What is a firm?

A firm is an entity concerned with the

purchase and employment of resources in
the production of various goods and
services.
Assumptions:

the firm aims to maximize its profit with the

use of resources that are substitutable to a
certain degree
the firm is" a price taker in terms of the
resources it uses.

The Theory of the Firm

The Production Function

The production function refers to the

physical relationship between the inputs
or resources of a firm and their output of
goods and services at a given period of
time.

The production function is dependent on

different time frames. Firms can produce
for a brief or lengthy period of time.

Production Function

Inputs

Process

Land
Labour
Capital

Product or
service
generated
value added

Output

Production Function

States the relationship between inputs and

outputs
Inputs the factors of production classified
as:
Land all natural resources of the earth .
Price paid to acquire land = Rent
Labour all physical and mental human
effort involved in production
Price paid to labour = Wages
Capital
buildings, machinery and
equipment
not used for its own sake but for the
contribution
it makes to production

Production Function

Fixed vs. Variable Inputs

Fixed inputs -resources used at a constant

amount in the production of a commodity.
Variable inputs - resources that can
change in quantity depending on the level
of output being produced.
The longer planning the period, the
distinction between fixed and variable
inputs disappears, i.e., all inputs are
variable in the long run.

Analysis of Production
Function:
Short Run

In the short run at least one factor fixed

in supply but all other factors capable
of being changed
Reflects ways in which firms respond to
changes
in output (demand)
Can increase or decrease output using
more or less of some factors but some
likely to be easier

Analysis of Production
Function:
Short Run
In times of rising
sales (demand)
firms can
increase labour
and capital but
only up to a
certain level
they will be
limited by the
amount of space.
In this example,
land is the fixed
factor which

Analysis of Production Function:

Short Run
If demand
slows down,
the firm can
reduce its
variable
factors in
this example,
it reduces its
labour and
capital but
again, land is
the factor
which stays

Analysing the Production

Function: Long Run

The long run is defined as the period of

time taken to vary all factors of
production
By doing this, the firm is able to
increase its total capacity not just
short term capacity
Associated with a change in the
scale of production
The period of time varies according

Analysis of Production Function:

Long Run

In the long run, the firm can change all its factors of
production thus increasing its total capacity. In this
example it has doubled its capacity.

Production Function

Mathematical representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon the
amount of capital (K), Land (L) and
Labour (La) used

Production Analysis with One

Variable Input

Total product (Q) refers to the total

amount of output produced in physical
units (may refer to, kilograms of sugar,
sacks of rice produced, etc)
The marginal product (MP) refers to the
rate of change in output as an input is
changed by one unit, holding all other
TPL
inputs constant.
MP
L

Total vs. Marginal

Product

Total Product (TPx) = total amount of

output produced at different levels of
inputs
Marginal Product (MPx) = rate of change
in output as input X is increased by one
unit.
TP

MPX

Production Function of a Rice

Farmer

Units of L

Total Product
(QL or TPL)

Marginal Product
(MPL)

12

20

26

30

32

32

30

-2

10

26

-4

QL

32
30

Total product

26

QL

20

12
6
2

L
0

10

Labor

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input
(e.g., labor) used in production assuming a certain technological level.

Marginal Product

The marginal product refers to the rate

of change in output as an input is
changed by one unit, holding all other
inputs constant.
Formula:

TPL
MPL
L

Marginal Product

Observe that the marginal product

initially increases, reaches a maximum
level, and beyond this point, the marginal
product declines, reaches zero, and
subsequently becomes negative.
The law of diminishing returns states
that "as the use of an input increases
(with other inputs fixed), a point will
eventually be reached at which the
resulting additions to output decrease"

Total and Marginal

Product
35
30
25

TPL

20
15
10
5

MPL

0
0
-5
-10

Law of Diminishing Marginal

Returns

As more and more of an input is

added (given a fixed amount of other
inputs), total output may increase;
however, as the additions to total
output will tend to diminish.

Average Product (AP)

Average product is a concept commonly

associated with efficiency.
The average product measures the total
output per unit of input used.

The "productivity" of an input is usually

expressed in terms of its average product.
The greater the value of average product, the
higher the efficiency in physical terms.

Formula:

TPL
APL
L

TABLE 5.2.

Average product of labor.

Labor (L)

Total product of
labor (TPL)

Average product of
labor (APL)

12

20

26

5.2

30

32

4.5

32

30

3.3

10

26

2.6

COSTS OF PRODUCTION

Opportunity Cost Principle - the

economic cost of an input used in a
production process is the value of output
sacrificed elsewhere. The opportunity
cost of an input is the value of foregone
income in best alternative employment.
Implicit vs. Explicit Costs

Explicit costs costs paid in cash

Implicit cost imputed cost of self-owned or
self employed resources based on their
opportunity costs.

7 Cost Concepts (Shortrun)

1.
2.
3.
4.

5.

6.

