TOPIC 6: FIRM,

PRODUCTION AND COSTS

WHAT IS A FIRM?

Business firm is an entity that employs factors of

production (resources) to produce goods and
services to be sold to consumers, other firms or
the government.

THE OBJECTIVE OF THE FIRM

There are two sides to a business firm: a revenue
side (total revenue) and a cost side (total cost).
Profit is the difference between total revenue and
total cost.

= TR TC

The firms objective is to maximize its profit.

TOTAL REVENUE AND TOTAL COST

Total revenue is amount of money the firm
receives from the sale of its product.
Total cost is the costs that the firm incurs for the
use of inputs.

Explicit

cost: a cost incurs when an actual

monetary payment is made.

Money payments for the use of resources supplied by

outsiders.

Implicit

cost: a cost that represents the value of

resource used in production for which no actual
monetary payment is made.

The opportunity costs of using resources owned by the

firm.

ACCOUNTING PROFIT VERSUS

ECONOMIC PROFIT
Accounting profit = Total revenue Accounting
costs
= Total revenue Explicit costs
Economic profit = Total revenue Economic costs
= Total revenue (Explicit costs +
Implicit costs)
When economic profit is zero, the firm still earns
positive accounting profit which is called normal
profit.
Normal profit = Zero economic profit

PRODUCTION
Production is a process of transforming inputs
into output.
Production function shows the relationship
between factors of production and the output of a
firm.

FIXED AND VARIABLE INPUTS

Inputs

are resources or factors of production

that are used in a production process.

input: input whose quantity employed

cannot be changed as output changes.
Variable input: input whose quantity employed
can be changed as output changes.
Fixed

SHORT RUN AND LONG RUN

Short run is a period of time when there are fixed

and variable inputs.
In

the short run the firms plant capacity is fixed. The

firm can vary its output by using more or less
amounts of other resources.

Long run is a period of time when all inputs are

variable.
In

the long run firm can change its plant. The

quantities of all resources used in the production
process can be varied.

SHORT RUN PRODUCTION

Total product curve shows the quantity of output
that can be produced from different quantities of
a variable input.
Marginal product of labor (MPL) is the additional
output the firm can produce when it employs one
more unit of labor.

MPL = Q / L

Average product of labor (APL) is output per unit

of labor input. It is also called labor productivity.

APL = Q / L

TOTAL, MARGINAL AND AVERAGE

PRODUCT
Labor

Total Product

Marginal

Average

(L)

(Q)

Product of

Product of

Labor (MPL)

Labor (APL)

18

18

18

37

19

18.5

57

20

19

76

19

19

94

18

18.8

111

17

18.5

127

16

18.14

137

10

17.12

133

-4

14.77

2
3
4

INCREASING, DIMINISHING AND

NEGATIVE MARGINAL RETURNS

Increasing marginal returns

As

more units of labor employed, the marginal

product of labor increases.

Diminishing marginal returns

As

more units of labor employed, the marginal

product of labor decreases.

Negative marginal returns

As

more units of labor employed, the marginal

product of labor is negative.

SHORT RUN PRODUCTION COSTS

In

the short run, some inputs are fixed and

other inputs are variable.
Short run total costs may be divided into
total fixed costs and total variable costs.
Total

fixed costs are the costs incurred for the

use of fixed inputs.
Total variable costs are the costs incurred for
the use of variable inputs.

FIXED, VARIABLE AND TOTAL

COSTS
Total

fixed costs (TFC): costs that do not vary

with the level of output produced.
Total variable costs (TVC): costs that change
with the level of output produced.
Total costs (TC) is the sum of total fixed cost
and total variable cost at each level of output.

TC = TFC + TVC

AVERAGE AND MARGINAL COSTS

Average fixed cost (AFC): fixed cost per unit of
output.
AFC = TFC / Q
Average variable cost (AVC): variable cost per unit
of output.
AVC = TVC / Q
Average total cost (ATC): total cost per unit of
output.
ATC = TC / Q = AFC + AVC

Marginal Cost (MC) is additional cost that the firm

incurs when it produces one more unit of output.
MC = TC / Q = TVC / Q

SHORT RUN PRODUCTION COSTS

RELATION OF MC TO AVC AND ATC

The MC curve intersects the ATC curves at its

minimum point.
When

MC is less than ATC then if Q increases

ATC will fall.
When MC is higher than ATC then if Q increases
ATC will rise.

The MC curve intersects the AVC curve at its

minimum point.
When

MC is less than AVC then if Q increases AVC

will fall.
When MC is higher than AVC then if Q increases
AVC will rise.

LONG RUN PRODUCTION COSTS

In the long run, a firm can adjust all its
resources: all inputs are variable.
In the long run, there are no fixed costs. All costs
are variable costs.
Total cost = Total variable costs
The long run average total cost (LRATC) curve
shows the lowest cost per unit at any level of
output produced.

LONG RUN AVERAGE TOTAL COSTS

ECONOMIES OF SCALE, CONSTANT ECONOMIES

OF SCALE AND DISECONOMIES OF SCALE

The long run average cost curve displays 3

regions:
Economies

of scale: long run average total cost falls

as quantity of output increases.
Constant returns to scale: long run average total
cost is unchanged as quantity of output increases.
Diseconomies of scale: long run average total cost
rises as quantity of output increases.

Minimum efficient scale: the lowest output level

at which average total cost is minimized.

SHIFTS IN COST CURVES

Cost

in

curves will shift when there is a change

Taxes

and subsidies
Input prices
Technology