Chapter 04 Firm Production, Cost, and Revenue McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • • • • Production Costs Revenue Maximizing Profit McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-2 1-2 Basic Definitions • Profit: The money that business makes: Revenue minus Cost • Cost: the expense that must be incurred in order to produce goods for sale • Revenue: the money that comes into the firm from the sale of their goods McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-3 1-3 Economic vs Accounting Cost • Economic Cost: All costs, both those that must be paid as well as those incurred in the form of forgone opportunities, of a business • Accounting Cost: Only those costs that must be explicitly paid by the owner of a business McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-4 1-4 Production • Production Function: a graph which shows how many resources we need to produce various amounts of output • Cost Function: a graph which shows how much various amounts of production cost McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-5 1-5 Inputs to Production • Fixed Inputs: resources that you cannot change • Variable Inputs: resources that can be easily changed McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-6 1-6 Concepts in Production • Division of Labor: workers divide up the tasks in such a way that each can build up a momentum and not have to switch jobs • Diminishing Returns: the notion that there exists a point where the addition of resources increases production but does so at a decreasing rate McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-7 1-7 Figure The Production Function Output D C A Production Function B Workers McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-8 1-8 A Numerical Example Labor Total Output Extra Output of the Group 0 100 100 317 217 500 183 610 110 700 90 770 70 830 60 870 40 900 30 13 1000 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-9 1-9 Costs • Fixed Costs: costs of production that we cannot change • Variable Costs: costs of production that we can change McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-10 1-10 Figure The Total Cost Function Total Cost D Total Cost Function C B A Output McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-11 1-11 Cost Concepts • Marginal Cost: the addition to cost associated with one additional unit of output • Average Total Cost: Total Cost/Output, the cost per unit of production • Average Variable Cost: Total Variable Cost/Output, the average variable cost per unit of production • Average Fixed Cost: Total Fixed Cost/Output, the average fixed cost per unit of production McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-12 1-12 Figure Marginal Cost, Average Total, Average Variable, and Average Fixed Cost P MC ATC AVC AFC Q McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-13 1-13 Numerical Example Outpu TVC t TFC TC MC* ATC AVC AFC 0 8500 8500 100 2500 8500 1100 25 110 25 85 200 3800 8500 1230 13 62 19 43 300 4800 8500 1330 10 44 16 28 400 6000 8500 1450 12 36 15 21 500 7500 8500 1600 15 32 15 17 600 9500 8500 1800 20 30 16 14 McGraw-Hill/Irwin 700 1250 8500 2100 30 30 18 4-14 1-14 12 * MC is per 100 ©2012 The McGraw-Hill Companies, All Rights Reserved Revenue • Marginal Revenue: additional revenue the firm receives from the sale of each unit McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-15 1-15 Figure Setting the Price When There are Many Competitors P P S P* P*=Marginal Revenue D Market for Memory McGraw-Hill/Irwin Our Firm ©2012 The McGraw-Hill Companies, All Rights Reserved 4-16 1-16 Figure Marginal Revenue When there are No Competitors P MR D Market for Memory McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-17 1-17 Numerical Example For the Many Competitors Case Q P TR 45 100 45 4,500 45 200 45 9,000 45 300 45 13,500 45 400 45 18,000 45 500 45 22,500 45 600 45 27,000 45 700 45 31,500 45 800 45 36,000 45 900 45 40,500 45 45 45,000 45 1000 * MR is per 100 McGraw-Hill/Irwin MR* ©2012 The McGraw-Hill Companies, All Rights Reserved 4-18 1-18 Numerical Example For the No Competitors Case Q P TR 75 100 70 7,000 70 200 65 13,000 60 300 60 18,000 50 400 55 22,000 40 500 50 25,000 30 600 45 27,000 20 700 40 28,000 10 800 35 28,000 900 30 27,000 -10 1000 25 25,000 -20 McGraw-Hill/Irwin MR* ©2012 The McGraw-Hill Companies, All Rights Reserved 4-19 1-19 Maximizing Profit • We assume that firms wish to maximize profits McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-20 1-20 Market Forms • Perfect Competition: a situation in a market where there are many firms producing the same good • Monopoly: a situation in a market where there is only one firm producing the good McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 4-21 1-21 Rules of Production • A firm should a) produce an amount such that Marginal Revenue equals Marginal Cost (MR=MC), unless b) the price is less than the average variable cost (P