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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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 What is the purpose of
this chapter?

The purpose of this chapter is

to study production and its
relationship to various types
of costs.

3
 Types of firms

• Sole Proprietorship

• Partnerships

• Close corporations

• Cooperatives

• Informal businesses

*****In this chapter we will only be dealing with the functioning of a

small, uncomplicated business.
 What is a basic assumption
in economics?

• The motivation for business

decisions is profit maximization.
• Other Objectives:
• Increase sales or market share
• Expanding the size of the firm 5
 Profit, Revenue and Cost
• Profit is the surplus of revenue over cost calculated as:
Total Revenue – Total Expenses.

• Total revenue (TR) – total sales of a company calculated as

price (P) multiplied by the quantity sold (Q).

• Average revenue – total revenue divided by the quantity

sold.

• Marginal revenue – additional revenue earned by selling

an additional unit of the product.

• Box 9-2: Total, Average and Marginal Revenue

 Short run and long run
production.
• Short run – a period during which at least one of the inputs is
fixed.

• For example, a restaurant may regard its building as a fixed

factor over a period of at least one year.

• It would take at least that much time to find a new building or to

expand or reduce the size of its present facility.

• Decisions concerning the operation of the restaurant during the

next year must assume the building will remain unchanged.

• Other factors of production could be changed during the year,

but the size of the building must be regarded as a constant.
 Short Run and Long Run
• While the managers of the restaurant are making choices concerning its operation
over the next year, they are also planning for longer periods.

• Over those periods, managers may contemplate alternatives such as modifying the
building, building a new facility, or selling the building and leaving the restaurant
business.

• The planning period over which a firm can consider all factors of production as
variables is called the long run.

• A firm makes both short-run and long-run choices.

• The managers can plan what to do for the next few weeks and for the next few years.

• Their decisions over the next few weeks are likely to be short-run choices.

• Decisions that will affect operations over the next few years may be long-run choices,
in which managers can consider changing every aspect of their operations.
 To understand profit, what is
necessary?

To distinguish between the

way economists measure
costs and the way
accountants measure costs
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 What are explicit costs?

Payments to non owners of a

firm for their resources.

10
 What are implicit
costs?

The opportunity costs of

using resources owned by
the firm.

11
 What is an example
of implicit costs?
When a firm uses its own
resources, such as the owner’s
labor, land, building, or savings,
the firm gives up the
opportunity of earning a return
on its resources.
12
 What are total
opportunity costs?

Explicit costs + Implicit costs

13
 What is
economic profit?
Total revenue minus explicit and
implicit costs, or total revenue
minus total opportunity costs

14
 What is normal profit?

The minimum profit necessary

to keep a firm in operation.

15
 What about
opportunity cost?

A firm that earns normal

profits earns total revenue
equal to its total opportunity
cost
16
 How is accounting
profit defined?

Total revenue minus

total explicit costs
17
18
 Basic cost and profit concepts

Economic profit and accounting profit (Textbook page

149)

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 Example – Economic and
Accounting Profits
• Wanda Wheeler earns R50,000 a year as an
aeronautical engineer with the Skyhigh Aircraft
Corporation. On her way home from work one day, she
gets an idea for a rounder, more friction resistant
airplane wheel. She decides to quit her job and start a
business, which she calls Wheeler Dealer.

• To buy the necessary machines and equipment, she

withdraws R20,000 from her savings account, where it
was earning interest of R1,000 a year. She hires an
assistant for R21 000 per year and starts producing the
wheel using the spare bay in her condominium’s
parking garage that she had been renting to a neighbor
for R100 a month.

• After a year, the company revenue totaled

R105,[Link] paying her assistant and for materials
and equipment, the firm shows an accounting profit of
how much?
 Example – Economic and
Accounting Profits

• Remember, she quit a R50,000-a-year job to

work full time on her business, thereby forgoing
that salary. Second is the R1,000 annual interest
she passes up by funding the operation with her
own savings. And third, by using the spare bay in
the garage for the business, she forgoes R1,200
per year in rental income.

