PRODUCTION

Presented by: Regi Mae Ledesma

The Production Process• We now turn to consider the other side of the market:

the Producer side• What will we do with this?• We examine the production process, which will allow

us to understand the costs faced by a firm, which in turn, provides us with an understanding of supply relationships

• Thus we consider, in sequence:– Production Theory– Cost Theory

Central Actor: The Firm• What are firms?

– A way of organizing resources to provide goods and services to a market

– An organization specializing in the production of some good or service

• What do firms do?– They engage in production– Production is a transformation process in which inputs are

transformed into outputs

• Why do they do it?– For profit

What is profit?

• Once again: Profits = Revenue - Costs

• Revenue--still easy--what you sell, how much you sell it for

• This can be obtained from demand curve

• Revenue = Price * Quantity

• Costs: Two types of costs we considered--– Explicit costs (paid to others)– Implicit costs (opportunity costs to owners)

Economic Profit vs. Accounting Profit

• If we calculate Profit = Revenue - Explicit Cost we have Accounting Profit

• If we calculate Profit = Revenue - Explicit Costs - Implicit Costs we have Economic Profit

The Firm

• What kinds of firms are there?– Sole proprietorships– Partnerships– Corporations

• Why do firms exist?– Cheaper

• Specialization arguments (firms, employees)

• Lower Transactions Costs

• Risk Reduction

Production• How do firms organize resources?

• The Production Process

• Dependent on the Technology available

• Can be translated into more precise terms:

• The Production Function--For a given production technology, the production function tells us how much output you can get from a particular combination of inputs

The Production Function• The is just a mathematical way of expressing these

ideas

• Q = f (K, L) [what are K, L?]

• The element of time:

• Short Run vs. Long Run

• Short run: a period in which at least one (or more) of the inputs used cannot be changed

• Long Run: a period in which all of the inputs used in production can be changed

Production RelationshipsCapital Labor Total Output

1 0 01 1 41 2 101 3 151 4 191 5 221 6 241 7 251 8 25

The Production FunctionTotal Output

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Quantity of Labor

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read

Production Relationships

• Types of Inputs: Depend upon the time frame (short run or long run) that we are considering

• Variable Inputs

• Fixed Inputs

• Consider the Relationships in the Short Run

Short RunProduction Relationships

• Total Product: measurement of the production function--how much output can you get from the inputs you are using

• Marginal Product: how much extra output do you get from an additional unit of the (variable) input

• Average Product: output per unit; total output per worker (or per hour)

Short RunProduction Relationships

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Marginal and AverageRelationships

Total Output Marginal Product Average Product04 4 4

10 6 515 5 519 4 4.7522 3 4.424 2 425 1 3.57125 0 3.125

What can we determine from the diagrams?

• How much output you can get from the inputs--in total, incrementally and on average

• Or, how much output do you get for each new unit of input: Marginal Product

• Or, how much output do you get for a unit of input--on average: Average Product

Short Run: Marginal Returns and the Law of Diminishing Returns

• The returns to the use of the input

• The Law of Diminishing Marginal Returns

• This is a relationship that implies that as we add additional amounts of an input (e.g., labor)--while holding the other inputs constant--the marginal product of that input (the extra output per unit of additional input) will decline

Marginal Relationships to the Total and the Average

• What does the marginal product tell us about what happens to total output?

• What does the marginal product tell us about what happens to average output (or average product)?

Now, for Some Economics: Cost

• Opportunity Costs, again• Production Costs: all of the opportunity costs

faced by the owners of the firm--all that they must forego to produce their output

• Two basic types of costs:– Explicit Costs: actual payments made to others who

supply inputs to the firm– Implicit Costs: (opportunity) costs faced by owners

who must forego some payment or return

More Costs

• Sunk costs: Costs that have already been incurred and that cannot be recovered. These do not change regardless of current decisions

• Production Costs: (Short vs Long)– Fixed Inputs imply Fixed Costs– Variable Inputs imply Variable Costs

Output and CostsCapital Labor Total OutputFixed Costs Variable CostsTotal Costs

1 0 0 $100 0 $1001 1 4 $100 6.25 $1061 2 10 $100 12.5 $1131 3 15 $100 18.75 $1191 4 19 $100 25 $1251 5 22 $100 31.25 $1311 6 24 $100 37.5 $1381 7 25 $100 43.75 $1441 8 25 $100 50 $150

Cost Per UnitTotal

OutputAVC ATC MC

04 1.56 26.56 1.56

10 1.25 11.25 1.0415 1.25 7.92 1.2519 1.32 6.58 1.5622 1.42 5.97 2.0824 1.56 5.73 3.1325 1.75 5.75 6.2525 2.00 6.00

