Production n Cost Analysis

8/8/2019 Production n Cost Analysis

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Analysis of Production and

Cost


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Introduction

In the supply process, people firstoffer their factors of production tothe market.

Then the factors are transformed byfirms into goods that consumers

want. Production is the name given to that

transformation of factors into goods


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What is a firm?

A firm is an entity concerned with the purchaseand employment of resources in the productionof various goods and services

The firm is an economic institution thattransforms factors of production into consumergoods it: Organizes factors of production. Produces goods and services.

Sells produced goods and services.

Assumptions:

the firm aims to maximize its profit with the use ofresources that are substitutable to a certaindegree

"


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The Production Function

Theproduction function refers to thephysical relationship between the inputsor resources of a firm and their output of

goods and services at a given period oftime, ceteris paribus.

Theproduction function

tells themaximum amount of output that can bederived from a given number of inputs.


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Firms Inputs

Inputs - are resources that contributein the production of a commodity.

Most resources are lumped into threecategories: Land,

Labor, Capital.


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Fixed vs. Variable Inputs

Fixed inputs -resources used at a constantamount in the production of acommodity.

Variable inputs - resources that canchange in quantity depending on thelevel of output being produced.

The longer planning the period, the

distinction between fixed and variableinputs disappears, i.e., all inputs arevariable in the long run.


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The Production Process

The production process can bedivided into the long run and theshort run.


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The Long Run and the ShortRun

A long-run decision is a decision inwhich the firm can choose amongall possible production techniques.

A short-run decision is one inwhich the firm is constrained in

regard to what production decisionit can make.


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The Long Run .

The terms long run and short run do notnecessarily refer to specific periods oftime.

They refer to the degree of flexibility

the firm has in changing the level ofoutput.

In the long run, all inputs are variable.

In the short run, some inputs are fixed.


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Production Tables andProduction Functions

Aproduction table shows theoutput resulting from variouscombinations of factors of

production or inputs.


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Production Analysis with One VariableInput

Total product, Average product,marginal product

Stages of production


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Total product

Total product (Q) refers to the totalamount of output produced in physicalunits (may refer to, kilograms of sugar,

sacks of rice produced, etc)

Total Product (TPx) = total amount ofoutput produced at different levels of

inputs


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Production Function of a RiceFarmer

Units of LUnits of L Total ProductTotal Product

(Q(QLL or TPor TPLL))00 00

11 22

22 66

33 1212

44 202055 2626

66 3030

77 3232

88 3232

99 3030

1010 2626


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L

QL

QL

2

6

12

20

26

30

32

Labor

To

ta

l

pro

duc

t

0 2 4 6 8 1097531


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Marginal Product

Marginal productis the additionaloutput that will be forthcoming from anadditional worker, other inputs

remaining constant Formula:

L

L

TPMP

L

=


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Production Function of a RiceFarmer

Units of LUnits of L Total ProductTotal Product

(Q(QLL or TPor TPLL))Marginal ProductMarginal Product

(MP(MPL)L)00 00

11 22

22 66

33 1212

44 202055 2626

66 3030

77 3232

88 3232

99 3030

1010 2626


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Draw Marginal ProductCurve

MPL


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Marginal Product

Marginal product initially increases,reaches a maximum level, and beyondthis point, the marginal product declines,reaches zero, and subsequentlybecomes negative.


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Average Product (AP)

Average product is a concept commonlyassociated with efficiency.

The averageproductmeasures the totaloutput per unit of input used.

The "productivity" of an input is usuallyexpressed in terms of its averageproduct.

The greater the value of average product,the higher the efficiency in physicalterms.

Formula:

L

L

TPAP

L=


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Average product of labor.Labor (L) Total product of labor

(TPL)

Average product oflabor (AP

L)

0 01 2

2 6

3 12

4 20

5 26

6 30

7 32

8 32

9 30

10 26


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Draw Average ProductCurve

MPL


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Law of Diminishing MarginalReturns

As more and more of an input isadded (given a fixed amount ofother inputs), total output may

increase; however, as the additionsto total output will tend to diminish.

Counter-intuitive proof: if the law of

diminishing returns does not hold,the worlds supply of food can beproduced in a hectare of land.


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Relationship between Average andMarginal Curves: Rule of Thumb

When the marginal is less than theaverage, the average decreases.

When the marginal is equal to theaverage, the average does notchange (it is either at maximum orminimum)

When the marginal is greater thanthe average, the average increases


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L

,AP MP

Max APLMax MPL

0 L1L2 L3

MPL

APL

,At Max AP=MP AP


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L

,AP MP

0 L1L2 L3

MPL

APL

tage I>MP AP

AP increasing

tage II


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Three Stages of Production

In Stage I

APL is increasing so MP>AP.

All the product curves are increasing

Stage I stops whereAPLreaches its

maximum at pointA.

MP peaks and then declines at point C

and beyond, so the law ofdiminishing returns begins tomanifest at this stage


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Stage II starts where theAPLof the input

begins to decline.

