Econ201 Microeconomics Production and Costs

PRODUCTION, INPUTS AND OUTPUTS Production Refers to any economic activity which combines the four factors of production (i.e., land, labor capital and entrepreneurship) to form an output that will give direct satisfaction to consumers It is the process of converting inputs into outputs Inputs Commodities and services that are used to produce goods and services Classifications: o Land or natural resources, represents the gift of nature to our productive processes. It includes those above and under the earth like forest products. o Labor is the mental and physical ability used in the production of goods and services o Capital resources are the goods that are used in the production of other goods and services. These include machines, equipment, buildings, and factories. Output Are the various useful goods and services that result from the production process and are either consumed or employed in further production. o Final goods are goods and services that are ultimately consumed o Intermediate goods are goods and services that are used to produce other goods. TECHNOLOGY: LABOR INTENSIVE OR CAPITAL INTENSIVE Technology is the body of knowledge applied to how goods are produced it is the production process employed by firms in creating goods and services Categories: Labor Intensive: utilizes more labor resources than capital resources which is usually employed by economies where labor resources are abundant and cheap. Examples: Philippines, China, Vietnam and other developing countries Capital Intensive: utilizes more capital resources that labor resources in the production process which is usually employed by industrialized economies since capital resources in these economies are cheaper than labor. Examples: Germany, Japan, Korea and United States. SHORT RUN VERSUS LONG RUN When we try to distinguish short run and long run, we should remember that economists do not partition production decisions based on any specific number of days, months or years. Instead, the distinction depends on the ability to vary the quantity of inputs or economics resources used in the production of a goods or service such as raw materials, labor, machineries, equipment, etc. Production Input Classifications: o Fixed input: is any resource the quantity of which cannot readily be changed when market conditions indicate that a change in output is desirable. These cannot be easily changed within a short period of time when there is a need to immediately increase (decrease) the production level thus they must remain as fixed amounts while managers to decide output Examples: plants, buildings, machineries and equipment o Variable input: is any economic resource the quantity of which can be easily changed in reaction to changes in output level

Page 1 of 5

Econ201 Microeconomics Production and Costs

Example: If the demand for t-shirt increases because of the Christmas season, we cannot readily buy additional new sewing machines or build a new factory. In this case, our fixed inputs are the sewing machines and factory since it takes time to buy new machinery or build new factory. However, the manager of the t-shirt can simply hire additional workers during a given period. He can also change the amount of materials used in production. In this case, our variable input is the additional sewers hired and/or the added raw materials required for the production of additional tshirts. Short run is the period of time so short that there is at least one fixed input therefore changes in the output level must be accomplished exclusively by changes in the use of variable inputs. Long run (planning horizon) is a period of time so long that all inputs are considered variable. Example: Going back to our previous example, the short run is a period of time during which the company can simply increase output by hiring more sewers or increasing the number of raw materials (variable inputs), while the size of its plants or machinery and equipment (fixed input) remains unchanged. Take note that the firms plant is the most difficult input to change quickly as it will require a firm to build a new one if it needs to expand its production of t-shirts. The long run is a period of time during which the firm can readily build new plants of purchase new machinery instead of just hiring additional labor or increasing the purchase of raw materials. THE PRODUCTION FUNCTION It is the functional relationship between quantities of inputs used in production and outputs to be produced. It specifies the maximum output that can be produced with a given quantity of inputs. TOTAL, AVERAGE AND MARGINAL PRODUCTS Total products refer to the total output produced after utilizing the fixed and variable inputs in the production process Marginal product is the extra output produced by 1 additional unit of that input while other inputs are held constant MPL = TPL/L Average product Total product total units of input used Example: In the production period of a month, Molly's lemonade stand combines variable inputs of her labor (and the raw materials) to the fixed inputs of her table and her license to operate. Molly adds employees to her plant and forecasts the change in production (cups per day) in the data below:

