BUSS1040 Production, costs and supply
Production, costs and supply
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Lecture 2:
Production, costs and supply
Reading: NW Ch.7 & 8
Online Quiz 1 – week 3
• Access on BUSS1040 Canvas
• Starts Monday – keep an eye on email and Canvas
• You have a week to complete
• 10 multiple choice questions, covering material from weeks 1-2
• Shortly after the quiz closes, correct answers will be available on Canvas
• Schedule enough time to work through the quiz!
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after the quiz closes. Questions with answers will be available on Canvas after the quiz closes.
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2BUSS1040 - Lecture 2
Introduction
• Now we focus on how firms operate.
o We want to describe firm behaviour with a view on understanding firm and market
supply
1. we examine the ideas of short and long run for a firm's production
process;
o In the short run the firm has at least one fixed input of production, whereas in the
long run all inputs can be adjusted if the firm wishes to.
2. we analyse the relationship between a firm's inputs and its outputs –
that is, its production function.
3. we examine how a firm's output is related to its costs in the short run
and in the long run.
o There is a one-to-one relation between production and costs
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Economic profit versus accounting profit
• We assume that firms aim to maximise profits, where
profit = Economic profit
• Economic profit may differ from accounting profit
• Accounting profits are revenues minus all explicit costs
• Economic profits are revenues minus total opportunity cost
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BUSS1040 - lecture 2
Economic profit
Total revenue – the amount a firm receives for the sale of its output
Total cost – the amount a firm pays to buy the inputs of production + forgone opportunities
= total opportunity cost of producing goods/services
o Opportunity costs include
explicit costs (that are not sunk)
= direct payments for inputs or factors of production
implicit costs (value of foregone opportunities)
e.g. forgone wages, interest earnings
Profit – total revenue minus total costs
π = TR – TC
Example: Helen uses $300 000 of savings, interest rate at 5 % Thus Helen gives up $15 000 per year in
interest
Not an explicit cost – but it is an opportunity cost while she is running the firm, so needs to be
included in costs (and measures of economic profit).
Zero economic profit – revenues just cover opportunity costs
5BUSS1040 - lecture 2
6Revenue
How an economist
views a firm
Explicit
costs
Economic
profit
Implicit
opp.
costs
Explicit
costs
Accounting
profit
How an accountant
views a firm
Revenue
Economic profit versus accounting profit
BUSS1040 - lecture 2
Economic Profit – Example
Tom recently opened a restaurant.
This requires Tom to (temporarily) give up a job working as a lecturer at the university that pays $20 000 a year.
The restaurant is located in a house he inherited from his grandmother, of which he is the sole owner. The house would
otherwise be rented out at a price of $30,000 a year.
This year, the restaurant has revenue of $200 000, personnel costs of $50 000 and costs of food inputs of $20 000. What is
Tom’s economic profit of running his restaurant this year?
(a) $80 000
(b) $90 000
(c) $110 000
(d) $130 000
(e) None of the above
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• Answer: (a) $80,000
• Explanation: Economic profit = Total revenue – Explicit costs – Implicit
costs
• Here, revenue = $200,000
• Explicit costs = $50,000 (personnel costs) + $20,000 (food inputs) =
$70,000
• Implicit costs = $20,000 (forgone wages) + $30,000 (forgone rental
income) = $50,000
• Therefore, Economic profit = $200,000 - $70,000 - $50,000 = $80,000
RMIT University©4/08/2022 8
The short run and long run
• What is a firm?
• A firm, using the available technology, converts inputs – labour, machinery
(often called capital), natural resources (typically called land) – into output
that is sold in the marketplace.
o Typically, a firm will require more than one input to produce its final output.
• We define the short run and the long run of a firm in relation to
whether or not any of the factors of production (inputs) are fixed
o An input is ‘fixed’ if it cannot be changed regardless of the output produced
9BUSS1040 - lecture 2
The Short and long run
• The short run is the period of time during which at least one of the
factors of production is fixed
o for example, the size of a factory might not be able to be changed.
• In the long run, all factors of production are variable (that is, not
fixed).
o Therefore, in when the firm's lease of the factory ends, the firm is free to
decide whether or not to renew the lease for that factory.
• The short run and the long run is not defined in relation to a set
period of time, but rather in relation to how long it takes for all of a
firm's inputs to become variable – this will differ between industries.
10BUSS1040 - lecture 2
Production
• A firm requires inputs or factors of production (labour, capital, land,
etc.) in order to produce its final output (i.e. goods or services).
• A production function shows the relationship between quantity of
inputs used and the (maximum) quantity of output produced, given
the state of technology.
11BUSS1040 - lecture 2
Example of a production function
• Jonathan owns a factory that makes umbrellas.
• Assume the factory size cannot be changed – that is, we are in the
short run.
• Jonathan chooses how many workers to use
o with one worker, he can make 60 umbrellas; with two workers, 110 umbrellas;
three workers, 150 umbrellas; four workers, 180 umbrellas.
• The relationship between inputs (number of workers) and output
(number of umbrellas) is the production function.
• Often a production function is represented using an equation.
o For example, q=f(L) where q is the level of output and L the amount of labour.
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Example of a production function
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Typical production function
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()
BUSS1040 - lecture 2
Marginal product
• The marginal product (MP) is the change in output when one more
input is used.
• In the umbrella example above:
o Hiring one worker (rather than having no workers at all) allows 60 umbrellas
to be made rather than 0 – the MP of the first worker is 60.
o If Jonathan has one worker and hires one additional worker, output increases
from 60 to 110 – the MP of the second worker is 110 - 60 = 50.
o If Jonathan has three workers and hires one additional worker, is output will
increase from 150 to 180; the MP of the fourth worker is 30 umbrellas.
• MP is the slope of the production function.