AF1605 Introduction to Economics

Topic 4: Production and Cost

Lecturer: Chau Tak Wai

School of Accounting and Finance

 Factors of Production

 Short run and long run production

 Product curves

 Cost curves

 Concept of cost and profit

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 On the supply side, the key decision-makers are the firms.
 A firm is a production unit.
 A firm has to decide the amounts of various inputs (factors of
production) to be employed.
 Types of input: Land, Labor, Capital
 A firm has to decide on the amount of output to be produced and sell
to the market.
 Whether a firm has the ability to decide the product price depends
on the type of the market structure.

 This and the next topic will introduce a basic theory on decisions of
firms. More detailed economic analysis on firm behavior are studied
in the field called industrial organization. 3
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 There can be many diverse goals or objectives for firms besides earning
money. (E.g. do good to the society, produce high-quality product,
increase market share, etc.)
 But some of these goals are just more complex ways of earning more
money (profit).
 To have a basic theory of a firm’s decision, we assume that the objective
of a firm is to maximize economic profit defined as total revenue minus
total economic cost (max π = TR – TC).
 Total revenue is the amount of money obtained from selling the output.
 A firm would determine its output level, and the amount and
combination of different inputs to produce this level of output to
maximize its profit.
 An implication: Given each target output level, a firm will choose the
amount and combination of different inputs to minimize cost of
producing this target to increase profit.
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 Factors of production are the productive resources used to produce
goods and services.

 Factors of production are grouped into four categories:

 Land
 Labor
 Capital
 Entrepreneurship

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 Land
 Land refers to the natural resources.
 Land includes minerals, water, as well as farmland and forests.

 Labor
 Labor is the work time and work effort that people devote to
producing goods and services.

 Capital
 Capital consists of tools, instruments, machines, buildings and other
items that have been produced in the past and that businesses now
use to produce goods and services.
 Not include financial capital (e.g., money, stocks and bonds) as they
are not productive resources.

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 Entrepreneurship
 Entrepreneurship is the human resource that organizes labor, land,
and capital, makes business decisions and takes the risks of the
business decisions.
 It is different from labor as entrepreneurs needs to take the risks
related to his business decisions that affects the profits of the firm.

 Production function: Q = f (input1, input2,…) shows the technological

relationship between amounts of input and level of the output.
 In the following discussions, we simplify and assume that there are
only two inputs: labor and capital.
 The production function becomes Q = f (labor, capital) = f(L, K), i.e.,
the amount of output produced depends on the amount of labor and
capital to be employed.
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 The short run is a time frame in which the quantities of some input factors are fixed.
 The input/factor that cannot be changed in a short run is known as fixed input / fixed
factor.
 The input/factor that can be adjusted in a short run in known as variable input /
variable factor.
 In the short run, a firm usually can change the quantity of labor it uses but not the
quantity of capital. Therefore, we assume capital is fixed factor and labor is variable
factor in the discussion below. (But it is not always the case!)

 The long run is a time frame in which the quantities of all input factors can be
changed.
 In the long run, all factors are variable.

 Different industries can take different length of time to become a long run.
 It can take a few years to change the plan of a real estate development, but it can take
within a month to start an online store from scratch.
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 In short run, to increase output with fixed capital (fixed factor), a
firm must increase the quantity of labor (variable factor) it uses.

 We describe the relationship between output and the quantity of

labor input by using three related concepts:

 Total product
 Marginal product
 Average product

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 Total product (TP) is
function of variable
input (L) with given
level of fixed input (K0)
giving the total quantity
of a good that can be
produced with these
amounts of inputs in a
given period of time.
 TP = f(L, K0)
 The figure on the right
shows how the total
product (TP) changes
with labor input (L),
with the same level of
capital (K0) used.

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 Marginal product (MP) is the
change in total product that
results from one unit increase in
the quantity of variable factor
employed, holding fixed the
amount of fixed factor.

 For a discrete case:

MP(L) = TP(L) – TP(L-1)

 More generally, if the change is

not one unit (also applicable to
continuous case), marginal
product of the variable factor,
here labor, can be calculated by:
MP = ∆TP / ∆L
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 Increasing marginal returns occur when a
small number of workers are employed and
arise from increased specialization and
division of labor in the production process
when we employ more labor.

