ECO0006

Economics for Managers

© 2022 Singapore Institute of Management Group Limited

 Lecture 3
Production and Costs in the Short
Run and Long Run

Ref:
Tan Khay Boon, Economics for Managers Module Book,
SIM Global Education, 2014
Session 3
 Learning Objectives
At the end of the lesson, students will be able to:
1. Comprehend the supply decisions of firms.

2. Explain the short run theory of production.

3. Explain the long run theory of production

4. Demonstrate the profit maximising output and

level of output using marginal cost and revenue
curves.
 Decision of Firms
• Objectives of the firm

– Primary objective

• Maximize profits

• Profit = Total Revenue – Total Cost

• Total Revenue = Price x Quantity

• Total Cost = Cost of production

 Types of Profit
Accounting profit Vs Economic profit

• Accountants take into account only explicit

costs: costs made to external parties (rental,
wages, utilities etc)

• Accounting profit = Total revenue – Explicit

cost
 Types of Profit
• Economic profit takes into account explicit
and implicit costs (opportunity costs).
– Implicit costs typically includes use of own
resources that could otherwise attract earnings

• Economic profit = Total Revenue – (Explicit

Cost + Implicit Cost)

• Accounting profit > Economic Profit

 Types of Profit
Normal Profit => Economic Profit = 0
• Accounting profit >0
• Profit ≡ Opportunity cost of resources
• Earning same amount as the next best use of firm’s
resources

Normal Profit = Total Revenue = (Explicit + Implicit Cost)

 Types of Profit
Example
A person gives up his job of monthly salary
$3,000 to set up a company selling shoes. He
converts his house to a shop to sell the shoes.
Previously he rented out his house to collect
rental of $1000 per month. He also hires an
assistant for $800 per month . The raw
materials, machines, utilities etc cost him
$20,000. Within one year, the company
produces 1500 pairs of shoes and they are sold
at $30 per pair. How much profit/loss does he
make for the year?
 Types of Profit
Example
• Total revenue = $30 X 1,500 = $45,000
• Wage cost = $800 X 12 = $9,600
• Raw materials and other costs = $20,000
• Salary forgone = $3,000 X 12 = $36,000
• Rental forgone = $1,000 X 12 = $12,000

Accounting profit = $45,000 - $20,000 - $9,600 = $15,400

(Profit)

Economic profit = $45,000 - $20,000 - $9,600 - $36,000 -

$12,000 = -$32,600 (Loss)
Types of Input & Production Period

2 types of inputs

• Variable input – Input whose quantity can be

changed during the period of time under
consideration e.g. workers.

• Fixed input – Input whose quantity cannot be

changed during the period of time under
consideration e.g. firm’s plant size.
Types of Input & Production Period
2 production periods

• Short run is a period of time so short that

there is at least one fixed input.
– E.g. Capital is usually fixed, Labour is
variable

• Long Run is a period of time so long that all

inputs are variable.
– E.g. Capital and labour are both variable
 Background to Supply

The Short-run Theory

of Production
Law of Diminishing Marginal Returns

• The law of diminishing returns

When increasing amounts of a variable
factor (e.g. Labour) are used with a given
amount of a fixed factor (e.g. Capital), the
marginal product will increase at first but
will eventually decline.

• Occurs in the short run when more variable

factors are applied to the fixed factor
The Short-Run Production Function:
Total product (TP)
• Total output (Q) of the firm
Average product (AP)
• AP = TP/L
• Output per unit of variable input (usually labour)
Marginal product (MP)
• MP = TP/L
• Output of an additional unit of variable input
(usually labour)
 The Short-Run Production Function:
Labour Total Marginal Average
Product (TP) Product (MP) Product (AP)
0 0 - -
1 5 5 5
2 14 9 7
3 30 16 10
4 42 12 10.5
5 52 10 10.4
6 58 6 9.67
7 62 4 8.86
8 65 3 8.13
9 66 1 7.33
10 64 -2 6.4

As labour increases:
• TP increases at an increasing rate (0-3 units of labour)
• TP then increases at a decreasing rate (4-9 units of labour)
 Law of diminishing returns has set in
• TP reaches maximum at 9 units of labour and decreases when 10th
unit of labour is added
The Short-Run Production Function:
Total Product
d TP

Maximum output

b
Diminishing returns
set in here

0
QL1 QL2
Quantity of Labour
The Short-Run Production Function:
• Total Product Curve (TP) is typically ‘S’
shaped
• As labour increases from 0 – QL1, the ratio of
workers to capital is ideal and productivity is
very high
• As labour increases from QL1- QL2,
diminishing returns set in as ratio of workers
to capital is too high. Productivity falls.
• After QL2, total product falls
The Short-Run Production Function:
Marginal/Average Product

