Topic 4a – Production

and Costs

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What will you learn?
 Types of firms
 Opportunity cost

 Cost and profit concepts

 Short run and long run

 Law of diminishing marginal returns

 Short run costs

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 Types of Firms
 A firm is an organization that employs factors of
production to produce goods and services.

Firms

Sole Proprietorship Partnership Companies

Single Owner 2 – 50 2–∞

A shop Law firms Vinamilk

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Opportunity Costs
 The opportunity cost of using something in a
particular venture or activity is the benefit
forgone, or opportunity lost, by not using it in
its best alternative uses.

 It can further be classified in two categories.

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Opportunity Costs
 Realopportunity cost is the maximum
quantity of output the inputs required to
produce a good or service could have
produced in their next best alternative use.

 Money opportunity cost the maximum value

which a particular input could realise in its
next best alternative use.

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Opportunity Cost
 In relation to production, it is the benefit forgone for
not using resources in their best alternative uses.

Opportunity
Cost

Real (or quantity) Money (or value)

of goods not produced of goods not produced

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Costs Concepts
 Explicitcosts are explicit payments for hiring
or purchasing resources used by the firm,
e.g. wages, rent, cost of raw materials.

 Implicit
cost is the opportunity cost of
resources owned and used by the firm but
not explicitly paid for by the firm as costs, e.g.
the opportunity cost of the proprietor’s labor.

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Costs Concepts

Cost Classification

Explicit Implicit

Money or accounting Opportunity

Wages, rent etc Using owner’s resources

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Profit Concepts
 Accounting profit = total revenue – total
explicit costs.

 Economic profit = total revenue – opportunity

costs of all the resources used by the firm OR
= total revenue – (total explicit costs + total
implicit costs)

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Profit Concepts
 Normal profit is earned when economic profit
is equal to zero.

 Normal profit is also known as break-even,

i.e. it is the minimum profit that would keep
the resources in the production process.

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 Profit Concepts
Profit

Accounting Economic Normal

TR – Ex. Cost TR – (Ex. C + Im. C) If EP = 0 or

Sales – Expenses Or AP – Im. C TR = Ex. C + Im. C

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Profit Calculation
 Suppose you are earning $22,000 a year as a sales
representative for a T-shirt manufacturer. At some
point you decide to open a retail store of your own to
sell T-shirts. You invest $20,000 of savings that
have been earning you $1,000 per year. You also
decided that your new firm will occupy a small store
that you own and have been renting out for $5,000
per year. You hire one clerk to help you in the store,
paying her $18,000 annually. You sold T-shirts
worth $40,000 for $120,000 and paid $5,000 for
other expenses.

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Profit Calculation
Total Sales 120,000
Cost of T- Shirts 40,000
Clerk’s Salary 18,000
Other Expenses 5,000
Total (Explicit) Cost 63,000
Accounting Profit 57,000

Making a lot of profit? 

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Profit Calculation
Not really! 

Accounting Profit 57,000

Interest Forgone 1,000
Rent Forgone 5,000
Wages Forgone 22,000
Total (Implicit) Costs 28,000
Economic Profit 29,000
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Short Run and Long Run
 Shortrun is the time period where at least
one of the factors of production is fixed.

 Long run is the time period where all factors

of production are variable.

 There is NO fixed calendar time for short run

or long run.

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 Short Run and Long Run
Production and
Resources

Short Run Long Run

At least one resource fixed All resources variable

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 Fixed and Variable Resources
Resources

Fixed Variable

Quantity does not change Quantity changes

Land Labour
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Short Run Production
 Assuming all factors of production are fixed
except for labour

 Average product of labor is average quantity

of output produced by one labor.
OR
APL = Q and
L
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Short Run Production
 Marginal product of labor is the additional
quantity of output produced by one labor.
OR
MPL = ∆ Q Change in quantity
∆ L Change in labor

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Short Run Production –
Example 1/3
 Pat has started up a document preparation service
for lecturers. She has leased office space, two
computers and a photocopier. The duration of the
lease is one year (fixed factor). In addition to herself,
Pat will be using casual labour and can vary the
labour units on a daily basis (variable factor). (Note:
To keep the example simple, we will ignore any
other costs). The tasks involved are to type,
proofread and photocopy documents, answer the
phone and deal with the lecturers directly.

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Short Run Production –
Example 2/3
 On a weekly basis, Pat working on her own
(i.e. L = 1 or 1 labour unit which could equal
40 hours) and can prepare 200 documents
(or Q = 2). Increasing the labour units to two
means that one person can focus on the
typing of the documents and output increases
to 700 documents. Further possibilities are
shown in the table in the next slide.

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Short Run Production –
Example 3/3
Labour Quantity APL MPL
0 0 - -
1 2 2.0 2
2 7 3.5 5
3 15 5.0 8
4 19 4.8 4
5 20 4.0 1
6 18 3.0 -2

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Total, Average and Marginal
Output Relationship
Total Product, TP
Total Output

Quantity of Labour
Average Product, AP, and
Marginal Product, MP

Average
Product

Marginal
Quantity of Labour Product
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Total, Average and Marginal
Output Relationship
 MP intersects AP where AP is maximum
 If MP > AP then AP is increasing

 If MP < AP then AP is decreasing

 If MP > 0 then TP is increasing

 If MP = 0 then TP is maximum

 If MP < 0 then TP is decreasing

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Total, Average and Marginal
Output Relationship
MP AP TP Remarks
MP X AP Max - Intersection
MP > AP Inc. -
MP < AP Dec -
MP > 0 - Inc. +ve MP
MP = 0 - Max
MP < 0 - Dec -ve MP

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Law of Diminishing Marginal
Returns
 Assuccessive units of a variable resource
(say, labour) are added to a fixed resource
(say, capital) beyond some point the extra, or
marginal, product attributable to each
additional unit of the variable resource will
decline. Jackson page 240

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Law of Diminishing Marginal
Returns
 Asunits of a variable resource are added to a
set of fixed resources, with technology being
constant, the marginal product of the variable
resource must eventually diminish.

 Applicable in short run only. Why?

 There are no fixed resources in long run.

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Law of Diminishing Marginal
Returns
 That is, when the optimal combination
between labor and fixed resources has been
reached, any further addition of labor means
that each worker will have less and less of
the fixed resources (plants & machinery) to
work with, and so they must become less and
less efficient.

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