TOPIC 13

Firm’s production and

costs

REVENUE, COST AND PROFIT

• Revenue is the amount a firm receives from
selling output.
– The value of its sales.

• Cost is the amount a firm pays to buy inputs.

• Profit is the total revenue minus total cost.

Profit = revenue − cost

• Economists normally assume that the goal of

a firm is to maximise profit.

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 COSTS AS OPPORTUNITY COSTS

• When economists speak of a firm’s total cost of

production, they include all the opportunity
costs of making its output of goods and
services.
• The amount spent on purchasing raw materials
and the wages of workers are opportunity costs
because this money cannot be used to buy
something else.

INTERPRETATION OF PROFITS
• Think of a firm’s inputs as being paid rewards
in accord with contracts.
– Workers get a wage, capital owners get a rental for
use of equipment etc on the basis of contract.

• Profits are residual

– what remains after contractual payments are made.

• For this reason a firm’s profits accrue to firm’s

residual claimants
– its shareholders, entrepreneurs.

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 COSTS AS OPPORTUNITY COSTS
• A firm’s cost of production includes all
opportunity costs of producing output.

• Includes explicit & implicit costs.

– Explicit cost: When an input cost involves money
flowing out of the firm.
– Implicit cost: The costs of resources owned and
used by the firm (or its owners) not requiring an
outlay of money
• an owner’s time or use of owner’s capital or premises.

ECONOMIC VS ACCOUNTING PROFIT

• Economists measure a firm’s economic profit
as revenue – cost
– including both explicit & implicit costs.

• Accountants measure accounting profit as the

firm’s revenue – explicit costs.

• When revenue exceeds both explicit & implicit

costs, the firm earns economic profit.
– Economic profit is generally less than accounting
profit.

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 ECONOMIC VSACCOUNTING PROFIT

THE PRODUCTION FUNCTION

• The production function shows the relationship
between quantity of inputs used to make a good
and the maximum achievable output of that
good.

• Summarizes the efficient production plans of

firm
– those maximizing output for given inputs.

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 THE PRODUCTION FUNCTION
• If I consider quantities of inputs used by a
firm….
– e.g. services of 600 hectares of land per year,
– services of 2 tractors,
– 3650 person days of work,
– 2500 litres of gasoline

• …. the production function associates the

maximum level of a single output that can be
derived from inputs.
– e.g. 35 tonnes of wheat

MEASURING INPUTS AND OUTPUT

• Everything is measured in flow terms – as a
quantity per unit of time.
– This contrasts with stock ideas. Think about the
distinction between the stock of water in a tank & the
net flows of water out of it.

• Services of inputs
– Might own 6 machines which you can operate 12
hours per day, 5 days per week.
– Weekly input would be 6*12*5 = 360 machine hours
per week.
– Cost of this input is the equivalent rental cost of
hiring these machines per hour.

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 MEASURING INPUTS AND OUTPUT
• Thus
– Output is measured as units produced per period.
– Inputs are measured as units used per period.
• Petrol usage is litres per period.
• Labour is measured as (for example) person-hours per
month.
• Machine inputs are measured (for example) as utilisation
times per month (& their cost as a rental rate per month).
• Land used is measured as services of so many hectares per
period.

• Don’t think of stocks of inputs but as service

flows from stocks.

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THE PRODUCTION FUNCTION

• Generally many inputs are used to produce an
output.

• For simplicity we illustrate idea of a production

function for the case of a single input alone.
– Labour hired

• Economists usually relate this sort of production

function with the short run
– The short run is a period of time during which at least
one factor of production is fixed.

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 THE PRODUCTION FUNCTION

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THE PRODUCTION FUNCTION

• Notice that this simple production function
– starts from the origin
– has a positive slope
– but the slope flattens out as more labour is added.

• The slope of the single input production function

is the marginal product of that input
– The marginal product of an input is the increase in
output obtained from an additional unit of that input.

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 THE PRODUCTION FUNCTION
• The marginal product is usually supposed to
diminish as more input is used
– the slope of the production function declines.

• Called diminishing marginal productivity.

– As more labour is hired, additional workers contribute
less & less. WHY?

