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# Week 8 background to supply production and cost

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### Week 8 background to supply production and cost

1. 1. Economics 1A Chapter 11 Background to Supply: Production and Cost
2. 2. CHAPTER 11 Introduction Goal of the firm – maximise profits Profit – the surplus of revenue over cost Total revenue – total value of sales (price x quantity, or P x Q = PQ) Average revenue – total revenue divided by quantity sold (PQ/Q)
3. 3. Marginal revenue – the additional revenue earned by selling an additional unit of the product Short run vs. long run: Short run – the period during which at least one of the inputs is fixed Long run – all the inputs are variable Difference not calendar time!
4. 4. Basic cost and profit concepts Opportunity cost – the best alternative sacrificed (or forgone) Accounting costs = explicit costs Economic costs = explicit costs + implicit costs
5. 5. • Normal profit – the monetary payments that the firm’s resources could have earned in their best alternative uses, forms part of the firm’s cost of production • Economic profit – the difference between total revenue from the sale of the firm’s product(s) and total explicit and implicit costs
6. 6. Economic profit and accounting profit
7. 7. Production in the short run Simplifying assumptions: •One product •Homogeneous •Inputs - infinitely divisible units •Production function is given •Prices of product and inputs are given •Fixed inputs and one variable input
8. 8. In the short run, a firm can expand output only by increasing the quantity of its variable input Production schedule of a maize farmer with one variable input EXAMPLE
9. 9. The law of diminishing returns or the law of diminishing marginal returns – when more of a variable input is combined with one or more fixed inputs in a production process, points will eventually be reached where first the marginal product, then the average product and finally the total product start to decline Marginal and average product of a maize farmer with one variable input EXAMPLE 1
10. 10. Total, average and marginal product of labour EXAMPLE 2
11. 11. Marginal product and average product EXAMPLE 3
12. 12. Costs in the short run Fixed cost – cost that remains constant irrespective of the quantity of output produced Variable cost – cost that changes when total product changes Total cost (TC) = Total fixed cost + Total variable cost Average cost (AC) = Average fixed cost + Average variable cost Marginal cost (MC) = the increase in total cost when one additional unit of output is produced
13. 13. Total, fixed and variable cost schedules of a maize farmer
14. 14. Marginal and average cost
15. 15. Marginal and average cost: smoothed curves
16. 16. Production and costs in the long run In the long run there are no fixed inputs, thus all the costs are variable Returns to scale – the long-run relationship between inputs and output (vary all inputs by a certain percentage) • Constant returns to scale • Increasing returns to scale • Decreasing returns to scale
17. 17. Economies of scale – costs per unit of output fall as the scale of production increases Diseconomies of scale – unit costs rise as output increases (Note difference between returns to scale and economies of scale)
18. 18. Two broad groups: • Internal economies or diseconomies of scale – can be controlled by the firm • External economies or diseconomies of scale – cannot be controlled by the firm Economies of scope – the cost savings achieved by producing related goods in one firm rather than in two separate firms
19. 19. Long-run average costs: Three basic possibilities Alternative long-run average cost curves
20. 20. Three key assumptions: ̶ The prices of factors of production are given ̶ The state of technology and the quality of factors of production are given ̶ Firms always choose the least-cost combination of factors of production to produce each level of output
21. 21. • Typical long-run average cost curve A typical long-run average cost curve