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124 5 BACKGROUND TO SUPPLY
Chapter 4 went behind the demand curve. It saw how the
‘rational’ consumer weighs up the benefits (utility) of con-
suming various amounts of goods or combinations of goods
against their costs (their price).
We now need to go behind the supply curve and find
out just how the rational producer (or ‘firm’ as we call all
producers) will behave.
In this case, we shall be looking at the benefits and costs
to the firm of producing various quantities of goods and
using various alternative methods of production. We shall
be asking:
• How much will be produced?
• What combination of inputs will be used?
• How much profit will be made?
Profit and the aims of a firm
The traditional theory of supply, or theory of the firm,
assumes that firms aim to maximise profit; this is a realistic
5.1 THE SHORT-RUN THEORY OF PRODUCTION
The cost of producing any level of output will depend on
the amount of inputs (or ‘factors of production’) used
and the price the firm must pay for them. Let us first
focus on the quantity of factors used.
Output depends on the amount of resources and
KEY
IDEA how they are used. Different amounts and
16
combinations of inputs will lead to different
amounts of output. If output is to be produced
efficiently, then inputs should be combined in the
optimum proportions.
Short- and long-run changes in production
If a firm wants to increase production, it will take time to
acquire a greater quantity of certain inputs. For example,
Definitions
Rational producer behaviour When a firm weighs up the
costs and benefits of alternative courses of action and then
seeks to maximise its net benefit.
Traditional theory of the firm The analysis of pricing
and output decisions of the firm under various market
conditions, assuming that the firm wishes to maximise
profit.
Alternative theories of the firm Theories of the firm based
on the assumption that firms have aims other than profit
maximisation.
assumption in many cases. The traditional profit-maximising
theory of the firm is examined in this and the following
two chapters. First we examine the general principles that
govern how much a firm supplies. Then, in Chapters 6 and
7, we look at how supply is affected by the amount of com-
petition a firm faces.
In some circumstances, however, firms may not seek to
maximise profits. Instead they may seek to maximise sales,
or the rate of growth of sales. Alternatively, they may have
no single aim, but rather a series of potentially conflicting
aims held by different managers in different departments
of the firm. Sometimes there may be a conflict between the
owners of the firm and those running it. Not surprisingly,
a firm’s behaviour will depend on just what its aims are.
Chapter 8 looks at various alternative theories to profit
maximisation, each theory depending on the particular
aims of the firm.
a manufacturer can use more electricity by turning on
switches, but it might take a long time to obtain and install
more machines, and longer still to build a second or third
factory.
If, then, the firm wants to increase output in a hurry, it
will only be able to increase the quantity of certain inputs.
It can use more raw materials, more fuel, more tools and
possibly more labour (by hiring extra workers or offering
overtime to its existing workforce). But it will have to make
do with its existing buildings and most of its machinery.
The distinction we are making here is between fixed fac-
tors and variable factors. A fixed factor is an input that can-
not be increased within a given time period (e.g. buildings).
A variable factor is one that can.
The distinction between fixed and variable factors
allows us to distinguish between the short run and the
long run.
Fixed factor An input that cannot be increased in supply
within a given time period.
Variable factor An input that can be increased in supply
within a given time period.
Short run The period of time over which at least one factor
is fixed.
Long run The period of time long enough for all factors to
be varied.
ECON_C05.qxd 3/04/2009 11:17 Page 125
The short run is a time period during which at least
one factor of production is fixed. In the short run, then,
output can be increased only by using more variable
factors. For example, if an airline wanted to carry more
passengers in response to a rise in demand, it could pos-
sibly accommodate more passengers on existing flights
if there was space. It could possibly increase the number
of flights with its existing fleet, by hiring more crew
and using more fuel. But in the short run it could not
buy more planes: there would not be time for them to be
built.
The long run is a time period long enough for all inputs
to be varied. Given long enough, a firm can build addi-
tional factories and install new machines.
The actual length of the short run will differ from firm
to firm. It is not a fixed period of time. Thus if it takes a
farmer a year to obtain new land, buildings and equip-
ment, the short run is any time period up to a year and the
long run is any time period longer than a year. If it takes an
airline two years to obtain an extra plane, the short run is
any period up to two years and the long run is any period
longer than two years.
1. How will the length of the short run for the airline
? depend on the state of the aerospace industry?
2. Up to roughly how long is the short run in the following
cases?
(a) A firm supplying DJs for clubs and parties
(b) Nuclear power generation
(c) A small grocery retailing business
(d) ‘Superstore Hypermarkets Ltd’
In each case specify your assumptions.
For the remainder of this section we will concentrate on
short-run production.
The law of diminishing returns
Production in the short run is subject to diminishing returns.
You may well have heard of ‘the law of diminishing
returns’: it is one of the most famous of all ‘laws’ of eco-
nomics. To illustrate how this law underlies short-run pro-
duction let us take the simplest possible case where there
are just two factors: one fixed and one variable.
Definitions
Law of diminishing (marginal) returns When one or
more factors are held fixed, there will come a point beyond
which the extra output from additional units of the variable
factor will diminish.
Total physical product The total output of a product
per period of time that is obtained from a given amount
of inputs.
5.1 THE SHORT-RUN THEORY OF PRODUCTION 125
Take the case of a farm. Assume the fixed factor is land
and the variable factor is labour. Since the land is fixed
in supply, output per period of time can be increased only
by increasing the amount of workers employed. But imag-
ine what would happen as more and more workers crowd
on to a fixed area of land. The land cannot go on yield-
ing more and more output indefinitely. After a point the
additions to output from each extra worker will begin to
diminish.
We can now state the law of diminishing (marginal)
returns.
KEY The law of diminishing marginal returns states that
IDEA when increasing amounts of a variable factor are
17
used with a given amount of a fixed factor, there will
come a point when each extra unit of the variable
factor will produce less extra output than the
previous unit.
A good example of the law of diminishing returns is
given in Case Study 5.1 in MyEconLab. It looks at dimin-
ishing returns to the application of nitrogen fertiliser on
farmland.
The short-run production function: total
product
Let us now see how the law of diminishing returns affects
total output, or total physical product (TPP) as it is some-
times called.
The relationship between inputs and output is shown in
a production function. In the simple case of the farm with
only two factors – namely, a fixed supply of land (L̄n) and a
variable supply of farm workers (Lb) – the production func-
tion would be
TPP = f (L̄n,Lb)
This states that total physical product (i.e. the output of
the farm) over a given period of time is a function of (i.e.
depends on) the quantity of land and labour employed. We
could express the precise relationship using an equation
(an example is given in Box 5.4).
Production function The mathematical relationship
between the output of a good and the inputs used to
produce it. It shows how output will be affected by
changes in the quantity of one or more of the inputs.
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126 5 BACKGROUND TO SUPPLY