– Remember we are only increasing one input.

• If the cake shop increases number of workers without
scaling up size of shop we can eventually expect extra
workers to be less productive.

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THE PRODUCTION FUNCTION- AGAIN

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 THE PRODUCTION FUNCTION
Output (quantity of
Number of cakes produced per Marginal product
workers hour) of labour
0 0 0
1 50 50
2 90 40
3 120 30
4 140 20

5 150 10

• Marginal product is positive.

– But slope flattens out – diminishing marginal productivity.

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PRODUCTION FUNCTION WITH MANY

INPUTS
• Economists are also interested in production
functions with many inputs.
– Example: Pizza output depends on
• daily number of worker hours employed in shop (L),
• number of ovens (O) &
• amount of cheese used (C).
(Ignore other inputs for simplicity).

• With 32 person hours, 2 ovens and 5 kgs of cheese

you might be able to produce a maximum of 120
pizza per day.
– This would be a point on pizza shop’s production function

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 PRODUCTION FUNCTION WITH MANY
INPUTS
• A numerical production function might be:

Y= 0.975L0.6K0.7E0.1

• where
– Y is output of cars per month,
– L is the person-hours of labour input on assembly lines
per month,
– K is the services of machines (in hours) per month and
– E is the input of electrical energy per month.

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PRODUCTION FUNCTION WITH MANY

INPUTS
• Suppose input use is scaled up.
– Instead of 32 L, 2O & 5 C which produce 120 pizza, the
quantities of all inputs are doubled.
• Thus now use 64L, 4O & 10C.
– Do you now:
• produce 240 pizza,
• produce less than 240 pizza or
• produce more than 240 pizza?

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 RETURNS TO SCALE
• If doubling all inputs provides double output there
are constant returns to scale in a technology.
– Idea is that you can replicate things on a larger scale.

• If doubling all inputs produces less than double

output there are decreasing returns to scale.
– An inefficiency impacts on production as we scale up.

• If doubling all inputs produces more than double

output there are increasing returns to scale.
– An efficiency impacts on production as we scale up.

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CONSTANT RETURNS TO SCALE

• The assumption is that you can exactly replicate a
production process on a larger scale without any
efficiency gains or losses
– If you can do something productive once, you should be
able to replicate it & do it twice & so on.

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 DECREASING RETURNS TO SCALE
• Here replication possibilities are inhibited as output
levels are scaled up.
– Could be some limiting input that cannot be increased
• e.g. land in farming might sometimes be fixed or
• extra management costs of running large firms.

• A bit hard to explain – but it is often observed.

– As we move to a larger scale, coordination and
management becomes more and more difficult leading to
inefficiencies.

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INCREASING RETURNS TO SCALE

• Here we get efficiencies as output levels are scaled
up.

• Some production technologies naturally exhibit

increasing returns
– Water delivery through pipes
• It can be easily shown that doubling the circumference causes 4
times the throughput of the pipe.
• This is because the cross-sectional area of a pipe equals
1
A= (C2 )
4p
• Hence pipes display increasing returns.

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 INCREASING RETURNS TO SCALE
• Some production technologies naturally exhibit
increasing returns
– Similarly warehousing/storage facilities
• Doubling the dimensions causes 8 times the volume of the
cubical space.
• This is because the volume of a cube equals
V = L´H´ W

• Hence warehouses display increasing returns.

– Similar returns to scale exist in transport industries.
• Case for bigger ships, bigger planes.

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INCREASING RETURNS TO SCALE

• More generally increasing returns to scale arise due
to division of labour and specialisation
– Compare your local general store with a large superstore.

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 COSTS OF PRODUCTION
• We can think of firms
– in terms of production functions & production
plans.
– or in terms of the minimum costs the firm needs
to incur to produce outputs.

• This latter way of thinking about things is

often easier.
– Costs are measured as accounting data.

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THE COST FUNCTION

• The relation between the quantity a firm can

produce & the minimum cost of producing that
output is its cost function.
– Can be represented as a table.
– The cost curve shows this relation graphically.

