TOPIC 6

Production & Cost

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 THE FIRM’S OBJECTIVE: MAXIMIZING
PROFIT
 Economists assume that a firm’s objective in producing &
selling goods is to maximize profit.
 Profit = Total revenue(TR) – Total Cost (TC).

 TR = price of the good  quantity of the good sold.

 For example, if a business firms sells 100 units of X at
RM10 per unit, TR = 10  100 = RM1000.

 While almost everyone defines TR the same way, a

disagreement sometimes arises as to what TC should
include (explicit cost vs implicit cost).

CH 20 • 2
 EXPLICIT COST VS IMPLICIT COST
Explicit Cost Implicit Cost

 A cost that represents the

value of resources used in
production for which no
 A cost that is incurred when actual (monetary) payment
an actual (monetary)
is made (opportunity costs).
payment is made.
 For example: payment for  This is incurred as a result of
wage, rent, electricity & etc. a firm using its own
resources that it owns or
that the owners of the firm
contribute to it.

CH 21 • 3
ACCOUNTING PROFIT VS ECONOMIC PROFIT
 Accounting profit = TR – TC (explicit)
 Economic Profit = TR – TC (explicit + implicit)
 Economic profit < Accounting profit

CH 20 • 4
Exhibit 1 Accounting and Economic Profit

5
 Self-test:
 Suppose Alia currently works as a lecturer
earning RM80,000 a year. One day she quit
her job an opens a pizzeria.
 At the end of her first year of operating the
pizzeria she sold 20,000 pizzas at a price of
RM10 per pizza. She spent RM2000 on plates,
RM2000 on cheese, RM4000 on soda,
RM20,000 for rent in the mall where the
pizzeria is located & RM2000 on electricity.

CH 20 • 6
(i) Total Revenue (TR)
TR = 20,000 pizzas  RM10
= RM200,000.

(ii) Explicit Costs

= RM2000 + RM2000 +RM4000 + RM20,000 +
RM2000
= RM30,000.

Accounting Profit
= RM200,000 - RM30,000
= RM170,000.

7
(iii) Implicit Cost
= RM80,000

Economic Profit
= RM200,000 – (RM30,000 + RM80,000)
= RM90,000

Economic Profit VS Accounting Profit

Economic profit < Accounting profit
(RM90,000) (RM170,000)

8
 1. Is accounting or economic profit
larger? Why?
SELFTEST
 Accounting profit is larger.
 Only explicit costs are subtracted from TR in
computing accounting profit, but both explicit &
implicit costs are subtracted from TR in computing
economic profit.
 Accounting profit = economic profit if implicit costs
=0
 Economic profit always < than accounting profit.

CH 22 • 9
 THREE TYPES OF ECONOMIC PROFIT
i. Zero economic profit
 The firm is able to generate a reasonable return for input used
(normal economic profit)
 Total revenue = total economic cost

ii. Negative economic profit

 The firm is not able to generate a reasonable return for input
used (less-than-normal economic profit)
 Total revenue < total economic cost

iii. Positive economic profit

 The firm is able to generate an “extra” return for input used
(excess economic profit)
 Total revenue > total economic cost
CH 20 • 10
 3. When can a business owner be earning a
profit but not covering his costs?
 A business owner can be earning a profit but not
SELFTEST
covering costs when he is earning (positive) accounting profit
but his TR does not cover the sum of his explicit & implicit
costs.
 For example, suppose Brad earns TR of $100,000 & has explicit
costs of $40,000 & implicit costs of $70,000.
 His accounting profit is $60,000, but his TR of $100,000 is not
large enough to cover the sum of his explicit & implicit costs
($110,000).
 Brad’s economic profit is a negative $10,000.
 In other words, although Brad earns an accounting profit, he
takes an economic loss.

CH 22 • 11
 PRODUCTION
 Production is a transformation of resources or
inputs into goods & services.
 For example: it take certain resources or input to
produce a computer, a piece of furniture & etc.

 There is an important link between production,

costs & time.
 Production involves costs & takes time to complete.

CH 20 • 12
PERIODS OF PRODUCTION, INPUTS & COSTS
 Short run -- a period in which some inputs in the
production process are fixed (fixed & variable inputs).
 Long run -- a period in which all inputs in the production
process can be varied (variable inputs).

