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ECO162 - Chapter 5 Production and Cost Theory
ECO162 - Chapter 5 Production and Cost Theory
Definition
Production means the process of using the factor of production to
produce goods and services.
Production is the process of transforming inputs into outputs.
OUTPUTS
INPUTS
Refers to what we
Inputs refers to the Processing get at the end of the
factors of production production process
that a firm use in the that is finished
production process. products.
CLASSIFICATION
OF FACTORS OF
PRODUCTION
CAPITAL ENTREPRENEUR
Part of man-made wealth A person who combines the different
used for further production factors of production, and initiates
the process of production and also
bears the risk
Where: Q = Output
K = Capital Complementary inputs
L = Labour
M = Raw Material
Principles of Economics second edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 5: 6
SHORT RUN AND LONG RUN
PRODUCTION FUNCTION
MP L = TP/ L
60 TP MAX
STAGE I STAGE II STAGE III
50
40
30 TP
MP
20
AP MAX;
AP =MP AP
10
MP=0
0
1 2 3 4 5 6 7 8 9 10
-10
Stage I Stage II
Proportion of fixed factors are Called law of diminishing returns
greater than variable factors The most efficient stage of production
Under utilization of fixed factor because the combinations of inputs are fully
STAGES OF PRODUCTION
Stage III
Proportion of fixed factors is lower than variable factors
SHORT RUN
A production period in which at least on
of the input is fixed*.
LONG RUN
A production period in which all the
inputs are variable**.
* A fixed input is an input which the quantity does not change
according to the amount of output. E.g. machinery
** A variable input is an input which the quantity varies according to
the amount of output. E.g. labour
Total cost (TC ) also defined as total fixed cost (TFC) plus
TC = TFC + TVC
TC = TVC + TFC
TFC
QUANTITY
COST Q
MC ATC
AVERAGE TOTAL COST (ATC)
Total cost per output
ATC = TC ATC = AFC + AVC
Q
AVC
AVERAGE VARIABLE COST (AVC)
Total variable cost (TVC) divided by total output
AVC = TVC
Q
AFC = TFC
Q
AFC
QUANTITY
0 20 0 20 - - - -
1 20 15 35 20 15 35 15
2 20 25 45 10 12.50 22.50 10
3 20 30 50 6.67 10 16.67 5
4 20 35 55 5 8.75 13.75 5
5 20 45 65 4 9 13 10
SAVC STAGE II
AFC continuous to decline and SATC will become minimum.
ATC remains constant at this stage since the falling effect of
AFC and rising effect of AVC is balanced.
.
STAGE III
The falling effect of AFC is lower than rising effect of AVC,
therefore ATC begins to increase.
SAFC
QUANITTY
ATC curve is “U-Shaped” because of the combined influences of AFC and AVC
ATC
Quantity
LRAC curve are derived by a series of short run average cost curves
COST
SRAC1
SRAC5
SRAC2
SRAC4 LRAC
SRAC3
A
QUANTITY
Cost
LRAC
Quantity
Principles of Economics second edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 5: 27
LONG RUN PRODUCTION COST
(cont.)
ECONOMIES OF SCALE
Advantages and benefits of a firm as it becomes larger and
larger.
Reduce long run average cost (LRAC).
Marketing economies, financial economies, labour
economies, technical economies, managerial economics.
DISECONOMIES OF SCALE
Problems faced by a firm as it becomes larger and larger.
Increase long run average cost (LRAC).
Mismanagement, competition, labour diseconomies.
INTERNAL
Internal economies happen inside an EXTERNAL
organization Advantages of the industry as a whole
INTERNAL EXTERNAL
Raise the cost of production of a firm as The disadvantages faced by the industry
the firm expands as a whole