Production
The Role of the Firm
In the supply process, people offer their factors of
production, such as land, labor, and capital, to the
market
Firms transform the factors into goods and services to
consumers
• Production is the transformation of factors into
goods and services.
Ultimately, all supply comes from individuals because
they control the factors of production
The Role of the Firm
A firm is an economic institution that transforms factors
of production into goods and services
Firms: 1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services
Some firms don’t have a physical location and don’t
“produce” anything; they simply subcontract out all
production.
Many of the organizational structures of business are
being separated from the production process
Firms Maximize Profit
The goal of a firm is to maximize profits
Profit = Total revenue – Total cost
For economists, total cost is explicit payments to the
factors of production plus the opportunity cost of the
factors provided by the owners of the firm
For economists, total revenue is the amount a firm
receives for selling its product or service plus any
increase in the value of the assets owned by the firm
Firms Maximize Profit
Economists and accountants measure profit differently
Accountants focus on explicit costs and revenues
Accounting profit = explicit revenue – explicit cost
Economists focus on both explicit and implicit costs
and revenue
Economic profit = (Explicit and implicit revenue)
– (Explicit and implicit cost)
The Production Process
The production process can be divided into the long run
and the short run
Short run Long run
• A firm is constrained in • A firm chooses from all
regard to what production possible production
decisions it can make techniques
• Some inputs are fixed • All inputs are variable
The terms long run and short run do not necessarily refer
to specific periods of time, but to the flexibility the firm has
in changing its inputs
Production Tables and Production Functions
Firms combine factors of production to produce
goods and services
A production table is a table showing the output
resulting from various combinations of factors of
production or inputs
Real-world production tables are complicated
This analysis will concentrate on short run production
in which one of the factors is fixed
A Production Table
# of Total Marginal Average
workers Output Product Product
0 0 --- Average product is
4 the output per worker
1 4 4
6
2 10 5
7
3 17 5.7
6 Marginal product is the
4 23 5.8
5 additional output that will
5 28 5.6 be forthcoming from an
3
6 31 5.2 additional worker, other
1
7 32 4.6 inputs constant
0
8 32 4.0
-2
9 30 3.3
-5
10 25 2.5
Graphing a Production Function
Q
32
A production
26 function is the
TP relationship
20
between the
14
inputs and the
outputs
8
2 Number
of workers
1 2 3 4 5 6 7 8 9 10
Increasing Diminishing Diminishing
marginal marginal Absolute
productivity productivity productivity
Graphing Marginal and Average Productivity
Q
8
Eventually marginal
Marginal
Then marginal
productivity
6 productivity is
productivity
first increases
declines
negative
4
2 AP
0 Number of workers
1 2 3 4 5 6 7 8 9 10
-2
-4
MP
-6
Increasing Diminishing Diminishing
marginal marginal Absolute
productivity productivity productivity
Law of Diminishing Marginal Productivity
# of Total Marginal Average Law of diminishing
workers Output Product Product marginal productivity
0 0 --- states as more of a variable
4 input is added to an existing
1 4 4
6 fixed input, after some point
2 10 5 the additional output from
7
3 17 5.7 the additional input will fall
6
4 23 5.8
5 Increasing
5 28 5.6
3 marginal productivity
6 31 5.2
1 Diminishing
7 32 4.6
0 marginal productivity
8 32 4.0
-2
9 30 3.3 Diminishing
-5
10 25 2.5
Absolute productivity
Fixed Costs, Variable Costs, and Total Costs
Fixed costs (FC) are those that are spent and cannot be
changed in the period of time under consideration
• In the long run, there are no fixed costs since all
inputs (and therefore their costs) are variable
• In the short run, a number of inputs and their costs
will be fixed
Workers are an example of variable costs (VC) which are
costs that change as output changes
The sum of the variable and fixed costs are total costs (TC)
TC = FC + VC
Average Costs
Average fixed costs (AFC) equals fixed cost divided
by quantity produced, AFC = FC/Q
Average variable costs (AVC) equals variable cost
divided by quantity produced, AVC = VC/Q
Average total costs (ATC) equals total cost divided by
quantity produced, ATC = TC/Q or ATC = AFC + AVC
Marginal Cost
Marginal cost (MC) is the increase in total cost when
output increases by one unit, MC = ΔTC/ΔQ
Costs of Production Table
Output FC VC TC MC AFC AVC ATC
3 50 38 88 16.67 12.66 29.33
12
4 50 50 100 12.50 12.50 25.00
9 50 100 150 5.56 11.11 16.67
8
10 50 108 158 5.00 10.80 15.80
16 50 150 200 3.12 9.38 12.50
7
17 50 157 207 2.94 9.24 12.18
22 50 200 250 2.27 9.09 11.36
10
23 50 210 260 2.17 9.13 11.30
27 50 255 305 1.85 9.44 11.29
15
28 50 270 320 1.79 9.64 11.43
32 50 400 450 1.56 12.50 14.06
Graphing Total Cost Curves
Total Cost
(TC = FC + VC) TC TC and VC
450
• VC curves
increase as
400
• Q increases
L
158 •O
108 •M FC curve is
50 • FC
Q
constant
10 32
Graphing Per Unit Output Cost Curves
Cost
MC MC, ATC,
30
and AVC
curves are U-
shaped
20
ATC
AVC
10
AFC curve
AFC decreases
0
Q
10 20 30
The Shapes of Cost Curves
The variable and total cost curves are upward sloping
• Increasing output increases VC and TC
The fixed cost curve is always constant
• Increasing output doe change FC
The average fixed cost curve is downward sloping
• Increasing output decreases AFC
The marginal cost, average variable cost, and average
total cost curves are U-shaped
• Increasing output initially leads to a decrease in
