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

PRODUCTION PROCESS

PRODUCTION OUTPUT

Land Labor Capital Raw Materials Entrepreneur

Manufacturing Assembly Processing Service

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 Necessity in Production Fixed Input Supplementary; even in their absence some amount of production can be carried out Variable Input 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 1 TOTAL PHYSICAL PRODUCT (TPP) 10 MARGINAL PHYSICAL PRODUCT (MPP) 10 AVERAGE PHYSICAL PRODUCT (APP) 10

2
3 4 5

30
90 120 130

30-10=20
90-30=60 120-90=30 130-120=10

15
30 30 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

16

Costs (dollar per day)

14

12
10 8 6 4 2 ATC AVC

AFC 1 2 3 4 5 6 7 8 9 10 11 Output (calculators per day)

Cost of Production: An Example

Costs (dollar per day)

ATC = AVC + AFC AFC = ATC - AVC

AFC AVC

ATC 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

Total Output (Q/day) Total Variable Costs (TVC) Total Costs (TC) Marginal Cost (MC)

16 Costs (dollar per day) 14

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

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

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

5 3 2 1 2 3 4 5

12 10
8 6 4 2 MC

6 7 8

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

Cost of Production: An Example

Panel (c)
16

Costs (dollars per recordable DVD)

14 12 10 8 6 MC ATC AVC AFC 1 2 3 4 5 6 7 8 9 10 11 Output (recordable DVDs per day)

4
2 0

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

Preferable Plant Size and the Long-Run Average Cost Curve

Panel (a)
Average Cost (dollars per unit of output) Average Cost (dollars per unit of output)

Panel (b) SAC1 SAC2

SAC3

SAC8 SAC7
SAC6 SAC5

SAC1 C2 C4

SAC2

C1
C3

SAC4 LAC

SAC3

Q1 Q2 Output per Time Period

Output per Time Period

Figure 22-4, Panels (a) and (b)

Long-Run Cost Curves

Long-Run Average Cost Curve
The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices

Why the Long-Run Average Cost Curve is UShaped

Economies of Scale
Decreases in long-run average costs resulting from increases in output

Why the Long-Run Average Cost Curve is UShaped

Reasons for economies of scale
Specialization Dimensional factor Improved productive equipment

Why the Long-Run Average Cost Curve is UShaped

Explaining diseconomies of scale
Limits to the efficient functioning of management

Minimum Efficient Scale

Minimum Efficient Scale (MES)
The lowest rate of output per unit time at which long-run average costs for a particular firm are at a minimum

Minimum Efficient Scale

Small MES relative to industry demand:
High degree of competition

Large MES relative to industry demand:

Small degree of competition

Minimum Efficient Scale

Long-Run Average Costs (dollars per unit)

LAC A

0 Figure 22-6

10 Output per Time Period

1,000

End

The Firm: Cost and Output Determination