This is a PowerPoint presentation on the production process and associated costs. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to exit the presentation, the escape key will do it! R. Larry Reynolds  1997

Fall ‘ 97Principles of MicroeconomicsSlide -- 2 Production ·Production is an activity where resources are altered or changed and there is an increase in the ability of these resources to satisfy wants. ·change in physical characteristics ·change in location ·change in time ·change in ownership

Fall ‘ 97Principles of MicroeconomicsSlide -- 3 Production and Cost ·Production is a technical relationship between a set of inputs or resources and a set of outputs or goods. Q X = f( inputs [land, labour, capital], technology,... ) [Legal and social/cultural institutions influence the production function.] ·Cost functions are the pecuniary relationships between outputs and the costs of production; Cost = f(Q X {inputs, technology}, prices of inputs,... ) ·Cost functions are determined by input prices and production relationships. It is necessary to understand production functions if you are to interpret cost data.

Fall ‘ 97Principles of MicroeconomicsSlide -- 4 Costs ·Costs are incurred as a result of production. The important concept of cost is opportunity cost [marginal cost]. These are the costs associated with an activity. When inputs or resources are used to produce one good, the other goods they could have been used to produce are sacrificed. ·Costs may be in real or monetary terms; ·implicit costs ·explicit costs

Fall ‘ 97Principles of MicroeconomicsSlide -- 5 Implicit Costs ·Opportunity costs or MC should include all costs associated with an activity. Many of the costs are implicit and difficult to measure. ·A production activity may adversely affect a person’s health. This is an implicit cost that is difficult to measure. ·Another activity may reduce the time for other activities. It may be possible to make a monetary estimate of the value.

Fall ‘ 97Principles of MicroeconomicsSlide -- 6 Explicit Costs ·Explicit costs are those costs where there is an actual expenditure in a market. The costs of labour or interest payments are examples. ·Some implicit costs are estimated and used in the decision process. Depreciation is an example.

Fall ‘ 97Principles of MicroeconomicsSlide -- 7 Normal Profit ·In neoclassical economics, all costs should be included: ·wages represent the cost of labour ·interest represents the cost of Kapital ·rent represents the cost of land ·“normal profit [  ]” represents the cost of entrepreneurial activity ·normal profit includes risk

Fall ‘ 97Principles of MicroeconomicsSlide -- 8 Production Function ·A production function expresses the relationship between a set of inputs and the output of a good or service. ·The relationship is determined by the nature of the good and technology. ·A production function is “like” a recipe for cookies; it tells you the quantities of each ingredient, how to combine and cook, and how many cookies you will produce.

Fall ‘ 97Principles of MicroeconomicsSlide -- 9 QX QX = f(L, K, R, technology,... ) Q X = quantity of output L = labour input K = Kapital input R = natural resources [land] Decisions about alternative ways to produce good X require that we have information about how each variable influences Q X. One method used to identify the effects of each variable on output is to vary one input at a time. The use of the ceteris paribus convention allows this analysis. The time period used for analysis also provides a way to determine the effects of various changes of inputs on the output.

Fall ‘ 97Principles of MicroeconomicsSlide Technology ·The production process [and as result, costs] is divided up into various time periods; ·the “very long run” is a period sufficiently long enough that technology used in the production process changes. ·In shorter time periods [long run, short run and market periods], technology is a constant.

Fall ‘ 97Principles of MicroeconomicsSlide Long Run ·The long run is a period that: ·is short enough that technology is unchanged. ·all other inputs [labour, kapital, land,... ] are variable, i.e. can be altered. ·these inputs may be altered in fixed or variable proportions. This may be important in some production processes. ·If inputs are altered, the output changes. ·Q X = f(L, K, R,... ) technology is constant

Fall ‘ 97Principles of MicroeconomicsSlide Short Run ·The short run is a period in which at least one of the inputs has become a constant and at least one of the inputs is a variable. ·If kapital [K] and land [R] are fixed or constant in the short run, labour [L] is the variable input. Output is changed by altering the labour input. Q X = f(L) Technology, K and R are fixed or constant.

Fall ‘ 97Principles of MicroeconomicsSlide Market Period ·When Alfred Marshall included time into the analysis of production and cost, he included a “market period” in which inputs, technology and consequently outputs could not be varied. ·The supply function would be perfectly inelastic in this case.

Fall ‘ 97Principles of MicroeconomicsSlide Production in the Short Run Consider a production process where K, R and technology are fixed: As L is changed, the output changes, Q X = f(L) L = labour input TP L = Q X = output of good X AP L = average product [TP/L] MP L = Marginal product [  TP/  L] Production of Good X LAP L MP L TP L 00 AP L = TP L L AP L = TP L L 4 MP L =  TP L LL  L = 1  TP L = AP L = TP L L 5 MP L =  TP L LL AP L = TP L L = output input = Efficiency Maximum of AP L is at the 3 input of labour.

Fall ‘ 97Principles of MicroeconomicsSlide Production in the Short Run AP L = TP L L = output input Efficiency of labour = Production of Good X LAP L MP L TP L Notice that the AP L increases as the first three units of labour are added to the fixed inputs of K and R. The maximum efficiency of Labour or maximum AP L, given our technology, plant and natural resources is with the third worker. As additional units of labour are added beyond the third worker the output per worker [AP L ] declines.

