THEORY OF PRODUCTION AND COST

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THEORY OF PRODUCTION AND COST
Production is the use of factors of production to
produce and market goods and services. Inputs
include the broad categories of land, labor,
capital, other intermediate inputs and
entrepreneurship. In a mixed economy, both firms
and governments organize the production of
various goods and services.
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Production in the Short-run
An input that cannot vary in quantity during the
relevant time period is called a fixed input or
fixed factor. An input having a quantity that can
change during the relevant time period is called
a variable input or variable factor. The
short-run is a period of time such that there is
at least one fixed factor. The long-run is a
period of time such that all inputs are variable
in quantity.
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• A production function summarizes the relationship
  between all combinations of inputs and the
  corresponding maximum attainable levels of
  output, for a given technology.
• The total product, TP, of a variable input is the
  amount of output produced over the period when
  that input is used with fixed quantities of all
  other inputs.
• The marginal product of an input F, MPF, is the
  additional output per unit increase in the input,
  holding all other inputs (and technology)
  constant

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Diminishing marginal product As more of a
variable input is employed, with the quantities
of all other inputs held constant, the marginal
product of the variable input will decline after
some point.

• Diminishing marginal product results from the
  process of adding additional units of a variable
  input to given quantities of other inputs.

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Measuring costs and profits
Total (Economic) Cost is the monetary value of
all inputs used in a particular activity over a
given period. Explicit Costs correspond to the
monetary payments for inputs. Implicit Costs are
the opportunity costs of inputs that have no
explicit monetary payments as a result of the
inputs not being purchased in markets. All
opportunity costs, both explicit and implicit,
are part of economic costs.
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Measuring costs
Economic depreciation is the reduction in the
value of a capital good over the relevant period
that results from wear and tear as well as
obsolescence. Accounting depreciation measures
the annual accounting cost of capital, expressed
as some portion of the capitals monetary
cost. Accounting costs measure the explicit
costs of production during a given period plus
accounting depreciation.
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Measuring costs and profits
Total revenue is the explicit monetary return
associated with an economic activity over a given
period. Economic activities can also yield
implicit returns. The total return includes both
total revenues and implicit returns.
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Economic and accounting profits are defined
below
Total return Total revenue less less
explicit costs explicit costs economic
depreciation accounting depreciation other
implicit costs Economic Profits Accounting
Profits
Economic profits measure the net (private)
economic gain resulting from an economic
activity. When economic profits are zero the
returns to owner supplied inputs exactly equal
the opportunity costs of those inputs. These
returns are called normal profits.
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• Related Cost Measures
• Variable cost, VC, is the cost of the variable
  input(s) used to produce any given level of
  output.
• Fixed costs, FC, is the cost of all fixed inputs.
• Total cost, TC, is the sum of the costs of all
  inputs used to produce output during the period
• TC VC FC.

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Example of Potato Production (The price of
fertilizer is 50 per unit and the costs
associated with fixed input 40.)
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• Related Cost Measures
• Marginal cost, MC, is the increase in total or
  variable cost per unit increase in output, Q

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• Average variable cost, AVC, is the variable cost
  of production per unit of output
• Average fixed cost, AFC, is the fixed cost per
  unit of output
• Average cost, AC, is the total cost of all inputs
  per unit of output

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Family of Average Costs
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Marginal Cost
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Note the relationship between MP and MC.
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• The marginal cost of output directly depends upon
  the marginal product and price of each variable
  input

For example, if MPL 0.5 widgets per hour and
the wage rate is a constant 10.00 per hour, MC
(10 per hour) / (0.5 widgets per hour)
20 per widget . Intuition If MPL 0.5, it
takes two hours of work to create one widget.
With a wage of 10 per hour, this translates into
a marginal cost of 20.00 for an additional
widget.
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• Implications
• An increase in the price of a variable input,
  ceteris paribus, will result in an increase in
  the marginal cost of output.
• Holding the input price constant, an increase in
  the marginal product of a variable input will
  cause MC to decrease.
• Often we talk about MC increasing as output
  increases (after some point). The underlying
  reason is diminishing marginal product of the
  variable input(s).

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Total-Cost Curve...(Another Example)
16.00
Total-cost curve
14.00
12.00
10.00
Total Cost
8.00
6.00
4.00
2.00
0.00
2
4
6
8
10
12
0
Quantity of Output
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Average-Cost and Marginal-Cost Curves...
3.50
3.00
2.50
2.00
Costs
1.50
1.00
0.50
0.00
2
4
6
8
10
12
0
Quantity of Output
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Relationship Between Marginal Cost and Average
Variable Cost

• Whenever MC is greater than AVC, AVC will be
  rising.
• Whenever MC is less than AVC, AVC will be falling.

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Relationship Between Marginal Cost and Average
Total Cost
3.50
3.00
2.50
2.00
Costs
1.50
1.00
0.50
0.00
0
2
4
6
8
10
12
Quantity of Output
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Relationship Between Marginal Cost and Average
Total Cost

• Whenever MC is less than ATC, ATC will be
  falling.
• Whenever MC is greater than ATC, ATC will be
  rising.

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Average-Cost and Marginal-Cost Curves...
3.50
3.00
2.50
2.00
Costs
1.50
1.00
0.50
0.00
2
4
6
8
10
12
0
Quantity of Output
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Cost Curves and Their Shapes

• The average total-cost curve is U-shaped.
• At very low levels of output ATC is high because
  fixed cost is spread over only a few units.
• ATC initially declines as output increases
  because of the decline in AFC.
• ATC eventually starts to rise because AVC rises
  substantially.

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Total-Cost Curve...
16.00
Total-cost curve
14.00
12.00
10.00
Total Cost
8.00
6.00
4.00
2.00
0.00
2
4
6
8
10
12
0
Quantity of Output
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Big Bobs Cost Curves...
20.00
18.00
Total Cost Curve
16.00
14.00
12.00
Total Cost
10.00
8.00
6.00
4.00
2.00
0.00
0
2
4
6
8
10
12
14
16
Quantity of Output
(bagels per hour)
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Big Bobs Cost Curves...
3.5
3
2.5
2
Costs
1.5
1
0.5
0
0
2
4
6
8
10
12
14
16
Quantity of Output
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Big Bobs Cost Curves...
3.5
3
2.5
2
Costs
1.5
1
0.5
0
0
2
4
6
8
10
12
14
16
Quantity of Output
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Big Bobs Cost Curves...
3.5
3
2.5
2
Costs
1.5
1
0.5
0
0
2
4
6
8
10
12
14
16
Quantity of Output
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Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity
  of output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the
  average-total-cost and average-variable-cost
  curves at their minimums.

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Cost Curves and Their Shapes

• The bottom of the U-shape AC curve corresponds to
  the quantity that minimizes the average cost of
  production.
• This quantity is sometimes called the efficient
  scale of the firm.
• The marginal-cost curve crosses the
  average-total-cost curve at the efficient scale.

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Costs in the Long Run

• For many firms, the division of total costs
  between fixed and variable costs depends on the
  time horizon being considered.
• In the short run some costs are fixed.
• In the long run fixed costs become variable costs.

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Average Total Cost in the Short and Long Runs...
Average
Total
Cost
0
Quantity of
Cars per Day
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Economies and Diseconomies of Scale

• Economies of scale occur when long-run average
  total cost declines as output increases.
• Diseconomies of scale occur when long-run average
  total cost rises as output increases.
• Constant returns to scale occur when long-run
  average total cost does not vary as output
  increases.

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Economies and Diseconomies of Scale
Average
Total
Cost
0
Quantity of
Cars per Day