ECONOMICS 1 (ECON101)Firm’s Production DecisionsMODULE.docx

ECONOMICS 1
(ECON101)
Firm’s Production Decisions
MODULE 5 : Textbook Chapter 5
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
1
Nature and Goal of the firm
Firms may have different and many goals at the same time.
They can be as follows,
Maximize profit
Maximize sales
Rate of growth of sales
Product differentiation
Market leadership
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SHORT-RUN THEORY OF PRODUCTION
Factors of production :
a) Fixed factor – an input that cannot be increased in
supply within a given time period. Example: buildings.
b) Variable factor – an input that can be increased in
supply within a given time period. Example: raw material,
Labour.
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Long-run and short-run production:
The distinction between fixed and variable factors allows us
to distinguish between the short-run and long-run production.
a) Short-run – the period of time over which at least one
factor is fixed.
In short-run output can increased only by using more
variable factors. For example: if an airline wanted to carry more
passengers in response to a rise in demand, it could possibly
accommodate more passengers on existing flights if there was
space. It could possibly increase the number of flights with its
existing fleet, by hiring more new crew and by using more fuel.
But in short-run it could not buy more planes.
b) Long-run – the period of time long enough for all
factors to be varied.
In long-run a firm can build additional factories and install
new machines.
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The short-run production function:
Total Physical Product (TPP) – the total output of a product per
period of time that is obtained from a given amount of inputs.
Average Physical Product (APP) – the total output (TPP) per
unit of the variable factor (QV)/input in question
APP = TPP/QV
Marginal Physical Product (MPP) –
gained by the employment of one more unit of the variable
factor/input
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Wheat production per year from a particular farm (tonnes)
6

7
8
Wheat(Qamah) production per year from a particular farm
(tonnes)
9
Number of farm workers

Wheat production per year from a particular farm
Tonnes of wheat produced per year
Number of
workers
0
1
2
3
4
5
6
7
8
TPP
0
3
10
24
36
40
42
42
40
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10

Number of
workers
0
1
2
3
4
5
6
7
8
TPP
0
3
10
24
36
40
42
42
40
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TPP
b
Diminishing returns
set in here
d
Maximum output
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12

Number of
farm workers (L)
Tonnes of wheat per year
TPP
Number of
farm workers (L)
DTPP = 7
DL = 1
MPP = DTPP / DL = 7
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13
TPP

MPP
Number of
farm workers (L)
Number of
farm workers (L)
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14
TPP
APP
MPP
APP = TPP / L
Number of
farm workers (L)
Number of
farm workers (L)
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15
Law of diminishing returns:
When increasing amounts of a variable factor are used with a
given amount of a fixed factor, there will come a point when
each extra unit of the variable factor will produce less extra
output than the previous unit.
This can be illustrated by taking a simplest case where there
are just two factors i.e., one fixed and one variable.
Take the case of a farm. Assume the fixed factor is land and the
variable factor is labour.
Since the land is fixed in supply, output per period of time can
be increased only by increasing the amount of workers
employed.
But imagine what would happen as more and more workers
crowd on to a fixed area of land. The land cannot go on yielding
more and more output. After a point the additions to output
from each extra worker will begin to diminish.
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LONG-RUN THEORY OF PRODUCTION
Economies of scale : when increasing the scale of production
leads to a lower cost per unit of output
Diseconomies of scale : where costs per unit of output increases

as the scale of production increases
The scale of production
Constant return of scale
This is where a given percentage increase in inputs will lead to
the same percentage increase in output
(increase in input = increase in output)
Increasing return of scale
a larger percentage increase in output
(increase in input < increase in output)
Decreasing return of scale
a smaller percentage increase in output
(increase in input > increase in output)
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Cost
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SHORT-RUN COST
Measuring costs of production:
a) Opportunity costs – cost measured in terms of the next best
alternative forgone.
b) Explicit costs – the payments to outside suppliers of inputs