• The forgone salary, interest, and rental income

are implicit costs because she no longer earns
income generated from their best alternative
uses.

• Economic profit equals total revenue minus

all costs, both implicit and explicit; economic
profit takes into account the opportunity cost of
 Example – Economic and
Accounting Profits
• Wheeler Dealer earns a normal profit when accounting
profit equals implicit costs—the sum of the salary Wanda
gave up at her regular job (R50,000), the interest she
gave up by using her own savings (R1,000), and the rent
she gave up on her garage (R1,200). Thus, if the
accounting profit is R52,200 per year—the opportunity
cost of resources Wanda supplies to the firm—the
company earns a normal profit.

• Any accounting profit in excess of a normal profit is

economic profit. If accounting profit is large enough, it can
be divided into normal profit and economic profit. The
R64,000 in accounting profit earned by Wanda’s firm
consists of (1) a normal profit of R52,200, which covers
her implicit costs—the opportunity cost of resources she
supplies the firm, and (2) an economic profit of R11,800,
which is over and above what these resources, including
Wanda’s time, could earn in their best alternative use.
 Production in the short run

• Suppose a new McDonald’s has just opened in your

neighborhood and business is booming far beyond
expectations.

• The manager responds to the unexpected demand

by quickly hiring more workers.

• But cars are still backed up into the street waiting for
a parking space. The solution is to add a drive-
through window, but such an expansion takes time.
 Fixed and Variable Resources
• Some resources, such as labor, are called variable resources because
they can be varied quickly to change the output rate. But adjustments in
some other resources take more time.

• Resources that cannot be altered easily—the size of the building, for

example—are called fixed resources.

• When considering the time required to change the quantity of resources

employed, economists distinguish between the short run, at least one
resource is fixed and the long run, no resource is fixed.

• Length of the long run differs from industry to industry because the
nature of production differs. For example, the size of a McDonald’s
outlet can be increased more quickly than can the size of an auto plant.
Thus, the long run for that McDonald’s is shorter than the long run for
an automaker.
 The short run production function

• The relationship between the amount of resources

employed and a firm’s total product.

• See the slide below for the relationship between

land, labour and the total product.

• As labour increases , the total product increases at a

decreasing rate, until a maximum point is reached,
then the TP starts decreasing (law of diminishing
returns).
 What do technological
advances make possible?

More output is possible

from a given quantity of
inputs.

26
 Assumptions – analysing
production
• The firm produces only one product

• All units of a given input are identical or homogenous

• The inputs can be used in infinitely divisible amounts

• The technical relationship between inputs and output, called

the production function, is given and cannot be changed

• The prices of the product and of the inputs are given

• The firm uses fixed inputs and one variable input.

 Production in the short run
Table 9-1 Production schedule of a maize farmer with one
variable input (Textbook page 149)
 What is
Average product?

• This is the average number of units of output

produced per unit of the variable input.

• Average Product =
 What is
marginal product?

The change in total output

produced by adding one unit
of a variable input, with all
other inputs used held
constant.
30
 What is the law of diminishing
returns?

The principle that beyond some

point the marginal product
decreases as additional units of
a variable resource are added
to a fixed factor.
31
 What does the law of
diminishing returns assume?

Fixed inputs; it is therefore a

short-run concept

32
33
 Total Output Curve
60
50
40

(bushels of grapes per day)

Total Product
30 Total Output
20
10

0 1 2 3 4 5 6
Quantity of Labor
34
(number of workers per day)
 Marginal Product Curve

12
10

(bushels of grapes per day)

Marginal Product
8 Marginal
Product
6
Law of
Diminishing
4 Returns

0 1 2 3 4 5 6
Quantity of Labor 35
(number of workers per day)
 Production in the short run

Table 9-2 Production schedule of a maize farmer

with one variable input (Textbook page 151)
 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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 Marginal product and total product

When marginal product is rising, total

product increases by increasing amounts.
When marginal product is falling but still
positive, total product increases by
decreasing amounts. When marginal
product equals 0, total product is at a
maximum. When marginal product is
negative, total product is falling.
 Comparison of total, average and
marginal product
• The law states that as more units of labour are combined with the
fixed of land, first the marginal product, then the average product and
finally the total product will start to decline.

