Chapter 4: Theory of Firm

1. Production
● A transformation of resources or input into goods and services.

● Example: It takes certain resources or input to produce a computer.

2. Profit
● Profit is the money a business earned after accounting for all expenses.

● Profit = Total revenue - Total cost

@

● Profit= (Price X Quantity of Good Sold) – Total Cost

3. Explicit cost :
● A cost that is incurred when an actual (monetary) direct payment is made to the
resources which are not belongs to the firm. It is a direct cost paid for the resources
to do the business
● Eg: Wages, Materials, Equipment and etc

4. Implicit cost:
● A cost that represents the value of resources used in production for which no actual
(monetary) payment is made. It refer to ‘opportunity cost’
● Eg: As long as the statement explains about the owner used to be …and gave up
his/her job or saving to start his/her business, that statement is refer to Implicit cost

5. Accounting Profit:
● The difference between total revenue and explicit costs.

● Accounting Profit = Total Revenue (TR) - Total Explicit Cost

6. Economics Profit:
● The difference between total revenue and total cost, including both explicit and
implicit costs. Smaller than accounting profit.
● Economics Profit: Total Revenue (TR) – (Total Explicit Cost+ Total Implicit Cost)
Practice Session:
Question1:
David previously worked as a manager with an annual salary of RM50000. Now, he decides
to open a restaurant at his own shop. Below is the yearly data of David’s business:

Items Amount (RM)

Payment to raw material suppliers 20,000

Interest earned from saving in bank 2,000

Rental earned from own shop 6,000

Salary of helper in restaurant 8,000

Total yearly sales 120,000

(i) How much is David’s implicit cost?

(ii) Calculate his accounting profits.
(iii) How much is his economic profits?

Question2:

Joseph is thinking of quitting his job as a marketing manager where he earned RM240,000 a year. He
intends to set up a cafe using his RM300,000 personal savings that earned interest of RM5,000 per
year.
During the year, he estimates that he will make RM240,000 in total revenue. His estimated costs are
about RM20,000 for the costs of equipment, utilities, internet service and supplies.

(i) Calculate Joseph’s estimated accounting profit and economic profit.

Question3:

Tim decided to quit from his job as an event manager where he earned RM130,000 a year. Tim sets up
a telecommunication business, using his RM600,000 personal savings that earned interest of RM6,000
per year. During that year, he made RM240,000 in total revenue and paid RM13,000 for the costs of
equipment, utilities, internet service and office supplies.
 (i) Calculate Tim’s accounting profit and economic profit.

7. Production
● A transformation of resources or input into goods and services.

● Example: It takes certain resources or input to produce a computer.

8. Types of the Input:

Fixed Input
• A fixed input is an input whose quantity •
cannot be changed as output changes in
the short run.
• The costs associated with fixed inputs are •
fixed costs. A fixed cost doesn’t change
as output changes.
• Example: Machine, Building
Variable Input
A variable input is an input whose
quantity can be changed as output changes
in the short run.
The costs associated with variable inputs
are variable costs. A variable cost
changes as output changes
• Example: Material, Labour

9. Production and Cost

Production in the Short Run Production in the Long Run

● Production in the Short Run consist of 2 ● Production in the Long Run consist of
types of Input, known as Variable Input only and there is no Fixed
i) Fixed Input Input.
ii) Variable Input

● In the SR, The cost associated with these ● In the LR, since the production only
inputs are known as ‘FIXED COST’ and consists of ‘VARIABLE INPUTS’, so the
‘VARIABLE COST’ cost associated with these inputs are
known as ‘VARIABLE COST’
Practice Session: Complete the table below. The cost of using 1 unit of worker is RM3 and the cost of
using 1 capital is RM5

Variable Fixed Outpu Total Total Total Average Average Average Marginal
Input Input t (Q) Variable Fixed Cost Fixed Variable Total Cost
(Worker) (Capital) Cost Cost (TC) Cost Cost Cost (MC)
(TVC) (TFC) (AFC) (AVC) (ATC)

0 1 0

1 1 18

2 1 37

3 57

4 76

5 94

6 111

7 127

8 137

9 1 133

10 1 125

Rough Work:
10. Marginal Physical Product (MPP)

● The change in output that results from changing the variable input (Worker) by one unit.

● MPP is calculated by:

11. Law of diminishing marginal returns:

When variable inputs (Workers) are continue to add on a fix input (Land), the
productivity or Marginal Physical Product will decline.
Practice Session:

At which unit of labour employed does the law of diminishing marginal returns set in?
Variable Input Fixed Input Output Marginal Physical Product
(Worker) (Capital) (Q)
(MPP)
 0 1 0

1 1 18

2 1 37

3 57

4 76

5 94

6 111

7 127

8 137

9 1 133

10 1 125

Rough Work:

12. Average and Marginal Cost:

● Average Cost (ATC): Total cost divided by quantity of output @ ATC = TC / Q. (Refer
to practice session item 9)
● Marginal Cost (MC): The change in total production cost that comes from making or producing
one additional unit. MC= Change in TC / Change in Output . (Refer to practice session item 9)

13. Average-Marginal rule:

When the marginal magnitude is above the average magnitude, the average magnitude rises
When the marginal magnitude is below the average magnitude, the average magnitude falls
14. Relationship between Marginal Physical Product(MPP) and Marginal Cost (MC):
● What the marginal cost curve looks like depends on what the marginal physical product
curve looks like.
● When MPP increase, MC will drop;

● When MPP reached Max, MC reached Min.

● When MPP drop, MC will increase

15. Sunk cost :

● A cost incurred in the past that cannot be changed by current decisions and therefore
cannot be recovered. Economists advise individuals to ignore sunk costs.
 ● Example: The money Vincent paid for the movie ticket is a sunk cost (the movie
theaters do not give your money back if you dislike the movie).

16. Long Run Average Total Cost Curve (LRATC)

• Economies of Scale (EOS) exist when inputs are increased by some percentage (10%)
and output increases by a greater percentage (>10%), causing unit costs to fall.
• Constant Returns to Scale (CRS) exist when inputs are increased by some percentage
(10%) and output increases by an equal percentage (10%), causing unit costs to remain
constant.
• Diseconomies of Scale (DOS) exist when inputs are increased by some percentage(10%)
and output increases by a smaller percentage(<10%), causing unit costs to rise.
• Minimum Efficient Scale is the lowest output level at which average total costs are
minimized

● Why Economies of Scale??

● The used of high level of technology will caused the firm to produce more products
and services at cheaper cost
● The used of skilled workers will help the firm to produce the products and services
faster and cheaper.
● Why Diseconomies of Scale??
 ● Management inefficiency: There is a conflict in terms of communication and work
allocation. Causing the cost of production to increase.

IMPORTANT FORMULAS:

● Average Physical Product (APP) = Q/L