CHAPTER 9: BACKGROUND TO SUPPLY: PRODUCTION AND COST

In Chapter 4, we learned about the law of supply. In this Chapter we look at the theory behind the supply
curve (the theory of the firm) and examine the firm’s decision on how many units of a good to supply at
each price…

In Chapter 7, we covered the theory of DEMAND and we have established that the aim of consumption
is to MAXIMISE UTILITY.

The aim of firms (SUPPLY) is to MAXIMISE PROFIT.

PROFIT = Total Revenue (TR) – Total Cost (TC)

REVENUE COST (short run) (see section 9.4)

Total Total Revenue (TR) = Price x Quantity (Q) Total cost (TC) = Total fixed cost (TFC) +
(Quantity = total production (TP)) Total variable cost (TVC)
TC = AC x Q

Average Average Revenue (AR) = TR / Q Average cost (AC) = TC / Q and

AC = Average fixed cost + Average variable
cost (AVC)

Marginal Marginal Revenue (MR) = ∆TR / ∆Q Marginal cost (MC) = ∆TR / ∆Q

PROFIT MAXIMISATION is where Marginal Revenue (MR) = Marginal Cost (MC)

This means that a firm maximises profit where the additional revenue that an additional unit of output
earn (MR) is equal to the additional cost that an additional unit of output cost (MC).

Chapter 9, 10 and 11 will cover the theory of SUPPLY and REVENUE, PRODUCTION and COST applies to all three
these Chapters.

9.1 INTRODUCTION

TYPES OF FIRMS

FORMAL:

Firms that are formally registered: Pick ‘n Pay or Audi

INFORMAL:

Firms that are not formally registered: hawking, street vending

PRODUCTION happens at a certain cost. We look at production over the SHORT run (SR) and the LONG run (LR).

*SR: At least one of the inputs is fixed

*LR: All inputs are variable

LECTURER NOTES | ECON 112 CHAPTER 9

SR and LR difference is not calendar time!
9.1 BASIC COST AND PROFIT CONCEPTS

GOAL of the firm is to MAXIMIZE profit

How? Maximise the positive difference between Total Revenue (TR) & Total Cost (TC)

Accounting cost = explicit cost / actual expenses / monetary payments

Economic cost = explicit cost + implicit cost (non-monetary cost_

Example (see BOX 9-5)

A teacher, who earns R300 000 per year decides to start his own furniture business.

He uses R150 000 savings to buy equipment, supplies and machinery for his business.

• Explicit cost = actual payments (flow of money) for equipment, machinery, supplies and others

• Implicit cost = foregone / sacrificed income that he gave up = foregone salary PLUS foregone interest on
savings (opportunity cost).

Accounting profit = Total Revenue (TR) MINUS explicit cost

Economic profit / loss = Total Revenue (TR) MINUS (explicit cost + implicit cost)

➢ Abnormal profit / Economic profit (+) when TR > (explicit cost + implicit cost)

➢ Normal profit = 0 when TR = explicit cost + implicit cost [the monetary payments that the firm’s
resources could have earned in their best alternative uses, forms part of the firm’s cost of production]

➢ Economic loss (-) when TR < (explicit cost + implicit cost)

9.2 PRODUCTION IN THE SHORT RUN

Supply = production

INPUTS are used to produce OUTPUT (total production (TP) or quantity (Q)) at COST

Short term = when at least one INPUT is fixed (e.g. land) combined with variable inputs (e.g. labour)

Long term = when all INPUTS are variable.

