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Chap4

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  • 1. CHAPTER 4 The Production Process of Firms
  • 2. <ul><li>4.1 Production and Firm </li></ul><ul><li>4.2 Cost and Profit: Economics and Accounting Concepts </li></ul><ul><li>4.3 The Production Decision </li></ul><ul><li>4.4 The Production Process </li></ul><ul><li>4.5 Production Theory </li></ul><ul><li>4.6 Short Run Cost Curves and Relationship </li></ul><ul><li>4.7 Short Run Revenue and Profit Maximization </li></ul><ul><li>4.8 Long Run Cost Curve </li></ul>
  • 3. <ul><li>Production: </li></ul><ul><ul><li>Is the process of using the factors of production to produce goods and services. </li></ul></ul><ul><ul><li>In other words, it can be stated as the “transformation of inputs into outputs ”. </li></ul></ul><ul><ul><li>Usually, by firm </li></ul></ul><ul><li>Firm: </li></ul><ul><ul><li>An output producing organization </li></ul></ul><ul><ul><li>Demand production factors from input market </li></ul></ul><ul><ul><li>Maximize profit (rational assumption) </li></ul></ul>
  • 4. <ul><li>Accounting Cost (Explicit Cost) </li></ul><ul><ul><li>Considered as “normal” cost (or profit) </li></ul></ul><ul><ul><li>What was paid out (in money) </li></ul></ul><ul><ul><li>Example: wages or rental </li></ul></ul><ul><li>Economics Cost (Implicit Cost) </li></ul><ul><ul><li>Reflex the opportunity cost </li></ul></ul><ul><ul><li>The 2nd best alternative lost </li></ul></ul><ul><ul><li>Considered as implicit cost </li></ul></ul><ul><ul><li>Example : Owner time/effort or using own building </li></ul></ul>
  • 5. <ul><li>Accounting Profits </li></ul><ul><ul><li>A firm’s total revenue minus its explicit costs. </li></ul></ul><ul><ul><li>Formula: </li></ul></ul><ul><li>Economics Profits </li></ul><ul><ul><li>A firm’s total revenue minus its explicit and implicit costs. </li></ul></ul>Explicit Cost: What was paid out (in money) Implicit Cost: The opportunity Cost Maximum Profits
  • 6. <ul><li>Simon spends at least 40 hours a week at his place of business. If he closed the bar, he could work for his competitor and earn RM30,000 per year. He also owns the building that houses the bar and could rent it out for RM24,000 per year if he closes his business. The data below provides information on the company’s annual cost and revenue. Calculate explicit cost, implicit cost, accounting profit and economic profit. </li></ul>Items Cost / Revenue (RM) Wages Interest paid on loans Other expenditure for factors of production Total revenue 85,000 7,000 67,000 250,000
  • 7. <ul><li>Explicit Cost: </li></ul><ul><li>Implicit Cost: </li></ul><ul><li>Accounting Cost: </li></ul><ul><li>Economic Cost: </li></ul>
  • 8. <ul><li>All firms must make several basic decisions to achieve what we assume to be their primary objective—maximum profits. </li></ul>The Three Decisions That All Firms Must Make Market price Techniques Prices of inputs 1. How much output to supply 2. Which production technology to use 3. How much of each input to demand
  • 9. q = f (K, L, M…) 4.4 The Production Process Input: Raw Material Input: Capital Input: Labour Output Technology Input decision : >>How many >>Which types Cost decision Selling price
  • 10. <ul><li>Production Function : </li></ul><ul><ul><li>Refers to the relationship between inputs and outputs. </li></ul></ul><ul><ul><li>It can be represented in the form of a mathematical equation such as: </li></ul></ul><ul><ul><li>Q=f(K,L,M…) </li></ul></ul><ul><li>Marginal Product (MP): </li></ul><ul><ul><li>Additional output that can be produced by adding one more unit of a particular input, ceteris paribus . </li></ul></ul><ul><ul><li>MP slopping down reflex the law of diminishing marginal returns </li></ul></ul><ul><ul><li>Formula: ∆ TP / ∆L </li></ul></ul><ul><li>Average Product of labor (AP): </li></ul><ul><ul><li>Average amount produced by each unit of a variable factor ( e.g labor ) </li></ul></ul><ul><ul><li>Formula: TP / L </li></ul></ul>
