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R. Larry Reynolds 1997

 Production
· Production is an activity where
resources are altered or changed and
there is an increase in the ability of
these resources to satisfy wants.
· change in physical characteristics
· change in location
· change in time
· change in ownership
Fall ‘ 97 Principles of Microeconomics Slide -- 2
 Production and Cost
· Production is a technical relationship between a set of inputs
or resources and a set of outputs or goods.
QX = f( inputs [land, labour, capital], technology, . . . )
[Legal and social/cultural institutions influence the production
function.]
· Cost functions are the pecuniary relationships between
outputs and the costs of production;
Cost = f(QX {inputs, technology} , prices of inputs, . . . )
· Cost functions are determined by input prices and
production relationships. It is necessary to understand
production functions if you are to interpret cost data.

Fall ‘ 97 Principles of Microeconomics Slide -- 3

 Costs
· Costs are incurred as a result of production. The
important concept of cost is opportunity cost
[marginal cost]. These are the costs associated
with an activity. When inputs or resources are
used to produce one good, the other goods they
could have been used to produce are sacrificed.
· Costs may be in real or monetary terms;
· implicit costs
· explicit costs

Fall ‘ 97 Principles of Microeconomics Slide -- 4

 Implicit Costs
· Opportunity costs or MC should include all costs
associated with an activity. Many of the costs are
implicit and difficult to measure.
· A production activity may adversely affect a
person’s health. This is an implicit cost that is
difficult to measure.
· Another activity may reduce the time for other
activities. It may be possible to make a
monetary estimate of the value.

Fall ‘ 97 Principles of Microeconomics Slide -- 5

 Explicit Costs

· Explicit costs are those costs where

there is an actual expenditure in a
market. The costs of labour or
interest payments are examples.
· Some implicit costs are estimated and
used in the decision process.
Depreciation is an example.

Fall ‘ 97 Principles of Microeconomics Slide -- 6

 Normal Profit
· In neoclassical economics, all costs
should be included:
· wages represent the cost of labour
· interest represents the cost of Kapital
· rent represents the cost of land
· “normal profit [ P ]” represents the cost
of entrepreneurial activity
· normal profit includes risk

Fall ‘ 97 Principles of Microeconomics Slide -- 7

 Production Function
· A production function expresses the
relationship between a set of inputs and
the output of a good or service.
· The relationship is determined by the
nature of the good and technology.
· A production function is “like” a recipe for
cookies; it tells you the quantities of each
ingredient, how to combine and cook, and
how many cookies you will produce.
Fall ‘ 97 Principles of Microeconomics Slide -- 8
QX = f(L, K, R, technology, . . . )
QX = quantity of output
L = labour input
K = Kapital input
R = natural resources [land]
Decisions about alternative ways to produce good X require
that we have information about how each variable influences
QX.

One method used to identify the effects of each variable on

output is to vary one input at a time. The use of the ceteris
paribus convention allows this analysis.

The time period used for analysis also provides a way to

determine the effects of various changes of inputs on the
output.

Fall ‘ 97 Principles of Microeconomics Slide -- 9

 Technology
· The production process [and as result, costs]
is divided up into various time periods;
· the “very long run” is a period
sufficiently long enough that technology
used in the production process changes.
· In shorter time periods [long run, short
run and market periods], technology is a
constant.

Fall ‘ 97 Principles of Microeconomics Slide -- 10

 Long Run
· The long run is a period that:
· is short enough that technology is unchanged.
· all other inputs [labour, kapital, land, . . . ] are
variable, i.e. can be altered.
· these inputs may be altered in fixed or variable
proportions. This may be important in some
production processes.
· If inputs are altered, the output changes.
· QX = f(L, K, R, . . . ) technology is constant

Fall ‘ 97 Principles of Microeconomics Slide -- 11

 Short Run
· The short run is a period in which at least
one of the inputs has become a constant
and at least one of the inputs is a variable.
· If kapital [K] and land [R] are fixed or
constant in the short run, labour [L] is the
variable input. Output is changed by
altering the labour input. QX = f(L)
Technology, K and R are fixed or constant.

