EC1002 Introduction to Economics Blocks 5 & 6

BLOCKS 5 & 6: THE FIRM

Read: Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 6 & 7 (including Chapter
7 Appendix)

Learning outcomes:

 distinguish between economic and accounting definitions of cost

 describe the relationship between revenue, cost and profit
 describe the production function
 identify the point of diminishing marginal returns
 demonstrate how the choice of production technique depends on input prices
 use isoquants and iso-cost curves to derive the firm’s total cost curve
 calculate marginal cost and marginal revenue
 find the profit maximising level
 identify fixed and variable factors in the short-run
 analyse total, average and marginal cost, in the short-run and long-run
 draw the relevant cost curves and explain why they have certain shapes
 define returns to scale and their relation to average cost curves
 describe how a firm choses output, in the short-run and the long-run
 describe the relationship between short-run cost and long-run cost.

Basics of Revenue & Cost

The theory of supply is the theory of how much output firms choose to produce.

Revenue is what the firm earns from sales. Costs are the expenses incurred in producing
and selling. Profits are the excess of revenue over costs.

Costs should include opportunity costs of all resources used in production. Opportunity
cost is the amount an input could obtain in its next highest paying use. In particular,
economic costs include the cost of the owner’s time and effort in running a business.
Economic costs also include the opportunity cost of financial capital used in the firm.
Supernormal profit is the pure profit accruing to the owners after allowing for all these
costs.

Page 1 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Total Revenue (TR) > Total Total Revenue (TR) = Total Total Revenue (TR) < Total
Economic Cost (TC) Economic Cost (TC) Economic Cost (TC)
Positive Profit Break-Even Loss

Firms are assumed to aim to maximize profits. Even though the firm is run by its managers,
not its owners, profit maximization is a useful assumption in understanding the firm’s
behaviour. Firms that make losses cannot continue in business indefinitely.

In aiming to maximize profits, firms necessarily produce each output level as cheaply as
possible. Profit maximization requires minimization of costs for each output level.

Firm’s Objective – Profit-Maximisation

Firms choose the optimal output level to maximise total economic profits. This decision
can be described equivalently by examining marginal cost and marginal revenue. Marginal
cost is the increase in total cost when one more unit is produced. Marginal revenue is the
corresponding change in total revenue and depends on the demand curve for the firm’s
product. Profits are maximized at the output at which marginal cost equals marginal
revenue. If profits are negative at this output, the firm should close down if this reduces
losses.

Conditions to Maximise Profits

1.

2.

Page 2 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Draw the graphs:

An upward shift in the marginal cost curve reduces output. An upward shift in the marginal
revenue curve increases output.

It is unnecessary for firms to calculate their marginal cost and marginal revenue curves.
Setting MC equal to MR is merely a device that economists use to mimic the hunches of
smart firms who correctly judge, by whatever means, the profit-maximizing level of output.

Math:

Page 3 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Production

This section of the block discusses short-run and long-run production decisions, based on
the corresponding cost curves. In the long run, a firm can fully adjust all its inputs. In the
short run, some inputs are fixed. The length of the short run varies from industry to industry.

The production function shows the maximum output that can be produced using given
quantities of inputs. The inputs are machines, raw materials, labour and any other factors of
production. The production function summarizes the technical possibilities faced by a firm.

Draw the Total, Marginal and Average Production Curves:

Page 4 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Production Formulas:

Cost
The total cost curve is derived from the production function, for given wages and rental
rates of factors of production.

In the short run the firm cannot adjust some of its inputs. But it still has to pay for them. It
has short-run fixed costs (SFC) of production. The cost of using the variable factors is short-
run variable cost (SVC). Short-run total costs (STC) are equal to SFC plus SVC.

Short-run average total costs (SATC) are equal to short-run total costs (STC) divided by
output. SATC is equal to short-run average fixed costs (SAFC) plus short-run average
variable costs (SAVC). The SATC curve is U-shaped. The falling part of the U results both
from declining SAFC as the fixed costs are spread over more units of output and from
declining SAVC at low levels of output. The SATC continues to fall after SAVC begins to
increase, but eventually increasing SAVC outweighs declining SAFC and the SATC curve
slopes up.

The short-run marginal cost curve (SMC) reflects the marginal product of the variable
factor holding other factors fixed. Usually we think of labour as variable but capital as fixed
in the short run. When very little labour is used, the plant is too big for labour to produce
much. Increasing labour input leads to large rises in output and SMC falls. Once machinery
is fully manned, extra workers add progressively less to output. SMC begins to rise.

The SMC curve cuts both the SATC and SAVC curves at their minimum points.

Page 5 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Cost Formulas:

Cost Diagrams:

In the short run the firm supplies the output at which SMC is equal to MR, provided price is
not less than short-run average variable cost. In the short run the firm is willing to produce
at a loss provided it is recovering at least part of its fixed costs.

