production and cost
DESCRIPTION
EconomicsTRANSCRIPT
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
Three Stages of Three Stages of ProductionProduction
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.
Three Stages of Three Stages of ProductionProduction
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
Short Run AnalysisShort Run Analysis
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.
Short Run AnalysisShort Run Analysis
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
TVC(Total Variable Cost)
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
TVC(Total Variable Cost)
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.