ECON 211: ELEMENTS OF ECONOMICS 1
THEORY OF THE FIRM II
Dr. Prince Adjei
pradjei@[Link]
Department of Economics, University of Ghana
Reading List
• Lipsey and Chrystal (2004) Economics. Ch 7-8;
• Besanko and Braeutigam (2013) Microeconomics, Ch 7
•
• Lipsey and Chrystal (2004) Economics. Ch 7-8;
• Besanko and Braeutigam (2013) Microeconomics, Ch 8
Slide 2
THE THEORY OF COST
• The cost of production at a given point in time is dependent on
the prices of factor inputs, the quantity of output, and, the
production period.
Definition of Key Terms
• Explicit costs, also called accounting costs are money outlays
by a firm, on factors of production, which enable the firm to
produce and sell a given quantity of a product.
• Implicit cost, also called opportunity cost on the other hand, is
the amount the entrepreneur could earn in the best alternative use
of his time and money.
• Economic cost is the summation of the explicit (accounting)
cost and the implicit (opportunity) cost of production.
Short Run Production Cost Analysis
• In the short-run, a firm will incur two types of explicit cost:
• Fixed costs (also called supplementary, overhead or, generally,
indirect costs) are expenditure made on the fixed factors of
production. E.g. are expenditure on land, buildings, office
furniture, machineries and equipment, etc
• Variable costs on the other hand, consist of expenditure made on
the variable factors of production e.g., labour and raw materials.
• They are also called prime, direct or special costs. Such costs vary
directly with the level of output. The higher the output, the
greater the variable costs of production, and vice versa.
Analysis of Fixed Production Costs
1. The Total Fixed Cost (TFC): Is the total expenditure of
the firm on the fixed production factors. This is a fixed
constant and it is the same for all levels of output in the
short run.
2. The Average Fixed Cost (AFC): Is the fixed cost per
unit of output. It is defined by the ratio of the total fixed
cost to the level of output, i.e. AFC=TFC/Q
❑Analysis of Short Run Variable Costs
• Short-run costs can be divided into Total Variable Costs (TVC),
Average Variable Costs (AVC) and the Marginal Cost (SMC).
• The Total Variable Cost (TVC) defines the total cost incurred
on the variable factors in the production of some given units of
output.
• The Average Variable Cost (AVC) is the variable cost on a unit
of output produced. It is derived by dividing the TVC by the level
of output.
• i.e. AVC = TVC/Q where Q is the quantity of output.
The Short Run Total and Average Costs
• The short run total cost (STC) is the total fixed and
variable cost of producing some given units of output.
Algebraically, STC = TFC + TVC
• The short run average (total) cost (SAC) is the short run
total cost per unit of output, i.e., the total fixed and
variable costs expended on a unit of output.
Algebraically,
ATC = STC/Q = TFC + TVC = AFC + AVC
Q
Short-run
- TC
TVC TFC
Salaries of
Labour Raw Running Administrative Fixed Depreciation
Cost Materials Expenses and Production Expenses of fixed
Cost of Staff on fixed of plants capital
Machinery basis
Illustration
a. Assume at the initial period, ABC Ltd employed 5 units of labour
at per unit cost of GHc100 per hour. Given that total output per
hour is 60 units, calculate
i) TVC ii) AVC
b. Now, consider an increase in productivity resulting from acquired
skill, the 5 units of labour can now produce 120 units (packets) of
battery cells per hour instead of 60 units. Assume there is no
change in labour cost;
i. What is the change in value of the fixed factor?
ii. calculate for the TVC, AVC and MC
iii. Comment on the change in AVC
Solution
a. i) TVC = cost of one unit of labour per hour x the units of
labour = GHc100 x 5 => GHc500
ii) AVC = TVC/Q = 500 / 60 => GHc8.33
b. i) There is no change in the fixed factor
ii) TVC remains unchanged
Note: change in output reflects increase in TP
AVC = TVC / Q = 500 / 120 = GHc4.167
MC = ∆TC / ∆Q = 500/(120 – 60) = GHc8.33
iii) The new AVC is exactly half of the initial value, showing that
doubling productivity of the variable factor indicates that the
variable cost has been halved
A Hypothetical Short Run Cost Data of a Firm (1)
(1) (2) (3) (4) (5) (6) (7)
Output (Q) TVC TFC TC AVC AFC AC
(Unit) (2 + 3) (= 2 ÷ 1) (= 3÷1) (= 6+7 or 4÷1)
0 0 4 4 0 ∞
1 10 4 14 10 10 4 14
2 16 4 20 6 8 2 10
3 24 4 28 8 8 1.33 9.33
4 34 4 38 10 8.5 1 9.5
5 46 4 50 12 9.2 0.8 10
6 60 4 64 14 10 0.67 10.67
Hypothetical Short run cost schedules for ABC Ltd (2)
Unit of
Labour Output TVC TFC STC AVC AFC SAC SMC
0 0 0 500 500 0 ∞
1 5 100 500 600 20 100 120 20
2 12 200 500 700 16.6 41.7 58.3 14.3
3 25 300 500 800 12 20 32 7.7
4 40 400 500 900 10 12.5 22.5 6.7
5 60 500 500 1000 8.3 8.3 16.7 5
6 75 600 500 1100 8 6.7 14.7 6.7
7 85 700 500 1200 8.2 5.9 14.1 10
8 92 800 500 1300 8.7 5.4 14.1 14.3
9 95 900 500 1400 9.5 5.3 14.7 33.3
10 90 1000 500 1500 11.1 5.5 16.7
Short run cost curves
• Short-run cost curves depict the relationships between cost and output when
there is at least one fixed factor of production.