Page 6 of 14
EC1002 Introduction to Economics Blocks 5 & 6

The long-run total cost curve is obtained by finding, for each output, the least-cost method
of production when all inputs can be varied. If the relative price of using a factor of production
rises, the firm substitutes away from that factor in its choice of production techniques.

Average cost is total cost divided by output. The long-run average cost curve (LAC) is
derived from the long-run total cost curve.

LAC is typically U-shaped. As output rises, at first average costs fall because of
indivisibilities in production, the benefit of specialization and engineering advantages of large
scale. There are increasing returns to scale on the falling part of the U. The rising part of
the U reflects diseconomies of scale.

Much of manufacturing has economies of scale. For some industries, particularly personal
services, economies of scale run out at quite low output levels.

When marginal cost is below average cost, average cost is falling. When marginal cost is
above average cost, average cost is rising. Average and marginal cost are equal only at the
lowest point on the average cost curve.

Draw the graph for MC and AC:

Page 7 of 14
EC1002 Introduction to Economics Blocks 5 & 6

In the long run the firm supplies the output at which long-run marginal cost (LMC) equals
MR provided price is not less than the level of long-run average cost at that level of output.
If price is less than long-run average cost, the firm goes out of business.

The LAC curve is always below the SATC curve, except at the point where the two coincide.
This implies that a firm is certain to have higher profits in the long run than in the short run
if it is currently producing with a plant size that is not best from the viewpoint of the long run.

Draw the graph for LAC, LMC & MR:

Page 8 of 14
EC1002 Introduction to Economics Blocks 5 & 6

BLOCKS 5 & 6 – Tutorial Questions

1 (a) Do firms aim to maximise profits? (b) Should firms support charities, the arts and
political campaigns? Is there any conflict with (a)?

2 True or False: If the MR < MC at a given level of output, a firm should increase production
to increase profits.

3 Common fallacies Why are these statements wrong? (a) Firms with an accounting
profit must be thriving. (b) Firms do not know their marginal costs. A theory of supply
cannot assume that firms set marginal revenue equal to marginal cost. (c) To maximise
profit, maximize sales.

4 A firm with the costs shown in following table can now sell as much output as it wants
at a price of £12. (a) Draw the MR and MC curves. (b) What output will it produce?

Output Total cost (£) Marginal cost (£)

0 10
1 25 15
2 36 11
3 44 8
4 51 7
5 59 8
6 69 10
7 81 12
8 95 14
9 111 16
10 129 18

5 How do the following affect the income statement for R-a-P shown in the table below (a)
R-a-P owes £70,000 to its workers for work done in the year. (b) Instead of renting an
office (for the rent of £50,000 shown under Cost), R-a-P owns its office. (c) During the
year R-a-P was paid by a creditor owing money from the year before.

R-a-P income statement, year to 31 December 2012

Revenue
100,000 hours @ £10 £1,000,000

Page 9 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Cost
Wages £700,000
Adverts £50,000
Office rent £50,000
Other expenses £100,000
–£900,000
Pre-tax profit £100,000
Tax £25,000
Post-tax profit £75,000

6 In the table below, assume the total costs of making each unit of output, as shown in the
second column, increase by £40. What level of output should the firm produce? Explain.

Cost, revenue, profit (weekly)

(1) (2) (3) (4) (5)

Output Total cost Price Total revenue Profit
(1) × (3) (4) – (2)
(£) (£) (£) (£)
0 10 – 0 –10
1 25 21 21 –4
2 36 20 40 4
3 44 19 57 13
4 51 18 72 21
5 59 17 85 26
6 69 16 96 27
7 81 15 105 24
8 95 14 112 17
9 111 13 117 6
10 129 12 120 –9

7 A firm faces the following linear inverse demand for its product P = 60 − 2Q . Find the
firm’s total revenue function TR (Q) . Plot the total revenue function. (Hint: Using P = 60
– 2Q, plot a demand schedule for an arbitrary number of quantities, say from 5 to 25
in fives).

Page 10 of 14
EC1002 Introduction to Economics Blocks 5 & 6

8 The following table reports the total revenue and the total cost of Keinko International, a
firm producing coffee. Keinko does not have any fixed cost. Complete the columns for
the marginal revenue (MR) and the marginal cost (MC). In a graph plot the MR and the
MC curves and show the profit maximizing level of output.

Quantity TR TC MR MC
1 48 5 - -
2 90 20
3 128 45
4 163 80
5 195 125
6 225 180
7 251 245
8 273 320
9 293 405
10 309 500

9 Now suppose that Keinko faces an increase of the demand for its coffee. For each unit
of coffee, total revenues increase by 20. Find the new total revenue for each level of
output and the corresponding new marginal revenue. In a graph, plot the new MR and
the MC curves. How the increase in the demand has affected the output choice of
Keinko?