• AP and MP – shaped like inverted “U”s, they increase at decreasing

rates, reach maximum points and then decrease at increasing rates

• MP – reaches maximum before AP

• Before AP reaches a maximum, MP lies above AP

• MP equals AP at the maximum point of AP

• After the maximum point of AP is reached, MP lies below AP

 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) © VAN SCHAIK PUBLISHERS
 Costs in the short run
• Fixed cost pays for fixed resources and variable cost pays for variable
resources.

• A firm must pay a fixed cost even if no output is produced. Even if a

firm hires no labor, it incurs property taxes, insurance, vehicle
registration, plus any opportunity cost for warehouse and equipment.
By definition, fixed cost is just that: fixed—it does not vary with output
in the short run.

• Variable cost, as the name implies, is the cost of variable resources—

in this case, labor. When no labor is employed, output is zero, as is
variable cost. As workers are hired, output increases, as does variable
costs.

• Variable cost depends on the amount of labor employed and the

wage. If the wage is R100 per day, variable cost equals the number of
workers hired times R100.
 What is total cost?

The sum of total fixed cost

and total variable cost at each
level of output

TC = TFC + TVC
44
 What is
average fixed cost?

Total fixed cost divided by

the quantity of output
produced
AFC = TFC / Q
45
 What is average variable cost?

Total variable cost

divided by the quantity
of output produced
AVC = TVC / Q
46
 What is
average total cost?

Total cost divided by the

quantity of output produced.
Also called per-unit cost.
ATC = TC/Q
OR

ATC=AFC +AVC
47
 What is marginal cost?

The change in total cost

when one unit of output
is produced.
MC = TC/Q

48
 Short-Run Cost Curves

800
700 TC
600 TVC

Total Costs
500
400
300
200
100
TFC

0 2 4 6 8 10 12
Quantity of Output 49
(units per hour)
 Fixed cost, total variable cost and
total fixed cost
• The fixed cost is R100 at all levels of output.

• Variable cost starts from the origin and increases slowly

at first as output increases.

• When the variable resource generates diminishing

marginal returns, variable cost begins to increase more
rapidly.

• Total cost is the vertical sum of fixed cost and variable

cost.
 Exhibit 4(b) Short-Run Cost Curves
160
140
120 MC

Cost per unit

100
80
60 ATC
AVC
40
20
AFC
0 2 4 6 8 10 12
Quantity of output (units 51
per hour)
 Marginal cost, average fixed cost,
average total cost and average
total cost
• Average variable cost and average total cost curves first decline, reach
low points, and then rise.

• Overall, they have U shapes.

• When marginal cost is below average variable cost, average variable cost
is falling.

• When marginal cost equals average variable cost, average variable cost is
at its minimum.

• When marginal cost is above average variable cost, average variable cost
is increasing.

• The same relationship holds between marginal cost and average total
cost.
53
 Costs in the short run
Table 9-3 Total, fixed and variable cost schedules of a maize
farmer (Textbook page 154)
• Average and marginal Costs in the short run

cost9-4 Short-run total and unit cost schedule for a firm with
Table
one variable input (Textbook page 155)
 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) © VAN SCHAIK PUBLISHERS
 Costs in the short run

• The law of diminishing marginal returns determines the shapes of

short-run cost curves.

• When the marginal product of labor increases, the marginal cost of

output falls.

• Once diminishing marginal returns take hold, the marginal cost of

output rises.

• Thus, marginal cost first falls and then rises.

• And the marginal cost curve dictates the shapes of the average cost
curves.

• When marginal cost is less than average cost, average cost declines.

• When marginal cost is above average cost, average cost increases.

The relationship between production and
cost in the short run
 Relationship between production (or productivity )
and cost

• Marginal product – extra output that can be produced by using one

more unit of the input

• Marginal cost – the change in the total cost that arises when the
quantity produced changes by 1 unit

• When units are cheap , the cost will be low and productivity will be
high.