BOX 5.1 MALTHUS AND THE DISMAL SCIENCE OF ECONOMICS

Population growth + diminishing returns = starvation

The law of diminishing returns has potentially cataclysmic
implications for the future populations of the world.
If the population of the world grows rapidly, then
food output may not keep pace with it. There could be
diminishing returns to labour as more and more people
crowd on to the limited amount of land available.
This is already a problem in some of the poorest
countries of the world, especially in sub-Saharan Africa.
The land is barely able to support current population
levels. Only one or two bad harvests are needed to cause
mass starvation – witness the appalling famines in recent
years in Ethiopia and Sudan.
The relationship between population and food output
was analysed as long ago as 1798 by the Reverend
Thomas Robert Malthus (1766–1834) in his Essay on the
Principle of Population. This book was a bestseller and
made Robert Malthus perhaps the best known of all social
scientists of his day.
Malthus argued as follows:
I say that the power of population is indefinitely
greater than the power in the earth to produce
subsistence for man.
Population when unchecked, increases in a
geometrical ratio. Subsistence increases only in an
arithmetical ratio. A slight acquaintance with numbers
will show the immensity of the first power in
comparison with the second.1
What Malthus was saying is that world population
tends to double about every 25 years or so if unchecked. It
grows geometrically, like the series 1, 2, 4, 8, 16, 32, 64,
etc. But food output, because of diminishing returns,
cannot keep pace with this. It is likely to grow at only an
arithmetical rate, like the series 1, 2, 3, 4, 5, 6, 7, etc. It is
clear that population, if unchecked, will soon outstrip
food supply.
So what is the check on population growth?
According to Malthus, it is starvation. As population
grows, so food output per head will fall until, with more
and more people starving, the death rate will rise. Only
then will population growth stabilise at the rate of growth
of food output.
Have Malthus’ predictions been borne out by events?
Two factors have mitigated the forces that Malthus
described:
• The rate of population growth tends to slow down as
countries become more developed. Although improved
health prolongs life, this tends to be more than offset
by a decline in the birth rate as people choose to have
smaller families. This is illustrated in the table below.
Population growth peaked in the 1960s, has fallen
substantially since then and is projected to fall further
in future decades.
• Technological improvements in farming have greatly
increased food output per hectare. (See Case Study 5.1
in MyEconLab for an example.)
The growth in food output has thus exceeded the rate
of population growth in developed countries. Also certain
developing countries have seen significant advances in
agriculture. These include the ‘green revolution’ of the
1960s, whereby new high-yielding crop varieties were
developed (especially in the cases of wheat and rice), and
the development of genetically modified crops in recent

