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Chapter 9:
Background
to supply:
production and
cost
Chapter outcomes
Once you have studied this chapter you should be able to
• Define the various revenue, cost and profit concepts
• Distinguish between the total, average and marginal product of a
variable input
• Explain the relationship between the law of diminishing returns
and the shapes of the total, average and marginal product curves
in the short run
• Distinguish between total, average and marginal cost
• Explain the relationship between the product curves and the cost
curves in the short run
• Explain the nature of production and costs in the long run
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Introduction
• Types of firms
• The most common formal types of firms in South Africa are individual proprietorships,
partnerships, companies, close corporations, cooperatives, trust companies and public
corporations. There are also numerous informal businesses, that is, businesses which are not
formally registered.
• The goal of the firm
• All firms seek to maximise profits.
• The principal-agent problem may arise, where owners may want the firm to make maximum
profit and the managers may pursue their own objectives, such as expanding the size of the
firm, since their status, power and remuneration tend to increase as the firm grows.
• Profit, revenue and cost: a brief introduction
• Profit is simply the surplus of revenue over cost.
• Total revenue (TR) is simply the total value of its sales and is equal to the price (P) of its product
multiplied by the quantity sold (Q)
• Average revenue (AR) is equal to total revenue (TR or PQ) divided by the quantity sold (Q). If all
units are sold at the same price, then average revenue is equal to the price of the product.
• Marginal revenue (MR) is the additional revenue earned by selling an additional unit of the
product.
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Basic cost and profit concepts
• The short run and the long run in production and cost
theory
• The short run is defined as the period during which at least one of the inputs is fixed.
• In the long run all the inputs are variable.
• Cost
• Economist uses the opportunity cost principle to determine the value of all the resources
used in production by measuring the cost of production as the best alternative sacrificed
(or forgone) by choosing to produce a particular product.
• Accountants, business people and others usually consider only the actual expenses
incurred to produce a product.
• Accountants tend to consider explicit costs only. Explicit costs are the monetary payments
for the factors of production and other inputs bought or hired by the firm.
• Economist consider implicit costs as well as explicit costs. Implicit costs are those
opportunity costs which are not reflected in monetary payments.
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Basic cost and profit concepts
Box 9-1 The principal–agent problem (Textbook page 145)
Box 9-2 Total, average and marginal revenue (Textbook page
145)
Box 9-3 Economic costs (Textbook page 147)
Box 9-4 Private costs and social costs (Textbook page 148)
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Basic cost and profit concepts
• Profit
Figure 9-1 Economic profit and accounting profit
(Textbook page 149)
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Production in the short run
• The short-run production function
• Production is the physical transformation of inputs into output. Some goods and services (the inputs) are
combined to produce other goods and services (the output).
• The inputs typically consist of factors of production and intermediate inputs.
• An intermediate input is any good or service other than the basic factors of production (natural
resources, labour, capital and entrepreneurship) which is used to produce something else (eg screws,
nails and hinges for making furniture, flour for producing bread, or parts assembled into an electric
toaster or a computer)
• A fixed input is thus an input whose quantity cannot be altered in the short run.
• a variable input is one whose quantity can be changed in the short run (as well as the long run).
• The short run assumptions:
1. The firms produces only one product.
2. All units of a given input are identical or homogenous.
3. The inputs can be used in infinitely divisible amounts.
4. The technical relationship between inputs and output, called the production function, is given and
therefore cannot be changed.
5. The prices of the product and of the inputs are given.
6. The firm uses fixed inputs and one variable input
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Production in the short run
• The short-run production function
Table 9-1 Production schedule of a maize farmer
with one variable input (Textbook page 149)
• The law of diminishing returns
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Production in the short run
• Average and marginal product
Table 9-2 Production schedule of a maize farmer
with one variable input (Textbook page 151)
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Production in the short run
Average and marginal product
Figure 9-2 Total, average and marginal product of labour
(Textbook page 152)
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Production in the short run
Figure 9-2 Total, average and marginal product of labour continued
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Production in the short run
• Comparison of total, average and marginal product
Figure 9-3 Marginal product and average product
(Textbook page 152)
Box 9-5 Total, average and marginal product: a mathematical
interpretation (Textbook page 153)
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Costs in the short run
• Fixed and variable costs
Table 9-3 Total, fixed and variable cost schedules of a maize farmer
(Textbook page 154)
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Costs in the short run
• Average and marginal cost
Table 9-4 Short-run total and unit cost schedule for a firm with one
variable input (Textbook page 155)
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Costs in the short run
Average and marginal cost
Table 9-5 Calculation of marginal cost (Textbook page 155)
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Costs in the short run
Average and marginal cost
Figure 9-4 Marginal and average cost (Textbook page 156)
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Costs in the short run
Average and marginal cost
Figure 9-5 Marginal and average cost (Textbook page 156)
Box 9-6 Total, average and marginal cost: a mathematical
interpretation (Textbook page 158)
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Costs in the short run
• The relationship between production and cost in the
short run
Figure 9-6 The relationship between production (or productivity)
and cost (Textbook page 157)
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Costs in the short run
The relationship between production and cost in the short run
Figure 9-6 The relationship between production (or productivity) and cost continued
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Production and costs in the long run
• What is meant by the long run?