SR-ASSUMPTIONS

1. _________________________________

2. _________________________________

3. _________________________________

4. _________________________________
5. _________________________________

6. _________________________________
In the short run, a firm can expand output only by increasing the quantity of its variable input

LECTURER NOTES | ECON 112 CHAPTER 9

Consider the production schedule of a maize farmer with one variable input in TABLE 9-1 & 9-2 (complete
the table):

LAND LABOUR TP MP AP

Fixed Variable TP = ΣMP MP =TP ÷N AP = TP/N

3rd Max. 1st Max. 2nd Max.
N
20 0 0 - -
20 1 0+16= 16 (16-0)/1= 16 16÷1= 16
20 2 16+28= 44 44-16= 28 44÷2= 22
20 3 44+34= 78 78-44= 34 16÷3= 26
20 4 16+28+34+35= 113 113-78= 35 16÷4= 28.25
20 5 29
20 6 26
20 7 19
20 8 200
20 9 0
20 10 18.70

Note the following:

- N is number of labour - therefore variable input

- Total Product (TP) is the sum of all the Marginal Products (MP)
- MP = Change in TP / Change in N
- Average Product (AP) = TP/N

Circle the MAX amount per columns (TP, MP and AP) …Which column reached max first? Second?
And third?

LAW OF DIMINISHING RETURNS:

As more of a variable input is combined with one or more fixed inputs in a production process,
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________

Now see FIG 9.2

LECTURER NOTES | ECON 112 CHAPTER 9

 TP increase while MP>0
TP max then MP = 0
MP max before AP max
MP cuts AP in max point
TP decrease when MP <0
AP increases while MP> AP
AP decreases while MP<AP

Watch the following video on PRODUCTION (INPUT and OUTPUT):

https://www.youtube.com/watch?v=xLSRMt-wWAM

Make sure you understand and know the LAW OF DIMINISHING MARGINAL RETURNS and that you can
draw the TP, MP, AP curves.

9.3 COST IN THE SHORT RUN

COST of INPUTS to produce OUTPUT (TP = Q)

Short term = when at least one INPUT is fixed, meaning that there are FIXED COST (for fixed inputs e.g. land)
and VARIABLE COST (for variable inputs e.g. labour (N units of labour)).
Total cost = Total fixed cost (TFC) + Total variable cost (TVC)

The following formulas is very import to know!

Koste Inkome Produksie

Cost Revenue Production

Totale TC = AC x Q
TR = P x Q TP = AP x N
(Total) TC = TVC + TFC
Gemiddeld AC = TC ÷ Q AR = TR ÷ Q
AP = TP ÷ N
(Average) AC = AVC + AFC AR = P.Q ÷ Q
Grens
MC = ΔTC ÷ ΔQ MR = ΔTR ÷ ΔQ MP = ΔTP ÷ ΔN
(Marginal)

LECTURER NOTES | ECON 112 CHAPTER 9

Table 9.3 total fixed and variable cost schedules of a maize farmer (complete the table):

Land Labour TP TFC TVC TC

N Q … produced = TC - TVC = TC - TFC = TFC + TVC

20 0 0 9 000 0 9 000
20 1 16 2 400 11 400
20 2 44 4 800
20 3 78 7 200
20 4 113 18 600
20 5 145 21 000
20 6 171 14 400 23 400
20 7 190 16 800
20 8 200 19 200
20 9 200 30 600
20 10 187 33 000

TIPS:

1. Find each column’s friend ☺

- E.g.: TFC (total fixed cost)….find its friends…
o TVC and TC – all the friends are pink in the table below…

What is the relationship between TC, TVC and TC?

TC= TVC +TFC (use this to complete the table below)

2. The relationship between every column that starts with a Total (T) …… and Average (A)
o To go from Total (T) …… to Average (A) …. DIVIDE by Q…do this for all columns
starting with a T
o To go from Average (A)…. to Total (T)…… MULTIPLY by Q…do this for all
columns starting with an A
3. The relationship between every column that starts with a Total (T) …… and Marginal (M)
o To go from Total (T) …… to Marginal (M) …. Change in T/change in Q…. do this for
all columns starting with a T and M

LECTURER NOTES | ECON 112 CHAPTER 9

 TABLE 9-3/9-4 (Complete the table before looking at the answers in the textbook)

N TP TFC AFC TVC AVC TC AC MC

(Q)

20 0 0 - 0 - - -

20 1 16 2 400

20 2 44 4 800

20 3 78 92.31

20 4 113 84.96 68.57

20 5 145 82.76

20 6 171 14 400

20 7 190 135.79

20 8 200 45.00 19 200

20 9 200 30 600

20 10 187 176.47

Circle the minimum values of the AVC, AC and MC.

