Chapter 5



Chapter 4

Firm Production, Cost and Revenue

Chapter Objectives

After reading this chapter you should be able to

• Understand the relationship between production and costs and the relationship between sales and revenues.

• Recognize that models of production are based on the assumption that firms seek to maximize profit.

• See how profit maximization dictates that firms set production so that marginal cost equals marginal revenue.

Definitions

• Profit: The money that business makes: Revenue-Cost

• Cost: the expense that must be incurred in order to produce goods for sale

• Revenue : the money that comes into the firm from the sale of their goods

Accounting vs. Economic Profit

• Economic Cost: All costs, both those that must be paid as well as those incurred in the form of forgone opportunities, of a business

• Accounting Cost: Only those costs that must be explicitly paid by the owner of a business

Production

• Production Function: a graph which shows how many resources we need to produce various amounts of output

• Cost Function: a graph which shows how much various amounts of production cost

Inputs to Production

• Fixed Inputs: resources that you cannot change

• Variable Inputs : resources that can be easily changed

Concepts of Production

• Division of Labor: workers divide up the tasks in such a way that each can build up a momentum and not have to switch jobs

• Diminishing Returns: the notion that there exists a point where the addition of resources increases production but does so at a decreasing rate

The Production Function

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Numerical Example

Table 1

Numerical Example

Production Function

|Labor |Total Output |Extra Output of the|

| | |Group |

|0 |0 | |

|1 |100 |100 |

|2 |317 |217 |

|3 |500 |183 |

|4 |610 |110 |

|5 |700 |90 |

|6 |770 |70 |

|7 |830 |60 |

|8 |870 |40 |

|9 |900 |30 |

|13 |1000 | |

Costs

Fixed vs. Variable Costs

• Fixed Costs: costs of production that we cannot change

• Variable Costs: costs of production that we can change

The Total Cost Function

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Cost Concepts

• Marginal Cost: the addition to cost associated with one additional unit of output

• Average Total Cost: Total Cost/Output, the cost per unit of production

• Average Variable Cost: Total Variable Cost/Output, the average variable cost per unit of production

• Average Fixed Cost: Total Fixed Cost/Output, the average fixed cost per unit of production

Average Total, Average Variable, Average Fixed and Marginal Costs

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Table 2

Numerical Example

Cost Functions

|Output |Total |Total |Total |MarginalCost*|Average |AverageVariab|Average Fixed|

| |Variable Cost|Fixed |Cost | |Total |le Cost |Cost |

| | |Cost | | |Cost | | |

|0 |0 |8500 |8500 | | | | |

|100 |2500 |8500 |11000 |25 |110 |25 |85 |

|200 |3800 |8500 |12300 |13 |62 |19 |43 |

|300 |4800 |8500 |13300 |10 |44 |16 |28 |

|400 |6000 |8500 |14500 |12 |36 |15 |21 |

|500 |7500 |8500 |16000 |15 |32 |15 |17 |

|600 |9500 |8500 |18000 |20 |30 |16 |14 |

|700 |12500 |8500 |21000 |30 |30 |18 |12 |

|800 |17000 |8500 |25500 |45 |32 |21 |10.6 |

|900 |22500 |8500 |31000 |55 |34 |25 |9.4 |

|1000 |32500 |8500 |41000 |100 |41 |32.5 |8.5 |

* change in Total Cost / 100

Revenue

• Marginal Revenue : additional revenue the firm receives from the sale of each unit

Setting the Price When There are Many Competitors

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Marginal Revenue When there are No Competitors

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Numerical Example

Table 3

Numerical Example

Revenue When There are Many Competitors.

|Q |Price |TR |MR* |

|0 |45 |0 | |

|100 |45 |4,500 |45 |

|200 |45 |9,000 |45 |

|300 |45 |13,500 |45 |

|400 |45 |18,000 |45 |

|500 |45 |22,500 |45 |

|600 |45 |27,000 |45 |

|700 |45 |31,500 |45 |

|800 |45 |36,000 |45 |

|900 |45 |40,500 |45 |

|1000 |45 |45,000 |45 |

• the change in Total Revenue / 100

Table 4

Numerical Example

Revenue When There Are No Competitors

|Q |Price |TR |MR* |

|0 |75 |0 | |

|100 |70 |7,000 |70 |

|200 |65 |13,000 |60 |

|300 |60 |18,000 |50 |

|400 |55 |22,000 |40 |

|500 |50 |25,000 |30 |

|600 |45 |27,000 |20 |

|700 |40 |28,000 |10 |

|800 |35 |28,000 |0 |

|900 |30 |27,000 |-10 |

|1000 |25 |25,000 |-20 |

• change in Total Revenue / 100

Maximizing Profit

•We assume that firms wish to maximize profits

Market Forms

• Perfect Competition: a situation in a market where there are many firms producing the same good

• Monopoly: a situation in a market where there is only one firm producing the good

Rules of Production

• A firm should

– produce an amount such that Marginal Revenue equals Marginal Cost (MR=MC),

– unless

– the price is less than the average variable cost (P ................
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