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R. Larry Reynolds 1997

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 97 Principles of Microeconomics Slide -- 2

Production and Cost

Production is a technical relationship between a set of inputs or resources and a set of outputs or goods.

QX = 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(QX {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 97

Principles of Microeconomics

Slide -- 3

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 97

Principles of Microeconomics

Slide -- 4

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 persons 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 97

Principles of Microeconomics

Slide -- 5

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 97 Principles of Microeconomics Slide -- 6

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 [ P] represents the cost of entrepreneurial activity
normal profit includes risk
Fall 97 Principles of Microeconomics Slide -- 7

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 97 Principles of Microeconomics Slide -- 8

QX = f(L, K, R, technology, . . . )
QX = 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 QX. 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 97 Principles of Microeconomics Slide -- 9

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 97 Principles of Microeconomics Slide -- 10

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.

QX = f(L, K, R, . . . ) technology is constant

Fall 97 Principles of Microeconomics Slide -- 11

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. QX = f(L) Technology, K and R are fixed or constant.
Fall 97 Principles of Microeconomics Slide -- 12

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 97 Principles of Microeconomics Slide -- 13

Production in the Short Run

Consider a production process where K, R and technology are fixed: As L is changed, the output Production of Good X changes, QX= f(L)
L = labour input TPL = QX = output of good X APL = average product [TP/L] MPL = Marginal product [DTP/ DL]

TPL

APL

MPL

DL = 1

0 1

0 0 DTPL=4 4 4 10 5 20 6.67 25 6.25 29 32 5.8 5.3

-4 6

TPL output APL = = Efficiency = L input Maximum of APL is at the 3 input of labour.
Fall 97 Principles of Microeconomics

TPL L = APL = AP = L L L DTPL MPL = DL

2
3 4

10
5 4 3 2 1

5 6
7 8 9

34 4.87 35 4.37 35 3.89

Slide -- 14

Production in the Short Run

APL = TPL output = L input

= Efficiency of
labour

Production of Good X

Notice that the APL 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 APL , 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 [APL ] declines.

L 0 1 2 3 4 5 6 7 8 9

TPL 0 4 10

APL 0 4 5 6.67 6.25 5.8 5.3

MPL

-4 6 10 5 4 3 2 1 0

20
25 29 32

34 4.87 35 4.37 35 3.89

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Principles of Microeconomics

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Graphically TPL can be shown:

TPL initially increases at an increasing rate; it is convex from below.
Maximum 30 output 25 20

35

Output, QX

15

10
5

. . . . . . . . . .
After some point it then increases at a decreasing rate and reaches a maximum level of output, and declines
5 6 7 8 1 2 3 4

L 0 1 2 3 4 5 6 7 8 9

TPL

TPL

0 4
10 20 25 29 32

34
35 35
Slide -- 16

Labour

Fall 97

Principles of Microeconomics

Given the TP , the APL can calculated: APL = TPL = output = Efficiency of L labour input

TPL

APL

0 4
10 20

0 1
2 3 4 5 6

0
4 5 6.67 6.25 5.8 5.3

APL
10

8
6 4

.
1

. . . .. .
2 3 4 5 6 7

25

..
Labour
8 9

29 32 34 35

7 4.87 8 4.37

APL

35

9 3.89

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Principles of Microeconomics

Slide -- 17

35 30

25 20

15
10 5 4 0 8 6 4

The APL is the slope of a ray from the origin to the TPL .

APL 10

. .
1

.
2

.
3

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. . . . . . .. .
4 5 6 7

. . .
Z M H Labour
8 9

Output, QX

. .

1 unit of L produces 4Q, APL is 4/1 = 4 or the slope of line 0H. 2 units of L produces 10Q, APL is 10/2 = 5 or the slope of line 0M. 3 units of L produces 20Q, APL is 20/3 = 6.67 or the slope of line 0Z. 4 units of L produces 25Q,

Graphically the relationship between APL and TPL can be shown:

TPL

APL is 25/4 = 6.25 or

the slope of line 0W.

As additional units of L are added, the AP falls. The maximum AP is where APL the ray with the greatest slope is tangent to the TP.
Slide -- 18

5Principles 6 7 8 9 of Microeconomics

Labour

35 30

25 20

15
10 5 4 0 8

APL 10
6

MPL = APL

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. . . . . . . . . . . .. . . .. . . . . .
1 2 3 4 5 6 7 8 9 2 3 4

MPL was calculated as the change in TPL given a change in L. The first unit of labour added 4 units of output. Between the 1st and 2cd units of labour, Q increases by 6.

Output, QX

. .

Given TPL , the APL was calculated and graphed.

Labour Note: Where MPL = APL, APL is a maximum.

at between units of L. 5Principles 6 7 8 9 of Microeconomics Slide -- 19

.
Labour

TPL

L
0 1 2

MP APL L

TPL
0 4-0 4 10 20 25

-0
4 4 5 6 10 6.67 5 6.25 4 5.8 3 5.3 2 4.87 1 4.37

3
4

5
6

29
32 34 35

7 8

0 9 3.89 35 APL MPL Remember: MP is graphed

.
5 6 7

35 30

25 20

15
10 5 4 0 8 6

APL 10

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. . . . . . . . . . . .. . . .. . . . . .
1 2 3 4 2 3 4

.
Labour

Output, QX

. .

