2025 Firms and Decisions (1) Production Cost ACJC

© ACJC Economics Dept/JC1/2025/H2 Firms & Decisions (1) – Production & Costs 1 Section Content Page 1 Objectives of Firms 3 1.1 Primary Objective of Firms: Profit Maximization 3 2 Decisions by Firms: Production and Cost Concepts 6 2.1 Production And Cost Concepts 6 3 Short-Run Cost of Production 8 3.1 Total Cost 8 3.2 Marginal Cost 8 3.3 Average Cost 9 4 Long-Run Cost of Production 10 4.1 Internal Economies and Diseconomies of Scale 11 4.2 Minimum Efficient Scale of Production 13 4.3 External Economies and Diseconomies of Scale 16 Learning Reflection & Annex 19 Reference Texts: 1. Case, Fair and Oster. Principles of Economics, Special Edition for ACJC, Pearson, 2013. Chapters 7-9 2. John Sloman. Economics, 8th Edition, Prentice Hall. Chapter 5. 3. Mankiw, Quah & Wilson. Principles of Economics, an Asian Edition, CENGAGE Learning. Chapter 13 ANGLO-CHINESE JUNIOR COLLEGE JC1 Economics H2 Firms and Decisions (1) PRODUCTION & COSTS

© ACJC Economics Dept/JC1/2025/H2 Firms & Decisions (1) – Production & Costs 2 WHAT IS THIS TOPIC ABOUT? In the free market economy, resources are allocated through the price mechanism, i.e. forces of demand and supply. The topic “Firms and How They Operate” examines issues related to resource allocation and resource utilisation from the perspective of firms. This topic gives you a better understanding of what decisions lie behind the supply curve in a market . This topic is divided into two main sections: (1) Production & Costs (2) Market Structure Firms allocate resources to produce goods and services, with the aim of making profit. Profit is the difference between revenue earned from the sale of the goods and the cost incurred in producing the goods. i.e. Profit = Total Revenue – Total Cost Section (1), Production & Costs, begins with the examination of production behaviour of firms since firms are primarily the agent that is responsible for transforming input s (i.e. resources) into output s (i.e. goods and services) for consumers. From production behaviour, we will go on to determine how cost varies when firms decide to adjust its output in the short run and in the long run. In Section (2), Market Structure, we then examine the concept of revenue (what firms get when they sell an output ) and highlight the difference between average revenue and marginal revenue of firms in perfectly competitive markets as well as markets with imperfect competition. With the knowledge of cost and revenue, we can derive the firm’s profit. This section then examines what is meant by “profit” and the different types of profit. This topic also analyses the behaviour of firms and whether the resulting outcomes are desirable in terms of efficiency, equity and product’s quality and variety. LEARNING OUTCOMES Enduring Understanding: • Profit is the difference between total revenue and total cost, with Economic profit taking Opportunity Cost into account. • In the short run, the firm incurs both fixed costs and variable costs. • In the long run, the firm incurs only variable costs. • Total Revenue is the product of price per quantity unit and quantity sold: TR = P x Q • Internal economies and diseconomies of scale can affect the firm’s average cost. Essential Question: What influences the quantity of output a firm decides to produce?

© ACJC Economics Dept/JC1/2025/H2 Firms & Decisions (1) – Production & Costs 3 Recall: 1. What is the central economic problem? 2. What is the firm’s main objective when deciding how to allocate resources? 3. Which economic principle do firms use to decide on the quantity to produce? 1. OBJECTIVES OF FIRMS A firm is a business unit that combines units of factors of production (inputs) to produce goods and services (outputs). 1.1 Primary Objective of Firms: Profit- maximisation • Profit is the difference between Total Revenue (TR) and Total Cost (TC). Firms can increase profit by either raising total revenue or reducing total cost. • A primary assumption in economics is that all firms aim to maximise profit or minimise loss if they are experiencing losses. • By the marginal principle, total profit will be maximised at the output level where Marginal Revenue = Marginal Cost. This output level is termed the firm’s equilibrium output. Note: The profit-maximising condition will be covered in the next set of lecture notes, “Market Structure”. 1.1.1 Revenue Concepts Total Revenue (TR) is a firm’s earnings from the total outputs sold, i.e. TR = Price (P) x Output (Q) INPUT S OUTPUT INPUT S INPUT S INPUT S SLS Lesson: “Overview” SLS Lesson: “Objectives of Firms”

© ACJC Economics Dept/JC1/2025/H2 Firms & Decisions (1) – Production & Costs 4 1.1.2 Cost Concepts Accounting Cost Considers only the actual expenses incurred, e.g. the monetary cost from payments on factor of production (such as cost of labour, capital goods and raw materials) in the form of wages, interest and rent. These are actual monetary expenses incurred also known as explicit cost. Economic Cost Economists measure costs in terms of both explicit and implicit/opportunity cost. The economic cost is the sum of the explicit/accounting and implicit/opportunity cost Opportunity Cost Opportunity cost refers to the value (or net benefit) of the next best alternative forgone. To a firm, this refers to the revenue forgone when deciding to produce an alternative good other to the one it is currently producing. In economics, opportunity costs need to be included to provide an accurate reflection of the true costs in producing a good or a service. Some examples of opportunity costs include: • Value of the alternative good / service that the resources could have been used to produce • Profits earned as an entrepreneur in a different industry 1.1.3 Profit Concepts Profit = Total Revenue – Total Cost Accounting Profit Accounting profit only considers accounting cost, i.e. the explicit cost incurred. Thus, accounting profit = total revenue – total accounting cost. Economic Profit Economic profit considers economic cost, i.e. the explicit cost and implicit cost incurred. Thus, economic profit = total revenue – total economic cost. • When TR=TC, firms are making normal profit, i.e. an earning equivalent to the next best alternative earnings (whether another job or industry). • When TR>TC, firms are said to make supernormal profit. • When TR<TC, firms are said to be making a loss and subnormal profit.

© ACJC Economics Dept/JC1/2025/H2 Firms & Decisions (1) – Production & Costs 5 Summary of types of profit: Economic Profit TR & TC relationship What it means Normal or Zero Economic Profit TR = TC, or TR–TC = 0 • Considered as a profitable firm. • The minimum profit required for a firm to remain in the industry in the long run. • No incentive for movement of resources out of or into this industry as the profit made is equivalent to the next highest outside of the industry. Supernormal Profit TR > TC, or TR–TC > 0 • Profit earned exceeds the minimum required for firm to stay in the industry. • Considered as a profitable firm. • There is an incentive for resources to flow into this industry via expansion of existing firms or the entry of new firms, if there are no or weak barriers to entry1. Subnormal Profit Or Losses TR < TC or TR–TC < 0 • Firm is making a loss. • Considered as an unprofitable firm. • Firm must decide whether to stay or leave, depending on the different types of cost it faces • Some existing firms would leave the industry and /or fewer resources are put into this industry. *Note: The concepts on types of profits will be covered in greater details in the next set of lecture notes “Market Structure”. 1 Barriers