Shahjalal University of Science And Technology, Sylhet

Dept: Computer Science And Engineering

Course name: Principles of Economics
Course code: ECO105D
Group : 3A

Chapter 3

THEORY OF FIRM

SUBMITTED TO
Dr Mohammad Sadiqunnabi Choudhury
Professor
Department of Economics
Shahjalal University of Science And Technology, Sylhet

SUBMITTED BY
1.Dipu Debnath (2021331011)
2.Partha Protim Biswas (2021331015)
3.Mehedi Hasan Masum (2021331019)
4.Shourov Roy (2021331085)
5.Hridoy Kumar Biswas (2021331097)
Index
Theory of Firm

3.1 Theory of Production

3.1.1 Production function

3.1.2 Total, Average and Marginal Product(TP, AP and MP)
3.1.3 Relationship among TP, AP and MP
3.1.4 Law of Diminishing Returns

3.2 Producer’s Equilibrium

3.2.1 Isoquant and Isocost line

3.2.2 Marginal Rate of Technical Substitution
3.2.3 Optimal Combination of Factors
3.2.3 Expansion Path

3.3 Cost of Production

3.3.1 Short run cost curves(TC, TFC and TVC; AC, AFC, AVC and MC)
3.3.2 Long run cost curves
3.3.3 Relationship between cost curves

​
Chapter 3: Theory of Firm

Firm: A firm is an organization that produces goods or services for sale to earn a profit.

3.1 Theory of Production

Production: In economics, production refers to the process of converting inputs

(resources) into outputs (goods and services) that satisfy human wants and needs.

Factors of Production Price

​ Land r(rent)
​ Labour w(weight)
​ Capital i(interest)
​ Organization pi(profit)

3.1.1 Production Function

A production function shows the relationship between input factors and the quantity of
output produced. Mathematically, it can be expressed as:

Q = f(L, La, K, O)

Where: Q = Quantity of output

L = Land
La= Labour
K = Capital
O = Organization

For short-run production, where only labor is variable:

Q = f(L)

For long-run production, both capital and labor are variable:

Q = f(L, K)

3.1.2 Total, Average, and Marginal Product (TP, AP, and MP)
Total Product (TP): The total quantity of output produced with a given amount of

inputs.Average Product (AP): The output per unit of a particular input, calculated as
AP = TP / L.

Marginal Product (MP): The additional output produced by using one more unit of input,
calculated as MP = dTP / dL.

## Data Table: TP, AP, and MP Relationship

Labor(L) Quantity(q) MP = dTP / dL AP = TP / L

0 0

1 3 3 3

2 8 5 4

3 12 4 4

4 15 3 3.75

5 17 2 3.4

6 17 0 2.83

7 16 -1 2.28

8 13 -3 1.625

9 9 -4 1
Figure 3.1
Figure: 3.2
Figure: 3.3
3.1.3 Relationship Among TP, AP, and MP

Relationship between TP and MP

1. When TP increases at an increasing rate, MP is also increasing.
2. When TP is on inflection point, MP is maximum.
3. When TP is increasing at a decreasing rate, MP is decreasing.
4. When TP is at its maximum, MP becomes zero.
5. When TP is decreasing, MP is negative.

Relationship between TP and AP

1. AP = TP / q
2. AP is at max at the point where a ray from the origin is tangential to TP.

Relationship between MP and AP

1. Before APmax, MP > AP
2. After APmax, AP > MP

3.1.4 Law of Diminishing Returns

The Law of Diminishing Returns states that as more units of a variable input (e.g., labor)
are added to a fixed input (e.g., land or machinery), the additional output (marginal
product) from each extra unit of input will eventually decline, assuming all other factors
remain constant.

Initially, increasing the variable input leads to higher productivity due to specialization
and better resource utilization. However, after a certain point, congestion, inefficiencies,
and overutilization of fixed resources cause the marginal product to decrease.
Eventually, adding more input may even reduce total output.

