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Chapter 4
Firm Production, Cost and Revenue
Chapter Objectives
After reading this chapter you should be able to
 Understand the relationship between production and costs and the relationship
between sales and revenues.
 Recognize that models of production are based on the assumption that firms seek
to maximize profit.
 See how profit maximization dictates that firms set production so that marginal
cost equals marginal revenue.
Definitions



Profit: The money that business makes: Revenue-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
Accounting vs. Economic Profit


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
Teaching Tips
1) This is another opportunity to talk about the cost of a college education. The lost
opportunity to work full time is an economic cost but not an accounting cost.
2) Let students discuss the difference between the two concepts by giving examples.
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
Inputs to Production


Fixed Inputs: resources that you cannot change
Variable Inputs : resources that can be easily changed
Teaching Tip
Let students discuss the difference between fixed and variable costs by having them generate
examples for a particular firm (like a farm or a fast food restaurant.
Concepts of 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
Teaching Tip
Note for students that these two influences have opposite impacts. Adding labor allows for
increased specialization through the division of labor but eventually adding more labor is
decreasingly effective because the fixed inputs are insufficient to make good use of the labor.
The Production Function
Drawing Tip
Draw and label the axes.
Teaching Tip
Note for students that the level of the
input (workers) is on the horizontal axis
and their production is on the vertical
axis.
Draw Tip
Label the origin point A.
Teaching Tip
Note for students that all machinery
requires at least some human attention
so “no workers equals no output.”
Drawing Tip
Place point B up and to the right of point
A.
Teaching Tip
Make it clear that the first worker (or
group of workers) cannot take advantage
of the division of labor so they produce
little output.
Drawing Tips
1) Place point C up and to the right of
point B.
2) Make the horizontal gap between B
and C the same as the gap between A
and B.
3) Make the vertical gap between B and
C much greater than the gap between
A and B.
Teaching Tip
Make it clear that the second worker (or
group of workers) can take advantage of
the division of labor so they produce much
more output.
Drawing Tips
1) Place point D up and to the right of
point C.
2) Make the horizontal gap between C
and D the same as the gap between B
and C.
3) Make the vertical gap between C and
D much less than the gap between B
and C.
Teaching Tip
Make it clear that the third worker (or
group of workers) is running up against a
fixed level of capital so the benefits of the
division of labor are not nearly as great.
Drawing Tip
Connect the points and label it as the
production function.
Numerical Example
Table 1
Numerical Example
Production Function
Labor
Total Extra Output
Output of the Group
0
0
1
2
3
4
5
6
7
8
9
13
100
317
500
610
700
770
830
870
900
1000
100
217
183
110
90
70
60
40
30
Costs
Fixed vs. Variable Costs


