Block 5
THE FIRM
Readings
Main Textbook
CHAPTER SIX : INTRODUCING SUPPLY
DECESIONS
CHAPTER SEVEN : COSTS AND SUPPLY
Begg, D., G. Vernasca, S. Fischer and R.
Dornbusch Economics.
Study Guide
BLOCK Five :Consumer Choice
O. Birchall with D. Verry, M. Bray and D. Petropoulou,
Introduction to economics.
© 2012 Pearson Addison-Wesley
Student Assessment
 This course is assessed by a three-hour unseen written
examination set and marked by the University of London.
 The exam consists of three main sections.
Section A (40 marks) :Contains Eight True/False/Uncertain
questions evenly drawn from microeconomics and
macroeconomics.
Section B (30 marks):Contains One microeconomics
question.
Section C (30 marks) :contains One macroeconomics
question.
© 2012 Pearson Addison-Wesley
Outline Chapter 6
 recognize the legal forms in which businesses are
owned and run
 describe revenue, cost, profit and cash flow
 analyze accounts for flows and for stocks
 recognize economic and accounting definitions of cost
 understand whether a firm chooses output to maximize
profits
 describe how this choice reflects marginal cost and
marginal revenue
© 2012 Pearson Addison-Wesley
WHAT ARE COSTS
•
The economy is made up of thousands and
thousands of firms providing goods and services
that we buy.
•
According to the law of supply these firms are
willing to produce more when prices are higher.
Consequently the supply curve slopes upwards.
A firm’s costs are a key determinant of both pricing
and production decisions.
We therefore need to understand the nature of a
firm’s costs in making or providing goods and
services.
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Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output.
© 2012 Pearson Addison-Wesley
the market
value of the
inputs a firm
uses in
production.
Costs as Opportunity Costs
Explicit costs require an outlay of money,
e.g., paying wages to workers.
Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
This is true whether the costs are implicit or explicit.
Both matter for firms’ decisions.
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Economic Profit vs. Accounting Profit
Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher
than economic profit.
© 2012 Pearson Addison-Wesley
The Cost of Capital as an Opportunity Cost
You need $100,000 to start your business.
The interest rate is 5%.
Case 1: borrow $100,000
explicit cost = $5000 interest on loan.
Case 2: use $40,000 of your savings,
borrow the other $60,000
explicit cost = $3000 (5%) interest on the loan.
implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (explicit + implicit) costs are $5000.
© 2012 Pearson Addison-Wesley
Firm’s supply decision's – Producer
behavior theory
1. Maximum (output) Production
2. Minimum Costs
 Maximum profit
© 2012 Pearson Addison-Wesley
PRODUCTION AND COSTS
We will now examine the link between a firm’s
production process and its total cost.
We assume that the size of the enterprise (in our
example a farm) is fixed and that output is changed
by employing more or less workers (land and
equipment are fixed).
This is a realistic assumption in the short-run time
horizon.
© 2012 Pearson Addison-Wesley
The Production Function
A production function shows the relationship between
the quantity of inputs used to produce a good and
the quantity of output of that good.
It can be represented by a table, equation, or graph.
Example 1:
•
A farmer, Mahmud grows wheat.
•
He has 5 acres of land.
•
He can hire as many workers as he wants.
© 2012 Pearson Addison-Wesley
EXAMPLE 1: Farmer’s Production Function
3,000
Q (bushels
(no. of
of wheat)
workers)
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
No. of workers
© 2012 Pearson Addison-Wesley
5
The Production Function:
Marginal Product
If the farmer Mahmud hires one more worker, his
output rises by the marginal product of labor.
The marginal product of any input is the increase in
output arising from an additional unit of that
input, holding all other inputs constant.
Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
∆Q
Marginal product of labor (MPL) = ∆L
© 2012 Pearson Addison-Wesley
EXAMPLE 1: Total & Marginal
L
Product
Q
(no. of (bushels
workers) of wheat)
0
0
∆Q = 1000
∆L = 1
1
2
5
© 2012 Pearson Addison-Wesley
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
2400
∆L = 1
4
∆Q = 800
1800
∆L = 1
3
1000
1000
∆L = 1
∆L = 1
MPL
2800
3000
EXAMPLE 1: MPL = Slope of Prod Function
Q
(no. of (bushels
workers) of wheat)
0
MPL
3,000
MPL
0
1000
1
1000
800
2
1800
600
3
2400
400
4
2800
200
5
3000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
No. of workers
© 2012 Pearson Addison-Wesley
5
Why MPL Is Important
 When Farmer Mahmud hires an extra worker,
 his costs rise by the wage he pays the worker
 his output rises by MPL.
