Micro economics 3

1. Unit -3: Production and Business Organization and Analysis of Costs

2. Production function A production function relates physical output of a production process to physical inputs or factors of production. Production function The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output. Put in other way, the function gives for each set of inputs, the maximum amount of output of a product that can be produced. It is defined for a given state of technical knowledge (If technical knowledge changes, the amount of output will change.)

3. A production function provides an abstract mathematical representation of the relation between the production of a good and the inputs used. A production function is usually expressed in this general form: Q =f(L, K) where: Q = quantity of production or output, L = quantity of labor input, and K = quantity of capital input. The letter "f" indicates a generic, as of yet unspecified, functional equation.

4. A production function can be expressed in a functional form as the right side of where is the quantity of output and are the quantities of factor inputs (such as capital, labour, land or raw materials).

5. Short run and long run production function Economists define the short run as being the time period when at least one of the factors of production is completely fixed. so the relationship between input and out put in short run is called short term production function. In short run , factors of production are both fixed and variable. Q= f(L,K) Where, q=production L= labour (variable) K= capital (fixed) Note: here capital means machinery

6. If the situation is like that ,to increase production(Q) we can change only the labour(L) and the capital(K) is fixed, it will be treated as short term production function. Example: ABC corporation is used to export RMG products to Europe. It receives an order for 10,000 pieces of RMG products whereby it should supply as per order with in 2 weeks. In this situation the owner will not establish new building or machinery. He will try to accomplish the order by increasing the number of labour . so here we see labour is variable and capital is fixed. The relationship between input and output in this situation is called short term production function.

7. Long run production function: Economists define the long-run as being the time period when all the factors of production can be changed. In long run all the factors of production are variable. Q=f(L,K) Where, Q=production L= labour ,K= capital If the situation is like that ,to increase production(q) we can change both the labour(L) and capital(K) , it will be treated as long term production function. Example: after the order for 10,000 piec es, if the firm gets order on continuous basis, it will establish new building and machinery. That means in long run both the labour and capital can be changed. So the production function is called long run production function.

8. Law of returns or law of variable proportions Law of returns, in economics, the quantitative change in output of a firm or industry resulting from a proportionate increase in one input , where other inputs are fixed. Law of returns can be 1.Law of increasing return 2.Law of constant return 3.Law of diminishing return. Note: law of returns is associated with short term , because in short term there are some fixed factors and returns to scale is associated with long term ,because in long run all the factors are variable.

9. Example Look at the table below. Let us assume that the firm in question is making computer laser printers and they have four machines in the factory (capital = 4). Capital Labour (L) Marginal product (MP) Total product (TP) Average product (AP) 4 0 - 0 - 4 1 5 5 5.0 4 2 8 13 6.5 4 3 10 23 7.7 4 4 11 34 8.5 4 5 10 44 8.8 4 6 7 51 8.5 4 7 4 55 7.9 4 8 1 56 7.0 4 9 -2 54 6.0

10. Law of increasing return If the output of a firm increases at a rate higher than the rate of increase in one input while others factors are held constant, the production is said to exhibit increasing returns to scale. A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output will rise increasingly at the primary stage.

11. Law of constant returns: If the output of a firm increases at a rate equal to the the rate of increase in one input while others factors are held constant, the production is said to exhibit constant law of returns. A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output will rise proportionately at the middle stage.

12. Law of diminishing returns A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish. The law of diminishing returns is a classic economic concept that states that as more investment in an area is made, overall return on that investment increases at a declining rate, assuming that all variables remain fixed.

13. Returns to Scale returns to scale, in economics, the quantitative change in output of a firm or industry resulting from a proportionate increase in all inputs. If the quantity of output rises by a greater proportion e.g., if output increases by 2.5 times in response to a doubling of all inputsthe production process is said to exhibit increasing returns to scale. Such economies of scale may occur because greater efficiency is obtained as the firm moves from small- to large-scale operations. Decreasing returns to scale occur if the production process becomes less efficient as production is expanded, as when a firm becomes too large to be managed effectively as a single unit

14. Returns to Scale In economics, returns to scale describes what happens when the scale of production increases over the long run when all input levels are variable (chosen by the firm). There are three stages in the returns to scale: increasing returns to scale (IRS), constant returns to scale (CRS), and diminishing returns to scale (DRS). Returns to scale vary between industries, but typically a firm will have increasing returns to scale at low levels of production, decreasing returns to scale at high levels of production, and constant returns to scale at some point in the middle .

