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  • 1. PRODUCTION and COSTS Economics 11 University of the Philippines Los Banos Econ 11-UPLB
  • 2. Note: The contents of this presentation are found in Chapter 5 of the textbook.
  • 3. Theory of Production and Costs   Focus- mainly on the the firm. We will examine Its production capacity given available resources  the related costs involved 
  • 4. What is a firm?   A firm is an entity concerned with the purchase and employment of resources in the production of various goods and services. Assumptions:   the firm aims to maximize its profit with the use of resources that are substitutable to a certain degree the firm is" a price taker in terms of the resources it uses.
  • 5. The Production Function  The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus.  The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time.
  • 6. Firm’s Inputs  Inputs - are resources that contribute in the production of a commodity.  Most resources are lumped into three categories: Land,  Labor,  Capital. 
  • 7. Fixed vs. Variable Inputs    Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.
  • 8. Production Analysis with One Variable Input   Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. ∆TPL MPL = ∆L
  • 9. Total vs. Marginal Product   Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus. ∆TPX MPX = ∆X
  • 10. Production Function of a Rice Farmer Units of L Total Product (QL or TPL) Marginal Product (MPL) 0 0 - 1 2 2 2 6 4 3 12 6 4 20 8 5 26 6 6 30 4 7 32 2 8 32 0 9 30 -2 10 26 -4
  • 11. QL 32 30 Total product 26 QL 20 12 6 2 L 0 1 2 3 4 5 6 7 8 9 10 Labor FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input (e.g., labor) used in production assuming a certain technological level.
  • 12. Marginal Product   The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula: ∆ TPL MPL = ∆L
  • 13. Marginal Product   Observe that the marginal product initially increases, reaches a maximum level, and beyond this point, the marginal product declines, reaches zero, and subsequently becomes negative. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease"
  • 14. Total and Marginal Product 35 30 25 TPL 20 15 10 5 MPL 0 0 -5 -10 1 2 3 4 5 6 7 8 9
  • 15. Law of Diminishing Marginal Returns   As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish. Counter-intuitive proof: if the law of diminishing returns does not hold, the world’s supply of food can be produced in a hectare of land.
  • 16. Average Product (AP)   Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used.    The "productivity" of an input is usually expressed in terms of its average product. The greater the value of average product, the higher the efficiency in physical terms. Formula: TPL APL = L
  • 17. TABLE 5.2. Average product of labor. Labor (L) Total product of labor (TPL) Average product of labor (APL) 0 0 0 1 2 2 2 6 3 3 12 4 4 20 5 5 26 5.2 6 30 5 7 32 4.5 8 32 4 9 30 3.3 10 26 2.6
  • 18. The slope of the line from the origin is a measure of the AVERAGE Y Slope = rise Y = run L b a Y Rise = Y 0 Run = L L1 L2 L
  • 19. Total Product Q The average product at b is highest. AP at c is less than at a. AP at d is less than at c. b c d QL a 0 L
  • 20. Q Highest Slope of Line from Origin Max APL Inflection point TPL Max MPL 0 L1 L2 L3 L
  • 21. Relationship between Average and Marginal Curves: Rule of Thumb    When the marginal is less than the average, the average decreases. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum) When the marginal is greater than the average, the average increases
  • 22. Relationship between Average and Marginal Curves: Example of Econ 11 Scores    When the marginal score (new exam) is less than your average score, the average decreases. When the marginal score (new exam) is equal to the average score, the average does not change. When the marginal score (new exam) is greater than your average score, the average increases.
  • 23. AP,MP At Max AP, MP=AP Max MPL Max APL APL 0 L1 L2 L3 L MPL
  • 24. TP TPL 0 L1 L2 L3 Stage I MP>AP AP increasing AP,MP Stage II MP<AP AP decreasing MP still positive L Stage III MP<0 AP decreasing APL 0 L1 L2 L3 L MPL
  • 25. Three Stages of Production  In Stage I  APL is increasing so MP>AP. All the product curves are increasing  Stage I stops where AP reaches its maximum at L point A.  MP peaks and then declines at point C and beyond, so the law of diminishing returns begins to manifest at this stage 
  • 26. Three Stages of Production  Stage II starts where the APL of the input begins to decline.  QL still continues to increase, although at a decreasing rate, and in fact reaches a maximum  Marginal product is continuously declining and reaches zero at point D, as additional labor inputs are employed. 
  • 27. Three Stages of Production  Stage III starts where the MPL has turned negative. all product curves are decreasing.  total output starts falling even as the input is increased 
  • 28. COSTS OF PRODUCTION   Opportunity Cost Principle - the economic cost of an input used in a production process is the value of output sacrificed elsewhere. The opportunity cost of an input is the value of foregone income in best alternative employment. Implicit vs. Explicit Costs   Explicit costs – costs paid in cash Implicit cost – imputed cost of self-owned or self employed resources based on their opportunity costs.
