Introduction to Production and Resource Use Chapter 6

Topics of Discussion Conditions of perfect competition Classification of inputs Important production relationships (assume one variable input in this chapter) Assessing short-run business costs Economics of short-run decisions

Conditions for Perfect Competition Homogeneous products No barriers to entry or exit Large number of sellers Perfect information Page 86

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 Management: production decisions designed to achieve specific economic goal Pages 86-87

Production Function Output = f(labor | capital, land, and management) Start with one variable input Page 88

Production Function Output = f(labor | capital, land, and management) Start with one variable input assume all other inputs fixed at their current levels… Page 112

Coordinates of input and output on the TPP curve Page 89

Total Physical Product (TPP) Curve Variable input Page 89

Law of Diminishing Marginal Returns “As successive units of a variable input are added to a production process with the other inputs held constant, the marginal physical product (MPP) eventually declines” Page 93

Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Pages 90

Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Average Physical = Output ÷ Input Pages 90-91

Change in output as you increase inputs Page 89

Marginal physical product is .45 as labor is increased from 16 to 20 Total Physical Product (TPP) Curve Marginal physical product is .45 as labor is increased from 16 to 20 output input Page 89

Output per unit input use Page 89

Average physical product is .31 if Total Physical Product (TPP) Curve Average physical product is .31 if labor use is 26 output input Page 89

Plotting the MPP curve Page 91 Change in output associated with a change in inputs Page 91

Marginal Physcial Product Change from point A to point B on the production function is an MPP of 0.33 Page 91

Plotting the APP Curve Page 91 Level of output divided by the level of input use Page 91

Average Physical Product Output divided by labor use is equal to 0.19 Page 91

Three Stages of Production Average physical product (yield) is increasing in Stage I Page 91

product falls below the Three Stages of Production Marginal physical product falls below the average physical product in Stage II Page 91

Three Stages of Production MPP goes negative in stage III… Page 91

Three Stages of Production Why are Stage I and Stage III irrational? Page 91

Productivity rising so why stop??? Three Stages of Production Productivity rising so why stop??? Output falling Page 91

The question therefore is where should I operate in Stage II? Three Stages of Production The question therefore is where should I operate in Stage II? Page 114

Economic Dimensions We need to account for the price of the product We also need to account for the cost of the inputs

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Page 117-120

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Page 117-120

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost fixed = total fixed cost ÷ output total = total cost ÷ output = AVC+AFC Pages 94-96

From TPP curve on page 113 Page 94

Fixed costs are $100 no matter the level of production Page 94

Column (2) divided by column (1) Page 94

Costs that vary with level of production Page 94

Column (4) divided by column (1) Page 94

Column (2) plus column (4) Page 94

Change in column (6) associated with a change in column (1) Page 94

Column (6) divided by column (1) or Page 94

or column (3) plus column (5) Page 94

Let’s graph the cost series in this table

Plotting costs for levels of output Plotted cost relationships from table 6.3 on page 94 Plotting costs for levels of output Page 95

Now let’s assume this firm can sell its product for $45/unit

Key Revenue Concepts Page 98 Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition. Page 98

Let’s see this in graphical form

$45 11.2 Page 99 Profit maximizing level of output, where MR=MC P=MR=AR Profit maximizing level of output, where MR=MC 11.2 Page 99

Average Profit = $17, or AR – ATC P=MR=AR $45-$28 $28 Page 99

11.2  ($45 - $28) = $190.40 Grey area represents total economic profit if the price is $45… P=MR=AR 11.2  ($45 - $28) = $190.40 Page 99

Firm would only produce output OBE . AR-ATC=0 P=MR=AR Zero economic profit if price falls to PBE. Firm would only produce output OBE . AR-ATC=0 Page 99

Economic losses if price falls to PSD. Firm would shut down P=MR=AR Economic losses if price falls to PSD. Firm would shut down below output OSD Page 99

Where is the firm’s supply curve? P=MR=AR Page 99

Marginal cost curve above AVC curve? P=MR=AR Page 99

Key Revenue Concepts Page 98 The previous graph indicated that profit is maximized at 11.2 units of output, where MR ($45) equals MC ($45). This occurs between lines G and H on the table above, where at 11.2 units of output profit would be $190.40. Let’s do the math…. Page 98

Doing the math…. Produce 11.2 units of output (OMAX on p. 123) Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00

Doing the math…. Produce 11.2 units of output Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00 Average total cost at 11.2 units of output = $28 Total costs = 11.2 × $28 = $313.60 Profit = $504.00 – $313.60 = $190.40

Doing the math…. Produce 11.2 units of output Price of product = $45.00 Total revenue = 11.2 × $45 = $504.00 Average total cost at 11.2 units of output = $28 Total costs = 11.2 × $28 = $313.60 Profit = $504.00 – $313.60 = $190.40 Average profit = AR – ATC = $45 – $28 = $17 Profit = $17 × 11.2 = $190.40