QLstill continues to increase,although at a decreasing rate, andin fact reaches a maximum

Marginal product is continuouslydeclining and reaches zero at point

D, as additional labor inputs areemployed.


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qStage III starts where the MPL hasturned negative.

all product curves are decreasing.

total output starts falling even as theinput is increased


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COSTS OF PRODUCTION

Opportunity Cost Principle- the economiccost of an input used in a productionprocess is the value of output sacrificed

elsewhere. The opportunity cost of aninput is the value of foregone income inbest alternative employment.

Implicit vs. Explicit Costs

Explicit costs costs paid in cash Implicit cost imputed cost of self-owned or

self employed resources based on theiropportunity costs.


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7 Cost Concepts (Short-run)

1.Total Fixed Cost (TFC)

2.Total Variable Cost (TVC)

3.Total Cost (TC=TVC+TFC)

4.Average Fixed Cost (AFC=TFC/Q)

5.Average Variable Cost (AVC=TVC/Q)

6.Average Total Cost (AC=AFC+AVC)7.Marginal Cost (MC= AVC/Q


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Short Run Analysis

Total fixed cost(TFC) is morecommonly referred to as "sunkcost" or "overhead cost." Examples: include the payment or

rent for land, buildings andmachinery.

The fixed cost is independent of thelevel of output produced.

Graphically, depicted as ahorizontal line


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Short Run Analysis

Total variable cost(TVC) refers tothe cost that changes as theamount of output produced is

changed. Examples - purchases of raw

materials, payments to workers,electricity bills, fuel and power

costs.Total variable cost increases as the

amount of output increases. If no output is produced, then total

variable cost is zero; the lar er the out ut the reater the


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Short Run Analysis

Total cost(TC) is the sum of totalfixed cost and total variable cost

TC=TFC+TVC

As the level of output increases, total

cost of the firm also increases.


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Total Costs of Production

Units ofLabor TotalProduct TotalFixedCost

TotalVariableCost

TotalCost MarginalCost AverageCost

L TPL TFC TVC

0 0 100 01 6 100 302 10 100 50

3 12 100 604 13 100 65

5 15 100 75

6 19 100 95

7 25 100 125

8 33 100 165

9 43 100 215

10 55 100 275


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Q0

TFC

(Total Fixed Cost)

Pesos

TVC

(Total Variable Cost)

TC(Total Cost)

TOTAL COST CURVES


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Q0

AFC

(Average Fixed Cost)

Pesos

AFC=TFC/Q.

As more output is produced, theAverage Fixed Cost decreases.


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Q0

Pesos

TVC(Total Variable Cost)

q1

The Average VariableCost at a point on theTVC curve is measured

by the slope of the linefrom the origin to that

point.

AVC=TVC/Q

Minimum AVC


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Average Costs of Production

(Q) (TC)0 1001 1302 1503 160

4 1655 175

6 195

7 225

8 265

9 315

10 375


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Average Costs of Production

TotalProduct(Q)

TotalVariableCost (AVC)

AverageVariableCost (AVC)

0 01 302 503 60

4 655 75

6 95

7 125

8 165

9 215

10 275


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Q0

Pesos

MCq1

Inflectionpoint

TVC(Total Variable Cost)

q1

AVC


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Q0

Pesos

AVC

(Average Variable Cost)

q1

The Average Variable Cost is Ushaped. First it decreases, reaches a

minimum and then increases.

Minimum AVC


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Q0

Pesos

AVC

q1

MC

AFC

AC

The PER UNIT COST CURVES


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LongR

unTota

lCost

LTC LTC

QTotal Product

All inputs are variable in the longrun. There are no fixed costs.

LONG-RUN TOTAL COST CURVE


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The LAC

The LAC curve is an envelop curve ofall possible plant sizes. Also knownas planning curve

It traces the lowest average cost ofproducing each level of output.

It is U-shaped because of

Economies of Scale Diseconomies of Scale


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LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE


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LAC

Q0

COST

SAC1

q0


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LAC

Q0

COST

SAC1

q0

SAC2

Building a larger sized plant (size2) will result in a lower averagecost of producing q0


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LAC

Q0

COST

SAC1

q0

SAC2

Likewise, a larger sized plant(size 3) will result to a loweraverage cost of producing q

1

q1

SAC3

E i d Di i f


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Economies and Diseconomies ofScale

Economies of Scale- long runaverage cost decreases as outputincreases.

Technological factors Specialization

Diseconomies of Scale: - long run

average cost increases as outputincreases. Problems with management

becomes costly, unwieldy


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LAC

SAC1

Q0

COST

SAC2

LONG-RUN AVERAGE COST CURVE

Q1

Economies of

Scale

Diseconomies of Scale


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LAC

SAC1

Q0

COST

-ONG RUN AVERAGE nd ARGINAL COSTCURVES

Q1

LMC

SMC1

SMC2

SAC2


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LAC and LMC

Long-run Average Cost (LAC) curve

is U-shaped.

the envelope of all the short-run

average cost curves; driven by economies and

diseconomies of size.