Fall ‘ 97 Principles of Microeconomics Slide -- 12

 Market Period
· When Alfred Marshall included time
into the analysis of production and
cost, he included a “market period” in
which inputs, technology and
consequently outputs could not be
varied.
· The supply function would be
perfectly inelastic in this case.
Fall ‘ 97 Principles of Microeconomics Slide -- 13
Production in the Short Run
Consider a production process where K, R and technology are
fixed: As L is changed, the output
changes, QX= f(L) Production of Good X

L = labour input L TPL APL MPL

TPL = QX = output of good X
APL = average product [TP/L]
0 0 0 --
DL = 1 DTPL=4
MPL = Marginal product [DTP/ DL] 1 4 4 4
2 10 5 6
TPLL
APLLL===
AP 3 20 6.67 10
L
DTPL 4 25 6.25 5
MPL =
DL 5 29 5.8 4
TPL output 3
APL = = = Efficiency 6 32 5.3
L input
7 34 4.87 2
Maximum of APL is at the 3 input of
8 35 4.37 1
labour.
9 35 3.89 0
Fall ‘ 97 Principles of Microeconomics Slide -- 14
Production in the Short Run

TPL output Production of Good X

APL =
L = = Efficiency of
input labour L TPL APL MPL
Notice that the APL increases as the first
0 0 0 --
three units of labour are added to the
fixed inputs of K and R. The maximum 1 4 4 4
efficiency of Labour or maximum APL , given 2 10 5 6
our technology, plant and natural
3 20 6.67 10
resources is with the third worker.
4 25 6.25 5
As additional units of labour are added 5 29 5.8 4
beyond the third worker the 6 32 5.3 3
output per worker [APL ] declines.
7 34 4.87 2
8 35 4.37 1
9 35 3.89 0

Fall ‘ 97 Principles of Microeconomics Slide -- 15

 Graphically TPL can be shown:
TPL initially increases at an increasing

..
L TPL

.
rate; it is convex from below.

.
0 0

.
TPL
Output, QX 1 4

.
35
Maximum
2 10

.
30 output
3 20
25
After some point it 4 25

.
20
then increases at a
5 29
decreasing rate and

.
15
reaches a maximum 6 32

.
10
level of output, 7 34
5 and declines
8 35
1 2 3 4 5 6 7 8 9 9 35
Labour
Fall ‘ 97 Principles of Microeconomics Slide -- 16
 Given the TP , the APL can calculated: TPL L APL
TPL 0 0 0
APL = = output = Efficiency of
L input labour 4 1 4
10 2 5
20 3 6.67
APL 25 4 6.25

. .
10

.
29 5 5.8

. ..
8

. ..
32 6 5.3
6
34 7 4.87
4

.
35 8 4.37
2 APL 35 9 3.89

1 2 3 4 5 6 7 8 9
Labour
Fall ‘ 97 Principles of Microeconomics Slide -- 17
 Output, QX

.
Z

.
35 TPL

.
.
The APL is the

.
30 slope of a Graphically the relationship

.
ray from between APL and TPL can be shown:
25 M
the origin
to the 1 unit of L produces 4Q, APL is 4/1 = 4 or the
20
slope of line 0H.

.
TPL . H
15 2 units of L produces 10Q,

.
10 APL is 10/2 = 5 or the slope of line 0M.

.
3 units of L produces 20Q,
5
4 APL is 20/3 = 6.67 or the slope of line 0Z.
0

.
APL 10 1 2 3 4 5 6 7 8 9 4 units of L produces 25Q,

. .
Labour

. .
APL is 25/4 = 6.25 or

...
8

.
the slope of line 0W.
6 As additional units of L are added,
the AP falls.
4

.
The maximum AP is where
2 APL the ray with the greatest
slope is tangent to the TP.
Fall ‘ 97 1 2 3 4 5Principles
6 7of Microeconomics
8 9 Slide -- 18
Labour
 Output, QX

.
.
35 TPL

.
Given TPL , the APL was
30
calculated and graphed.
25
20 . MPL was calculated as
the change in TPL given a
change in L.
L
0
MP
APLL
--
0 0
TPL

.
4-0
15 The first unit of labour added 1 44 4
4 units of output.