  • 11. <ul><li>Short run – Period of time which quantities of one or more inputs cannot be changed and firm is operating under fixed scale, firms can neither enter nor exit an industry. </li></ul><ul><li>Long run – Period of time which quantities of all inputs can be varied (no fixed input). Firms can change the scale of production (increase/decrease). </li></ul>
  • 12. A Production Function and Total Cost For Hungry Helen’s Cookie Factory QUANTITY OF WORKERS OUTPUT MP AP COST OF FACTORY COST OF WORKERS TOTAL COST 0 1 2 3 4 5 6 7 8 0 2 5 9 12 14 15 15 14 - 2 3 4 3 2 1 0 -1 - 2 2.5 3 3 2.8 2.5 2.1 1.8 $30 30 30 30 30 30 30 30 30 $0 10 20 30 40 50 60 70 80 $30 40 50 60 70 80 90 100 110
  • 13. Number of Workers Hired Quantity of output TP Hungry Helen’s Production Function
  • 14. Relationship between TP& MP <ul><li>When MP is increasing, TP will increase at an increasing rate. (stage 1) </li></ul><ul><li>When MP is decreasing, TP will increase at a decreasing rate. (stage 2) </li></ul><ul><li>When MP is zero, TP is at its maximum </li></ul><ul><li>When MP is negative, TP declines. (stage 3) </li></ul>Stage 1 Stage 2 Stage 3 Relationship between MP& AP <ul><li>When MP is above AP, AP is increasing </li></ul><ul><li>When MP is below AP, AP is decreasing </li></ul><ul><li>When MP equals to AP, AP is at maximum. </li></ul>
  • 15. <ul><li>Definition : </li></ul><ul><ul><li>This law explains the behaviour of production functions in the short run, when at least one of the inputs must be fixed. </li></ul></ul><ul><ul><li>The law of diminishing marginal returns states that as more of variable inputs is used, while other inputs are fixed, the marginal product of the variable input will eventually declines. </li></ul></ul>
  • 16. <ul><ul><li>Increasing Marginal Returns (Stage 1: A to B) </li></ul></ul><ul><ul><ul><li>The marginal product (MP) of a variable resource increases as each additional unit of that resource is employed. </li></ul></ul></ul><ul><ul><ul><li>TP increase at an increasing rate (specialization) </li></ul></ul></ul><ul><ul><li>Diminishing Marginal Returns (Stage 2: B to C) </li></ul></ul><ul><ul><ul><li>As more of a variable resources is added to a given amount of another resource, marginal product (MP) eventually declines. </li></ul></ul></ul><ul><ul><ul><li>TP increases at a decreasing rate (less efficient / abundant) </li></ul></ul></ul><ul><ul><li>Negative Marginal Returns (Stage 3: After C) </li></ul></ul><ul><ul><ul><li>The marginal product (MP) of a variable resource turn to negative as each additional unit of that resource is employed </li></ul></ul></ul><ul><ul><ul><li>TP decreases (overcrowded). </li></ul></ul></ul>
  • 17. Labor Labor TP AP, MP Stage 1 Stage 2 Stage 3 TP AP MP Stages of Production B C A
  • 18. Increasing Marginal Returns Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns
  • 19. Diminishing Marginal Returns Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns
  • 20. Negative Marginal Returns Total Product Quantity of Labor Average Product, and Marginal Product Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns
  • 21. <ul><li>Types of costs: </li></ul><ul><ul><li>Fixed cost (FC) </li></ul></ul><ul><ul><ul><li>Any cost that does not depend on the firm’s level of output. </li></ul></ul></ul><ul><ul><ul><li>Costs that incurred even if the firm is producing nothing. </li></ul></ul></ul><ul><ul><ul><li>No fixed cost in long run. </li></ul></ul></ul><ul><ul><li>Variable cost (VC) </li></ul></ul><ul><ul><ul><li>Costs associated with input ( e.g. labor ) </li></ul></ul></ul><ul><ul><ul><li>Depend on the level of production chosen. </li></ul></ul></ul><ul><ul><li>Total cost (TC) </li></ul></ul><ul><ul><ul><li>Sum of the fixed cost (FC) and variable cost (VC) </li></ul></ul></ul><ul><ul><ul><li>TC = FC + VC </li></ul></ul></ul>