(factors not owned by the firm).
c) Implicit costs – costs that do not involve a direct payment of
money to a third party, but which nevertheless involve a
sacrifice of some alternative (factors already owned by the
firm).
Fixed costs and variable costs
a) Fixed costs – total costs that do not vary with the
amount of output produced (rent, insurance, accounting). Also
known as sunk costs.
b) Variable costs – total costs that do vary with the
amount of output produced (cost of raw materials, labour).
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SHORT-RUN COSTS
Total Cost (TC):
The total cost (TC) of production is the sum of Total Fixed
Costs (TFC) and Total Variable Costs (TVC).
TC = TFC + TVC
The TC curve is simply vertically upwards.
Average Cost (AC):
Average cost (AC) is cost per unit of production.
AC = TC/Q
OR
Average cost (AC) is the Total Cost (fixed plus variable) per
unit of output.
AC = AFC + AVC
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SHORT-RUN COSTS
Marginal Cost (MC):
Marginal cost is the cost of producing one more unit of output.
The shape of MC curve follows directly from the law of
diminishing returns. As more of the variable factor is used,
extra units of output cost less than previous units, MC falls.
Beyond a certain level of output, diminishing returns set in and
thereafter MC rises. Additional units of output cost more and
more to produce, since they require ever increasing amounts of
the variable factor.
If MC<AC, AC must be falling : as long as new units of output
cost less than the average, their production must pull the AC
down
If MC>AC, AC must be rising : if new units cost more than the
average , their production must drive the AC up
MC crosses the AC and AVC at their minimum point
The output level at which MC = lowest AVC is the most
efficient level of production. In this example it is at output level
4
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SHORT-RUN COSTS
Total Fixed Cost (TFC):
The TFC does not vary with output, it is shown by a horizontal
straight line.
Total Variable Cost (TVC):
With a zero output, no variable factors will be used. Thus, TVC

= 0. The TVC curve, therefore starts from the origin.
The shape of the TVC curve follows from the law of
diminishing returns. Initially, before diminishing returns set in,
TVC rises less and less rapidly as more variable factors are
added. As output increase, diminishing returns set in. Thus,
TVC rises more and more rapidly, TVC curve gets steeper.
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SHORT-RUN COSTS
Average Fixed Cost (AFC):
Total fixed cost per unit of output.
AFC = TFC/Q
The shape of AFC is downward slopping since TFC are being
spread over a greater and greater output.
Average Variable Cost (AVC):
AVC is the total variable cost per unit of output.
AVC = TVC/Q
AVC is U shaped.
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Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
Example: Total costs for firm X
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24

TFC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
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25

TFC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0

10
16
21
28
40
60
91
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26
TVC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)

12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TFC
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27

TVC
TFC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28

40
60
91
TC
(£)
12
22
28
33
40
52
72
103
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28
TC
Output
(Q)
0
1
2

3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TC
(£)
12
22
28
33
40

52
72
103
TVC
TFC
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29
TC
TVC
TFC
Diminishing marginal
returns set in here
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30

Output
(Q)
0
1
2
3
4
5
6
7
TFC
(SR)
12
12
12
12
12
12
12
12
TVC
(SR)
0
10
16
21
28
40

60
91
TC
(SR)
12
22
28
33
40
52
72
103
Example : Total costs for firm X
AC
(SR)
0
22
14
11
10
10.4
12
14.7
AFC
(SR)
0
12
6
4
3
2.4
2
1.7

AVC
(SR)
0
10
8
7
7
8
10
13
MC
(SR)
0
10
6
5
7
12
20
31
4/8/2018
31

Output (Q)
Costs (SR)
MC
x
Diminishing marginal
returns set in here
Marginal cost
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32
Output (Q)
Costs (SR)
AFC
AVC
MC
x

AC
z
y
Average and marginal costs
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33
LONG-RUN COSTS
All costs in long run are variable costs as there are no fixed
factors in the long run.
Long-run average cost (LRAC):
A curve that shows how average cost varies with output on the
assumption that all factors are variable.
It will initially experience economies of scale and thus face a
downward sloping LRAC curve. After a point, all such
economies of scale will have been achieved and thus the curve
will flatten out. Then, the firm will get so large that it will start
experiencing diseconomies of scale and thus a rising LRAC.
Result is a ‘U’ shape curve.
Assumptions :-
1) Factor prices are given.
2) The state of technology and factor quality are given.
3) Firm choose the least-cost combination of factors for each
output.
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LONG-RUN COSTS
Long-run marginal cost (LRMC):
The extra cost of producing one more unit of output assuming
that all factors are variable.
If there are economies of scale : LRMC curve must be below
LRAC.
If there are diseconomies of scale : LRMC curve must be above
LRAC.
If no economies or diseconomies of scale : LRAC curve is
horizontal.
Envelope Curve:
A long-run average cost curve drawn as the tangency points
of a series of short-run average cost curves.
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A typical long-run average cost curve
Output
O
Costs
LRAC

Economies
of scale
Constant
costs
Diseconomies
of scale
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36
Output
O
Costs
Long-run average and marginal costs
LRMC
LRAC
Initial economies of scale,
then diseconomies of scale
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37
Deriving long-run average cost curves: factories of fixed size
SRAC3
Costs
Output
O
SRAC4
SRAC5
5 factories
4 factories
3 factories
2 factories
1 factory
SRAC1
SRAC2
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38

