PRODUCTION AND COST

1. PRODUCTION AND COST Hellen A. Seshie-Nasser

2. The Firm • The firm is the agent in the economy that makes decisions about production. It constitutes the economic entity which combines the factors of production in a process to produce goods and services for consumption. • It is made up of various sizes ranging from a micro one-man table-top business to a very large conglomerate with thousands of owners

3. Types of Firms • Sole proprietorship • Partnership • Joint-stock companies

4. The Firm in theory • The firm in theory includes all business organizations ranging from sole proprietorship to companies. • In theory, two assumptions are made about the firm; • That all firms are profit maximizers; seeking to make as much profit for their owners as possible • Each firm is considered as a single, consistent decision-making unit.

5. PRODUCTION • Production is the process of combining economic inputs to come up with output. • Production function is a table, graph or equation showing the maximum output that can be achieved from a given combination of inputs. • The production function shows the technological relationship between inputs and outputs.

6. Short Run vs. Long Run • Short Run (SR) • time frame where some resources are fixed -- plants, equipment • some inputs variable -- labour • SR decisions are reversible • Long Run (LR) • time frame where all inputs are variable --build a bigger plant • LR decisions are hard to reverse -- cannot easily get rid of capital -- sunk cost

7. Production in the Short run • It is a process in which at least one of the inputs is fixed while all the other are variable within a given production period • Fixed inputs are resources or factors that a firm cannot feasibly vary over the time period involved. • Variable inputs are factors of production that a firm can feasibly vary over the time period involved.

8. Production in the Short run • Total product (TP) is the total amount produced during some period of time by all the inputs that the firm uses • Average Product (AP) is the total product per unit of the variable input, say labour. • Marginal product (MP) is the change in total product resulting from the use of one more (or one less) unit of the variable input.

9. Production in the Short run Total product/output is the total quantity of good produced in a given period. It increases with the variable input (labour), then falls # workers TP 0 1 2 3 4 5 6 7 0 1 3 6 8 9 9 8

10. 9 5 6 TP # workers

11. Marginal product (MP) • Marginal product (MP) is the change in total product resulting from the use of one more (or one less) unit of the variable input. where V= the variable input change in TP MPL = change in labour

12. Shape of the MP curve • Marginal product rises, reaches a maximum and falls. • For example, when a firm adds more workers, greater specialization results in larger MP of each worker than the previous worker’s MP. Hence, increasing marginal returns. • However, the fixed input (capital) remains the same. As a result, MP of more workers become smaller than MP of previous workers, leading to decreasing marginal returns

13. 1 2 3 2 1 0 -1 TP, MP: chair production # workers TP MP 0 1 2 3 4 5 6 7 0 1 3 6 8 9 9 8

14. 3 0 3 MP Q = # workers

15. law of decreasing returns • As firm uses more labour • with capital fixed, • MP of labourwill eventually fall

16. Law of diminishing marginal returns • As the amount of some input is increased in equal increments, while technology and other inputs are held constant, the resulting increments in output will eventually begin to decrease. • Two conditions for the law to hold: • Some inputs must be fixed • Technology is held constant

17. Average Product (AP) TP APinput = Input TP APL = labour = productivity

18. 1 2 3 2 1 0 -1 AP # workers TP MP 0 1 2 3 4 5 6 7 0 1 3 6 8 9 9 8 1 1.5 2 2 1.8 1.5 1.1

19. 3 0 3 MP AP # workers

20. The Law of Diminishing Returns • The law of diminishing returns states that, if increasing quantities of a variable input are applied to a given quantity of a fixed input, the marginal product, and the average product, of the variable input will eventually decrease. • The law of diminishing returns is also called the “law of variable proportions” because it predicts the consequences of varying the proportions in which input types are used.

21. K TPPL APPL 0 L MPPL Relationship between product curves Assuming capital is fixed and labour is variable; L2 L3

22. Relationship between product curves • When total product (TP) reaches maximum, marginal product (MP) reaches zero. • As long as MP is positive, TP will rise. Thus, as long as extra units of the variable inputs produce some extra output, total output increases • A rational producer will not operate where MP is negative because production at that point is technologically inefficient.

23. Relationship between product curves • MP intersects AP at max of AP. That is, at the maximum of AP, MPL=APL • When MP is greater than AP, (MPL>APL), AP will be rising • When MP is less than AP, (MPL<APL), AP will be falling

24. Cost concept • Accounting cost refers to the monetary outlay on inputs. Thus, the explicit cost of inputs. • Economic cost refers to the opportunity cost of use of resources. This involves both the explicit and implicit costs of resources

25. Cost concept Implicit costs forgone wages forgone rent (forgone benefits as a result of use of owner resources) Explicit costs Plant and equipment • Raw materials • Wages and salaries • (cost of resources acquired from outside the firm and paid for) Economic cost

26. Explicit costs arise from transactions in which the firm purchases inputs or the services of other parties. E.g. wages and salaries of workers, cost of raw materials, insurance, electricity • Implicit costs are those associated with the use of the firm’s own resources and reflect the fact that these resources could have been employed elsewhere. These costs are sometimes difficult to measure. Examples: • A firm in the owner’s own building, where he does not pay rent. This cost is implicit • Being a manager of his own production firm, he does not pay himself a salary.

