Copyright 2014, Prof.

Tagelsir
Mohamed

Industrial Management
CHAPTER 5
The Theory of the firm
Professor
Tagelsir Mohamed Gasmelseid

Copyright 2014, Prof. Tagelsir

Mohamed

The Theory of the Firm

Copyright 2014, Prof. Tagelsir

Mohamed

Production Function

Copyright 2014, Prof. Tagelsir

Mohamed

Production Function
States the relationship between inputs and
outputs
Inputs the factors of production classified
as:
Land all natural resources of the earth not just
terra firma!
Price paid to acquire land = Rent

Labour all physical and mental human effort

involved in production
Price paid to labour = Wages

Capital buildings, machinery and equipment

not used for its own sake but for the contribution
it makes to production
Price paid for capital = Interest.
Copyright 2014, Prof. Tagelsir
Mohamed

Production Function
Inputs

Process

Land
Labour
Capital

Product or
service
generated
value added

Copyright 2014, Prof. Tagelsir

Mohamed

Production Function
Jonathan's Apple Farm Production Function
Apples
Land
Labor
Proprietor's
(tons/year)
(acres)
(hired) time (hours)
0
100
0
1,100
50
100
2,500
1,100
100
100
3,700
1,100
150
100
5,000
1,100
200
100
6,800
1,100
250
100
10,000
1,100
300
100
15,000
1,100
350
100
27,000
1,100

The table describes A companys inputs for the annual

production of apples shown in the first column.
Copyright 2014, Prof. Tagelsir
Mohamed

Fixed Factors
A fixed factor is one that does not
vary as the quantity produced
increases or decreases.
Some factors are fixed in the short
run (managerial time).
Some factors are fixed in the medium
run (cultivated acreage).
No factors are fixed in the long run.
Copyright 2014, Prof. Tagelsir
Mohamed

A companys Fixed Factors

The company has two fixed factors

Its cultivated acreage (100

acres)
Its own managerial time (1,100
hours)

Copyright 2014, Prof. Tagelsir

Mohamed

Variable Factors
A variable factor is one that must be
increased in order to increase output.
The classic variable factor is labor.
Variable factors usually exhibit
diminishing marginal productivity-the amount of extra product
generated by each additional unit of
the input, holding other inputs
constant, declines.
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Mohamed

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Variable Factors
It must vary his labor input to increase
his production of apples.
At first this variation is modest going
from 50 tons/year to 100 tons/year
requires an additional 1,200 hours
Going from 200 to 250 tons/year
requires an additional 3,200 hours.
It cannot increase the size of his farm,
his acreage is fixed.
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Mohamed

11

Analysis of Production Function:

Short Run

In the short run at least one factor fixed

in supply but all other factors capable of
being changed
Reflects ways in which firms respond to
changes in output (demand)
Can increase or decrease output using
more or less of some factors but some
likely to be easier to change than others
Increase in total capacity only possible
in the long run
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Mohamed

12

Analysis of Production Function:

Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level they
will be limited by
the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the short
run.

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Analysis of Production Function:

Short Run

If demand slows
down, the firm can
reduce its variable
factors in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.

Copyright 2014, Prof. Tagelsir

Mohamed

14

Analysis of Production Function:

Short Run

If demand slows
down, the firm can
reduce its variable
factors in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.

Copyright 2014, Prof. Tagelsir

Mohamed

15

Analysing the Production

Function: Long Run
The long run is defined as the period of time taken to
vary all factors of production
By doing this, the firm is able to increase its total
capacity not just short term capacity
Associated with a change in the scale of production
The period of time varies according to the firm
and the industry
In electricity supply, the time taken to build new
capacity could be many years; for a market stall
holder, the long run could be as little as a few weeks
or months!

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Mohamed

16

Analysis of Production Function:

Long Run

In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.
Copyright 2014, Prof. Tagelsir
Mohamed

17

Production Function
Mathematical representation
of the relationship:
Q = f (K, L, La)
Output (Q) is dependent upon the
amount of capital (K), Land (L) and
Labour (La) used.