Fixed Costs: costs of production that we cannot change
Variable Costs: costs of production that we can change
Teaching Tip
Let students discuss by giving examples of fixed and variable costs.
The Total Cost Function
Drawing Tip
Draw the axes and label as shown
Teaching Tip
Have students notice that output is
now on the horizontal axis whereas
with the production function it was
on the vertical axis.
Drawing Tip
Place point A up on the vertical
axis.
Teaching Tips
1) Let students discuss why it is not at
the origin. Try to steer them to the
idea of fixed costs.
2) Make sure students realize that
point A on the production function
corresponds to point A here.
Drawing Tip
Place point B up and to the right of
point A.
Teaching Tip
Make sure students understand that
the horizontal change from A to B is
the production caused by the
addition of those workers and the
vertical change from A to B is the
cost of hiring those workers.
Drawing Tip
Place point C substantially to the
right of point B and make the
vertical change from point B to
point C the same as from A to B.
Teaching Tips
1) Note that the horizontal change
from B to C reflects the vast
increase in output because of the
division of labor.
2) Note the constant vertical change
reflects hiring an additional
worker (or group of workers).
Drawing Tip
Place point D slightly to the right
of point C and make the vertical
change from point C to point D
the same as from B to C.
Teaching Tips
1) Note that the horizontal change
from C to D reflects the slight
increase in output because of the
constraining capital.
2) Note the constant vertical change
reflects hiring an additional
worker (or group of workers).
Drawing Tip
Connect the points and label.
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
Average Total, Average Variable, Average Fixed and Marginal Costs
Drawing Tip
Label the axes price and quantity
Drawing Tip
Draw a check-shaped marginal
cost curve.
Teaching Tips
1) Note that the level of marginal cost
is the slope of the total cost curve.
2) Note that TC starts relatively steep,
flattens out then rises rapidly
again. Because of this MC begins
relatively high, decreases and then
increases again.
Drawing Tips
1) Draw a U-shaped ATC curve.
2) Make sure the MC cuts the ATC
at the minimum of ATC.
Teaching Tip
It is probably best to save the
“why” for point 2 above for the
numerical example.
Drawing Tips
1) Draw a U-shaped AVC curve.
2) Make sure the MC cuts the
AVC at the minimum of AVC.
3) Make sure that the AVC curve
begins a substantial vertical
distance from ATC and the gap
narrows as production
increases.
Teaching Tips
1) It is probably best to save the
“why” for point 2 above for the
numerical example.
2) Note the reason that the gap
between ATC and AVC shrinks
is because fixed costs are
spread over a higher level of
production.
Drawing Tips
1) Draw a ever decreasing AFC
curve
2) Draw it such that the gap
between ATC and AVC is
roughly the level of the AFC.
Output
Total
Total
Variable Fixed
Cost
Cost
0
0
8500
100
2500
8500
200
3800
8500
300
4800
8500
400
6000
8500
500
7500
8500
600
9500
8500
700
12500
8500
800
17000
8500
900
22500
8500
1000
32500
8500
* change in Total Cost / 100
Table 2
Numerical Example
Cost Functions
Total Marginal Average Average Average
Cost
Cost*
Total Variable Fixed
Cost
Cost
Cost
8500
11000
25
110
25
85
12300
13
62
19
43
13300
10
44
16
28
14500
12
36
15
21
16000
15
32
15
17
18000
20
30
16
14
21000
30
30
18
12
25500
45
32
21
10.6
31000
55
34
25
9.4
41000
100
41
32.5
8.5
Teaching Tip
Note the minimums of ATC and AVC are places where these levels are equal to MC.
Revenue

Marginal Revenue : additional revenue the firm receives from the sale of each
unit
Teaching Tips
1) Note that when there are many competitors a firm must accept the market price
or sell nothing.
2) Let discus discuss why this is the case.
Setting the Price When There are Many Competitors
Drawing Tip
Draw a Supply and Demand diagram.
Teaching Tip
Note that this is for a market for a good.
Drawing Tip
Draw a new graph to the right with
production of the firm as the horizontal axis
and price as the vertical axis.
Drawing Tip
Draw the equilibrium price line all the way
across both graphs.
Teaching Tip
Note for students that the marginal revenue
is the price because the firm is a price taker.
Marginal Revenue When there are No Competitors
Drawing Tip
Draw a downward sloping demand curve
Teaching Tips
Remind students that this is the market for
memory and that since there is only one
seller of it, the market demand curve is the
same as the demand for that firm’s
memory.
Drawing Tip
Draw a marginal revenue curve by
connecting the vertical intercept of the
demand curve with a point half-way
between the origin and the horizontal
intercept.
Teaching Tip
Do not try to graphically explain why it is
“half-way”. Wait until the numerical
example.
Numerical Example
Table 3
Numerical Example
Revenue When There are Many Competitors.
Q
Price
TR
MR*
0
45
0
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
1000
45
45,000
45
 the change in Total Revenue / 100
Teaching Tip
Note that price and marginal revenue are the same.
Table 4
Numerical Example
Revenue When There Are No Competitors
Q
Price
TR
MR*
0
75
0
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
0
900
30
27,000
-10
1000
25
25,000
-20
 change in Total Revenue / 100
Teaching Tip
Note that if the table were continued to the end Q would be 1600 and P would be 0. Therefore half
of 1600 is 800 and that is where MR is 0.
Maximizing Profit
•We assume that firms wish to maximize profits
Teaching Tip
Let students discuss whether they think this is a good assumption. Ask them why businesses
donate to charity. Is this consistent with profit maximization.
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
Teaching Tip
Acknowledge that there are points in between these extremes and that this will be dealt with in
the next chapter.
Rules of Production

