1.

5 Theory of the Firm 1: Production, Costs,

Revenues and Profits

 Learning Outcomes:
 1.5 Theory of the Firm 1: Production, Costs,
Revenues and Profits

 Learning Outcomes:
 1.5 Theory of the firm: Production, Costs,
Revenues and Profits
Firms in a market economy are the providers of the goods and services that households demand
in the product market. The incentive that drives firms to provide households with products is
that of Profit maximization: The goal of most firms is to maximize their profits. To do so, they
must produce at a level of output at which the difference between their revenues and their costs
is maximized.

To determine whether it will earn a profit at a particular level of output, a firm must, therefore,
consider two economic variables: its costs and its revenues

Economic Costs: These are the explicit money payments a firm makes to resources owners for the use of
land, labor and capital:
• Includes variable costs (payments for those resources which vary with the level of output)
• And fixed costs (payments for those resources which do not vary in quantity with the level of output),
• As well as the opportunity cost of the business owner

Economic Revenues: This is the money income a firm earns from the sale of its products to households. At a
particular level of output, a firm’s total revenue equals the price of its product times the quantity sold.
 Short run and Long run in the
context of Production
 When examining a firm’s costs, we must consider two
periods of time
 Short run: is a time period where one input is fixed and
cannot be changed.
 Example: if a firm wants to increase output it can hire
more labour, material and tools but cannot quickly change
the size of its building, factories and heavy machinery.
 As long as these inputs are fixed short run
 Long run: is a time period when ALL inputs can be
changed
 In the long run a firm has no fixed inputs all inputs are
variable.
 Short run and long run do not correspond to any particular
length of time
 Short-run versus Long-run Costs of Production

 When examining a firm’s costs, we must consider two periods of time.

• The short-run: The period of time in which firms can vary only the amount
of labor and the raw materials it uses in its production. Capital and land
resources are fixed, and cannot be varied. Example: When the demand for
American automobiles fell in the late 2000s, Ford and General Motors
responded in the short-run by reducing the size of their workforces.
• The long-run: The period of time over which firms can vary the quantities
of all resources they use in production. The quantities of labor, capital and
land resources can all be varied in the long-run. Example: When demand
for American automobiles remained week for over two years, Ford and
General Motors began closing factories and selling off their capital
equipment to foreign car manufacturers.

 Variable costs and fixed costs: A firm’s variable costs are those which
change in the short-run as the firm changes its level of output.
 Fixed costs, on the other hand, remain constant as output varies in the
short-run.
 In the long-run, all costs are variable, since all
resources can be varied…
 Total product, Average product and Marginal
product
 Determining Short-run Costs of Production
 The primary determinant of a firm’s short-run production costs is the
productivity of its short-run variable resources (primarily the labor the firm
employs).
 Productivity: The output produced per unit of input
• The greater the average product of variable resources, the lower the average
costs of production in the short-run
• The lower the productivity of the variable resource, the higher the average
costs of production
• Since in the short-run, only labor and raw materials can be varied in quantity,
LABOR IS THE PRIMARY VARIABLE RESOURCE…
 Labor productivity in the short-run: As different amounts of labor are
added to a fixed amount of capital, the productivity of labor will vary based
on the law of diminishing returns, which states…

 The Law of Diminishing Returns: As more and more of a variable resource

(usually labor) is added to fixed resources (capital and land) towards
production, the marginal product of the variable resource will increase until
a certain point, beyond which marginal product declines.
 Productivity in the Short-run