Fall ‘ 97Principles of MicroeconomicsSlide L TP L Labour Output, Q X Graphically TP L can be shown: TP L TP L initially increases at an increasing rate; it is convex from below. After some point it then increases at a decreasing rate and reaches a maximum level of output, Maximum output and declines

Fall ‘ 97Principles of MicroeconomicsSlide Labour Given the TP, the AP L can calculated: AP L = TP L L = output input Efficiency of labour = L TP L AP L AP L

Fall ‘ 97Principles of MicroeconomicsSlide unit of L produces 4Q, 4 AP L is 4/1 = 4 or the slope of line 0H. H rise/run = 4 2 units of L produces 10Q, AP L is 10/2 = 5 or the slope of line 0M. M rise/run = 5 3 units of L produces 20Q,. AP L is 20/3 = 6.67 or the slope of line 0Z. Z 4 units of L produces 25Q,. AP L is 25/4 = 6.25 or the slope of line 0W. W As additional units of L are added, the AP falls Labour Output, Q X Labour TP L... AP L Graphically the relationship between AP L and TP L can be shown: 0 AP L The AP L is the slope of a ray from the origin to the TP L. The maximum AP is where the ray with the greatest slope is tangent to the TP. Z

Fall ‘ 97Principles of MicroeconomicsSlide Labour Output, Q X Labour TP L... AP L Given TP L, the AP L was calculated and graphed. AP L TP L MP L was calculated as the change in TP L given a change in L. MP L The first unit of labour added 4 units of output Remember: MP is graphed at “between” units of L. “ Between” the 1st and 2cd units of labour, Q increases by MP L Note: Where MP L = AP L, AP L is a maximum. MP L = AP L

Fall ‘ 97Principles of MicroeconomicsSlide Labour Output, Q X Labour TP L... AP L MP L Useful things to notice: 1. MP L is the slope of TP L. 2. When TP L increases at an increasing rate, MP L increases. At the inflection point in the TP L, MP L is a maximum. When TP L increases at a decreasing rate, MP L is decreasing. 3. The AP L is a maximum when: a. MP L = AP L, b. the slope of the ray from origin is tangent to TP L. 4. When MP L > AP L the AP L is increasing. When MP L < AP L the AP L is decreasing. 5. When MP L is 0, the slope of TP L is 0, and TP is a maximum. Z

Fall ‘ 97Principles of MicroeconomicsSlide Summary: TP L, MP L and AP L MP L AP L TP L L L In many production processes Q initially increases at an increasing rate. This is due to division of labour and a “better” mix of the variable input with the fixed inputs. TP L As Q [ TP L ] increases at an increasing rate, MP increases. As Q [ TP L ] increases at a decreasing rate, MP L decreases. MP L At the inflection point Diminishing marginal product MP L is a max Where 0Z is tangent to TP L, AP L is a maximum; AP L = MP L. 0 Z AP L When TP L is a maximum, MP L is zero. Whe n TP L is decreasing, MP L is negative. {MP> AP, AP rises} {MP< AP, AP falls} L1L1 L2L2 L3L3

Fall ‘ 97Principles of MicroeconomicsSlide To calculate AP: AP L = TP L L 0  0 = ? 8  1 =  2 =  3 =  4 =  5 = To calculate MP: MP L =  TP L LL  L= 1  TP L = 8 8  L= 1  TP L =  L= 1  TP L =  L= 1  TP L =  L= 1  TP L =  L= 1  TP L = AP is a maximum when L = 4. MP is a maximum between 2cd and 3rd unit of L. Note that MP is 15 between 3rd & 4th units of L, it is 10 between 4th & 5th, so it equals AP = at L=4.

Fall ‘ 97Principles of MicroeconomicsSlide PRODUCTION LABOURKAPITALOUTPUT MPAP As L is added to production process, output per worker [AP] increases. to a maximum “efficiency” [output/input which occurs at L = 4. MP increases to a max between the 2cd & 3rd units of L. When MP > AP the output per worker is increasing. Division of Labour and a more efficient mix of L, K & R causes AP to increase. Output per worker decreases after the 4th worker. “Too many” workers for K, R & tech, MP< AP. Diminishing Marginal Productivity begins with the 4rth unit of L.