 Decreasing marginal returns arise when more

and more workers use the same equipment
and workspace. As more workers are
employed, the additional worker becomes
less and less productive as each worker can
work with less capital goods.

 The law of diminishing returns (or

diminishing marginal product) states that: As
a firm uses more of a variable input, with a
given quantity of fixed input, the marginal
product of the variable input eventually
decreases.
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 Average product (AP) of labor
is the total product per worker
employed.

 APL = TP ÷ Quantity of labor

(APL = TP/L)

 Relations between MP and AP:

 When MP exceeds AP, AP is
increasing.
 When MP is less than AP, AP is
decreasing.
 When MP equals AP, AP is at
maximum.

 When MP decreases
eventually, AP also decreases
eventually in the short run.
(Why?)
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 1. When does law of diminishing returns start to kick in?

 2. Can you observe the relationship between average product and

marginal product?
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 To produce more output in the short run, a firm employs more labor,
which means the firm must increase its costs.

 We describe the relationship between output and cost using three

cost concepts:

 Total cost
 Average cost
 Marginal cost

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 A firm’s total cost (TC) is the cost of all the factors of production the
firm uses as a function of output level Q.

 Total cost has two components:

 Total fixed cost (TFC) is the cost of the fixed factor of production
used by a firm as a function of Q.
 Total variable cost (TVC) is the cost of the variable factor of
production used by a firm as a function of Q.

 Total cost is the sum of total fixed cost and total variable cost:
TC(Q) = TFC(Q) + TVC(Q).

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 There are three average cost functions concepts:
 Average fixed cost (AFC(Q)) is total fixed cost per unit of output.
 Average variable cost (AVC(Q)) is total variable cost per unit of output.
 Average total cost (ATC(Q)) is total cost per unit of output.

 TC(Q) = TFC(Q) + TVC(Q)

 TC(Q)/Q = TFC(Q)/Q + TVC(Q)/Q
 ATC(Q) = AFC(Q) + AVC(Q)

 Marginal cost (MC(Q)) is the additional cost incurred for one additional
unit of output.
For a discrete 1-unit change in output: MC(Q) = TC(Q) – TC(Q-1)
 More generally, MC(Q) = ∆TC(Q) / ∆Q

 Question: Is this MC(Q) referred to MFC(Q) or MVC(Q)?

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Note: “Total” can mean
(1) the sum of fixed and variable costs.
(2) ”Total” rather than ”average” and ”marginal”.
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Complete the following table by filling in the empty spaces:

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 Which of the following increase the marginal cost at all quantity levels?

 A. An increase in fixed cost by $10.

 B. An increase in total cost by $10 at all quantity levels.

 C. An increase in average total cost by $10 at all quantity levels.

 D. A decrease in average variable cost by $10 at all quantity levels.

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 Average fixed cost (AFC)
decreases as output increases.
(AFC = TFC/Q)
 The average variable cost curve
(AVC), the average total cost
curve (ATC) and the marginal
cost (MC) curve are generally U-
shaped. This is due to the law of
diminishing returns.
(But notice that if specific situation is
given in a question, follow the
information given but not this general
description.)
 Diminishing returns implies MP
eventually decreases. Thus, MC
eventually rises. 25
 Δ𝑇𝐶
(Q) 𝑀𝐶 =
Δ𝑄

 If the wage of workers per day is $500, and the fixed cost is $5000,
calculate the corresponding marginal cost between each level of output.
 Is MC increasing when MP is decreasing?

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 Recall the following relations:
 When MC is less than AVC, AVC is
decreasing.
 When MC is larger than AVC, AVC is
increasing.
 When MC equals AVC, AVC is at
minimum.
 The same applies to the relationship
between MC and ATC.
 The marginal cost curve (MC) is U-
shaped and intersects the average
variable cost (AVC) curve and the
average total cost (ATC) curve at
their respective minimum points.
 The increasing MC will eventually
drive up the AVC and ATC.
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 In the long run, the firm can change all inputs, including the originally fixed
factors such as capital (or plant size) in the short run.
 A short run ATC corresponds to a particular level of capital (fixed) input.
 When a firm uses the smallest plant, its ATC curve is ATC1.
 With successively larger plants, the firm’s ATC curves are ATC2, ATC3, and ATC4.
 In the long run, a firm would choose the capital level (plant size) (level of fixed
input in the short run) that minimizes the total or average cost given the
target long run output level to maximize profit.