 Comparing them helps Mahmud decide
whether he should hire the worker.
© 2012 Pearson Addison-Wesley
Why MPL Diminishes
The farmer’s output rises by a smaller and smaller amount
for each additional worker. Why?
 As he adds workers, the average worker has less
land to work with and will be less productive.
 In general, MPL diminishes as L rises whether the
fixed input is land or capital (equipment, machines,
etc.).
 Diminishing marginal product: The marginal
product of an input declines as the quantity of the
input increases (other things equal).
© 2012 Pearson Addison-Wesley
From the Production Function to the
Total Cost Curve
Farmer Mahmud must pay $1000 per month for the land,
regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Mahmud’s costs are related to how much wheat he
produces….(see next two slides).
© 2012 Pearson Addison-Wesley
EXAMPLE 1: Farmer Mahmud’s Costs
L
(no. of
workers)
Q
(bushels
of wheat)
Cost of land Cost of labor
Total
Cost
0
0
$1,000
$0
$1,000
1
1000
$1,000
$2,000
$3,000
2
1800
$1,000
$4,000
$5,000
3
2400
$1,000
$6,000
$7,000
4
2800
$1,000
$8,000
$9,000
5
3000
$1,000
$10,000
$11,000
© 2012 Pearson Addison-Wesley
EXAMPLE 1: Farmer Mahmud’s Total Cost
Curve
Q
(bushels
of wheat)
Total
Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
© 2012 Pearson Addison-Wesley
$10,000
Total cost
0
$12,000
$8,000
$6,000
$4,000
$2,000
$0
0
1000
2000
3000
Quantity of wheat
THE VARIOUS MEASURES OF COST
Marginal Cost (MC) is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
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EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of wheat)
0
Total
Cost
$1,000
∆Q = 1000
1000
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$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
$9,000
∆Q = 200
3000
∆TC = $2000
$7,000
∆Q = 400
2800
$2.00
$5,000
∆Q = 600
2400
∆TC = $2000
$3,000
∆Q = 800
1800
Marginal Cost
(MC)
$11,000
EXAMPLE 1: The Marginal Cost Curve
$12
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
3000 $11,000
© 2012 Pearson Addison-Wesley
$10.00
$0
0
1,000
2,000
Q
3,000
Why Marginal Cost Is Important
 Mahmud is rational and wants to maximize his
profit. To increase profit, should he produce
more or less wheat?
 To find the answer, Mahmud needs to “think at
the margin.”
 If the cost of additional wheat (MC) is less than
the revenue he would get from selling it, then the
farmer’s profits rise if he produces more.
© 2012 Pearson Addison-Wesley
Fixed and Variable Costs
 Fixed costs (FC) do not vary with the quantity of
output produced.
 For Mahmud, FC = $1000 for his land
 Other examples: cost of equipment, loan payments, rent.
 Variable costs (VC) vary with the quantity
produced.
 For Mahmud, VC = wages he pays workers.
 Other example: cost of materials.
 Total cost (TC) = FC + VC
© 2012 Pearson Addison-Wesley
EXAMPLE 2: Costs
FC
VC
TC
0
$100
$0
$100
1
100
70
170
2
100
120
220
3
100
160
260
4
100
210
310
FC
$700
VC
TC
$600
$500
Costs
Q
$800
$400
$300
$200
5
100
280
380
$100
6
100
380
480
$0
7
100
520
620
0
1
2
3
4
Q
© 2012 Pearson Addison-Wesley
5
6
7
EXAMPLE 2: Marginal Cost
0
TC
MC
$100
$70
1
170
50
2
220
40
3
260
50
4
310
70
5
380
100
6
620
© 2012 Pearson Addison-Wesley
∆TC
MC =
∆Q
$100
Usually,
MC rises as Q rises, due
$75
to diminishing marginal product.
$125
$50
Sometimes (as here), MC falls
$25
before rising.
$0
480
140
7
$200 Marginal Cost (MC)
Recall,
is $175
the change in total cost from
producing
one more unit:
$150
Costs
Q
(In other0 examples,
1 2 3 MC
4 may
5 6be 7
constant.)