and the top diagram in Figure 5.1 show how total wheat
Table 5.1 Wheat production per year from a output per year varies as extra workers are employed on a
particular farm
fixed amount of land.
Number of TPP APP MPP With nobody working on the land, output will be zero
workers (Lb) = TPP/Lb)
(= = ΔTPP/Δ
(= ΔLb) (point a). As the first farm workers are taken on, wheat
output initially rises more and more rapidly. The assump-
a 0 0 –
3 tion behind this is that with only one or two workers
1 3 3
7 efficiency is low, since the workers are spread too thinly.
2 10 5
b 14
3 24 8 With more workers, however, they can work together –
12
c 4 36 9 each, perhaps, doing some specialist job – and thus they
4
5 40 8 can use the land more efficiently. In Table 5.1, output rises
2
6 42 7
d 0 more and more rapidly up to the employment of the third
7 42 6
−2 worker (point b). In Figure 5.1 the TPP curve gets steeper up
8 40 5
to point b.
After point b, however, diminishing marginal returns
Alternatively, the production function could be set in: output rises less and less rapidly, and the TPP curve
expressed in the form of a table or a graph. Table 5.1 and correspondingly becomes less steeply sloped.
Figure 5.1 show a hypothetical production function for a When point d is reached, wheat output is at a maxi-
farm producing wheat. The first two columns of Table 5.1 mum: the land is yielding as much as it can. Any more
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5.1 THE SHORT-RUN THEORY OF PRODUCTION 127

EXPLORING
ECONOMICS

years. In some countries food output growth has World population levels and growth: actual and
outstripped population growth. India, for example, now projected
exports grain.
Average annual rate of increase (%)
Nevertheless, the Malthusian spectre is very real for
some of the poorest developing countries, which are Year World More Less
simply unable to feed their populations satisfactorily. population developed developed
It is these poorest countries of the world which have some (billions) World regions regions
of the highest rates of population growth – around 3 per 1950 2.5
cent per annum in many African countries. 1.8 1.2 2.1
A further cause for concern arises from the move in 1960 3.0
Asia towards a westernised diet, with meat and dairy 2.0 1.0 2.4
products playing a larger part. This further increases 1970 3.7
pressure on the land, since cattle require considerably 1.9 0.7 2.2
more grain to produce meat than would be needed to 1980 4.5
feed humans a vegetarian diet. 1.7 0.6 2.1
A third factor is cited by some commentators, who 1990 5.3
remain unconvinced of the strength of Malthus’ gloomy 1.4 0.3 1.7
prognostication for the world. They believe that he 2000 6.1
seriously underestimated humankind’s capacity to 1.2 0.3 1.4
innovate; perhaps human ingenuity is one resource that 2010 6.9
doesn’t suffer from diminishing returns. 1.0 0.2 1.2
2020 7.7
1. Why might it be possible for there to be a zero marginal 0.8 0.1 1.0
2030 8.3
? productivity of labour on many family farms in poor
countries and yet just enough food for all the members
of the family to survive? (Illustrate using MPP and APP 2040 8.8
0.6 0.0 0.7

curves.) 0.4 − 0.1 0.5

2. The figures in the following table are based on the 2050 9.2
assumption that birth rates will fall faster than Sources: Various.
death rates. Under what circumstances might these
forecasts underestimate the rate of growth of world
population? 1
T. R. Malthus, First Essay on Population (Macmillan, 1926), pp. 13–14.

workers employed after that are likely to get in each other’s Average physical product
way. Thus beyond point d, output is likely to fall again: This is output (TPP) per unit of the variable factor (Q v ). In
eight workers produce less than seven workers. the case of the farm, it is the output of wheat per worker.

