Economics 1A

Chapter 11

Background to Supply: Production

and Cost

CHAPTER 11Introduction

Goal of the firm – maximise profits

Profit – the surplus of revenue over cost

Total revenue – total value of sales

(price x quantity, or P x Q = PQ)

Average revenue – total revenue divided by quantity sold (PQ/Q)

Marginal revenue – the additional revenue earned by selling an additional unit of the product

Short run vs. long run:Short run – the period during which at least one of the inputs is

fixed

Long run – all the inputs are variable

Difference not calendar time!

Basic cost and profit concepts

Opportunity cost – the best alternative sacrificed (or forgone)

Accounting costs = explicit costs

Economic costs = explicit costs + implicit costs

• Normal profit – the monetary payments that the firm’s resources could have earned in their best alternative uses, forms part of the firm’s cost of production

• Economic profit – the difference between total revenue from the sale of the firm’s product(s) and total explicit and implicit costs

Economic profit and accounting profit

Production in the short run

Simplifying assumptions:

•One product

•Homogeneous

•Inputs - infinitely divisible units

•Production function is given

•Prices of product and inputs are given

•Fixed inputs and one variable input

In the short run, a firm can expand output only by increasing the quantity of its variable input

Production schedule of a maize farmer with one variable input

EXAMPLE

The law of diminishing returns or the law of diminishing marginal returns – when more of a variable input is combined with one or more fixed inputs in a production process, points will eventually be reached where first the marginal product, then the average product and finally the total product start to decline

Marginal and average product of a maize farmer with one variable input

EXAMPLE 1

Total, average and marginal product of labour

EXAMPLE 2

Marginal product and average product

EXAMPLE 3

Costs in the short runFixed cost – cost that remains constant irrespective

of the quantity of output produced

Variable cost – cost that changes when total product changes

Total cost (TC) = Total fixed cost + Total variable cost

Average cost (AC) = Average fixed cost + Average variable cost

Marginal cost (MC) = the increase in total cost when one additional unit of output is produced

Total, fixed and variable cost schedules of a maize farmer

Marginal and average cost

Marginal and average cost: smoothed curves

Production and costsin the long run

In the long run there are no fixed inputs, thus all the costs are variable

Returns to scale – the long-run relationship between inputs and output (vary all inputs by a certain percentage)

• Constant returns to scale

• Increasing returns to scale

• Decreasing returns to scale

Economies of scale – costs per unit of output fall as the scale of production increases

Diseconomies of scale – unit costs rise as output increases

(Note difference between returns to scale and economies of scale)

Two broad groups:

• Internal economies or diseconomies of scale – can be controlled by the firm

• External economies or diseconomies of scale – cannot be controlled by the firm

Economies of scope – the cost savings achieved by producing related goods in one firm rather than in two separate firms

Long-run average costs:

Three basic possibilities

Alternative long-run average cost curves

Three key assumptions:

/̶ The prices of factors of production are given

/̶ The state of technology and the quality of factors of production are given

/̶ Firms always choose the least-cost combination of factors of production to produce each level of output

• Typical long-run average cost curve

A typical long-run average cost curve