Costs of

production and
Resource
Combinations
• By the end of this topic students would be able to:

• Identify what profit consists of

• Explain how costs of production are measured

• Explain the relationship between inputs and outputs in the long run

• Explain how costs vary with output in both the short and long run

• Explain economies of scale and the reasons for such economies

• Explain how a business can combine its inputs efficiently

 The firm and its economic
problem

• A firm is an institution that organizes factors of

production in an attempt to make a profit

• The ultimate goal of a firm is to maximize profit;

however, it also emphasizes improving quality,
increasing market share, and satisfying customer
wants

• So the question is, how does a firm maximize its

profit?
Total Revenue, Total Cost, Profit
 Two alternative approaches to
measure profit

Measure a firm’s profit using set standards established by the concerned

authorities (OR)

Measure profit based on opportunity cost as the relevant measure of

cost

• Opportunity cost: The value of the firm’s best alternative use of

resource

• Opportunity cost needs to be expressed in monetary terms. A

firm’s opportunity cost should include its:
• Implicit costs
• Explicit costs
 Costs: Explicit vs. Implicit

• Explicit costs require an outlay of money

• e.g., paying wages to workers, rent, electricity bills, etc.
• Implicit costs are equal to what factors of production
could earn for the firm in an alternative use, and they do
not require a cash outlay,
• e.g., the opportunity cost of the owner’s time or financial
resources, the firm’s capital
• Remember that the cost of something is what you give
up to get it.
• This is true whether the costs are implicit or explicit.
Both matter for a firms’ decisions.
Explicit vs. Implicit Costs: An Example
 Costs
• Fixed Costs: Costs that do not vary with output;
e.g. cost of a factory
• Variable Costs: Costs that do vary with output;
e.g. electricity, materials
• Total Costs: Fixed + variable costs
• Marginal Cost: This is the cost of producing one
extra unit.
• Sunk Costs: These are costs that are not
recoverable e.g. advertising
 Fill the table
Quantity FC TC VC MC AVC ATC

0 1000 1000

1 1000 1200

2 1000 1300

3 1000 1550

4 1000 1900
• Total Product- the total amount produced during
some period of time by all the inputs that the firm
uses

• Average product- the total product per unit of the

variable input, which is labour in the present case.
AP=TP/L

• Marginal Product- is the change in total product

resulting from the use of one more (or one less)
unit of the variable input. MP=Change in
TP/Change in L
Q of Labour TP AP MP
1 43
2 160
3 351
4 600
5 875
6 1152
7 1372
8 1536
9 1656
10 1750
11 1815
12 1860
 Economists describe both short run and long run
average cost curves as u shaped. Why?

• Short Run Cost curves are U shaped because

of diminishing returns.

The Law Of Diminishing Marginal Returns

• Total Product (TP) This is the total output

produced by workers

• Marginal Product (MP) This is the output

produced by an extra worker
 Law of diminishing
marginal returns
• Diminishing Returns occurs in the short run when one factor is fixed
(e.g. Capital)

• If the variable factor of production is increased, there comes a point

where it will become less productive and therefore there will
eventually be a decreasing marginal and then average product

• This is because if capital is fixed extra workers will eventually get in

each other’s way as they attempt to increase production.
• E.g. think about the effectiveness of extra workers in a small café. If
more workers are employed production could increase but more and
more slowly.

• This law only applies in the short run because in the long run all
factors are variable
• Therefore as MP increases MC declines and
vice versa

• A good example of Diminishing Returns

includes the use of chemical fertilizers- a small
quantity leads to a big increase in output.

• However, increasing its use further may lead

to declining Marginal Product (MP) as the
efficacy of the chemical declines
 Difference between diminishing
returns and diseconomies of scale
• Diminishing returns relates to the short run –
higher SRAC.

• Diseconomies of scale is concerned with long

run. (higher LRAC)
 Short run cost curves
• In the short run capital is fixed. After a certain point,
increasing extra workers leads to declining
productivity. Therefore, as you employ more workers
the Marginal Cost increases.
• Note FC (fixed costs) remain constant. Therefore
the more you produce, the lower the average
fixed costs will be.

• To work out Marginal cost, you just see how much

TC has increased by.

• For example, the first unit sees TC increase from

1,000 to 1,200 (therefore the increase (MC) is 200)

• For the second unit, TC increases from 1,200 to

1,300 (therefore the increase MC is 100)
 Long run cost curves
• The long run cost curves are u shaped for
different reasons.

• It is due to economies of scale and

diseconomies of scale. If a firm has high fixed
costs, increasing output will lead to lower
average costs.
 Revenue
A firm’s revenue are it’s receipts of money from the sale
of goods and services over a time period such as a
week or a year.
• Total revenue (TR) is the total amount of money received from the sale
of any given level of output. It is the total quantity sold times the price.
TR=TQ x P

• Average revenue (AR) is the average receipt per unit sold. It can
be calculated by dividing total revenue by the quantity sold. AR=TR/QS=P

• Marginal revenue (MR) is the receipts from selling an extra unit

of output. It is the difference between total revenue at different levels of
output. MR= NTR-OTR
Quantity Price (£) TR MR AR
1 8
2 7
3 6
4 5
5 4
6 3
7 2
 • Under normal conditions, the
demand curve facing the firm is
downward sloping from left to
right. This implies that to sell
increasing items of a product a
firm must accept a lower price for
Price each successive unit.

• Marginal Revenue (MR) is the

Ped = -1 addition to TR as a result of
selling one extra unit of output. If
the D curve is downward sloping,
each unit is sold at a
progressively lower price. The
MR curve lies under the D(AR)
curve.
• At the point where the MR cuts
D = AR the horizontal axis, MR = O. That
means that the addition to TR
from selling one extra unit was 0.
This is the definition for unit price
elasticity of demand.
MR • Therefore the equivalent point on
the D curve is where Ped = - 1
 • When price elasticity of
demand is elastic, the %
change in Qd is > % change in
P. In such circumstances, a
reduction in price of 10% would
see D rising by more than 10%
and TR would rise. The addition
Price
to TR must therefore be
positive shown by the
Ped = -1 highlighted area on the MR
curve.
• It follows that when MR is
negative, the addition to TR
must be negative. If this is the
case then a reduction in price
by 10% would lead to Qd rising
by less than 10% meaning TR
D = AR would fall.
• Elasticity in this range of the
demand curve must therefore
be between infinity and -1 or
elastic.
MR
 • When MR is negative, the
addition to TR must be negative.
If this is the case then a
reduction in price by 10% would
lead to Qd rising by less than
Price
10% meaning TR would fall.
• Elasticity in this range of the
demand curve must therefore be
between 0 and -1 - inelastic

Ped in this range

is between 0 and -1
D = AR

MR
Cost / Revenue
TC
Putting the two together:
If we put the two
diagrams together we
can see that profit
maximisation occurs
where the difference
between TR and TC is
greatest (where MC =
TR
MR)
Output/Sales
MC If a firm was to target
revenue maximisation
as an objective, this
would not necessarily
correlate with the profit
maximising output –
D = AR revenue maximisation
Output/Sales occurs where TR is at
Q1 Q2
a maximum (MR = 0)
MR