MC reaches a minimum first, then AVC and then AC.

LECTURER NOTES | ECON 112 CHAPTER 9

Drawing the cost curves:

• AFC is L-shaped (see video above)

• AVC, MC and AC is U-shaped
• MC (Nike sign shape) cuts AVC and AC
in its minimum points
• AC is always above AVC and AFC
because AC = AFC + AVC

Relationship between cost and production curves (see FIGURE 9-6):

The maximum of MP (at N 1) corresponds to

the minimum of MC (at Q1). Similarly, the
maximum of AP (at N 2) corresponds to the
minimum of AVC (at Q2).
• Where marginal product (MP) rises,
marginal cost (MC) falls.
• Where MP falls, MC rises.
• Where MP is at a maximum, MC is at
a minimum.
• Where average product (AP) rises,
average variable cost (AVC) falls.
• Where AP falls, AVC rises.
• Where AP is at a maximum, AVC is at
a minimum.

LECTURER NOTES | ECON 112 CHAPTER 9

For further explanation, watch the following videos on short term COST
Short term costs (Part 1)
https://www.youtube.com/watch?v=ucJBO9UTmwo
Short term cost (Part 2)
https://www.youtube.com/watch?v=qYKJdooEnwU
Short term cost curves (Part 3)
https://www.youtube.com/watch?v=C3m9FC3T3vw

9.4 PRODUCTION IN THE LONG RUN:

NB: In the Long Run (LR), all inputs are variable

NO “law of diminishing returns” applies. WHY?...because the is NO fixed inputs – remember

the law of diminishing returns states that if fixed inputs are combined with variable inputs
and there are NO fixed inputs in the long run.

Long run key assumptions

1. ______________________________________________________________________

2. ______________________________________________________________________

3. ______________________________________________________________________

In the long run, there are three important concepts:

1. Returns to scale
2. Economies of scale
3. Economies of scope

1. Returns to scale (RTS): Compares % in output to % in input

Think about if your production of mugs goes up from 80 to a 100 (25% increase in output) …. what
was the % change in input?

a. Constant RTS:
% output = % input
b. Increasing RTS:
% output > % input
c. Decreasing RTS:
% output < % input

2. Economies/ diseconomies of scale: considers cost per unit

a. Economies of scale:
- Cost per unit produced decreases as production (Q) increases
- Gets cheaper per unit the more you produce
- Normally a high fixed cost (high start-up cost)

b. Constant cost:
- Cost per unit stays constant as production (Q) increases.

c. Diseconomies of scale:
- Cost per unit produced increases as production (Q) increases.

LECTURER NOTES | ECON 112 CHAPTER 9

Economies of scale is represented in the long run average cost curve (LRAC).

FIGURE 9-8 A typical long-run average cost curve

As long as economies of scale are experienced, average costs fall. This is followed by a range of output
over which average costs remain constant. At some level of output diseconomies of scale may set in
resulting in an increase in average costs.

Watch the following additional video that explains economies of scale and the Long Run Average Cost
(LRAC) curve:
https://www.youtube.com/watch?v=JdCgu1sOPDo

3. Economies of scope: Related production

- Cost saving if one firm produces related products.

- Use same capital-intensive inputs for production of both products

Long run marginal cost curve (LRMC)

FIGURE 9-9 The relationship between long-run average and marginal costs (see textbook page 160)

See summary Table 9-6

END

LECTURER NOTES | ECON 112 CHAPTER 9

Exercise
Try to complete the following table on your own:

TIPS:

- Try to find/ calculate total fixed cost first (this is the same for all quantities Q)

- Then, start from the first line and complete the table using the formula for each column

ANSWER will be available on eFundi after class

LECTURER NOTES | ECON 112 CHAPTER 9