BEPMC 311: MANAGERIAL ECONOMICS

MODULE 4: ANALYSIS OF THE THEORY OF

PRODUCTION, COST, REVENUE AND PROFIT
The main focus of this module is the behavior of business firms. In market economies, a wide variety
of business produce wide variety of goods and services. Everyday decisions are made about the
production, cost and sales (profits) of goods and services. This module therefore brings into the
analysis microeconomic concepts of costs, profit, output and revenue to explain how firms use scarce
inputs to be able to become efficient in production.

The theory of the firm presents a framework for understanding the economics of the firm. In this
module you will learn about one of the most important economic agents: the producer. The producer
(a company or firm) is responsible for creating the production function (output) and is subject to
various cost measures and the results of diminishing returns. We explore these ideas more fully as we
delve into the relationship between quantity of input and quantity of output. We will discuss how and
why a firm's costs may differ in the short run versus the long run. This module presents learnings on
the behavior a firm in pursuit of profit maximization, analyzed in terms of (1) what are its inputs, (2)
what production techniques are employed,

At the end of this module, you are expected to:

UNIT LEARNING OUTCOMES

Distinguish between explicit and implicit costs, and economic profit and accounting profit.
Describe the output produced and costs incurred in the short-run and in the long-run.
Demonstrate in graphs the output and costs data.

TOPIC 1: ECONOMICS COSTS AND PROFIT

ECONOMIC COSTS

Costs exist because resources are scarce, are productive, and have alternative uses. When society uses
a combination of resources to produce a particular product, it for- goes all alternative opportunities to
use those resources for other purposes. The measure of the economic cost, or opportunity cost, of
any resource used to produce a good is the value or worth the resource would have in its best
alternative use.

 Explicit and Implicit Costs

Economic costs are the payments a firm must make, or the incomes it must provide, to attract the
resources it needs away from alternative production opportunities. Those payments to resource
 suppliers are explicit (revealed and expressed) or implicit (present but not obvious). So, in
producing products firms incur explicit costs and implicit costs.

1. A firm’s explicit costs are the monetary payments (or cash expenditures) it makes to those
who supply labor services, materials, fuel, transportation services, and the like. Such money
payments are for the use of resources owned by others.

2. A firm’s implicit costs are the opportunity costs of using its self-owned, self-employed
resources. To the firm, implicit costs are the money payments that self-employed resources
could have earned in their best alternative use.

Example:

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 $1000 per year. And you decide that your new firm will
occupy a small store that you own and have been renting out for $5000 per year. You hire one
clerk to help you in the store, paying her $18,000 annually. A year after you open the store, you
total up your accounts and find the following:

Total Sales Revenue $120,000

Cost of T-shirts $40,000
Clerk’s Salary 18,000
Utilities 5,000
Total (explicit) Costs 63,000
Accounting Profit $ 57,000

Looks good. You have an accounting profit of $57,000. A firm’s accounting profit is what
remains after it has paid individuals and other firms for the materials, capital, and labor they have
supplied. But unfortunately your $57,000 accounting profit ignores your implicit costs and thus
overstates the economic success of your venture. By providing your own financial capital,
building, and labor, you incur implicit costs (forgone incomes) of $1000 of interest, $5000 of
rent, and $22,000 of wages. If your entrepreneurial talent is worth, say, $5000 annually in other
business endeavors of similar scope, you have also ignored that implicit cost. So:

Accounting Profit $120,000

Foregone Interest $ 1,000
Foregone rent 5,000
Foregone wages 22,000
Foregone entrepreneurial income 5,000
Total Implicit Costs 33,000
Accounting Profit $ 24,000

 Normal Profit as a Cost

The $5000 implicit cost of your entrepreneurial talent in the above example is a normal profit.
As is true of the forgone rent and forgone wages, the payment you could otherwise receive for
performing entrepreneurial functions is indeed an implicit cost. If you did not realize at least this
minimum, or normal, payment for your effort, you could withdraw from this line of business and
shift to a more attractive endeavor. So, a normal profit is a cost of doing business.

The economist includes as costs of production all the costs—explicit and implicit, including a
normal profit— required to attract and retain resources in a specific line of production. For
economists, a firm’s economic costs are the opportunity costs of the resources used, whether
 those resources are owned by others or by the firm. In our example, economic costs are $96,000
(= $63,000 of explicit costs + $33,000 of implicit costs).

 Economic Profit (or Pure Profit)

Obviously, then, economists use the term “profit” differently from the way accountants use it. To
the accountant, profit is the firm’s total revenue less its explicit costs (or accounting costs). To
the economist, economic profit is total revenue less economic costs (explicit and implicit costs,
the latter including a normal profit to the entrepreneur). So when an economist says a certain firm
is earning only enough revenue to cover its costs, this means it is meeting all explicit and implicit
costs and the entrepreneur is receiving a payment just large enough to retain his or her talents in
the present line of production.

