San Francisco State University

ECON 101

Michael Bar

Theory of the Firm: Production, Costs and Prot

Introduction

There are millions of businesses and rms in the world and the U.S., and they are all dierent.
Nevertheless, there are some principles of economics, that apply to all rms. One feature
common to all rms, is that they all want to maximize prot, even non-prot organizations
or charity organizations. This chapter focuses on the most fundamental choices that all
businesses must make: how much output to produce and how many inputs to employ in
order to achieve maximum prot.
Consider a simple rm that produces a single product. The prot of such rm, as a
function of the rms output, is given by:
(Q) = R (Q)

T C (Q) = R (Q)

TFC

T V C (Q)

where
Q - rms output (quantity),
(Q) - rms prot (as a function of output),
R (Q) - rms Revenue (as a function of output),
T C (Q) - rms Total Cost (as a function of output),
T F C - Total Fixed Cost (cost that are committed in advance, for certain period of
time, and do not depend of the amount of output produced),
T V C (Q) - Total Variable Cost (cost that depend on the amount of output produced).
Before we proceed, we need to explain what do we mean by cost. Economists distinguish
between explicit and implicit costs.
Explicit cost - cost paid in money
Implicit cost - opportunity cost of using the factors of production for other purposes
When calculating prot, economists include both types of costs.
Economic Prot = Revenue - Explicit cost - Implicit cost
In all the examples below, the cost will include both explicit and implicit cost, and the
resulting prot is economic prot. For example, say you invest $100,000 to start a business,
and in that year you earn $170,000 in revenue. Your accounting prot would be $70,000.
However, say that same year you could have earned an income of $80,000 had you been
employed. Therefore, you have an economic loss of $10,000 (170,000 - 100,000 - 80,000 =
-10,000).
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What is the optimal output of the rm? In other words, we would like to nd the output
level that maximizes the rms prot. At the optimal output, a small change in output
should not change the prot, as illustrated in the next gure.

Thus, the slope of the prot at the optimum is:

R(Q)
Q

(Q)
Q

R (Q)
Q

reads "the change in prot

T C (Q)
=0
Q
as we increase Q by 1 unit". The

reads "the change in revenue as we increase Q by 1 unit", and this is

change is called marginal revenue, and denoted M R (Q). Finally, the expression T C(Q)
Q
is "the change in total cost as we increase Q by 1 unit", and this change is called marginal
cost. Therefore, at the optimum output, we must have
M R (Q ) = M C (Q )
That it, the marginal revenue is equal to the marginal cost. It is easy to see why M R (Q ) =
M C (Q ) must hold whenever the rm maximizes its prot. Suppose that M R (Q ) >
M C (Q ). This means that producing one more unit will bring more revenue than the cost
of producing that unit, and the rm can increase its prot by producing more. If instead,
M R (Q ) < M C (Q ), then the last unit produced at a higher cost than the revenue it
generated. The rm can then increase prot by producing less.
Even if the rm produces the optimal output, the rm may still lose money. Thus, we

also want the prot to be positive, in order for the rm to stay in business.
(Q ) = R (Q ) T C (Q )
(Q )
R (Q ) T C (Q )
=
Q
Q
Q
AR (Q )
AT C (Q )

0
0

However, in the short run, the rm is committed to pay the xed cost, even if it does not
operate. Thus, in the short-run, the rm will operate (stay in business) as long as
R (Q)
AR (Q )

T V C (Q)
AV C (Q )

We can see from the above discussion, that understanding the cost structure of the rm,
is essential for its most basic decisions: how much to produce, and whether to produce at
all. The next section illustrates how the rms costs are derived from the rms production
process.

Production and Cost

We start with describing a simple short-run production of a rm that produces a single

L
0
1
2
3
4
5
6
7
8
9
10

TP/L TP(L)/L
Q = TP( L ) AP( L ) MP( L )
0
5
5
5
15
7.5
10
28
9.333
13
41
10.25
13
52
10.4
11
60
10
8
65
9.286
5
67
8.375
2
68
7.556
1
68.5
6.85
0.5
3

The next gure plots the graphs of the total product, and the associated average and
marginal products of labor.

