Introduction to Production and Resource Use

1. Introduction toProduction and Resource Use Chapter 6

2. Topics of Discussion • Conditions of perfect competition • Classification of productive inputs • Important production relationships (Assume one variable input in this chapter) • Assessing short run business costs • Economics of short run production decisions 2

3. Conditions for Perfect Competition • Homogeneous products • i.e., Corn grain, mined low-sulfur coal • No barriers to entry or exit • No regulatory barriers • No extremely high fixed costs • Large number of sellers • How large is large? • Perfect information • Information cost is relatively small • No one firm has access to information that others don’t Page 86 3

4. Classification of Inputs • Economists view the production process as one where a variety of inputs are combined to produce a single or multiple outputs • Cheese plant example • Many inputs: Labor, stainless steel cheese vats, raw milk, energy, starter cultures, cutting and wrapping tables, water, etc. • Multiple outputs: Cheese, dry whey, whey protein concentrates are produced by the plant Pages 86-87 4

5. Classification of Inputs Land: includes renewable (forests) and non-renewable (minerals) resources Labor: all owner and hired labor services, excluding management Capital: Manufactured goods such as fuel, chemicals, tractors and buildings that may have an extended lifetime Management: Makes production decisions designed to achieve specific economic goals Pages 86-87 5

6. Classification of Inputs Inputs can also be classified depending on whether amount of input used changes with production level Fixed inputs: The amount of input used does not change with output level Up to a point the size of milking parlor does not change with ↑ milk production/cow or for initial ↑ in herd size Variable Inputs: The amount of input used changes directly with the level of output Usually the amount of labor supplied is a variable input (i.e., car assembly plant that ↑ the speed of assembly line to ↑ production/hour Pages 86-87 6

7. Production Function “given the level of” Output = f(labor|capital, land, and management) Start with one variable input Assume remaining inputs fixed at current levels • f(•) is general functional notation • Could be any functional form Page 88 7

8. Production Function • We can graph the relationship between output and amount of labor used • Known as the Total Physical Product (TPP) curve • Purely a physical relationship, no economics involved • X lbs of fertilizer/acre generates a yield of Y Page 89 8

9. Total Physical Product (TPP) Curve Maximum Output Decreasing output Data from previous table Variable input Page 89 9

10. Other Physical Relationships • The following derivations of the TPP curve play an important role in decision-making • Marginal Physical Product (MPP) = • Average Physical Product (APP)= Page 90 10

11. Production Function MPP = Change in output as you change input use ↑MPP ↓MPP Page 89 11

12. Total Physical Product (TPP) Curve Data from previous table 4.8 • MPP = 1.8/4.0 = .45 • Output ↑ from 3.0 to 4.8 units = 1.8 • Labor ↑ from 16 to 20 units = 4.0 Output 3 Input Page 89 12

13. Law of DiminishingMarginal Returns • Pertains to what happens to the MPP with increased use of a single variable input • If there are other inputs their level of use is not changed • Diminishing Marginal Returns • The MPP↑ with initial use of a variable input • At some point, MPP reaches a maximum with greater input use • Eventually MPP↓ as input use continues to ↑ Page 93 13

14. Production Function 14

15. Plotting the MPP Curve Change from A to B on the production function → a MPP of 0.33 Change in output associated with a change in inputs Data from previous table Page 91 15

16. Plotting the MPP Curve Q of Output MPP = Slope of the line tangent at a point (A) on the TPP curve = ∆Q*/∆I* A ∆Q* Q of Input 0 ∆I* Page 91 16

17. Plotting the MPP Curve Q of Output At A, MPP = ∆Q/∆I = 0/∆I* = 0 A TPP is at a maximum when MPP = 0 Q of Input 0 ∆I* Page 91 17

18. Production Function Average Physical Product (APP) = Amount of output ÷ amount of inputs used = Output/unit of input used Page 89 18

19. Total Physical Product (TPP) Curve Data from previous table Output APP = .31 (= 8÷26) with labor use = 26 Input Page 89 19

20. Plotting the APP Curve Output divided by labor use at B (3 ÷ 16) =0.19 APP = output level divided by level of input use Data from previous table Page 91 20

21. Plotting the APP Curve Q of Output B APP = Q*/I* = Slope of the line from the origin to the point on the TPP curve At I**, APP is at a maximum, as line OB is just tangent to the TPP curve A Q* 0 Q of Input I* I** Page 91 21

22. Relationship Between APP and MPP Q of Output APP is at a maximum at input level where APP = MPP MPP APP* APP Q of Input 0 I* Page 91 22