If a firm’s total revenue exceeds all its economic costs (explicit implicit), any residual goes to the
entrepreneur. That residual is called an economic, or pure, profit. In short:

Economic Profit = Total Revenue – Economic Cost

In our example, economic profit is $24,000, found by subtracting the $96,000 of economic cost
from the $120,000 of revenue. An economic profit is not a cost because it is a return in excess of
the normal profit that is required to retain the entrepreneur in this particular line of production.
Even if the economic profit is zero, the entrepreneur is still covering all explicit and implicit
costs, including a normal profit. In our example, as long as accounting profit is $33,000 or more
(so economic profit is zero or more), you will be earning a $5000 normal profit and will therefore
continue to operate your T-shirt store.

Figure 1: Economic Profit vs. Accounting Profit

TOPIC 2: THEORY OF PRODUCTION

We now look at how individual firms behaved in terms of production, costs and profit maximization.
Generally, production is the transformation of inputs into finished goods.

Production is simply described in a very simple mathematical statement: the production function. A
production function is an equation that expresses the relationship between the amount of output that
can be produced given the quantities of productive factors (e.g., labor and capital) used in the
production, assuming that the most efficient available methods of production are used. In a summary,
a production function is given as (in a general form):

Q = f(K, L)

where: Q = output
L = labor
K = capital (e.g., machinery)

The output (Q) produced by the firm is a function of (or influenced by) the use of labor and capital.
(Note that there may be many other factors that can be included in the right-hand-side of the equation
as it can influence output (Q) at a given time period, but for now we assume that labor and capital are
the inputs used to produce an output.)

The production function is differently defined in the short-run and in the long-run. This distinction is
based on the nature of factor inputs. A short-run is a time period that is brief or short that does not
permit the firm to alter its scale of operation and the only available business decision is the number of
workers to employ (or anything input that could be easily adjusted). The long-run is defined as the
time horizon needed for a producer to have flexibility over all relevant production decisions. It is a
time horizon necessary not only to change the number of workers but also to scale the size of the
factory up or down and alter production processes as desired.

Those inputs that vary directly with the output are called variable factors. These are the factors that can
be changed. Variable factors exist in both, the short run and the long run. Examples of variable factors
include daily-wage labor, raw materials, etc. On the other hand, those factors that cannot be varied or
changed as the output changes are called fixed factors. These factors are normally characteristic of the
short run or short period of time only. Fixed factors do not exist in the long run.

Therefore, short-run and long-run time periods are not about a specific time period, it is about how
soon or how long firms are able to adjust their resources. Thus, even if the firm is already existing for a
long time now and have not altered its fixed resources, then it is still facing a short-run time period.

Short run: Quantity of labor is variable but the quantity of capital and production
processes are fixed (i.e. taken as a given).
Long run: Quantity of labor, the quantity of capital, and production processes are all
variable (i.e. changeable).

SHORT-RUN PRODUCTION: OUTPUT

We now consider how output is produced in the short-run. A short-run time period is a time period
that is too brief that does not allow firms to alter its fixed resources. The output is therefore dependent
on the variable resources, with is production function:

Q=f ( Ḱ , L), where Ḱ (K-bar) means capital is constant (can’t be varied); and with capital being
constant and labor is the variable input, the short-run production function becomes: Q = f(L). The
current output can change only so much.
The question now is, “is output (Q) always increasing as labor input is increased in usage?” Let’s
examine the output behavior in the short-run. Consider first the following concepts needed to
understand the behavior.

1. Total Product (TP) – (sometimes referred to as TPP or total physical product) or total output (Q)
is the total amount or units of output produced by the firm.

2. Marginal Product (MP) – (sometimes referred to as MPP or marginal physical product) is the
change in total product as a result of changing the variable input of production by 1 unit. MP is
the slope of the TP.

∆ TP ∆ Q where: TP or Q = total product/output

MP= ∨ L = labor (the variable input)
∆L ∆L

3. Average Product (AP) – (sometimes referred to as APP or average physical product) is the output
per variable input, since total product is spread over a level of variable input. For example, if
labor is the variable input, AP is measured as:

TP Q AP is a measure of labor productivity

AP= ∨
L L

Example:

Consider a firm data (hypothetical) below:

Table 1: Product Concepts in the Short-run

Units of Labor Total Product Marginal Product Average Product
(in units) (in units) (in units)
L Q ∆Q Q
∆L L
0 0 -
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55
10 480 -15 48

From the table above, Q (or TP) provides a total number of output at a certain level of labor use
(combined with fixed capital input/s). Thus, when one unit of labor is used with a given quantity of
capital 80 units of output are produced. With two units of labor 170 units of output are produced, and
with three units of labor total product of labor increases to 270 units and so on.

