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.

are resources that contribute in the production of a commodity. Most resources are lumped into three categories: Land.  Labor.Firm’s Inputs  Inputs .  Capital.   .

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

holding all other inputs constant. TPL MPL  L . sacks of rice produced.Production Analysis with One Variable Input   Total product (Q) refers to the total amount of output produced in physical units (may refer to. etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit. kilograms of sugar.

Total vs. ceteris paribus. 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. 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. The total product curve shows the behavior of total product vis-a-vis an input (e. Total product curve.1.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. and beyond this point. reaches a maximum level. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed). reaches zero. a point will eventually be reached at which the resulting additions to output decrease" . the marginal product declines. and subsequently becomes negative.

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 .

total output may increase. the world’s supply of food can be produced in a hectare of land. . however. Counter-intuitive proof: if the law of diminishing returns does not hold.Law of Diminishing Marginal Returns   As more and more of an input is added (given a fixed amount of other inputs). as the additions to total output will tend to diminish.

The average product measures the total output per unit of input used. the higher the efficiency in physical terms.Average Product (AP)   Average product is a concept commonly associated with efficiency.   The "productivity" of an input is usually expressed in terms of its average product.  Formula: TPL APL  L . The greater the value of average product.

TABLE 5.6 .3 2. Labor (L) Average product of labor.2.2 5 4.5 8 9 10 32 30 26 4 3. 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.

The slope of the line from the origin is a measure of the AVERAGE Y Slope = rise Y  run L a b Y Rise = Y 0 Run = L L1 L2 L .

AP at c is less than at a. AP at d is less than at c.Total Product Q The average product at b is highest. b c d QL a 0 L .

Q Highest Slope of Line from Origin Max APL Inflection point Max MPL TPL 0 L1 L2 L3 L .

When the marginal is equal to the average.Relationship between Average and Marginal Curves: Rule of Thumb    When the marginal is less than the average. the average increases . the average does not change (it is either at maximum or minimum) When the marginal is greater than the average. the average decreases.

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

AP.MP At Max AP. MP=AP Max MPL Max APL APL 0 L1 L2 L3 MPL L .

MP APL 0 L1 L2 L3 MPL L .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 L AP.

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  .

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

 total output starts falling even as the input is increased  .Three Stages of Production  Stage III starts where the MPL has turned negative. all product curves are decreasing.

the economic cost of an input used in a production process is the value of output sacrificed elsewhere. Explicit Costs   Explicit costs – costs paid in cash Implicit cost – imputed cost of self-owned or self employed resources based on their opportunity costs. . Implicit vs. The opportunity cost of an input is the value of foregone income in best alternative employment.COSTS OF PRODUCTION   Opportunity Cost Principle .

3.7 Cost Concepts (Short-run) 1. 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 . 6. 4. 5. 2. 7.

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

 the larger the output. fuel and power costs.  If no output is produced.purchases of raw materials. the greater the total variable cost. Examples . payments to workers.  .Short Run Analysis  Total variable cost (TVC) refers to the cost that changes as the amount of output produced is changed. electricity bills. then total variable cost is zero.  Total variable cost increases as the amount of output increases.

 .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.

14 33.5 32.25 35 32.5 .12 35 37.3 41.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.

Pesos TC (Total Cost) TVC (Total Variable Cost) TFC (Total Fixed Cost) 0 “TOTAL” COST CURVES Q .

Pesos AFC=TFC/Q. As more output is produced. the Average Fixed Cost decreases. AFC (Average Fixed Cost) 0 Q .

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 0 q1 Q .

Pesos Inflection point TVC (Total Variable Cost) 0 q1 MC Q AVC q1 .

AVC (Average Variable Cost) Minimum AVC 0 q1 Q .Pesos The Average Variable Cost is U shaped. First it decreases. reaches a minimum and then increases.

Pesos The Marginal Cost curve passes through the minimum point of the AVC curve. First it decreases. MC (Marginal Cost) It is also U-shaped. AVC (Average Variable Cost) Minimum AVC 0 q1 Q . reaches a minimum and then increases.

Pesos MC AC AVC AFC 0 q1 Q The “PER UNIT” COST CURVES .

13 35.00 37.50 7 8 9 10 225 265 315 375 32.Table 5.4 Average Cost of Production (Q) 0 1 2 3 4 5 6 (TC) 100 130 150 160 165 175 195 (AC) 130.14 33.33 41.00 75.25 35.50 .00 32.00 53.

0 4 5 6 7 65 75 95 125 16.6 23.0 25.3 15.9 27.8 17.0 15.0 20.9 8 9 10 165 215 275 20.Table 5.5 .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.

LTC Long Run Total Cost Total Product Q LONG-RUN TOTAL COST CURVE .LTC All inputs are variable in the long run. There are no fixed costs.

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

COST LAC SAC1 SAC2 0 Q LONG-RUN AVERAGE COST CURVE .

COST SAC1 LAC 0 q0 Q .

COST Building a larger sized plant (size 2) will result in a lower average cost of producing q0 SAC1 SAC2 LAC 0 q0 Q .

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 Q .

long run average cost decreases as output increases. Technological factors  Specialization   Diseconomies of Scale: .long run average cost increases as output increases.Economies and Diseconomies of Scale  Economies of Scale. unwieldy .  Problems with management – becomes costly.

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 0 Q1 Q .

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

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