23. Definition of the Three Stages of Production Stage I: MPP > APP APP is ↑ APP is increasing in Stage I Page 91 23

24. Definition of the Three Stages of Production Stage II: MPP < APP MPP > 0 Page 91 24

25. Definition of the Three Stages of Production Stage III: MPP < 0 Page 91 25

26. The Three Stages of Production Q of Output MPP APP Stage III Q of Input 0 Stage II Stage I • Stage II starts at input use where APP is at a maximum (pt A) • Stage II ends at input where MPP = 0 (or TPP is at a maximum) Page 91 26

27. The Three Stages of Production Why are using the amount of input in Stage Iand Stage III of production irrational from the producer’s perspective? Q of Output MPP APP Stage III Q of Input 0 Stage II Stage I Page 91 27

28. The Three Stages of Production Q of Output Can increase output by using less inputs: →More output and less cost MPP APP Stage III Q of Input 0 Stage II Stage I Average productivity is increasing as more inputs are being used so why stop if the average return is greater than cost? Page 91 28

29. The Three Stages of Production Q of Output MPP APP Stage III Q of Input 0 Stage II Stage I The producer’s economic question: What level of input amount contained in Stage II should the I use to maximize profits? Page 91 29

30. Economic Dimension • To answer the above question • We need to account for the price of the product being produced • We also need to account for the cost of the inputs used to produce the above product 30

31. Key Cost Relationships • The following cost concepts play key roles in determining where in Stage II a producer will want to produce • Total Variable Cost (TVC) = the total value of costs that change with the level of output (e.g. energy costs, labor costs, material costs, etc.) • Total Fixed Cost (TFC) = total value of costs that do not changed with the level of output (e.g. property taxes) • Total Costs (TC) = the sum of total variable and fixed costs • TC = TVC + TFC Page 94-96 31

32. Key Cost Relationships • The following cost concepts play key roles in determining where in Stage II a producer will want to produce • Marginal Cost (MC) =  total cost of production ÷  output produced as output level changes =  variable cost of production ÷  output produced given that total fixed costs by definition do not change with output = ∆TC/∆Q = ∆TVC/∆Q • Average Variable Cost (AVC) = total variable cost of production ÷ total amount of output produced = TVC/Q Page 94-96 32

33. Key Cost Relationships • The following cost concepts play key roles in determining where in Stage II a producer will want to produce • Average Fixed Cost (AFC) = total fixed cost of production ÷ total amount of output produced = TFC/Q • Average Total Cost (ATC) = total cost of production ÷ total amount of output produced = TC/Q = AVC + ATC Page 94-96 33

34. From TPP curve on page 113 Page 94 34

35. Fixed costs are $100 no matter the level of production Page 94 35

36. Total fixed costs (Col. 2) ÷ by total output (Col. 1) Page 94 36

37. Costs that vary with level of production Page 94 37

38. Total variable cost (Col. 4) ÷ by total output (Col. 1) 38 Page 94

39. Total Fixed Cost (Col. 2) + Total Variable Cost (Col.4) Page 94 39

40. Change in Total Cost (Col. 4 or 6) associated with a change in output (Col. 1) 40 Page 94

41. [Total Cost (Col. 6) ÷ by Total Output (Col. (1)] or [Avg. Variable Cost + Avg. Fixed Cost] Page 94 41

42. Let’s Graph the Above Cost Items Contained in the Previous Table 42

43. Table 6.3 Cost Relationships • MC = min(ATC) and min(AVC) • Vertical distance between ATC and AVC = AFC Cost ($) AFC Input Use Page 95 43

44. Key Revenue Concepts • The following revenue concepts play key roles in determining where in Stage II a producer will want to produce • Total Revenue (TR) =Multiplication of total amount of output produced by the sale price ($) • Average Revenue (AR) = Total revenue ÷ total amount of output produced ($/unit of output) = TR/Q • Marginal Revenue (MR) = ∆ total revenue ÷ ∆ total amount of output produced = ∆TR÷ ∆Q • How much revenue is generated by one additional unit of output? • Under perfect competition, it is the per unit price 44

45. Now let’s assume this firm can sell its product for $45/unit 45

46. Key Revenue Concepts • Remember we are assuming perfect competition • The firm takes price as given • Price (Col. 2) = MR (Col. 7) • What is the AR value? Page 98 46

47. Profit Maximization • With perfect competition, where would the firm maximize profit in the above example? 47 Page 98

48. Let’s see this in graphical form 48

49. Profit maximizing Output where MR=MC P=MR=AR $45 11.2 Page 99 49

50. Profit Maximization • The previous graph indicated that • Profit is maximized at 11.2 units of output • MR ($45) equals MC ($45) at 11.2 units of output • Profit maximizing output occurs between points G and H • At 11.2 units of output profit would be $190.40. Let’s do the math…. 50