economic cost

7/29/2019 Economic Cost

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http://www.bized.co.uk

Copyright 2006 Biz/ed

The Theory of the Firm


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Production Function


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Production Function States the relationship between inputs and

outputs

Inputs the factors of production classifiedas: Land all natural resources of the earth not just

terra firma! Price paid to acquire land = Rent

Labour all physical and mental human effortinvolved in production

Price paid to labour = Wages

Capital buildings, machinery and equipmentnot used for its own sake but for the contributionit makes to production

Price paid for capital = Interest


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Production Function

Inputs Process Output

Land

Labour

Capital

Product orservice

generated

value added


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Analysis of Production Function:Short Run

In the short run at least one factor fixed in supply

but all other factors capable of being changed Reflects ways in which firms respond to changes

in output (demand)

Can increase or decrease output using more or lessof some factors but some likely to be easier

to change than others

Increase in total capacity only possiblein the long run


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In times of risingsales (demand)firms can increaselabour and capitalbut only up to acertain level they will be limitedby the amount ofspace. In thisexample, land is

the fixed factorwhich cannot bealtered in theshort run.


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If demand slows

down, the firm canreduce its variablefactors in thisexample it reducesits labour andcapital but again,land is the factorwhich stays fixed.


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If demand slows

down, the firm canreduce its variablefactors in thisexample, itreduces its labourand capital butagain, land is thefactor which staysfixed.


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Analysing the ProductionFunction: Long Run

The long run is defined as the period of time taken to vary allfactors of production

By doing this, the firm is able to increase its totalcapacity not just short term capacity

Associated with a change in the scale of production

The period of time varies according to the firmand the industry

In electricity supply, the time taken to build new capacitycould be many years; for a market stall holder, the longrun could be as little as a few weeks or months!


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Analysis of Production Function:Long Run

In the long run, the firm can change all its factors of production thusincreasing its total capacity. In this example it has doubled its capacity.


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Production Function

Mathematical representationof the relationship:

Q = f (K, L, La)

Output (Q) is dependent upon theamount of capital (K), Land (L)

and Labour (La) used


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Costs


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Costs

In buying factor inputs, the firmwill incur costs

Costs are classified as: Fixed costs costs that are not related

directly to production rent, rates,insurance costs, admin costs. They canchange but not in relation to output

Variable Costs costs directly relatedto variations in output. Raw materialsprimarily


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Costs

Total Cost -the sum of all costsincurred in production

TC = FC + VC Average Cost the cost per unitof output

AC = TC/Output

Marginal Cost the cost of one moreor one fewer units of production

MC= TCn TCn-1 units


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Costs

Short run Diminishing marginalreturns results from adding

successive quantities of variablefactors to a fixed factor

Long run Increases in capacity

can lead to increasing, decreasingor constant returns to scale


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Revenue


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Revenue Total revenue the total amount

received from selling a given output

TR = P x Q

Average Revenue the averageamount received from selling each unit

AR = TR / Q

Marginal revenue the amountreceived from selling one extra unitof output

MR = TRn TRn-1 units


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Profit


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Profit

Profit = TR TC

The reward for enterprise

Profits help in the process ofdirecting resources to alternativeuses in free markets

Relating price to costs helps a firmto assess profitability in production


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Profit Normal Profit the minimum amount

required to keep a firm in its currentline of production

Abnormal or Supernormal profit profit made over and above normalprofit Abnormal profit may exist in situations

where firms have market power

Abnormal profits may indicate the existenceof welfare losses

Could be taxed away without alteringresource allocation


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Profit

Sub-normal Profit profit belownormal profit

Firms may not exit the market even ifsub-normal profits made if they areable to cover variable costs

Cost of exit may be highSub-normal profit may be temporary

(or perceived as such!)


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Profit

Assumption that firms aim tomaximise profit

May not always hold true there are other objectives

Profit maximising output would be

where MC = MR


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ProfitWhy?

Cost/Revenue

Output

MR

MR the additionto total revenue asa result ofproducing one

more unit ofoutput the pricereceived fromselling that extraunit.

MCMC The costof producingONE extra unit

of production

100

Assume output is at100 units. The MC ofproducing the 100thunit is 20.

The MR received from

selling that 100th unitis 150. The firm canadd the difference ofthe cost and therevenue received fromthat 100th unit toprofit (130)

20

150

Totaladded

toprofit

If the firm decides toproduce one more unit the 101st the additionto total cost is now 18,the addition to total

revenue is 140 the firmwill add 128 to profit. itis worth expandingoutput.

101

18

140

Added tototalprofit

30

120

Addedto totalprofit

The process continuesfor each successiveunit produced.Provided the MC isless than the MR it

will be worthexpanding output asthe differencebetween the two isADDED to total profit

102

40

145

104103

Reducestotalprofit bythisamount

If the firm were toproduce the 104th unit,this last unit would costmore to produce than itearns in revenue (-105)this would reduce totalprofit and so would notbe worth producing.

The profit maximisingoutput is where MR =MC

economic cost

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