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PRODUCTION AND COST

THEORY

BASIC PRODUCTION
CONCEPTS

The Firm:
Production Function
Cost Function

The Firm
Firm
An organization that brings together factors of
productionlabor, land, physical capital,
human capital, and entrepreneurial skillto
produce a product or service that it hopes can
be sold at a profit

The Firm
Profit and costs
Accounting profits = total revenues - explicit costs
Explicit Costs
Costs that business managers must take account of because they
must be paid

The Firm
The goal of the firm: profit maximization
Firms are expected to try to make the
positive difference between total revenues
and total costs as large as they can.

The Relationship
Between Output and Inputs
Production Function
The relationship between inputs and output
A technological, not an economic, relationship
The relationship between inputs and
maximum physical output

The Relationship
Between Output and Inputs
Production
Any activity that results in the conversion of
resources into products that can be used in
consumption

PRODUCTION
INPUTS

Land
Labor
Capital
Raw Materials
Entrepreneur

PRODUCTION
PROCESS

Manufacturing
Assembly
Processing
Service

PRODUCTION
OUTPUT

Finished Products
Semi-processed products
Services

The Relationship
Between Output and Inputs

Output/time period = some function of capital and labor inputs

or

Q = (K,L)*
*Q = output/time period
K = capital
L = labor

Two types of Production Inputs


Fixed Input
Variable Input
Point of comparison

Fixed Input

Variable Input

Necessity in Production

Supplementary; even in
their absence some
amount of production
can be carried out

Without these factors no


production can be
carried out

Examples

Plant, machinery,
manager, land, factory
premises

Labor, raw materials,


transport, frieght

THE LAW OF DIMINISHING RETURNS

When one of the factors of production is


held fixed in supply, successive additions
of other factors will lead to an increase in
returns up to a point, but beyond this point
returns will diminish

The Law of Diminishing Returns


NUMBER OF
WORKERS

TOTAL
PHYSICAL
PRODUCT (TPP)

MARGINAL
AVERAGE
PHYSICAL
PHYSICAL
PRODUCT (MPP) PRODUCT (APP)

10

10

10

30

30-10=20

15

90

90-30=60

30

120

120-90=30

30

130

130-120=10

26

120

120-130=-10

20

The Relationship
Between Output and Inputs
Marginal Physical Product
The physical output that is due to the addition
of one more unit of a variable factor of
production
The change in total product occurring when a
variable input is increased and all other inputs
are held constant
Also called marginal product or marginal
return

Diminishing Returns, the Production Function,


and Marginal Product

Diminishing Returns, the Production Function,


and Marginal Product: A Hypothetical Case

Figure 22-2, Panel (b)

Diminishing Returns, the Production Function,


and Marginal Product

Figure 22-2, Panel (c)

COST & PROFIT CONCEPT


Types of Cost

Variable Cost : are


expenses incurred in
production that tend to
change directly as
production increases
Fixed Cost : are
expenses that do not
change or vary with
production

TC = TFC + TVC
TVC = (VC/u) (u)

Revenue : sales generated


by an enterprise

Profits : difference between the


total revenue and total cost

TR = (Sp/u) (u)

TP = TR- TC
TR= TC (Break Even)
TR> TC (Profit)
TC>TR
(Losses)

Cost of Production: An Example

Figure 22-2, Panel (a)

Cost of Production: An Example

Costs (dollar per day)

16
14
12
10
8
6

ATC
AVC

4
2

AFC

2 3 4 5 6 7 8 9 10 11
Output (calculators per day)

Costs (dollar per day)

Cost of Production: An Example

ATC = AVC + AFC


AFC = ATC - AVC

ATC
AVC

AFC
AVC
TP
Output (calculators per day)

Short-Run Costs to the Firm


Marginal Cost
The change in total costs due to a one-unit
change in production rate
change in total cost
Marginal costs (MC) =
change in output

Cost of Production: An Example

0
1
2
3
4
5
6
7
8
9
10
11

Total
Costs
(TC)

0
5
8
10
11
13
16
20
25
31
38
46

10
15
18
20
21
23
26
30
35
41
48
56

Marginal
Cost
(MC)

5
3
2
1
2
3
4
5
6
7
8

16
Costs (dollar per day)

Total
Output
(Q/day)

Total
Variable
Costs
(TVC)

14
12
10
MC

8
6
4
2

2 3 4 5 6 7 8 9 10 11
Output (calculators per day)

Cost of Production: An Example


Panel (c)

Costs (dollars per recordable DVD)

16
14

12
10
MC

8
6

ATC

AVC

2
0

AFC
1

2 3 4 5 6 7 8 9 10 11
Output (recordable DVDs per day)

Short-Run Costs to the Firm


Answer
As long as marginal physical product rises,
marginal cost will fall, and when marginal
physical product starts to fall (after
reaching the point of diminishing marginal
returns), marginal cost will begin to rise.

The Relationship Between Diminishing


Marginal Returns and Cost Curves

MC =

DTC
DOutput

Labor cost assumed constant

MC =

W
MPP

Recall: labor is the variable input

The Relationship Between Diminishing


Marginal Returns and Cost Curves

The Relationship Between


Physical Output and Costs

Figure 22-3, Panels (b) and (c)

The Relationship Between


Physical Output and Costs

Figure 22-3, Panels (c) and (d)

The Relationship Between Diminishing


Marginal Returns and Cost Curves
Firms short-run cost curves are a
reflection of the law of diminishing
marginal returns.
Given any constant price of the variable
input, marginal costs decline as long as
the marginal product of the variable
resource is rising.

The Relationship Between Diminishing


Marginal Returns and Cost Curves
At the point at which diminishing marginal
returns begin, marginal costs begin to rise
as the marginal product of the variable
input begins to decline.

The Relationship Between Diminishing


Marginal Returns and Cost Curves
TVC
AVC =
output
W
AVC =
AP

TR = TC
TR =100; TC= 100; TR=TC
TR=100; TC =50, P/L= TR-TC= 100-50= 50Profit
TR=100; TC=200, P/L =TR-TC = 100-200= (100)
Breakeven?
P200price shirt; P200,000(machine)); (80/hr labor)
TR= TC
(sp/u) (u)= TFC+TVC
200(x) = 200,000 + 80(x)
200x-80x = 200,000
120x = 200,000
X= 200,000/120
1,667 pairs will have to be sold to break even
< = profit; >=loss

200x= 200,000 + 80 x; 2,000 (P/L) Profit=


how much profit
200(2,000) = 200,000 + 80 (2,000)
400,000 = 200,000 + 160,000
TR= 400,000
TC =360,000
P/L = 400,000-360,000
P= 40,000

End

The Firm: Cost and Output


Determination