Production and cost

• A firm is an entity concerned with the purchase and employment of resources in the production of various goods and services.
• Different forms of firm are:

  • sole proprietorship
  • partnership
  • corporation.
• Sole proprietorship is easy to set up and organize

  • All profits and all costs assumed by the owner
  • Unlimited liability
• Partnership is easy to organize; less legal expense and paperwork

  • Partnership is dissolved when partner dies
  • Unlimited liability
• Corporation is the most dominant form of business enterprise

  • Most effective for raising financial capital
  • When any of its owners dies, corporation is NOT dissolved
  • Substantial legal expense in setting up
  • Principal-agent problem may occur:

  Principal (owners may want maximum profit);

  Agent (managers may go for power and prestige)
• The production function is a physical relationship between the inputs of a firm and its output of goods and services, ceteris paribus.
• inputs of a firm are resources that contribute to the production of a good/service.
• Fixed inputs are resources that are used at a constant amount in the production of a commodity.
• Variable inputs are resources that can change in quantity depending on the level of output being produced.
• The change in output for a one unit change in the quantity of an input, holding all other inputs constant.

  marginal product
• states that "as the use of an input increases (with other inputs fixed),

  a point will eventually be reached at which the resulting additions to output decrease"

  diminishing marginal product
• The average product measures the total output per unit of

  input used

  • The "productivity" of an input is usually expressed here
  • The greater the value of average product, the higher the efficiency in physical terms.
• MP is dragging AP:

  • If MP > AP, AP is rising
  • If MP = AP, AP is at maximum
  • If MP < AP, AP is falling
• Stage I of production

  • AP is increasing so MP > AP

  • Stage I stops where AP reaches its maximum point (MP = AP)
• Stage II of production

  • starts where the AP begins to decline

  • Q continues to increase, although at a decreasing rate, and in fact reaches a maximum

  • MP declines, until it reaches zero, as additional labor inputs are employed.
• Stage III of production

  • starts where the MPL has turned negative.

  • Q falls as more inputs are used in production

  • TP, AP and MP curves are decreasing
• Why does the firm produces at stage 2?

  In this stage, the additional units of input result in diminishing increases in output. This allows producers to make rational decisions about how much input to use in order to maximize output and minimize costs
• Payments made by the firm

  explicit cost
• These are imputed costs of self-owned or self employed resources based on their opportunity costs; no actual payment made from one entity to another.

  implicit cost
• in the long run, all costs are variable
• This component of cost is independent of the level of

  output produced.

  total fixed costs
• Component of cost that changes with the level of output

  total variable cost
• sum of total fixed cost and total variable cost. As the level of output increases, the total cost of the firm also increases.


  total cost
• This declines as Q increases.

  average fixed cost
• This generates a U shaped curve

  average variable cost
• Sum of average fixed cost and average variable cost

  average cost
• The gap between AC and AVC narrows as Q increases due to the falling AFC
• Shows the change in total cost for a unit change in output

  marginal cost
• MC drags AC and AVC and intersect on both lowest points
• Long run average cost decreases as output increases

  economies of scale
• Long run average cost increases as output increases

  diseconomies of scale