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 At each output level, the long-run average cost (LRAC) is the lowest possible
average cost across all possible fixed input levels, when the firm can adjust all
inputs to minimize the cost and maximize the profit.

Note: only four

discrete capital
levels are possible
in this case.

 The LRAC curve traces, for each target level of output, the lowest attainable
average total cost among all possible short-run average cost curves for different
level of fixed inputs.
 Thus, the LRAC is the lower envelop of all possible short-run average cost
curves (SRACs).
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Example: How to find the long-run AC from three different scales of production?

Short-run AC Short-run AC of Long-run AC

Output, Q Short-run AC of
of small plant medium plant ($)
(units) large plant ($)
($) ($)
10,000 13 18 22
20,000 10 15 18
30,000 9 13 15
40,000 12 11 13
50,000 16 13 12
60,000 20 17 13
70,000 25 21 15

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Example: How to find the long-run AC from three different scales of production?
(Note: it is a discrete case.)

Short-run AC Short-run AC of
Output, Q Short-run AC of Long-run AC
of small plant medium plant
(units) large plant ($) ($)
($) ($)
10,000 13 18 22 13
20,000 10 15 18 10
30,000 9 13 15 9
40,000 12 11 13 11
50,000 16 13 12 12
60,000 20 17 13 13
70,000 25 21 15 15

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 There are economies of scale when the long-run average cost (LRAC)
decreases as output (scale) increases.

 The main sources of increasing returns to scale are as follows:

 Technical economies resulting from the indivisibility of capital like
specialized machinery whose full capacity can be utilized only when
output is large enough.
Another possibility is related to the fact that materials required to make a
container (cost) can grow slower than the volume (output) it can contain.
 Managerial economies resulting from better specialization of labor, the
indivisibility of specialized managers and experts such as accountants,
marketing managers, whose full contribution can only be realized for a
large enough output.
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 Marketing economies resulting from more favorable terms of transaction,
such as lower purchase prices of raw materials and higher sales prices of
finished products with a larger level of output.

 Financial economies resulting from better access to financial resources

on more favorable terms (such as the ability to raise funds by issuing
shares in the stock market, issuing bonds in the capital market, and
borrow from banks at lower interest rates) when the scale of the firm is
large enough.

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 When there are constant returns to (economies of) scale, the long-run
average cost (LRAC) remains constant as output increases.
 Constant returns to scale occur when a firm is able to replicate its existing
production capacity to increase output.

 There are diseconomies of scale when the long-run average cost (LRAC)
increases as output (scale) increases.
 Decreasing returns to scale arise from the difficulty of coordinating and
controlling the enterprise when it becomes too large.
 e.g. harder to monitor employees so that they make less efforts in their
work; becoming more bureaucratic to maintain fairness among
employees, yet diverting efforts and resources.
 It may also be due to an increasing cost in expanding to markets further
away from its production base.
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 Which of the following is NOT true about law of diminishing returns and
diseconomies of scale?

 A. Law of diminishing returns applies to the case with fixed input.

 B. Diseconomies of scale applies to the case when all inputs can change
with output level.
 C. Law of diminishing returns implies the long run marginal cost curve
will eventually becomes upward sloping.
 D. Diseconomies of scale implies the long run average cost curve will be
rising with output.

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 In economics, cost refers to opportunity cost which is defined as the value of
the best alternative forgone.
 A firm’s production cost has two components: Explicit Cost and Implicit Cost.
 Explicit cost: The actual monetary payments a firm makes to its factors of
production and other suppliers.
 Implicit cost: Include (1) the net direct benefit from the best alternative use of
the the firm owners’ resources and (2) economic depreciation.
 (1) includes the forgone salary the firm owners can earn from the use of their
labor effort; forgone interest from using the funds of the firm owners; forgone
rental income from using firm owners’ property.
 Note that (1) also includes the “normal profit”: the return to
entrepreneurship, measured by the extra return after deducting the usual
costs above if one uses such efforts to run another business. (Note: some
scholars uses a different definition.)
 Economic depreciation is the change in the market value of the capital good
over a given period of time with the associated amount of output produced.
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 Economic cost
 Takes into account all opportunity costs that include all the implicit
costs and explicit costs relevant to the activity under consideration.
 Accounting cost
 Accounting cost equals explicit costs plus accounting depreciation.
 It does NOT include some implicit costs such as forgone income from
firm owners’ labor efforts, funds, property and extra return of
alternative business, etc.
 Depreciation method can be different from economic depreciation.