The short-run production function: average
and marginal product
In addition to total physical product, two other important
concepts are illustrated by a production function: namely,
average physical product (APP) and marginal physical
product (MPP).
APP = TPP/Qv
Thus in Table 5.1 the average physical product of labour
when four workers are employed is 36/4 = 9 tonnes per year.
Marginal physical product
This is the extra output (ΔTPP) produced by employing one
more unit of the variable factor.

Definitions
Average physical product Total output (TPP) per unit of Marginal physical product The extra output gained by
the variable factor in question: APP = TPP/Qv. the employment of one more unit of the variable factor:
MPP = ΔTPP/ΔQv.
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128 5 BACKGROUND TO SUPPLY

Figure 5.1 Wheat production per year (tonnes)

CASE STUDIES AND

BOX 5.2 DIMINISHING RETURNS IN THE BREAD SHOP APPLICATIONS

Is the baker using his loaf?

Just up the road from where John lives is a bread shop. • There is only one cash till. Assistants frequently
Like many others, he buys his bread there on a Saturday had to wait while other assistants used it.
morning. Not surprisingly, Saturday morning is the busiest • There is only one pile of tissue paper for wrapping
time of the week for the shop and as a result it takes on the bread. Again the assistants often had to wait.
extra assistants.
The fifth and maybe even the fourth assistant ended
During the week only one assistant serves the
up serving very few extra customers.
customers, but on a Saturday morning there used to be
five serving. But could they serve five times as many John is still going to the same bread shop and they still
customers? No, they could not. There were diminishing have only one till and one pile of tissue paper. But now
returns to labour. only three assistants are employed on a Saturday! The
shop, however, is just as busy.
The trouble is that certain factors of production in the
shop are fixed:
How would you advise the baker as to whether he should
• The shop is a fixed size. It gets very crowded on
Saturday morning. Assistants sometimes had to wait
while customers squeezed past each other to get to the
? (a) employ four assistants on a Saturday; (b) extend his
shop, thereby allowing more customers to be served on a
Saturday morning?
counter, and with five serving, the assistants
themselves used to get in each other’s way.
ECON_C05.qxd 3/04/2009 11:17 Page 129
Thus in Table 5.1 the marginal physical product of the
fourth worker is 12 tonnes. The reason is that by employing
the fourth worker, wheat output has risen from 24 tonnes
to 36 tonnes: a rise of 12 tonnes.
In symbols, marginal physical product is given by
MPP = ΔTPP/ΔQv
Thus in our example:
MPP = 12/1 = 12
The reason why we divide the increase in output (ΔTPP)
by the increase in the quantity of the variable factor (ΔQv)
is that some variable factors can be increased only in mul-
tiple units. For example, if we wanted to know the MPP of
fertiliser and we found out how much extra wheat was
produced by using an extra 20 kg bag, we would have to
divide this output by 20 (ΔQv) to find the MPP of one more
kilogram.
Note that in Table 5.1 the figures for MPP are entered in
the spaces between the other figures. The reason is that
MPP can be seen as the difference in output between one
level of input and another. Thus in the table the difference
in output between five and six workers is 2 tonnes.
The figures for APP and MPP are plotted in the lower dia-
gram of Figure 5.1. We can draw a number of conclusions
from these diagrams:
• The MPP between two points is equal to the slope of the
TPP curve between those two points. For example, when
the number of workers increases from 1 to 2 (ΔLb = 1),
BOX 5.3 THE RELATIONSHIP BETWEEN AVERAGES AND MARGINALS
In this chapter we have just examined the concepts of
average and marginal physical product. We shall be
coming across several other average and marginal
concepts later on. It is useful at this stage to examine
the general relationship between averages and
marginals. In all cases there are three simple rules
that relate them.
To illustrate these rules, consider the following
example.
Imagine a room with ten people in it. Assume that the
average age of those present is 20.
Now if a 20-year-old enters the room (the marginal
age), this will not affect the average age. It will remain
at 20. If a 56-year-old now comes in, the average age
will rise: not to 56, of course, but to 23. This is found
by dividing the sum of everyone’s ages (276) by the
number of people (12). If then a child of 10 were to
enter the room, this would pull the average age
down.
5.1 THE SHORT-RUN THEORY OF PRODUCTION 129
TPP rises from 3 to 10 tonnes (ΔTPP = 7). MPP is thus 7:
the slope of the line between points g and h.
• MPP rises at first: the slope of the TPP curve gets steeper.
• MPP reaches a maximum at point b. At that point the
slope of the TPP curve is at its steepest.
• After point b, diminishing returns set in. MPP falls. TPP
becomes less steep.
• APP rises at first. It continues rising as long as the addi-
tion to output from the last worker (MPP) is greater than
the average output (APP): the MPP pulls the APP up (see
Box 5.3). This continues beyond point b. Even though
MPP is now falling, the APP goes on rising as long as the
MPP is still above the APP. Thus APP goes on rising to
point c.
• Beyond point c, MPP is below APP. New workers add less
to output than the average. This pulls the average down:
APP falls.
• As long as MPP is greater than zero, TPP will go on ris-
ing: new workers add to total output.
• At point d, TPP is at a maximum (its slope is zero).
An additional worker will add nothing to output: MPP is KI 17
p125
zero.
• Beyond point d, TPP falls. MPP is negative.
1. What is the significance of the slope of the line ac in the
? top part of Figure 5.1?
2. Given that there is a fixed supply of land in the world,
what implications can you draw from Figure 5.1 about
the effects of an increase in world population for food
output per head? (See Box 5.1.)
EXPLORING
ECONOMICS
From this example we can derive the three universal
rules about averages and marginals:
• If the marginal equals the average, the average will not
change.
• If the marginal is above the average, the average will
rise.
• If the marginal is below the average, the average will
fall.
A cricketer scores the following number of runs in five
? successive innings:
Innings:
Runs:
1
20
2
20
3
50
4
10
5
0
These can be seen as the marginal number of runs from
each innings. Calculate the total and average number of
runs after each innings. Show how the average and
marginal scores illustrate the three rules above.
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130 5 BACKGROUND TO SUPPLY