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 THE COST FUNCTION
• Consider a single variable input (labour) used
with a factory that costs a constant amount.
– As additional workers are hired, the cost of labour
increases.
– However, because the size of the factory is fixed,
the cost of the factory does not change.

• Suppose that the cost of factory is $30 per

hour, and that each worker is paid $10 per
hour.

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FROM THE PRODUCTION FUNCTION

TO THE TOTAL COST CURVE
• We can use the production function to
determine how the firm’s total costs vary with
the quantity produced.
– The total cost function

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 FROM THE PRODUCTION FUNCTION
TO THE TOTAL COST CURVE
Total cost
Output of inputs
(quantity of (cost of
Number cakes Marginal factory +
of produced product Cost of Cost of cost of
workers per hour) of labour factory workers workers)
0 0 - $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80

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FROM THE PRODUCTION FUNCTION

TO THE TOTAL COST CURVE

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 NOTICE….
• Each point on a cost curve shows the minimum
cost of producing a certain output.

• The curve gets steeper since input of labour

shows diminishing marginal productivity with
factory size fixed.

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TWO COMPONENTS OF COSTS

• Fixed costs
– costs that do not vary with the quantity of output
produced.
• Fixed costs are incurred even if the firm produces nothing
at all.

• Variable costs
– costs that vary with the quantity of output produced.
• costs of workers, electricity, raw materials, etc.

• A firm’s total cost is the sum of fixed and

variable costs.
– C = FC + VC

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 SUNK COSTS
• Some fixed costs are sunk.
– Once you incur them they cannot be recouped.
– e.g. buying a specifically-designed piece of capital
equipment which has no alternative use. If not
needed it has no second-hand value.

• Not all fixed cost is sunk

– the machine may have some resale value.

• In general sunk costs do not affect decision-

making
– Feasibility studies

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AVERAGE COST
• Average total cost
– total cost divided by the quantity of output.
– AC = C/Q

• Average fixed cost

– fixed costs divided by the quantity of output.
– AFC = FC/Q

• Average variable cost

– variable costs divided by the quantity of output.
– AVC = VC/Q
AC = AFC + AVC

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 MARGINAL COST
• Marginal cost is the increase in total cost that
arises from an extra unit of production.
– MC shows how much it costs to produce an
additional unit of output
– The slope of the cost function.

MC = ΔC/ΔQ where often ΔQ = 1.

• Example:
– If the total cost of producing 6 cakes is $7.80 & the
total cost of producing 7 cakes is $9.30 the
marginal cost of producing the 7th cake is $1.50.

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THE VARIOUS MEASURES OF COST

Quantity
of
lemonade Average Average Average
(bottles Fixed Variable fixed variable total Marginal
per hour) Cost cost cost cost cost cost cost
0 $3.00 $3.00 $ 0.00 — — — —
1 3.30 3.00 0.30 $3.00 $0.30 $3.30 0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
5 6.50 3.00 3.50 0.60 0.70 1.30 1.10
6 7.80 3.00 4.80 0.50 0.80 1.30 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33 1.50
8 11.00 3.00 8.00 0.38 1.00 1.38 1.70
9 12.90 3.00 9.90 0.33 1.10 1.43 1.90
10 15.00 3.00 12.00 0.30 1.20 1.50 2.10

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 MARGINAL COST CURVE
• Marginal cost rises with the amount produced.
– Past some point the marginal cost curve slopes
upward.
– This reflects diminishing marginal product of inputs.

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AVERAGE COST CURVES

• The AFC curve has a downward slope
– fixed costs are spread over more and more units of
output.
• The AVC curve is (eventually) upward sloping
– This is also a consequence of diminishing marginal
product.
• The AC curve is U-shaped.
– At low output, AC is high because fixed cost is spread
over only a few units.
– AC declines as output increases because fixed cost is
spread over more and more units.
– AC starts rising beyond a certain point because AVC
rises substantially.

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 AVERAGE COST CURVE
• The bottom of the U-shaped AC curve occurs
at the quantity that minimises AC.
– Called the firm’s efficient scale.