  • 29. 7 Cost Concepts (Short-run) 1. 2. 3. 4. 5. 6. 7. Total Fixed Cost Total Variable Cost Total Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost (TFC) (TVC) (TC=TVC+TFC) (AFC=TFC/Q) (AVC=TVC/Q) (AC=AFC+AVC) (MC= ∆AVC/∆Q
  • 30. Short Run Analysis  Total fixed cost (TFC) is more commonly referred to as "sunk cost" or "overhead cost." Examples: include the payment or rent for land, buildings and machinery.  The fixed cost is independent of the level of output produced.  Graphically, depicted as a horizontal line 
  • 31. Short Run Analysis  Total variable cost (TVC) refers to the cost that changes as the amount of output produced is changed. Examples - purchases of raw materials, payments to workers, electricity bills, fuel and power costs.  Total variable cost increases as the amount of output increases.  If no output is produced, then total variable cost is zero;  the larger the output, the greater the total variable cost. 
  • 32. Short Run Analysis  Total cost (TC) is the sum of total fixed cost and total variable cost  TC=TFC+TVC  As the level of output increases, total cost of the firm also increases.
  • 33. Total Costs of Production Units of Labor Total Fixed Cost Total Product Total Variable Cost Total Cost TC Marginal Cost Average Cost MC AC L TPL TFC TVC 0 0 100 0 1 6 100 30 130 30 130 2 10 100 50 150 20 75 3 12 100 60 160 10 53.3 4 13 100 65 165 5 41.25 5 15 100 75 175 10 35 6 19 100 95 195 20 32.5 7 25 100 125 225 30 32.14 8 33 100 165 265 40 33.12 9 43 100 215 315 50 35 10 55 100 275 375 60 37.5 100 - -
  • 34. Pesos TC (Total Cost) TVC (Total Variable Cost) TFC (Total Fixed Cost) Q 0 “TOTAL” COST CURVES
  • 35. Pesos AFC=TFC/Q. As more output is produced, the Average Fixed Cost decreases. AFC (Average Fixed Cost) 0 Q
  • 36. Pesos The Average Variable Cost at a point on the TVC curve is measured by the slope of the line from the origin to that point. TVC (Total Variable Cost) AVC=TVC/Q Minimum AVC 0 q1 Q
  • 37. Pesos TVC Inflection point 0 q1 q1 (Total Variable Cost) MC Q AVC
  • 38. Pesos The Average Variable Cost is U shaped. First it decreases, reaches a minimum and then increases. AVC (Average Variable Cost) Minimum AVC 0 q1 Q
  • 39. Pesos The Marginal Cost curve passes through the minimum point of the AVC curve. MC (Marginal Cost) It is also U-shaped. First it decreases, reaches a minimum and then increases. AVC (Average Variable Cost) Minimum AVC 0 q1 Q
  • 40. MC Pesos AC AVC AFC 0 q1 The “PER UNIT” COST CURVES Q
  • 41. Table 5.4 Average Cost of Production (Q) (TC) (AC) 0 100 - 1 130 130.00 2 150 75.00 3 160 53.33 4 165 41.25 5 175 35.00 6 195 32.50 7 225 32.14 8 265 33.13 9 315 35.00 10 375 37.50
  • 42. Table 5.5 Average Variable Costs of Production Total Product (Q) Total Variable Cost (AVC) Average Variable Cost (AVC) 0 0 0 1 30 30.0 2 50 25.0 3 60 20.0 4 65 16.3 5 75 15.0 6 95 15.8 7 125 17.9 8 165 20.6 9 215 23.9 10 275 27.5
  • 43. LTC LTC Long Run Total Cost All inputs are variable in the long run. There are no fixed costs. Total Product LONG-RUN TOTAL COST CURVE Q
  • 44. The LAC    The LAC curve is an envelop curve of all possible plant sizes. Also known as “planning curve” It traces the lowest average cost of producing each level of output. It is U-shaped because of Economies of Scale  Diseconomies of Scale 
  • 45. COST LAC SAC1 SAC2 0 Q LONG-RUN AVERAGE COST CURVE
  • 46. COST SAC1 0 LAC Q q0
  • 47. Building a larger sized plant (size 2) will result in a lower average cost of producing q0 COST SAC1 LAC SAC2 0 Q q0
  • 48. Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1 COST SAC1 LAC SAC2 SAC3 0 Q q0 q1
  • 49. Economies and Diseconomies of Scale  Economies of Scale- long run average cost decreases as output increases. Technological factors  Specialization   Diseconomies of Scale: - long run average cost increases as output increases.  Problems with management – becomes costly, unwieldy
  • 50. COST LAC SAC1 SAC2 Diseconomies of Scale Economies of Scale 0 Q1 LONG-RUN AVERAGE COST CURVE Q
  • 51. LONG-RUN AVERAGE and MARGINAL COST CURVES LMC COST SMC2 SMC1 0 LAC SAC2 SAC1 Q1 Q
  • 52. LAC and LMC  Long-run Average Cost (LAC) curve is U-shaped.  the envelope of all the short-run average cost curves;  driven by economies and diseconomies of size.   Long-run Marginal Cost (LMC) curve Also U-shaped;  intersects LAC at LAC’s minimum point. 