15. Returns to Scale (1) Increasing Returns to Scale: If the output of a firm increases at a rate higher than the rate of increase in all inputs, the production is said to exhibit increasing returns to scale. For example, if the amount of inputs are doubled and the output increases by more than double, it is said to be an increasing returns returns to scale. When there is an increase in the scale of production, it leads to lower average cost per unit produced as the firm enjoys economies of scale.

16. (3) Diminishing Returns to Scale: The term 'diminishing' returns to scale refers to scale where output increases in a smaller proportion than the increase in all inputs. For example, if a firm increases inputs by 100% but the output decreases by less than 100%, the firm is said to exhibit decreasing returns to scale. In case of decreasing returns to scale, the firm faces diseconomies of scale. The firm's scale of production leads to higher average cost per unit produced. Increasing, constant, and diminishing returns to scale describe how quickly output rises as inputs increase

17. Explanation The figure 11.6 shows that when a firm uses one unit of labor and one unit of capital, point a, it produces 1 unit of quantity as is shown on the q = 1 isoquant. When the firm doubles its outputs by using 2 units of labor and 2 units of capital, it produces more than double from q = 1 to q = 3. So the production function has increasing returns to scale in this range. Another output from quantity 3 to quantity 6. At the last doubling point c to point d, the production function has decreasing returns to scale. The doubling of output from 4 units of input, causes output to increase from 6 to 8 units increases of two units only.

18. Iso product curve/Iso quant curve An iso quant may be defined as a curve showing all the various combinations of two factors that can produce a given level of output In Latin, "iso" means equal and "quant" refers to quantity. This translates to "equal quantity". The isoquant curve helps firms to adjust their inputs to maximize output and profits. A graph of all possible combinations of inputs that result in the production of a given level of output.

19. An isocost line is a term used in economics. It shows all combinations of inputs which cost the same total amount. An isoquant is a firms counterpart of the consumers indifference curve. An isoquant is a curve that show all the combinations of inputs that yield the same level of output. Iso means equal and quant means quantity. Therefore, an isoquant represents a constant quantity of output. The isoquant curve is also known as an Equal Product Curve or Production Indifference Curve or Iso-Product Curve.

20. The concept of isoquants can be easily explained with the help of the table given below: Table 1: An Isoquant Schedule Combinations of Labor and Capital Units of Labor (L) Units of Capital (K) Output of Cloth (meters) A 5 9 100 B 10 6 100 C 15 4 100 D 20 3 100

21. The above table is based on the assumption that only two factors of production, namely, Labor and Capital are used for producing 100 meters of cloth. Combination A = 5L + 9K = 100 meters of cloth Combination B = 10L + 6K = 100 meters of cloth Combination C = 15L + 4K = 100 meters of cloth Combination D = 20L + 3K = 100 meters of cloth The combinations A, B, C and D show the possibility of producing 100 meters of cloth by applying various combinations of labor and capital. Thus, an isoquant schedule is a schedule of different combinations of factors of production yielding the same quantity of output. An iso-product curve is the graphic representation of an iso-product schedule.

22. Thus, an iso quant is a curve showing all combinations of labor and capital that can be used to produce a given quantity of output.

23. Isoquant Map An isoquant map is a set of isoquants that shows the maximum attainable output from any given combination inputs.

24. Isoquants Vs Indifference Curves Isoquants Vs Indifference Curves An isoquant is similar to an indifference curve in more than one way. The properties of isoquants are similar to the properties of indifference curves. However, some of the differences may also be noted. Firstly, in the indifference curve technique, utility cannot be measured. In the case of an isoquant, the product can be precisely measured in physical units. Secondly, in the case of indifference curves, we can talk only about higher or lower levels of utility. In the case of isoquants , we can say by how much IQ2 actually exceeds IQ1 (figure 2).