This principle is crucial in economics and production planning, helping firms determine
the optimal level of input used to maximize efficiency, and says that MP is normally
declining.
3.2 Producer’s Equilibrium

The value of all assets used for production is limited. Hence, the producer has to use
such a combination of inputs as would provide him with maximum output and profits.
This optimum level of production, also called producer’s equilibrium, is achieved when
maximum output is derived from minimum costs.

In order to achieve this, producers first have to classify their resources into different
combinations. Each combination would provide production in different quantities. The
combination that provides the highest amount of produce at the least amount of costs is
the optimum level of production.

In order to find out the producer's equilibrium, we first need to understand isoquant
curves and iso-cost lines. These two concepts help us calculate optimum production.

3.2.1 Isoquant and Isocost line

Isoquant Line: These lines represent various input combinations which produce the
same levels of output. The producer can choose any of these combinations available to
him because their outputs are always the same. Thus, we can also call them
equal–product curves or production indifference curves.

#Data table for Isoquant Curve

Land(L) Capital(K)

A 1 10
 B 2 5

C 3 3

D 4 2

E 5 1

#Isoquant Curve
 Figure 3. 4

Properties of Isoquant Curve

1.IQ is negatively sloped(MP is diminishing)

2.Convex to the origin(Declining MRTS)

3. Higher IQ gives higher level of Production

4. IQ never cross

Proof: Two IQ never cross

 Figure 3.5

→ A, B

→ A, C

→ false,
Isocost Line: Isocost lines represent combinations of two factors that can be bought with
different outlays. In other words, it shows how we can spend money on two different
factors to produce maximum output.

Figure 3.6

3.2.2 Marginal Rate of Technical Substitution

The marginal rate of technical substitution (MRTS) is the rate at which production
inputs, typically labor and capital, can be substituted while maintaining the same level of
output.

An isoquant is a graph showing combinations of capital and labor that will yield the
same output. The slope of the isoquant indicates the MRTS or at any point along the
isoquant how much capital would be required to replace a unit of labor at that
production point.

where:

K = Capital

L = Labor

MP = Marginal products of each input

3.2.3 Optimal Combination of Factors

The optimal combination of labor and capital is typically determined by finding the point
where the isoquant (representing equal levels of output) is tangent to the isocost line
(representing equal levels of cost). At this point, the marginal rate of technical
substitution (MRTS) is equal to the ratio of the input prices (wage rate for labor and
rental rate for capital).

Figure 3.7

At curve, optimal output will be found, as first IQ curve gives low production and
third IQ curve is out of bound(Unattainable).
Mathematical Reasoning for Optimal Condition(Unconstrained Optimization):

- - - - - - - - - (i)

- - - - - - - - - (ii)

--- --- - - - (iii)

From equation (ii),

- - - - - - - - - (iv)

From eq^n (iii) and (iv),

3.2.4 Expansion Path

The expansion path in production theory illustrates the cost-minimizing combination

of two inputs (typically labor (L) and capital (K)) as a firm expands its production. It is
derived from the points of tangency between a series of isoquant curves
(representing different output levels) and isocost lines (representing different total cost
levels).

The expansion path is a crucial concept in production and cost theory, showing how
firms efficiently allocate resources as they expand output. It is derived from the
tangency points between isoquant curves and isocost lines, ensuring cost
minimization at each production level.
 Figure 3.8

3.3 Cost of Production

The cost of production refers to the total expenses incurred in the process of creating a
product or service. It typically includes both fixed costs (e.g., rent, salaries) and variable
costs (e.g., raw materials, labor).

Total Cost C = w × L + r × K
3.3.1 Short-run Cost Curves (TC, TFC and TVC, AC AFC and AVC, MC Curves)

Short-run cost curves are fundamental in microeconomics, representing the various costs
incurred by a firm when producing goods. These include Total Cost (TC), Total Fixed Cost
(TFC), Total Variable Cost (TVC), Average Costs (AC, AFC, AVC), and Marginal Cost (MC).