MC, AVC, and ATC but eventually they increase
The Shapes of the Average Cost Curves
The U-shape of ATC and AVC curves is due to:
• When output is increased in the short run, it can
only be done by increasing the variable input
• The law of diminishing productivity causes
marginal and average productivities to fall
• As average and marginal productivities fall,
average and marginal costs rise
The marginal cost curve goes through the minimum
points of the ATC and AVC curves
The Relationship Between
Marginal Productivity and Marginal Costs
Costs
per unit
MC
AVC
If marginal productivity is rising,
marginal costs are falling
Q
Output If average productivity is falling,
per worker
average costs are rising
AP of workers
MP of workers
Q
The Relationship Between
Marginal Cost and Average Cost
If MC > ATC, then ATC is rising
If MC > AVC, then AVC is rising
If MC < ATC, then ATC is falling
If MC < AVC, then AVC is falling
If MC = AVC and MC = ATC, then AVC and ATC
are at their minimum points
The Relationship Between
Marginal Cost and Average Cost
Costs
per unit
MC The marginal cost curve
ATC goes through the
minimum point of both
AVC the ATC and AVC curves
Q
Production Decisions
Firms have more options in the long run and they can
change any input they want
Neither plant size or technology available is given
Firms look at costs of various inputs and the
technologies available for combining these inputs
They choose the combination that offers the lowest cost
Technical Efficiency and Economic Efficiency
When choosing among existing technologies in the
long run, firms are interested in the lowest cost
(economically efficient) methods of production
Technical efficiency in production means that as few
inputs as possible are used to produce a given output
The economically efficient method of production is the
method that produces a given level of output at the
lowest possible cost.
• It is the least-cost technically efficient process
The Shape of the Long-Run Cost Curve
The law of diminishing marginal productivity does
not apply in the long run
All inputs are variable in the long run
The shape of the long-run cost curve is due to the
existence of economies and diseconomies of scale
Economies of Scale
Production exhibits economies of scale when long-run
average total costs decrease as output increases
• These are shown by the downward sloping portion
of the long-run average total cost curve
An indivisible setup cost is the cost of an indivisible
input for which a certain minimum amount of production
must be undertaken before the input becomes
economically feasible to use
• The cost of a blast furnace or an oil refinery is
an example of an indivisible setup cost
• Indivisible setup costs create many real-world
economies of scale
Economies of Scale
Because of the importance of economies of scale,
business people often talk about the minimum efficient
level of production
The minimum efficient level of production is the
amount of production that spreads setup costs out
sufficiently for firms to undertake production profitably
The minimum efficient level of production is reached
once the size of the market expands to a size large
enough for firms to take advantage of all economies
of scale
Diseconomies of Scale
Production exhibits diseconomies of scale when long-
run average total costs increase as output increases
• These are shown by the upward sloping portion
of the long-run average total cost curve
Diseconomies of scale usually, but not always, start
occurring as firms get large
Diseconomies of Scale
Two reasons for diseconomies of scale are:
1. Increased monitoring costs (the costs incurred
by the organizer of production in seeing to it that
the employees do what they’re supposed to do)
2. Loss of team spirit (the feelings of friendship and
being part of a team that bring out people’s best
efforts)
Constant Returns to Scale
Firms experience constant returns to scale when long-
run average total costs do not change as output
increases
Constant returns to scale are shown by the flat portion of
the long-run average total cost curve
Constant returns to scale occur when production techniques
can be replicated again and again to increase output
• This occurs before monitoring costs rise and
team spirit is lost
The Importance of Economies
and Diseconomies of Scale
Economies and diseconomies of scale play important
roles in real-world production decisions
The long-run and short-run average cost curves have
the same U-shape, but the underlying causes of this
shape differ
Economies and diseconomies of scale account for the
shape of the long-run average cost curve
Initially increasing and eventually diminishing marginal
productivity accounts for the shape of the short-run
average cost curves
A Typical Long-Run Average Total Cost Table
TC of Labor TC of Machines
Q TC ($) ATC ($)
($) ($)
11 381 254 635 58 ATC falls
because of
12 390 260 650 54
economies of
13 402 268 670 52 scale
14 420 280 700 50
ATC is constant
15 450 300 750 50 because of
16 480 320 800 50 constant
returns to scale
17 510 340 850 50
18 549 366 915 51 ATC rises
because of
19 600 400 1000 53
diseconomies
20 666 444 1110 56 of scale
A Typical Long-Run Average Total Cost Curve
Costs
per unit
$60
Long-run
Minimum
average total
efficient cost (LRATC)
$55 level of
production
$50
Q
11 14 17 20
ATC falls because ATC is constant ATC rises because
of economies because of constant of diseconomies
of scale returns to scale of scale
The Envelope Relationship
Long-run costs are always less than or equal to short-run
costs because:
• In the long run, all inputs are flexible
• In the short run, some inputs are fixed
There is an envelope relationship between long-run and
short-run average total costs. Each short-run cost curve
touches the long-run cost curve at only one point.