• The average fixed cost curve decreases with output, but never becomes zero.
Hence the curve asymptotically approaches the horizontal axis.
• The short-run total cost and total variable cost curves are both upward
sloping. Geometrically, the distance between the two curves is constant for
every output level and represents the total fixed costs.
• The short run marginal cost, and average variable cost and average cost
curves are all U-shaped, because the law of diminishing returns reflects in
eventually rising marginal and average costs.
• The short run marginal cost curves cuts the average variable cost and the
short-run. Average cost curves at their minimum points.
SHORT RUN COST CURVES
Short run cost curves
III. Total fixed costs, total variable cost and
I. The rectangular hyperbola AFC curve. The short run total cost curves
MP AP
MC AC
Q
II. Asymmetrical relation between IV. The Average Variable cost, short run Average
Productivity and Cost Total Cost and short run Marginal Cost
❑ Reasons for the U-shaped Cost Curves
• Why do the AVC and MC curves first fall, reach their minimum
points and begin to rise?
• The reason is because of the law of diminishing returns.
• The same phenomenon that explains the mountain shape of the
short run productivity curves explains the valley shape nature of
the cost curves.
• At the initial stage of production, as more of the variable factor is
added to the fixed factor, the productivity of the variable factor
increases (hence the marginal cost and the per unit variable
cost falls) until a point when diminishing returns sets in and the
marginal cost as well as the per unit variable cost begin to rise.
❑ The Relationship between Short run Total Cost, Total Fixed Cost
and Total Variable Cost
• From the diagrams above ;
1. STC and TVC curves are both upward sloping hence they have the
same slope at all levels of output. This is not a coincidence since
the difference between the two curves at any output level is the
TFC
2. TFC is constant, the difference between the STC and TVC curves
will be constant at every level of output.
3. STC curve cuts the vertical axis where the TFC intercepts the
same axis. The meaning of this is that when output is zero, the
TVC is also zero, and STC = TFC
❑ Relationship between Short Run Average Total Cost, Average
Variable Cost and Marginal Cost
1. When the AVC is falling, the SMC must also be falling, and at a
faster rate.
2. When the AVC is rising, then SMC is rising, and at a faster rate.
3. SMC must be equal to the AVC at the minimum point of the
latter.
• Geometrically, ( With reference to diagrams above)
✓ When the AVC curve is falling, the SMC curve lies blow it.
✓ When the AVC curve is rising, the SMC curve lies above it.
✓ The SMC curve intercepts the AVC curve at its minimum point.
✓ When the SAC curve is falling, the SMC curve lies below it (i.e.,
SMC is falling at a faster rate).
✓ When the SAC curve is rising, the SMC curve lies above it, and
✓ The SMC curve cuts the SAC curve at its minimum point.
Long Run Production Costs
• In the long run all factors are variable. The firm can change its plant size for
another whenever the market condition demands.
• In the short run, the firm can only operate on a given plant size (since at
least one factor is fixed) but in the long run, it can vary the size of its plant
(since all factors are variable).
• A plant size is defined in terms of a specified short run average and
marginal costs.
• If we assume in the first instance that our hypothetical firm ABC Ltd. has a
technology that permits it to use any of the three given plants (SAC1 and
SMC1, SAC2 and SMC2, and lastly, SAC3 and SMC3).
•
• In the long run, it is also assumed that the first plant (SAC1 and SMC1) is
smaller than the second (SAC2 and SMC2) and the second is smaller than
the third. See diagram below
❑Choosing between three alternative plants in
the long run
• In the long run, the firm can choose the plant size to operate.
• A given plant size is defined by a combination of short run Average
Cost and Marginal Cost Curves.
