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Introduction to Production and Resource Use

Introduction to Production and Resource Use. Chapter 6. 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

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Introduction to Production and Resource Use

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  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 • i.e., Regulatory, 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 and 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 • Labor, cheese vats, milk, energy, starter cultures, cutting and wrapping tables, water, etc. • 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 goal 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 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 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 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/A generates a yield of Y Page 89 8

  9. Total Physical Product (TPP) Curve Maximum Output ↓ Output Variable input Page 89 9

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

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

  12. Total Physical Product (TPP) Curve • 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 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 Page 89 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 Page 91 15

  16. Production Function Average Physical Product (APP) = Amount of output/ amount of inputs used = Output/unit of input used Page 89 16

  17. Total Physical Product (TPP) Curve Output APP = .31 (= 8÷26) with labor use = 26 Input Page 89 17

  18. Plotting the APP Curve Output divided by labor use at B (3 ÷ 16) =0.19 APP = output level divided by level of input use Page 91 18

  19. Definition of the Three Stages of Production Stage I: MPP > APP APP is ↑ APP is increasing in Stage I Page 91 19

  20. Definition of the Three Stages of Production Stage II: MPP < APP MPP > 0 Page 91 20

  21. Definition of the Three Stages of Production Stage III: MPP < 0 Page 91 21

  22. Definition of the Three Stages of Production Why are Stage I and Stage III irrational from the producer’s perspective? Page 91 22

  23. Definition of the Three Stages of Production Can increase output by using less inputs: →More output and less cost Productivity is increasing as more inputs are being used so why stop if the average return is greater than cost? 23

  24. Definition of the Three Stages of Production The question for the producer is: What level of input amount represented by Stage II should the I use? 24

  25. 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 25

  26. 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 • Average Variable Cost (AVC) = total variable cost of production ÷ total amount of output produced Page 94-96 26

  27. 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 • Average Total Cost (ATC) = total cost of production ÷ total amount of output produced = AVC + ATC Page 94-96 27

  28. From TPP curve on page 113 Page 94 28

  29. Fixed costs are $100 no matter the level of production Page 94 29

  30. Total fixed costs (Col. 2) ÷ by total output (Col. 1) Page 94 30

  31. Costs that vary with level of production Page 94 31

  32. Total variable cost (Col. 4) ÷ by total output (Col. 1) Page 94 32

  33. Total Fixed Cost (Col. 2) + Total Variable Cost (Col.4) Page 94 33

  34. Change in Total Cost (Col. 4 or 6) associated with a change in output (Col. 1) Page 94 34

  35. [Total Cost (Col. 6) ÷ by Total Output (Col. (1)] or [Avg. Variable Cost + Avg. Fixed Cost] Page 94 35

  36. Let’s Graph the Above Cost Items Contained in this Table 36

  37. Table 6.3 Cost Relationships • MC=min(ATC) and min(AVC) • Vertical distance between ATC and AVC = AFC Cost ($) Input Use Page 95 37

  38. 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 • Marginal Revenue (MR) = ∆ total revenue ÷ ∆ total amount of output produced • How much revenue is generated by one additional unit of output? • Under perfect competition, it is the per unit price 38

  39. Now let’s assume this firm can sell its product for $45/unit 39

  40. 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 40

  41. Profit Maximization • With perfect competition, where would the firm maximize profit in the above example? Page 98 41

  42. Let’s see this in graphical form 42

  43. Profit maximizing Output where MR=MC P=MR=AR $45 11.2 Page 99 43

  44. 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…. 44

  45. Profit at Price of $45? $ Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40 MC P =45 ATC 28 AVC Q 11.2 45

  46. Profit at Price of $45? $ Revenue = $45  11.2 = $504.00 Total cost = $28  11.2 = $313.60 Profit = $504.00 – $313.60 = $190.40 Since P = MR = AR Average profit = $45 – $28 = $17 Profit = $17  11.2 = $190.40 MC P =45 $190.40 ATC 28 AVC Q 11.2 46

  47. P=MR=AR • Zero economic profit if price falls to PBE • Firm would only produce output OBE where AR (MR) ≥ ATC Page 99 47

  48. Profit at Price of $28? Revenue = $28  10.3 = $288.40 Total cost = $28  10.3 = $288.40 Profit = $288.40 – $288.40 = $0 Since P = MR = AR Average profit = $28 – $28 = $0 Profit = $0  10.3 = $0 (break even) $ MC 45 ATC P=28 AVC Q 10.3 11.2 48

  49. P=MR=AR • Firm can just cover variable cost if price falls to PSD. • Firm would shut down if price falls below PSD Page 99 49

  50. Profit at Price of $18? Revenue = $18  8.6 = $154.80 Total cost = $28  8.6 = $240.80 Profit = $154.80 – $240.80 = $0 Since P = MR = AR Average profit = $18 – $28 = –$10 Profit = –$10  8.6 = –$86 (Loss) $ MC 45 ATC 28 AVC P=18 Q 8.6 10.3 11.2 50

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