PRODUCTION and COSTS

BY GOWRISHANKKAR.V DIVYA.S

Econ 11-UPLB

Theory of Production and Costs

 

FocusFocus- mainly on the the firm. firm. We will examine

Its production capacity given available resources  the related costs involved


What is a firm?


A firm is an entity concerned with the purchase and employment of resources in the production of various goods and services. Assumptions:


the firm aims to maximize its profit with the use of resources that are substitutable to a certain degree the firm is" a price taker in terms of the resources it uses.

The Production Function



The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time.

Firms Inputs


Inputs - are resources that contribute in the production of a commodity. Most resources are lumped into three categories:
Land,  Labor,  Capital.


Fixed vs. Variable Inputs



Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.

Production Analysis with One Variable Input



Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

(TPL MPL ! (L

Total vs. Marginal Product



Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus. paribus.

(TPX MPX ! (X

Production Function of a Rice Farmer

Units of L 0 1 2 3 4 5 6 7 8 9 10 Total Product (QL or TPL) 0 2 6 12 20 26 30 32 32 30 26 Marginal Product (MPL) 2 4 6 8 6 4 2 0 -2 -4

QL

32 30 26 Total product QL

20

12

6 2

L
0 1 2 3 4 5 6 Labor 7 8 9 10

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input (e.g., labor) used in production assuming a certain technological level.

Marginal Product


The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula:

(TPL MPL ! (L

Marginal Product


Observe that the marginal product initially increases, reaches a maximum level, and beyond this point, the marginal product declines, reaches zero, and subsequently becomes negative. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease"

Total and Marginal Product

35 30 25 20 15 10 5 0 0 -5 -10 1 2 3 4 5 6 7 8 9

TPL

MPL

Law of Diminishing Marginal Returns



As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish. CounterCounter-intuitive proof: if the law of diminishing returns does not hold, the worlds supply of food can be produced in a hectare of land.

Average Product (AP)



Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used.


The "productivity" of an input is usually expressed in terms of its average product. The greater the value of average product, the higher the efficiency in physical terms.

Formula:

TPL APL ! L

TABLE 5.2.
Labor (L)

Average product of labor.

Total product of labor (TPL) Average product of labor (APL)

0 1 2 3 4 5 6 7 8 9 10

0 2 6 12 20 26 30 32 32 30 26

0 2 3 4 5 5.2 5 4.5 4 3.3 2.6

The slope of the line from the origin is a measure of the AVERAGE Y

rise Y Slope = ! run L

Rise = Y

Run = L

L1

L2

Total Product Q

The average product at b is highest. AP at c is less than at a. AP at d is less than at c.

b c d QL a

Highest Slope of Line from Origin

Max APL

Inflection point
Max MPL

TPL

L1

L2

L3

Relationship between Average and Marginal Curves: Rule of Thumb



When the marginal is less than the average, the average decreases. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum) When the marginal is greater than the average, the average increases

Relationship between Average and Marginal Curves: Example of Econ 11 Scores



When the marginal score (new exam) is less than your average score, the average decreases. When the marginal score (new exam) is equal to the average score, the average does not change. When the marginal score (new exam) is greater than your average score, the average increases.

AP,MP

At Max AP, MP=AP

Max MPL Max APL

APL

L1

L2

L3
MPL

TP

TPL

0
Stage I

L1
MP>AP AP increasing

L2
Stage II
MP<AP AP decreasing MP still positive

L3
Stage III
MP<0 AP decreasing

AP,MP

APL

L1

L2

L3
MPL

Three Stages of Production



In Stage I
APL is increasing so MP>AP.  All the product curves are increasing  Stage I stops where APL reaches its maximum at point A.  MP peaks and then declines at point C and beyond, so the law of diminishing returns begins to manifest at this stage


Three Stages of Production



Stage II
starts where the APL of the input begins to decline.  QL still continues to increase, although at a decreasing rate, and in fact reaches a maximum  Marginal product is continuously declining and reaches zero at point D, as additional labor inputs are employed.


Three Stages of Production

Stage III starts where the MPL has turned negative.
all product curves are decreasing.  total output starts falling even as the input is increased


COSTS OF PRODUCTION


Opportunity Cost Principle - the economic cost of an input used in a production process is the value of output sacrificed elsewhere. The opportunity cost of an input is the value of foregone income in best alternative employment. Implicit vs. Explicit Costs
 

Explicit costs costs paid in cash Implicit cost imputed cost of self-owned or self employed selfresources based on their opportunity costs.