Fall ‘ 97Principles of MicroeconomicsSlide The price of labour [P L ] is $4 per unit and the price of kapital [P K ] is $6 per unit. Calculate the cost functions for this production process. TFC = P K x K = $6K = 6 x5 = $30, This cost does not change in the short run. $30 TVC = P L x L = $4L, as L changes TVC and Output change. x $4 = $ 0 $ 4 $ 8 $12 $16 $20 $24 $28 $32 $36 $40 TC = TVC+TFC + =$30 + =$34 + =$38 + =$42 + =$46 + =$50 + =$54 + =$58 + =$62 + =$66 + =$70

Fall ‘ 97Principles of MicroeconomicsSlide PRODUCTION AND COST LABOURKAPITALOUTPUTAPMPTFCTVCTCAFCAVCATC The price of labour [P L ] is $4 per unit and the price of kapital [P K ] is $6 per unit. Calculate the cost functions for this production process. $30 $ 0 $ 4 $ 8 $12 $16 $20 $24 $28 $32 $36 $40 $30 $38 $42 $46 $50 $54 $58 $62 $66 $70 $34 AFC = TFC  Q = $30  Q $3.75 $1.30 $.71 $.53 $.45 $.41 $.38 $.37 $.36 $.37 AVC = TVC  Q $.50 $.35 $.29 $.28 $.30 $.32 $.35 $.39 $.43 $.49 ATC = AVC + AFC = TC  Q $4.25 $1.65 $1.00 $.81 $.75 $.729 $.734 $.76 $.79 $.86

Fall ‘ 97Principles of MicroeconomicsSlide PRODUCTION AND COST LABOURKAPITALOUTPUTAPMPTFCTVCTCAFCAVCATC $30 $ 0 $ 4 $ 8 $12 $16 $20 $24 $28 $32 $36 $40 $30 $38 $42 $46 $50 $54 $58 $62 $66 $70 $34 $3.75 $1.30 $.71 $.53 $.45 $.41 $.38 $.37 $.36 $.37 $.50 $.35 $.29 $.28 $.30 $.32 $.35 $.39 $.43 $.49 $4.25 $1.65 $1.00 $.81 $.75 $.729 $.734 $.76 $.79 $.86 Things to note... As AP increases, AVC decreases. When AP is a maximum, AVC is a minimum. AFC declines so long as Q or output increases. {Up to the point where TP becomes negative.} Since AFC declines, it will “pull” the ATC down as Q increases beyond the minimum of the AVC.

Fall ‘ 97Principles of MicroeconomicsSlide TP L L TP L L 1 At L 1 [inflection point] the MP is a maximum; the point of Diminishing Marginal productivity begins, each additional worker increases output, but at a smaller and smaller amount. 0 Z L 2 At L 2 the AP is a maximum; output per worker is a maximum, “maximum efficiency;” additional units of labour are less “productive.” L 3 At L 3 the TP is a maximum; this is the maximum amout of output [Q] that can be produced given the size of the plant [fixed input K]. Additional [marginal] L is negative. TP L is Q TP L TP L = Q Q TVC = L x P L L x P L = TVC TVC [a mirror image] When TP or Q increases at an increasing rate, TVC increases at a decreasing rate. L 1 x P L [ a mirror image] TVC 0 Z’ L 2 x P L Q* Q* is the output with the lowest AVC! [Max AP] L 2 x P L

Fall ‘ 97Principles of MicroeconomicsSlide MP L AP L L MP L AP L L3L3 The average variable cost [AVC] and marginal cost [MC] are “mirror” images of the AP and MP functions. L1L1 L2L2 L3L3 Q $ AP L MP L AP L MP L MC AVC MC = 1 MP x P L AVC = 1 AP x P L AP L AP L x L 2 AVC The maximum of the AP is consistent with the minimum of the AVC.

Fall ‘ 97Principles of MicroeconomicsSlide Q $ MC AVC MC will intersect the AVC at the minimum of the AVC [always]. Q* At Q* output, the AVC is at a minimum AVC* [also max of AP L ]. AVC* TVC = AVC* x Q* ATC Q** ATC* MC will intersect the ATC at the minimum of the ATC. TC = ATC* x Q** At Q** the ATC is at a MINIMUM. The vertical distance between ATC and AVC at any output is the AFC. At Q** AFC is RJ. R J

Fall ‘ 97Principles of MicroeconomicsSlide The Long Run ·The long run is a period of time where: ·technology is constant ·All inputs are variable ·The long run period is a series of short run periods. [For each short run period there is a set of TP, AP, MP, MC, AFC, AVC, ATC, TC, TVC & TFC for each possible scale of plant]

Fall ‘ 97Principles of MicroeconomicsSlide LONG RUN COSTS $ Q For Plant size 1, the costs are ATC 1 and MC 1 : ATC ! MC 1 For a bigger Plant 2, the unit costs move out and down. It is more cost effective. ATC 2 MC 2 As bigger plants are built the ATC moves out and down. ATC 3 ATC* Eventually, the plant size is “too large,” the ATC moves out but also up! ATC 5 ATC 6 An “envelope curve” is constructed to represent the long run AC [LRAC]. LRAC There is a long run marginal cost function. LRMC Plant ATC* is the optimal size! ATC* At Q* the cost per unit are minimized [the least inputs used]. Q* C min

Fall ‘ 97Principles of MicroeconomicsSlide The LRAC ·LRAC is “U-Shaped” ·The LRAC initially decreases due to “economies of scale” ·economies of scale are due to division of labour. ·Eventually, “diseconomies of scale” begin ·usually lack of adequate information to manage the production process

Fall ‘ 97Principles of MicroeconomicsSlide Calculation of LRAC ·With a little mathematics, the long run cost functions can be calculated. ·It is easier to use equations rather than tables and graphs. ·If consumer behavior, production and cost is understood, you can then think about how to achieve your objectives.