ECS 1501
Topic 13 – Theory of supply
Cost of production
Learning outcomes:
In this learning unit you will learn more about:
• Revenue, cost and profits concepts
• Total, average and marginal of revenue, cost &
profit
• The law of diminishing returns
• Difference between short run and long run
Introduction
• Theory of the firm – the theory of the supply
of goods that attempts to explain the
behaviour of the firm
• We assume that the
main goal of firms are
to maximise profits
• Profit is the surplus of revenue over cost
• Total revenue (TR) – A firm’s total value of its
sales and is equal to the price of its product
multiplied by the quantity sold
• Firms use inputs to produce outputs
• The cost of production depends on the factors
such as the technological links between inputs
and outputs
• So, theory of costs is based on the theory of
production
Explicit versus implicit cost
Economists make
opportunity cost use of
Economists They measure th
(Learning Unit 1
& 2).
e cost of productio
consider both Cost as the best altern
sacrificed to prod ative
n
implicit and uce a particular
product
explicit costs
Explicit Implicit
Monetary payments for the Opportunity costs which are
factors of production and not reflected in monetary
other inputs bought or hired payments. Like the costs of
by the firm. Explicit costs are self-owned or self-employed
also opportunity costs resources
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑐𝑜𝑠𝑡𝑠𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛=𝑒𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝑐𝑜𝑠𝑡𝑠+𝑖𝑚𝑝𝑙𝑖𝑐𝑖𝑡 𝑐𝑜𝑠𝑡𝑠
Profit
Total (Accounting) Profit = Total Revenue – Total Explicit costs
Normal Profit = Best return that a firm’s resources could earn
elsewhere
Economic profit is an additional return over and above the
opportunity cost of the inputs. It is also called excess, abnormal
supernormal or pure profit
If total sales revenue > total economic costs the firm makes an
economic profit
If total revenue = total economic costs, firm makes a normal profit
If total revenue < total economic costs, firm makes an economic loss
Economic Profit = Total Revenue – Total Costs (costs of all resources,
opportunity costs, implicit and explicit costs incl. normal profit)
Law of diminishing marginal
returns
Production – The physical transformation of inputs into outputs
Inputs – Usually factors of production and intermediate inputs
Intermediate inputs – Any good or service other than the basic factors of
production which is used to produce something else
Fixed input – An input whose quantity cannot be altered in the short run
Variable input – An input whose quantity can be altered in the short run
Short run vs long run
Short run
The period in which at least one of the inputs is
fixed. Meaning, you only have one factory but
you can employ as many labours as you want.
Long run
All inputs are variable. Meaning you can still
employ as many labourers as you want but now
you can also build another factory.
Assumptions about short run production
• The firm produces only 1 product
• All units of an input are homogenous
• Inputs can be used in infinitely divisible
amounts
• The production function (technical relationship
between inputs and outputs) cannot be
changed
• The prices of products and inputs are given
In the short run, a firm can expand
output only by increasing the
quantity of its variable inputs
Production function – The
relationship between inputs and
outputs
Let’s assume that a tailor has 50 sewing machines (fixed
input) and labour (only variable input). The below table
shows the total product that can be produced with the
available inputs
Sewing machine
Units of Labour Total Product When depicted graphically,
units
50 0 0
the quantity of labour will
50 1 25 be measured on the
50 2 51 horizontal axis and the total
50 3 78 product on the vertical axis
50 4 108
50 5 150
50 6 190
50 7 220
50 8 240
50 9 220
50 10 187
Sewing
The tailor’s Production Function machine
Units of Total
labour product
300
units
50 0 0
250
50 1 25
200 50 2 51
Total Product
50 3 78
150
50 4 108
100 50 5 150
50
50 6 190
50 7 220
0
0 2 4 6 8 10 12 50 8 240
Units of Labour 50 9 220
50 10 187
Total product increases at an
increasing rate and then at a This is as a result of the
decreasing rate until a maximum Law of Diminishing
point is reached after which TP Returns, or the Law of
decreases Diminishing Marginal
Returns
• The Law of Diminishing Returns has to do with the
total product that a firm can get out using its inputs
• A frim decides how many labour units they can
employ given the resources that they have
• Depending on how many people need to use a single
unit of capital, like a computer, at a given time, the
firm will employ workers until all computers are
occupied, if they keeps on hiring people, they will
have too many workers and too few computers,
therefore his TP will decrease as in the graph
Average & marginal product
• Average Product (AP) – Average number of units of output produced per
unit of the variable input. Average product is the TP divided by the
quantity of the variable input (N)
• Marginal Product (MP) – The number of additional units of output
produced by adding one additional unit of the variable input
• AP will thus be TP divided by the number of workers. MP will be the
output that a firm gets by adding an additional worker to their production
• Once MP reached a maximum, it will keep on declining
• There is a limit on the output that any firm can produce due to the state of
technology
• Thus, the Law of Diminishing Returns state that as more of a variable input
is combined with one or more fixed inputs, eventually the MP will start to
decline
TP and MP
From the graph we can see
that:
• TP is S-shaped, it first
increases at an increasing
rate, then at a decreasing
rate and after is reaches its
maximum, decreases
• MP equals zero where TP
reaches its maximum
Fixed and variable cost
• Fixed inputs cannot be altered in the short run, therefore fixed
costs are formally defined as costs that remain constant
irrespective of the quantity of output produced.
• Fixed costs are also called overhead costs, indirect costs or
unavoidable costs
• Variable inputs can be altered in the short run, therefore
variable costs are defined as costs that change when TP changes
• Variable costs are also called direct costs, prime costs or
avoidable costs
• Total cost (TC) – The sum of the total fixed cost (TFC) and the
total variable cost (TVC) associated with each level of production
Average & marginal cost
• There are 3 measures of average cost
– Average Fixed Cost (AFC) = TFC divided by TP
– Average Variable Cost (AVC) = TVC divided by TP
– Average Cost (AC) = TC divided by TP
• AC is sometimes called Average Total Cost (ATC)
• AC includes AVC and AFC
• Marginal Cost (MC) = Increase in TC when one
additional unit of output is produced
Formulas
𝑇𝑅=𝑃 ∗ 𝑄 𝑇𝐶=𝑇𝐹𝐶 +𝑇𝑉𝐶 𝐴𝐶= 𝐴𝐹𝐶+ 𝐴𝑉𝐶
𝑇𝑅 𝑇𝐶 𝑇𝑃 Δ𝑇𝐶
𝐴𝑅= 𝐴𝐶= 𝐴𝑃 = 𝑀𝐶=
𝑄 𝑄 𝑁 Δ 𝑇𝑃
Δ𝑇𝐶 𝑇𝐶 𝑇𝑉𝐶
𝑀𝐶= 𝐴𝐶= 𝐴𝑉𝐶=
Δ𝑄 𝑇𝑃 𝑇𝑃
Δ 𝑇𝑅 Δ 𝑇𝑃 𝑇𝐹𝐶
𝑀𝑅= 𝑀𝑃 = 𝐴𝐹𝐶=
Δ𝑄 Δ𝑁 𝑇𝑃
END