.
10 2 65 10
“Between” the 1st and 2cd units
5
4
0. . of labour, Q increases by 6. 3
4
10
6.67
5
6.25
20
25

.
APL 10 1 2 3 4 5 6 7 8 9

.
5 4
5.8 29

.
Labour

.. .
.. . . .. .
8 Note: Where MPL = APL, APL 3

.
6 5.3 32
MPL = APL is a maximum.
6 7 2
4.87 34

.
8 1
4.37 35

.
4

. .
2 APL 9 3.89 0 35
MPL Remember: MP is graphed
at “between” units of L.
Fall ‘ 97 1 2 3 4 5Principles
6 7of Microeconomics
8 9 Slide -- 19
Labour
 Output, QX

.
Z

.
35 TPL

.
30 Useful things to notice:

.
1. MPL is the slope of TPL.
25
2. When TPL increases at an increasing
20 rate, MPL increases. At the inflection

.
point in the TPL , MPL is a maximum.
15 When TPL increases at a decreasing rate,
MPL is decreasing.

.
10

. .
3. The APL is a maximum when:
5
4 a. MPL = APL ,
0 b. the slope of the

.
APL 10 1 2 3 4 5 6 7 8 9 ray from origin is tangent to

. .
Labour TPL .

.. .
.. . . .. .
8

.
4. When MPL > APL the APL is increasing.
6 When MPL < APL the APL is decreasing.

. .
4 5. When MPL is 0, the

. .
slope of TPL is 0, and TP
2 APL
is a maximum.
MPL
Fall ‘ 97 1 2 3 4 5Principles
6 7of Microeconomics
8 9 Slide -- 20
Labour
Summary: TPL , MPL and APL

In many production processes Z

Q initially increases at an TPL
TPL
increasing rate. This is due to At the
division of labour and a “better” inflection
mix of the variable input with the point
fixed inputs. Diminishing
marginal
product
As Q [TPL ]increases at an increasing
rate, MP increases.
0 L
As Q [TPL ]increases at a
MPL MPL is
decreasing rate, MPL decreases. {MP< AP,
APL a max AP falls}
Where 0Z is tangent to TPL , APL is a
maximum; APL = MPL .
When TPL is a maximum, MPL is zero. APL
When TPL is decreasing, MPL is MPL
negative.
{MP> AP, AP rises} L1 L2 L3 L
Fall ‘ 97 Principles of Microeconomics Slide -- 21
 To calculate AP:
PRODUCTION TPL
APL =
L
LABOUR KAPITAL OUTPUT MP AP

