The Firm:

Production Function
Cost Function

BASIC PRODUCTION
CONCEPTS
The Firm
Firm
An organization that brings together factors of
productionlabor, land, physical capital, human
capital, and entrepreneurial skillto produce a
product or service that it hopes can be sold at a
profit
The Firm
Profit and costs
Accounting profits = total revenues - explicit costs
Explicit Costs
Costs that business managers must take account of
because they must be paid
The Firm
The goal of the firm: profit maximization
Firms are expected to try to make the positive
difference between total revenues and total
costs as large as they can.
The Relationship
Between Output and Inputs
Production Function
The relationship between inputs and output
A technological, not an economic, relationship
The relationship between inputs and maximum
physical output
The Relationship
Between Output and Inputs
Production
Any activity that results in the conversion of
resources into products that can be used in
consumption
PRODUCTION
INPUTS
PRODUCTION
PROCESS
PRODUCTION
OUTPUT
Land
Labor
Capital
Raw Materials
Entrepreneur

Manufacturing
Assembly
Processing
Service
Finished Products
Semi-processed products
Services

The Relationship
Between Output and Inputs
*Q = output/time period
K = capital
L = labor
Q = (K,L)*
or
Output/time period = some function of capital and labor inputs
Two types of Production Inputs
Fixed Input
Variable Input
Point of comparison Fixed Input Variable Input
Necessity in Production Supplementary; even in
their absence some
amount of production can
be carried out
Without these factors no
production can be carried
out
Examples Plant, machinery, manager,
land, factory premises
Labor, raw materials,
transport, frieght
THE LAW OF DIMINISHING RETURNS

When one of the factors of production is held
fixed in supply, successive additions of other
factors will lead to an increase in returns up to
a point, but beyond this point returns will
diminish
The Law of Diminishing Returns
NUMBER OF
WORKERS
TOTAL PHYSICAL
PRODUCT (TPP)
MARGINAL
PHYSICAL
PRODUCT (MPP)
AVERAGE PHYSICAL
PRODUCT (APP)
1 10 10 10
2 30 30-10=20 15
3 90 90-30=60 30
4 120 120-90=30 30
5 130 130-120=10 26
6 120 120-130=-10 20
The Relationship
Between Output and Inputs
Marginal Physical Product
The physical output that is due to the addition of
one more unit of a variable factor of production
The change in total product occurring when a
variable input is increased and all other inputs are
held constant
Also called marginal product or marginal return
Diminishing Returns, the Production Function,
and Marginal Product
Diminishing Returns, the Production Function,
and Marginal Product: A Hypothetical Case
Figure 22-2, Panel (b)
Figure 22-2, Panel (c)
Diminishing Returns, the Production Function,
and Marginal Product
COST & PROFIT CONCEPT


Types of Cost
Variable Cost : are expenses
incurred in production that
tend to change directly as
production increases
Fixed Cost : are expenses
that do not change or vary
with production
TC = TFC + TVC
TVC = (VC/u) (u)

Revenue : sales generated by an
enterprise
TR = (Sp/u) (u)
Profits : difference between the total
revenue and total cost
TP = TR- TC
TR= TC (Break Even)
TR> TC (Profit)
TC>TR (Losses)
Cost of Production: An Example
Figure 22-2, Panel (a)

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2
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2 4 6 8 10 0 1 3 5 7 9 11
16
Output (calculators per day)
10
14
ATC
AVC
AFC
Cost of Production: An Example
AFC
AVC

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Output (calculators per day)
ATC
Cost of Production: An Example
TP
ATC = AVC + AFC
AFC = ATC - AVC
AVC
Short-Run Costs to the Firm
Marginal Cost
The change in total costs due to a one-unit
change in production rate
Marginal costs (MC) =
change in total cost
change in output
Total
Total Variable Total Marginal
Output Costs Costs Cost
(Q/day) (TVC) (TC) (MC)
0 0
1 5
2 8
3 10
4 11
5 13
6 16
7 20
8 25
9 31
10 38
11 46
10
15
18
20
21
23
26
30
35
41
48
56
5
3
2
1
2
3
4
5
6
7
8

