Production and cost

Econ 11-UPLB

PRODUCTION and PRODUCTION and COSTSCOSTS

Economics 11Economics 11

University of the Philippines University of the Philippines

Los BanosLos Banos

Note:

The contents of this presentation are found

in Chapter 5 of the textbook.

Theory of Production and Theory of Production and CostsCosts

Focus- mainly on the the Focus- mainly on the the firmfirm. . We will examineWe will examine

Its production capacity given available Its production capacity given available resources resources

the related costs involvedthe related costs involved

What is a firm?What is a firm?

A firm A firm is an entity concerned with the is an entity concerned with the purchase and employment of resources in purchase and employment of resources in the production of various goods and the production of various goods and services. services.

Assumptions: Assumptions: the firm aims to maximize its profit with the the firm aims to maximize its profit with the

use of resources that are substitutable to a use of resources that are substitutable to a certain degreecertain degree

the firm is" a price taker in terms of the the firm is" a price taker in terms of the resources it uses.resources it uses.

The Production FunctionThe Production Function

The The production functionproduction function refers to the refers to the physical relationship between the inputs physical relationship between the inputs or resources of a firm and their output of or resources of a firm and their output of goods and services at a given period of goods and services at a given period of time, time, ceteris paribus. ceteris paribus.

The production function is The production function is dependentdependent on on different time frames. Firms can produce different time frames. Firms can produce for a brief or lengthy period of time. for a brief or lengthy period of time.

Firm’s InputsFirm’s Inputs

Inputs - are resources that Inputs - are resources that contribute in the production of a contribute in the production of a commodity. commodity.

Most resources are lumped into Most resources are lumped into three categories: three categories: Land, Land, Labor,Labor, Capital. Capital.

Fixed vs. Variable InputsFixed vs. Variable Inputs

Fixed inputs -resources used at a constant Fixed inputs -resources used at a constant amount in the production of a commodity. amount in the production of a commodity.

Variable inputs - resources that can Variable inputs - resources that can change in quantity depending on the level change in quantity depending on the level of output being produced. of output being produced.

The longer planning the period, the The longer planning the period, the distinction between fixed and variable distinction between fixed and variable inputs disappears, i.e., all inputs are inputs disappears, i.e., all inputs are variable in the long run.variable in the long run.

Production Analysis with One Production Analysis with One Variable InputVariable Input

Total product (Q) Total product (Q) refers to the total refers to the total amount of output produced in physical amount of output produced in physical units (may refer to, kilograms of sugar, units (may refer to, kilograms of sugar, sacks of rice produced, etc)sacks of rice produced, etc)

The The marginal product (MP) marginal product (MP) refers to the refers to the rate of change in output as an input is rate of change in output as an input is changed by one unit, holding all other changed by one unit, holding all other inputs constant.inputs constant.

L

L

TPMP

L

Total vs. Marginal Total vs. Marginal ProductProduct

Total Product (TPx) = total amount of Total Product (TPx) = total amount of output produced at different levels of output produced at different levels of inputsinputs

Marginal Product (MPx) = rate of change Marginal Product (MPx) = rate of change in output as input X is increased by one in output as input X is increased by one unit, unit, ceteris paribusceteris paribus..

XX

TPMP

X

Production Function of a Rice Production Function of a Rice FarmerFarmer

Units of LUnits of L Total Product Total Product

(Q(QLL or TP or TPLL))Marginal Product Marginal Product

(MP(MPL)L)

00 00 --

11 22 22

22 66 44

33 1212 66

44 2020 88

55 2626 66

66 3030 44

77 3232 22

88 3232 00

99 3030 -2-2

1010 2626 -4-4

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input (e.g., labor) used in production assuming a certain technological level.

L

QL

QL

2

6

12

20

26

30

32

Labor

Tot

al p

rodu

ct

0 2 4 6 8 1097531

Marginal ProductMarginal Product

The The marginal product marginal product refers to the rate refers to the rate of change in output as an input is of change in output as an input is changed by one unit, holding all other changed by one unit, holding all other inputs constant.inputs constant.