27. Economists thus count the opportunity cost of the owner’s capital as part of a firm’s costs. • It includes an estimate of what the capital, and any other advantages owned by the firm, could have earned in their best alternative uses. • Thus economic cost is the opportunity cost of resources used • explicit costs • paid in money • wages, rent, material, etc. • implicit costs • opportunity cost of resources used

28. Accounting profit and Economic profit • Accounting profit = total revenue(TR) – explicit costs • TR = (price)(quantity) • It ignores opportunity cost • Economic profit includes opportunity costs. Economic profit = total revenue - total costs = (price)(quantity) - (explicit + implicit costs)

29. Normal profit • occurs when • amount of accounting profit = opportunity costs of resources • It is the same as zero economic profit • That is, TR – opportunity costs = 0

31. Costs in the Short run • Costs are measured in 3 ways: • total cost • marginal cost • average cost Total cost of production varies with the rate of output. In the short run, there are two types of costs; • Fixed costs • Variable costs

32. Short run costs of production • Total Fixed cost (TFC) is the cost of fixed inputs. • It is the cost incurred by the firm that does not depend on how much output it produces. Examples include building, interest on loan, salaries of workers, etc. • Even if the firm shuts down, it incurs this cost. It does not change in the short run. • Total variable cost (TVC) is the expenditure on variable inputs in the production process. It is the cost incurred by the firm the depends on the amount of output it produces. • E.g. the quantity of raw materials, labour cost, costs of energy, fuel and transportation, etc.

33. Total cost (TC) is the cost of all factors used. It is the sum of total fixed cost and total variable cost at a given level of output. • It identifies the cost of all inputs, fixed or variable, used to produce a given output.

34. workers TP TFC TVC TC Assume the costs of producing chairs as: Labour = ¢6/ hour TFC = ¢10/ hour (the cost of the workshop) 0 0 10 0 10 1 1 10 6 16 1.6 2 10 9.6 19.6 2 3 10 12 22 10 10 24 30 34 40 4 5 8 9

35. TC TC TVC TFC 10 Q = output

36. Cost Cost TC TC TVC TVC TFC TFC Output Output Short run Total cost curves

37. Per unit costs • Average fixed cost (AFC) is the total fixed cost divided by the quantity of output. It is the fixed cost per unit of output. • It declines with output level. Since fixed cost is constant, the greater the output, the lower the AFC • Average variable cost (AVC) is the variable cost per unit of output.

38. Per unit costs • Average total cost (ATC) is the total cost per unit of output. Total cost divided by quantity of output. • It can also be expressed as the sum of AFC and AVC.

39. TP TFC TVC TC AFC AVC AC 0 10 0 10 1 10 6 16 10 6 16 2 10 9.6 19.6 5 4.8 9.8 3 10 12 22 3.33 4 7.33 10 10 1.25 3 4.25 8 9 24 30 34 40 1.11 3.33 4.44

40. Marginal Cost • Marginal cost (MC) is the change in total cost resulting from changing the rate of production by one unit. • In other words, change in TC due to one-unit increase in output (Q) change in TC MC = change in Q

41. TP TFC TVC TC 6 3.6 2.4 6 MC 0 10 0 10 1 10 6 16 2 10 9.6 19.6 3 10 12 22 10 10 8 9 24 30 34 40

42. AC, MC MC ATC AVC AFC Q = output

43. ATC MC AVC AFC Output Relationship between short run per unit cost curves Cost

44. MC and AC • MC intersects AC at the minimum of AC • When MC < AC, AC is falling • When MC > AC, AC is rising

45. what shifts cost curves? • technology • make more with same inputs • shifts TP, MP, AP up • changes ATC curve • changes in factor prices (e.g. increase in input prices) • increase fixed costs -- TFC, AFC shift up -- TC shifts up • increase wages (variable) -- TVC, AVC, MC shift up -- TC shift up

46. Long Run costs: Average Cost (LRAC) • In the LR, all inputs (and costs) are variable. • TC = TVC • AC = AVC • Short Run AC curves are from different plant sizes • The long run AC gives the lowest average cost when all inputs are variable. It is the envelop of all short run ACs

47. AC AC1 AC2 AC3 AC4 Q = output LRAC

48. Economies of scale • What happens if the Long run the firm increases plant AND labour by 10%? Will; • AC fall? • AC rise? • AC stay same? ECONOMIES OF SCALE • If inputs are increased by 10% and this leads to an increase in output by more than 10%, then AC falls. • why? • gains from specialization both from -- labour -- capital The firm is said to exhibit Increasing Returns to Scale

49. Diseconomies of scale • On the other hand, if inputs are increased by 10%, and output increases by less than 10%, then AC rises. • why? • The firm has grown large such that, it has become too hard to control. • The firm is said to be exhibiting Decreasing Returns to Scale • CONSTANT RETURNS TO SCALE • It occurs if for example, the firm increases inputs by 10%, and output also increases by same 10%. AC remains same

50. AC AC1 ATC2 ATC3 ATC4 Q = output diseconomies of scale economies of scale constant returns to scale