 The productivity of labor is the primary determinant of a

firm’s short-run production costs. The table below presents
some of the key measures of productivity we must
consider when determining short-run costs.
 Productivity in the Short-run
Assume a bakery with three ovens wishes to start making bread. To do so, it
must hire workers. How many workers should the bakery hire? That depends
on the productivity of the labor as more workers are added to the three
ovens. Quantit Margin Averag
Total
The table presents a realistic estimate
y of al e
Produc
of the productivity of labor in the labor Produc Produc
t
short-run (QL) t t
• Total product increases as more 0 0 - -
workers are hired, UNTIL the 8th worker,
then total product decreases 1 4 4 4
• Marginal product (the output 2 9 5 4.5
contributed by the last worker hired)
increases until the 4th worker, and then 3 15 6 5
marginal product begins decreasing. 4 20 5 5
• Average product (the output per
worker) increases until the marginal 5 24 4 4.8
product becomes lower than AP (at the 6 26 2 4.33
5th worker) and then begins decreasing.
• The productivity of labor is at its 7 26 0 3.7
greatest at around 3 or 4 workers, which 8 24 -2 3
means the bakery’s average costs will be
minimized when employing
 Productivity in the Short-run
The data from our productivity table can be plotted in a graph, with the quantity of labor on the
horizontal axis and the total, marginal and average product on the vertical axis.

Key observations about short-run

production relationships:
• The MP is the rate of change in the TP. As
MP is increasing, TP becomes steeper, but
when MP decreases, TP becomes flatter.
When MP becomes negative, TP begins
decreasing.
• MP intersects AP at its highest point.
Whenever MP>AP, AP is increasing, but
when MP<AP, AP is decreasing.
• The bakery begins experiencing diminishing
marginal returns (the output of additional
workers begins decreasing) after the third
worker
 Productivity in the Short-run
If we look more closely at just the marginal product and average product
curves, we can learn more about the relationship between these two
production variables.
Explanation for diminishing
returns:
• With only three ovens in the bakery, the
output attributable to the 4th – 8th worker
becomes less and less.
• This is because there is not enough
capital to allow additional workers to
continue to be more and more
productive!
• Up to the 5th worker, adding additional
workers caused the average product to
rise, since the marginal product was
greater than the average.
• But beyond the 5th worker, diminishing
returns was causing marginal product to
fall at such a rate that it was pulling
average output down with it. Worker
productivity declines rapidly after four
workers.
• A bakery wanting to minimize costs will
not hire more than four workers.
 LAW of DIMINISHING RETURNS
 In the short run, the technical relationship between
inputs and output is explained by the law of
diminishing marginal product
 LDR: as more and more units of a variable input are
added to one or more fixed input (land), the marginal
product of the variable input at first increase but
after a certain point it starts to decrease.
 Assumption: This relationship presupposes that the
fixed input remains fixed and technology of
production is also fixed.
 Previous example: MP first increase till 4th worker.
After 5th worker, MP decrease and DR begins. Why? In
a farm, over crowding.
 Calculating TP, AP and MP
 If we are given data on the total product of a firm,
it is a simple matter to calculate AP & MP.
 If given data on AP we can find TP using the
formula:
 TP=AP * Units of variable input
 AP= TP/ units of variable input

If we are given MP, we can find TP by adding up

the successive MP’s of each additional unit of
Units
labour.1 2 3 4 5
of
labour
MP 20 25 20 15 10
TP 20 45(25+2 65(20+25+2 80(15+20+25+ 90(10+15+20
0) 0) 20) +25+20)
 Solve Example 1
Units of Total product MP AP
variable input
(labour)
0 0 - -
1 2 2 2
2 5 3 2.5
3 9 4 3
4 14 5 3.5
5 18 4 3.6
6 21 3 3.5
7 23 2 3.3
8 24 1 3
9 24 0 2.7
10 23 -1 2.3
11 21 -2 1.9
 Solve Example 2
Units of Total product MP AP
variable input
(labour)
0 - -
1 3
2 5
3 4
4 3
5 2
6 0
7 -1
8 -3
ANSWER TO EXAMPLE 2
 Solve Example 3
Units of Total product MP AP
variable input
(labour)
0 -
1 4.00
2 5.00
3 4.33
4 3.75
5 3.20
6 2.50
ANSWER TO EXAMPLE 3
PLOT THE NUMBERS
 Increasing MP: addition to TP
gets bigger with each additional
unit of labour

 Decreasing MP: addition to TP

by successive units of labour
becomes smaller

 Negative MP: TP falls

 OBSERVATION:
 AP rises at first and then falls
 When MP curve lies above AP
curve, AP is increasing
 When MP curve lies below AP
curve, AP is decreasing
 This means that MP curve
always intersects the AP curve
when this is at its maximum.