This document provides an introduction to production and resource use. It discusses topics including conditions of perfect competition, classification of productive inputs, production relationships, costs of production, and economics of short-run production decisions. Key concepts covered include the production function, total physical product curve, marginal physical product curve, average physical product curve, stages of production, total costs, average costs, marginal costs, total revenue, average revenue, and marginal revenue. The document uses examples and tables to illustrate these concepts and how firms can determine profit-maximizing output levels under perfect competition.
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
No regulatory barriers
No 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 that
others don’t Page 863
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
Many inputs: Labor, stainless steel cheese vats,
raw milk, energy, starter cultures, cutting and
wrapping tables, water, etc.
Multiple outputs: Cheese, dry whey, whey
protein concentrates are produced by the plant
Pages 86-874
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 goals
Pages 86-875
6. Classification of Inputs
Inputs can also be classified depending
on whether amount of input used changes
with production level
Fixed inputs: The amount of input 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 directly 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 86-876
7. Production Function
Output = f(labor | capital, land,
and management)
Page 88
Start with
one variable
input
f(•) is general functional notation
Could be any functional form
Assume remaining inputs
fixed at current levels
7
“given the level of”
8. Page 89
Point Labor (hr) Output
A 10 1.0
B 16 3.0
C 20 4.8
D 22 6.5
E 26 8.1
F 32 9.6
G 40 10.8
H 50 11.6
I 62 12.0
J 76 11.7
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/acre
generates a yield of Y
8
9. Page 89
Total Physical Product (TPP) Curve
Variable input
Maximum Output
Decreasing output
9
Data from previous table
10. Other Physical Relationships
The following derivations of the TPP curve
play an important role in decision-making
Marginal Physical Product (MPP) =
Average Physical Product (APP) =
Page 90
Output
Input
Output Qty
Input Qty
10
11. MPP = Change
in output as you
change input use
Page 89
Production Function
Output
Input
Point
Labor
[1]
Output
[2]
∆Labor
[3]
∆Output
[4]
MPP
[5] = [4]
÷ [3]
A 10 1.0 ----- ----- -----
B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76 11.7 14 -0.3 -0.02
11
↓MPP
↑MPP
12. Page 89
Total Physical Product (TPP) Curve
Input
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
12
4.8
3
Data from previous table
13. Law of Diminishing
Marginal 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 9313
14. Point
Labor
[1]
Output
[2]
∆Labor
[3]
∆Output
[4]
MPP
[5] = [4]
÷ [3]
∆MPP
A 10 1.0 ----- ----- -----
B 16 3.0 6 2 0.33
C 20 4.8 4 1.8 0.45
D 22 6.5 2 1.7 0.85
E 26 8.1 4 1.6 0.40
F 32 9.6 6 1.5 0.25
G 40 10.8 8 1.2 0.15
H 50 11.6 10 0.8 0.08
I 62 12.0 12 0.4 0.02
J 76 11.7 14 0.3 -0.02
Production Function
14
15. Plotting the MPP Curve
Page 91
Change in output
associated with a
change in inputs
Change from A to B on
the production function
→ a MPP of 0.33
15
Data from previous table
16. Page 91
Plotting the MPP Curve
16
Q of
Output
Q of
Input0
∆I*
MPP = Slope of the line
tangent at a
point (A) on the
TPP curve
= ∆Q*/∆I*
A
∆Q*
17. Page 91
Plotting the MPP Curve
17
Q of
Output
Q of
Input0
∆I*
At A, MPP = ∆Q/∆I
= 0/∆I* = 0
A
TPP is at a maximum
when MPP = 0
18. Page 89
Point
Labor
[1]
Output
[2]
∆Labor
[3]
∆Output
[4]
APP
[6] = [2] ÷
[1]
A 10 1.0 ----- ----- 0.10 -----
B 16 3.0 6 2 0.19
C 20 4.8 4 1.8 0.24
D 22 6.5 2 1.7 0.30
E 26 8.1 4 1.6 0.31
F 32 9.6 6 1.5 0.30
G 40 10.8 8 1.2 0.27
H 50 11.6 10 0.8 0.23
I 62 12.0 12 0.4 0.19
J 76 11.7 14 0.3 0.15
Production Function
Average Physical
Product (APP) =
Amount of
output ÷ amount
of inputs used
= Output/unit of
input used
18
19. Page 89
Total Physical Product (TPP) Curve
APP = .31 (= 8÷26)
with labor use = 26
Output
Input
19
Data from previous table
20. Page 91
Plotting the APP Curve
APP = output level
divided by level of
input use
Output divided
by labor use at
B (3 ÷ 16) =0.19
20
Data from previous table
21. Page 91
Plotting the APP Curve
21
Q of
Output
Q of
Input
0
A
Q*
I*
APP = Q*/I*
= Slope of the line from
the origin to the point
on the TPP curve
At I**, APP is at a maximum,
as line OB is just tangent
to the TPP curve
I**
B
22. Page 91
Relationship Between APP and MPP
22
MPP
APP
Q of
Output
Q of
Input
0
APP is at a maximum at
input level where APP = MPP
I*
APP*
23. Page 91
Definition of the Three Stages of Production
APP is increasing in Stage I
Stage I: MPP > APP
APP is ↑
23
26. Page 91
The Three Stages of Production
26
MPP
APP
Stage I Stage II
Stage III
Q of
Output
Q of
Input
0
Stage II starts at input use where APP is
at a maximum (pt A)
Stage II ends at input where MPP = 0 (or
TPP is at a maximum)
27. Page 91
The Three Stages of Production
27
MPP
APP
Stage I Stage II
Stage III
Q of
Output
Q of
Input
0
Why are using the amount of input in
Stage I and Stage III of production
irrational from the producer’s perspective?
