PRODUCTION and COSTS

Economics 11 University of the Philippines Los Banos

Econ 11-UPLB

Note:
The contents of this presentation are found in Chapter 5 of the textbook.

Theory of Production and Costs

Focus- mainly on the the 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.

TPX MPX X

Production Function of a Rice Farmer

Units of L Total Product (QL or TPL) Marginal Product (MPL)

0
1 2 3 4 5 6

0
2 6 12 20 26 30

2 4 6 8 6 4

7
8 9 10

32
32 30 26

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. 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.

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

0 2 6 12

0 2 3 4

4
5 6 7

20
26 30 32

5
5.2 5 4.5

8
9 10

32
30 26

4
3.3 2.6

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

Slope =

rise Y 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

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 resources based on their opportunity costs.

7 Cost Concepts (Short-run)

1.

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

Marginal Cost

Average Cost

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

MC

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

Inflection point

TVC
(Total Variable Cost)

q1

MC

Q 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 Q

The PER UNIT COST CURVES

Table 5.4 Average Cost of Production

(Q)
0 1 2 3 4 5 6

(TC)
100 130 150 160 165 175 195

(AC)
130.00 75.00 53.33 41.25 35.00 32.50

7
8 9 10

225
265 315 375

32.14
33.13 35.00 37.50

Table 5.5

Average Variable Costs of Production

Total Product (Q)

Total Variable Cost (AVC)

Average Variable Cost (AVC)

0
1 2 3

0
30 50 60

0
30.0 25.0 20.0

4
5 6 7

65
75 95 125

16.3
15.0 15.8 17.9

8
9 10

165
215 275

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
Economies of Scale Diseconomies of Scale

COST

LAC SAC1 SAC2

LONG-RUN AVERAGE COST CURVE

COST

SAC1

LAC

0 q0

COST

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

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 decreases as output increases.

Technological factors Specialization

Diseconomies of Scale: - long run average cost 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

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.