Output and Costs

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Cost Curves

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Average Cost Curves

D=MR

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Average Cost Curves

Short run to Long run

• We have focused thus far on the short run, where one (or some) of the inputs cannot be changed

• Over longer periods of time, these inputs can also be changed: this is the Long Run

• Some people often refer to the Long Run as the Planning Period

The Long Run• The underlying principle, which operates both

short and long run is to find the combination of inputs--what we can call the scale of operations for the long run--allows the firm to produce the output it wants to produce at the lowest possible cost

• One way to think about the long run is to consider it to be the decision that you make about which short run you want to choose

The Long Run

• This choice of the short run, and the scale of operations, generally pertains to which level of fixed costs you choose to have

• In many cases, this implies investing in more capital--more (or more productive) machines, a bigger facility

• This also often means that less of some other input--such as labor-- will be used

Quantity

PriceLRMC

LRAC

QEQ

Pm

From the Short Run to the Long Run

SRAC

SRMC

Quantity

Price

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From the Short Run to the Long Run

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PriceLRMC

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From the Short Run to the Long Run

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The Long Run Average Cost Curve

• Why does this curve look like it does?

• Basic concept: Returns to Scale

• Economies of Scale

• Diseconomies of Scale

• Constant Returns to Scale

• Sources of Economies of Scale

The Long Run Average Cost Curve

• Why does this curve look like it does?

• Basic concept: Returns to Scale

• Economies of Scale

• Diseconomies of Scale

• Constant Returns to Scale

• Sources of Economies of Scale

Quantity

PriceLRMC

LRAC

QEQ

The Long Run

Economies of Scale Diseconomies of Scale

Constant Returns to Scale

Quantity

Price

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The Long Run and Returns to Scale

Economies of ScaleDiseconomies of Scale

Constant Returns to Scale

Returns to Scale

• Economies of Scale (Increasing Returns to Scale): Cost per unit falls as output rises

• Diseconomies of Scale (Decreasing Returns to Scale): Cost per unit rises as output rises

• Constant Returns to Scale: Cost per unit stays the same as output rises

Maximizing Profit

• What does it take to maximize profits?

• Simple: make the (positive) difference between revenues and costs as big as possible

• How do you do this?

• This is another example of how important understanding things at the margin is.

Maximizing Profits

• Suppose we start out and the firm under consideration is producing a particular quantity.

• Now consider that they increase their output by one unit

• When they sell more output, revenues rise, but so do costs

Maximizing Profits

• But if--when you increase output--revenues rise by more than costs, then profit goes up

• We can call the increase in revenues Marginal Revenue (MR = R/Q)

• We can call the change in costs (and have already talked about) Marginal Cost (MC = C/Q)

• As long as we can increase output and MR exceeds MC (ie., MR > MC), then profits go up

Bread Making: A Competitive Market

Total OutputTotal Costs MC Price Revenue MR0 100.00 6.00 0.004 106.25 1.56 6.00 24.00 6.0010 112.50 1.04 6.00 60.00 6.0015 118.75 1.25 6.00 90.00 6.0019 125.00 1.56 6.00 114.00 6.0022 131.25 2.08 6.00 132.00 6.0024 137.50 3.13 6.00 144.00 6.0025 143.75 6.25 6.00 150.00 6.0025 150.00 6.00

Bread Making: A Competitive Market

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Bread Making Example

Total OutputTotal Costs MC Price Revenue MR0 100.00 24.00 0.004 106.25 1.56 20.00 80.00 20.0010 112.50 1.04 17.00 170.00 15.0015 118.75 1.25 15.00 225.00 11.0019 125.00 1.56 13.80 262.20 9.3022 131.25 2.08 13.00 286.00 7.9324 137.50 3.13 12.25 294.00 4.0025 143.75 6.25 11.80 295.00 1.0025 150.00

Bread Making Example

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Bread Making Example

Total OutputTotal Costs MC Price Revenue MR Profit0 100.00 24.00 0.00 -100.004 106.25 1.56 20.00 80.00 20.00 -26.2510 112.50 1.04 17.00 170.00 15.00 57.5015 118.75 1.25 15.00 225.00 11.00 106.2519 125.00 1.56 13.80 262.20 9.30 137.2022 131.25 2.08 13.00 286.00 7.93 154.7524 137.50 3.13 12.25 294.00 4.00 156.5025 143.75 6.25 11.80 295.00 1.00 151.25

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Revenues and Costs

Maximizing Profits

• If, however, you go too far and costs rise by more than revenues (MC > MR), profits fall

• So what this implies is that you find the output level where MR no longer goes up by more than MC--that is, where they are equal MR = MC