 Fixed input -- an input whose quantity cannot be changed

as output changes in the short run.
 Variable input --an input whose quantity can be changed
as output changes in the short run.

 The costs associated with fixed inputs & variable inputs are
fixed costs & variable costs.

CH 20 • 14
 PRODUCTION IN THE SHORT RUN
 The process of production involves the transformation of input
into output given a certain level of technology.
 Productivity of input ↑ output ↑

 Three measurements of input productivity:

 Total product (TP) – the total amount of output produced
by the inputs (L)
 Average product (AP) – the amount of output produced by
each input (TP/L)
 Marginal product (MP) – the additional output produced by
one additional unit of input (∆TP/∆L)

 Table 9.3 & Figure 9.1 illustrate the concepts of TP, AP & MP
 assuming there is only one variable input – labour H 20 • 15
TOTAL, AVERAGE & MARGINAL PRODUCT

CH 20 • 16
• TP achieves maximum, MP=0 • Shape of MP reflects the
• MP > AP, AP is increasing law of diminishing marginal return
• MP = AP, AP achieves maximum • As more units of the variable input
• MP < AP, AP is decreasing are added, each one has fewer units
of the fixed input to work with;
consequently, output rises at a
decreasing rate. 17
18
 THREE STAGES OF PRODUCTION
 First stage
 MP > AP until MP=AP
 TP ↑as input ↑ (increasing rate)
 Efficient combination of fixed & variable input.
 Firm will continue to ↑ output.
 Second stage
 MP < AP until MP=0
 TP ↑as input ↑ (decreasing rate)
 Optimum combination of fixed & variable input.
 Firm will continue to ↑ output until TP achieves its maximum
 Third stage
 MP is negative
 TP↓
 Inefficient combination of fixed & variable input.
 Firm will not produce output at this stage.
CH 20 • 19
 Self-test: Why Does MP  ?
 Think of adding agricultural workers (variable input) to
10 acres of land (fixed input).
 In the early stages of adding labor to the land, perhaps
the MP  or remains constant.
 But eventually, as we continue to add more workers to
the land, there comes a point where the land is
overcrowded with workers.
 Workers are stepping around each other, stepping on the
crops & so on.
 Because of this problems, output growth begins, to slow.

CH 20 • 20
 SHORT RUN PRODUCTION COST
 There are 3 types of production cost in the short run:
 Total Fixed Costs (TFC) - the cost of using fixed input
(Costs that do not vary with output).
 Total Variable Cost (TVC) - the cost of using variable
input (Costs that vary with output).
 Total Cost (TC) - The sum of total fixed costs & total
variable costs.
TC = TFC + TVC

 Marginal Cost (MC) - The change in total cost that

results from a change in output.
MC = ΔTC/Δ Q
CH 22 • 21
 Average Fixed Cost (AFC) - Total fixed cost divided by
quantity of output.
AFC = TFC / Q

 Average Variable Cost (AVC) - Total variable cost

divided by quantity of output.
AVC = TVC / Q

 Average Total Cost (ATC), or Unit Cost - Total cost

divided by quantity of output.
ATC = TC / Q or ATC = AFC + AVC

CH 22 • 22
Short Run Production Costs

23
Short Run Production Costs (Continued)

24
 RELATIONSHIP BETWEEN MP & MC

 Inverse relationship between MP & MC shows the link

between the law of diminishing marginal return of the
MP curve to the MC curve.
 MP  , MC 
 MP max, MC min
 MP  , MC 

CH 22 • 25
Relationship between Marginal Product & Marginal Cost

26
• Law of diminishing
marginal returns: shape
of MP and MC

• MP is increasing, MC is
decreasing
• MP achieves its max, MC
achieves its min
• MP is decreasing, MC is
increasing

Principles of Economics | 27
ANOTHER WAY TO LOOK AT THE
RELATIONSHIP BETWEEN MP & MC
 MP & MC are related (refer Exhibit 3).
 MP  MC  , MP  MC 

 MC = ΔTC/ΔQ
 ΔTC -- the additional cost of adding an additional
unit of the variable input (labor)
 ΔQ -- MP of the variable input