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2 4 6 8 10 0 1 3 5 7 9 11
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Output (calculators per day)
10
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MC
Cost of Production: An Example
Cost of Production: An Example
11 10
AFC
AVC
MC
ATC
9 8 7 6 5 4 3 2 1 0
2
4
6
8
Panel (c)
16
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12
10
Output (recordable DVDs per day)
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Short-Run Costs to the Firm
Answer
As long as marginal physical product rises,
marginal cost will fall, and when marginal
physical product starts to fall (after reaching
the point of diminishing marginal returns),
marginal cost will begin to rise.
The Relationship Between Diminishing Marginal
Returns and Cost Curves
Labor cost assumed constant
MC =
DTC
DOutput
Recall: labor is the variable input
MC =
W
MPP
The Relationship Between Diminishing Marginal
Returns and Cost Curves
Figure 22-3, Panels (b) and (c)
The Relationship Between
Physical Output and Costs
The Relationship Between
Physical Output and Costs
Figure 22-3, Panels (c) and (d)
The Relationship Between Diminishing Marginal
Returns and Cost Curves
Firms short-run cost curves are a reflection of
the law of diminishing marginal returns.
Given any constant price of the variable input,
marginal costs decline as long as the marginal
product of the variable resource is rising.
The Relationship Between Diminishing Marginal
Returns and Cost Curves
At the point at which diminishing marginal
returns begin, marginal costs begin to rise as
the marginal product of the variable input
begins to decline.
The Relationship Between Diminishing Marginal
Returns and Cost Curves
AVC =
TVC
output
AVC =
W
AP
Preferable Plant Size
and the Long-Run Average Cost Curve
Figure 22-4, Panels (a) and (b)
Panel (b)
Output per Time Period
Q
2
Q
1
C
3
C
1
C
4
C
2
Panel (a)
Output per Time Period
SAC
2
1
SAC
SAC
3
LAC
1
SAC
2
SAC
3
SAC
4
SAC
5
SAC
6
SAC
SAC
7
SAC
8
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Long-Run Cost Curves
Long-Run Average Cost Curve
The locus of points representing the minimum
unit cost of producing any given rate of output,
given current technology and resource prices
Long-Run Cost Curves
Planning Curve
The long-run average cost curve
Long-Run Cost Curves
Observation
Only at minimum long-run average cost curve is
short-run average cost curve tangent to long-run
average cost curve
What do you think?
Why is the long-run average cost curve U-shaped?
Why the Long-Run Average Cost Curve is U-
Shaped
Economies of Scale
Decreases in long-run average costs resulting from
increases in output
Why the Long-Run Average Cost Curve is U-
Shaped
Reasons for economies of scale
Specialization
Dimensional factor
Improved productive equipment
Why the Long-Run Average Cost Curve is U-
Shaped
Explaining diseconomies of scale
Limits to the efficient functioning of management
Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-5, Panel (a)
LAC
Panel (a)
Output per Time Period
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Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-5, Panel (b)
LAC
Panel (b)
Output per Time Period
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Economies of Scale, Constant Returns to Scale,
and Diseconomies of Scale Shown with the
Long-Run Average Cost Curve
Figure 22-5, Panel (c)
LAC
Panel (c)
Output per Time Period
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Minimum Efficient Scale
Minimum Efficient Scale (MES)
The lowest rate of output per unit time at which
long-run average costs for a particular firm are at
a minimum
Minimum Efficient Scale
Small MES relative to industry demand:
High degree of competition
Large MES relative to industry demand:
Small degree of competition
Minimum Efficient Scale
Figure 22-6
0
Output per Time Period
LAC
B
1,000
A
10
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TR = TC
TR =100; TC= 100; TR=TC
TR=100; TC =50, P/L= TR-TC= 100-50= 50Profit
TR=100; TC=200, P/L =TR-TC = 100-200= (100)
Breakeven?
P200price shirt; P200,000(machine)); (80/hr labor)
TR= TC
(sp/u) (u)= TFC+TVC
200(x) = 200,000 + 80(x)
200x-80x = 200,000
120x = 200,000
X= 200,000/120
1,667 pairs will have to be sold to break even
< = profit; >=loss

200x= 200,000 + 80 x; 2,000 (P/L) Profit= how
much profit
200(2,000) = 200,000 + 80 (2,000)
400,000 = 200,000 + 160,000
TR= 400,000
TC =360,000
P/L = 400,000-360,000
P= 40,000
The Firm: Cost and Output
Determination
End
Common Law in Business
IT IS UNWISE TO PAY MUCH, BUT IT IS
WORST TO PAY TOO LITTLE
When you pay too little you sometimes loose everything
because the thing you bought was incapable of doing the
thing it was bought to do; the common law of business
balances prohibits paying too little and getting a lot; it cant
be done
If you deal with the lowest bidder it is well to add
something for the risk you run, and if you do that you will
have enough to pay for something better. There is hardly
anything in the world that one man can make a little worst
and sell a little cheaper and people who do consider price
alone are this mans lawful prey