14

12

10

8 AP

0
MP
0 1 2 3 4 5 6 7 8
-2 Quantity of Labour
The Short-Run Production Function:

• When labour first increases, capital:labour

ratio is ideal so AP and MP increases
• If labour continues to increase, diminishing
returns set in and AP and MP eventually
decreases
• MP>AP => AP increases
• MP< AP => AP decreases
• MP = AP when AP is max
The Short-Run Production Function:
40
TP
30

20 b
Diminishing returns
10 set in here

0
0 1 2 3 4 5 6 7 8 Quantity of Labour
14
b
12

10

4 AP
2

0
0 1 2 3 4 5 6 7 8 Quantity of Labour
-2
MP
The Short-Run Production Function:
d
40
TP
30

20 Maximum
b
output
10

0
0 1 2 3 4 5 6 7 8 Quantity of Labour

14
b
12

10

4 AP
2

0 d
0 1 2 3 4 5 6 7 8 Quantity of Labour
-2
MP
Short-run Costs
 Short Run Costs

• Fixed costs and variable costs

– Fixed costs are costs that must be paid
irrespective of output. E.g: rental costs,
advertising costs
– Variable costs are costs that change with
output. E.g: wages, costs of raw materials

• Total costs = Total fixed cost + Total variable cost

– (TC = TFC + TVC)
 Short-Run Costs
Out Total Fixed Total Total
put Cost (TFC) Variable Cost • Total fixed costs remain
Cost (TVC) (TC) unchanged as output
0 10 0 10 increases
1 10 5 15
2 10 8 18
• Output = 0, TVC = 0
3 10 10 20 • TVC increases slowly
4 10 11 21 from output 0 – 4
5 10 15 25 • TVC increases rapidly
6 10 20 30 from output 5 onwards
7 10 30 40
8 10 45 55
as law of diminishing
9 10 65 75 returns has set in
10 10 93 103
 SHORT-RUN COSTS

• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
– relationship between AC and MC
 Average Cost Curves

AFC
($) • Average Fixed Cost
(AFC)
• AFC = TFC
• Q
• Diminishes as output
increases
Output • Spreading the
overheads.

AFC
 Average Cost Curves
Average Variable Cost (AVC)
– Total variable costs divided by the quantity
of output produced
– U-shaped
– Reason: Productivity and
Cost are inversely related
Formula: AVC = TVC
Q

i.e. variable cost per unit of output

 Average Cost Curves
Average Total Cost (ATC)
– Total cost divided by the quantity of
output produced
– It measures the total cost per unit of
output
– Alternatively: ATC = AFC + AVC
– U-shaped
Formula:

ATC = TC
Q
 Marginal Cost Curve

Marginal Cost (MC)

• The change in total cost when one additional

unit of output is produced.
• U-Shaped

Formula for MC:

MC =  TC OR TVC
Q Q
 Total Costs Curves
TC
TVC
100

80

60

40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Average Cost Curves
MC
Cost
ATC

B AVC

Output
 Average Cost Curves

Relationship between ATC and AVC

• ATC is always greater than AVC.
• Gap between ATC and AVC = AFC
• Gap between ATC and AVC gets smaller as
output increases.
• AFC falls as output increases
 Average Cost Curves
Relationship between ATC and AVC
• Min AVC occurs at a smaller output
than min ATC.
$
WHY: ATC
AVC
Remember
ATC = AFC + AVC;
and that AFC
is always falling

AFC
0 Q0 Q1 output
 Marginal Cost Curve

• When output first increases, capital:labour

ratio is ideal and productivity rises => MC
decreases

• When diminishing returns set in, productivity

falls => MC increases

• MC curve is U-shaped
 Average & Marginal Cost Curves
Relationship between the Average and Marginal
Cost Curves
• When MC < AVC or ATC, MC
AVC and ATC will fall Cost

ATC
• When MC > AVC or AVC
ATC, AVC and ATC will rise

• MC must equal AVC

and ATC at their respective
minimums
Q0 Q1 Output
Long-run Costs
 Returns to Scale

Firm increases all inputs by same proportion:

• Increasing Returns to Scale

– Output increases by larger proportion than
increase in input
– Due to specialisation or division of labour
resulting in economies of scale
– LRAC falls as Q increases
 Returns to Scale
Firm increases all inputs by same proportion:

• Decreasing Returns to Scale

– Output increases by smaller proportion than
increase in input
– Due to management problems, co-
ordination/communication breakdown,
resulting in diseconomies of scale
– LRAC rises as Q increases
 Returns to Scale

Firm increases all inputs by same proportion:

• Constant Returns to Scale

– Output increases by same proportion than
increase in input
– Any increasing returns to scale is offset by
decreasing returns to scale
– LRAC constant as Q increases
A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
 LRMC & MRAC Curves
Increasing returns to scale occur: MC<AC
Cost