The MP is the addition to total output by the employment of an extra unit of labor. Suppose when two
workers are employed to produce the output and they produce 170 units of output. Now, if instead of
two workers, three workers are employed and as a result total product increases to 270 units, then the
third worker has added 100 units to the total production. Thus 100 units is the MP of the third worker
(270-170/3-2). Similarly, if the firm adds the 4th worker, the MP or the contribution of the 4th worker
to total output of 368 is 98 units.
The AP is determined simply as output divided by labor, making it a measure of labor productivity.
Thus when two units of L are employed, the AP is Q/L = 170/2 = 85, which means that on average,
each of these 2 workers can produce 85 units. Similarly, when 3 units of L are employed, AP is 270/3
= 90, which means that on average, each of these 3 works can produce 90 units, and so on.

Graphically, we can illustrate the above product concepts to better understand the behavior of output
in the short run.

Total Product (TP) Curve:

550
500
450
400
350
Total Product

300
250
200
150
100
50
0
0 1 2 3 4 5 6 7 8 9 10 11

Labor

Figure 1: Total Product Curve

The TP curve exhibit a unique pattern and graphically it looks like an S-shaped curve. Production in
the short run can be described in 3 stages. First, it will be seen that in the beginning TP curve
increases at an increasing rate. This means that the slope of the TP curve is rising in the beginning.
This stage is a stage where the firm experiences increasing returns from hiring additional unit of
labor, where returns is measured by the value of the MP. Increasing returns happen because firms start
to realize gains from division of labor and specialization.

Imagine a firm fully equipped with machineries, tools and/or equipment but with only one labor. With
this labor use, total output is expected to be very few or low as only one worker is to do all the tasks
or work processes/procedures before an output is produced. One worker has to devote time on one
task and some time on other tasks. This therefore is inefficient and wastes time and effort. But what
happens when additional worker or workers are hired? As additional workers are hired work tasks can
now be divided among them, saving time and used efficiently by workers. This is the essence of
division of labor, it allows breaking down of a production process into specific tasks and roles to be
performed by cooperating individuals. It is the separation of a work process into a number of tasks,
with each task performed by a separate or group of persons, thereby allowing more contribution of
additional worker to total output produced. Division of labor eventually leads to specialization.
Specialization is the separation of tasks within a system, and allows workers to become expert in one
task.

After a point TP curve starts rising at a decreasing rate as the employment of the variable factor is
increased. This is the stage of production where the firm experiences what is called the law of
diminishing marginal returns. If more and more of a variable factor is used in a combination with a
fixed factor of production, eventually its contribution (MP) to TP will diminish. If the firm will
continue to hire additional worker, there comes a point where it will become less productive. Since
capital goods are fixed, these inputs will become less relative to the laborers, the users of capital
goods. As more of them are to work, machines, tools or equipment are not enough, making workers to
wait in line for their turn. Waiting in line means loss in output, not able to contribute yet to TP.
Similarly, if capital is fixed, extra workers will eventually get in each other’s way as they attempt to
increase production, and this eventually cause their productivity to fall.

At what point does the law of diminishing returns set in? Look for the point at which the marginal
increase is at the highest point and the next marginal increase is less. In this example, that occurs after
the firm adds the 4th laborer. At three units, the marginal output is 100, but when the fourth laborer
was hired, the marginal output drops to 98. Again, this does not mean the total production starts to
decrease. In fact, the total production is still increasing, however the increase is already at a
decreasing rate. TP reaches the maximum value at 504 units when 7 th and even 8th laborer is hired. At
this change in labor, we note that the marginal output (MP) is already 0, indicating that hiring the 8 th
worker means there is no longer a contribution to total output. A positive MP is still experienced by
hiring the 7th worker.

The third stage of production indicates that at the 9th unit of labor, the firm starts to experience
negative returns, where the increase in labor actually decreases the total output and the marginal
output becomes negative. The firm’s fixed plant becomes so crowded that another worker actually
reduces output, overcrowding puts so much pressure on fixed capital inputs that could eventually be
damaged, resulting to a decrease in output instead of increasing the output. A rational firm does not
want its output to fall, since its goal is to maximize output given some fixed inputs and variable inputs
combined.

Table 2: TP and MP relationship

TP Curve MP
Increasing at increasing rate Positive, increasing
Increasing at decreasing rate Positive, decreasing
Maximum Zero
Decreasing Negative

Average Product (AP) and Marginal Product (MP) Curves:

AP and MP curves have similar properties and interesting relationship. Note that MP describes the
addition to total output as additional labor is hired, technically MP is the slope of the TP curve, and
AP describes the labor’s productivity.

