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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 Short Run Cost Curves and Relationship

4.6 Long Run Cost Curve

4.7 Short Run Revenue and Profit Maximization

CHAPTER 4:CHAPTER 4:The Production Process of FirmsThe Production Process of Firms

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4.1 Production and Firm

Production process:

i. The process by which inputs are combined, transformed, and turned into outputs

ii. Usually, by firm

Firm:

i. An output producing organization ii. Demand production factors from input market iii. Maximize profit (rational assumption)

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4.2 Cost & Profit: Economics & Accounting Concepts

Accounting Cost:

i. Considered as “normal” cost (or profit) ii. What was paid out (in money) iii. Considered as explicit cost iv. E.g. wages or rental

Economics Cost:

i. Reflex the opportunity cost ii. The 2nd best alternative lost iii. Considered as implicit cost iv. E.g. Owner time/effort or using own building

4q = 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

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4.4 Production Process4.4 Production Process

Terms:

a) Marginal Product (MP): i. additional output that can be produced by adding

one more unit of a particular input ii. MP slopping down reflex the law of diminishing

marginal returns

b) Average Product of labour (AP): i. average amount produced by each unit of a variable

factor (e.g labour) ii. Total product / Units of Labour

The law of diminishing marginal returns states that when additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.

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4.4 Production Process4.4 Production Process

Relationship between TP, AP & MP

MP is the slope of the total product function (dTP/dL). AP is the slope of the line from origin.

At point B, the slope of the total product function is highest; thus, average product is highest (and AP = MP).

At point C, total product is maximum, the slope of the total product function is zero, and marginal product intersects the horizontal axis. Additional labour didn’t yield additional output.

When marginal product falls below the horizontal axis (negative marginal product), total product decline.

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4.4 Production Process4.4 Production Process

Relationship between TP, AP & MP

When average product is maximum, average product and marginal product are equal.

As long as marginal product rises, average product rises.

When average product falls; marginal product is less than average product.

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a) Fixed cost (FC): i. Costs that incurred even if the firm is producing

nothing ii. No fixed cost in long run iii. Sunk cost is a type of fixed cost (but not recoverable)

4.5 Short Run Cost Curve & Relationship

Types of cost:

b) Variable cost (VC): i. Costs associated with input (e.g. labour) ii. Depend on production iii. VC = VC (q)

c) Total cost (TC): i. Sum of fixed and variable costs ii. TC = TFC + TVC

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d) Average cost (AC): i. Total cost / output >>> AC = TC / q ii. Total cost per unit

f) Average fixed cost (AFC): i. AFC = TFC / q ii. When output increase, FC constant, AFC decline

e) Marginal cost (MC): i. MC = ΔTC / Δq ii. Additional cost of producing one more unit of output

4.5 Short Run Cost4.5 Short Run Cost

g) Average variable cost (AVC): i. AVC = TVC / q

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4.5 Short Run Cost4.5 Short Run Cost

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 .

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4.6 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) shape

Effect on average cost

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4.6 Long Run Cost Curve4.6 Long Run Cost Curve

LRAC for Economies of Scale

>> Also called “increasing returns to scale”>> LRAC downward slopping

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4.6 Long Run Cost Curve4.6 Long Run Cost Curve

LRAC for Diseconomies of Scale

>> Also called “decreasing returns to scale”>> LRAC become upward slopping>> optimal scale = minimum LRAC = q*

Diseconomies of Scale

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4.7 4.7 Short Run Revenue & Profit Maximization

Refresh …….

(TP, AP & MP) (TC, TVC, TFC, AVC & MC)

(TR & MR)

Input:Raw Material

Input:CapitalInput:Labour

Output

Technology

Input decision:>>How many>>Which types

Cost decision Selling price

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4.7 SR Rev & Profit Max4.7 SR Rev & Profit Max

a) Total revenue (TR): i. The total amount that a firm takes in from the sale of

its output ii. TR = p*q

Types of revenue:

b) Average total revenue (ATR): i. The amount that a firm received from the sales of

each units of output ii. ATR = TR / q

c) Marginal revenue (MR): i. Additional revenue that a firm takes in when it

increases output by one additional unit ii. MR = ∆TR/∆q iii. For perfect competition, MR = (p∆q) / ∆q = p

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4.7 SR Rev & Profit Max4.7 SR Rev & Profit Max

a) Profit ( π ): i. Difference between total revenue and total economic

cost ii. π = TR – TC iii. Total economic cost reflects a normal rate of return

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

Profit Maximization:

b) Breakeven: i. π = 0 >> TR = normal rate of return >> normal profit

c) Profit maximization: i. π = TR – TC the largest ii. When MC = MR

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(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

Cost, Revenues & Profit Calculation

MC = MR