Profit at Price of $45? $ 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 MC P =45 ATC 28 AVC 11.2 Q

Profit at Price of $45? $190.40 $ 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 MC P =45 $190.40 ATC 28 AVC 11.2 Q

Price falls to $28.00…. Produce 10.3 units of output (OBE on p. 123) Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40

Price falls to $28.00…. Produce 10.3 units of output Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40 Average total cost at 10.3 units of output = $28 Total costs = 10.3 × $28 = $288.40 Profit = $288.40 – $288.40 = $0.00

Price falls to $28.00…. Produce 10.3 units of output Price of product = $28.00 Total revenue = 10.3 × $28 = $288.40 Average total cost at 10.3 units of output = $28 Total costs = 10.3 × $28 = $288.40 Profit = $288.40 – $288.40 = $0.00 Average profit = AR – ATC = $28 – $28 = $0 Profit = $0 × 10.3 = $0.00

Profit at Price of $28? $ Revenue = $28  10.3 = $288.40 Total cost = $28  10.3 = $288.40 Profit = $288.40 – $288.40 = $0 Since P = MR = AR Average profit = $28 – $28 = $0 Profit = $0  10.3 = $0 (break even) MC 45 ATC P=28 AVC 10.3 11.2 Q

Price falls to $18.00…. Produce 8.6 units of output (OSD on p. 123) Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80

Price falls to $18.00…. Produce 8.6 units of output Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80 Average total cost at 8.6 units of output = $28 Total costs = 8.6 × $28 = $240.80 Profit = $154.80 – $240.80 = – $86.00

Price falls to $18.00…. Produce 8.6 units of output Price of product = $18.00 Total revenue = 8.6 × $18 = $154.80 Average total cost at 8.6 units of output = $28 Total costs = 8.6 × $28 = $240.80 Profit = $154.80 – $240.80 = – $86.00 Average profit = AR – ATC = $18 – $28 = – $10 Profit = – $10 × 8.6 = – $86.00

Profit at Price of $18? $ Revenue = $18  8.6 = $154.80 Total cost = $28  8.6 = $240.80 Profit = $154.80 – $240.80 = -$86 Since P = MR = AR Average profit = $18 – $28 = –$10 Profit = –$10  8.6 = –$86 (Loss) MC 45 ATC 28 AVC P=18 8.6 10.3 11.2 Q

Price falls to $10.00…. Produce 7.0 units of output (below OSD on p. 123) Price of product = $10.00 Total revenue = 7.0 × $10 = $70.00

Price falls to $10.00…. Produce 7.0 units of output Price of product = $10.00 Total revenue = 7.0 × $10 = $70.00 Average total cost at 7.0 units of output = $30 Total costs = 7.0 × $30 = $210.00 Profit = $70.00 – $210.00 = – $140.00 Average variable costs = $19 Total variable costs = $19 × 7.0 = $133.00 Revenue – variable costs = –$63.00 !!!!! (not covering variable costs)

Profit at Price of $10? $ Revenue = $10  7.0 = $70.00 Total cost = $30  7.0 = $210.00 Profit = $70.00 – $210.00 = $140.00 Since P = MR = AR Average profit = $10 – $30 = –$20 Profit = –$20  7.0 = –$140 Average variable cost = $19 Variable costs = $19  7.0 = $133.00 Revenue – variable costs = –$63 Not covering variable costs!!!!!! MC 45 ATC 28 AVC 18 P=10 7.0 8.6 10.3 11.2 Q

The Firm’s Supply Curve $ MC 45 ATC 28 AVC 18 P=10 8.6 10.3 11.2 Q 7.0

Now let’s look at the demand for a single input: Labor

Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product Page 100

Key Input Relationships The following input-related derivations also play a key role in decision-making: Marginal value = marginal physical product × price product (MVP) input = wage rate, rental rate, etc. cost (MIC) Page 100

D Wage rate represents the MIC for labor C B E F G 5 I H J Page 101

Use a variable input like labor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC D C B E F G 5 I H J Page 101

Page 101 The area below the green lined MVP curve and above the red lined MIC curve represents cumulative net benefit. C B E F G 5 I H J Page 101

MVP = MPP × $45 Page 100

Profit maximized where MVP = MIC or where MVP =$5 and MIC = $5 Page 100

= – Marginal net benefit in column (5) is equal to MVP in column (3) minus MIC of labor in column (4) Page 100

The cumulative net benefit in column (6) is equal to the sum of successive marginal net benefit in column (5) Page 100

For example… $25.10 = $9.85 + $15.25 $58.35 = $25.10 + $33.25 Page 100

– = Cumulative net benefit is maximized where MVP=MIC at $5 Page 100

D 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. C B E F G 5 I H J Page 101

D If you went beyond the point where MVP=MIC, you begin incurring losses. C B E F G 5 I H J Page 101

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)

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