McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 04Firm

Production, Cost, and Revenue

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Chapter Outline

• Production• Costs• Revenue• Maximizing Profit

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Basic Definitions

• Profit: The money that business makes: Revenue minus Cost

• Cost: the expense that must be incurred in order to produce goods for sale

• Revenue: the money that comes into the firm from the sale of their goods

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Economic vs. Accounting Cost

• Economic Cost: All costs, both those that must be paid as well as those incurred in the form of forgone opportunities, of a business

• Accounting Cost: Only those costs that must be explicitly paid by the owner of a business

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Production

• Production Function: a graph which shows how many resources we need to produce various amounts of output

• Cost Function: a graph which shows how much various amounts of production cost

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Inputs to Production

• Fixed Inputs: resources that you cannot change

• Variable Inputs: resources that can be easily changed

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Concepts in Production• Division of Labor: workers

divide up the tasks in such a way that each can build up a momentum and not have to switch jobs

• Diminishing Returns: the notion that there exists a point where the addition of resources increases production but does so at a decreasing rate

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Figure 1 The Production Function

Output

Workers

Production Function

AB

C

D

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A Numerical Example

Labor Total Output Extra Output of the Group

0 0

1 100 100

2 317 217

3 500 183

4 610 110

5 700 90

6 770 70

7 830 60

8 870 40

9 900 30

13 1000

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Costs

• Fixed Costs: costs of production that we cannot change

• Variable Costs: costs of production that we can change

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Figure 2 The Total Cost Function

Output

Total Cost

Total Cost Function

A

B

C

D

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Cost Concepts

• Marginal Cost: the addition to cost associated with one additional unit of output

• Average Total Cost: Total Cost/Output, the cost per unit of production

• Average Variable Cost: Total Variable Cost/Output, the average variable cost per unit of production

• Average Fixed Cost: Total Fixed Cost/Output, the average fixed cost per unit of production

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Figure 3 Marginal Cost, Average Total, Average Variable, and Average Fixed Cost

P

Q

MCATC

AVC

AFC

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Numerical Example

Output

TVC TFC TC MC* ATC AVC AFC

0 0 8500 8500

100 2500 8500 11000

25 110 25 85

200 3800 8500 12300

13 62 19 43

300 4800 8500 13300

10 44 16 28

400 6000 8500 14500

12 36 15 21

500 7500 8500 16000

15 32 15 17

600 9500 8500 18000

20 30 16 14

700 12500

8500 21000

30 30 18 12

800 17000

8500 25500

45 32 21 10.6

900 22500

8500 31000

55 34 25 9.4

1000 32500

8500 41000

100 41 32.5 8.5

* MC is per 100

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Revenue

• Marginal Revenue: additional revenue the firm receives from the sale of each unit

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Figure 4 Setting the Price When There are Many Competitors

Our Firm

P

Market for Memory

P

D

S

P*P*=Marginal Revenue

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Figure 5 Marginal Revenue When there are No Competitors

MR

Market for Memory

P

D

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Numerical Example For the Many Competitors CaseQ P TR MR*

0 45 0

100 45 4,500 45

200 45 9,000 45

300 45 13,500 45

400 45 18,000 45

500 45 22,500 45

600 45 27,000 45

700 45 31,500 45

800 45 36,000 45

900 45 40,500 45

1000 45 45,000 45* MR is per 100

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Numerical Example For the No Competitors Case

Q P TR MR*

0 75 0

100 70 7,000 70

200 65 13,000 60

300 60 18,000 50

400 55 22,000 40

500 50 25,000 30

600 45 27,000 20

700 40 28,000 10

800 35 28,000 0

900 30 27,000 -10

1000 25 25,000 -20

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Maximizing Profit

• We assume that firms wish to maximize profits

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Market Forms

• Perfect Competition: a situation in a market where there are many firms producing the same good

• Monopoly: a situation in a market where there is only one firm producing the good

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Rules of Production

• A firm should a) produce an amount such that

Marginal Revenue equals Marginal Cost (MR=MC),

unlessb) the price is less than the average variable cost (P<AVC).

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Numerical Example of Profit Maximization With Many Competitors

Q P TR TC MR MC Profit

0 45 0 8,500 -8,500

100 45 4,500 11,000

45 25 -6,500

200 45 9,000 12,300

45 13 -3,300

300 45 13,500 13,300

45 10 200

400 45 18,000 14,500

45 12 3,500

500 45 22,500 16,000

45 15 6,500

600 45 27,000 18,000

45 20 9,000

700 45 31,500 21,000

45 30 10,500

800 45 36,000 25,500

45 45 10,500

900 45 40,500 31,000

45 55 9,500

1000 45 45,000 41,000

45 75 4,000

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Numerical Example of Profit Maximization

With No CompetitorsQ P TR TC MR MC Profit

0 75 0 8,500 -8,500

100 70 7,000 11,000

70 25 -6,500

200 65 13,000 12,300

60 13 -3,300

300 60 18,000 13,300

50 10 200

400 55 22,000 14,500

40 12 3,500

500 50 25,000 16,000

30 15 6,500

600 45 27,000 18,000

20 20 9,000

700 40 28,000 21,000

10 30 7,000

800 35 28,000 25,500

0 45 2,500

900 30 27,000 31,000

-10 55 -4,000

1000

25 25,000 41,000

-20 75 -16,000