Unit 3: Production and Cost

3.1 Introduction
3.2 The relationship between revenue, costs, and profit
3.3 Production and costs
3.4 The various measures of costs in the short term
3.4.1 Total cost
3.4.2 Marginal cost
3.4.3 Average or unit cost
3.5 Average cost in the long term: economies of scale

Learning Outcomes
The main outcomes of this unit are that, once you have studied the
unit, you should be able to:
▪ define and calculate the different types of revenue and profit
▪ distinguish between and calculate, the total, average and
marginal product of a variable input.
▪ distinguish between and calculate, the total, average and
marginal costs, as well as fixed and variable costs in the
short term.
▪ use your calculation of a firm’s marginal or average costs in
the short term to assess whether production in the firm is
efficient or not
▪ determine whether a firm is experiencing increasing,
constant or decreasing economies of scale by calculating the
firm’s average costs in the long term.

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3.1 Introduction
Whether firms are large or small, however, to survive and contribute to the
economy they need to make a profit. To do this, they have to keep a very
accurate record of the money they spend and the money they receive. If they
lose track of their costs or their revenue at any point, they will be running
the risk of getting into financial difficulties or operating inefficiently or at a
loss without even knowing it. They, therefore, need a system to analyze
precisely what their cost and their revenue are.
In this Unit, we will examine the different types of cost and revenue that play
a role in the operation of a firm. We will also see how a firm should calculate
its various types of costs and revenue.
Thus, in this unit, we will explore how producers can determine whether
they are maximizing their revenue.
3.2 The relationship between revenue, costs, and profit
The amount that a firm receives for the sale of its output (in our example,
cookies) is called total revenue.
𝑻𝒐𝒕𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 = 𝑷𝒓𝒊𝒄𝒆 𝒙 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒔𝒐𝒍𝒅
The amount that the firm pays to buy inputs (flour, sugar, workers, ovens,
etc.) is called the total cost.
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 = 𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕 + 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕
We define profit as a firm’s total revenue minus its total cost.
𝑷𝒓𝒐𝒇𝒊𝒕 = 𝑻𝒐𝒕𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 – 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕
Thus, the objective of most of firm’s is to make their profit as large as
possible.

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3.3 Production and costs
Firms incur costs when they buy inputs to produce goods and services that
they plan to sell. In this section we will examine the relationship between
the firm’s production process and its total cost.
The output of a firm’s production process is also called its product. The total
product of a firm is everything that it produces. Suppose that the size of
Lucky’s factory is fixed, but that Lucky can vary the quantity of cookies
production by changing the number of workers. Let’s look at the below table
that depict cookies production per hour.

Number of workers Output (Quantity of cookies

produced per hour)
0 0
1 50
2 90
3 120
4 140
5 150
Table A: Cookie production per hour

If there are no worker in the factory, there is no production of cookies during

that hour. When there is one worker, the factory produces 50 cookies per
hour. When there are two workers, 90 cookies per hour are produced, and
120 cookies per hour are produced when there are three workers.
The relationship between a firm’s input (e.g. workers) and its outputs
(product) is called the firm’s production function. On a graph, the
production function can be shown as a curve that illustrates total product.

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 160
Quantity of Cookies produced per hour TP
140

120

100

80

60

40

20

0
0 1 2 3 4 5 6
Number of Workers

Figure A: Production function for cookies

The firm’s average product is the number of units of output produced per
unit of the variable input. In other words:
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 (𝑨𝑷) = 𝑻𝒐𝒕𝒂𝒍 𝒐𝒖𝒕𝒑𝒖𝒕 ÷ 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚
The marginal product of the variable input (worker) is the quantity of
additional output produced by adding one additional unit of the variable
input.
Number of Output Average Marginal
workers (Quantity of product (AP) of product (AP) of
cookies cookies cookies
produced per
hour)
0 0 0 0
1 50 50 50
2 90 45 40
3 120 40 30
4 140 35 20
5 150 30 10

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3.4 The various measures of costs in the short term
3.4.1 Total cost
Is all the cost incurred by the entrepreneur in producing a given
quantity for example the cost of raw material, labour, electricity,
the renting of premises, and so on.
Whatever the quantity produced, some of these cost items will
remain the same. For example, the rent of the premises will remain,
say, N$ 7 000 per month, no matter how much is produced on the
premises. These costs that stay the same are known as fixed costs.
Other costs vary with the quantity produced, such as the cost of
raw materials. For examples, to produced 400 cars a company may
need N$ 20 000 worth of steel, while to produce 200 cars it may
need N$ 10 000 worth of steel. The cost will thus vary, depending
on how much material is used. Costs that vary in this way are called
variable costs.
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 = 𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕 + 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕

Quantity of lemonade Fixed cost Variable Total Cost

(tins produced per (N$) Cost (N$) (N$)
hour)
0 3 0 3.00
1 3 0.30 3.30
2 3 0.80 3.80
3 3 1.50 4.50
4 3 2.40 5.40
5 3 3.50 6.50
6 3 4.80 7.80
7 3 6.30 9.30
8 3 8.00 11.00
9 3 9.90 12.90
10 3 12.00 15.00
Table B: Total, fixed and variable costs

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3.4.2 Marginal cost
Marginal cost is the amount by which total costs increase (or
decrease) when one extra product is produced. Marginal cost can
be defined as the extra or additional cost incurred by the
production of one more production unit.
Quantity of lemonade Total Cost Marginal Cost
(tins produced per hour) (N$) (N$)
0 3.00 0
1 3.30 0.30
2 3.80 0.50
3 4.50 0.70
4 5.40 0.90
5 6.50 1.10
6 7.80 1.30
7 9.30 1.50
8 11.00 1.70
9 12.90 1.90
10 15.00 2.10
Table C: Marginal cost of producing lemonade

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3.4.3 Average or unit cost
Is the unit cost of production -that is, the cost to manufacture every
individual unit.
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒄𝒐𝒔𝒕 (𝑨𝑪) = 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 (𝑻𝑪) ÷ 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 (𝑸)

Quantity of lemonade Total Cost Average Cost

(tins produced per hour) (N$) (N$)
0 3.00 0
1 3.30 3.30
2 3.80 1.90
3 4.50 1.50
4 5.40 1.35
5 6.50 1.30
6 7.80 1.30
7 9.30 1.33
8 11.00 1.38
9 12.90 1.43
10 15.00 1.50
Table D: Average cost of producing lemonade

3.5 Average cost in the long term: economies of scale

The long term (also called long run) is a period in which a firm can
completely change all its input – a period long enough, for example, for the
firm to move to a different factory, or to start producing a new type of
product.
If a firm has increasing returns in the long term, we say that the firm is
experiencing economies of scale. Increasing economies of scale occur
when a firm increases its inputs and then receives outputs that are
greater than the inputs it used. For example, a firm will have increasing
economies of scale if it doubles its input in the production process, and then
gets outputs that are more than double.
A situation can arise where a firm experiences constant economies of
scale. This means that the firm’s output will double exactly when the inputs
in the production process are doubled.

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An enterprise may also experience decreasing economies of scale (also
diseconomies of scale). If the enterprise expands and becomes bigger than
the most effective size, the output will increase by less than the inputs. One
possible reason for this is that the large size of the enterprise might make it
more difficult to manage effectively.

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