Long-run Marginal Cost (LMC) curve Also U-shaped;

intersects LAC at LACs minimumpoint.

Perfectly Competitive


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Perfectly CompetitiveMarket

A p e rfe ctly co m p e titiv e m a rke t h a s th e:fo llo w in g ch a ra cte ristics

.There are many buyers and sellers in the market

The goods offered by the various sellers are largely the.same .Firms can freely enter or exit the market Firms are price takers


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TR = (P Q)

AR = TR = P x Q = Price Q Q

MR =

TR/

Q = Price

Revenue of a competitive firm


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Revenue of a competitive firm

Quantity(Q)

Price(P)

Total revenue(TR = P X Q)

Averagerevenue(AR = TR/Q)

Marginalrevenue(MR = /R Q)

1 lawn $20 $ 20

2 20 40

3 20 60

4 20 80

5 20 100

6 20 120

7 20 140

8 20 160


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Profit maximisation

Profit maximisation occurs at thequantity where marginal revenueequals marginal cost.

When MR > MC, increase Q

When MR < MC, decrease Q

When MR = MC, profit is maximised


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Quantity(Q)

Totalrevenue

(TR)

Total cost(TC)

Profit(TR TC)

Marginalrevenue(MR = /R Q)

Marginalcost(MC =

TC/Q)

0 lawns $ 0 $ 101 20 14

2 40 22

3 60 34

4 80 50

5 100 70

6 120 94

7 140 122

8 160 154

Profit maximisation


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Profit maximisation

-opyright 2004 South Westernuantity0

CostsandRevenueMC

ATC

AVC

MC 1

Q1

MC 2

Q2

The firm maximisesprofit by producing

the quantity at whichmarginal cost equals

.marginal revenue

Q MAX

P= MR 1= MR 2 P= AR= MR

The firms short run


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The firm s short-rundecision to shut down

A shutdown refers to a short-rundecision not to produce anythingduring a specific period of time

because of current marketconditions.

- Shut down if TR < VC- Shut down if TR/Q < VC/Q

- Shut down if P < AVC

The competitive firms short


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The competitive firm s shortrun supply curve

MC

Quantity

ATC

AVC

0

Costs

Firmshuts

down ifP< AVC

Firm -s short runsupply curve

If P > ,AVCfirmwill continue to

produce in the.short run

If P > ATC, thefirm will

continue toproduce at a

.profit

The firms long-run decision to


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The firm s long-run decision toexit or enter a market

In the long run, the firm exits if therevenue it would get fromproducing is less than its total

cost. Exit if TR < TC Exit if TR/Q < TC/Q

Exit if P < ATC A firm will enter the industry if such an

action would be profitable.

The firms long run decision to


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The firm s long-run decision toexit or enter a market

In the long run, the firm exits ifthe revenue it would get from

producing is less than its totalcost.

A firm will enter the industry ifsuch an action would be

profitable.Exit if TR < TC Enter if TR > TC

Exit if TR/Q < TC/Q Enter if TR/Q > TC/Q

Exit if P < ATC Enter if P > ATC

The competitive firms long-run


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The competitive firm s long-runsupply curve

= -MC long run S

Firmexits if

P ATC


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Supernormal Profit

-opyright 2004 South Western

( ) A firm with profits

Quantity0

Price

P= AR = MR

ATCMC

P

ATC

Q

( - )profit maximising quantity

Profit


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Subnormal Profit

-opyright 2004 South Western

( ) A firm with losses

Quantity0

Price

ATCMC

( - )loss minimising quantity

P= AR = MRP

ATC

Q

Loss

The competitive firms


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The competitive firm slong-run equilibrium

At the end of the process of entryand exit, firms that remain mustbe making zero economic profit.

The process of entry and exit endsonly when price and averagetotal cost are driven to equality.

Long-run equilibrium must havefirms operating at their efficientscale.

Question: In perfectly competitive industry


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the goods demand function D = 7000 500Pand supply function S = 4000 + 250P. Given

the following Q and TC, find out the breakeven point.

Quantity Total Cost

0 40

10 100

20 130

30 150

40 16050 170

60 185

70 210


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Question

In a perfectly competitive market,

Demand function Qd = 20000 400P Supply function Qs = 14000 + 200P What is the price charged by a member

firm having a cost function TC = 100

+ 50Q?


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Question

There are 100 firms, with identicalcost functions, in a perfectlycompetitive industry. The demand

function for the industry isestimated to be Qd = 2000 200P.

If the cost function of a firm is TC

= 200 50Q+2Q2

Find out the equilibrium price.


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Question

The market supply and demandfunctions for a product are given by Qs = 3000 + 20P

Qd = 13500 50P The industry supplying the product is

perfectly competitive. An individualfirm has Fixed cost of Rs. 500 perperiod. Its average variable costfunction is AVC = 150 18Q + Q2.

What is the maximum profit that can

Production n Cost Analysis

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