Page 2 of 5

Econ201 Microeconomics Production and Costs

THE LAW OF DIMINISHING RETURNS This law holds that we will get less and less extra output when we add additional doses of input while holding other inputs fixed. The marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant. Example: Imagine what happens to the lemonade stand as Molly adds more and more workers. At first, tasks are divided. (For example, Josh squeezes the lemons; Molly adds the sugar; Kelli stirs.) Specialization occurs. The marginal productivity of successive workers is rising in the early stage of production, but at some point, adding more workers increases the total product by a lesser amount. Maybe the fourth worker is pouring the lemonade and stocking while the fifth is taking money and making change. Beyond the fifth worker, the table is too crowded with employees, cups are spilled, product is wasted, and total production actually falls. The marginal contribution of these workers is negative. This illustrates one of the most important production concepts in the short run, the Law of Diminishing Marginal Returns, which states that as successive units of a variable resource are added to a fixed resource, beyond some point the marginal product falls. INCREASING MARGINAL RETURNS This happens when the marginal product of an additional worker exceeds the marginal product of the previous worker We can also say that there is increasing marginal returns when a small number of workers are employed and arise from increased specialization and division of labor in the production process. DECREASING MARGINAL RETURNS It occurs when the marginal product of an additional worker is less than the marginal product of the previous worker. It arises from the fact that more and more workers use the same equipment and workspace. Thus, as more and more workers are employed, there is less and less production for the additional worker to do. RETURNS TO SCALE 1. Constant return to scale indicates a case where a change in all inputs leads to a proportional change of output. Example: if farm land, number of farmers, and other farm inputs are doubled, then we can assume that under this condition rice production would also double. 2. Increasing return to scale or economies of scale happen when an increase in all inputs leads to a more-than-proportional increase in the level of output. Example: a farmer will generally find that increasing the inputs of labor, irrigations, fertilizers, and pesticides by 10% will increase the rice production by more than 10%. 3. Decreasing returns to scale occur when a balanced increase in all inputs leads to a less-thanproportional increase in total output. THE FIRMS BASIC GOAL MAXIMIZE PROFIT

ECONOMIC VS. ACCOUNTING COSTS Explicit costs require outlays of money. Examples: 1. wages paid to employees 2. rent payments 3. utility bills

Page 3 of 5

Econ201 Microeconomics Production and Costs

Implicit costs are the opportunity costs of resources the firm's owner makes available for production with no direct cash outlays. Examples: 1. The value of an entrepreneur's labor and the interest that could be earned were the owners' assets (including the values of stock in corporations) not tied up in the business. 2. In entering the software business and creating Windows, and subsequently Microsoft, Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed. 3. When you use a vacant room of your house to be your office you forego an opportunity of renting it out to others 4. If you start your business and act as its general manager, you are giving up the opportunity of earning a salary a manager of a bank or a manufacturing firm. Economic costs of production include both explicit and implicit costs. Economic profit occurs only when a firm's revenue exceeds all costs, including explicit and implicit costs. Example: Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Year's Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the year, your books tell the following story: Accounting Profit Sales Less: Expenses Cost of pogo sticks Employees' wages Utilities Taxes Advertising Profit

130,000.00 85,000.00 20,000.00 5,000.00 5,000.00 10,000.00

125,000.00 5,000.00

Now we will subtract our implicit costs. Being in this business caused me to lose as income: Salary 28,000.00 Rent 10,000.00 Interest 3,000.00 Total Implicit Costs 41,000.00 Therefore, I've had an economic profit that's negative, a loss of -$36,000. This business is in loss FIXED COST or overhead or supplementary costs are those expenses which are spent for the use of fixed factors of production. These stay the same no matter how much output changes. These costs are such expenses that a firm has to incur or bear even if production has stopped temporarily. Examples: Rent Interest Depreciation Salary and wages of employees under guaranteed contract

Page 4 of 5

Econ201 Microeconomics Production and Costs

VARIABLE COSTS or prime or operating costs are those expenses which change as consequences of a change in quantity of output produced. Examples: Raw materials Labor inputs Fuel TOTAL FIXED COSTS (TFC) are those costs that do not vary with changes in short-run output. They must be paid even when output is zero. These include rent on building or equipment, insurance or licenses. TOTAL VARIABLE COSTS (TVC) are those costs that change with the level of output. If output is zero, so are total variable costs. They include payment for materials, fuel, power, transportation services, most labor, and similar costs. TOTAL COST (TC) is the sum of total fixed and total variable costs at each level of output. TC = TVC + TFC MARGINAL COST is the additional cost of producing one more unit of output MC = TC/Q. Since TVC are the only costs that change with the level of output, marginal cost is also calculated as MC = TVC/Q. If quantity is changing one unit at a time, MC = TC = TVC. Marginal analysis asks how much it cost to produce an additional unit of output AVERAGE FIXED COST (AFC) is total fixed cost divided by output. AFC = TFC/Q. It continuously falls as output rises. AVERAGE VARIABLE COST (AVC) is total variable cost divided by output. AVC = TVC/Q. AVERAGE TOTAL COST (ATC) is total cost divided by output ATC = TC/Q. Note that ATC = AFC + AVC. Q 0 1 2 3 4 5 6 7 8 9 10 FC 100 100 100 100 100 100 100 100 100 100 100 VC 0 40 68 90 115 148 195 260 350 460 600 TC 100 140 168 190 215 248 295 360 450 560 700 MC 0 40 28 22 25 33 47 65 90 110 140 AFC 0 100 50 33 25 20 17 14 13 11 10 AVC 0 40 34 30 29 30 33 37 44 51 60 ATC 0 140 84 63 54 50 49 51 56 62 70

Page 5 of 5