Formula:Formula:

LL

TPMP

L

Marginal ProductMarginal Product Observe that the marginal product Observe that the marginal product

initially increases, reaches a maximum initially increases, reaches a maximum level, and beyond this point, the marginal level, and beyond this point, the marginal product declines, reaches zero, and product declines, reaches zero, and subsequently becomes negative.subsequently becomes negative.

The The law of diminishing returns law of diminishing returns states states that "as the use of an input increases that "as the use of an input increases (with other inputs fixed), a point will (with other inputs fixed), a point will eventually be reached at which the eventually be reached at which the resulting additions to output decrease" resulting additions to output decrease"

Total and Marginal Total and Marginal ProductProduct

-10

-5

0

5

10

15

20

25

30

35

0 1 2 3 4 5 6 7 8 9

TPL

MPL

Law of Diminishing Marginal Law of Diminishing Marginal ReturnsReturns

As more and more of an input is As more and more of an input is added (given a fixed amount of other added (given a fixed amount of other inputs), total output may increase; inputs), total output may increase; however, as the additions to total however, as the additions to total output will tend to diminish.output will tend to diminish.

Counter-intuitive proof: if the law of Counter-intuitive proof: if the law of diminishing returns does not hold, diminishing returns does not hold, the world’s supply of food can be the world’s supply of food can be produced in a hectare of land.produced in a hectare of land.

Average Product (AP)Average Product (AP)

Average product is a concept commonly Average product is a concept commonly associated with efficiency. associated with efficiency.

The The averageaverage product product measures the total measures the total output per unit of input used. output per unit of input used. The "productivity" of an input is usually The "productivity" of an input is usually

expressed in terms of its average product. expressed in terms of its average product. The greater the value of average product, the The greater the value of average product, the

higher the efficiency in physical terms. higher the efficiency in physical terms. Formula:Formula: L

L

TPAP

L

TABLE 5.2. Average product of labor.

Labor (L)Total product of

labor (TPL)Average product of

labor (APL)

0 0 0

1 2 2

2 6 3

3 12 4

4 20 5

5 26 5.2

6 30 5

7 32 4.5

8 32 4

9 30 3.3

10 26 2.6

Rise = Y

Run = L0L

Y

The slope of the line from the origin is a measure of the AVERAGE

Y

L1 L2

a b

riseSlope =

run

Y

L

L

Q

QL

0

Total Product

a

bc

d

The average product at b is highest.

AP at c is less than at a.

AP at d is less than at c.

L

Q

TPL

Highest Slope of Line from Origin

Max APL

Inflection point

Max MPL

0 L1 L2 L3

Relationship between Relationship between Average and Marginal Average and Marginal

Curves: Rule of ThumbCurves: Rule of Thumb When the marginal is less than the When the marginal is less than the

average, the average decreases.average, the average decreases. When the marginal is equal to the When the marginal is equal to the

average, the average does not average, the average does not change (it is either at maximum or change (it is either at maximum or minimum)minimum)

When the marginal is greater than When the marginal is greater than the average, the average increasesthe average, the average increases

Relationship between Average and Relationship between Average and Marginal Curves: Example of Econ Marginal Curves: Example of Econ

11 Scores11 Scores When the marginal score (new When the marginal score (new

exam) is less than your average exam) is less than your average score, the average decreases.score, the average decreases.

When the marginal score (new When the marginal score (new exam) is equal to the average score, exam) is equal to the average score, the average does not change. the average does not change.

When the marginal score (new When the marginal score (new exam) is greater than your average exam) is greater than your average score, the average increases.score, the average increases.

