Firms and Production Costs

Chisomo Mkwanda

Malawi University of Business and Applied Sciences

February 18, 2025

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 1 / 27
 Introduction

The firm is the most important agent in the economy that makes
decisions about production of the specific goods or services in which
it specializes.
The firms’ options are affected by the market structure in which they
operate.
They also have to make supply decisions in the light of their costs of
production.
They organize resources such as land, labor, capital, and
entrepreneurship to produce outputs. Understanding
Production costs is essential for analyzing how firms make decisions
regarding production and pricing.

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Applied
andSciences)
Production Costs February 18, 2025 2 / 27
 Learning Outcomes

Learning Outcomes

Real-world firms can adopt one of several different legal structures

Sole traders
Partnerships
Joint-stock companies
Public corporations
Non-profit organizations
For most analyses in the book, firms are assumed to have a very
simple structure.

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Applied
andSciences)
Production Costs February 18, 2025 3 / 27
 Learning Outcomes

Economists’ vs. Accountants’ Measures of Profit

Accountants’ Profit: Total revenue minus explicit costs (e.g., wages,

materials).
Economists’ Profit
Difference between total revenue and total cost.
Includes both explicit and implicit costs, such as the opportunity cost
of capital.

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Applied
andSciences)
Production Costs February 18, 2025 4 / 27
 Learning Outcomes

Cost Curves and Production Function

Production Function: Relates physical quantities of inputs to the

quantity of output.
Cost Curves
Short-run cost curves are U-shaped due to fixed inputs and diminishing
returns.
Long-run cost curves vary with scale effects as all inputs are variable.
Very long-run costs are altered by technical changes.

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Applied
andSciences)
Production Costs February 18, 2025 5 / 27
 Firms in Practice and Theory

Firms in Practice and Theory

Production is organized by private sector firms, which take various

forms.
This section explores the main types of firms in the private and public
sectors.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 6 / 27
 Firms in Practice and Theory

Sole Traders

A business owned and operated by a single individual.

Simple to set up and operate.
Owner has full control and receives all profits.
Unlimited liability – personal assets are at risk.
Common for small-scale businesses and self-employed individuals.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 7 / 27
 Firms in Practice and Theory

Ordinary Partnerships

A business owned by two or more individuals who share

responsibilities and profits.
Partners contribute capital, skills, or labor.
Profits and losses are shared based on an agreed ratio.
Unlimited liability for each partner.
Often used in professional services (e.g., law, accountancy).

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 8 / 27
 Firms in Practice and Theory

Limited Partnerships

A partnership where at least one partner has limited liability.

Limited partners invest capital but do not actively manage the
business.
General partners manage the business and have unlimited liability.
Protects some investors from greater financial risk.
Common in industries requiring large capital investments.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 9 / 27
 Firms in Practice and Theory

Joint-Stock Companies

A business owned by shareholders who invest capital in return for

shares.
Limited liability for shareholders.
Managed by a board of directors on behalf of shareholders.
Can raise large amounts of capital by selling shares.
Examples include large corporations and publicly listed companies.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 10 / 27
 Firms in Practice and Theory

Public Corporations

Businesses owned and operated by the government.

Provide essential goods or services (e.g., utilities, transportation).
Aim to serve public interests rather than maximizing profits.
Funded by taxes or service fees.
Examples include nationalized industries and public hospitals.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 11 / 27
 Firms in Practice and Theory

Non-Profit Units

Organizations that operate for purposes other than generating profit.

Focus on social, cultural, educational, or charitable objectives.
Surpluses are reinvested in the organization rather than distributed.
Often rely on donations, grants, or volunteer work.
Examples include charities, NGOs, and community organizations.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 12 / 27
 Firms in Practice and Theory

Financing and Purpose of Modern Firms

Modern firms finance themselves through various methods.

Selling shares to raise capital.
Reinvesting profits back into the business.
Borrowing from lenders such as banks.
The primary goal of firms is to generate profits.
Profits are the difference between revenue (from selling output) and
production costs.
Profits represent the return to the owner’s capital.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 13 / 27
 Firms in Practice and Theory

Production Function and Costs

The production function relates inputs of factor services (e.g., labor,

capital) to outputs.
Economists’ view of costs includes both explicit costs and imputed
opportunity costs of the owner’s capital
Economists include imputed opportunity costs of owners’ capital in
total costs: - Pure return: Income from a riskless investment. - Risk
premium: Additional return from an equally risky investment.

