Part 5The Theory of

Production and Cost• Production normally organized in

Firms• A Firm hires inputs, organizes

production, and sells goods or services

• A firm is a governance structure that can range from simple to highly complex (sole owner to large multi-nation corporation)

• Firms allocate resources and coordinate economic activities internally using commands and incentive systems

Why Firms?

• Why is all economic activity not coordinated through markets?

• Firms exist because they offer cost advantages over market transactions

- Transactions costs

- Monitoring

- Economies of scale or scope

- Economies of team production

Why Markets?

• Why is all economic activity not coordinated through organized firms (or just one giant firm)?

• Principal-agent and incentive problems

• Problems of information and management provide limits to firm size

The Firm’s Goals

• The goal of the owners of the firm is to maximize the return on their capital investment—to maximize profit

• Profit is revenue less cost-- defined as opportunity cost

• Explicit and implicit costs

• Normal profit and economic profit

The Firm’s Constraints

• Available technology• Prices of inputs• Fixed capital in the short run• Degree of competition in the

output market• Given these constraints the firm

needs to choose the method of production and output level that will maximize profit

• Maximizing profit implies minimizing the cost of production

Output and Cost: Short Run

• In the short run the firm has a plant of given size

• The firm can add or subtract labour and other inputs to vary output, but cannot alter the size of the plant

• The fixed plant size affects how output will change with changes in the inputs that can be varied

The Short Run Production Function

• Total product curve

TP

Labour

Output

TP= Total output as labour (and other variable inputs) are added to a plant of fixed size

Inflection point

TP increasing at adecreasing rate

L’

Short Run Production Functions

• Other possible shapes

TPOutput

Labour

TPOutput

Labour

Average and Marginal Product Curves

TP

APMP

TP

L

L

APMP

MP max

AP max &AP = MP

Point of diminishingmarginal returns

Point of diminishing average returns

L’ L”

Diminishing Returns

• When there is a fixed factor must eventually run into diminishing marginal returns

• The constraint of the fixed factor eventually makes it more and more difficult (costly) to obtain additional output from the plant of fixed size

• Law of Diminishing Returns

• Is our world a world of diminishing returns?

Short Run Cost• Our production function

showed output as a function of the quantity of variable input (labour) with a given quantity of a fixed input (capital).

• We need to convert this into a cost function showing cost as a function of output

• To do this we assume that the prices of inputs are given

Short Run Total Costs

• Total cost is total variable cost plus total fixed cost

• The total variable cost of a given level of output is the quantity of labour it takes to produce that output (with the fixed level of capital) times the price of labour

• The total fixed cost is the quantity of the fixed input times the price of that input

• Total fixed cost does not vary with output

TP and TVC

Q

L

Q

$ TVC= L x Wage

Q’

L’

Q’

(L’ x W)TVC’

TP

Total Cost Curves

TFC

TVC

TC

Q

$

Diminishing returns due to the fixed factorMeans that TVC and TC must eventually Rise at an increasing rate

Marginal and Average Costs

• Average total cost is total cost divided by output

• Average variable cost is total variable cost divided by output

• Average fixed cost is total fixed cost divided by output

• ATC = AVC + AFC• Marginal cost is the additional

cost of an additional unit of output

• MC = ΔTC/ΔQ

Marginal and Average Cost Curves

MCATC

AVC

AFC

$

Q

Min ATC

Min AVC

ATC = AVC + AFC

Marginal and Average Product and Cost Curves

• As a firm expands output along its production function the output at which average product is at its greatest will be where AVC is at a minimum

• The output level at which MP is at a maximum will the output level where MC is at a minimum

• As MP and AP eventually decline due to diminishing returns, so MC and AVC will eventually rise.

Shifts in Cost Curves

• New Technology

• Costs of inputs– Fixed inputs– Variable inputs

• Scale of plant (long run)

Long Run Cost

• Changes to the scale of the plant

• Each plant size has a TC curve

• Larger plant increases fixed cost but delays onset of diminishing returns

• Each plant size has a short run ATC curve

• Long run average cost curve is the lower boundary of all short run ATC curves

• Long run and the least possible cost of production

Long Run Cost

Q

$ TC1 TC2

Q1

Long Run Cost

$

Q

ATC1 ATC2

Q1

LAC

Constant returns to scale

Long Run Average Cost

ATC1 ATC2

ATC3

ATC4ATC5

$

Q

LRATC

Q*Q’

Least cost plant size to produce Q’ is ATC2

Q* is the lowest possible average cost, butwhether this is the firm’s profit maximizingoutput will depend on market structure.

Generalized case: increasing followed bydecreasing returns to scale

Economies of Scale

• Economies of scale due to specialization of labour and capital

• Diseconomies of scale due to problems of information and management

• Constant returns to scale

• Minimum efficient scale