#Data Table for TFC, TVC, TC, AC, AFC, AVC, MC

Q TFC TVC TC AC AFC AVC MC

0 60 0 60

1 60 30 90 90 60 30 30

2 60 40 100 50 30 20 10

3 60 45 105 35 20 15 5

4 60 55 115 28.75 15 13.75 10

5 60 75 135 27 12 15 20

6 60 120 180 30 10 20 45

1. Total Fixed Cost (TFC) :

The costs on which the output level does not have a direct impact are known as Fixed Costs.
For example, salary of staff, rent on office premises, interest on loans, etc. Fixed cost is the cost
spent on fixed factors such as land, building, machinery, etc. The amount spent on these factors
cannot be changed in the short run. Also, the payment made on these factors remains the same
whether the output is small, large, or zero.

Example: Here is the table for TFC

Output (in units) Total Fixed Cost (TFC)

0 ​ 10

1 ​ 10

2 ​ 10

3 ​ 10

4 ​ 10

5 ​ 10

##Curve for TFC:

​ ​ ​ ​ Figure 3.9​ ​ ​ ​ ​ ​ ​
​ ​

In the above graph, X-axis represents the Units of Output and Y-axis represents the Fixed Cost.
TFC is the fixed cost curve formed by plotting the points in the above schedule.

2. Total Variable Cost (TVC) or Variable Cost (VC):

The costs on which the output level has a direct impact are known as Variable Costs. For
example, fuel, power, payment for raw materials, etc. Other names of variable costs are
Prime Cost, Avoidable Cost, or Direct Cost. In other words, variable cost is the cost spent
on variable factors such as power, direct labour, raw material, etc. The amount spent on
these factors changes with the change in output level. Also, these costs arise till there is
production and become zero at zero output level.

Example: Here is the table for TVC

Output (in units) ​ Total Variable Cost (TVC)

.

​ 0 ​0

​ 1 ​5

​ 2 ​8

​ 3 ​12

​ 4 ​20

​ 5 ​30
##Curve for TVC

Figure 3.10

In the above graph, X-axis represents the Units of Output and Y-axis represents the Variable
Cost. TVC is the total variable cost curve formed by plotting the points in the above schedule.

3. Total Cost (TC):

The total expenditure incurred by an organisation on the factors of production which are
required for the production of a commodity is known as Total Cost. In simple terms, total
cost is the sum of total fixed cost and total variable cost at different output levels.

TC = TFC + TVC

As the Total Fixed Cost remains the same at all output levels, the change in Total Cost
completely depends upon Total Variable Cost.

Example: Here is the table for TVC

Output (in units) Total Fixed Cost (TFC) Total Variable Cost (TVC) Total Cost (TC)

0 10 0 10

1 10 5 15
2 10 8 18

3 10 12 22

4 10 20 30

5 10 30 40

##Curve for TC

Figure 3.11

In the above graph, the TC curve is obtained by adding TVC and TFC curves. As TFC remains
the same at all output levels, the change in TC is solely due to TVC. Therefore, the distance
between the TC curve and the TVC curve always remains the same.
4.Average Fixed Cost (AFC):

The per unit fixed cost of production is known as Average Fixed Cost. The formula for
calculating Average Fixed Cost (AFC) is:

AFC = TFC / Q

With an increase in the output, Average Fixed Cost falls. It is because the total fixed cost
remains the same at all output levels.

Example: Here is the table for AFC

Output (in units) Total Fixed Cost (TFC) Average Fixed Cost (AFC) (AFC = TFC / Q)

0 10 ∞ (undefined)

1 10 10.0

2 10 5.0

3 10 3.3

4 10 2.5

5 10 2.0

It can be seen in the above schedule that with the increase in output level, AFC falls. It is
because the constant TFC; i.e., 10 is divided by the increasing output.

