1

CHAPTER 4

The The Production Production Process of Process of

FirmsFirms

4.1 Production and Firm

4.2 Cost and Profit: Economics and Accounting Concepts

4.3 The Production Decision

4.4 The Production Process

4.5 Production Theory

4.6 Short Run Cost Curves and Relationship

4.7 Short Run Revenue and Profit Maximization

4.8 Long Run Cost Curve2

Production:◦ Is the process of using the factors of production to

produce goods and services.◦ In other words, it can be stated as the

“transformation of inputs into outputs”.◦ Usually, by firm

Firm:◦ An output producing organization◦ Demand production factors from input market◦ Maximize profit (rational assumption)

3

Accounting Cost (Explicit Cost)◦ Considered as “normal” cost (or profit)◦ What was paid out (in money)◦ Example: wages or rental

Economics Cost (Implicit Cost)◦ Reflex the opportunity cost◦ The 2nd best alternative lost◦ Considered as implicit cost◦ Example: Owner time/effort or using own building

4

Accounting Profits◦ A firm’s total revenue minus its

explicit costs.◦ Formula:

Economics Profits◦ A firm’s total revenue minus its

explicit and implicit costs.

licitTR exp

5

)(exp implicitlicitTR

Explicit Cost: What was paid out (in money)

Implicit Cost: The opportunity Cost

Simon spends at least 40 hours a week at his place of business. If he closed the bar, he could work for his competitor and earn RM30,000 per year. He also owns the building that houses the bar and could rent it out for RM24,000 per year if he closes his business. The data below provides information on the company’s annual cost and revenue. Calculate explicit cost, implicit cost, accounting profit and economic profit.

6

Items Cost / Revenue (RM)

WagesInterest paid on loansOther expenditure for factors of productionTotal revenue

85,0007,00067,000250,000

(i) Explicit Cost:

(i) Implicit Cost:

(i) Accounting Cost:

(i) Economic Cost:

7

All firms must make several basic decisions to achieve what we assume to be their primary objective—maximum profits.

8

1.How muchoutput to

supply

2.Which production

technologyto use

3.How much ofeach input to

demand

The Three Decisions That All Firms Must Make

Market price Techniques Prices of inputs

9

q = f (K, L, M…)

4.4 The Production Process

Input:Raw Material

Input:Capital

Input:Labour Output

Technology

Input decision:>>How many>>Which types

Cost decision Selling price

Production Function:◦ Refers to the relationship between inputs and

outputs. ◦ It can be represented in the form of a

mathematical equation such as: Q=f(K,L,M…)

Marginal Product (MP): ◦ Additional output that can be produced by adding

one more unit of a particular input, ceteris paribus.◦ MP slopping down reflex the law of diminishing

marginal returns ◦ Formula: ∆ TP / ∆L

Average Product of labor (AP): ◦ Average amount produced by each unit of a

variable factor (e.g labor)◦ Formula: TP / L

10

Short run – Period of time which quantities of one or more inputs cannot be changed and firm is operating under fixed scale, firms can neither enter nor exit an industry.

Long run – Period of time which quantities of all inputs can be varied (no fixed input). Firms can change the scale of production (increase/decrease).

11

QUANTITY OF

WORKERS

OUTPUT MP AP COST OF FACTORY

COST OF WORKERS

TOTAL COST

0

1

2

3

4

5

6

7

8

0

2

5

9

12

14

15

15

14

-

2

3

4

3

2

1

0

-1

-

2

2.5

3

3

2.8

2.5

2.1

1.8

$30

30

30

30

30

30

30

30

30

$0

10

20

30

40

50

60

70

80

$30

40

50

60

70

80

90

100

110

12

A Production Function and Total Cost For Hungry Helen’s Cookie Factory

13

0

2

4

6

8

10

12

14

16

18

20

0 1 2 3 4 5 6 7 8Number of Workers Hired

Quantity of output

TP

Hungry Helen’s Production Function

14

Relationship between TP& MP

When MP is increasing, TP will increase at an increasing rate. (stage 1)

When MP is decreasing, TP will increase at a decreasing rate. (stage 2)

When MP is zero, TP is at its maximum When MP is negative, TP declines. (stage 3)

Stage 1

Stage 2

Stage 3

Relationship between MP& AP

When MP is above AP, AP is increasing When MP is below AP, AP is decreasing When MP equals to AP, AP is at maximum.

Definition:

◦This law explains the behaviour of production functions in the short run, when at least one of the inputs must be fixed.

◦The law of diminishing marginal returns states that as more of variable inputs is used, while other inputs are fixed, the marginal product of the variable input will eventually declines.

15

◦ Increasing Marginal Returns (Stage 1: A to B) The marginal product (MP) of a variable resource

increases as each additional unit of that resource is employed.

TP increase at an increasing rate (specialization)

◦ Diminishing Marginal Returns (Stage 2: B to C) As more of a variable resources is added to a given

amount of another resource, marginal product (MP) eventually declines.

TP increases at a decreasing rate (less efficient / abundant)

◦ Negative Marginal Returns (Stage 3: After C) The marginal product (MP) of a variable resource turn to

negative as each additional unit of that resource is employed

TP decreases (overcrowded).

17

Labor

Labor

TP

AP, MP

Stage 1 Stage 2 Stage 3

TP

AP

MP

Stages of Production

B

CA

18

Increasing Marginal Returns

To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

IncreasingMarginalReturns

19

Diminishing Marginal Returns

To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

DiminishingMarginalReturns

20

Negative Marginal Returns

To

tal P

rod

uct

Quantity of Labor

Ave

rag

e P

rod

uct

, an

dM

arg

inal

Pro

du

ct

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

NegativeMarginalReturns

Types of costs:◦Fixed cost (FC)

Any cost that does not depend on the firm’s level of output.