7 Cost Concepts (Short-run) (Short1. 2. 3. 4. 5. 6. 7.

Total Fixed Cost Total Variable Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost

(TFC) (TVC) (TC=TVC+TFC) (AFC=TFC/Q) (AVC=TVC/Q) (AC=AFC+AVC) (MC= AVC/Q

Short Run Analysis



Total fixed cost (TFC) is more commonly referred to as "sunk cost" or "overhead cost."
Examples: include the payment or rent for land, buildings and machinery.  The fixed cost is independent of the level of output produced.  Graphically, depicted as a horizontal line


Short Run Analysis



Total variable cost (TVC) refers to the cost that changes as the amount of output produced is changed.
Examples - purchases of raw materials, payments to workers, electricity bills, fuel and power costs.  Total variable cost increases as the amount of output increases.


If no output is produced, then total variable cost is zero;  the larger the output, the greater the total variable cost.


Short Run Analysis



Total cost (TC) is the sum of total fixed cost and total variable cost


TC=TFC+TVC As the level of output increases, total cost of the firm also increases.

Total Costs of Production

Units of Labor
L

Total Product
TPL

Total Fixed Cost

TFC

Total Variable Cost

TVC

Total Cost TC 100 130 150 160 165 175 195 225 265 315 375

Marginal Cost MC

Average Cost AC -

0 1 2 3 4 5 6 7 8 9 10

0 6 10 12 13 15 19 25 33 43 55

100 100 100 100 100 100 100 100 100 100 100

0 30 50 60 65 75 95 125 165 215 275

30 20 10 5 10 20 30 40 50 60

130 75 53.3 41.25 35 32.5 32.14 33.12 35 37.5

Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 TOTAL COST CURVES

Pesos

AFC=TFC/Q. As more output is produced, the Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

Pesos

The Average Variable Cost at a point on the TVC curve is measured by the slope of the line from the origin to that point. AVC=TVC/Q

TVC
(Total Variable Cost)

Minimum AVC

q1

Pesos

TVC

Inflection point

(Total Variable Cost)

q1 MC AVC

q1

Pesos The Average Variable Cost is U shaped. First it decreases, reaches a minimum and then increases. AVC
(Average Variable Cost)

Minimum AVC

q1

Pesos

The Marginal Cost curve passes through the minimum point of the AVC curve.
MC (Marginal Cost)

It is also U-shaped. First it decreases, reaches a minimum and then increases.

AVC
(Average Variable Cost)

Minimum AVC

q1

Pesos

MC AC

AVC

AFC 0 q1 The PER UNIT COST CURVES Q

Table 5.4 Average Cost of Production

(Q)
0 1 2 3 4 5 6 7 8 9 10

(TC)
100 130 150 160 165 175 195 225 265 315 375

(AC)
130.00 75.00 53.33 41.25 35.00 32.50 32.14 33.13 35.00 37.50

Table 5.5

Average Variable Costs of Production

Total Product (Q) 0 1 2 3 4 5 6 7 8 9 10

Total Variable Cost (AVC) 0 30 50 60 65 75 95 125 165 215 275

Average Variable Cost (AVC) 0 30.0 25.0 20.0 16.3 15.0 15.8 17.9 20.6 23.9 27.5

LTC All inputs are variable in the long run. There are no fixed costs.

LTC

Long Run Total Cost

Total Product

LONG-RUN TOTAL COST CURVE

The LAC


The LAC curve is an envelop curve of all possible plant sizes. Also known as planning curve It traces the lowest average cost of producing each level of output. It is U-shaped because of UEconomies of Scale  Diseconomies of Scale


COST

LAC SAC1 SAC2

LONG-RUN AVERAGE COST CURVE

COST

LAC SAC1

0 q0

COST

Building a larger sized plant (size 2) will result in a lower average cost of producing q0
LAC SAC1 SAC2

0 q0

COST

Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1
SAC1 SAC2 SAC3 LAC

0 q0 q1

Economies and Diseconomies of Scale



Economies of Scale- long run average cost Scaledecreases as output increases.

Technological factors  Specialization


Diseconomies of Scale: - long run average cost Scale: increases as output increases.


Problems with management becomes costly, unwieldy

COST

LAC SAC1 SAC2

Economies of Scale
0 Q1

Diseconomies of Scale
Q

LONG-RUN AVERAGE COST CURVE

LONG-RUN AVERAGE and MARGINAL COST CURVES

COST
SMC2

LMC

LAC

SMC1

SAC1

SAC2

Q1

LAC and LMC



LongLong-run Average Cost (LAC) curve

is U-shaped. U the envelope of all the short-run average cost shortcurves;  driven by economies and diseconomies of size.


LongLong-run Marginal Cost (LMC) curve

Also U-shaped; U intersects LAC at LACs minimum point.