10 Essay question ‘The industrial revolution was built on the ability of entrepreneurs to float
companies and obtain funding. Today, it is often argued that stock exchanges force firms
to focus too much on the short term, making it hard to raise long-term funds. Private
equity firms see themselves as addressing this shortcoming of stock markets. The
amazing thing about private equity is not its recent appearance but that it took so long
to appear.’ Discuss.

11 A firm faces the following linear demand for its product Q D = 30 – P/2. The firm has a
marginal cost of production given by MC = 8. Find the expression for the firm’s marginal
revenue. Plot the MC and MR curves on a graph. What is the amount of output that
the firm should produce? At what price is the output sold?

12 A firm’s revenue function if given by TR(Q) = 10Q and its cost function is given by TC(Q)
= 150 + 2Q2. Find the marginal revenue MR(Q) and the marginal cost MC(Q) for the
firm, and then find the profit maximizing output for the firm. Does this quantity satisfy the

Page 11 of 14
EC1002 Introduction to Economics Blocks 5 & 6

first and second order conditions for maximum?

13 (a) Calculate the marginal and average costs for each level of output from the following
total cost data. (b) Show how marginal and average costs are related. (c) Are these
short-run or long-run cost curves? Explain how you can tell.

Output 0 1 2 3 4 5 6 7 8 9
TC (£) 12 27 40 51 60 70 80 91 104 120

14 (a) Explain why it might make sense for a firm to produce goods that it can only sell at a
loss. (b) Can it keep on doing this forever? Explain.

15 Common fallacies Why are these statements wrong? (a) Firms making losses should
quit at once. (b) Big firms can always produce more cheaply than smaller firms can. (c)
Small-scale production is always better.

16 The table given below shows how output changes as inputs change for three different
output levels. The wage rate is £5 and the rental rate of capital is £2.

Column Column Column Column Column Column

1 2 3 4 5 6
Capital input 4 2 7 4 11 8

Labour input 5 6 10 12 15 16

Output 4 4 8 8 12 12

(a) For each output level in the above table, which technique of production is more capital
intensive? (b) Refer to columns 2, 3 and 6. Does the firm switch towards or away from
more capital-intensive techniques as output rises?

17 For each of the following cases, explain how long you think is the short run:
a) An electric power station; b) A superstore hypermarket; c) A small grocery retail
business;
In explaining your answer, specify any assumptions you need to make. For each case, do
you expect the law of diminishing marginal returns to hold?

18 Suppose the rental rate of capital in table below is £3 and the wage rate is £5. (a)
Suppose the firm is currently using the production techniques shown in columns 1, 3
and 5 for output levels 4, 8 and 12 respectively. Would the firm switch to columns 2, 4
or 5 respectively for any levels of output? (b) How do the firm’s total and average costs
change when the rental rate of capital rises?

Page 12 of 14
EC1002 Introduction to Economics Blocks 5 & 6

Colum Column Colum Colum Colum Column

n1 2 n3 n4 n5 6
Capital input 4 2 7 4 11 8
Labour input 5 6 10 12 15 16
Output 4 4 8 8 12 12

19 The marginal cost of supplying another unit of output of an electronic product on the
internet is almost zero. If long-run equilibrium has price equal to marginal cost, internet
firms will all go broke. Can you resolve the puzzle?

20 What kind of returns to scale do the following production functions display?

a) Q = K L ; b) Q = K L ; c) Q = K + L
0..3 0.2

21 (a) What are economies of scale and why might they exist? (b) The table shows how
output changes as inputs change. The wage rate is £5 and the rental rate of capital is
£2. Calculate the lowest-cost method of making 4, 8 and 12 units of output. (c) Are there
increasing, constant or decreasing returns to scale between those outputs? Which
applies where?

Capital input 4 2 7 4 11 8
Labour input 5 6 10 12 15 16
Output 4 4 8 8 12 12

22 The following graph shows the isoquant for a firm. What do points A, B, C and D on the
isoquant represent? Which is the most labour intensive and the most capital intensive
technique of production on this isoquant?

Page 13 of 14
EC1002 Introduction to Economics Blocks 5 & 6

23 Suppose that Firm A has the following short-run production function: Q = K 0 L , where
K = 10
K denotes capital and L labour. Suppose that the level of capital is fixed at 0 . The
total cost of firm A in the short-run is: STC = 10 + wL , where w is the wage paid to each
worker. Assume that the wage is £20. Using the production function show how the short-
run total cost depends on the quantity produced Q . Plot the short-run total cost on a
graph where you put Q on the horizontal axis.

24 The following table shows the data about quantity produced and the total cost of
production in the long run for a given firm:

Q LTC
1 102
2 112
3 136
4 180
5 250
6 352
7 492
8 676
9 910
10 1200

Find the long run marginal cost and the long run average cost faced by the firm. In a
graph plot the LMC and the LAC curves. Explain why the LMC curve cuts the LAC curve
from below.

Page 14 of 14