110
100
90
80
70
60
50
AP/MP

40
30 AP
20
10
MP
0
0 1 2 3 4 5 6 7 8 9 10 11
-10
-20
-30 Labor
Figure 2: AP and MP Curves
Note that both AP and MP curves initially increase, researches a maximum, then eventually decrease
(having an inverted U-shaped form). This shape of productivity is expected because of the law of
diminishing marginal returns.

An important relationship exists between AP and MP. When MP > AP (MP curve is above AP curve),
AP is rising (increasing); when MP = AP (MP curve cuts across AP curve), AP is maximum; and
when MP < AP (MP curve is below AP curve) AP is decreasing. This relationship happens to all
marginal and average values, not only between AP and MP. For example, this is also true to grades.
Suppose that your current grade is 75 and you want your average grade to rise. To get a higher
average grade greater than 75, the marginal grade (added grade) must be higher than the current
grade. Therefore, if marginal grade is 80 added to 75 (=155) the average grade becomes 77.5 (150/2)
which is higher than 75. If you want your average grade to fall, then you know that the marginal grade
that should be added to current grade of 75 must be lower.

At increasing rate of TP curve,

MP and AP curves are also
rising, as firms gain from
specialization and division of
labor. As TP curve increases
however at a decreasing rate,
MP and AP curves begin to
decline as additional workers
adds less and less to TP and
labor productivity declines.

Figure 3: TP, AP and MP relationship

SHORT-RUN PRODUCTION: COSTS

In the short-run, some of the firm’s inputs to production are fixed, yet others can be varied to change
the rate of output. The various measures of the cost of production can be distinguished on this basis.
 Total Cost (TC):

The total cost of production has two components:

1. Fixed Cost (FC) – this is borne by the firm whatever level of output it produces; this is also
the cost associated with the use of fixed input. Fixed costs may include expenditures for
plant maintenance, insurance, a minimal number of employees (regular, permanent
employees), rent, interest (cost of borrowing). This must be paid even if there is no output.
(A firm can only forgo its outlays on FC when it decides to out of business.

2. Variable Costs (VC) – costs that varies with the level of output, i.e., as output increases,
VC also increases and vice-versa. These are costs associated with the use of variable inputs.
Variable costs include expenditures for wages, raw materials, fertilizers, ingredients to a
food production, among others. Since VC depends on the variable input/s used, it is
computed as the price of the variable input times the quantity of variable input used. For
example, if labor is the variable input the price of labor is wage. Thus, VC = w x L (w =
wage, L = labor)

TC = FC + VC

We use a specific example that explains the cost situation of many firms. Consider the example
above under the output behavior. Assume that a worker receives $50.

Table 6: Total Costs in the Short-Run

L Q FC ($) VC =w x L ($) TC ($)
0 0 100 $0 $100
1 80 100 50 150
2 170 100 100 200
3 270 100 150 250
4 368 100 200 300
5 430 100 250 350
6 480 100 300 400
7 504 100 350 450
8 504 100 400 500
9 495 100 450 550
10 480 100 500 600

Fixed costs are, therefore, an integral part of the decision-making process of the manager of a
firm. To decide how much to produce, managers of firms need to know how variable costs
increase with the level of output. To address this issue, we need to develop some additional cost
measures.

 Other Cost Measures:

1. Average Costs – These are costs per unit of output. There are three types of average cost:

Average Fixed Cost (AFC) is fixed cost per unit of output; it is sometimes called overhead
cost.

FC
AFC=
Q

Average Variable Cost (AVC) is variable cost per unit of output.

 VC
AVC=
Q

Average Total Cost (ATC) is the cost incurred per unit of output

TC
ATC= ∨ATC= AFC + AVC
Q

2. Marginal Cost (MC)

Marginal cost, also incremental cost, is the increase in cost that results from producing one
extra unit of output. Since FC does not change as the firm’s level of output changes, MC is
just the increase in variable cost that results from an extra unit of output.
∆ TC ∆ VC
MC= ∨MC =
∆Q ∆Q

MC is therefore the slope of both the TC and VC curves.

Example:

Table 7: Other Cost Measures

L Q FC VC ($) TC ($) AFC AVC AC MC
($)
0 0 100 $0 $100 - - - -
1 80 100 50 150 1.25 0.63 1.88 0.63
2 170 100 100 200 0.59 0.59 1.18 0.56
3 270 100 150 250 0.37 0.56 0.93 0.50
4 368 100 200 300 0.27 0.54 0.82 0.51
5 430 100 250 350 0.23 0.58 0.81 0.81
6 480 100 300 400 0.21 0.63 0.83 1.00
7 504 100 350 450 0.20 0.69 0.89 2.08
*Note: Other values were removed after the maximum output is reached as firm’s goal is to
maximize output and not wait for output to decrease .