EXPLORING
*BOX 5.4 THE RELATIONSHIP BETWEEN TPP, MPP AND APP ECONOMICS

Using calculus again

The total physical product of a variable factor (e.g. Maximum output (484 tonnes) is achieved with 8 kg of
fertiliser) can be expressed as an equation. For example: fertiliser per hectare. At that level, MPP is zero: no
additional output can be gained.
TPP = 100 + 32Qf + 10Q f2 − Q f3 (1)
where TPP is the output of grain in tonnes per hectare, Qf TPP APP MPP
and Qf is the quantity of fertiliser applied in kilograms
per hectare. 1 141 141 49
From this we can derive the APP function. APP is 2 196 98 60
simply TPP/Qf: i.e. output per kilogram of fertiliser. 3 259 86 65
Thus: 4 324 81 64
5 385 77 57
100 6 436 72 44
APP = + 32 + 10Q f − Q f2 (2)
Qf 7 471 67 25
8 484 60 0
We can also derive the MPP function. MPP is the rate
9 469 52 −31
of increase in TPP as additional fertiliser is applied.
It is thus the first derivative of TPP: dTPP/dQf.
Thus: This maximum level of TPP can be discovered from the
equations by using a simple technique. If MPP is zero at
MPP = 32 + 20Q f − 3Q f 2
(3) this level, then simply find the value of Q f where
From these three equations we can derive the table MPP = 32 + 20Q f − 3Q f2 = 0 (4)
shown.
Solving this equation gives Q f = 8.
1

Check out some figures by substituting values of Q f into 1

By applying the second derivative test (see Appendix 1) you can verify that

? each of the three equations.

Qf = 8 gives the maximum TPP rather than the minimum. (Both the maximum
and the minimum point of a curve have a slope equal to zero.)

Section summary
1. A production function shows the relationship between
the amount of inputs used and the amount of output
produced from them (per period of time).
2. In the short run it is assumed that one or more factors
(inputs) are fixed in supply. The actual length of the
short run will vary from industry to industry.
3. Production in the short run is subject to diminishing
returns. As greater quantities of the variable factor(s)
are used, so each additional unit of the variable factor
will add less to output than previous units: marginal
physical product will diminish and total physical
product will rise less and less rapidly.
4. As long as marginal physical product is above
average physical product, average physical product
will rise. Once MPP has fallen below APP, however,
APP will fall.