25. Properties of isoquants: Properties of isoquants: 1. Convex to the origin. 2. Slopes downward to the right. 3. Never parallel to the x-axis or y-axis. 4. Never horizontal to the x-axis or y-axis. 5. No 2 curves intersect each other. 6. Each iso quant is a part of an oval. 7. It cannot have a positive slope. 8. It cannot be upward sloping

26. Each iso quant is oval-shaped An important feature of an isoquant is that it enables the firm to identify the efficient range of production consider figure 11

27. In economics an isocost line shows all combinations of inputs which cost the same total amount. The isocost line is an important component when analysing producers behaviour. The isocost line illustrates all the possible combinations of two factors that can be used at given costs and for a given producers budget. In simple words, an isocost line represents a combination of inputs which all cost the same amount. Iso cost curve:

28. Now suppose that a producer has a total budget of Rs 120 and and for producing a certain level of output, he has to spend this amount on 2 factors A and B. Price of factors A and B are Rs 15 and Rs. 10 respectively.

29. Combinations Units of Capital Units of Labour Total expenditure Price = 150Rs Price = 100 Rs ( in Rupees) A 8 0 120 B 6 3 120 C 4 6 120 D 2 9 120 E 0 12 120

30. What is isocost line? What is isocost line? An isocost line is also called outlay line or price line or factor cost line. An isocost line shows all the combinations of labour and capital that are available for a given total cost to the producer. Just as there are infinite number of isoquants, there are infinite number of isocost lines, one for every possible level of a given total cost. The greater the total cost, the further from origin is the isocost line. The isocost line can be explained easily by taking a simple example.

31. Let us examine a firm which wishes to spend Rs.100 on a combination of two factors labour and capital for producing a given level of output. We suppose further that the price of one unit of labour is Rs. 5 per day. This means that the firm can hire 20 units of labour. On the other hand if the price of capital is Rs.10 per unit, the firm will purchase 10 units of capital. In the fig. 12.7, the point A shows 10 units of capital used whereas point T shows 20 units of labour are hired at the given price. If we join points A and T, we get a line AT. This AT line is called isocost line or outlay line. The isocost line is obtained with an outlay of Rs.100.

32. Let us assume now that there is no change in the market prices of the two factors labour and capital but the firm increases the total outlay to Rs.150. The new price line BK shows that with an outlay of Rs.150, the producer can purchase 15 units of capital or 30 units of labour. The new price line BK shifts upward to the right. In case the firm reduces the outlay to Rs.50 only, the isocost line CD shifts downward to the left of original isocost line and remains parallel to the original price line. The isocost line plays a similar role in the firms decision making as the budget line does in consumers decision making. The only difference between the two is that the consumer has a single budget line which is determined by the income of the consumer. Where as the firm faces many isocost lines depending upon the different level of expenditure the firm might make. A firm may incur low cost by producing relatively lesser output or it may incur relatively high cost by producing a relatively large quantity.

33. Iso cost curve: Although similar to the budget constraint in consumer theory, the use of the isocost line relates to cost- minimization in production, as opposed to utility- maximization. For the two production inputs labour and capital, with fixed unit costs of the inputs, the equation of the isocost line is where w represents the wage rate of labour, r represents the rental rate of capital, K is the amount of capital used, L is the amount of labour used, and C is the total cost of acquiring those quantities of the two inputs

34. Least cost combination or producers equilibrium A rational firm combines the various factors of production in such a way that gives maximum output from minimum input and minimum cost. Such a combination is referred to as the least cost combination.

35. 41 0 1 2 3 4 5 6 7 8 9 10 Capital,K(machinesrented) 2 4 6 8 10 Labor, L (worker-hours employed) a equ. W = $6; R = $3;C = $30 Choose the recipe where the desired isoquant is tangent to the lowest isocost. C = $18 12 C = $36

36. Producers equilibrium or least cost combination producers equilibrium is achieved with isoquants and isocost curves

37. Least Cost Decision Rule The least cost combination of two inputs (i.e., labor and capital) to produce a certain output level Occurs where the iso-cost line is tangent to the isoquant Lowest possible cost for producing that level of output represented by that isoquant This tangency point implies the slope of the isoquant = the slope of that iso-cost curve at that combination of inputs

38. Explanation

39. In figure 2, NM is the firms isocost line. Isoquants IQ1, IQ2 and IQ3 represent different levels of output. Equilibrium is attained at the point where the isoquant is tangent to the isocost line. The isocost line NM sets the upper boundary for the purchase of the inputs when outlay and input prices are given. Outlay is not sufficient to move to IQ3. Likewise, the segments of isoquants falling below the isocost line indicate under-utilization of his outlay fully. Rationality on the part of the producer requires full utilization of resources for optimization of output.