##Curve for AFC

 Figure 3.12

In the above graph, the AFC curve is formed by plotting the points shown in the above
schedule. AFC will keep on falling because of the increasing output level; however, it can never
be equal to zero. Therefore, the AFC curve is a rectangular hyperbola.

5. Average Variable Cost (AVC):

The per unit variable cost of production is known as Average Variable Cost. The formula for
calculating Average Variable Cost is:

AVC = TVC​/ Q

Initially, Average Variable Cost falls with an increase in output. Once the output increases till the
optimum level, the average variable cost starts to rise.

Example: Here is the table for AVC

Output (in Total Variable Cost Average Variable Cost (AVC) (AVC =
units) (TVC) TVC / Q)

0 0 - (undefined)
 1 5 5.0

2 8 4.0

3 12 4.0

4 20 5.0

5 30 6.0

##AVC curve

Figure 3.13

In the above graph, the AVC curve is obtained by plotting the points shown in the above
schedule. AVC curve is a U-shaped curve. In the beginning, the AVC curve falls and after
reaching its minimum level; i.e., optimum output level, it starts on increasing with every
additional output.

6. Average Cost (AC):

The per unit total cost of production is known as Average Total Cost or Average Cost. The
formula for calculating Average Total Cost is:

AC = TC​/ Q
Another way to define Average Total Cost is by the sum of Average Fixed Cost and Average
Variable Cost; i.e., AC = AFC + AVC.

Just like Average Variable Cost, average cost also initially falls with an increase in output. Once
the output increases till the optimum level, the average cost starts to rise.

Example: Here the table for AC

Output (in Total Average Variable Average Fixed Average Cost (AC) (AC
units) Cost (TC) Cost (AVC) Cost (AFC) = AFC + AVC)

0 10 - (undefined) - (undefined) - (undefined)

1 15 5.0 10.0 15.0

2 18 4.0 5.0 9.0

3 22 4.0 3.3 7.3

4 30 5.0 2.5 7.5

5 40 6.0 2.0 8.0

##AC curve

Figure 3.14

In the above graph, the AC curve is a U-shaped curve, which means that initially, AC falls, and
after reaching its minimum point, it starts to rise.
AC, AVC, and AFC Curve

Figure 3.15

7. Marginal Cost

The additional cost incurred to the total cost when one more unit of output is produced is known
as Marginal Cost. Marginal Cost can be used to determine the optimal production volume and
pricing. It includes both variable costs and fixed costs .

The Marginal Cost (MC) is calculated using the formula:

MC = ΔTVC / ΔQ

Example: Here is the table for MC

Output (Q) ​ TVC ​ MC Formula ​ MC

​

​ 0 ​ - ​ -
​ 0
 ​ 5 ​ (5 - 0)/1 ​ 5
​ 1

​ 8 ​ (8 - 5)/1 ​ 3
​ 2

​ 12 ​ (12 - 8)/1 ​ 4
​ 3

​ 20 ​ (20 - 12)/1 ​ 8
​ 4

​ 30 ​ (30 - 20)/1 ​ 10
​ 5

##MC Curve
​
FIgure 3.16

In the above graph, the MC curve is formed by plotting the points shown in the above schedule.
MC is a U-shaped curve . In the beginning, the units of the variable factor are employed along
with the fixed factors, yielding increasing returns to factor and reducing MC. It pushes down the
MC curve. Now, when more variable factors are employed, it results in diminishing returns and
increasing MC after it reaches its minimum level. Therefore, the MC curve falls to its minimum
level and then increases, making the short-run MC curve, U-shaped.

3.3.2 Long-run Cost Curves

The long-run cost curve represents the minimum cost at which any given level of output
can be produced when all inputs are variable. In the long run, firms can adjust all factors
of production, meaning there are no fixed costs. The long-run cost curve is derived as
the envelope of all short-run cost curves.