• When MC goes down than up it is because of the law of diminishing

marginal returns

• When each worker adds less and less the firm will still pay the
workers their wage.
Marginal cost’s mirror image

62
 Costs in the long run

• In the long run, all inputs that are under the firm’s control
can be varied, so there is no fixed cost.

• The long run is not just a succession of short runs. The long
run is best thought of as a planning horizon.

• In the long run, the choice of input combinations is flexible.

But once the size of the plant has been selected and the
concrete has been poured, the firm has fixed costs and is
operating in the short run.

• Firms plan for the long run, but they produce in the short
run.
 Returns to scale

• The relationship between inputs and

output.

• Measured by varying all the inputs by a

certain percentage change and comparing
the resulting percentage change in
production with the percentage change in
the inputs.
 Constant returns to scale

A given percentage change in inputs will

give rise to the same percentage increase
in output.
 Increasing returns to scale

A given percentage increase in inputs

will lead to a larger percentage
increase in output.
 Decreasing returns to scale

A given percentage increase in

inputs will lead to a smaller
percentage increase in output.
 What is the long-run average cost curve?

The curve that traces the

lowest cost per unit at which
a firm can produce any level
of output when the firm can
build any desired plant size.
68
 What are
economies of scale?

A situation in which the

long-run average cost curve
declines as the firm
increases output
69
 Production and costs in the long run

• Long-run average
costsFigure 9-7 Alternative long-run average cost curves
(Textbook page 159)

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 What are
diseconomies of scale?

A situation in which the

long-run average cost curve
rises as the firm increases
output
71
 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

Constant costs – costs per unit of output remains constant as

output increases.

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 Economies of scope
• Economies of scope occur where it is cheaper to produce a
range of products rather than specialize in a handful of
products.

• Toshiba uses its designers and specialised equipment to

make the hard drive for the iPod. And it also produces
different types of hard drives and other related products.
Therefore, Toshiba produces the iPod hard drive at a lower
cost than a firm making only the iPod hard drive.

• For example a restaurant that has catering facilities and

uses it for multiple occasions – as a coffee shop during the
day and as a supper-bar and jazz room in the evenings.
 Typical Long-run Average Cost Curve

Cost per unit

LRAC

Economies Constant Diseconomies

of scale returns to scale of scale

0 Q1 Q2
Quantity of Output 75
 Production and costs in the long run

• Up to output level Q1, long-run average

cost falls as the firm experiences
economies of scale.

• Output level Q1 is the minimum efficient

scale—the lowest rate of output at which
the firm takes full advantage of economies
of scale.

• Between Q1 and Q2, the average cost is

constant. Beyond output level Q2, long-run
average cost increases as the firm
 Assumptions for the LRAC
• The prices of the factors of production are given.

• The state of technology and the quality (or

productivity) of the factors of production are
given.

• Firms always choose the least cost combination of

the factors of production to produce each level of
output.
 Long run marginal cost
• If there are economies of scale the LRMC curve must lie below
the LRAC.

• If there are diseconomies of scale, the LRMC curve must lie

above the LRAC curve.

• If constant costs are experienced the LRAC is horizontal. Here

LRMC is equal to LRAC

• Economies of scale followed by diseconomies of scale the

LRMC curve will intersect the LRAC curve at the minimum of
LRAC curve.
 Production and costs in the long run

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

© VAN SCHAIK PUBLISHERS

The relationship between long-run and short-
run average cost curves
• A curve that indicates the lowest average cost of production at
each rate of output when the size, or scale, of the firm varies; also
called the planning curve.

• The LRAC is formed by connecting the points on the various short-

run average cost curves that represent the lowest per-unit cost for
each rate of output.

• Each of the short-run average cost curves is tangent to the long-

run average cost curve.

• These points of tangency represent the least-cost way of producing

each particular rate of output, given the technology and resource
prices.
 Production and costs in the long run

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

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)
 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
• Total fixed cost (TFC) (LRAC)
• Total variable cost (TVC) • Long-run marginal
• Average fixed cost (AFC) cost (LRMC)
• Average variable cost (AVC) • Envelope curve
• Long-run costs

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