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Mohamed

18

Production
Fixed inputs - resources a firm cannot feasibly
vary over the time period involved
Total product - the total output of the firm
Average product - the total output divided by
the amount of the input used to produce that
output
Marginal product - the change in total output
that results from a one-unit change in the
amount of an input, holding the quantities of
other inputs constant
Copyright 2014, Prof. Tagelsir
Mohamed

19

The Relationship Between Average and

Marginal Product Curves

When the marginal product is greater

than average product, average
product must be increasing.
When the marginal product is less
than average product, average
product must be decreasing.
When the marginal and average
products are equal, average product
is at a maximum.
Copyright 2014, Prof. Tagelsir
Mohamed

20

Costs

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Mohamed

21

Costs
In buying factor inputs, the firm
will incur costs
Costs are classified as:
Fixed costs costs that are not related
directly to production rent, rates,
insurance costs, admin costs. They can
change but not in relation to output
Variable Costs costs directly related
to variations in output. Raw materials
primarily.

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Mohamed

22

Costs
Total Cost - the sum of all costs
incurred in production
TC = FC + VC
Average Cost the cost per unit
of output
AC = TC/Output
Marginal Cost the cost of one more
or one fewer units of production
MC = TCn TCn-1 units
Copyright 2014, Prof. Tagelsir
Mohamed

23

Costs
Short run Diminishing marginal
returns results from adding
successive quantities of variable
factors to a fixed factor
Long run Increases in capacity can
lead to increasing, decreasing or
constant returns to scale.

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Mohamed

24

Revenue

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Mohamed

25

Revenue
Total revenue the total amount
received from selling a given output
TR = P x Q
Average Revenue the average
amount received from selling each unit
AR = TR / Q
Marginal revenue the amount
received from selling one extra unit
of output
MR = TRn TR n-1 units
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Mohamed

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Profit

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Mohamed

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Profit
Profit = TR TC
The reward for enterprise
Profits help in the process of directing
resources to alternative uses in free
markets
Relating price to costs helps a firm to
assess profitability in production

Copyright 2014, Prof. Tagelsir

Mohamed

28

Profit
Normal Profit the minimum amount
required to keep a firm in its current line
of production
Abnormal or Supernormal profit
profit made over and above normal
profit
Abnormal profit may exist in situations
where firms have market power
Abnormal profits may indicate the existence
of welfare losses
Could be taxed away without altering
resource allocation
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Mohamed

29

Profit
Sub-normal Profit profit below
normal profit
Firms may not exit the market even if
sub-normal profits made if they are able
to cover variable costs
Cost of exit may be high
Sub-normal profit may be temporary (or
perceived as such!)

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Mohamed

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Profit
Assumption that firms aim to
maximise profit
May not always hold true
there are other objectives
Profit maximising output would be
where MC = MR

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Mohamed

31

Profit
Why?
MC

Cost/Revenue
150
145
140

Reduces
total
profit by
this
amount

Total
120
added
Added
to
Added
to total
profit
to total
profit
profit

The
process
continues
If the
firm decides
to
MC

The
cost
of
forMR
each
successive
the
addition
produce
one
more
unit
producing
ONE
unit
st produced.
to
total
revenue
as
the 101
the
addition
extra
unit
the
MC
a result
ofofis
to Provided
total cost
is now
18,
production
less
than
the
MR
producing
oneit
the addition
to total
will
worth
more
unit
of firm
revenue
is be
140
the
expanding
output
as
output
the
price
will
add
128to
profit.
difference
received
from
it is the
worth
expanding
between
the
is
selling
thattwo
extra
output.
ADDED tounit.
total profit

40
30

20
18

MR
100

101

102 103

104

Copyright 2014, Prof. Tagelsir

Mohamed

Output
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Factors Giving Rise to

Increasing Returns
Specialization and division of labor
Volume capacity increases faster
than area dimensions (arithmetic
relationship)
Available of techniques that are
unique to large-scale operation.

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Mohamed

33

Factors Giving Rise to

Decreasing Returns
Inefficiency of managing large
operations:

Coordination and control become difficult

Loss or distortion of information
Complexity of communication channels
More time is required to make and
implement decisions.

Copyright 2014, Prof. Tagelsir

Mohamed

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