Theory of Production and cost.pdf

7/27/2019 Theory of Production and cost.pdf

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Broad types of businesses organizations

Proprietorship

Partnership

Corporations


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What is a firm?Specialized organization devoted tomanaging the process of production

Produce goods or services

Raise resources

Manage and coordinate production process

Why do firms exist?

Transaction cost (Ronald Coase, 1937)-specificassets, contractual issues, hold up problems

Horizontal and vertical boundaries of firms


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1. Produce maximum output from given levelof inputs (technical efficiency)

2. Produce at least cost (cost efficiency), givenThe output level

Price of inputs

3. Supply output that maximize profit

Firms objectives


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Production function


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Cost min. subject to output level


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Production with one variable input


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Production with one variable input

Labour(L) Total output AP MP

0 0 - -

1 10 10 10

2 30 15 20

3 60 20 304 80 20 20

5 95 19 15

6 108 18 13

7 112 16 4

8 112 14 0

9 108 12 -4

10 100 10 -8


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Product curves

A

B

C

D

Labour

Output

Labour

AP, MP

112

60

2 4 8

E

Stage I Stage II Stage III

80

303


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Relationship between AP and MP


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Technology improvement/Change in K

Labour

Output

A

B

C

L1L2 L3

Q3Q2

Q1


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Returns to scale (all inputs are variable)


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Short run costs


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Relationship between short runproduction and short run costs


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The shapes of the cost curves

Output

Cost

A

Fixed cost

Variable cost

Total cost

B


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The shapes of the cost curves

Output

Cost

AFC

MC

ATC

AVC


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Relationship between AC and MC


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If MC > ATC, then ATC is rising.

If MC = ATC, then ATC is at its low point.

If MC < ATC, then ATC is falling.

If MC > AVC, then AVC is rising.

If MC = AVC, then AVC is at its low point.If MC < AVC, then AVC is falling.

Relationship between Average and

Marginal costs


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Long run cost curves

Output

Cost

LRMC

LRAC

A


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Long run AC falls if economies of scale

Long run AC rises if diseconomies of scale

Reasons for economies of scale:

Specialization and IRS

Cheaper inputs, loans

Lower advertising cost/marketing cost

Reasons for diseconomies of scale Inefficient management and coordination issue

Bulk effect disappears

Specialization effect disappears and DRS

Economies of scale


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Cost elasticity and economies of scale


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IRS: LRAC exhibits economies of scale

CRS: LRAC is constant as output increases

DRS: LRAC exhibits diseconomies of scale

Returns to scale and cost


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1. Assume that the marginal cost of production is

increasing. Can you determine whether the averagevariable cost is increasing or decreasing? Explain.

2. Assume that the marginal cost of production is greaterthan the average variable cost. Can you determine whetherthe average variable cost is increasing or decreasing?Explain.

3. If the firms average cost curves are U-shaped, why doesits average variable cost curve achieve its minimum at alower level of output than the average total cost curve?

Exercise

Theory of Production and cost.pdf

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