• The exact plant the firm will operate in the long run would depend on
the Expected demand.
• The higher the level of output the firm expects to sell, the larger the
plant size it would build or operate.
• The optimum production point for any given plant size is the output
level that corresponds to the minimum point on the corresponding
SAC curve (See Diagram below…)
Long run three alternative plants
.
SMC 1
SAC 1 SMC 2
Cost
a
a SMC 3
SAC 2
c e
SAC 3
b d
Q
q1 q2 q3 q4 q5 q6 q7 q8
• From these various plants, we can derive the firm's long run
average cost (LAC) curve.
• The curve shows the minimum average cost that can be used to
produce any level of output when all factors of production are
variable (assuming the prices of factor inputs remains
constant).
• It is drawn tangent to every possible plant size, that is, a point
on each SAC curve corresponds to a point on the LAC curve.
• But the curve does not join the minimum points of all possible
SAC curves. In fact, it only corresponds with the minimum point
of only one SAC curve.
THE LONG RUN AVERAGE COST CURVE
SMC5
LMC
Cost
g
SMC3 SMC4
SMC1
SMC2 SAC5
SAC1
SAC2
SAC4 LAC
a
f e
d
b
h
c
i
Increasing Decreasing
returns to returns to
scale scale
q1 q2 q3 q4 q5 Output
The law of Return to Scale
• Return to scale measures the rate of increase in output as all factor
inputs are increased by a constant amount.
❑ The law of returns to scale states that as a firm increase its scale of
production (produces larger and larger output by increasing the size of
plant) it would first enjoy increasing returns to scale (in other words,
productivity would first increases or the per unit cost of production
would first fall) but after a point, deceasing returns to scale (falling
productivity or rising average cost) would set in.
• Total output may respond to increases in the scale of production in three
ways:
1) It may increase at an increasing rate; in which case, we are experiencing
increasing returns to scale.
2) It may increase at a constant rate; in which case, we are experiencing
constant returns to scale.
3) It may increase at a decreasing rate; in which case, we are experiencing
decreasing returns to scale.
• Illustration: Assume total input of labour and capital are increased progressively by 100
units (as shown in the Table below) while the levels of output associated with the
changes in the scale of production are given in column two.
• It is clear that between the input levels of 100 to 300 units, the firm experienced
increasing returns to scale (since output increased at an increasing rate). However, as
inputs increased beyond 300 to 500 units, there were constant returns to scale, then
diminishing returns to scale set in after 500 units of inputs.
• NOTE: The law of returns to scale is different from law of diminishing returns
(to the variable factor). The former relates to the long run and changes in all
factor inputs (variation of the scale of production) while the latter relates to
the short run and thus, the intensive application of a variable factor on a fixed
factor.
Returns to the scale of production
Inputs of K and L 100 200 300 400 500 600 700
Output (Q) 1500 3500 6000 8500 11000 13000 14500
❑ Economics and Diseconomies of Scale
❑ Economies (advantages, benefits) of scale: Benefits a firm enjoys by producing
on large scale. Grouped into Internal and external Economies of scale
• Internal Economies of Scale: Includes benefits such as the ability to employ
more superior (efficient) , machineries and equipments as well as highly skilled
labour.
• External Economies of Scale: Includes benefits such as specialized training,
transportation, housing and medical facilities etc
❑ Diseconomies of scale: are problems associated with an excessive growth in
the size of a firm's operations. Also, grouped into Internal and external.
• Internal Diseconomies: These arise mainly from communication, supervision,
and co-ordination difficulties associated with the management of very large
enterprise.
• External Diseconomies: a big firm may also encounter external diseconomies
such as increasing cost of factor inputs (raw materials, skilled and unskilled
labour) etc.
❑ Choosing the Optimal Plant Size
• The long run decision of the firm is to determine the plant size
that will yield maximum long run profit.
• This plant size is the one which corresponds to the minimum
point on the LAC curve. At this point, two conditions are
fulfilled simultaneously:
1. The LAC curve is minimum and,
2. The corresponding SAC curve is also minimum.
• This plant is the optimal plant size for the firm, and the output
level is called the firm’s plant capacity.
Exercise
1. (a) Fill the gaps in the following table, and plot the graphs of the
corresponding cost curves.
Q 10 20 30 40 50 60
STC 1000 1200 - 1450 - 1850
TFC 500 500 - 500 - -
TVC 500 - 850 - 1100 -
SAC - - - - - -
AFC - - - - - -
SMC - - - - - -
(b) Rigorously examine the relationship between
i) The AFC, SAC and AVC curves.
ii) The STC, TVC and TFC curves.
THANK YOU