0 5 0 0 0 = ? AP is a maximum
DL= 1 DTPL = 8
8 DTP8.0 8 1 = 8 when L = 4.
L = 15
1 5 8
DL= 1
15DTP11.5 23 2 = 11.5 Note that MP is
L = 19
2 5 23
DL= 1
3 5 42 19 14.0 42 3 = 14 15 between 3rd & 4th
DL=5 1 DTPL = 15
4 57 15DTP14.25 574 = 14.25 units of L, it is 10
DL=5 1 L = 10 between 4th & 5th,
5 67 10 DTP
13.4 67 5 = 13.4
DL=5 1 L= 7 so it equals
6 74 7 12.33 AP = 14.25 at L=4.
7 5 79 5 11.28
8 5 82 3 10.25
To calculate MP:
1 9.22
9 5 83
DTPL
10 5 82 -1 8.2 MPL =
DL
MP is a maximum between 2cd and 3rd unit of L.
Fall ‘ 97 Principles of Microeconomics Slide -- 22
 As L is added to production
PRODUCTION process, output per worker [AP]
increases. to a maximum
LABOUR KAPITAL OUTPUT MP AP “efficiency” [output/input which
occurs at L = 4.
0 5 0 0
1 5 8 8 8.0 MP increases to a max between
2 5 23 15 11.5 the 2cd & 3rd units of L.
3 5 42 19 14.0 When MP > AP the output per
4 5 57 15 14.25 worker is increasing.
5 5 67 10 13.4
Division of Labour and a more
6 5 74 7 12.33 efficient mix of L, K & R causes
7 5 79 5 11.28 AP to increase.
8 5 82 3 10.25 Output per worker decreases
9 5 83 1 9.22 after the 4th worker. “Too
10 5 82 -1 8.2 many” workers for K, R & tech,
Diminishing Marginal Productivity begins MP< AP.
with the 4rth unit of L.

Fall ‘ 97 Principles of Microeconomics Slide -- 23

The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
TFC = PK x K = $6K = 6 x5 = $30, This cost does not change in the short run.
TVC = PL x L = $4L, as L changes TVC and Output change.
PRODUCTION AND COST TC = TVC+TFC
LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 x $4 5
= 0 0
$30 + $ 0
--

1 x $4 5
= 8 8 8
$30 =$30
+ $4
2 x $4 5
= 23 11.5 15 $30 =$34
+ $8
3 x $4 5
= 42 14 19 $30 =$38
+ $12
4 x $4 5
= 57 14.25 15
$30 =$42
+ $16
5 x $4 5
= 67 13.4 10
$30 =$46
+ $20
6 5 74 12.33 7 $30 +
=$50
$24 =$54
7 5 79 11.28 5
$30 + $28
8 5 82 10.25 3
$30 =$58
+ $32
9 5 83 9.22 1 $30 =$62
+ $36
10 5 82 8.2 -1
+ $40
$30 =$66
=$70
Fall ‘ 97 Principles of Microeconomics Slide -- 24
The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
AFC = TFCQ = $30Q ATC = AVC + AFC = TCQ
AVC = TVC Q
PRODUCTION AND COST

LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 5 0 0 --
$0 $30
$30
1 5 8 8 8 $4 $34 $3.75 $ .50 $4.25
$30
2 5 23 11.5 15 $30 $8 $38 $1.30 $ .35 $1.65
3 5 42 14 19 $30 $12 $42 $ .71 $ .29 $1.00
4 5 57 14.25 15 $30 $16 $46 $ .53 $ .28 $.81
5 5 67 13.4 10 $30 $20 $50 $ .45 $ .30 $.75
6 5 74 12.33 7 $30 $24 $54 $ .41 $ .32 $.729
7 5 79 11.28 5 $30 $28 $58 $ .38 $ .35 $.734
8 5 82 10.25 3 $30 $32 $62 $ .37 $ .39 $.76
9 5 83 9.22 1 $30 $36 $66 $ .36 $ .43 $.79
10 5 82 8.2 -1 $30 $40 $70 $ .37 $ .49 $.86

Fall ‘ 97 Principles of Microeconomics Slide -- 25

Things to note . . .
As AP increases, AVC decreases. Since AFC declines, it will “pull”
When AP is a maximum, AVC is a minimum. the ATC down as Q increases
AFC declines so long as Q or output increases. beyond the minimum of the AVC.
{Up to the point where TP becomes negative.}
PRODUCTION AND COST

LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 5 0 0 $30
--
$30 $0
1 5 8 8 8 $4 $34 $3.75 $ .50 $4.25
$30
2 5 23 11.5 15
$30 $8 $38 $1.30 $ .35 $1.65
3 5 42 14 19
$30 $12 $42 $ .71 $ .29 $1.00
4 5 57 14.25 15
$30 $16 $46 $ .53 $ .28 $.81
5 5 67 13.4 10
$30 $20 $50 $ .45 $ .30 $.75
6 5 74 12.33 7
$30 $24 $54 $ .41 $ .32 $.729
7 5 79 11.28 5
$30 $28 $58 $ .38 $ .35 $.734
8 5 82 10.25 3
$30 $32 $62 $ .37 $ .39 $.76
9 5 83 9.22 1 $30 $36 $66 $ .36 $ .43 $.79
10 5 82 8.2 -1
$30 $40 $70 $ .37 $ .49 $.86

Fall ‘ 97 Principles of Microeconomics Slide -- 26

 TPL is Q
Z TVC = L x PL

TPL When TP or Q
L2 x PL
increases TVC
TVC increases at a decreasing rate.
at an
increasing TPL
L2 x PL
rate, L1 x PL Q* is the output
with the lowest
AVC! [Max AP]

0 L1 L2 L3 L Q* Q
At L1 [inflection point] the MP is a maximum; the point of Diminishing Marginal
productivity begins, each additional worker increases output, but at a smaller and
smaller amount.
At L2 the AP is a maximum; output per worker is a maximum, “maximum efficiency;”
additional units of labour are less “productive.”
At L3 the TP is a maximum; this is the maximum amout of output [Q] that can
be produced given the size of the plant [fixed input K]. Additional [marginal] L is
negative.

Fall ‘ 97 Principles of Microeconomics Slide -- 27

 The average variable cost [AVC] and marginal cost [MC] are “mirror” images
MPL of the AP and MP functions.
APL
APL
APL APL

MPL MPL
L1 L2 L3 L The maximum of the AP is consistent with
the minimum of the AVC.
1 $
MC = x PL MC
MPL
MP
APL
AVC
1
AVC = x PL
AP AVC

Q
APL x L2
Fall ‘ 97 Principles of Microeconomics Slide -- 28
 MC will intersect the AVC at the
$ minimum of the AVC [always].

ATC
AVC
ATC* R MC will intersect the ATC
at the minimum of the ATC.
AVC* TC = ATC* x Q** J The vertical distance between
TVC = AVC* x Q* ATC and AVC at any output is
the AFC. At Q** AFC is RJ.

Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.

Fall ‘ 97 Principles of Microeconomics Slide -- 29

 The Long Run

· The long run is a period of time where:

· technology is constant
· All inputs are variable
· The long run period is a series of short run
periods. [For each short run period there is a set of TP,
AP, MP, MC, AFC, AVC, ATC, TC, TVC & TFC for each
possible scale of plant]

Fall ‘ 97 Principles of Microeconomics Slide -- 30

 LONG RUN COSTS

MC1 Plant ATC* is the LRMC

$ ATC! optimal size!
MC2 ATC6
ATC2
ATC3 ATC5
ATC*
ATC*
LRAC
There is a long run
Cmin marginal cost function.
At Q* the cost per unit are
minimized [the least inputs
used].
Q* Q
For Plant size 1, the costs are ATC1 and MC1 :
For a bigger Plant 2, the unit costs move out and down. It is more cost
effective. As bigger plants are built the ATC moves out and down.
Eventually, the plant size is “too large,” the ATC moves out but also up!
An “envelope curve” is constructed to represent the long run AC [LRAC].

Fall ‘ 97 Principles of Microeconomics Slide -- 31

 The LRAC
· LRAC is “U-Shaped”
· The LRAC initially decreases due to “economies of
scale”
· economies of scale are due to division of labour.
· Eventually, “diseconomies of scale” begin
· usually lack of adequate information to manage
the production process

Fall ‘ 97 Principles of Microeconomics Slide -- 32

 Calculation of LRAC
· With a little mathematics, the long
run cost functions can be calculated.
· It is easier to use equations rather
than tables and graphs.
· If consumer behavior, production and
cost is understood, you can then think
about how to achieve your objectives.

Fall ‘ 97 Principles of Microeconomics Slide -- 33