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Applied
andSciences)
Production Costs February 18, 2025 14 / 27
 Firms in Practice and Theory

Pure Profits and Resource Allocation

Pure or economic profits are the difference between revenues and all
costs (explicit and opportunity costs).
Pure profits play a crucial role in resource allocation
1 Positive pure profits attract resources into an industry.
2 Negative pure profits cause resources to move elsewhere

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 15 / 27
 Firms in Practice and Theory

Types of Production Costs

Production costs are the expenses incurred in producing goods and
services. These can be categorized as:

Fixed Costs (FC)

Do not vary with the level of output.
Examples: Rent, salaries of permanent staff, insurance premiums.
Remain constant regardless of production volume.

Variable Costs (VC)

Vary directly with the level of output.
Examples: Raw materials, wages of temporary workers, electricity for
production.
Increase as production increases.
Chisomo Mkwanda (Malawi University of Business andFirms
Applied
andSciences)
Production Costs February 18, 2025 16 / 27
 Firms in Practice and Theory

Total Costs and Average Costs

Total Costs (TC):
The total cost of production is the sum of fixed and variable costs:
TC = FC + VC

Average Costs (AC):

Cost per unit of output is calculated as:
TC
AC =
Q
Components of Average Costs:
Average Fixed Cost (AFC):
FC
AFC =
Q
Average Variable Cost (AVC):
VC
AVC =
Q
Chisomo Mkwanda (Malawi University of Business andFirms
Applied
andSciences)
Production Costs February 18, 2025 17 / 27
 Firms in Practice and Theory

Marginal Cost

Definition
Marginal cost is the additional cost incurred to produce one more unit
of output.

Formula
∆TC
MC =
∆Q
Importance of Marginal Cost

Helps firms decide whether to increase or decrease production.

Crucial for determining the optimal production level to maximize
efficiency and profitability.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 18 / 27
 Firms in Practice and Theory

Short-Run vs. Long-Run Costs

The behavior of production costs changes over time based on firms’

ability to adjust inputs.
In the short run, certain inputs remain fixed, creating unique cost
dynamics.
In the long run, firms can adjust all inputs to optimize efficiency and
scale operations.
Understanding these distinctions lays the foundation for detailed
analysis of firm decision-making in varying timeframes.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 19 / 27
 Firms in Practice and Theory

Costs in the Short Run

Short run variations in output are subject to the law of diminishing

returns:
Equal increments of the variable input sooner or later produce smaller
and smaller additions to total output and, eventually, a reduction in
average output per unit of variable input.

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Applied
andSciences)
Production Costs February 18, 2025 20 / 27
 Firms in Practice and Theory

Costs in the Short Run

Short-run average and marginal cost curves are U-shaped, the rising
portion reflecting diminishing average and marginal returns.
The marginal cost curve intersects the average cost curve at the
latter’s minimum point, which is called the firm’s capacity output.
There is a family of short-run average and marginal cost curves, one
for each amount of the fixed factor

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 21 / 27
 Firms in Practice and Theory

Costs in the Short Run

Marginal Cost (MC)

Marginal cost refers to the additional cost of producing one more unit
of output.
It is influenced by the productivity of labor.

Marginal Product of Labor (MPL)

The marginal product of labor measures the additional output
generated by hiring one more worker.
Initially, as more workers are hired, the MPL increases due to
specialization and efficiency gains.
However, beyond a certain point, MPL begins to decline because of
diminishing returns (e.g., overcrowding or limited resources).

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 22 / 27
 Firms in Practice and Theory

Impact of MPL on Marginal Cost

Rising MPL
When MPL increases, each additional worker contributes more output.
This reduces the cost per unit of output, causing Marginal Cost (MC)
to fall.
Falling MPL
When MPL decreases, each additional worker contributes less output.
This increases the cost per unit of output, causing Marginal Cost (MC)
to rise.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 23 / 27
 Firms in Practice and Theory

Costs in the Short Run

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 24 / 27
 Firms in Practice and Theory

Costs in the Short Run

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 25 / 27
 Firms in Practice and Theory

Costs in the Long Run

In the long run, the firm can adjust all inputs to minimize the cost of
producing any given level of output.
Cost minimization condition
Marginal Product of Input (MP)
is equal for all inputs.
Price of Input (P)

Principle of Substitution: When relative input prices change, firms

will substitute relatively cheaper inputs for relatively more expensive
ones.

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 26 / 27
 Firms in Practice and Theory

Thank You

Thank you for your attention!

Authored by: Chisomo Mkwanda

Email: chisomomkwanda96@gmail.com
Phone: 0991571722

Chisomo Mkwanda (Malawi University of Business andFirms

Applied
andSciences)
Production Costs February 18, 2025 27 / 27