1. Concept of Long-Run Cost

●​ The long-run cost function can be expressed as: C = b * q
●​ In the long run, costs depend on labor and capital, meaning firms can adjust
their production processes freely.
●​ Since all inputs are variable, there are no fixed costs in the long run.

2. Long-Run Total Cost Curve (LRTC)

●​ The Long-Run Total Cost Curve (LRTC) is derived as the envelope of all
short-run total cost curves (SRTC).
●​ Each Short-Run Total Cost Curve (SRTC) represents the cost structure for a
firm under a specific fixed input constraint.
●​ The LRTC is the sum of all SRTC tangential points, meaning it always lies
below or touches the short-run total cost curves.
3. Relationship Between Short-Run and Long-Run Cost Curves
●​ The Long-Run Average Cost (LRAC) curve is the envelope of all Short-Run
Average Cost (SRAC) curves.
●​ Mathematically, Envelope of (SRAC₁ + SRAC₂ + SRAC₃) > LRAC
This means the LRAC curve is always lower than or equal to any SRAC at a given level
of output.
The LRAC curve is U-shaped because of economies and diseconomies of scale:
●​ Decreasing costs (economies of scale): As production increases, the average
cost falls due to better resource utilization.
●​ Constant costs: At the minimum LRAC, the firm operates at the most efficient
scale.
●​ Increasing costs (diseconomies of scale): Beyond this point, costs rise due to
inefficiencies in large-scale production.

4. Tangency Points and Cost Behavior

Each SRAC curve represents a different scale of production.
The LRAC curve touches each SRAC curve at one tangential point:
Before the minimum LRAC point: The SRAC is tangent from above, meaning higher
costs in the short run.
At the minimum LRAC point: The corresponding SRAC is at its lowest cost, meaning the
firm is producing at the optimal scale.
Beyond the minimum LRAC point: The SRAC is tangent from below, meaning short-run
costs start rising.
 Figure 3.17

Figure 3.18

5. Key Observations from the Graphs

1.​ The LRTC curve is the smooth envelope of all short-run total cost curves.
2.​ The LRAC curve is the lower boundary of all SRAC curves.
3.​ Firms can adjust their scale of production in the long run to operate at the
lowest possible cost.
3.3.3 Relationship Between Cost Curves
1. Relationship Between Total Cost (TC) and Marginal Cost (MC)
●​ MC is decreasing when TC is increasing at a decreasing rate (before the
point of inflection in TC).
●​ At the point of inflection of the TC curve, MC is at its minimum.
●​ Since MC is derived from TC as the additional cost of producing one more
unit, its behavior depends on the slope of TC.
2. Relationship Between Total Cost (TC), Average Cost (AC), Total Variable Cost
(TVC), and Average Variable Cost (AVC)
●​ The Total Cost (TC) curve is the sum of Total Fixed Cost (TFC) and Total
Variable Cost (TVC): TC = TFC + TVC
●​ The TVC curve has the same shape as the TC curve but starts from the origin
since it excludes fixed costs.
●​ AC (Average Cost) and AVC (Average Variable Cost) are derived as:
AC = TC / Q
AVC = TVC / Q
●​ Both AC and AVC are U-shaped due to the Law of Variable Proportions

3. Relationship Between Marginal Cost (MC), Average Variable Cost (AVC), and
Average Cost (AC)
●​ At the minimum point of AC, MC = AC.
●​ Before the minimum AC, MC < AC.
●​ After the minimum AC, MC > AC.
●​ MC always passes through the minimum points of both AC and AVC from
below.
●​ This means that when MC is below AC or AVC, it pulls them down; when MC
is above them, it pulls them up
Key Takeaways:
1.​ The MC curve intersects both AC and AVC at their minimum points.
2.​ The MC curve initially declines, reaches a minimum, and then rises, causing
AVC and AC to follow similar trends.
3.​ TVC and TC curves exhibit an inflection point where MC is at its minimum.
4.​ The difference between AC and AVC is always the Average Fixed Cost
(AFC), which continuously declines.