 Accounting depreciation vs Economic Depreciation

 Economic depreciation: opportunity cost of using the capital that the
firm owns. Measured as the decrease in the market value of the
capital good during the period with the associated production.
 Accounting depreciation: A fixed rule that divides the expenditure of
the capital goods into periods over its lifespan. (e.g. equal division)
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 Profit = Total revenue – Total cost

 Accounting profit = Total revenue – Accounting cost

= Total revenue – Explicit cost – Accounting
depreciation

 Economic profit = Total revenue – Economic cost

= Total revenue – Explicit cost – All implicit cost
= Total revenue – Explicit cost – Economic depreciation
–net direct benefit from the best alternative use given
up of resources supplied by owner

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 (including economic
depreciation)

Opportunity cost of the owner’s

entrepreneurship (best alternative business) Opportunity cost of capital used and owned by the firm

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 Cost of capital goods includes depreciation, interest for the fund
used to buy the capital and regular maintenance cost but it does
NOT include the initial purchase expenditure of the capital goods.
 Depreciation refers to the value of the capital goods that is actually
used up in the production process in the specific period of time
with the associated level of production.
 Before the capital good is used for production, its value is
maintained. It is an asset that can be sold for money.
 The firm only gives up the value of the capital good when it is
actually used in production that reduces its value. This is measured
by economic depreciation.
 The initial purchase of the capital good is just to convert money in
the bank account to an asset the firm owns.
 Thus, we do not count the initial purchase expenditure of capital as
the cost of capital. Otherwise, that is double-counting. 41
 Example: If a machine can be used for 2 years. Initial price is
$10,000. After a year of production, its value falls to $5,000 and
after 2 years of production, its value is 0. Then, the depreciation of
the first year and second year are both $5,000.
 Here we should only take into account $5,000 for the first year.
 Capital goods are usually purchased by the firms before their use on
actual production, and the firm has to pay its purchase expenditure
much earlier than the time it is used for production, involving an
early use of fund. The firm has to pay the opportunity cost for using
the fund earlier (i.e. interest). The related interest is part of the
cost.
 Whether the interest cost is explicit or implicit depends on whether
the firm borrows money from others or uses owner’s money.
 If there are also explicit costs of maintenance during the period of
production, it should also be counted towards the cost of the capital
good. 42
 Which of the following is NOT part of the cost of using the mask
producing machine, which can be used for five years, in its first year of
production for a mask production firm?

 A. The machine is bought with $100,000.

 B. The firm needs to fund the purchase of this machine by its own fund,
giving up $5,000 of interest.

 C. Its value decreases by 1/5 (i.e. $20,000) after a year of production.

 D. The regular maintenance cost of the machine is $10,000 a year.

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 Accounting Economic
Total revenue $1,230,000 $1,230,000
Explicit cost:
Rent $240,000 $240,000
Material $280,000 $280,000
Labor cost $360,000 $360,000
Implicit cost:
Accounting depreciation $40,000
Economic depreciation $40,000
David’s foregone income $300,000
David’s foregone interest income ($200,000 × 5%) $10,000
Profit $310,000 $0

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 Even though the owner can earn an accounting profit of $310,000, one
can only earn an economic profit of $0, since some of the implicit costs
are failed to be taken into account in the accounting cost, and thus
giving rise to a higher accounting profit.

 The owner should stay if the economic profit is positive.

 The owner should quit (in the long run) if the economic profit is
negative.

 The owner is indifferent between staying and quitting as profit is zero.

(Usually, assume the business will stay.)

 Note: zero profit means the firm owner can earn the same amount of
money as the best alternative.
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 Factors of production

 Short run and long run production

 Product curves

 Cost curves

 Concept of cost and profit

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