PRODUCTION and COSTSBY GOWRISHANKKAR.V DIVYA.S

Econ 11-UPLB

Theory of Production and Costs

FocusFocus- mainly on the the firm. firm. We will examineIts production capacity given available resources the related costs involved

What is a firm?

A firm is an entity concerned with the purchase and employment of resources in the production of various goods and services. Assumptions:

the firm aims to maximize its profit with the use of resources that are substitutable to a certain degree the firm is" a price taker in terms of the resources it uses.

The Production Function

The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time.

Firms Inputs

Inputs - are resources that contribute in the production of a commodity. Most resources are lumped into three categories:Land, Labor, Capital.

Fixed vs. Variable Inputs

Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.

Production Analysis with One Variable Input

Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

(TPL MPL ! (L

Total vs. Marginal Product

Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus. paribus.

(TPX MPX ! (X

Production Function of a Rice FarmerUnits of L 0 1 2 3 4 5 6 7 8 9 10 Total Product (QL or TPL) 0 2 6 12 20 26 30 32 32 30 26 Marginal Product (MPL) 2 4 6 8 6 4 2 0 -2 -4

QL

32 30 26 Total product QL

20

12

6 2

L0 1 2 3 4 5 6 Labor 7 8 9 10

FIGURE 5.1. Total product curve. The total product curve shows the behavior of total product vis-a-vis an input (e.g., labor) used in production assuming a certain technological level.

Marginal Product

The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula:

(TPL MPL ! (L

Marginal Product

Observe that the marginal product initially increases, reaches a maximum level, and beyond this point, the marginal product declines, reaches zero, and subsequently becomes negative. The law of diminishing returns states that "as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease"

Total and Marginal Product35 30 25 20 15 10 5 0 0 -5 -10 1 2 3 4 5 6 7 8 9

TPL

MPL

Law of Diminishing Marginal Returns

As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish. CounterCounter-intuitive proof: if the law of diminishing returns does not hold, the worlds supply of food can be produced in a hectare of land.

Average Product (AP)

Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used.

The "productivity" of an input is usually expressed in terms of its average product. The greater the value of average product, the higher the efficiency in physical terms.

Formula:

TPL APL ! L

TABLE 5.2.Labor (L)

Average product of labor.Total product of labor (TPL) Average product of labor (APL)

0 1 2 3 4 5 6 7 8 9 10

0 2 6 12 20 26 30 32 32 30 26

0 2 3 4 5 5.2 5 4.5 4 3.3 2.6

The slope of the line from the origin is a measure of the AVERAGE Y

rise Y Slope = ! run L

a

b

Y

Rise = Y

0

Run = L

L1

L2

L

Total Product Q

The average product at b is highest. AP at c is less than at a. AP at d is less than at c.b c d QL a

0

L

Q

Highest Slope of Line from OriginMax APL

Inflection pointMax MPL

TPL

0

L1

L2

L3

L

Relationship between Average and Marginal Curves: Rule of Thumb

When the marginal is less than the average, the average decreases. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum) When the marginal is greater than the average, the average increases

Relationship between Average and Marginal Curves: Example of Econ 11 Scores

When the marginal score (new exam) is less than your average score, the average decreases. When the marginal score (new exam) is equal to the average score, the average does not change. When the marginal score (new exam) is greater than your average score, the average increases.

AP,MP

At Max AP, MP=AP

Max MPL Max APL

APL

0

L1

L2

L3MPL

L

TP

TPL

0Stage I

L1MP>AP AP increasing

L2Stage IIMP