q

Marginal cost

AFC

AVC, ATC, MC

MC,AVC, ATC
MC rises with the quantity of output
The AC curve is U-shaped
The MC curve intersects the AVC and ATC at
their respective minimum points
MC curve reflects the law of DMP
At low levels of output, few workers are hired, much
of the equipment are unused
MP of an extra worker is large
MC of an extra unit produced is small
At larger outputs, MP is of an extra worker is low, MC
of an extra unit produced is large

ATC
ATC=AFC + AVC
AFC always declines as output rises
because fixed cost is spread over larger
number of units
AVC rises as output rises because of DMP
ATC reflects the shape of the AFC and
AVC curves

LONG RUN cost curves

For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
In the short run, some costs are fixed.
In the long run, fixed costs become variable costs.

Because many costs are fixed in the short run

but variable in the long run, a firms long-run cost
curves differ from its short-run cost curves.

L-R cost curves

LR cost curves
In the long run, a firm may choose its level
of capital, and will select a size of firm that
provides the lowest level of ATC.

Economies and Diseconomies of

Scale
Economies of scale refer to the property
whereby long-run average total cost falls
as the quantity of output increases.
Economies of scale factors that lower
average cost as the size of the firm rises in
the long run
Sources: specialization and division of labor,
indivisibilities of capital, etc.

Economies and Diseconomies of

Scale
Diseconomies of scale refer to the
property whereby long-run average total
cost rises as the quantity of output
increases.
Diseconomies of scale factors that raise
average cost as the size of the firm rises in
the long run
Sources: increased cost of managing and
coordination as firm size rises

Economies and Diseconomies of

Scale
Constant returns to scale refers to the
property whereby long-run average total
cost stays the same as the quantity of
output increases

Economies of Scale

Minimum efficient Scale

Minimum efficient scale = lowest level of
output at which LRATC is minimized

Questions
Given the ff info indicate if the industry
exhibits, Economies of scale or
diseconomies of scale
A 5% increase in all resources used in
production cause output to increase by 20%
A 5% increase in all resources used in
production causes output to increase by 2%

Discuss three sources of economies of

scale

MES & industry structure

Economies & diseconomies are important
determinants of industry structure
An industry where economies of scale are:
few & diseconomies set in quickly, i.e. MES
occurs at low output levels will be populated by
small firms (size is not an advantage)
large and diseconomies set in only at very high
levels of output, i.e., MES occurs at high levels of
output will be populated by few large firms
Continue over an extended range of output, i.e.,
MES at low output and extend to high output
levels, will be populated by firms of different
sizes. Size doesnt matter in competitiveness

Summary
The goal of firms is to maximize profit,
which equals total revenue minus total
cost.
When analyzing a firms behavior, it is
important to include all the opportunity
costs of production.
Some opportunity costs are explicit while
other opportunity costs are implicit.

Summary
A firms costs reflect its production process.
A typical firms production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
A firms total costs are divided between fixed and
variable costs. Fixed costs do not change when
the firm alters the quantity of output produced;
variable costs do change as the firm alters
quantity of output produced.

Summary
Average total cost is total cost divided by
the quantity of output.
Marginal cost is the amount by which total
cost would rise if output were increased by
one unit.
Average cost and marginal cost first fall as
output increases and then rise.

Summary
The average-total-cost curve is U-shaped.
The marginal-cost curve always crosses
the average-total-cost curve at the
minimum of ATC.
A firms costs often depend on the time
horizon being considered.
In particular, many costs are fixed in the
short run but variable in the long run.