AAEC 3315Agricultural Price Theory

CHAPTER 4

Theory of Production

Some General Concepts

The Economic Setting

Market Structure Perfect Competition Imperfect Competition

Monopoly Monopolistic Competition Oligopoly

Characteristics of Perfect Competition Many Buyers & Sellers Homogenous Product Freedom of Entry & Exit (i.e. there are no barriers to entry

or exit) Perfect Information

The Assumption of Profit Maximization

As a first approximation, economists generally assume that firms attempt to maximize expected profits.Expected profit is defined as the long-

term average value of profit – the sum of the various possible levels of profit, after each level is weighted by the probability of its occurrence.

Assessing Profit

Generally speakingProfit = Total Revenue – Total Cost

where, TR = Price of the product x Quantity of Output TC = All costs to produce a certain quantity of the

product Accounting versus Economic Profits

In calculating Cost of Production, accountants only take costs of all inputs used to produce a product into account. Economists take cost of inputs as well as opportunity cost of production.

Short vs. Long Run

Immediate Short-Run: Time span so short that no resource changes can be made. All factors of production are fixed.

Short-Run: Time span such that some factors are variable & some factors are fixed.

Long-Run: Time span so long that no inputs are fixed.

Production Function (PF)

Definition: The technical relationship between inputs & output indicating the maximum amount of output that can be produced using alternative amounts of variable inputs in combination with one or more fixed inputs under a given state of technology.

Or, simply speaking, it is the technical relationship between inputs & output

Factors of Production

InputsFixed Inputs - factors must be

maintained (i.e. paid for, kept up, etc.) whether production occurs or not (ex. - land, buildings, heavy machinery, etc.)

Variable inputs - factors that vary as the output level changes (ex. - labor, fertilizer, seed, etc.)

Cost Definitions

Costs of Production or Economic Costs: The payments that a firm must make to attract inputs and keep them from being used to produce other products.

A firm’s cost functions show various relationships between its costs and output rate. Thus, the firm’s cost functions are determined by the firm’s production function and input prices.

Since the production function can pertain to the short run or the long run, it follows that the cost functions can also pertain to the short run or the long run.

The Nature of Cost

Opportunity Cost: The opportunity or alternative cost of using resources to produce a certain product is the value of the best alternative or opportunity that could have been produced by the same resources foregone.

In the case of active competition for productive resources, every variable resource must be paid at least what it can receive in its next best alternative, i.e., the opportunity costs.

Historical Cost: Historical cost is defined to be the amount the firm actually paid for an input. In the decision making process, the relevant cost is the opportunity cost, i.e., the maximum price the input can command today – not the historical cost that happened to be incurred in the past.

The Nature of Cost

Private, External and Social Cost: Private Cost: It is the cost to an individual producer that

includes both explicit and implicit costs. Explicit costs are costs such as wages, salaries, etc. Implicit costs are the alternative costs of self-owned and

self-employed resources.

External Costs: It is a cost that is not borne by the individual concerned but is incurred by others in the society (could be positive or negative)

Social Cost = Private Cost + External Cost

Cost Functions in the Short Run

Fixed Costs: Costs which do not vary with the level of production - These costs are associated with the fixed factors of production. Incurred regardless whether any output is produced

Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of production.

Revenue Definitions

Total Revenue: The amount of money received when the producer sells the product, i.e., Total Revenue = Price of the product x Quantity of the

product sold

Since the firm is a price taker under perfect competition, it sells each additional unit of the product for the same price.