Decision Making for Firms
Costs, revenues and profits
Production Theory
Diminishing marginal product
(MP)
Link between MP and MC
Firms and Industries
A firm is an organization that
produces goods and services
An industry is a group of firms that
produce identical or similar products
For example: Burger King and
Wendy’s are firms in the fast food
industry
Firms’ Decision Making
How effectively firms serve
consumers depends on the degree
of competition within the industry
To understand firm behavior we
need to investigate production
costs, revenues, and profits of firms
1
REVENUES & PROFITS
Total Revenue = Price x Quantity
Profit = Total Revenue - Total Cost
TOTAL COSTS
Costs = explicit + implicit costs
Explicit + Implicit measures the
Opportunity Costs of all resources
used
Explicit costs = out-of-pocket costs
Implicit costs = opportunity costs of
resources that the firm owns
EXAMPLE:
Labor
Supplies
Explicit Costs
$1000
$2500
$3500
Rental value of shop $400
Lost interest income $100
Income in other job $1000
Implicit Costs
$1500
Total Costs = $3500 + $1500 = $5000
2
PROFIT
ECONOMIC Profit
= Total Revenue - Total Cost
= TR - TC
ACCOUNTING Profit
= TR - Explicit Cost
IN THIS CLASS -- PROFIT IS ALWAYS
ECONOMIC PROFIT, because TC = all
costs of production
EXAMPLE:
Total Costs = $3500 + $1500 = $5000
Price = $1 Quantity = 5000
Total Revenue = $1 x 5000 = $5000
Profit = TR - TC = $0
Production and Costs
The costs that a firm incurs in
producing a specific output
depends on the adjustments it can
make in the amount of resources it
uses.
Some uses can vary easily, and
others require more time.
Short-run -- some inputs fixed
Long-run -- all inputs variable
3
Short Run -- costs are both
variable and fixed
Long Run -- all costs are
variable costs
Production Costs
Costs of Production depend on
prices of needed resources and on
TECHNOLOGY
TECHNOLOGY = the quantity of
resources it takes to produce the
output
Explore the relationship between
factors of production and output
Short Run Production
ASSUME:
two factors of production -- K and L
one factor fixed in short run -- K
one factor variable in short run -- L
Total Product = Quantity of Output
from different L with fixed K
4
Total Product
L
0
1
2
3
4
5
Q
0
8
23
42
57
67
L
6
7
8
9
10
Q
74
79
82
83
82
Total Product Curve
90
80
70
60
50
40
30
20
10
0
0
1
2
3
4
5
6
7
8
9
10
Labor
Shape of Total Product Curve
Marginal Product = Additional output
due to an additional unit of input
Increasing Marginal Product
Diminishing Marginal Product
Marginal Product of any variable factor
will eventually decline, holding all the
other factors fixed
5
Total and Marginal Product
L
0
1
2
3
4
5
Q
0
8
23
42
57
67
MP
8
15
19
15
10
L
6
7
8
9
10
Q MP
74 7
79 5
82 3
83 1
82 -1
Total Product Curve
90
80
70
60
50
40
30
20
10
0
+10
+15
+19
+15
+8
0
1
2
3
4
5
6
7
8
9
10
Labor
Marginal Product Curve
20
15
10
Marginal Product
5
0
-5
0
1
2
3
4
5
6
7
8
9 10 11
Labor
6
Marginal Cost (MC) and
Marginal Product (MP)
Marginal cost (MC) is the additional cost of
producing 1 more unit of output (∆C/∆Q)
If all units of labor are hired at the same
wage, the MC of each extra unit of output
will fall as long as the MP of each additional
worker is rising. This is because…
Marginal cost is the cost of an extra worker
divided by his or her MP.
$
Marginal Cost
MC
Output
What to Remember
Total Cost = Explicit Cost + Implicit Cost
Economic Profit = TR - TC
Short run and long run
Production Function
Marginal Product
Marginal Cost
7