28. Page 91
The Three Stages of Production
28
MPP
APP
Stage I Stage II
Stage III
Q of
Output
Q of
Input
0
Average productivity is increasing as more
inputs are being used so why stop if the
average return is greater than cost?
Can increase output by using
less inputs: →More output and
less cost
29. Page 91
The Three Stages of Production
29
MPP
APP
Stage I Stage II
Stage III
Q of
Output
Q of
Input
0
The producer’s economic question:
What level of input amount contained in
Stage II should the I use to maximize profits?
30. 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
30
31. Key Cost Relationships
The following cost concepts play key
roles in determining where in Stage II a
producer will want to produce
Total Variable Cost (TVC) = the total value
of costs that change with the level of output
(e.g. energy costs, labor costs, material
costs, etc.)
Total Fixed Cost (TFC) = total value of costs
that do not changed with the level of output
(e.g. property taxes)
Total Costs (TC) = the sum of total variable
and fixed costs
TC = TVC + TFC
Page 94-9631
32. 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 =
∆TC/∆Q = ∆TVC/∆Q
Average Variable Cost (AVC) = total variable
cost of production ÷ total amount of output
produced = TVC/Q
Page 94-9632
33. 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 = TFC/Q
Average Total Cost (ATC) = total cost of
production ÷ total amount of output
produced = TC/Q = AVC + ATC
Page 94-9633
40. Page 94
Change in Total Cost
(Col. 4 or 6) associated
with a change in output
(Col. 1)
40
41. Page 94
[Total Cost (Col. 6) ÷ by Total
Output (Col. (1)] or [Avg. Variable
Cost + Avg. Fixed Cost]
41
42. Let’s Graph the Above
Cost Items Contained
in the Previous Table
42
43. Page 95
Table 6.3 Cost Relationships
0
10
20
30
40
50
60
70
3.0 4.8 6.5 8.1 9.6 10.8 11.6
MC ATC
AVC AFC
MC = min(ATC) and
min(AVC)
Vertical distance between
ATC and AVC = AFC
Input Use
Cost($)
43
AFC
44. Key Revenue Concepts
The following revenue concepts play key roles in
determining where in Stage II a producer will
want to produce
Total Revenue (TR) =Multiplication of total
amount of output produced by the sale price ($)
Average Revenue (AR) = Total revenue ÷ total
amount of output produced ($/unit of output) =
TR/Q
Marginal Revenue (MR) = ∆ total revenue ÷ ∆
total amount of output produced = ∆TR ÷ ∆Q
How much revenue is generated by one additional
unit of output?
Under perfect competition, it is the per unit price
44
46. Page 98
Remember we are assuming perfect competition
The firm takes price as given
Price (Col. 2) = MR (Col. 7)
What is the AR value?
Key Revenue Concepts
46
47. Page 98
With perfect competition, where would the
firm maximize profit in the above example?
Profit Maximization
47
50. 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….
Profit Maximization
50
51. Profit at Price of $45?
28
P =45
$
Q11.2
MC
ATC
AVC
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
51
52. Profit at Price of $45?
28
P =45
$
Q11.2
MC
ATC
AVC
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
$190.40
52
59. Page 99
We know that so long as P (= MR) > AVC
some of the fixed costs can be covered
Better economic position then shutting down
altogether, WHY?
We know that when P (= MR)=MC, the
firm maximizes profit
Portion of MC curve defined by output
level that generates the minimum AVC is
referred to as the firm’s supply curve
The Firm’s Supply Curve
59
61. Now let’s look at the
demand for a single
input: Labor
61
62. Key Input Relationships
The following input-related derivations play
key roles in determining amount of variable
input to use to maximize profits
Marginal Value Product (MVP) =
MPP × Product Price
MPP → ∆Output ÷ ∆Input Use
Product Price → ∆Revenue ÷ ∆Output
MVP → ∆Revenue ÷ ∆Input Use
(Additional output value generated by
the last increment in input use)
Marginal Input Cost (MIC) = wage rate,
rental rate, seed cost, etc. Page 100
62
64. Page 101
5
B
C
D
E
F
G
H
I
J
Profit maximizing input use rule
Use a variable input up to the
point where
Value received from another
unit of input (MVP)
Equals cost of another unit of
input (MIC)
→ MVP=MIC
64
67. Page 100Profit are maximized where MVP = MIC
or where MVP =$5 and MIC = $567
68. Page 100
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor
MIC (Col. 4) = Value of additional output from last
unit of input net of the cost of that input
=–
68
69. Page 100
The cumulative net benefit (Col. 6) of input use
= the sum of successive marginal net benefits (Col. 5)
= the grey area in previous graph.69
72. Page 101
5
B
C
D
E
F
G
H
I
J
If you stopped at point E on the MVP curve,
for example, you would be foregoing all of the
potential profit lying to the right of that point
up to where MVP=MIC.
72
73. Page 101
5
B
C
D
E
F
G
H
I
J
If you use labor beyond the
point where MVP =MIC, you
begin incurring losses as the
return to another unit of
labor is < $5.00, its per unit
cost
73
74. A Final Thought
One final relationship needs to be made. The level
of profit-maximizing output (OMAX) in the graph on
page 99 where MR = MC corresponds directly with
the variable input level (LMAX) in the graph on page
101 where MVP = MIC.
Going back to the production function on page 88,
this means that:
OMAX = f(LMAX | capital, land and management)
74
75. In Summary…
Features of perfect competition
Factors of production (Land, Labor,
Capital and Management)
Key decision rule: Profit maximized at
output MR=MC
Key decision rule: Profit maximized
where MVP=MIC
75
76. Chapter 7 focuses on the choice
of inputs to use and products to
produce….
76