 Cost Curves (Total)

To further understand the behavior of the costs in the short-run, we provide a graphical
illustration of these costs. Let the quantity of output (Q) be placed on x-axis and the costs data on
y-axis.
 700
TC
600

500
V
C

400
Costs ($)

300

200
FC
100

0
0 50 100 150 200 250 300 350 400 450 500 550
Output (Q, TP)

Figure 4: TFC, TVC, and TC Curves

As expected, FC curve is a straight horizontal line as it is constant at all levels of output.

Interestingly are the shapes of the VC and TC curves. We notice that TC cost curve starts at 100
when Q = 0. TC will be entirely the value of FC even if the firm will not produce anything. Also,
TC just simply follows the behavior of the VC curve, since what is added to VC is just a constant
value of the FC to get TC. Therefore, TC curve will just simply “mimic” the behavior of VC.

VC/TC Behavior:

Initially both costs are increasing at a decreasing rate. The decreasing rate describes the slope of
TC and TVC curves, which means that as additional output is produced, the added cost ( MC) is
decreasing and this implies that it must be cheaper to produce additional output at first. This is
proven by the values of MC that initially decreases as additional output is produced, as illustrated
in Table 5. Why is MC initially decreases? The rate at which this cost change depends on the
nature of the production process, and in particular, on the extent to which production experiences
increasing or diminishing returns to variable factors. This means that the MC, the slope of TC
and VC curves, depends on the behavior of output. In fact, a better measure of MC is to use the
value of wage and MP.

w
MC=
MP

If we notice from Table 5, the change in both VC and TC is valued at 50, which happens to be the
value of wage (which is fixed). Also, we notice that the change in output ( ∆ Q ) happens to be the
value of the MP. To illustrate:

Table 8: Alternative MP Computation

L Q MP w MC = w/MP ($)
0 0 - 50 -
1 80 80 50 0.63
2 170 90 50 0.56 decreasing

increasing
 3 270 100 50 0.50
4 368 98 50 0.51
5 430 62 50 0.81
6 480 50 50 1.00
7 504 24 50 2.08

MC values are the same as calculated and illustrated in Table 5. The MC of additional output is
high at first because the first few inputs to production are not likely to raise output much with a
lot of equipment. From the formula given above, the numerator is a fixed value (w) and the
denominator is an increasing value (MP), the product (MC) will initially decrease. This is
because as a firm hires an additional worker and pays the same value of w, this wage is absorbed
by rising values of MP. This means that even if the firm incurs additional cost by hiring
additional workers, this added cost is more than offset by rising contribution (MP) of workers.
Also, as the inputs become more productive, the MC decreases substantially. Therefore, when
MC is decreasing it is because the MP is increasing. Take note that a rising MP is experienced
during the first stage of production where there is increasing returns.

Eventually, the VC/TC curves will increase at an increasing rate, indicating that the slope (MC) is
increasing in value. From the same reasoning above, if a constant value (w) is divided by a
decreasing value (MP), the product will eventually increase. This is because, as a firm hires
additional workers, their contribution to total output (the MP) declines. So, there is decreasing
additional output to absorb the cost of hiring them, which is the wage. Therefore, when MC is
rising it is because the MP is falling. And at this point, the firm is already experiencing the law of
diminishing marginal returns.

In a similar fashion, AVC is related to AP. AVC is alternatively measured as: AVC = w/AP.

Table 9: Alternative AP Computation

L Q AP w AVC = w/AP ($)
0 0 - 50 -
1 80 80 50 0.63
2 170 85 50 0.59 decreasing
3 270 90 50 0.56
4 368 92 50 0.54
5 430 86 50 0.58
6 480 80 50 0.63 increasing
7 504 72 50 0.69

We can see that when labor productivity is high and increasing, it makes VC per unit to decrease,
as there is more output to absorb the wage cost. On the other hand, when AP is decreasing, there
is less output per worker to absorb the wage cost, thus AVC rises. In short, the law of
diminishing returns also creates a direct link between the AP L and the AVC of production.

Marginal and average products tell us about the relationship between inputs and output. The
comparable cost variations tell us about the budgetary implications of the production function.

AFC, AVC, ATC, and MC Curves

 2.25
M
2.00 At Q = 80, the difference C
between AVC and ATC is
1.75 AFC=1.25
1.50

1.25
Costs, $

1.00 ATC

0.75 AVC
0.50
AFC
0.25

0.00
50 100 150 200 250 300 350 400 450 500 550

Output

Figure 6: AFC, AVC, ATC, and MC Curves

AFC curve is expected to decrease if output increases. Note that at very low level of output, AFC is
high (notice the difference between ATC and AVC at low level of output: there is a wide gap
between ATC and AVC because AFC is a high value. But as output increases, the gap between
ATC and AVC falls. So, it pays to be able to cover fixed cost if output increases as fixed cost is
spread over greater levels of output. ATC and AVC exhibit the same pattern. Both initially
decreases, reaches a minimum, then eventually increases (exhibiting a U-shaped form). As in the
case of TC and TVC, ATC simply follows the behavior of AVC.