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TYPICAL COST CURVES

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 COST CURVES: THE RELATIONSHIPS
• Recall the relation between MC & AC
– When AC is falling, MC is less than AC.
– When AC is rising, MC is greater than AC.
– The MC curve crosses the AC curve at the efficient
scale.
• This is the scale associated with minimum AC.

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COST CURVES: THE RELATIONSHIPS

Quantity
of
lemonade Average Average Average
(bottles Fixed Variable fixed variable total Marginal
per hour) Cost cost cost cost cost cost cost
0 $3.00 $3.00 $ 0.00 — — — —
1 3.30 3.00 0.30 $3.00 $0.30 $3.30 0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
5 6.50 3.00 3.50 0.60 0.70 1.30 1.10
6 7.80 3.00 4.80 0.50 0.80 1.30 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33 1.50
8 11.00 3.00 8.00 0.38 1.00 1.38 1.70
9 12.90 3.00 9.90 0.33 1.10 1.43 1.90
10 15.00 3.00 12.00 0.30 1.20 1.50 2.10

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 COST CURVES: THE RELATIONSHIPS

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COST CURVES: THE RELATIONSHIPS

• Digression: Why is this relationship important
– Competitive firms produce where P = MC.
– Competition means (in the long-run) they also
produce where P = AC.
– This means they produce where MC = AC.
– Thus competitive firms produce efficiently – at
scale where AC’s are minimised.

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 COSTS IN THE SHORT RUN AND
LONG RUN
• For most firms the division of total costs between
fixed and variable costs depends on the time
horizon being considered.
• In the short run, some costs are fixed and some are
variable
– some inputs, such as the size of a factory, are fixed.
– other inputs, such as workers, are variable.

• In the long run all factors of production are variable.

– Hence all costs are variable costs in the long run

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HOW LONG IS THE LONG RUN

• As mentioned, the long run is the period of time

needed for all factors of production to become
variable.
– For someone operating a coffee cart we may be
talking about a couple of months – the amount of
time it takes to acquire a coffee machine, build a
cart and acquire the necessary business permits.
– In the case of an airline, the long run could be a
decade or more.

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 LONG RUN AVERAGE TOTAL COST
• In the long run, a firm can adjust all inputs in
the production process.
– Hence firm’s LR cost curves differ from SR cost
curves.

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LONG RUN AVERAGE TOTAL COST

• Each short run average total cost curve is
drawn for a specific level of fixed inputs.

• Long-run cost curve is the lower envelope of

short-run cost curves.
– Note that initially average costs decline with output,
then remain constant, then they increase.
– This would seem to be linked to the ‘returns to scale’
idea. Indeed it is.

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 RETURNS TO SCALE
• Increasing returns to scale means that average
costs are decreasing with increased output.
– Economies of scale often arise because higher
production levels allow division and specialisation
among workers.
• Decreasing returns to scale means that
average costs are increasing with increased
output.
– Diseconomies of scale can arise because of
management and coordination problems that are
inherent in any large organisation.

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RETURNS TO SCALE
• When long run average total cost does not vary
with the level of output, there are constant
returns to scale.

• Thus we can infer returns to scale by

examining how AC varies with output in the
long run.

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 SUMMARY
• A typical firm’s production function is positively-
sloped but gets flatter as the quantity of input
increases – reflecting diminishing marginal product.

• If all inputs are scaled up at the same time we can

examine returns to scale.

• Returns to scale can be increasing decreasing or

constant.

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SUMMARY
• The goal of firms is to maximise profit, total
revenue minus total cost.

• It is important to include all opportunity costs of

production.

• Some opportunity costs explicit, others implicit.

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 SUMMARY
• A firm’s total costs are divided between fixed &
variable costs.

• Fixed costs do not change when the firm alters

its output.

• Variable costs change as the firm alters its

output.

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SUMMARY
• AC is cost divided by output.

• MC is the amount by which total cost would

rise if output were increased by one unit.

• MC often rises with output.

• AC first falls & then rises as output increases

further.

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 SUMMARY
• ATC curve is U-shaped.

• MC curve always crosses the ATC at minimum

ATC.

• A firm’s costs depend on the time horizon

considered.

• Many costs are fixed SR but all are variable in

LR.

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