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FOUNDATION
ECONOMICS
PART I :
PRINCIPLES OF
MICROECONOMICS
PRODUCTION COST
TOPIC 5 :
Introduction
This topic focuses on the fundamental task of a firm: the
physical combining of input to create output.
The technical possibilities are summarised by production
function that relates alternative input combinations used
during a period to maximum possible output qualities
associated with each state of technical knowledge.
These input -output relationship is explored in detail,
both for short run ( When some inputs are fixed) and the
long run ( when all inputs are varied).
Isoquant analysis is also introduced, a more
sophisticated approach to production functions.
Introduction
Economic activity is a process of converting inputs (factors
of production) into outputs or products (goods and services).
Inputs can be in the form of fixed or variable inputs
The output produced in the process of converting inputs is
called total product.
As additional inputs are employed in production process
additional increases in total product also occurs. This
additional increase is called marginal product.
Marginal product can be both positive and negative. When it
is positive, it can show whether total product is increasing at
a constant rate, increasing rate or, decreasing rate.
When marginal product decreases it shows that diminishing
returns is experienced in production and that total product is
increasing at decreasing rate, reaches its maximum and
eventually declines.
Introduction
Firms purchase factor inputs in the factor market and the
cost incurred in purchasing fixed inputs is called fix cost
while the cost incurred in purchasing variable inputs is
called variable cost. Whether a firm produces or not, it
is always liable to pay for the fix cost.
In this Unit, we will study the theory of production and
cost separately and see how the total cost, average cost,
marginal cost, average variable cost and fixed costs are
related to fixed and variable inputs and total product,
average product and marginal product. The study of
production and cost is the first step to understanding firm
behaviour.
Production Theory
Production refers to the transformation of
resources into outputs of goods and services.
The output of a firm can either be a final
commodity such as cars or an intermediate
product such as steel (which is used in the
production of cars and other goods). Output can
also be a service rather that a good, e.g.,
banking, accounting work etc.
A firm is an organization that combines and
organizes resources for the purpose of
producing goods and services for sale at a profit.
Production Theory
Firms generally seek to maximize profits.
= TR TC
PxQ
Costs: wages, Input purchases, Opportunity cost
opportunity cost refers to the income the owner of a firm would
have earned by working for someone else and the return that
he would have received from investing his or her capital in the
best alternative use.
The profit maximization assumption provides the framework for
analyzing the behavior of the firm in microeconomic theory.
Classification of inputs
Inputs, resources, or factors of production are
the means of producing the goods and services
demanded by society. Inputs can be classified
broadly into labour or human resources
(including entrepreneurial talent), capital, land or
natural resources.
Entrepreneurship: refers to the ability on the
part of some individuals to see opportunities to
combine resources in new and more efficient
ways to produce a particular commodity or to
produce entirely new commodities.
Further classification
Fixed inputs are those inputs that cannot be varied or
can be varied only with excessive cost during the time
period under consideration, e.g., firms plant and
specialized equipment. Generally, it takes many years to
build a new factory or equipment.
Variable inputs: those inputs that can be varied easily
and on a short notice during the time period under
consideration, e.g., raw materials, many types of workers
(low level of skills) etc.
Short run (SR): is the time period during which at least
one input is fixed.
Long run (LR): is the time period during which all inputs
are variable.
Labour
(workers per
year)
(1)
Output
TPP
APL
MP
PL
12
14
3.5
14
2.8
12
-2
TPP
APPL
L
TPP
MPPL
L
MR
TSLK
II
L
III
MR
TSLK
MRTS
LK
11
13
15
10
12
3.0
3.0
3.0
2.0
2.0
2.0
2.
3
0.7
4.2
0.8
6.
2
0.8
1.
8
0.5
3.5
0.7
5.
5
0.7
1.
6
0.2
3.2
0.3
1
0
5.
3
0.2
1.
8
3.5
1
1
5.