Q
EXAMPLE 2: Average Fixed Cost
FC
AFC
0
$100
n/a
1
100
$100
2
100
50
3
100
33.33
4
100
25
5
100
20
6
100
16.67
7
100
14.29
© 2012 Pearson Addison-Wesley
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Variable Cost
VC
AVC
0
$0
n/a
1
70
$70
2
120
60
3
160
53.33
4
210
52.50
5
280
56.00
6
380
63.33
7
520
74.29
© 2012 Pearson Addison-Wesley
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity of output:
$150
Costs
Q
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Total Cost
Q
TC
0 $100
ATC
AFC
AVC
n/a
n/a
n/a
1
170
$170
$100
$70
2
220
110
50
60
3
260 86.67 33.33
53.33
4
310 77.50
25
52.50
5
380
76
20
56.00
6
480
80 16.67
63.33
7
620 88.57 14.29
74.29
© 2012 Pearson Addison-Wesley
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
EXAMPLE 2: Average Total Cost
TC
0 $100
1
2
170
220
ATC
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n/a
$150
$170
110
Costs
Q
$125
$100
3
260 86.67
4
310 77.50
5
380
76
$25
6
480
80
$0
7
620 88.57
$75
$50
0
1
2
3
4
Q
© 2012 Pearson Addison-Wesley
5
6
7
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
© 2012 Pearson Addison-Wesley
5
6
7
ACTIVE LEARNING
3
Calculating costs
Fill in the blank spaces of this table.
Q
VC
0
1
10
2
30
TC
AFC
AVC
ATC
$50
n/a
n/a
n/a
$10
$60.00
80
3
16.67
4
100
5
150
6
210
©To
2012
Addison-Wesley
be Pearson
used with
Mankiw and
150
20
12.50
36.67
8.33
$10
30
37.50
30
260
MC
35
43.33
60
Rashwan, Principles of Economics, Arab World Edition, 3 rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
ACTIVE LEARNING
3
Answers
Use
AFC
FC/Q
ATC
AVC
= TC/Q
VC/Q
MC
and
First,relationship
deduce
FC between
= $50 and
use
FCTC
+ VC = TC.
Q
VC
TC
AFC
AVC
ATC
0
$0
$50
n/a
n/a
n/a
1
10
60
$50.00
$10
$60.00
2
30
80
25.00
15
40.00
3
60
110
16.67
20
36.67
4
100
150
12.50
25
37.50
5
150
200
10.00
30
40.00
6
210
260
8.33
35
43.33
©To
2012
Addison-Wesley
be Pearson
used with
Mankiw and
MC
$10
20
30
40
50
60
Rashwan, Principles of Economics, Arab World Edition, 3 rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
EXAMPLE 2: Why ATC Is Usually U-Shaped
$200
$175
Initially, falling AFC
pulls ATC down.
$150
Eventually, rising
AVC pulls ATC up.
Efficient scale:
The quantity that
minimizes ATC.
Costs
As Q rises:
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
© 2012 Pearson Addison-Wesley
5
6
7
As output increases, why do marginal costs start
high, then fall, then rise again?
Different production techniques
•
At low output, the firm uses simple
techniques. As output rises, more
sophisticated machines are used,
making extra output quite cheap.
•
As output rises still further, the
difficulties of managing a large firm
emerge. Raising output gets hard
and marginal costs rise.
•
In mass-production industries, as
output increases marginal cost may
decline and then become constant
© 2012 Pearson Addison-Wesley
EXAMPLE 2: ATC and MC
When MC < ATC,
ATC is falling.
$200
When MC > ATC,
ATC is rising.
$150
$175
Costs
The MC curve
crosses the ATC
curve at the ATC
curve’s minimum.
ATC
MC
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
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5
6
7
Marginal revenue
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Marginal revenue
Marginal revenue falls steadily for two reasons.
First, because demand curves slope down, the
extra unit must be sold at a lower price.
Second, successive price reductions reduce the
revenue earned from existing units of output, and
at larger output there are more existing units on
which revenue is lost when prices fall further.
To sum up,
(a) marginal revenue falls as output rises.
(b) marginal revenue is less than the price for which
the last unit is sold, because a lower price reduces
revenue earned from existing output.
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The firm’s optimal supply decision
The firm’s optimal output is
Q1, at which marginal
revenue is equal to marginal
cost.
The left of Q1, marginal
revenue is larger than
marginal cost and the firm
should increase output.
Where output is greater than
Q1, marginal revenue is less
than marginal cost and profits
are increased by reducing
output.
© 2012 Pearson Addison-Wesley
Change in costs
Suppose the firm faces a
price rise for a raw material.
At each output, marginal
cost is higher than before. It
shows this upward shift from
MC to MC’.
The firm now produces at E’.
Higher marginal costs
reduce profit-maximizing
output from Q1 to Q2
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A demand shift
• An increase in the number
of customers in the firm’s
market
• When the MR curve shifts
upwards from MR to MR’,
the intersection point
between the MR and MC
curves shifts from E to E’.
•
The firm’s optimal level of
output increases from Q1 to
Q3
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Business organization
• A sole trader is a business owned by a single individual.