In the short run all expansion must proceed by increasing
only the variable input
• This constraint increases cost
The Envelope of Short-Run Average Total
Cost Curves
Costs
per unit
LRATC
SRATC4
SRATC1
SRMC1 SRMC4 The long-run average
SRMC2
SRATC2
SRATC3
total cost curve (LRATC)
SRMC3 is an envelope of the
short-run average total
cost curves (SRATC1-4)
Q
Entrepreneurial Activity and the Supply
Decision
The difference between the expected price of a good
and the expected average total cost of producing it is
the supplier’s expected economic profit per unit
Profit underlies the dynamics of production in a market
economy
The expected price must exceed the opportunity cost
of supplying the good for a good to be supplied
Entrepreneurial Activity and the Supply
Decision
An entrepreneur is an individual who sees an
opportunity to sell an item at a price higher than the
average cost of producing it
They are the hidden element of supply that is essential
to the continued growth of an economy.
Social entrepreneurship – entrepreneurs focus on
achieving social, rather than just economic, ends; they
blend profit motives with other motives into the charters
of the corporations, making them for-benefit , not for-
profit , corporations.
Using Cost Analysis in the Real World
Some of the problems of using cost analysis in the real-
world include the following:
• Economies of scope • Uncertainty
• Learning by doing and • Asymmetries
technological change • Multiple planning and
• Many dimensions adjustment periods with
• Unmeasured costs many different short
• Joint costs runs
• Indivisible costs
Using Cost Analysis in the Real World
Economies of Scope
The cost of production of one product often depends
on what other products a firm is producing
There are economies of scope when the costs of
producing goods are interdependent so that it is less
costly for a firm to produce one good when it is already
producing another
Firms look for both economies of scope and economies
of scale
Globalization has made economies of scope even more
important to firms in their production decisions
Using Cost Analysis in the Real World
Learning by Doing and Technological Change
Production techniques available to real-world firms are
constantly changing
Learning by doing means that as we do something,
we learn what works and what doesn’t, and over time
we become more proficient at it
Technological change is an increase in the range of
production techniques that leads to more efficient ways
of producing goods and the production of new and
better goods
These changes occur over time and cannot be predicted
accurately
Using Cost Analysis in the Real World
Many Dimensions
Most decisions that firms make involve more than one
dimension, including:
• Quality
• Packaging
• Shipping
The only dimension of output in the standard model is
how much to produce
Good economic decisions take all relevant margins
into account
Using Cost Analysis in the Real World
Unmeasured Costs
Economists include opportunity costs while accountants
use explicit costs that can be measured
Economists include the owner’s opportunity cost which is
the forgone income that the owner could have earned in
another job
In measuring the costs of depreciable assets, accountants
use historical cost which is what a depreciable item costs
in terms of money actually spent for it as the cost basis
If the depreciable asset increased in value, an economist
would count its increased value as revenue
The Standard Model as a Framework
The standard model can be expanded to include
these real-world complications
Despite its limitations, the standard model provides
a good framework for cost analysis
Introductory cost analysis provides a framework for
starting to think about real-world cost measurement
Chapter Summary
Accounting profit is explicit revenue less explicit cost
Economists include implicit revenue and cost in
determining economic profit
Implicit revenue includes the increases in the value of
assets owned by the firm; implicit costs include
opportunity cost of time and capital provided by owners
of the firm
In the long run a firm can choose among all possible
production techniques; in the short run it is constrained
in its choices because at least one input is fixed
Chapter Summary
The law of diminishing marginal productivity states that as more of a
variable input is added to a fixed input, the additional output will eventually
be decreasing
TC = FC + VC
MC = ΔTC/ΔQ
AFC = FC/Q
AVC = VC/Q
ATC = AFC + AVC
MC goes through the minimum points of the AVC and ATC
If MC > ATC, then ATC is rising
If MC = ATC, then ATC is constant
If MC < ATC, then ATC is falling
