PRODUCTION and COSTS

1
PRODUCTION and COSTS

• Economics 11
• University of the Philippines
• Los Banos

2
Note The contents of this presentation are
found in Chapter 5 of the textbook.
3
Theory of Production and Costs

• Focus- mainly on the the firm.
• We will examine
• Its production capacity given available resources
  
• the related costs involved

4
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.

5
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.

6
Firms Inputs

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

7
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.

8
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.

9
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.

10
Production Function of a Rice Farmer
11
QL
32
30
26
QL
20
Total product
12
6
2
L
8
0
2
4
6
10
9
7
5
3
1
Labor
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.
12
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

13
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"
  

14
Total and Marginal Product
TPL
MPL
15
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.
• Counter-intuitive proof if the law of
  diminishing returns does not hold, the worlds
  supply of food can be produced in a hectare of
  land.

16
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

17
(No Transcript)
18
The slope of the line from the origin is a
measure of the AVERAGE
Y
Y
b
a
Rise Y
L
L1
L2
Run L
0
19
Total Product
The average product at b is highest. AP at c is
less than at a. AP at d is less than at c.
Q
c
b
d
QL
a
0
L
20
Q
Highest Slope of Line from Origin Max APL
Inflection point Max MPL
TPL
L1
L2
L3
L
0
21
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

22
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.

23
AP,MP
At Max AP, MPAP
Max MPL
Max APL
APL
L2
L3
L
0
L1
MPL
24
TP
TPL
0
L1
L2
L3
L
Stage I MPgtAP AP increasing
Stage II MPltAP AP decreasing MP still positive
Stage III MPlt0 AP decreasing
AP,MP
APL
L2
L3
L
0
L1
MPL
25
Three Stages of Production

• In Stage I
• APL is increasing so MPgtAP.
• 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

26
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.

27
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

28
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 resources based on their
  opportunity costs.

29
7 Cost Concepts (Short-run)

• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Total Cost (TCTVCTFC)
• Average Fixed Cost (AFCTFC/Q)
• Average Variable Cost (AVCTVC/Q)
• Average Total Cost (ACAFCAVC)
• Marginal Cost (MC ?AVC/?Q

30
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

31
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.

32
Short Run Analysis

• Total cost (TC) is the sum of total fixed cost
  and total variable cost
• TCTFCTVC
• As the level of output increases, total cost of
  the firm also increases.

33
Total Costs of Production
34
Pesos
TC(Total Cost)
TVC(Total Variable Cost)
TFC(Total Fixed Cost)
Q
0
TOTAL COST CURVES
35
Pesos
AFCTFC/Q. As more output is produced, the
Average Fixed Cost decreases.
AFC(Average Fixed Cost)
Q
0
36
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. AVCTVC/Q
TVC(Total Variable Cost)
Minimum AVC
Q
q1
0
37
Pesos
TVC(Total Variable Cost)
Inflection point
Q
q1
0
MC
AVC
q1
38
Pesos
The Average Variable Cost is U shaped. First it
decreases, reaches a minimum and then increases.
AVC (Average Variable Cost)
Minimum AVC
Q
q1
0
39
The Marginal Cost curve passes through the
minimum point of the AVC curve. It is also
U-shaped. First it decreases, reaches a minimum
and then increases.
Pesos
MC (Marginal Cost)
AVC (Average Variable Cost)
Minimum AVC
Q
q1
0
40
MC
Pesos
AC
AVC
AFC
Q
q1
0
The PER UNIT COST CURVES
41
Table 5.4 Average Cost of Production
42
Table 5.5 Average Variable Costs of Production
43
LTC
LTC
All inputs are variable in the long run. There
are no fixed costs.
Long Run Total Cost
Q
Total Product
LONG-RUN TOTAL COST CURVE
44
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
• Economies of Scale
• Diseconomies of Scale

45
COST
LAC
SAC1
SAC2
Q
0
LONG-RUN AVERAGE COST CURVE
46
COST
LAC
SAC1
Q
0
q0
47
Building a larger sized plant (size 2) will
result in a lower average cost of producing q0
COST
LAC
SAC1
SAC2
Q
0
q0
48
Likewise, a larger sized plant (size 3) will
result to a lower average cost of producing q1
COST
LAC
SAC1
SAC2
SAC3
Q
0
q0
q1
49
Economies and Diseconomies of Scale

• Economies of Scale- long run average cost
  decreases as output increases.
• Technological factors
• Specialization
• Diseconomies of Scale - long run average cost
  increases as output increases.
• Problems with management becomes costly,
  unwieldy

50
COST
LAC
SAC1
SAC2
Diseconomies of Scale
Economies of Scale
Q
0
Q1
LONG-RUN AVERAGE COST CURVE
51
LONG-RUN AVERAGE and MARGINAL COST CURVES
LMC
COST
SMC2
LAC
SAC2
SAC1
SMC1
Q
0
Q1
52
LAC and LMC

• Long-run Average Cost (LAC) curve
• is U-shaped.
• the envelope of all the short-run average cost
  curves
• driven by economies and diseconomies of size.
• Long-run Marginal Cost (LMC) curve
• Also U-shaped
• intersects LAC at LACs minimum point.

53
End