L

AP,MP

Max APL Max MPL

0 L1L2 L3

MPL

APL

At Max AP, MP=AP

L

AP,MP

0 L1L2 L3

MPL

APL

Stage IMP>AP

AP increasing

Stage IIMP<AP

AP decreasingMP still positive

Stage IIIMP<0

AP decreasing

L

TP

0 L1 L2 L3

TPL

Three Stages of Three Stages of ProductionProduction

In Stage I In Stage I APAPLL is increasing so MP>AP. is increasing so MP>AP. All the product curves are increasingAll the product curves are increasing Stage I stops where Stage I stops where APAPLL reaches its reaches its

maximum at point maximum at point A. A. MP peaks and then declines at point MP peaks and then declines at point C C

and beyond, so the law of diminishing and beyond, so the law of diminishing returns begins to manifest at this stagereturns begins to manifest at this stage


Stage IIStage II starts where the starts where the APAPLL of the input begins of the input begins

to decline. to decline. QQLL still continues to increase, although still continues to increase, although

at a decreasing rate, and in fact reaches at a decreasing rate, and in fact reaches a maximuma maximum

Marginal product is continuously Marginal product is continuously declining and reaches zero at point declining and reaches zero at point D, D, as additional labor inputs are employed.as additional labor inputs are employed.


Stage III starts where the Stage III starts where the MPL MPL has has turned negative. turned negative. all product curves are decreasing. all product curves are decreasing. total output starts falling even as the total output starts falling even as the

input is increased input is increased

COSTS OF PRODUCTIONCOSTS OF PRODUCTION

Opportunity Cost PrincipleOpportunity Cost Principle - the economic - the economic cost of an input used in a production cost of an input used in a production process is the value of output sacrificed process is the value of output sacrificed elsewhere. The opportunity cost of an elsewhere. The opportunity cost of an input is the value of foregone income in input is the value of foregone income in best alternative employment.best alternative employment.

Implicit vs. Explicit CostsImplicit vs. Explicit Costs Explicit costsExplicit costs – costs paid in cash – costs paid in cash Implicit costImplicit cost – imputed cost of self-owned or self – imputed cost of self-owned or self

employed resources based on their opportunity employed resources based on their opportunity costs.costs.

7 Cost Concepts (Short-7 Cost Concepts (Short-run)run)

1.1. Total Fixed Cost Total Fixed Cost (TFC)(TFC)

2.2. Total Variable Cost Total Variable Cost (TVC)(TVC)

3.3. Total Cost Total Cost (TC=TVC+TFC)(TC=TVC+TFC)

4.4. Average Fixed Cost Average Fixed Cost (AFC=TFC/Q)(AFC=TFC/Q)

5.5. Average Variable Cost Average Variable Cost (AVC=TVC/Q)(AVC=TVC/Q)

6.6. Average Total Cost Average Total Cost (AC=AFC+AVC)(AC=AFC+AVC)

7.7. Marginal Cost Marginal Cost (MC= ∆AVC/∆Q(MC= ∆AVC/∆Q

Short Run AnalysisShort Run Analysis

Total fixed costTotal fixed cost (TFC) (TFC) is more is more commonly referred to as "sunk commonly referred to as "sunk cost" or "overhead cost." cost" or "overhead cost." Examples: include the payment or rent Examples: include the payment or rent

for land, buildings and machinery.for land, buildings and machinery. The fixed cost is independent of the The fixed cost is independent of the

level of output produced.level of output produced. Graphically, depicted as a horizontal Graphically, depicted as a horizontal

line line


Total variable cost Total variable cost (TVC) (TVC) refers to the refers to the cost that changes as the amount of output cost that changes as the amount of output produced is changed. produced is changed. Examples - purchases of raw materials, Examples - purchases of raw materials,

payments to workers, electricity bills, fuel and payments to workers, electricity bills, fuel and power costs. power costs.

Total variable cost increases as the amount of Total variable cost increases as the amount of output increases. output increases. If no output is produced, then total variable cost is If no output is produced, then total variable cost is

zero;zero; the larger the output, the greater the total variable the larger the output, the greater the total variable

cost. cost.


Total costTotal cost (TC) is the sum of total (TC) is the sum of total fixed cost and total variable costfixed cost and total variable cost

TC=TFC+TVCTC=TFC+TVC

As the level of output increases, total As the level of output increases, total cost of the firm also increases. cost of the firm also increases.