  • 22. <ul><li>Types: </li></ul><ul><ul><li>Total fixed cost (TFC)/ overhead </li></ul></ul><ul><ul><ul><li>The total of all costs that do not change with output, even if the output is zero. </li></ul></ul></ul><ul><ul><li>Average fixed cost (AFC) </li></ul></ul><ul><ul><ul><li>Total fixed cost divided by the number of units of output or a per-unit measure of fixed costs. </li></ul></ul></ul><ul><ul><ul><li>Formula: </li></ul></ul></ul>
  • 23. q TFC (RM) AFC (RM) 0 1 2 3 4 5 1000 1000 1000 1000 1000 1000 - 1000 500 333 250 200
  • 24. <ul><li>Types: </li></ul><ul><ul><li>Total variable cost (TVC) </li></ul></ul><ul><ul><ul><li>The total of all costs that vary with output in the short run. </li></ul></ul></ul><ul><ul><li>Average variable cost (AVC) </li></ul></ul><ul><ul><ul><li>The variable cost divided by output. </li></ul></ul></ul><ul><ul><ul><li>Formula: </li></ul></ul></ul><ul><ul><li>Marginal cost (MC) </li></ul></ul><ul><ul><ul><li>Additional cost of producing one more unit of output. </li></ul></ul></ul><ul><ul><ul><li>Reflect the changes in variable costs. </li></ul></ul></ul><ul><ul><ul><li>Formula: </li></ul></ul></ul>
  • 25. <ul><li>Type: </li></ul><ul><ul><li>Average Total Cost (ATC) </li></ul></ul><ul><ul><ul><li>Total cost divided by the number of units of output. </li></ul></ul></ul><ul><ul><ul><li>Formula: </li></ul></ul></ul>
  • 26. Relationship between TVC, AVC & MC <ul><li>Total variable cost (TVC) always increases with output . </li></ul><ul><li>The marginal cost (MC) curve shows how total variable cost changes. </li></ul><ul><li>When MC is below average variable cost, AVC is declining. When MC is above AVC, AVC is increasing. </li></ul><ul><li>MC intersects AVC at the lowest, or minimum, point of AVC . </li></ul>
  • 27.
  • 28. Quantity of Output Costs $3.00 2.50 2.00 1.50 1.00 0.50 0 4 2 6 8 14 12 10 MC ATC AVC AFC Marginal Cost declines at first and then increases due to diminishing marginal product. Note how MC hits both ATC and AVC at their minimum points. AFC declines when output increases .
  • 29. <ul><li>The shapes of the cost curves are mirror-image reflections of the corresponding productivity curves. </li></ul><ul><li>When one is increasing, the other is decreasing. </li></ul><ul><li>When one is at a maximum, the other is at a minimum. </li></ul>
  • 30. Productivity and Costs Are Mirror Images MP AP MC AVC Pull down the average Pull up the average Costs (dollars) Average Product and Marginal Product Quantity of labor Quantity of output
  • 31. <ul><li>When marginal product is increasing, marginal cost is decreasing. </li></ul><ul><li>When marginal product is decreasing, marginal cost is increasing. </li></ul>
  • 32. <ul><li>4.7 </li></ul><ul><li>Short Run Revenue & Profit Maximization </li></ul>
  • 33. <ul><li>Types: </li></ul><ul><ul><li>Total revenue (TR): </li></ul></ul><ul><ul><ul><li>The total amount that a firm takes in from the sale of its output </li></ul></ul></ul><ul><ul><ul><li>Formula : </li></ul></ul></ul><ul><ul><li>Average total revenue (ATR): </li></ul></ul><ul><ul><ul><li>The amount that a firm received from the sales of each units of output </li></ul></ul></ul><ul><ul><ul><li>Formula : </li></ul></ul></ul><ul><ul><li>Marginal revenue (MR): </li></ul></ul><ul><ul><ul><li>Additional revenue that a firm takes in when it increases output by one additional unit </li></ul></ul></ul><ul><ul><ul><li>Formula : </li></ul></ul></ul>
