1. Part 5 The Theory of Production and Cost
Production normally organized in Firms
A Firm hires inputs, organizes production, and sells goods or services
A firm is a governance structure that can range from simple to highly complex (sole owner to large multi-nation corporation)
Firms allocate resources and coordinate economic activities internally using commands and incentive systems

2. Why Firms?
Why is all economic activity not coordinated through markets?
Firms exist because they offer cost advantages over market transactions
- Transactions costs
- Monitoring
- Economies of scale or scope
- Economies of team production

3. Why Markets?
Why is all economic activity not coordinated through organized firms (or just one giant firm)?
Principal-agent and incentive problems
Problems of information and management provide limits to firm size

4. The Firm’s Goals
The goal of the owners of the firm is to maximize the return on their capital investment—to maximize profit
Profit is revenue less cost-- defined as opportunity cost
Explicit and implicit costs
Normal profit and economic profit

5. The Firm’s Constraints
Available technology
Prices of inputs
Fixed capital in the short run
Degree of competition in the output market
Given these constraints the firm needs to choose the method of production and output level that will maximize profit
Maximizing profit implies minimizing the cost of production

6. Output and Cost: Short Run
In the short run the firm has a plant of given size
The firm can add or subtract labour and other inputs to vary output, but cannot alter the size of the plant
The fixed plant size affects how output will change with changes in the inputs that can be varied

7. The Short Run Production Function
Total product curve
Output TP
Inflection point
TP increasing at a
decreasing rate L’
Labour
TP= Total output as labour (and other variable
inputs) are added to a plant of fixed size

8. Short Run Production Functions
Other possible shapes
Output TP
Labour
Output TP
Labour

9. Average and Marginal Product CurvesTP TP
AP max &
AP = MP
MP max L
Point of diminishing
marginal returns AP MP
Point of diminishing
average returns AP MP L L’ L”

10. Diminishing Returns
When there is a fixed factor must eventually run into diminishing marginal returns
The constraint of the fixed factor eventually makes it more and more difficult (costly) to obtain additional output from the plant of fixed size
Law of Diminishing Returns
Is our world a world of diminishing returns?

11. Short Run Cost
Our production function showed output as a function of the quantity of variable input (labour) with a given quantity of a fixed input (capital).
We need to convert this into a cost function showing cost as a function of output
To do this we assume that the prices of inputs are given

12. Short Run Total Costs
Total cost is total variable cost plus total fixed cost
The total variable cost of a given level of output is the quantity of labour it takes to produce that output (with the fixed level of capital) times the price of labour
The total fixed cost is the quantity of the fixed input times the price of that input
Total fixed cost does not vary with output

13. TP and TVC Q TP Q’ L L’ $
TVC
= L x Wage
TVC’
(L’ x W) Q Q’

14. Total Cost Curves TC $ TVC TFC Q
Diminishing returns due to the fixed factor
Means that TVC and TC must eventually
Rise at an increasing rate

15. Marginal and Average Costs
Average total cost is total cost divided by output
Average variable cost is total variable cost divided by output
Average fixed cost is total fixed cost divided by output
ATC = AVC + AFC
Marginal cost is the additional cost of an additional unit of output
MC = ΔTC/ΔQ

16. Marginal and Average Cost Curves$
Min ATC MC
ATC
AVC
Min AVC
AFC Q
ATC = AVC + AFC

17. Marginal and Average Product and Cost Curves
As a firm expands output along its production function the output at which average product is at its greatest will be where AVC is at a minimum
The output level at which MP is at a maximum will the output level where MC is at a minimum
As MP and AP eventually decline due to diminishing returns, so MC and AVC will eventually rise.

18. Shifts in Cost Curves New Technology Costs of inputs
Fixed inputs
Variable inputs
Scale of plant (long run)

19. Long Run Cost Changes to the scale of the plant
Each plant size has a TC curve
Larger plant increases fixed cost but delays onset of diminishing returns
Each plant size has a short run ATC curve
Long run average cost curve is the lower boundary of all short run ATC curves
Long run and the least possible cost of production

20. Long Run Cost $
TC1
TC2 Q1 Q

21. Long Run Cost $
ATC1
ATC2
LAC Q Q1
Constant returns to scale

22. Long Run Average Cost Generalized case: increasing followed by
decreasing returns to scale $
ATC3
ATC1
ATC5
ATC2
ATC4
LRATC Q* Q Q’
Least cost plant size to produce Q’ is ATC2
Q* is the lowest possible average cost, but
whether this is the firm’s profit maximizing
output will depend on market structure.

23. Economies of Scale
Economies of scale due to specialization of labour and capital
Diseconomies of scale due to problems of information and management
Constant returns to scale
Minimum efficient scale