• A partnership is a business jointly owned by two or more
people, sharing the profits and being jointly responsible for
any losses. Partnerships usually have unlimited liability
• A company is an organization legally allowed to produce
and trade.
• Shareholders of a company have limited liability. The most
they can lose is the money they spent buying shares
•
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A firm’s accounts
• Stocks are measured at a given point in time.
• Flows are corresponding measures during a period of time
• Revenue is what the firm earns from selling goods or services in
a given period.
• Cost is the expense incurred in production in that period and
profit is revenue minus cost.
• A firm’s cash flow is the net amount of money actually received
during the period.
• Physical capital is machinery, equipment and buildings used in
production.
• Depreciation is the loss in value of a capital good during the
period.
© 2012 Pearson Addison-Wesley
A firm’s accounts
• Inventories are goods held in stock by the firm for future
sales
• A firm’s net worth is the assets it owns minus the
liabilities it owes.
• Retained earnings are the part of after-tax profits
ploughed back into the business.
© 2012 Pearson Addison-Wesley
The firm’s short-run output decision

The firm sets output at Q1, where
short-run marginal costs equal
marginal revenue. Then it checks
whether it should produce at all.

If price is above SATC1, the level
of short-run average total cost at
output Q1, the firm is making a
profit and should certainly produce
Q1.

If price is between SATC1 and
SAVC1, the firm partly covers its
fixed costs, even though it is
losing money. It should still
produce output Q1.

Only if the price is below SAVC1
should the firm produce zero. At
those prices, the firm is not even
covering its variable costs
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Short run supply decisions
Choose the output at which :
MR=SMC
P>AVC Otherwise produce zero
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Long-run total, marginal and average costs
 Long-run total cost (LTC) is the minimum cost of
producing each output level when the firm can adjust all
inputs.
 Long-run marginal cost (LMC) is the rise in long-run total
cost if output rises permanently by one unit.
 Long-run average cost (LAC) is the total cost LTC
divided by the level of output Q
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Long-run costs
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Long run Average costs and marginal costs
There are two special features of
the relationship between the
marginal cost curve (LMC) and the
average cost curve (LAC).
First, LAC is declining whenever
LMC is below LAC, and rising
whenever LMC is above LAC.
Second, the LMC curve cuts the
LAC curve at the minimum point
of the LAC curve – in other
words, at the point where output
is produced at lowest unit cost.
Minimum efficient scale (MES) is the
lowest output at which the LAC
curve reaches its minimum
© 2012 Pearson Addison-Wesley
How ATC Changes as
the Scale of Production Changes
Economies of scale: ATC
ATC falls as Q
increases.
LRATC
Constant returns to
scale: ATC stays the
same as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
© 2012 Pearson Addison-Wesley
Q
Economies and Diseconomies of Scale
 Economies of scale occur when increasing
production allows greater specialization: workers
more efficient when focusing on a narrow task.
 More common when Q is low.
 Diseconomies of scale are due to coordination
problems in large organizations. E.g.,
management becomes stretched, can’t control
costs.
 More common when Q is high.
© 2012 Pearson Addison-Wesley
The firm’s long-run output decision
 In the long run the firm chooses its
output level at the point B here MR is
equal to LMC. It has then to check
whether it is making losses at that
output level Q1.
 If price is equal to or more than
LAC1, the long-run average cost
corresponding to output Q1, the
firm is not making losses and
stays in business.

If the price is less than LAC1, the
firm’s long-run output decision
should be zero – it closes down
permanently.
 MR=LMC, Choose the output
where the P>=LAC
© 2012 Pearson Addison-Wesley
The relationship between short-run and
long-run average costs
Firm can choose from
three factory sizes: S, M,
L.
Each size has its own
SRATC curve.
Avg.
Total
Cost
ATCS
ATCM
ATCL
The firm can change to a
different factory size in the
long run, but not in the
short run.
Q
© 2012 Pearson Addison-Wesley
The relationship between short-run and
long-run average costs
To produce less
than QA, firm will
choose size S
in the long run.
Avg.
Total
Cost
ATCS
ATCM
To produce between
QA and QB, firm will
choose size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.
© 2012 Pearson Addison-Wesley
ATCL
LRATC
QA
QB
Q
The relationship between short-run
and long-run average costs
 To construct the LAC curve we select at each output the
plant size which gives the lowest SATC at this output.
Thus points such as A, B, C and D lie on the LAC
curve.
 The LAC curve shows the minimum average cost way to
produce a given output when all factors can be
varied, not the minimum average cost at which a given
plant can produce.
© 2012 Pearson Addison-Wesley