Notice that when the number of workers is small, there is increasing marginal return to
labor (M P (L) is increasing), but after 4 workers, there is a deceasing marginal return
to labor (M P (L) is decreasing). When few workers are employed, they may help each other
perform task as a team, so additional worker may contributes to the productivity more than
the one before him. However, with xed capital, as the number of workers increases, at
some point the contribution of additional worker to output will start decreasing (due to
congestion).
Also notice that as long as the marginal is above the average, the average is increasing,
and whenever the marginal is below the average, the average is decreasing. This is true for
any marginal and average quantities in the world. For example, if your next grade is above
your GPA, the GPA will increase, and if your next grade is below your GPA, the GPA will
decrease.

Short-Run Costs

Suppose that the in the short run, some inputs are xed. For example, the physical capital,
i.e. the machines and the rms plant (building). The costs associated with xed factors do
not vary with the level of production, and are called xed cost, and denoted by T F C - Total
Fixed Cost. The cost of the rms variable inputs are called variable cost, and denoted
T V C (Q) - Total Variable Cost. We write T V C as a function of quantity to emphasize that
variable cost vary with the level of output. In our example above, with the only variable
input being labor, the T V C is the cost of labor. In real business, the variable cost can also
include electricity or other energy, food ingredients for a restaurant, etc.
Thus, the total cost of the rm is the sum of xed and variable cost:
T C (Q) = T F C + T V C (Q)
In the above example, lets suppose that the xed cost is T F C = 50, and labor is paid $10
per hour. Thus, the last 3 columns in the next table, show the cost gures for the above
example.

L
0
1
2
3
4
5
6
7
8
9
10

Q = TP( L )
0
5
15
28
41
52
60
65
67
68
68.5

AP( L )

MP( L )

5
7.5
9.333
10.25
10.4
10
9.286
8.375
7.556
6.85

5
10
13
13
11
8
5
2
1
0.5

TFC
50
50
50
50
50
50
50
50
50
50
50

TVC(Q) TC(Q)
0
50
10
60
20
70
30
80
40
90
50
100
60
110
70
120
80
130
90
140
100
150

These costs are plotted in the next gure.

3.1

Average and marginal cost

From the total costs above, we can derive the average cost per unit produced:
TFC
Q
T V C (Q)
AV C (Q) =
Q
T C (Q)
T F C + T V C (Q)
AT C (Q) =
=
= AF C (Q) + AV C (Q)
Q
Q
AF C (Q) =

Notice that the Average Fixed Cost is decreasing with the volume of production. As we
showed in the introduction, the importance of the average costs is that they determine
whether the rm should operate or not. The marginal cost determine the optimal (prot
maximizing) output. The marginal cost is given by:
M C (Q) =

T C (Q)
=
Q

T V C (Q)
Q

The last step follows from the fact that xed cost does not change as output changes. The
next table uses data from the above example, and adds 3 more columns with AT C, AV C,

and M C.
L
0
1
2
3
4
5
6
7
8
9
10

Q = TP( L )
0
5
15
28
41
52
60
65
67
68
68.5

TP/L TP(L)/L
AP( L ) MP( L )
5
7.5
9.333
10.25
10.4
10
9.286
8.375
7.556
6.85

5
10
13
13
11
8
5
2
1
0.5

TFC
50
50
50
50
50
50
50
50
50
50
50

TVC(Q)
0
10
20
30
40
50
60
70
80
90
100

TFC+TVC(Q)
TC(Q)
50
60
70
80
90
100
110
120
130
140
150

TC(Q)/Q
ATC(Q)

TVC(Q)/Q
AVC(Q)

TC(Q)/Q
MC(Q)