40. Points A and B also satisfy the tangency condition and they lie within the reach of the producer. However, at these points the firm remains at a lower isoquant IQ1, which yields a lesser level of output than that on IQ2. Thus, E is the point of equilibrium from where there is no tendency on the part of the producer to move away. The firm will get its maximum output when it employs OL0 units of labor and OK0 units of capital.

41. Cost functionCost function is the relationship between production cost and production. Generally an increase in production rises the production cost and an decrease in production decreases the production cost. C=f(q)

42. Short-run and long run cost function Short run cost function: it is the relationship between production cost and quantity of production in short term. Fixed cost exists in short term. In short term- Total cost= total fixed cost + total variable cost In short run some costs are not change in response to increase or decrease in production. Those are fixed costs. Example: abc corporation has 10 sewing machines and 10 workers . It receives an order for 10,000 pieces of rmg products whereby it should supply as per order with in 2 weeks. In this situation the owner will not establish new machine. He will try to accomplish the order by increasing the number of labours or workers. so here we see labour is variable and capital is fixed.

43. Long run cost function: economists define the long-run as being the time period when all the factors of production can be changed. In long run all the costs of production are variable. Relationship between variable costs and production in long run is called long run production cost function. Short-run and long run cost function

44. Concepts of cost Total cost is the cost incurred to produce a quantity of output. A total cost schedule shows the total cost for various output amounts Fixed Cost Fixed cost is the cost that does not increase with the increase in production. Firms have to commit costs for production capacity at the start of a period and they have to incur these costs irrespective of the production output. Such committed capacity costs are termed fixed cost for a period. Variable Cost Variable cost is incurred when production is there and it varies with the level of output.

45. Marginal Cost At each output level or at any output level, marginal cost of production is the additional cost incurred in producing one extra unit of output. Marginal cost can be calculated as the difference between the total costs or producing two adjacent output levels. The difference in variable cost of two adjacent output levels also gives marginal cost, as fixed cost is constant for the two levels. Marginal cost is a central economic concept with a crucial important role to play in resource allocation decisions by organizations.

46. Average Costs or Units Costs Average cost or unit cost is the total cost divided by number of units produced. Average fixed cost is total fixed cost divided by number of units produced. It keeps on decreasing as output increases. Average variable cost is total variable cost divided by number of units produced.

47. Relationship among total , average and marginal cost Quantity (Q) Total cost(TC) Average cost(AC) Marginal cost (MC) 1 unit 2unit 3 unit 4 unit Tk.5 Tk.8 Tk.12 Tk.20 Tk.5 Tk.4 Tk.4 Tk.5 Tk.5 Tk.3 Tk.4 Tk.8

48. 1.When the production increases total cost also increases but average cost and marginal cost decreases. That means total cost increases in decreasing trend. 2.Marginal cost decreases at a rate higher than the rate of decrease in average cost. 3.When the average cost is lowest it is equal to marginal cost at this production level. 4.From this level of production , if we increases the production total cost will increase In increasing trend. 5.When average cost increases, marginal cost increases at a higher rate than AC.

49. Relationship between production function and cost function 1. when TP rises increasingly then TC rises decreasingly. Again ,when TP rises decreasingly then TC rises increasingly.

50. 2.If AP rises, MP rises at a higher rate. If AC decreases, MC decreases at a higher rate. 3.When AP decreases , MP decreases at a higher rate. when AC increases, MC increases at a higher rate. 4.MP curve intersects AP curve at a point where AP is highest. MC curve intersects ac curve when ac is lowest.

