Consider a hockey stick manufacturer.

They require materials such as lumber, labour,

Unit 2: Theory of Production & Costs machinery, and a factory. If the demand for hockey sticks increased, the company
would start producing more hockey sticks to meet the demand.
Concept of production (goods & services):
They would order the necessary raw materials (lumber, for example) with little delay
The theory of the consumer is used to explain the market demand for goods and thus increasing their stock of those materials. In addition, the company would require a
services. larger workforce. To guarantee a larger workforce, the company could hire more
The theory of the firm provides an explanation for the market supply of goods and workers or give extra shifts and night shifts to its current workers.
services. In this case, both of these factors (the raw materials and the labour force) would be
considered variable inputs.
A firm is defined as any organization of individuals that purchases factors of production
(labour, capital, and raw materials) in order to produce goods and services that are sold On the other hand, an additional factory can’t be a variable input. A new factory would
to consumers, governments, or other firms. be a fixed input, as the company wouldn’t be able to build a new one in a short time.
Furthermore, machinery could also be a fixed input since producing it and installing it
The firm's production decision is to determine how much of each factor of production to might take the firm a long time.
employ.

Long Run Production Function:

Different factors of production (fixed and variable factors): Long-run production in microeconomic theory is the period where the scale of all
factors of production is variable and can be changed.
In the short‐run, some of the factors of production that the firm needs are available only
in fixed quantities. For example, the size of the firm's factory, its machinery, and other Example:
capital equipment cannot be varied on a day‐to‐day basis.
In the hockey stick manufacturer example, all the inputs (lumber, labour, machinery,
and the factory) are variable in the long run.

In the long‐run, the firm can adjust the size of its factory and its use of machinery and This means that the firm could change all of them so that it wouldn’t have fixed factors
equipment, but in the short‐run, the quantities of these factors of production are that prevented an increase in production output.
considered fixed. The short‐run is defined as the period during which changes in certain In the hockey stick industry, it means that existing firms are not constrained and can
factors of production are not possible. The long‐run is defined as the period during change the size of the company and the number of factories they own.
which all factors of production can be varied.
Short Run Cost Curves:
Other factors of production, however, are variable in the short‐run. For example, the Short-run cost curves refer to curves that represent the amount of cost a firm face
number of workers the firm employs or the quantities of raw materials the firm uses during the short run. Short run is characterized by
can be varied on a day‐to‐day basis.
having the amount of one of the factors of production function kept constant. In
A factor of production that can be varied in the short‐run is called a variable factor of
contrast, the number of other factors may change.
production.
A factor of production that cannot be varied in the short‐run is called a fixed factor of
production. In the short‐run, a firm can increase its production of goods and services
only by increasing its use of variable factors of production.

Short Run Production Function:

Short-run production in microeconomic theory is when at least one of the factors of
production (land, labour, capital, or technology) is fixed and can’t be changed Fig 1. - Short-run cost curves
Example:

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Figure 1 shows the short-run cost curves that a company faces. In the short run, the Total Cost Curves:
costs that are considered for a company include marginal cost (MC), average total cost
(ATC), average fixed cost (AFC), and average variable cost (ATC). Total cost curves represent the aggregate of all the expenses a company faces when
producing a certain quantity of product.

The formula for total cost is as follows:

Long Run Cost Curves:

Long-run cost curves show the cost that a company faces in the long run for producing
a certain amount of output.

Fixed costs include costs such as the costs of a building lease and machinery used during
While in the short run, some of the factors of production are fixed, meaning that the the production process. Within reason, fixed costs do not change as if output increases
firm isn't flexible in changing these factors, their cost is also fixed. or decreases.
In other words, regardless of the company's production level, the company will still face
fixed costs.
On the other hand, the cost faced by a company, in the long run, is entirely variable.
That's because all factors of production during the long run are to be variable. Variable costs include costs such as the cost of labour and raw materials. These costs do
change with the level of output.

Fig. 3 - Total cost curve

Fig. 2 - Long-run cost curves Figure 3 illustrates the total cost curve. In Figure 3, there are also fixed and variable
Figure 2 shows the long-run cost curve. The long-run cost curve is the long-run average costs. That's because the total cost curve consists of these two main curves.
total cost curve which consists of many short-run average total costs (ATC).

Marginal Cost Curves:

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 Marginal cost (MC) is the additional cost of producing one more unit of a good or Average variable cost (AVC) equals the total variable cost per unit of produced quantity.
service. Similarly, to calculate the average variable cost, we should divide the total variable cost
by the total quantity:
It is calculated by dividing the change in total cost by the change in the quantity of
output.

The marginal cost formula is:

Average fixed cost (AFC) shows us the total fixed cost for each unit. To calculate the
average fixed cost, we have to divide the total fixed cost by the total quantity:

Fig. 4 - Marginal cost curve

In Figure 4 , we can see the marginal cost function, which illustrates how the marginal
cost changes with different levels of quantity. The quantity is shown on the x-axis,
whereas the marginal cost in dollars is given on the y-axis.

Fig. 5 - Average costs

Average Cost Curves:

Average Cost, also called average total cost (ATC), is the cost per output unit. We can Figure 5 shows the curves of average costs.
calculate the average cost by dividing the total cost (TC) by the total output quantity
(Q).
Notice that the average fixed cost per unit produced decreases. That's because as a firm
produces more output while the fixed cost remains the same, the fixed cost will decrease
per unit of production.

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On the other hand, the average variable cost (AVC) increases with the increase in Profit will be maximized at the point of production and sales where Marginal Revenue
output. That's because as the production volume increases, a firm's variable cost = Marginal Cost.
increases as well.

The average total cost is U shaped; it initially decreases with the decline of AFC and
begins to increase again as the AVC increases.

Economic concept of profit:

Profit is defined as total revenue minus total production cost.

Mathematically, this is written as:

In economic terms, total production costs refer to all the costs the firm incurs to employ
inputs. On the other hand, total revenue refers to the quantity of products sold by the
firm multiplied by the price per unit of product.
Total cost refers to all costs the firm incurs to employ inputs.
As you can see, the market sets the price (Pm), therefore MR = Pm, and in the blue shirt
Total revenue refers to the price per product multiplied by the quantity of the product market that price is $10.
sold.
Mathematically, total revenue is written as: Conversely, the MC curve initially curves downward before curving upward, as a direct
result of the Law of Diminishing Returns. As a result, when the MC rises up to the point
where it meets the MR curve, that's precisely where the blue shirt company will set its
level of production, and maximize its profits!
Economic profit refers to total revenue minus total explicit costs and minus total
implicit costs.
Mathematically, this is written as:

An explicit cost refers to an outlay of money.

An implicit cost refers to an input cost that does not require an outlay of money.

profit maximization:
Profit maximization is the process of finding the level of production that generates the
maximum amount of profit for a business.

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