12.00
4.67
2.86
2.20
1.92
1.83
1.85
1.94
2.06
2.19

2.00
1.33
1.07
0.98
0.96
1.00
1.08
1.19
1.32
1.46

2.00
1.00
0.77
0.77
0.91
1.25
2.00
5.00
10.00
20.00

Notice once again, that when the marginal is above the average, the average goes up, and
when the marginal is below average, the average must go down. This is true for marginal
and average product, marginal and average cost, or any marginal and average quantities you
can think of.
Also notice from the last table, that marginal product of labor and marginal cost are
moving in opposite directions. When M P (L) is increasing, we have M C (Q) decreasing,
and vice versa. To see why this has to be the case, compare the output produced by workers
number 9 and 8. The 8th worker produces 2 units, and is paid $10, so each unit produced by
the 8th worker cost $5 (see the above table). The 9th worker is also paid $10, but produces
only 1 unit. So the cost of each unit produced by the 9th worker is $10.
You can use Excel to plot the graphs of AT C, AV C, and M C in the above table. The
average and marginal costs curves, typically look like in the next gure.

In the next section we will illustrate how these curves can be used to determine the
optimal output of a competitive rm, and determine whether the rm operates or not (i.e.
to stay in business or not).
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Prot of Perfectly Competitive Firm

A competitive rm takes the market price as given (a price taker). Thus, the revenue of such
a rm is:
R (Q) = P Q
where P is the market price. The marginal and the average revenue of a competitive rm is
simply the market price:
M R = AR = P
The prot of a competitive rm is therefore:
(Q) = P Q

T C (Q)

The optimal output, if the rm operates, is given by:

min (AV C)

min (AT C)

The rm operates in the long run is:

Thus, the section of the M C curve, which is above the min (AV C), is the rms short run
supply curve of the rm. At any given price, M C gives the optimal output that the rm
wants to sell.
The next gure illustrates these conditions graphically.
Break-even
point

Costs, price
MC

ATC
min(ATC)

AVC

min(AVC)
Shutdown
point
Q

In the short run, the rm is committed to pay its T F C, and therefore will operate if the
price is above min (AV C). This way, the rm covers all of the variable cost, and some of
xed cost. If the rm shuts down, it still has to pay the xed cost. The shutdown point
indicates the min (AV C), so that if the price is below that point, the rm will shut down,
and will not operate even in the short run.
In the long run, the rm must make positive prot. Thus, the rm will operate if the
price is above min (AT C). The point of min (AT C) is called break-even point, because if
the price is at the level of min (AT C), the rm has zero economic prot (breaks even).
Example 1 Suppose the Total Fixed Cost
given in the next table.
Q
0
1
2
3
4
5
6
7
8
9
10

and Total Variable Cost of a competitive rm are

TVC(Q)
0
90
170
240
300
370
450
540
650
780
930

1. (a) Find the rms Total Cost, Average Total Cost, Average Variable Cost, and Mar-

ginal Cost, and plot the graph of AT C, AV C, and M C.

TFC
100
100
100
100
100
100
100
100
100
100
100

TFC+TVC(Q)
TVC(Q)
TC(Q)
0
100
90
190
170
270
240
340
300
400
370
470
450
550
540
640
650
750
780
880
930
1030

TC(Q)/Q
ATC(Q)

TVC(Q)/Q
AVC(Q)

TC(Q)/Q
MC(Q)

190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
103.00

90.00
85.00
80.00
75.00
74.00
75.00
77.14
81.25
86.67
93.00

90
80
70
60
70
80
90
110
130
150

(b) What is the minimal market price at which the rm will operate in the short run?
That is, nd the shutdown point.
min (AV C) = 74
Thus, the rm will shut down if the market price falls below $74 per unit.
(c) What is the minimal market price at which the rm will operate in the long run?
That is, nd the break-even point.
min (AT C) = $91:43
Thus, the rm will operate in the long run, if the market price is at least $91.43 per
unit.
10

(d) Find the rms optimal output in the short run, and the rms prot, for the
following market prices: $70, $74, $80, $91.43, $130.

P
70
74
80
91.43
130

Q
0
5
6
7
9

R
0
370
480
640
1170

TC
100
470
550
640
880

(Q)
-100
-100
-70
0
290

(e) Illustrate the economic prot graphically, when the market price is $130.

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