Chapter 6 – Theory of the firm I: Production, costs, revenues and profit

(Cambridge Economics)

6.1. Production in the short run: the law of diminishing returns

a. The short run and the long run
Short run Long run
A time period during which at least one A time period when all inputs can be
input is fixed and cannot be change by the changed
firm
Ex: if a firm wants to increase output, it
can hire more labor and increase
materials, tools and equipment. But it
cannot quickly change the size of its
buildings, factories and heavy machinery

Note: the short run and the long run do not correspond to any particular length of time.
b. Total product, marginal product and average product
Items Definition Formula
Total product (TP) The total quantity of output
produced by a firm
Marginal product (MP) The extra or additional ∆ TP
MP=
output resulting from one ∆ unit of labour
additional unit of the
variable input, labor. It tells
how much output increases
as labor increases by one
worker
Average product (AP) The total quantity of output TP
AP=
per unit of variable input or unit of labour
labor. This tells us how
much output each unit of
labor produces on average
The diagram (a) and (b) are divided into three parts:
- Increasing marginal product: when labour units increase, the marginal product
of labour is increasing. The addition to total product made by each unit of labour
gets bigger and bigger. When 4 workers are employed, marginal product equal to 5
units of output, is maximum.
- Decreasing marginal product: when labour units are 4-9, the marginal product of
labout is decreasing. The addition to total product made by successive units of
labour becomes smaller and smaller.
- Negative marginal product: at 8 and 9 units of labour, total product is maximum.
But the ninth unit of labour adds zero units of output  MP of ninth unit of labour
= 0. At 9 units of labour, total products to fall and correspond to the negative
marginal product of the tenth and eleventh workers.
c. The relationship between the marginal and average product curves
- when the MP curve lies above the AP curve (MP>AP)  AP increases
- when the MP curve lies below the AP curve (MP<AP)  AP decreases
 the marginal product curve always intersects the average product curve when this is at
AP’s maximum.
d. Law of disminishing returns (Quy luat loi nhuan giam dan) = law of diminishing
marginal
As more and more units of a variable input are added to one or more fixed inputs, the
marginal product of the variable input at first increases, but there comes a point when it
begins to decrease. This relationship presupposes that the fixed input(s) remain fixed, and
that the technology of production is also fixed.

6.2. Introduction to costs of production: economic costs

- Costs of production as opportunity costs
- In economics, because of the condition of scarcity, economic costs which include all
costs of production are opportunity costs of all resources used in production.
- Explicit, implicit costs and economic costs:
Explicit costs (chi phi thay ro): payments made by a firm to outsiders to acquire
resources for use in production
Implicit costs (chi phi an): the scarificed income arising from the use of self-
owned resources by a firm
Economic costs: the sum of explicit and implicit costs, or total opportunity costs
incurred by a firm for its use of resources, whether purchased or self-owned. When
economists refer to ‘costs’ they mean ‘economic costs’
Example:
Suppose you had a job with a salary of $60,000 a year, which you decided to quit to open
your own business. You estimate that your entrepreneurial talent you are putting into
your business is worth $45,000 a year. You set up your office in a spare room of your
house that you used to rent out for $4,000 a year. Futher, you borrow $30,000 for which
you are paying interest of $2,000 a year, and use the borrowed amount to buy supplies
and materials. You also hire an assistant whom you pay $18,000 a year. Your explicit,
implicit and economic costs are:
Implicit costs:
$60,000 (opportunity cost of your foregone salary)
$45,000 (opportunity cost of your entrepreneurial talent)
$4,000 ( opportunity cost of foregone rental income from your spare room)
 Total $109,000
Explicit costs:
$2,000 (interest on your loan)
$30,000 (purchase of supplies and materials)
$18,000 (assistant’s salary)
 Total $50,000
Economic costs = (total opportunity costs) = $109,000 + $50,000 = 159,000