51. Short-run Economists define the short run as being the time period when at least one of the factors of production is completely fixed. For example, for a particular company this might mean that they have reached full capacity in a warehouse or at a factory site. These short-run costs consist of both fixed and variable costs. These are both defined fully in the Key Terms section. Long-run In contrast, economists define the long-run as being the time period when all the factors of production can be changed. So in the example above, the company can now look to expand its warehouse or factory capacity without any problems. Cost in short and long run: Long run costs have no fixed factors of production, while short run costs have fixed factors and variables that impact production.

52. Producers equilibrium Producers equilibrium (MC = MR)

53. Concepts of revenue Meaning of Revenue: The amount of money that a producer receives in exchange for the sale proceeds is known as revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs. 16,000 is known as revenue. Revenue refers to the amount received by a firm from the sale of a given quantity of a commodity in the market. Revenue is a very important concept in economic analysis. It is directly influenced by sales level, i.e., as sales increases, revenue also increases.

54. Concept of Revenue The concept of revenue consists of three important terms; Total Revenue, Average Revenue and Marginal Revenue.

55. Total Revenue (TR): Total Revenue refers to total receipts from the sale of a given quantity of a commodity. It is the total income of a firm. Total revenue is obtained by multiplying the quantity of the commodity sold with the price of the commodity. Total Revenue = Quantity Price For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the total revenue will be: 10 Chairs Rs. 160 = Rs 1,600 Average Revenue (AR): Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total revenue by the number of units sold. Average Revenue = Total Revenue/Quantity For example, if total revenue from the sale of 10 chairs @ Rs. 160 per chair is Rs. 1,600, then: Average Revenue = Total Revenue/Quantity = 1,600/10 = Rs 160

56. Marginal Revenue (MR): Marginal revenue is the additional revenue generated from the sale of an additional unit of output. It is the change in TR from sale of one more unit of a commodity. MRn = TRn-TRn-1 Where: MRn = Marginal revenue of nth unit; TRn = Total revenue from n units; TR n-1 = Total revenue from (n 1) units; n = number of units sold For example, if the total revenue realised from sale of 10 chairs is Rs. 1,600 and that from sale of 11 chairs is Rs. 1,780, then MR of the 11th chair will be: MR11 = TR11 TR10 MR11 = Rs. 1,780 Rs. 1,600 = Rs. 180

57. AR and Price are the Same: We know, AR is equal to per unit sale receipts and price is always per unit. Since sellers receive revenue according to price, price and AR are one and the same thing. This can be explained as under: TR = Quantity Price (1) AR = TR/Quantity (2) Putting the value of TR from equation (1) in equation (2), we get AR = Quantity Price / Quantity AR = Price

58. Additional data Total cost (TC) is the sum of all the different costs they incur when producing and selling their product. Average cost (AC) is the total cost divided by the quantity of goods: AC = TC/q Marginal cost (MC) is the extra cost incurred in producing one more of the product. This can be found by measuring the slope of the TC curve: MC = (change in TC)/(change in q)

59. Costs can also be broken down into types of costs: Total variable costs (TVC) refers to costs which vary with the amount of goods a firm makes and sells. An example of TVC could be the cost of chocolate chips, if the firm makes chocolate chip cookies. Total fixed costs (TFC) refers to costs THAT a firm has to pay, no matter how much or how little it produces. One example might be the monthly rent on a store.

60. Added together, TVC and TFC are equal to TC: TVC + TFC = TC TVC and TFC, when divided by q, yield average variable cost (AVC) and average fixed cost (AFC): AVC = TVC/q AFC = TFC/q Added together, AVC and AFC are equal to AC: AVC + AFC = AC

61. We can also find the marginal variable cost (MVC) and the marginal fixed cost (MFC) by taking the slopes of the two curves. Because fixed costs don't change with quantity, however, the MFC will be 0: MVC = (change in TVC)/(change in q) MFC = (change in TFC)/(change in q) = 0 Added together, MVC and MFC are equal to MC, but since MFC is 0, the marginal cost is equal to the marginal variable cost: MVC + MFC = MC MVC + 0 = MC MVC = MC

62. If we can combine a firm's costs and revenues, we can calculate the firm's profits. Using the variables we have been working with, we can represent profit as: Profit = TR - TC TR - TC = q(AR - AC) = q(P - AC) Profit = q(P - AC)