• The long run is defined as a period that is long enough for the firm to change the quantities of
all the inputs in the production process as well as the process itself.
• In the long run there are no fixed inputs
• All the inputs (including all the factors of production) are variable
• In the long run there are thus no fixed costs ,all the costs are variable
• The law of diminishing returns does not apply.
• Returns to scale
• The term “returns to scale” refers to the long-run relationship between inputs and output.
• Returns to scale are measured by varying all the inputs by a certain percentage and comparing
the resulting percentage change in production with the percentage change in the inputs.
•Three possible situations can be distinguished:
• Constant returns to scale- this is where a given percentage increase in inputs will give rise to the same
percentage increase in output.
• Increasing returns to scale- this is where a given percentage increase in inputs will lead to a larger
percentage increase in output.
• Decreasing returns to scale- this is where a given percentage increase in inputs will give rise to a smaller
percentage increase in output
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Production and costs in the long run
• Economies of scale
• Economies of scale refer to the relationship between costs and output and specifically to a
decline in unit costs as output expands
• Economies of scale can be achieved by increasing the quantity or productivity of only one or
a few of the inputs, and where all the inputs are increased they do not necessarily have to
increase by the same percentage.
• Diseconomies of scale occurs when unit costs rise as output increases.
• Economies of scope
• The cost savings achieved by producing related goods in one firm rather than in two
separate firms are called economies of scope.
• Three key assumptions in the long-run:
1. The prices of the factors of production are given.
• 2. The state of technology and the quality (or productivity) of the factors of production are
given.
• 3. Firms always choose the least-combination of the factors of production to produce each
level of output.
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Production and costs in the long run
• Long-run average costs
Figure 9-7 Alternative long-run average cost curves
(Textbook page 159)
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Production and costs in the long run
Long-run average costs
Figure 9-7 Alternative long-run average cost curves continued
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Production and costs in the long run
Long-run average costs
Figure 9-7 Alternative long-run average cost curves continued
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Production and costs in the long run
Long-run average costs
Figure 9-8 A typical long-run average cost curve
(Textbook page 159)
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Production and costs in the long run
• Long-run marginal cost
Figure 9-9 The relationship between long-run average and marginal
costs (Textbook page 160)
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Production and costs in the long run
Long-run marginal cost
Figure 9-9 The relationship between long-run average and marginal costs continued
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Production and costs in the long run
Long-run marginal cost
Figure 9-9 The relationship between long-run average and marginal costs continued
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Production and costs in the long run
Long-run marginal cost
Figure 9-9 The relationship between long-run average and marginal costs continued
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Production and costs in the long run
• The relationship between long-run and short-run
average cost curves
Figure 9-10 A long-run average cost curve for three scales of
production (Textbook page 161)
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Production and costs in the long run
The relationship between long-run and short-run average cost curves
Figure 9-11 The long-run average cost curve when short-run fixed
inputs can be varied by any amount (in the long run)
(Textbook page 161)
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Summary
Table 9-6 The short run and long run in production and cost theory:
a summary (Textbook page 162)
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Important concepts
• Principal–agent problem • Explicit costs
• Profit • Implicit costs
• Revenue • Accounting costs
• Cost • Economic costs
• Production function • Private costs
• Total revenue (TR) • Social costs
• Average revenue (AR) • Externalities
• Marginal revenue (MR) • Accounting profit
• Long run • Normal profit
• Short run • Economic profit
• Fixed inputs • Total cost (TC)
• Variable inputs • Average cost (AC)
• Opportunity cost • Marginal cost (MC)
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• Law of diminishing (marginal) • Returns to scale
returns • Economies of scale
• Total product (TP) • Diseconomies of scale
• Average product (AP) • Internal economies
• Marginal product (MP) • External economies
• Fixed cost • Economies of scope
• Variable cost • Long-run average cost (LRAC)
• Total fixed cost (TFC) • Long-run marginal cost
• Total variable cost (TVC) (LRMC)
• Average fixed cost (AFC) • Envelope curve
• Average variable cost (AVC)
• Long-run costs
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