6.3. Costs of production in the short run

a. Fixed, variable and total costs in the short run and long run
- fixed costs arise from the use of fixed inputs. Fixed costs are the cost that do not change
as output changes.
- variable costs arise from the use of variable inputs. These are costs that vary (change) as
output increases or decreases. Therefore, they are ‘variable’.
- Total costs are the sum of fixed and variable costs.
In the short run, a firm’s total costs are the sum of fixed and variable costs.
In the long run, there are no fixed costs, therefore, a firm’s total costs are equal to its
variable costs.
b. Total, average and marginal costs
Average costs are costs per unit of output or total cost divided by the number of units of
output. They tell us how much each unit of output produced costs on average.
Total costs Average costs
Total fixed costs (TFC) Average fixed costs (AFC) = TFC/Q
Total variable costs (TVC) Average variable costs (AVC) = TVC/Q
Total costs (TC) = TFC + TVC Average total costs (ATC) = TC/Q = AVC
+ AFC
c. Marginal costs
Marginal costs MC is the extra or additional cost of producing one more unit of output. It
tells us by how much total costs increase if there is an increase in output by one unit.
∆ TC ∆TVC
MC= =
∆Q ∆Q

d. Costs curves and product curves

e. Relating the cost and product curves: the law of diminishing returns
The U-shape of the AVC, ATC and MC curve is due to the law of diminishing returns.
This law also explains why the AVC and MC curves are mirror images (hinh anh phan
chieu) of the AP and MP curves.
f. Shifts in the cost curves (supplementary material)
6.4. Production and costs in the long run
a. Production in the long run: returns to scale
- Constant returns to scale means that output increases in the same proportion as all
inputs: given a percentage change in all inputs, output increases by the same percentage.
- Increasing returns to scale means that output increases more than in proportion to the
increase in all inputs: given a percentage increase in all inputs, output increases by a
larger percentage.
- Decreasing returns to scale means that output increases less than in proportion to the
increase in all inputs: given a percentage increase in all inputs, output increases by a
smaller percentage.
b. Costs of production in the long run
The long run avearage total cost curve LRATC is defined as a curve that shows the
lowest possible average cost that can be attained by a firm for any level of output when
all of the firm’s inputs are variables. It is a curve that just touches (is tangent to) each of
many short-run average total cost curves. It is also known as a planning curve.
c. The shape of the LRATC curve: economies and diseconomies of scale
c1. Economies of scale
Economies of scale are decreases in the average costs of production over the long run as a
firm increases all its inputs. Economies of scale explain the downward-sloping portion of
the LRATC curve: as output increases, and a firm increases all inputs, average cost or
cost per unit of output, falls.
There are several reasons why this can occur:
- Specialisation of labour: as a scale of production increases, more workers must be
employed, allowing for greater labor specialisation.
- Specialisation of management: large scales of production allow for more managers to be
employed, each of whom can be specialised in a particular area, again resulting in greater
efficiecency and lower average cost.
- Efficiency of capital equipment: Large machines are more efficient than smaller ones.
However, a small firm with a small volume of output cannot make effective use of large
machines and is forced to use smaller, less efficient ones.
- Indivibities of capital equipment: Some machines are only available in large size thar
require large volumes of output in order to used effectively. They cannot divided up into
smaller pieces of equipment.
- Spreading of certain costs, such as marketing, over larger volumes of output: costs of
certain activities such as marketing and advertising, design, research and development
result in lower average costs if they can be spread over large volumes of output.
c2. Diseconomies of scale
Diseconomies of scale are increase in the average costs of production as a firm its output
by increasing all its inputs. Diseconomies of scale are responsible for the upward-sloping
part of the LRATC curve: as a firm increases its scale of production, costs per unit of
output increase.
Reasons for diseconomies of scale can include:
- Coordination and monitoring difficulties: as a firm grows larger and larger, there may
come a point where its management runs into difficulties of co-ordination, organisation,
co-operation and mornitoring. The result involves growing inefficiencies causing average
costs to increase as the firm expands.
- Communication difficulties: a larger firm size may lead to difficulties in communication
between various component parts of the firm, again resulting in inefficiencies and higher
average costs.
- Poor worker motivation: if workers begin to lose their motivation, to feel bored and to
care little about their work, they become less efficient, with the result that costs per unit
of output start to increase.
C3. Constant returns to scale
After exhausting economies of scale, many firms exhibit constant returns to scale, and do
not run into diseconomies of scale even as size becomes very large.
C4. The minimum efficient scale and the structure of industries (supplementary
materials)
There is a point on the long-run average total cost curve that represents the lowest level
of output at which the lowest long-run total average costs are achieved, called the
minimum efficient scale (MES).
6.5. Revenues
a. Total revenue, marginal revenue and average revenue
Revenues are the payments firms receive when they sell the goods and services they
produce over a given time period.
Total revenue TR is obtained by multiplying the price at which a good is sold P by the
number of units of the goods sold Q
TR=PxQ
Marginal revenue MR is the additional revenue arising from the sale of an additional unit
of output
∆ TR
MR=
∆Q