Just like MP and AP, MC and AVC also have an important relationship:

MC < AVC (ATC), AVC (ATC) is decreasing

MC = AVC (ATC), AVC (ATC) is minimum
MC > AVC (ATC), AVC (ATC) is increasing

Table 10: Summary Relationship: Output and Cost

Stage of Output Cost
Production TP MP AP TC MC AVC
Increasing at Increasing at a
Positive,
I increasing Increasing decreasing rate Decreasing Decreasing
increasing
rate
Increasing at Increasing at
Positive,
II a decreasing Decreasing an increasing Increasing Increasing
decreasing
rate, rate
Decreasing Continuously
II Negative Decreasing Increasing Increasing
increase

Graph:
 The marginal-cost (MC) curve and the
average-variable-cost (AVC) curve in (b)
are mirror images of the marginal-
product (MP) and average-product (AP)
curves in (a). Assuming that labor is the
only variable input and that its price (the
wage rate) is constant, then when MP is
rising, MC is falling, and when MP is
falling, MC is rising. Under the same
assumptions, when AP is rising, AVC is
falling, and when AP is falling, AVC is
rising.

Figure 7: Relationship Between Output and Cost

LONG-RUN PRODUCTION COSTS

In the long run an industry and the individual firms it comprises can undertake all desired resource
adjustments. That is, they can change the amount of all inputs used. The firm can alter its plant
capacity; it can build a larger plant or revert to a smaller plant than that assumed in Table 7. The
industry also can change its overall capacity; the long run allows sufficient time for new firms to enter
or for existing firms to leave an industry. We will discuss the impact of the entry and exit of firms to
and from an industry in the next chapter; here we are concerned only with changes in plant capacity
made by a single firm. Let’s couch our analysis in terms of average total cost (ATC), making no
distinction between fixed and variable costs because all resources, and therefore all costs, are variable
in the long run.

 Firm Size and Costs

Suppose a manufacturer with a single plant begins on a small scale and, as the result of
successful operations, expands to successively larger plant sizes with larger out- put capacities.
What happens to average total cost as this occurs? For a time, successively larger plants will
lower average total cost. However, eventually the building of a still larger plant may cause ATC
to rise.

Figure 8 illustrates this situation for five possible plant sizes. ATC-1 is the short-run average-
total-cost curve for the smallest of the five plants, and ATC-5, the curve for the largest.
 Constructing larger plants will lower the minimum average total costs through plant size 3. But
then larger plants will mean higher minimum average total costs.

Figure 8: The Long-run Average Total-Cost Curve: Five Possible Plant Sizes

 The Long-Run Cost Curve

The vertical lines perpendicular to the output axis in Figure 8 indicate the outputs at which the
firm should change plant size to realize the lowest attainable average total costs of production.
These are the outputs at which the per-unit costs for a larger plant drop below those for the
current, smaller plant. For all outputs up to 20 units, the lowest average total costs are attainable
with plant size 1. However, if the firm’s volume of sales expands beyond 20 units but less than
30, it can achieve lower per-unit costs by constructing a larger plant, size 2. Although total cost
will be higher at the expanded levels of production, the cost per unit of output will be less. For
any output between 30 and 50 units, plant size 3 will yield the lowest average total costs. From
50 to 60 units of output, the firm must build the size-4 plant to achieve the lowest unit costs.
Lowest average total costs for any output over 60 units require construction of the still larger
plant, size 5.

Tracing these adjustments, we find that the long-run ATC curve for the enterprise is made up of
segments of the short-run ATC curves for the various plant sizes that can be constructed. The
long-run ATC curve shows the lowest average total cost at which any output level can be
produced after the firm has had time to make all appropriate adjustments in its plant size. In
Figure 8.7 the blue, bumpy curve is the firm’s long-run ATC curve or, as it is often called, the
firm’s planning curve.

