Production

ECON 4 - Microeconomics
Lecture Notes - Production
Introduction – Theory of the Firm

The theory of the firm seeks to understand what motivates firms to make the operating decisions that they do.
Focus on production and costs.
LEARNING OUTCOMES
1. Define the term “production” and explain what a production function is
2. Define & differentiate between marginal, average, & total product; compute & graph marginal, average, & total product
3. Differentiate between Explicit & Implicit Costs, Accounting & Economic Profit
4. Differentiate between short-run and long-run costs
5. Define and explain long-run costs
Total Revenue, Total Cost, Profit

We assume that the firm’s goal is to maximize profit.
Costs: Explicit vs. Implicit

Explicit costs require an outlay of money,
Implicit costs do not require a cash outlay,
Remember one of the Ten Principles:

This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
Explicit vs. Implicit Costs: An Example

You need $100,000 to start your business.
Case 1: borrow $100,000

explicit cost =
Case 2: use $40,000 of your savings, borrow the other $60,000
explicit cost = interest on the loan
implicit cost = foregone interest you could have earned on your $40,000.
Economic Profit vs. Accounting Profit

Accounting profit = total revenue minus
Economic profit = total revenue minus
Accounting profit ignores implicit costs,
The Production Function

A production function shows the relationship between the quantity of inputs used to produce a good and the
quantity of output of that good.
It can be represented by a
Example 1:
Farmer Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
Example 1: Farmer Jack’s Production Function

Marginal Product
If Jack hires one more worker,
The marginal product of any input is the increase in output arising from an additional unit of that input, holding
all other inputs constant.
Notation:
∆ (delta) =
Examples:
= change in output,
= change in labor
Marginal product of labor
EXAMPLE 1: Total & Marginal Product
Why MPL Is Important

Recall one of the Ten Principles:
When Farmer Jack hires an extra worker,
his costs rise by the
his output rises by
Comparing them helps Jack decide whether he would benefit from hiring the worker.
Why MPL Diminishes

Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has less land to work with and
In general, whether the fixed input is land or capital (equipment, machines,
etc.).
Diminishing marginal product:
the marginal product of an input as the quantity of the input (other things equal)
EXAMPLE 1: Farmer Jack’s Costs

Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jack’s costs are related to how much wheat he produces….
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Marginal Cost
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
EXAMPLE 1: The Marginal Cost Curve
Why MC Is Important
Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less
wheat?
To find the answer, Farmer Jack needs to
If the cost of additional wheat (MC) is less than the revenue he would get from selling it,
Fixed and Variable Costs

Fixed costs (FC) do not vary with the quantity of output produced.
For Farmer Jack, FC =
Other examples: cost of equipment,
Variable costs (VC) vary with the quantity produced.
For Farmer Jack, VC =
Other example:
Total cost (TC) =
EXAMPLE 2
Our second example is more general, applies to any type of firm producing any good with any types of inputs.
EXAMPLE 2: Costs
Q FC VC TC
0 100 0
1 100 70
2 100 120
3 100 160
4 100 210
5 100 280
6 100 380
7 100 520
EXAMPLE 2: Marginal Cost
Q TC MC
0
1
2
3
4
5
6
7
EXAMPLE 2: Average Fixed Cost
Q FC AFC
0 100
1 100
2 100
3 100
4 100
5 100
6 100
7 100
EXAMPLE 2: Average Variable Cost
Q VC AVC
0 0
1 70
2 120
3 160
4 210
5 280
6 380
7 520
EXAMPLE 2: Average Total Cost

Average total cost (ATC) equals total cost divided by the quantity of output:
ATC =
Also,
ATC =
EXAMPLE 2: The Various Cost Curves Together
EXAMPLE 2: Why ATC Is Usually U-Shaped

As Q rises: Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale:
EXAMPLE 2: ATC and MC

When MC < ATC,
When MC > ATC,
The MC curve crosses the ATC curve at the ATC curve’s
Costs in the Short Run & Long Run

Short run: Some inputs are fixed
The costs of these inputs are
Long run: All inputs are variable
(e.g., firms can build more factories,
In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q
EXAMPLE 3: LRATC with 3 factory Sizes

Firm can choose from 3 factory sizes:
Each size has its own
The firm can change to a different factory size in the long run,
To produce less than QA, firm will choose size S in the long run.
To produce between QA and QB, firm will choose size M in the long run.
To produce more than QB, firm will choose size L in the long run.
A Typical LRATC Curve

In the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this:
How ATC Changes as the Scale of Production Changes
Economies of scale occur when increasing production allows greater
workers more efficient when focusing on a narrow task.
More common when
Diseconomies of scale are due to in large organizations.
E.g., management becomes stretched,
More common when

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ECON 4 - Microeconomics

Lecture Notes - Production

Introduction – Theory of the Firm

Total Revenue, Total Cost, Profit

Costs: Explicit vs. Implicit

Implicit costs do not require a cash outlay,

Remember one of the Ten Principles:

Explicit vs. Implicit Costs: An Example

Case 1: borrow $100,000

Economic Profit vs. Accounting Profit

The Production Function

Example 1: Farmer Jack’s Production Function

EXAMPLE 1: Total & Marginal Product

Why MPL Is Important

Why MPL Diminishes

EXAMPLE 1: Farmer Jack’s Costs

EXAMPLE 1: The Marginal Cost Curve

Fixed and Variable Costs

EXAMPLE 2: Marginal Cost

EXAMPLE 2: Average Fixed Cost

EXAMPLE 2: Average Variable Cost

EXAMPLE 2: Average Total Cost

EXAMPLE 2: The Various Cost Curves Together

EXAMPLE 2: Why ATC Is Usually U-Shaped

EXAMPLE 2: ATC and MC

Costs in the Short Run & Long Run

EXAMPLE 3: LRATC with 3 factory Sizes

A Typical LRATC Curve

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