Pr. of eco_prod & cost

*

Principles of EconomicsLecture slides: Production and Cost

Production and Cost*

*The Production FunctionThe production function specifies the maximum amount of output that can be produced with a given quantity of inputs. It is defined for a given state of technical knowledge. The concept of a production function is a useful way of describing the productive capabilities of a firm.

*The Production Function Contd.Mathematically, Y = F (x); where x = level of input Y = The maximum level of outputOr more generally, Y = F (K, L)This equation states that output is a function of the amount of capital and the amount of laborThe production function reflects the available technology for turning capital and labor into output

*Production Function 1. The slope of production function equals marginal product2. As more input added, MP declinesxYWith the available technology This curve shows how output depends on input Y = F(x)

*Total, Average and Marginal ProductTotal Product is the total amount of output produced in physical units such as bushels of wheat or number of sneakers.Marginal Product of an input is the extra product or output produced by 1 additional unit of that input while other inputs are held constant.For example, assume that we are holding land, machinery and all other inputs constant. Then labors marginal product is the extra output obtained by adding 1 unit of labor.

Average Product is the total output divided by total units of input. Average product of labor or APL = Q/LThis is the accounting measure of productivity.

*A numerical example

Units of labor (a)Total product (b)Marginal product (c)Average product(d=b/a)00120002000200023000100015003350050011674380030095053900100780

*Production Function 111MPLMPLMPL1. The slope of production function equals marginal product2. As more labor is added, MPL declinesLabor, LOutput, YThis curve shows how output depends on labor input, holding the amount of capital constant

*Marginal Product of Labor Marginal product curve is downward slopping.Marginal productLaborMPL = dQ/dLMeasures the output produced by the last worker.Slope of the production function

*Production FunctionDiminishing Marginal ProductDiminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

*From the Production Function to the Total-Cost CurveThe relationship between the quantity a firm can produce and its costs determines pricing decisions.The total-cost curve shows this relationship graphically.

*THE VARIOUS MEASURES OF COSTEverywhere that production goes, costs follow close behind like a shadow.Costs of production may be divided into fixed costs and variable costs.

Fixed costs are those costs that do not vary with the quantity of output produced.Variable costs are those costs that do vary with the quantity of output produced

*$ CostQFCC(Q) = FC + VC

Total Cost =Fixed Cost + Variable CostVC(Q)Fixed Cost & Variable CostTC

*Figure 4 Thirsty Thelmas Total-Cost CurvesCopyright 2004 South-WesternTotal Cost$15.0014.0013.0012.0011.0010.009.008.007.006.005.004.003.002.001.00Quantityof Output(glasses of lemonade per hour)014327659810Total-cost curve

* Average costs can be determined by dividing the firms costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. Average Fixed Costs (AFC)Average Variable Costs (AVC)Average Total Costs (ATC)ATC = AFC + AVCAverage Costs

*Average Costs

*Marginal CostMarginal cost (MC) measures the increase in total cost that arises from an extra unit of production.Marginal cost helps answer the following question:How much does it cost to produce an additional unit of output?

*Marginal Cost

Quantity

Total Cost

Marginal Cost

Quantity

Total Cost

Marginal Cost

0

$3.00

1

3.30

$0.30

6

$7.80

$1.30

2

3.80

0.50

7

9.30

1.50

3

4.50

0.70

8

11.00

1.70

4

5.40

0.90

9

12.90

1.90

5

6.50

1.10

10

15.00

2.10

*Figure 5 Thirsty Thelmas Average-Cost and Marginal-Cost CurvesCopyright 2004 South-WesternCosts$3.503.253.002.752.502.252.001.751.501.251.000.750.500.25Quantityof Output(glasses of lemonade per hour)014327659810MCATCAVCAFC

*Cost Curves and Their ShapesMarginal cost rises with the amount of output produced.This reflects the property of diminishing marginal product.

*Cost Curves and Their ShapesThe average total-cost curve is U-shaped.At very low levels of output average total cost is high because fixed cost is spread over only a few units.Average total cost declines as output increases.Average total cost starts rising because average variable cost rises substantially.

*Cost Curves and Their ShapesThe bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

*Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total CostWhenever marginal cost is less than average total cost, average total cost is falling.Whenever marginal cost is greater than average total cost, average total cost is rising.The marginal-cost curve crosses the average-total-cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost.

*Typical Cost Curves Three Important Properties of Cost CurvesMarginal cost eventually rises with the quantity of output.The average-total-cost curve is U-shaped.The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

*COSTS IN THE SHORT RUN AND IN THE LONG RUNFor many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.In the short run, some costs are fixed.In the long run, fixed costs become variable costs.Because many costs are fixed in the short run but variable in the long run, a firms long-run cost curves differ from its short-run cost curves.

*Economies and diseconomies of scaleEconomies of scale factors that lower average cost as the size of the firm rises in the long runSources: specialization and division of labor, indivisibilities of capital, etc.Diseconomies of scale factors that raise average cost as the size of the firm rises in the long runSources: increased cost of managing and coordination as firm size risesConstant returns to scale average costs do not change as firm size changes

*Long-run average total cost (LRATC)

*

The Firms Objective

The Firms ObjectiveThe economic goal of the firm is to maximize profits.

*Total Revenue, Total Cost, and ProfitTotal RevenueThe amount a firm receives for the sale of its output.Total CostThe market value of the inputs a firm uses in production.

*Total Revenue, Total Cost, and ProfitProfit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

*Costs as Opportunity CostsA firms cost of production includes all the opportunity costs of making its output of goods and services.Explicit and Implicit CostsA firms cost of production include explicit costs and implicit costs.Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.

*Economic Profit versus Accounting ProfitEconomists measure a firms economic profit as total revenue minus total cost, including both explicit and implicit costs.Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.Economic profit is smaller than accounting profit.

*Figure 1 Economic versus AccountantsCopyright 2004 South-WesternHow an EconomistViews a FirmHow an AccountantViews a Firm

*

Documents

Pr. of eco_prod & cost