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Summary Micro Economics: Background to Supply (CH5)
Chapter 5: Background to Supply 5.1-5.5
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Chapter 5: Background to SupplyA firm’s total profit (TΠ) is thus the difference between its total sales revenue (TR) and its
total costs of production (TC):
TΠ=TR−TC
Rational producer behaviour When a firm weighs up the costs and benefits of alternative
courses of action and then seeks to maximise its net benefit.
Profit and the aims of a firm
Traditional theory of the firm The analysis of pricing and output decisions of the firm under
various market conditions, assuming that the firm wishes to maximise profit.
Alternative theories of the firm Theories of the firm based on the assumption that firms
have aims other than profit maximisation.
5.1 The short-run theory of production
The cost of producing any level of output will depend on the amount of inputs (or ‘factors of
production’) used and the price the firm must pay for them.
Short- and long-run changes in production
If a firm wants to increase production, it will take time to acquire a greater quantity of
certain inputs.
If the firm wants to increase output in a hurry, it will only be able to increase the quantity of
certain inputs. It may be able to use more labour by offering overtime work.
Fixed factor An input that cannot be increased in supply within a given time period.
Variable factor An input that can be increased in supply within a given time period.
Short run The period of time over which at least one factor is fixed. (within a year)
Long run The period of time long enough for all factors to be varied. (longer than one year)
The law of diminishing returns
Production in the short run is subject to diminishing returns.
Law of diminishing (marginal) returns When oneor more factors are held fixed, there will
come a point beyond which the extra output from additional units of the variable factor will
diminish.
The short-run production function: total product
Total physical product The total output of a product per period of time that is obtained from
a given amount of inputs.
Production function The mathematical relationship between the output of a good and the
inputs used to produce it. It shows how output will be a ected by changes in the quantity of
one or more of the inputs.
,With nobody working on the land, output will be zero (point a). As the first farm workers are
taken on, wheat out- put initially rises more and more rapidly. The assumption behind this is
that with only one or two workers efficiency is low, since the workers are spread too thinly.
With more workers, however, they can work together – each, perhaps, doing some specialist
job – and thus they can use the land more efficiently. In Table 5.1, output rises more and
more rapidly up to the employment of the third worker (point b). In Figure 5.1 the TPP curve
gets steeper up to point b.
After point b, however, diminishing marginal returns set in: output rises less and less rapidly,
and the TPP curve correspondingly becomes less steeply sloped.
When point d is reached, wheat output is at a maximum: the land is yielding as much as it
can. Any more workers employed after that are likely to get in each other’s way. Thus
beyond point d, output is likely to fall again: eight workers actually produce less than seven
workers.
The short-run production function: average and marginal product
Average physical product Total output (TPP) per unit of the variable factor in question: APP
= TPP/Qv.
Marginal physical product The extra output gained by the employment of one more unit of
the variable factor: MPP = ΔTPP/ΔQv.
Average physical product
Marginal physical product
The figures for APP and MPP are plotted in the lower diagram of Figure 5.1. We can draw a
number of conclusions from these diagrams:
- The MPP between two points is equal to the slope of the TPP curve between those
two points.
- MPP rises at first: the slope of the TPP curve gets steeper.
- MPP reaches a maximum at point b. At that point the slope of the TPP curve is at its
steepest.
, - After point b, diminishing returns set in. MPP falls. TPP becomes less steep.
- APP rises at first.
- Beyond point c, MPP is below APP. New workers add less to output than the average.
This pulls the average down: APP falls.
- As long as MPP is greater than zero, TPP will go on rising: new workers add to total
output.
- At point d, TPP is at a maximum (its slope is zero). An additional worker will add
nothing to output: MPP is zero.
- Beyond point d, TPP falls. MPP is negative.
5.2 Costs in the short run
Measuring costs of production
Opportunity cost Cost measured in terms of the next best alternative forgone. (It is the cost
of any activity measured in terms of the sacrifice made in doing it.)
Measure the sacrifice involved. To do this it is necessary to put factors into two categories.
Factors not owned by the firm: explicit costs
The opportunity cost of using factors not already owned by the firm is simply the price that
the firm has to pay for them.
Explicit costs The payments to outside suppliers of inputs.
Factors already owned by the firm: implicit costs
When the firm already owns factors (e.g. machinery), it does not as a rule have to pay out
money to use them.
Implicit costs Costs that do not involve a direct payment of money to a third party, but
which nevertheless involve a sacrifice of some alternative.
Example: A firm owns some buildings. The opportunity cost of using them is the rent it could
have received by letting them out to another firm.
If there is no alternative use for a factor of production, as in the case of a machine designed
to produce a specific product, and if it has no scrap value, the opportunity cost of using it is
zero.
What the firm paid for the machine – its historic cost – is irrelevant. Not using the machine
will not bring that money back. It has been spent. These are sometimes referred to as ‘sunk
costs’.
Historic costs The original amounts the firm paid for factors it now owns.
Likewise the replacement cost is irrelevant. That should be taken into account only when the
firm is considering replacing the machine.
Replacement costs What the firm would have to pay to replace factors it currently owns.
Costs and inputs
A firm’s costs of production will depend on the factors of production it uses. The more
factors it uses, the greater will its costs be.
This relationship depends on two elements:
. The productivity of the factors. The greater their physical productivity, the smaller
will be the quantity of them required to produce a given level of output, and hence
the lower will be the cost of that output. In other words, there is a direct link
between TPP, APP and MPP and the costs of production.
. The price of the factors. The higher their price, the higher will be the costs of
production.
Fixed costs Total costs that do not vary with the amount of output produced. (Rent on land)
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