Total Costs of ProductionTotal Costs of Production

Units of Labor

Total Product

Total FixedCost

TotalVariable

Cost Total Cost

MarginalCost

AverageCost

L TPL TFC TVC TC MC AC

0 0 100 0 100 - -

1 6 100 30 130 30 130

2 10 100 50 150 20 75

3 12 100 60 160 10 53.3

4 13 100 65 165 5 41.25

5 15 100 75 175 10 35

6 19 100 95 195 20 32.5

7 25 100 125 225 30 32.14

8 33 100 165 265 40 33.12

9 43 100 215 315 50 35

10 55 100 275 375 60 37.5

Q0

TFC(Total Fixed Cost)

Pesos

TVC(Total Variable Cost)

TC(Total Cost)

“TOTAL” COST CURVES

Q0

AFC(Average Fixed Cost)

Pesos

AFC=TFC/Q.

As more output is produced, the Average Fixed Cost decreases.

Q0

Pesos


q1

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

Minimum AVC

Q0

Pesos

MCq1

Inflection point


q1

AVC

Q0

Pesos

AVC(Average Variable Cost)

q1

The Average Variable Cost is U shaped. First it decreases, reaches a minimum and then increases.

Minimum AVC

Q0

Pesos

AVC(Average Variable Cost)

q1

The Marginal Cost curve passes through the minimum point of the AVC curve.

It is also U-shaped. First it decreases, reaches a minimum and then increases.

Minimum AVC

MC (Marginal Cost)

Q0

Pesos

AVC

q1

MC

AFC

AC

The “PER UNIT” COST CURVES

Table 5.4 Average Cost of ProductionTable 5.4 Average Cost of Production

(Q) (TC) (AC)0 100 -

1 130 130.00

2 150 75.00

3 160 53.33

4 165 41.25

5 175 35.00

6 195 32.50

7 225 32.14

8 265 33.13

9 315 35.00

10 375 37.50

Total Product (Q)

Total Variable Cost (AVC)

Average Variable Cost (AVC)

0 0 0

1 30 30.0

2 50 25.0

3 60 20.0

4 65 16.3

5 75 15.0

6 95 15.8

7 125 17.9

8 165 20.6

9 215 23.9

10 275 27.5

Table 5.5 Average Variable Costs of Production

Lon

g R

un

Tota

l C

ost

LTC

LTC

QTotal Product

All inputs are variable in the long run. There are no fixed costs.

LONG-RUN TOTAL COST CURVE

The LACThe LAC

The LAC curve is an envelop curve The LAC curve is an envelop curve of all possible plant sizes. Also of all possible plant sizes. Also known as “planning curve”known as “planning curve”

It traces the lowest average cost of It traces the lowest average cost of producing each level of output.producing each level of output.

It is U-shaped because of It is U-shaped because of Economies of ScaleEconomies of Scale Diseconomies of Scale Diseconomies of Scale

LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

LAC

Q0

COST

SAC1

q0

LAC

Q0

COST

SAC1

q0

SAC2

Building a larger sized plant (size 2) will result in a lower average cost of producing q0

LAC

Q0

COST

SAC1

q0

SAC2

Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1

q1

SAC3

Economies and Diseconomies Economies and Diseconomies of Scaleof Scale

Economies of ScaleEconomies of Scale- long run average - long run average cost decreases as output increases.cost decreases as output increases. Technological factorsTechnological factors SpecializationSpecialization

Diseconomies of ScaleDiseconomies of Scale: - long run : - long run average cost increases as output average cost increases as output increases.increases. Problems with management – becomes Problems with management – becomes

costly, unwieldycostly, unwieldy

LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

Q1

Economies of Scale

Diseconomies of Scale

LAC

SAC1

Q0

COST

LONG-RUN AVERAGE and MARGINAL COST CURVES

Q1

LMC

SMC1

SMC2

SAC2

LAC and LMCLAC and LMC

Long-run Average Cost (LAC) curve Long-run Average Cost (LAC) curve is U-shaped. is U-shaped. the envelope of all the short-run average the envelope of all the short-run average

cost curves; cost curves; driven by economies and diseconomies of driven by economies and diseconomies of

size.size. Long-run Marginal Cost (LMC) curve Long-run Marginal Cost (LMC) curve

Also U-shaped; Also U-shaped; intersects LAC at LAC’s minimum point.intersects LAC at LAC’s minimum point.