Average revenue AR is revenue per unit of output sold

TR
AR=
Q

Note: AR is always equal to P, or the price of the product. The reason is that since
TR
AR= , it follows that TR=ARxQ but since TR=PxQ AR=P
Q

b. Revenue curves where the firm has no control over price

Note: The price at which the good is sold does not change
c. Revenue curves where the firm has some control over price

The price at which the good is sold changes as the quantity of output changes

6.6. Profit
a. Distinguishing between economic and normal profit
Economic Profit Normal profit
Economic profit Can be defined as the minimum amount of
= total revenue - economic costs revenue that the firm must receive so that
= total revenue – the sum of explicit costs it will keep the business running (as
and implicit costs opposed to shutting down).
Also can be defined the amount of
revenue that covers all implicit costs
 (including the payment fro
entrepreneurship which is itself an implicit
costs) This prepurposes that total revenues
are just enough to cover both explicit and
inplicit costs
 A firm earns normal profit when
total revenue = economic costs and
Economic profit = zero
 This called break-even point of the
firm.

b. Why a firm continues to operate even when earning zero economic profit
Economic profit can be positive, zero and negative.
Positive economic profit: TR > economic cost  the firm earns supernormal profit (or
abnormal profit)
Zero economic profit: TR = economic cost  the firm earns normal profit
Negative economic profit TR < economic cost  ther firm makes a loss.
6.7. Goals of firms
a. Profit maximisation
Standard economic theory of the firm assumes that firms behavior is guided by the firm’s
goal to maximise profit.
Profit maximisation involves determining the level of output that the firm should produce
to make profit as large as possible.
There are 2 approaches to analysing profit maximisation: (i) total revenue and total cost
concepts, (ii) marginal revenue and costs.
a1. Profit maximisation based on the total revenue and cost approach
The firm’s profit-maximisation rule is to produce the level of output where TR – TC (=
economic profit) is as large as possible.

a2. Profit maximisation based on the marginal revenue and cost approach
The firm’s profit- maximisation rule is to choose to produce the level of output where
MC = MR. The same rule is used by the firm that is interested in minimishing its loss.

b. Additional goals of firms

b1. Revenue maximisation
Increasing sales and maximising the revenues may be more useful to a firm than profit
maximisation:
 - Sales can be indentified and measured more easily over the short run than profits,
and increased sales targets can be used to motivate employees.
- Rewards for managers and employees are often linked to increased sales rather
than increased profits.
- It is often assumed that revenues from more sales will increase more rapidly than
costs, profit (=TR – TC) will increase.
- Increased sales give rise to a feeling of success, whereas declining sales create a
feeling of failure.
b2. Growth maximisation
Growth maximisation can be attractive for the following reasons:
- A growing firm can be achieve economies of scale and lower its average costs.
- As a firm grows it can diversity into production of different products and markets
and reduce its dependence on a single product or market.
- A large firm has greater market power and increased ability to influence prices.
- A large firm reduces its risks because it may be less affected in an economic
downturn and is less likely to be taken over (bought) by another firm.
- The objective of growth maximisation reconciles (dan xep, hoa giai) the interests
of both owners and managers becausee both groups have much to gain from a
growing firm.
b3. Managed utility maximisation
When firm management is separated from firm ownership, managers develop their own
objectives that resolve around the maximisation of their own utility (satisfaction).
Managerial utility can be derived from increased salaries, larger fringe benefits,
employment of more staff that gives rise to a feeling of importance, and investment in the
managers’ favourite projects.
The result may be to cut into profits and make lower than they would be.
b4. Satisficing
Firms try to establish processes through which they can make compromises and reconcile
conflicts to arrive at agreements, the result of which is the pursuit of many objectives that
are replaced in a hierarchy. This behavior was termed satisficing by H. Simon, a Nobel
Prize-winning economist.
b5. Ethical and evironmental concersn: corporate social responsibility
The self-interested behavior of firms often leads to negative consequences for society.
However, many firms are increasingly recognishing that the pursuit of self-interest need
not necessarily conflict with ethical and environmentally responsible behavior.
The firms face strong incentives to display corporate social responsibility by engaging in
socially beneficial activities:
- Avoidance of polluting activities
- Engaging in environmentally sound practices
- Support for human rights, such as avoding exploitation of child labor and labor in
genear in less developed countries, or avoiding investment in countries with
politically oppresive regimes (che do ap buc)
- Art and athletics sponsorships (tai tro nghe thuat va dien kinh)
- Donation to charities ( quyen gop cho cac to chuc tu thien)