1. Economics 1A
Chapter 11
Background to Supply: Production
and Cost

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. 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. Basic cost and profit concepts
Opportunity cost – the best alternative sacrificed
(or forgone)
Accounting costs = explicit costs
Economic costs = explicit costs + implicit costs

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. Economic profit and accounting profit

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. 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. 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. Total, average and marginal product of labour
EXAMPLE 2

12. Marginal product and average product
EXAMPLE 3

13. 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

14. Total, fixed and variable cost schedules of a maize farmer

15. Marginal and average cost

16. Marginal and average cost: smoothed curves

17. 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

18. 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)

19. 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

20. Long-run average costs:
Three basic possibilities
Alternative long-run average cost curves

23. 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

24. • Typical long-run average cost curve
A typical long-run average cost curve