5
- K
TPP
MPPL
L
TPP
MPPK
K
equate both
( L) MPPL TPP
so that
MPPL - K
MRTS LK
MPPK
L
Characteristics of isoquants
1) Isoquants are negatively sloped (so that always
more L will substitute for less K),
(2) Isoquants are convex to the origin (reflection of
diminishing MRTSLK).
(3) Isoquants never cross. If they cross, the point of
intersection would imply that the firm could produce two
different levels of output with the same combination of L
and K. This is impossible if we assume that the firm uses
the most efficient production techniques at all times.
Lets recap what we have learnt so far. Remember,
production involves the transformation of inputs into
outputs. And inputs are not free.
Isocosts
TC w
-
L
K=
r
r
Producer equilibrium
1) Producer is in
equilibrium when he
maximizes output
given total cost or
when the highest
isoquant is reached,
given the particular
isocost line.
Producer equilibrium
he
our
st
Producer is in
equilibrium when he
minimizes cost given
output level or when the
lowest isocost line is
reached, given the
particular isocost line.
That is at equilibrium
MRTSLK = PL/PK, and
also note that MRTSLK
= MPL/MPK.
MPL PL
MPL MPK
or
MPK PK
PL
PK
Expansion Path
If firm changes input
requirements while
factor prices remain
constant, the firms
isocost shifts parallel
to itself. The
expansion path can
be traced through the
origin by joining all
the tangency points.
Factor substitution
MPL w
MPK
r
MPL w
MPK
r
Costs of production
Explicit costs refer to the actual expenditures of the firm
to purchase or hire the inputs it needs, i.e., out-of-pocket
expenses.
e.g., wages
interest
rent
expenditures on raw materials etc.
Implicit costs refer to the value of the inputs owned by
the firm and used by the firm in its own production
processes. The value of these owned inputs should be
imputed or estimated from what they could earn in their
next best alternative use or opportunity cost.
TFC
rK
Q
Q
TVC
wL
w
w
Q
Q
Q/L APL
Q
Q
Q
Q/L MPL
LMC = ,
Q
where LMC is long run
marginal cost.
The value of the productivity of
the last unit of labour (or input)
is:
MRP = MPP X P, where MRP
is marginal revenue product.
E.g., LabourMPP of 5th labour
is 5Q
Price of labour is K5
MRP = 5x5
= K25
To find MPPL,
dQ
differentiate
5
dL
at
L = 200
Q = 1000 500
= 500
P = 600-500
= K100
= K500
Costs of Production
Explicit costs are actual out-of-pocket expenditures of the firm
to purchase or hire the inputs it requires in production. These
include wages to hire labour, interest on borrowed capital, rent
on land and buildings, and expenditures on raw and semi
finished materials.
Implicit costs refer to the value of the inputs owned by the
owner and used by the firm in its own production processes.
The value of these owned inputs must be imputed or estimated
from what these inputs could earn in their best alternative use.
These include maximum wages that the entrepreneur could
earn in working for someone else in a similar capacity (e.g., as
the manager of another firm), and the highest return that the
firm could obtain from investing its capital elsewhere and
renting out its land and other inputs to others
Costs of Production
From firms production function and the
price of inputs, we can derive firms cost
functions. This will show minimum costs
that the firm would incur in producing
various levels of output. We assume that
the firm is too small to influence input
prices.
Costs include explicit and implicit costs.
Costs of Production
Accountants traditionally include only actual
expenditures in costs, while economists always
include both explicit and implicit costs.
Implicit costs are the opportunity costs.
Private costs: Explicit + Implicit costs
Social costs: Explicit + Implicit + External costs
In this course we concentrate on private costs.
Reference
Dr. M Fogiel, 1999, The Essentials of
Microeconomics, Chapters 3 & 6,
Research and Education Association, New
Jersey , US
Paul Wonnacott & Ronald Wonnacott,
1990, Economics, 4th Edition, chapter 24,
John Wiley and Sons, USA