5.2 COSTS IN THE SHORT RUN

We have seen how output changes as inputs are varied in
the short run. We now use this information to show how
costs vary with the amount a firm produces. Obviously,
before deciding how much to produce, it has to know the
precise level of costs for each level of output.
But first we must be clear on just what we mean by the
word ‘costs’. The term is used differently by economists
and accountants.
defined opportunity cost. It is the cost of any activity mea-
sured in terms of the sacrifice made in doing it: in other
words, the cost measured in terms of the opportunities
forgone.
How do we apply this principle of opportunity cost to a
firm? First we must discover what factors of production it is

Definition
Measuring costs of production
Opportunity cost Cost measured in terms of the next
When measuring costs, economists always use the concept best alternative forgone.
of opportunity cost. Remember from Chapter 1 how we
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136 5 BACKGROUND TO SUPPLY

Section summary
1. When measuring costs of production, we should be
careful to use the concept of opportunity cost. In the
case of factors not owned by the firm, the opportunity
cost is simply the explicit cost of purchasing or hiring
them. It is the price paid for them. In the case of factors
already owned by the firm, it is the implicit cost of what
the factor could have earned for the firm in its next best
alternative use.
2. In the short run, some factors are fixed in supply. Their
total costs are thus fixed with respect to output. In the
case of variable factors, their total cost will increase as
more output is produced and hence as more of the
variable factor is used.
3. Total cost can be divided into total fixed and total
variable costs. Total variable cost will tend to increase
less rapidly at first as more is produced, but then, when
diminishing returns set in, it will increase more and
more rapidly.
4. Marginal cost is the cost of producing one more unit of
output. It will probably fall at first (corresponding to the
part of the TVC curve where the slope is getting
shallower), but will start to rise as soon as diminishing
returns set in.
5. Average cost, like total cost, can be divided into fixed
and variable costs. Average fixed cost will decline as
more output is produced. The reason is that the total
fixed cost is being spread over a greater and greater
number of units of output. Average variable cost will
tend to decline at first, but once the marginal cost has
risen above it, it must then rise.

5.3 THE LONG-RUN THEORY OF PRODUCTION

In the long run, all factors of production are variable. There marginal returns (where only the variable factor increases).
is time for the firm to build a new factory (maybe in a dif- The differences between marginal returns to a variable fac-
ferent part of the country), to install new machines, to use tor and returns to scale are illustrated in Table 5.4.
different techniques of production, and in general to com-
bine its inputs in whatever proportion and in whatever
KI 16 quantities it chooses. Table 5.4 Short-run and long-run increases in
p124 output
In the long run, then, there are several decisions that a
firm has to make: decisions about the scale and location of Short run Long run
its operations and what techniques of production it should
Input 1 Input 2 Output Input 1 Input 2 Output
use. These decisions affect the costs of production. It is
important, therefore, to get them right. 3 1 25 1 1 15
3 2 45 2 2 35
3 3 60 3 3 60
The scale of production 3 4 70 4 4 90
3 5 75 5 5 125
If a firm were to double all of its inputs – something it could
do in the long run – would it double its output? Or will out-
put more than double or less than double? We can distin- In the short run, input 1 is assumed to be fixed in supply
guish three possible situations: (at 3 units). Output can be increased only by using more of
the variable factor (input 2). In the long run, however, both
Constant returns to scale. This is where a given percentage input 1 and input 2 are variable.
increase in inputs will lead to the same percentage increase
in output. Referring still to Table 5.4, are there diminishing or

Increasing returns to scale. This is where a given percentage

? increasing marginal returns, and are there decreasing
or increasing returns to scale?

increase in inputs will lead to a larger percentage increase in

output.
Decreasing returns to scale. This is where a given per-
centage increase in inputs will lead to a smaller percentage
increase in output.
Notice the terminology here. The words ‘to scale’ mean
that all inputs increase by the same proportion. Decreasing
returns to scale are therefore quite different from diminishing
Economies of scale
The concept of increasing returns to scale is closely linked
to that of economies of scale. A firm experiences economies
Definition
Economies of scale When increasing the scale of
production leads to a lower cost per unit of output.