 Thus MC = W/MP

CH 22 • 28
HOW MP AFFECTS MC

CH 22 • 29
RELATIONSHIP BETWEEN ATC, AVC & MC
 What do the ATC & AVC curves look like in
relation to the MC curve?
 The average-marginal rule tells us that:
 When the marginal magnitude is above the
average magnitude, the average magnitude 
 When the marginal magnitude is below the
average magnitude, the average magnitude 

Marginal > Average  Average 

Marginal < Average  Average 

CH 22 • 30
RELATIONSHIP BETWEEN ATC, AVC & MC
 In other words, as Exhibit 5 shows, when
MC < AVC & ATC  AVC & ATC curve 
MC > AVC & ATC  AVC & ATC curve 

 The MC curve must intersect the AVC & ATC curves at

their respective minimum points.
 The average-marginal rule does not apply to the AFC
curve, since MC do not affect FC.
 In this case, the AFC curve will  continuously as
output .

CH 22 • 31
Relationship between MC, ATC & AVC Curves

32
TYING SHORT-RUN PRODUCTION TO COSTS
 In the short run, at least one input is fixed.

 When production , MP  & MC 

 If MC > AVC & ATC  AVC & ATC 

 When production , MP  & MC 

 If MC < AVC & ATC  AVC & ATC 

 Thus, the cost of a good is tied to the production of the

good.

CH 22 • 33
Exhibit 6 Tying Short-Run Production to Costs

34
 4. If the short run is 6 months, does it follow
that the long run is longer than 6 months?
 No. The short run & the long run are not lengths of
SELFTEST
time. The short run is that period of time when
some inputs are fixed & therefore the firm has
fixed costs. The long run is any period of time when
no inputs are fixed (i.e., all inputs are variable) &
thus all costs are variable costs.
 The short run can be, say, six months & the long
run can be a much shorter period of time. In other
words, the time period when there are no fixed
inputs can be shorter than the time period when
there are fixed inputs.

CH 22 • 35
 5. “As we add more capital to more labor,
eventually the law of diminishing marginal
returns will set in.” What is wrong with this
SELFTEST
statement?
 The law of diminishing marginal returns holds only
when we add more of one input to a given (fixed)
quantity of another input.
 The statement does not identify one input as fixed
(it says that both increase), and so the law of
diminishing marginal returns is not relevant in this
situation.

CH 22 • 36
 6. Suppose a MC curve falls when output is in the
range of 1 unit to 10 units, flattens out & remains
constant over an output range of 10 units to 20
units, & then rises over a range of 20 units to 30
SELFTEST
units. What does this have to say about the
marginal product (MP) of the variable input?
 When MC is ↓, MP is ↑
 When MC is constant, MP is constant
 When MC is ↑ , MP is ↓.

CH 22 • 37
 7. What happens to unit costs as MC↑ ? Explain your
answer.
 Unit costs are another name for ATC; so the question is what
SELFTEST
happens to ATC as MC ↑?
 You might be inclined to say that as MC ↑, so does ATC, but
this is not necessarily so. What matters is whether MC is > ATC.
If it is, then ATC will ↑. If it is not, then ATC will ↓.
 There is a tendency to misinterpret the average-marginal rule
& to believe that as MC ↑, ATC ↑ & that as MC ↓ , ATC ↓ .
 But the average-marginal rule actually says that when MC is
above ATC, ATC ↑ & when MC is below ATC, ATC ↓.

CH 22 • 38
 8. Do changes in marginal product (MP)
influence unit costs? Explain your answer.
 Yes.
SELFTEST
 As MP ↑, MC ↓. If MC falls enough to move below
unit cost (which is the same as ATC), then unit cost
↓.
 Similarly, as MP ↓, MC ↑. If MC rises enough to
move above unit cost, then unit cost ↑.

CH 22 • 39
 PRODUCTION IN THE LONG RUN
 In the short run, there are fixed costs & variable costs
 TC = TFC + TVC
 In the long run, there is no fixed costs.
 TC = TVC

 Firm has greater flexibility in the long run than in the

short run.

 Concepts related to the long-run cost of production are:

 Long-run average total costs (LRATC) curve

CH 20 • 40
 LRATC CURVE
 The three short–run average total cost curves (SRATC)
curves, representing the different plant sizes (small,
medium & large) are illustrated in Exhibit 7a.