SRAC1
SRAC3
SRAC2
SRAC4
SRAC5
LRAC
Costs
Output
O
Deriving long-run average cost curves: factories of fixed size
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39

LRAC
Costs
Output
O
Deriving a long-run average cost curve: choice of factory size
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40
Economic Cost and Accounting Cost
Accounting costs - Accounting costs are the costs most often
associated with the costs of producing.
Economic cost: Economic costs are not only the costs of
producing a good, it also includes the opportunities forgone by
producing this product.
Example:
If a firm is producing Computers then the accounting costs
are the costs incurred for producing the computers. Economic
costs include the cost of producing the computers as well as
opportunity cost. Suppose, If this firm could lease its office and
the plant for say $100,000 then that is the opportunity cost.

4/8/2018
Reference :
Basic Text : John Sloman; Economics; 2009; 7th Edition;
Pearson Prentice Hall
End of Module 5
4/8/2018
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=
D
TPP/
D
Lb)
(a)
0
0
-
3
1
3

3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Number of
Workers (Lb)

TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5

(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8

2
6
42
7
(d)
0
7
42
6
-2
8
40
5

Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3

7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9

4
5
40
8
2
6
42
7
(d)
0
7
42
6

-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3

-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-

3
1
3
3
7
2
10
5
(b)
14
3
24
8

12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)

0
7
42
6
-2
8
40
5
0
10
20
30
40
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40
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ECONOMICS 1
(ECON101)
Supply
MODULE 4 : Textbook Chapter 2 and 3

4/8/2018
1
Prepared by: Ms.Farha Zeba Ibrahim
Supply
It is the total amount or quantity of a good or product that
producers are willing and able to sell at various price levels
(Schiller, 1986)
It is the total amount of output of goods and services in an
economy (Sloman, 2006)
The amount of goods and services that firms can supply
depends on the available resources and technology.
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2
The relationship between supply and price
When the price of good rises, the quantity supplied will also
rise.
This can be explained with help of an example.
Now imagine that a farmer is deciding what to do with his land.
Part of his land is fertile and part of it is having poor soil.
The farmer will think of growing vegetables in the fertile part
and keeping sheep on the unfertile part.
The vegetable farmer will choose depends on the price of it. Say

if the price of tomatoes is high, the farmer will use a lot of the
fertile part for growing tomatoes.
If the price of potatoes is still increasing, then the farmer would
use the unfertile land also to grow tomatoes, even though the
yield is much lower there.
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3
He prices
3
Law of Supply
As price rises, firms supply more quantity.
It is worth incurring the extra unit costs.
They switch from less profitable goods.
In the long run, new firms will be encouraged to enter the
market.
As price decreases, firms supply less quantity.
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4
The supply Curve
Supply Schedule
The supply schedule is a table that shows the different
quantities of good that producers are willing and able to supply
at various prices over a given time period. Below is an example
:

4/8/2018
5Table 2.2 : The supply of tomatoes (monthly)Price
(SR per kg)Rudy’s supply (tonnes)TOTAL market supply
(tonnes :
000s)a2050100b4070200c60100350d80120530e100130700
The supply curve
The supply schedule can be represented graphically as a supply
curve.
Supply curve
A graph showing the relationship between the price of a good
and the quantity of the good supplied over a given period of
time. Supply curve is upward sloping (positively sloped).
A supply curve can be for an individual firm’s supply curve or
for a market curve ( that of the whole industry).
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6
Market supply of tomatoes (monthly)
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7

a
a
b
c
d
e
P
20
40
60
80
100
Q
100
200
350
530
700
b
c
d
e

Price (SR per kg)
Quantity (tonnes: 000s)
Supply
Determinants of supply
Price
The costs of production due to :
Change in input prices e.g. raw materials
Change in technology e.g. high capacity machine
Organizational change e.g. flat organization
Government policies e.g. subsidy, tax
The profitability of alternative products
The profitability of goods in joint supply
Calamities e.g. Typhoon, earthquake, war
Expectations of future price changes
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8
Movement along and shift in the supply curve:
To distinguish between movement along the supply curve and
the shift in the supply curve, we need to understand the
difference between a change in supply and a change in the

quantity supplied.
A shift in the supply curve is referred to as a change in supply.
A movement along the supply curves as a result of a change in
price is referred to as a change in the quantity supply.
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9
Movements along the supply curve
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10
Price of Pepsi
Quantity of Pepsi
0
SR1.00
SR3.00
1
5
S
A