In most lines of production, the choice of plant size is much wider than in our illustration. In
many industries the number of possible plant sizes is virtually unlimited, and in time quite small
changes in the volume of output will lead to changes in plant size. Graphically, this implies an
unlimited number of short-run ATC curves, one for each output level, as suggested by Figure 8.
Then, rather than being made up of segments of short-run ATC curves as in Figure 8, the long-
run ATC curve is made up of all the points of tangency of the unlimited number of short-run
ATC curves from which the long-run ATC curve is derived. Therefore, the planning curve is
smooth rather than bumpy. Each point on it tells us the minimum ATC of producing the
corresponding level of output.
 Figure 8: The Long-Run Average Total-Cost Curve: Unlimited Number of Plant Sizes

 Economies and Diseconomies of Scale

We have assumed that, for a time, larger and larger plant sizes will lead to lower unit costs but
that, beyond some point, successively larger plants will mean higher average total costs. That is,
we have assumed the long-run ATC curve is U-shaped. But why should this be? It turns out that
the U shape is caused by economies and diseconomies of large- scale production, as we explain
in a moment. But before we do, please understand that the U shape of the long-run average-total-
cost curve cannot be the result of rising resource prices or the law of diminishing returns. First,
our discussion assumes that resource prices are constant. Second, the law of diminishing returns
does not apply to production in the long run. This is true because the law of diminishing returns
only deals with situations in which a productive resource or input is held constant. Under our
definition of “long run,” all resources and inputs are variable.
 Figure 9: Various Possible Long-Run Average-Total-Cost Curves

1. Economies of Scale
Economies of scale, or economies of mass production, explain the downsloping part of the
long-run ATC curve, as indicated in Figure 9, graphs (a), (b), and (c). As plant size
increases, a number of factors will for a time lead to lower average costs of production.

a. Labor Specialization

Increased specialization in the use of labor becomes more achievable as a plant

increases in size. Hiring more workers means jobs can be divided and subdivided. Each
worker may now have just one task to perform instead of five or six. Workers can work
full-time on the tasks for which they have special skills. In a small plant, skilled
machinists may spend half their time performing unskilled tasks, leading to higher
production costs.

Further, by working at fewer tasks, workers become even more proficient at those
tasks. The jack-of-all-trades doing five or six jobs is not likely to be efficient in any of
them. Concentrating on one task, the same worker may become highly efficient.
 Finally, greater labor specialization eliminates the loss of time that occurs whenever a
worker shifts from one task to another.

b. Managerial Specialization

Large-scale production also means better use of, and greater specialization in,
management. A supervisor who can handle 20 workers is underused in a small plant
that employs only 10 people. The production staff could be doubled with no increase in
supervisory costs.

Small firms cannot use management specialists to best advantage. For example, a
marketing specialist working in a small plant may have to spend some of her time on
functions outside of her area of expertise—for example, accounting, personnel, and
finance. A larger scale of operations would allow her to supervise marketing full-time,
while other specialists perform other managerial functions. Greater productivity and
efficiency, along with lower unit costs, would be the net result.

c. Efficient Capital

Small firms often cannot afford the most efficient equipment. In many lines of
production such machinery is available only in very large and extremely expensive
units. Furthermore, effective use of the equipment demands a high volume of
production, and that again requires large-scale producers.

In the automobile industry the most efficient fabrication method employs robotics and
elaborate assembly-line equipment. Effective use of this equipment demands an annual
output of several hundred thousand automobiles. Only very large-scale producers can
afford to purchase and use this equipment efficiently. The small-scale producer is faced
with a dilemma. To fabricate automobiles using other equipment is inefficient and
therefore more costly per unit. But so, too, is buying and underutilizing the equipment
used by the large manufacturers. Because it cannot spread the high equipment cost over
very many units of output, the small-scale producer will be stuck with high costs per
unit of output.

d. Other Factors

Many products entail design and development costs, as well as other “start-up” costs,
which must be incurred regardless of projected sales. These costs decline per unit as
output is increased. Similarly, advertising costs decline per auto, per computer, per
stereo system, and per box of detergent as more units are produced and sold. Also, the
firm’s production and marketing expertise usually rises as it produces and sells more
output. This learning by doing is a further source of economies of scale.

All these factors contribute to lower average total costs for the firm that is able to
expand its scale of operations. Where economies of scale are possible, an increase in all
resources of, say, 10% will cause a more-than-proportionate increase in output of, say,
20%. The result will be a decline in ATC.

2. Diseconomies of Scale

In time the expansion of a firm may lead to diseconomies and therefore higher aver- age
total costs.
 The main factor causing diseconomies of scale is the difficulty of efficiently controlling and
coordinating a firm’s operations as it becomes a large-scale producer. In a small plant a
single key executive may make all the basic decisions for the plant’s operation. Because of
the firm’s small size, the executive is close to the production line, understands the firm’s
operations, and can make efficient decisions because the small plant size requires only a
relatively small amount of information to be examined and understood in optimizing
production.

This neat picture changes as a firm grows. One person cannot assemble, digest, and
understand all the information essential to decision making on a large scale. Authority must
be delegated to many vice presidents, second vice presidents, and so forth. This expansion
of the management hierarchy leads to problems of communication and cooperation,
bureaucratic red tape, and the possibility that decisions will not be coordinated. Similarly,
decision making may be slowed down to the point that decisions fail to reflect changes in
consumer tastes or technology quickly enough. The result is impaired efficiency and rising
average total costs.