Total Fixed Cost

(TFC)
Total Variable Cost (TVC)
Total Cost
(TC=TVC+TFC)
Average Fixed Cost
(AFC=TFC/Q)
Average Variable Cost
(AVC=TVC/Q)
Average Total Cost
(AC=AFC+AVC)

Short Run Analysis

Total fixed cost (TFC) is more

commonly referred to as "sunk
cost" or "overhead cost."
Examples: include the payment or
rent for land, buildings and
machinery.
The fixed cost is independent of the
level of output produced.
Graphically, depicted as a horizontal
line

Short Run Analysis

Total variable cost (TVC) refers to

the cost that changes as the amount
of output produced is changed.
Examples - purchases of raw materials,
payments to workers, electricity bills,
fuel and power costs.
Total variable cost increases as the
amount of output increases.

If no output is produced, then total variable

cost is zero;
the larger the output, the greater the total

Short Run Analysis

Total cost (TC) is the sum of total

fixed cost and total variable cost

TC=TFC+TVC

As the level of output increases, total

cost of the firm also increases.

Total Costs of Production

Units of
Labor

Total
Fixed
Cost

Total
Product

Total
Variable
Cost

Total
Cost

Marginal
Cost
TC

Average
Cost

MC

AC

TPL

TFC

TVC

100

100

30

130

30

130

10

100

50

150

20

75

12

100

60

160

10

53.3

13

100

65

165

41.25

15

100

75

175

10

35

19

100

95

195

20

32.5

25

100

125

225

30

32.14

33

100

165

265

40

33.12

43

100

215

315

50

35

10

55

100

275

375

60

37.5

100 -

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0
TOTAL COST CURVES

AFC=TFC/Q.
As more output is produced,
the Average Fixed Cost
decreases.

AFC
(Average Fixed
Cost)

Peso
s

The Average
Variable Cost at a
point on the TVC
curve is measured
by the slope of the
line from the origin
to that point.

TVC
(Total Variable Cost)

AVC=TVC/Q

Minimum AVC

q1

Peso
s

The Average Variable Cost

is U shaped. First it
decreases, reaches a
minimum and then
increases.

AVC
(Average Variable
Cost)

Minimum AVC

q1

Peso
s

The Marginal Cost curve

passes through the
minimum point of the
AVC curve.
It is also U-shaped. First
it decreases, reaches a
minimum and then
increases.

MC

(Marginal

Cost)

AVC
(Average Variable
Cost)

Minimum AVC

q1

MC

Peso
s

AC

AV
C

AF
C
0

q1
The PER UNIT COST

Table 5.4 Average Cost of Production

(Q)

(TC)

(AC)

100

130

130.00

150

75.00

160

53.33

165

41.25

175

35.00

195

32.50

225

32.14

265

33.13

315

35.00

10

375

37.50

Table 5.5

Average Variable Costs of Production

Total Product
(Q)

Total Variable Cost

(AVC)

Average Variable Cost

(AVC)

30

30.0

50

25.0

60

20.0

65

16.3

75

15.0

95

15.8

125

17.9

165

20.6

215

23.9

10

275

27.5

Long Run Total Cost

LT
C

LTC
All inputs are variable in
the long run. There are
no fixed costs.

Total Product

LONG-RUN TOTAL COST CURVE

The LAC

The LAC curve is an envelop curve

of all possible plant sizes. Also
known as planning curve
It traces the lowest average cost of
producing each level of output.
It is U-shaped because of
Economies of Scale
Diseconomies of Scale

COST

LAC
SAC1
SAC2

LONG-RUN AVERAGE COST

CURVE

COST

SAC1

LAC

Q
q
0

Building a larger sized

plant (size 2) will result in a
lower average cost of
producing q0

COST

SAC1

LAC

SAC2

Q
q
0

Likewise, a larger sized

plant (size 3) will result to
a lower average cost of
producing q1

COST

SAC1

LAC

SAC2
SAC3

Q
q

Economies and Diseconomies

of Scale

Economies of Scale- long run

average cost decreases as output
increases.
Technological factors
Specialization

Diseconomies of Scale: - long run

average cost increases as output
increases.

Problems with management becomes

costly, unwieldy

COST

LAC
SAC1
SAC2

Diseconomies of
Scale

Economies of
Scale
0

Q1

LONG-RUN AVERAGE COST

CURVE

LONG-RUN AVERAGE and MARGINAL COST CURVES

LM
C

COST
SMC2

SMC1

LAC

SAC2

SAC1

Q1

LAC and LMC

Long-run Average Cost (LAC)

curve
is U-shaped.
the envelope of all the short-run
average cost curves;
driven by economies and
diseconomies of size.

Long-run Marginal Cost (LMC)

curve

Also U-shaped;

Break Even Analysis and

Cost Control

BEA analysis is an important

technique to trace the relationship
between costs,revenue and profits at
the varying levels of output or sales.
In BEA ,the break-even point is
located at that level of output or
sales at which the net income or
profit is zero.At this point total cost
is equal to total revenue.Hence,the
break-even point is the no-profit-no-

BEP in terms of physical units BEP=TFC/P- AVC where ,

BEP= break even point
TFC=total fixed cost
P=the selling price
AVC=the avg.variable cost.
P-AVC is the contribution margin per
unit.

BEP in terms of sales valueBEP=Total fixed cost/contribution

ratio
Contribution ratio=TR-TVC/TR

End