Costs of pro

duction and
Resource Co
• By the end of this topic students would be able to:

• Identify what profit consists of

• Explain how costs of production are measured

• Explain the relationship between inputs and outputs in the long run

• Explain how costs vary with output in both the short and long run

• Explain economies of scale and the reasons for such economies

• Explain how a business can combine its inputs efficiently

 The firm and its economic
problem

• A firm is an institution that organizes factors of

production in an attempt to make a profit

• The ultimate goal of a firm is to maximize profit;

however, it also emphasizes improving quality,
increasing market share, and satisfying customer
wants

• So the question is, how does a firm maximize its

profit?
Total Revenue, Total Cost, Profit
 Two alternative approaches to
measure profit
Measure a firm’s profit using set standards established by
the concerned authorities (OR)
Measure profit based on opportunity cost as the relevant
measure of cost
• Opportunity cost: The value of the firm’s best
alternative use of resource

• Opportunity cost needs to be expressed in monetary

terms. A firm’s opportunity cost should include its:
• Implicit costs
• Explicit costs
 Costs: Explicit vs. Implicit

• Explicit costs require an outlay of money

• e.g., paying wages to workers, rent, electricity
bills, etc.
• Implicit costs are equal to what factors of
production could earn for the firm in an alternative
use, and they do not require a cash outlay,
• e.g., the opportunity cost of the owner’s time or
financial resources, the firm’s capital
• Remember that the cost of something is what you
give up to get it.
• This is true whether the costs are implicit or
Explicit vs. Implicit Costs: An Example
 Costs
• Fixed Costs: Costs that do not vary with
output; e.g. cost of a factory

• Variable Costs: Costs that do vary with

output; e.g. electricity, materials

• Total Costs: Fixed + variable costs

• Marginal Cost: This is the cost of producing

one extra unit.

• Sunk Costs: These are costs that are not

recoverable e.g. advertising
 Fill the table
Quanti FC TC VC MC AVC ATC
ty

0 1000 1000

1 1000 1200

2 1000 1300

3 1000 1550

4 1000 1900
• Total Product- the total amount produced
during some period of time by all the inputs
that the firm uses
• Average product- the total product per unit
of the variable input, which is labour in the
present case. AP=TP/L
• Marginal Product- is the change in total
product resulting from the use of one more
(or one less) unit of the variable input.
MP=Change in TP/Change in L
Q of Labour TP AP MP
1 43
2 160
3 351
4 600
5 875
6 1152
7 1372
8 1536
9 1656
10 1750
11 1815
12 1860
Economists describe both short run and
long run average cost curves as u
shaped. Why?

• Short Run Cost curves are U shaped

because of diminishing returns.

The Law Of Diminishing Marginal

Returns
• Total Product (TP) This is the total
output produced by workers
• Marginal Product (MP) This is the
output produced by an extra worker
 Law of diminishing
marginal returns
• Diminishing Returns occurs in the short run when one factor is
fixed (e.g. Capital)
• If the variable factor of production is increased, there comes a
point where it will become less productive and therefore there
will eventually be a decreasing marginal and then average
product
• This is because if capital is fixed extra workers will eventually
get in each other’s way as they attempt to increase production.
• E.g. think about the effectiveness of extra workers in a small café.
If more workers are employed production could increase but more
and more slowly.

• This law only applies in the short run because in the long run
all factors are variable
• Therefore as MP increases MC declines
and vice versa

• A good example of Diminishing Returns

includes the use of chemical fertilizers-
a small quantity leads to a big increase
in output.
• However, increasing its use further
may lead to declining Marginal Product
(MP) as the efficacy of the chemical
declines
 Difference between
diminishing returns and
diseconomies of scale
• Diminishing returns relates to the short
run – higher SRAC.

• Diseconomies of scale is concerned

with long run. (higher LRAC)
Short run cost curves
• In the short run capital is fixed. After a
certain point, increasing extra workers leads
to declining productivity. Therefore, as you
employ more workers the Marginal Cost
increases.
• Note FC (fixed costs) remain constant.
Therefore the more you produce, the lower
the average fixed costs will be.
• To work out Marginal cost, you just see how
much TC has increased by.
• For example, the first unit sees TC increase
from 1,000 to 1,200 (therefore the increase
(MC) is 200)
• For the second unit, TC increases from 1,200 to
1,300 (therefore the increase MC is 100)
Long run cost curves
• The long run cost curves are u shaped
for different reasons.

• It is due to economies of scale and

diseconomies of scale. If a firm has
high fixed costs, increasing output will
lead to lower average costs.
 Revenue
A firm’s revenue are it’s receipts of money
from the sale of goods and services over a time
period such as a week or a year.
• Total revenue (TR) is the total amount of money received
from the sale of any given level of output. It is the total
quantity sold times the price. TR=TQ x P

• Average revenue (AR) is the average receipt per unit sold. It

can be calculated by dividing total revenue by the quantity
sold. AR=TR/QS=P

• Marginal revenue (MR) is the receipts from selling an extra

unit of output. It is the difference between total revenue at
different levels of output. MR= NTR-OTR
Quantity Price (£) TR MR AR
1 8
2 7
3 6
4 5
5 4
6 3
7 2
 • Under normal conditions, the
demand curve facing the firm is
downward sloping from left to right.
This implies that to sell increasing
items of a product a firm must
Price
accept a lower price for each
successive unit.

Ped = -1 • Marginal Revenue (MR) is the

addition to TR as a result of selling
one extra unit of output. If the D
curve is downward sloping, each unit
is sold at a progressively lower price.
The MR curve lies under the D(AR)
curve.
D = AR • At the point where the MR cuts the
horizontal axis, MR = O. That means
that the addition to TR from selling
one extra unit was 0. This is the
definition for unit price elasticity of
MR demand.
• Therefore the equivalent point on the
D curve is where Ped = - 1
 • When price elasticity of demand
is elastic, the % change in Qd is
> % change in P. In such
circumstances, a reduction in
price of 10% would see D rising
Price by more than 10% and TR would
rise. The addition to TR must
therefore be positive shown by
Ped = -1
the highlighted area on the MR
curve.
• It follows that when MR is
negative, the addition to TR must
be negative. If this is the case
then a reduction in price by 10%
D = AR would lead to Qd rising by less
than 10% meaning TR would fall.
• Elasticity in this range of the
demand curve must therefore be
between infinity and -1 or
MR
elastic.
 • When MR is negative, the addition
to TR must be negative. If this is
the case then a reduction in price
by 10% would lead to Qd rising by
less than 10% meaning TR would
Price
fall.
• Elasticity in this range of the
demand curve must therefore be
between 0 and -1 - inelastic

Ped in this range

is between 0 and -1
D = AR

MR
Cost / Revenue
TC
Putting the two together:
If we put the two
diagrams together we
can see that profit
maximisation occurs
where the difference
between TR and TC is
greatest (where MC =
TR
MR)
Output/Sales
MC If a firm was to target
revenue maximisation
as an objective, this
would not necessarily
correlate with the profit
maximising output –
D = AR revenue maximisation
Output/Sales occurs where TR is at
Q1 Q2
a maximum (MR = 0)
MR