C
SR3.00
A rise in the price of Pepsi results in a movement along the
supply curve or called as “A change in the quantity supplied”.
10
Shift in supply curve
A supply curve is constructed on the assumption that other
factors (other determinants of demand) remains constant. But
when one of the other determinants of supply change?
The curve shifts.
For example:
If a change in cost of production, say cost of production
decreases will result in shift of the supply curve to the right.
On the other hand if the cost of production rises, the supply
curve will shift to the left.
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11
Shift in supply curve
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12
S0
S1
Increase
S2
Decrease
O
P
Q
Variables that influence sellers
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13
Equilibrium
It is the point where quantity demanded equals quantity
supplied. It is the point that lasts.
It is the intersection between the demand curve and supply

curve.
It is the point where conflicting interests between the consumers
and producers are balanced.
It is reached through the interaction between demand and supply
forces.
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14
Equilibrium
Equilibrium point – the intersection of the demand and supply
curves (D=S).
Equilibrium price – is the price at the equilibrium point. It is
the price that clears the market : the price where D=S.
Equilibrium quantity – is the quantity at the equilibrium point.
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The determination of market equilibrium
(tomatoes: monthly)
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16

a
b
d
e
Supply
Demand
A
B
D
E
Qe
Price (SR per kg)
The Determination of Price

Equilibrium price and output
response to shortages and surpluses
significance of “equilibrium”
Demand and supply curves
effect of price being above equilibrium (S>D)
effect of price being below equilibrium (D>S)
equilibrium: where D = S
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17
(tomatoes: monthly)
4/8/2018
18
a
b
d

e
Supply
Demand
A
B
D
E
Price (SR per kg)
SURPLUS
(360 000)
C
c
(tomatoes: monthly)
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19

a
b
d
e
Supply
Demand
A
B
D
E
Price (SR per kg)
C
c
SHORTAGE
(300 000)

Price elasticity of supply ( PeS )
It is the degree of responsiveness of quantity supplied to
changes in price.
For Example:
Curve S2 is more elastic between any two prices than curve S1.
Thus, when prices rises from P1 to P2 there is a larger increase
in quantity supplied with S2 ( Q1 to Q3) than there is with S1 (
Q1 to Q2 ).
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20
Price elasticity of supply ( PeS )
4/8/2018
21
0
Q
P
P1
P2

Q1
Q2
Q3
S1
S2
Measuring the price elasticity of supply
To compare the size of the change quantity supplied with the
size change in price.
But price and quantity are measured in different units,
therefore we use percentage or proportionate changes. That can
be given by,
supplied ,
4/8/2018
22
Price elasticity of supply (PεS)

=
Percentage (proportionate)Change in quantity supplied
Percentage (proportionate)Change in price
PεD
=
Measuring the price elasticity of Supply
Example : If a 10% rise in price caused a 25% rise in quantity
supplied, the price elasticity of supply would be 25/10 = 2.5
(Supply in ELASTIC)
Example : If a 10% rise in price caused ONLY a 5% rise in
quantity supplied, the price elasticity of supply would be 5/10
= 0.5 (Supply in INELASTIC)
Note: Unlike the price elasticity of demand, the figure is
positive. This is because price and quantity supplied change in
the same direction.
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23
Example:
If the price of Potatoes increases from $4.00 to $5.20 and
the amount of quantity supplied will rise from 100 to 300
kilograms, then elasticity of supply would be calculated as:

using the formula,
4/8/2018
24
Pεs
=
Pεs
=
{[QSupplied(NEW) - QSupplied(OLD)] / QSupplied(OLD)} X
100
{[Price(NEW) - Price(OLD)] / Price(OLD)} X 100
Therefore,
4/8/2018
25
PεS
=
{[ 300 – 100 ] / 100} x 100
{[ 5.20 -4.00] / 4.00 } x 100

PεS
=
200%
30%
PεS
=
6.6
4/8/2018
26Price elasticity of supplyElasticity value Vertical supplyZero
(0) : Totally unresponsive to a change in price Horizontal
supplyInfinite (∞) : There is no limit to the amount supplied at
the price where the curve crosses the vertical axisWhen two
supply curves cross, the steeper one will have the lower price
elasticity of supply (e.g. curve S1 in Figure on slide number-
21)Any straight line supply curve starting at the origin, however
will have an elasticity equal to 1 throughout its length,
irrespective of its slope. (e.g. Figure next slid)
Unit elastic supply curves
4/8/2018
27

