Theory of Production & Cost BEC Managerial Economics

Fundamental questions… How can production be optimized? How can cost be minimized? How does output behave when quantity of inputs is increased? How can the least-cost combination of inputs be achieved? What does happen to the rate of return when more plants are added? How does technology matter in reducing the cost of production? 2

Why production and cost??? Profit through managing the revenue is more interesting and exciting. Managers may enjoy time spent on revenue decisions. In a competitive market scenario; – Profitability fairly depends on optimization of production and minimization of costs. – Managers may find internalization of profitability is easier than externalization. 3

Some basic concepts of production theory… Fixed and variable inputs – Fixed inputs (Ex: buildings, machinery) Economic sense – supply is inelastic in the short run Technical sense – remains constant for a certain level of output Quasi-fixed inputs - unlike the fixed inputs, this can be avoided and cost is zero if the firm chooses to produce nothing – Variable inputs (Ex: raw materials, labour, fuel) Economic sense – supply is elastic in the short run Technical sense – changes with the change in output 4

Some basic concepts of production theory… 5

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Technical and economic efficiency – Technical efficiency Production of the maximum level of output that can be obtained from a given combination of inputs – Economic efficiency Production of a given amount of output at the lowest possible cost 7

Production in the short run Units of capital (K) Units of labour (L)

Total, Average & Marginal Product of Labour (with capital fixed at 2 units) No. of workers (L) Total product (TP) Average product (AP = Q/L) Marginal product (MP = ∆Q/∆L)

Average & Marginal Products 10

11 Total, average and marginal product curves (with capital fixed at 2 units)

Law of Diminishing Marginal Product Number of units of the variable input increases, a point will be reached beyond which the marginal product decreases Other inputs held constant Increasing, diminishing and negative marginal product situations 12

Short run cost of production 13

Short run total costs Output (Q) Total fixed cost (TFC) Total variable cost (TVC) Total cost (TC = TFC + TVC) 0 $ 6,000 $ 0 $ 6, ,0004,00010, ,000 12, ,0009,00015, ,00014,00020, ,00022,00028, ,00034,00040, TVC changes with the output but depends on the usage of variable inputs (labour).

Short run average and marginal costs Output (Q) Average fixed cost (AFC = TFC/Q) Average variable cost (AVC = TVC/Q) Average total cost (ATC = TC/Q) Short run marginal cost (SMC = ∆TC/∆Q) $ 6040 $ 100 $

Short run average and marginal cost curves 16 SMC curve crosses AVC and ATC curves at their respective minimum points. So, AVC and ATC falling when SMC is less than those.

Relationship between short run production and costs Short run productionShort run costs Labour (L) Output (Q) Total variable cost (TVC = wL) Total fixed cost (TFC = rK) Total cost (TC = wL + rK) 000 $ 6, $ 4,0006,00010, ,000 12, ,0006,00015, ,0006,00020, ,0006,00028, ,0006,00040, Assumptions Wage rate (w) = $ 1,000 per worker, Cost of capital (r) = $ 2,000 per unit

Average and marginal relations between cost and production Short run productionShort run costs LQAPMPAVCSMC $

AVC and AP 19

SMC and MP 20

21 Assume a wage rate of $21 First consider the product and cost curves over the range of 0 to 500 units of labour. MP lies above AP, so AP is rising. Because, SMC is inversely related to MP (SMC = w/MP) and AVC is inversely related to AP (AVC = w/AP) MP is maximized (9 units of output) and SMC is minimized to $ 2.33 (21/9) at the usage of 500 units of labour and 3,250 units (6.5 x 500) of output. Now consider the product and cost curves over the range of 500 to 800 units of labour. As MP falls SMC rises. But, AP rises as MP is still greater than AP and AVC falls as SMC is still less than AVC.

Implications for managers… Relations between production and cost curves in the short run involves the effect of the law of diminishing marginal product on the marginal cost of production. In the above example; – At 800 units of labour and 5,600 units of output, both SMC and AVC are equal ($3) and AVC reaches its minimum. – Beyond this point AP begins to decrease but never becomes negative. However, MP eventually becomes negative. So…what’s your decision? 22

Production and cost in the long run Increase in the scale of operations – Need to increase the amount of capital employed – Variability of all factors of production with the output change Economies of scale Economies of scope – Reduce the cost of one good by becoming the producer of other related goods in production Related diversification Mergers and acquisitions 23

Production Isoquants A curve showing all possible combinations of inputs physically capable of producing a given fixed level of output. 24

Marginal Rate of Technical Substitution 25

Isocost Curves 26

Isocost Curves 27

Optimal combination of inputs 28

Output optimization and cost minimization 29

Optimization and cost Expansion path gives the efficient (least-cost) input combinations for every level of output – Derived for a specific set of input prices – Along expansion path, input-price ratio is constant & equal to the MRTS 30

Expansion path 31