A firm should
 produce an amount such that Marginal Revenue equals Marginal Cost (MR=MC),
 unless
 the price is less than the average variable cost (P<AVC).
Numerical Examples
Table 5
Numerical Example
Profit Maximization When There Are Many Competitors
Q
Price
TR
TC
MR
MC
Profit
0
45
0
8,500
0
0 -8,500
100
45
4,500 11,000
45
25 -6,500
200
45
9,000 12,300
45
13 -3,300
300
45 13,500 13,300
45
10
200
400
45 18,000 14,500
45
12
3,500
500
45 22,500 16,000
45
15
6,500
600
45 27,000 18,000
45
20
9,000
700
45 31,500 21,000
45
30 10,500
800
45 36,000 25,500
45
45 10,500
900
45 40,500 31,000
45
55
9,500
1000
45 45,000 41,000
45
100
4,000
Table 6
Numerical Example
Profit Maximization When There Are No Competitors
Q
Price
TR
TC
MR
MC
Profit
0
75
0
8,500
0
0 -8,500
100
70
7,000 11,000
70
25 -4,000
200
65 13,000 12,300
60
13
700
300
60 18,000 13,300
50
10
4,700
400
55 22,000 14,500
40
12
7,500
500
50 25,000 16,000
30
15
9,000
600
45 27,000 18,000
20
20
9,000
700
40 28,000 21,000
10
30
7,000
800
35 28,000 25,500
0
45
2,500
900
30 27,000 31,000
-10
55 -4,000
1000
25 25,000 41,000
-20
100 -13,500
Teaching Tips
1) Note that the market with many competitors produces more output than the market
dominated by one firm.
2) Note that both firms produce where MC=MR.
3) Note that profits do not rise or fall in that range.
4) Students may ask why the last unit should be produced given that profit doesn’t rise.
Answer that this is an artifact of grouping units in 100’s and that if units were infinitely
divisible then there would be one unique profit maximizing level of output.
Back of Chapter Questions
A key assumption about the way firms behave is that they
a) minimize costs.
b) maximize market share.
c) maximize profit.
d) maximize revenue.
When workers subdivide the tasks of a job in such a way so as to become more efficient
economists refer to this as the benefits of
a) the division of labor.
b) the division of tasks.
c) the separation of powers.
d) none of these
A profit maximizing firm will always produce in such a way that
a) Marginal Cost equals Marginal Revenue.
b) Average Total Cost is minimized.
c) Total Revenue is maximized.
d) Marginal Cost equals Marginal Revenue except when price is less than average
variable cost.
The shut down condition for a firm is to close
a) if losses are made.
b) if price is less than Average Total Cost.
c) if price is less than marginal revenue.
d) if price is less than Average Variable Cost.
Marginal Revenue is
a) the extra revenue associated with one additional unit of sales.
b) the extra cost associated with one additional unit of output.
c) the revenue associated with the first unit of sales.
d) the revenue associated with the sale of the average unit.
Average Total Cost is
a) the addition to cost associated with one additional unit of output.
b) the per unit cost of production.
c) the per unit variable cost of production.
d) the per unit fixed cost of production.
Given the Total Cost function in the book, the Marginal Cost curve always
a) is check-shaped.
b) cuts through the minimum of the average variable cost curve.
c) cuts through the minimum of the average total cost curve.
d) all of the above