P (£)
Q
a
b
S1
c
d
S2
e
f
S3
Determinants of supply elasticity
Amount that costs rise as output rises - the less the additional
costs of producing additional output, the more firms will be
encouraged to produce for a given price rise : the more elastic
will supply be
Time period
- Supply is inelastic in the immediate time. Firms are
unlikely to be able to increase supply by much immediately.
Supply is virtually fixed or can only vary according to available
stocks.
- Supply elasticity improves in short run. If a slightly

longer period of time is allowed to elapse, some inputs can be
increased (e.g. raw materials) while others will remain fixed
(e.g. heavy machinery). Supply can increase somewhat.
- Supply is elastic in the long run. In the long run, there
will be sufficient time for all inputs to be increased and for new
firms to enter the industry. Supply therefore, is likely to be
highly elastic. In some circumstances, the long run supply surve
may even slope downwards.
4/8/2018
28
Reference :
Basic Text : John Sloman; Economics; 2009; 7th Edition;
Pearson Prentice Hall
End of Module 3
4/8/2018
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PROBLEMS & APPLICATIONS
Question1:
Determine the effect upon equilibrium price and quantity sold
with the help of demand and supply graphs if the following
changes occur in a particular market:
a. If consumers’ income increases and the good is normal what
happens to the equilibrium in the supply and demand market?
Draw and explain.

Reason:
_____________________________________________________
_________________________
b. If the price of a substitute good (in consumption) increases
what happends to the demand of that substitute good. Draw and
explain.

Reason:
_____________________________________________________
_________________________
c. The price of inputs used to produce the good increases.

Reason:
_____________________________________________________
_________________________
Question2:
The weekly demand and supply schedules for Jeans(in millions)
in a free market are as follows:
Price
(dollars
per pair)
Quantity demanded
(pairs per week)
Quantity
supplied
(pairs per week)
30
130

70
40
120
80
50
110
90
60
100
100
70
90
110
80
80
120
90
70
130
(a) What are the equilibrium price and quantity?
…………………………………………………………………………
…………
(b (b) Assume that changes in fashion cause the demand for
Jeans to rise by 40 at each price. What will be the new
equilibrium price and quantity? Has equilibrium quantity risen
as much as the rise in demand? Explain why or why not?

i.
…………………………………………………………………………
…………
ii.
…………………………………………………………………………
…………
…………………………………………………………………………
…………
(c) Now plot the new data in the table below and mark the
equilibrium.
Price
(dollars
per pair)
Quantity demanded
(pairs per week)
Quantity
supplied
(pairs per week)
30
70
40
80
50
90

60
100
70
110
80
120
90
130
Draw the old and new demand and suply curve on the following
graph
Question3:
Jana makes wedding flower bouquets and sells them during the
wedding season. The figure shows her supply curve of bouquets
per week. Use the midpoint method in this problem.
C

a. Calculate the price elasticity of supply using midpoint
method between points A andB
_____________________________________________________
___________________________
b. Calculate the price elasticity of supply using midpoint
method between point B & C.
_____________________________________________________
___________________________
c. Is the elasticity of supply same between points A & B, B &
C?
Question4: The table below shows the short-run total production
of books.

Quantity of labor
(workers)
Total Product
Average Product
Marginal Product
0
0
1
10
2
24
3
40
4
58
5
73

6
83
7
83
8
80
a. Complete the above table by calculating the average product
and marginal product.
b. In the above table the Diminishing Marginal Returns sets in
from _______unit of labour (0.5marks)
c. In the above table average product is maximum at ________
unit of labor
d. In the above table when total product is constant the marginal
product is ________
e. In the above table when average product is maximum,
marginal product starts to _________

(rise/fall)
f. In the above table the total product is maximum at
____________ unit of labour
g. The average product starts to fall at ____________ level of
output
h. Draw the total product curve on the below graph.
TOT
A
L
PRODUCT
QUANTITY OF LABOUR

i. Draw the MP and AP curve in the below graph.
Marginal
& average product
QUANTITY OF LABOR

Question5:
The following data table shows the short run costs of running a
toy manufacturing company.
Output
(Toys)
TFC
TVC
TC
AFC
AVC
AC
MC
0

5
30
6
34
a. Is the firm operating in short-run or long-run? Why?
__________________________________________________
b. What is the most efficient level of output? Why?
___________________________________________________
c. When MC<AC, AC must be ____________ (rising/falling)
d. The diminishing marginal returns is set in at ______ level of
output

e. Draw the TFC, TVC and TC curves in the graph below:

END OF ASSIGNMENT
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