Also, in massive production facilities workers may feel alienated from their employers and
care little about working efficiently. Opportunities to shirk, by avoiding work in favor of on-
the-job leisure, may be greater in large plants than in small ones. Countering worker
alienation and shirking may require additional worker supervision, which increases costs.

Where diseconomies of scale are operative, an increase in all inputs of, say, 10% will cause
a less-than- proportionate increase in output of, say, 5%. As a consequence, ATC will
increase. The rising portion of the long-run cost curves in Figure 9 illustrates diseconomies
of scale.

3. Constant Returns to Scale

In some industries a rather wide range of output may exist between the output at which
economies of scale end and the output at which diseconomies of scale begin. That is, there
may be a range of constant returns to scale over which long-run average cost does not
change. The q1q2 output range of Figure 9a is an example. Here a given percentage increase in
all in- puts of, say, 10% will cause a proportionate 10% increase in output. Thus, in this range
ATC is constant.

 Minimum Efficient Scale and Industry Structure

Economies and diseconomies of scale are an important determinant of an industry’s structure.

Here we introduce the concept of minimum efficient scale (MES), which is the lowest level of
output at which a firm can minimize long-run average costs. In Figure 9a that level occurs at q1
units of output. Because of the extended range of constant returns to scale, firms producing
substantially greater out- puts could also realize the minimum attainable long-run average costs.
Specifically, firms within the q1 to q2 range would be equally efficient. So we would not be
surprised to find an industry with such cost conditions to be populated by firms of quite different
sizes. The apparel, food processing, furniture, wood products, snowboard, banking, and small-
appliance industries are examples. With an extended range of constant returns to scale, relatively
large and relatively small firms can coexist in an industry and be equally successful.

Compare this with Figure 9b, where economies of scale continue over a wide range of outputs
and diseconomies of scale appear only at very high levels of output. This pattern of declining
long-run average total cost occurs in the automobile, aluminum, steel, and other heavy industries.
The same pattern holds in several of the new industries related to information technology, for
example, computer microchips, operating system software, and Internet service provision.
 Given consumer demand, efficient production will be achieved with a few large-scale producers.
Small firms cannot realize the minimum efficient scale and will not be able to compete. In the
extreme, economies of scale might extend beyond the market’s size, resulting in what is termed
natural monopoly, a relatively rare market situation in which average total cost is minimized
when only one firm produces the particular good or service.

Where economies of scale are few and diseconomies come into play quickly, the minimum
efficient size occurs at a low level of output, as shown in Figure 9c. In such industries a
particular level of consumer demand will support a large number of relatively small producers.
Many retail trades and some types of farming fall into this category. So do certain kinds of light
manufacturing such as the baking, clothing, and shoe industries. Fairly small firms are more
efficient than larger-scale producers in such industries.

Our point here is that the shape of the long-run average-total-cost curve is determined by
technology and the economies and diseconomies of scale that result. The shape of the long-run
ATC curve, in turn, can be significant in determining whether an industry is populated by a
relatively large number of small firms or is dominated by a few large producers, or lies
somewhere in between.

ACTIVITY
Activity 1:
Complete the table directly below by calculating MP and AP.
Inputs of L TP MP AP
0 0
1 15
2 34
3 51
4 65
5 74
6 80
7 83
8 82
Plot the TP, MP and AP and explain in detail the relationship between each pair of
curves. Explain why PM first rises, then declines, and ultimately becomes negative.

Activity 2:
List several fixed and variable costs associated with owning and operating an
automobile. Suppose you are considering whether to drive your car or fly 1000
miles to Albay for a semester break. Which costs – fixed, variable, or both –
would you take into account in making your decision? Would any implicit
costs be relevant? Explain.

Activity 3:
Use the concepts of economies and diseconomies of scale to explain the shape
of a firm’s long-run ATC curve. What is the concept of minimum efficient
scale? What bearing can the shape of the long-run ATC curve have on the
structure of an industry?
Activity 4:
Distinguish between explicit and implicit costs, giving examples of each. What
are some explicit and implicit costs of attending college? Why does the
economists classify normal profit as a cost? Is economic profit a cost of
production?

Activity 5:
Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays
annual rent of $5,000 for his shop, and spends $20,000 per year on materials.
He has $40,000 of his own funds invested in equipment (pottery wheels, kilns,
and so forth) that could earn him $4,000 per year if alternatively invested. He
has been offered $15,000 per year to work as a potter for a competitor. He
estimates his entrepreneurial talents are worth $3,000 per year. Total annual
revenue from pottery sales is $72,000. Calculate the accounting profit and the
economic profit for Gomez’s pottery firm.