LRATC

LRMC
Output
 LRMC & MRAC Curves
Constant returns to scale occur: MC=AC
Cost

LRATC = LRMC

Output
 LRMC & MRAC Curves
Decreasing returns to scale occur: MC>AC
Cost

LRMC

LRATC

Output
 LRMC & MRAC Curves
LRMC cuts LRAC at min point
Cost
LRMC

LRATC

Min LRATC

Output
Short Run and Long Run Curves

• Long run period of production is a planning

period
• It allows firms to upsize or downsize capacity
according to demand conditions
• Once optimal size is achieved, production
begins with fixed factors
• Actual production occurs in the short run
period again
 LRATC with 3 Factory Sizes
ATC
• To produce less
than Q1, firm will
choose size S SRATCS SRATCM
SRATCL
in the long run.
• To produce between
Q1 and Q2, firm will LRATC
choose size M
in the long run.
• To produce more Q
than Q2, firm will Q1 Q2
choose size L
in the long run.
 A Typical LRATC Curve
• In the real ATC
world, factories
come in many
LRATC
sizes,
each with its
own SRATC
curve.
• So a typical
LRATC curve
looks like this: Q
 Revenue
• Defining total, average and marginal revenue
– Total Revenue: Price x Quantity
• Revenue curves when firms are price takers
(horizontal demand curve)
– average revenue (AR): revenue per unit of
output ( = price of the good)
– marginal revenue (MR): revenue per
additional unit of output (= AR = P for price
takers)
 Revenue

Revenue curves when firms are price takers

(horizontal demand curve)
Price

P MR = Demand

Output
 Revenue

• Revenue curves when price varies with output

(downward sloping demand curve)

– average revenue (AR): revenue per unit of

output ( = price of the good)

– marginal revenue (MR): revenue per

additional unit of output (below the AR
curve for downward sloping demand curve)
 Revenue
Revenue curves when price varies with output
(downward sloping demand curve)
Price

MR

Demand = AR
MR
Output
Q
 Marginal Cost
• Marginal Cost = Change in Total Cost
Change in Output
Cost

MC

Quantity of Output
 Optimal Output
• MR>MC => Increase output to increase profit

• MC>MR => Decrease output to increase profit

• MC=MR => Optimal output where profits are

maximised or losses are minimised

– P>ATC: Profits maximised

– P<ATC: Losses minimised

 Optimal Output

Price taker MR curve

Price
MC

P MR

Output
Q*
 Optimal Output

Price Setter MR Curve

Price

MC

MR

Output
Q*
 Discussion Question 1

The law of diminishing returns ______________.

A.sets in because not all workers are equally

productive.
B.applies only in the short run.
C.explains why increased production results in
diseconomies of scale.
D.holds even when there are no fixed factors.
 Discussion Question 2
Suppose a firm sells its product at a price lower
than the opportunity cost of the inputs used to
produce it. Which is true?

A.The firm earns accounting and economic

profits.
B.The firm faces accounting and economic
losses.
C.The firm faces accounting loss but economic
profits.
D.The firm earns accounting profit but economic
losses.
 Discussion Question 3

If marginal product exceeds average product,

then

A. average product equals zero

B. average product is at its maximum
C. average product must be decreasing
D. average product must be increasing
 Discussion Question 4

The marginal product of labour is equal to the

___________.

A.incremental cost associated with a one unit

increase in labour.
B.incremental profit associated with a one unit
increase in labour.
C.increase in labour necessary to generate a one
unit increase in output.
D.increase in output obtained from a one unit
increase in labour.
 Discussion Question 5

Study the diagram below. At which output level

would the producer maximizes his profit?

$ TR
A.Q1
B.Q2
C.Q3
TC
D.Q4

Output
Q1 Q2 Q3 Q4
 Discussion Question 6
In a manufacturing plant producing aircraft parts, the
operation of complex machinery requires three workers
to a single machine. Due to a sudden spike in demand,
the plant manager is under pressure to increase
production and he tries to increase the number of
workers, without increasing the number of machines.
The productivity of his workers was observed to have
decreased.

a)Explain the relevant economic theory behind this

process
b)Suggest possible ways of increasing productivity of
the workers in both the short and long run.
 Discussion Question 7
Reed Ltd is involved in the production of Good X480M.
The following total cost data was gathered for this
product:
Quantity of X480M Total
Produced (Units) Cost ($)
0 1,200
1 1,600
2 1,800
3 2,400
4 3,600
5 6,000
a)State clearly the Total Fixed Cost for Reed Ltd.
b)Calculate the marginal cost for Reed Ltd for all levels
of production.
Thank you