THEORY OF THE FIRM: COSTS OF PRODUCTION

1. THEORY OF THE FIRM: COSTS OF PRODUCTION Dr. Michelle Commosioung

2. The Theory of the Firm

3. Production Function

4. Production Function • States the relationship between inputs and outputs • Inputs – the factors of production classified as: • Land – all natural resources of the earth – not just ‘terra firma’! • Price paid to acquire land = Rent • Labour – all physical and mental human effort involved in production • Price paid to labour = Wages • Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production • Price paid for capital = Interest

5. Production Function • Mathematical representation of the relationship: • Q = f (K, L, La) • Output (Q) is dependent upon the amount of capital (K), Land (L) and Labour (La) used

6. Production Function Inputs Process Output Land Product or service generated – value added Labour Capital

7. Production in the Short run • Long-run and short-run production • fixed and variable factors • distinction between short run and long run • The law of diminishing returns • The short-run production function: • total physical product (TPP) • average physical product (APP) • marginal physical product (MPP) • the graphical relationship between TPP, APP and MPP

8. Analysis of Production Function:Short Run In times of rising sales (demand) firms can increase labour and capital but only up to a certain level – they will be limited by the amount of space. In this example, land is the fixed factor which cannot be altered in the short run.

9. Analysis of Production Function:Short Run If demand slows down, the firm can reduce its variable factors – in this example it reduces its labour and capital but again, land is the factor which stays fixed.

10. Analysis of Production Function:Short Run If demand slows down, the firm can reduce its variable factors – in this example, it reduces its labour and capital but again, land is the factor which stays fixed.

11. Wheat production per year from a particular farm Number of workers 0 1 2 3 4 5 6 7 8 TPP 0 3 10 24 36 40 42 42 40 Tonnes of wheat produced per year Number of farm workers

12. Wheat production per year from a particular farm Number of workers 0 1 2 3 4 5 6 7 8 TPP 0 3 10 24 36 40 42 42 40 Tonnes of wheat produced per year Number of farm workers

13. Wheat production per year from a particular farm Maximum output Diminishing returns set in here d TPP Tonnes of wheat produced per year b Number of farm workers

14. Wheat production per year from a particular farm TPP = 7 L = 1 MPP = TPP / L = 7 Tonnes of wheat per year TPP Number of farm workers (L) Tonnes of wheat per year Number of farm workers (L)

15. Wheat production per year from a particular farm Tonnes of wheat per year TPP Number of farm workers (L) Tonnes of wheat per year Number of farm workers (L) MPP

16. Wheat production per year from a particular farm APP = TPP / L Tonnes of wheat per year TPP Number of farm workers (L) Tonnes of wheat per year APP Number of farm workers (L) MPP

17. Wheat production per year from a particular farm b Diminishing returns set in here b Tonnes of wheat per year TPP Number of farm workers (L) Tonnes of wheat per year APP Number of farm workers (L) MPP

18. Wheat production per year from a particular farm d Maximum output d Tonnes of wheat per year TPP b Number of farm workers (L) b Tonnes of wheat per year APP Number of farm workers (L) MPP

19. Total costs for firm X Output (Q) 0 1 2 3 4 5 6 7 TFC (£) 12 12 12 12 12 12 12 12 TFC

20. Total costs for firm X Output (Q) 0 1 2 3 4 5 6 7 TVC (£) 0 10 16 21 28 40 60 91 TFC (£) 12 12 12 12 12 12 12 12 TVC TFC

21. Total costs for firm X Diminishing marginal returns set in here TVC TFC

22. Total costs for firm X Output (Q) 0 1 2 3 4 5 6 7 TVC (£) 0 10 16 21 28 40 60 91 TFC (£) 12 12 12 12 12 12 12 12 TVC TFC

23. Total costs for firm X Output (Q) 0 1 2 3 4 5 6 7 TVC (£) 0 10 16 21 28 40 60 91 TC (£) 12 22 28 33 40 52 72 103 TFC (£) 12 12 12 12 12 12 12 12 TC TVC TFC

24. Total costs for firm X Diminishing marginal returns set in here TC TVC TFC

25. MC Diminishing marginal returns set in here x Average and marginal costs Costs (£) Output (Q)

26. Costs in the Short run • Average cost • average fixed cost (AFC) • average variable cost (AVC) • average (total) cost (AC) • Relationship between average and marginal cost

27. MC AC AVC z y x AFC Average and marginal costs Costs (£) Output (Q)

28. Generally we find: Marginal > Average Average rising Marginal < Average Average falling Marginal = Average Average constant • We can see this here in terms of costs and away from economics….

29. The marginal average relationship can also be observed in this sporting example

30. Production in the Long run • All factors variable in long run • The scale of production: • constant returns to scale • increasing returns to scale • decreasing returns to scale

31. CONSTANT RETURNS TO SCALE • when all inputs are doubled, output doubles INCREASING RETURNS TO SCALE when all inputs are doubled, output more than doubles DECREASING RETURNS TO SCALE • when all inputs are doubled, output rises less than doubles

32. Analysis of Production Function:Long Run In the long run, the firm can change all its factors of production thus increasing its total capacity. In this example it has doubled its capacity.

33. Production in the Long run • Economies and Diseconomies of Scale

34. Production in the Long run • Economies of scale • specialisation & division of labour • indivisibilities • container principle • greater efficiency of large machines • by-products • multi-stage production • organisational & administrative economies • financial economies

35. Production in the Long run • Diseconomies of scale • managerial diseconomies • effects of workers and industrial relations • risks of interdependencies

36. Alternative long-run average cost curves LRAC Economies of Scale Costs O Output

37. Alternative long-run average cost curves LRAC Diseconomies of Scale Costs O Output

38. Alternative long-run average cost curves LRAC Constant costs Costs O Output

39. Alternative long-run average cost curves LRAC Economies of scale Constant costs Diseconomies of scale Costs O Output

40. Costs