Costs that incurred even if the firm is producing nothing.

No fixed cost in long run.

◦Variable cost (VC) Costs associated with input (e.g. labor) Depend on the level of production chosen.

◦Total cost (TC) Sum of the fixed cost (FC) and variable cost (VC) TC = FC + VC

21

Types:◦Total fixed cost (TFC)/ overhead

The total of all costs that do not change with output, even if the output is zero.

◦Average fixed cost (AFC) Total fixed cost divided by the number of units of

output or a per-unit measure of fixed costs. Formula:

Fixed cost

Quantity

FCAFC

Q

22

23

q TFC (RM) AFC (RM)

012345

100010001000100010001000

-1000500333250200

Types:◦Total variable cost (TVC)

The total of all costs that vary with output in the short run.

◦Average variable cost (AVC) The variable cost divided by output. Formula:

◦Marginal cost (MC) Additional cost of producing one more unit of

output. Reflect the changes in variable costs. Formula: (change in total cost)

(change in quantity)

TCMC

Q

Variable cost

Quantity

VCAVC

Q

24

Type:◦ Average Total Cost (ATC)

Total cost divided by the number of units of output. Formula:

q

TCATC AVCAFC ATC

25

26

Relationship between TVC, AVC & MC

Total variable cost (TVC) always increases with output .

The marginal cost (MC) curve shows how total variable cost changes.

When MC is below average variable cost, AVC is declining. When MC is above AVC, AVC is increasing.

MC intersects AVC at the lowest, or minimum, point of AVC .

27

28

Quantity of Output

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0 42 6 8 141210

MC

ATCAVC

AFC

Marginal Cost declines at first and then increases due to diminishing marginal product.

Note how MC hits both ATC and AVC at their minimum points.

AFC declines when output increases .

29

The shapes of the cost curves are mirror-image reflections of the corresponding productivity curves.

When one is increasing, the other is decreasing.

When one is at a maximum, the other is at a minimum.

30

Productivity and Costs Are Mirror Images

Co

sts

(d

olla

rs)

Ave

rag

e P

rod

uct

an

dM

arg

inal

Pro

du

ctQuantity of labor

Quantity of output

MPAP

MCAVC

Pull down the average

Pull up the average

31

When marginal product is increasing, marginal cost is decreasing.

When marginal product is decreasing, marginal cost is increasing.

4.7 4.7 Short Run Revenue & Profit

Maximization

Types:◦Total revenue (TR):

The total amount that a firm takes in from the sale of its output

Formula:

◦Average total revenue (ATR): The amount that a firm received from the sales of each

units of output Formula:

◦Marginal revenue (MR): Additional revenue that a firm takes in when it

increases output by one additional unit Formula:

P x qTR quantity x pricerevenue total

33

q

TRATR

q

TRMR

◦Profit (π) Difference between total revenue and total

economic cost Total economic cost reflects a normal rate of return

(rate that is just sufficient to keep current investors interested in the industry).

Formula:

◦Breakeven (π = 0 ) TR = normal rate of return/ normal profit

◦Profit maximization: ( the largest) when MC = MR TCTR

34

TCTR

35

(1)Output

(q)(unit)

 (2)

TFC(RM)

 (3)

TVC (RM)

 (4)MC

(RM)

 (5)

P = MR(RM)

(6)TR

(p*q)(RM)

(7)TC

(TFC + TVC)(RM)

(8)PROFIT

(TR – TC)

(RM)

0 10 0 - 15 0 10 (10)

1 10 10 10 15 15 20 (5)

2 10 15 5 15 30 25 5

3 10 20 5 15 45 30 15

4 10 35 15 15 60 45 15

5 10 55 20 15 75 65 10

6 10 80 25 15 90 90 0

Table: Cost, Revenues & Profit Calculation

MC = MR

36

4.8 Long Run Cost Curve

>> No fix scale of operation <<

Larger scale Smaller scale

Economies of scale

Diseconomies of scale

Reduce production cost

Growth constraint

Constant return to scale

Reflect in the firm’s long run average cost (LRAC) is U-shape

Effect on average cost

No effect on the cost

Economies of scale ◦ An increase in a firm’s scale of production leads

to lower costs per unit produced. Forces that reduce a firm’s average cost as the scale

of operation increases in the LR. Diseconomies of scale

◦ An increase in a firm’s scale of production leads to higher costs per unit produced. Forces that may eventually increase a firm’s average

cost as the scale of operation increases in the LR. Constant returns to scale

◦ An increase in a firm’s scale of production has no effect on costs per unit produced.

37

A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization. Production techniques such as the assembly

line can be utilized only if the rate of output is large enough

Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines.

Example: compare the household-size kitchen of a small restaurant with the kitchen at a KFC.

The LRAC for a restaurant may fall as size increases compare to KFC.

38

As a firm expands, diseconomies of scale, eventually take over.• long-run average cost increase as output

expands. Additional layers of management are

needed to monitor production. The more levels of management in an

organization, the more difficult it is for top management to communicate with those that perform most of the production tasks.

Example: Top executive have more difficulty keeping in touch with the factory floor because information is distorted as it moves up and down the chain of command.

39

The term constant returns means that the quantitative relationship between input and output stays constant, or the same, when output is increased.◦ The firm’s long-run average cost curve remains

flat.

40

41

Quantity ofCars per Day

0

AverageTotalCost

1,000

10,000

Economiesof

scale Diseconomiesof

scale

Constantreturns to

scale

Long Run Average Cost Curve

ATC

QUESTIONS:

(i) Sketch MC, ATC, AVC and AFC curves.

(ii) Explain why ATC and AVC curves get closer together as

more output produced…

44