Lecture 8 Producer Theory

Objective of a Firm The main objective of firm is to maximize profit Firms engage in production process But when firm choose the level of inputs for production it must also consider the cost of inputs. So in the production process firms objective is to efficiently produce output and minimize cost. Total Revenue – The amount a firm receives for the sale of its output. Total Cost – The market value of the inputs a firm uses in production. Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost

Factor of Production When a firm engage in production it needs factors of production. The factors of production are : – Land Price paid to acquire land = Rent – Labour : all physical and mental human effort involved in production Price paid to labour = Wages – Capital : buildings, machinery and equipment used for production Price paid for capital = Interest Production Function: It shows the maximum amount of output that can be efficiently produced by given inputs and technology. Production function is expressed as Q = f (K, L, La) Output (Q) is dependent upon the amount of capital (K), Land (La) and Labour (L) used

Cost of a Firm A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs – A firm’s cost of production include explicit costs and implicit costs. Explicit costs are input costs that for which the firm make a direct payment. Like hiring a worker or renting a land. Implicit costs are input costs that for which the firm does not make a direct payment. For example if a owner of a shop don’t hire a manager, instead he himself operate the shop. In this case his opportunity cost of working in the shop is the wage that he could earn by working in another firm.

Economic Profit versus Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. – Economic profit is smaller than accounting profit.

Figure 1 Economist versus Accountants Copyright © 2004 South-Western Revenue Total opportunity costs How an Economist Views a Firm How an Accountant Views a Firm Revenue Economic profit Implicit costs Explicit costs Explicit costs Accounting profit

Total Product Vs Marginal Product Total product (TP) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) when we use different inputs in production process. The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

Total and Marginal Product and Total Cost:

Diminishing Marginal Product – Law of Diminishing marginal product states that the marginal product of an input declines as the quantity of the input increases. For example in the previous example when the no of labor was increasing the marginal product was decreasing. That means as more and more workers are hired at a firm, each additional worker contributes less and less to production. Suppose there is firm that makes cookies in a kitchen. In that case from the previous example we can see that the second worker has a marginal product of 40 cookies, the third worker has a marginal product of 30 cookies and the fourth worker has a marginal product of 20 cookies. The reason is at first, when only a few workers are hired, they have easy access to kitchen equipment. As the number of workers increases, additional workers have to share equipment and work in more crowded conditions. Hence, as more and more workers are hired, each additional worker contributes less to the production of cookies.

Average Product (AP) Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used. – The "productivity" of an input is usually expressed in terms of its average product. – The greater the value of average product, the higher the efficiency in physical terms. Formula:

Example: Average product of labor. Labor (L) Total product of labor (TP L ) Average product of labor (AP L )

Short Run and Long Run Short Run: Short run is defined as a situation where at least one of the factors will be fixed. Example: in short run production function land can be fixed. That means we cannot change the amount of land in our production process. Long Run: Long run is defined as a situation where all factors are variable that means we can change the amount of factors. Example: in long run production function we can even change the amount of land. That means in the long run we can even increase or decrease the amount of land which was fixed in the short run.

Costs in the Short Run and long run In the short run, all firms have costs that they must bear regardless of their output. These kinds of costs are called fixed costs. For example the cost for construction of a building. Firms will also have variable costs which vary with the output level. For example: no of workers a firm hire. To produce more output a firm needs to hire more workers. In the long run firms will not have any fixed costs. It will have only variable costs.

Costs in the Short Run Fixed cost is any cost that does not depend on the firm’s level of output. These costs are incurred even if the firm is producing nothing. Variable cost is a cost that depends on the level of production chosen. Total Cost = Total Fixed + Total Variable Cost Cost