 If the manager chooses to produce Q1

 He will choose the plant size represented by SRATC1
 This is because SRATC1 gives a lower unit cost of producing Q1
than SRATC2 (RM5 as opposed to RM6)

 If the manager chooses to produce Q2

 He will choose the plant size represented by SRATC3
 This is because SRATC3 gives a lower unit cost of producing Q2
than SRATC2 (RM5 as opposed to RM6)

CH 20 • 41
Exhibit 7 Long-Run Average Total Cost Curve (LRATC)

If we were to ask the same question for every (possible) output level, we would
derive the LRATC curve.

42
 LRATC CURVE
 LRATC is a curve that shows the lowest (unit) cost at
which the firm can produce any given level of output.

 In Exhibit 7a, LRATC curve is the heavily shaded, blue

scalloped curve.

 In Exhibit 7b, the LRATC curves is the heavily shaded,

blue smooth curve.
 The LRATC curve in (b) is not scalloped because it is assumed
that there are so many plant size that the LRATC curve touches
each SRATC curves at only one point.

CH 20 • 43
 ECONOMIES OF SCALE, DISECONOMIES OF
SCALE & CONSTANT RETURNS TO SCALE
Economies of Scale
 An increase in a firm’s scale of production leads to lower costs per
unit produced
 %  output > %  input  ATC 
 LRATC is falling

Constant Returns to Scale

 An increase in a firm’s scale of production has no effect on costs
per unit produced.
 %  output = %  input  ATC remain constant
 LRATC is constant

Diseconomies of Scale
 An increase in a firm’s scale of production leads to higher costs
per unit produced.
 %  output < %  input  ATC 
 LRATC is rising

CH 22 • 44
 ECONOMIES OF SCALE (EXAMPLE)
 Suppose good X is made with two inputs, Y & Z.
 To produce 5 unit of good X, we need 20Y & 10Z.
 The costs of each unit of input Y & Z = RM1
 Thus, TC to produce 5 unit of good X is RM30.
 ATC of good X [TC(30)/Q(5)] = RM6

 Now consider a doubling of inputs Y & Z to 40Y & 20Z &

a more than doubling in output say, to 15 units of X.
 This means a TC of RM60 is required to produced 15
unit of X.
 ATC of good X [TC(60)/Q(15)] = RM4

 Conclusion:
 An increase in a firm’s scale of production leads to
lower costs per unit produced

CH 22 • 45
WHY ECONOMIES OF SCALE?
 Up to a certain point, long-run unit costs of
production  as a firm grows.

 There are two main reasons for this:

i. Growing firms offer greater opportunities for
employees to specialize.
ii. Growing firms can take advantage of highly
efficient mass production techniques &
equipment that ordinarily require large setup
costs & thus are economical only if they can be
spread over a large number of units.

CH 22 • 46
WHY DISECONOMIES OF SCALE?
 In very large firms, managers often find it difficult to
 coordinate work activities
 communicate their directives to the right persons
in satisfactory time
 monitor personnel effectively.

 The business operation simply gets “too big”.

 Firm will usually find ways to avoid diseconomies
of scale.
 They will reorganize, divide operations, hire new
managers & etc.

CH 22 • 47
MINIMUM EFFICIENT SCALE

 The lowest output level at which ATC are minimized

(Point A in Exhibit 7b).

 Between point A & B, there are a constant return

to scale; ATC is the same over various output level
between the two points.

 This means that larger firms (firm producing

greater output levels) within this range do not
have a cost advantage over smaller firm that
operate at the minimum efficient scale.

CH 22 • 48
 What would the LRATC curve look like if
there were always constant returns to
scale? Explain your answer.
SELFTEST
 The LRATC curve would be horizontal.
 When there are constant returns to scale, output
doubles if inputs double.
 If this happens, unit costs stay constant.
 In other words, they don’t rise and they don’t fall; so
the LRATC curve is horizontal.

CH 22 • 49
SHIFTS IN COST CURVES

A firm’s cost curves will shift if there is a

change in:
 Taxes
 Input prices
 Technology

CH 22 • 50