  • 34. <ul><ul><li>Profit ( π ) </li></ul></ul><ul><ul><ul><li>Difference between total revenue and total economic cost </li></ul></ul></ul><ul><ul><ul><li>Total economic cost reflects a normal rate of return (rate that is just sufficient to keep current investors interested in the industry). </li></ul></ul></ul><ul><ul><ul><li>Formula: </li></ul></ul></ul><ul><ul><li>Breakeven ( π = 0 ) </li></ul></ul><ul><ul><ul><li>TR = normal rate of return/ normal profit </li></ul></ul></ul><ul><ul><li>Profit maximization: </li></ul></ul><ul><ul><ul><li>( the largest) when MC = MR </li></ul></ul></ul>
  • 35. Table: Cost, Revenues & Profit Calculation MC = MR (1) Output (q) (unit)   (2) TFC (RM)   (3) TVC (RM)   (4) MC (RM)   (5) P = MR (RM) (6) TR (p*q) (RM) (7) TC (TFC + TVC) (RM) (8) PROFIT (TR – TC) (RM) 0 10 0 - 15 0 10 (10) 1 10 10 10 15 15 20 (5) 2 10 15 5 15 30 25 5 3 10 20 5 15 45 30 15 4 10 35 15 15 60 45 15 5 10 55 20 15 75 65 10 6 10 80 25 15 90 90 0
  • 36. 4.8 Long Run Cost Curve >> No fix scale of operation << Larger scale Smaller scale Economies of scale Diseconomies of scale Reduce production cost Growth constraint Constant return to scale Reflect in the firm’s long run average cost (LRAC) is U-shape Effect on average cost No effect on the cost
  • 37. <ul><li>Economies of scale </li></ul><ul><ul><li>An increase in a firm’s scale of production leads to lower costs per unit produced. </li></ul></ul><ul><ul><ul><li>Forces that reduce a firm’s average cost as the scale of operation increases in the LR. </li></ul></ul></ul><ul><li>Diseconomies of scale </li></ul><ul><ul><li>An increase in a firm’s scale of production leads to higher costs per unit produced. </li></ul></ul><ul><ul><ul><li>Forces that may eventually increase a firm’s average cost as the scale of operation increases in the LR. </li></ul></ul></ul><ul><li>Constant returns to scale </li></ul><ul><ul><li>An increase in a firm’s scale of production has no effect on costs per unit produced. </li></ul></ul>
  • 38. <ul><li>A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization . </li></ul><ul><ul><li>Production techniques such as the assembly line can be utilized only if the rate of output is large enough </li></ul></ul><ul><li>Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines. </li></ul><ul><li>Example: compare the household-size kitchen of a small restaurant with the kitchen at a KFC. </li></ul><ul><ul><ul><li>The LRAC for a restaurant may fall as size increases compare to KFC. </li></ul></ul></ul>
  • 39. <ul><li>As a firm expands, diseconomies of scale, eventually take over. </li></ul><ul><ul><li>long-run average cost increase as output expands. </li></ul></ul><ul><li>Additional layers of management are needed to monitor production. </li></ul><ul><li>The more levels of management in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks. </li></ul><ul><li>Example: Top executive have more difficulty keeping in touch with the factory floor because information is distorted as it moves up and down the chain of command. </li></ul>
  • 40. <ul><li>The term constant returns means that the quantitative relationship between input and output stays constant, or the same, when output is increased. </li></ul><ul><ul><li>The firm’s long-run average cost curve remains flat. </li></ul></ul>
  • 41. Quantity of Cars per Day 0 Average Total Cost Long Run Average Cost Curve ATC 1,000 10,000 Economies of scale Diseconomies of scale Constant returns to scale
  • 42.  
  • 43. <ul><li>QUESTIONS: </li></ul><ul><li>(i) Sketch MC, ATC, AVC and AFC curves. </li></ul><ul><li>(ii) Explain why ATC and AVC curves get closer together as more output produced… </li></ul>
  • 44. THANK YOU

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