5Principles 6 7 8 9 of Microeconomics

Useful things to notice:

1. MPL is the slope of TPL. 2. When TPL increases at an increasing rate, MPL increases. At the inflection point in the TPL , MPL is a maximum. When TPL increases at a decreasing rate, MPL is decreasing.

TPL

3. The APL is a maximum when: a. MPL = APL , b. the slope of the 8 9 ray from origin is tangent to Labour TPL .

4. When MPL > APL the APL is increasing. When MPL < APL the APL is decreasing.

APL MPL

5. When MPL is 0, the slope of TPL is 0, and TP is a maximum.

Slide -- 20

Summary: TPL , MPL and APL In many production processes Q initially increases at an increasing rate. This is due to Z TPL
At the inflection point

TPL

division of labour and a better mix of the variable input with the fixed inputs.

As Q [TPL ]increases at an increasing rate, MP increases. As Q [TPL ]increases at a decreasing rate, MPL decreases.
Where 0Z is tangent to TPL , APL is a maximum; APL = MPL .

Diminishing marginal product

0 MPL APL

MPL is a max

L
{MP< AP, AP falls}

When TPL is a maximum, MPL is zero. When TPL is decreasing, MPL is

negative.
Fall 97

APL
MPL L 1 L2 L3
Slide -- 21

{MP> AP, AP rises}

Principles of Microeconomics

PRODUCTION
LABOUR 0 KAPITAL OUTPUT MP AP

To calculate AP: APL =

0 0 = ? 8 1 = 8 23 2 = 11.5 42 3 = 14 574 = 14.25 67 5 = 13.4

TPL L

1
2 3

DL= 1 5 DL= 1
5 5

8
23 42

DL= 1 DL= 1 5 DL= 1 5 DL= 1 5

5 5 5 5

4
5 6 7 8 9 10

57
67 74 79 82 83 82

DTPL = 8 8 DTP8.0 L = 15 11.5 15DTP L = 19 19 14.0 DTPL = 15 15DTP 14.25 L = 10 10 DTP 13.4 L= 7 7 12.33 5 11.28 3 10.25 1 9.22 -1 8.2

AP is a maximum when L = 4.
Note that MP is 15 between 3rd & 4th units of L, it is 10 between 4th & 5th, so it equals AP = 14.25 at L=4.

MP is a maximum between 2cd and 3rd unit of L.

Fall 97 Principles of Microeconomics

To calculate MP: DTPL MPL = DL

Slide -- 22

PRODUCTION
LABOUR 0 1 2 3 4 5 6 7 8 9 10 KAPITAL OUTPUT 5 5 5 5 5 5 5 5 5 5 5 0 8 23 42 57 67 74 79 82 83 82 MP AP

8 15 19 15 10 7 5 3 1 -1

0 8.0 11.5 14.0 14.25 13.4 12.33 11.28 10.25 9.22 8.2

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.

Diminishing Marginal Productivity begins with the 4rth unit of L.

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Output per worker decreases after the 4th worker. Too many workers for K, R & tech, MP< AP.

Principles of Microeconomics

Slide -- 23

The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6 per unit. Calculate the cost functions for this production process. TFC = PK x K = $6K = 6 x5 = $30, This cost does not change in the short run. TVC = PL x L = $4L, as L changes TVC and Output change.
PRODUCTION AND COST
LABOUR KAPITAL OUTPUT AP MP -TFC TVC

TC = TVC+TFC
TC AFC AVC ATC

= 0 x $4 5 = 1 x $4 5

8
23 42 57 67 74 79 82 83 82

8
11.5 14 13.4 12.33 11.28 10.25 9.22 8.2

8
15 19 10 7
5

= 2 x $4 5
= 3 x $4 5 = 4 x $4 5 = 5 x $4 5
6 7 8 9 10
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14.25 15

$30 + $ 0 + $4 $30 =$30 + $8 $30 =$34 + $12 $30 =$38

5 5 5 5 5

$30 =$42 + $16 $30 =$46 + $20 =$50 $30 + $24 =$54 $30 + $28 $30 =$58 + $32 $30 =$62 + $36 $30 =$66 + $40 =$70
Slide -- 24

3 1 -1

Principles of Microeconomics

The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6 per unit. Calculate the cost functions for this production process. AFC = TFCQ = $30Q AVC = TVC Q
LABOUR KAPITAL OUTPUT AP MP -TFC

ATC = AVC + AFC = TCQ

PRODUCTION AND COST

TVC TC AFC AVC ATC

0 8 23 42 57 67 74 79 82 83 82

0 8 11.5 14
14.25 13.4 12.33 11.28

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

8 15 19 15 10 7 5 3 1 -1

$30
$30 $30

$0 $4 $8 $12 $16 $20 $24 $28 $32 $36 $40

$30 $34 $3.75 $ .50 $4.25 $38 $1.30 $ .35 $1.65 $42 $ .71 $ .29 $1.00 $46 $ .53 $ .28 $.81 $50 $ .45 $ .30 $.75 $54 $ .41 $ .32 $.729 $58 $62 $66 $70
$ .38 $ .37 $ .36 $ .37 $ .35 $.734 $ .39 $.76 $ .43 $.79 $ .49 $.86
Slide -- 25

$30
$30 $30 $30 $30 $30 $30 $30

10.25
9.22 8.2

Principles of Microeconomics

Things to note . . .
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.}
LABOUR KAPITAL OUTPUT AP MP -TFC

As AP increases, AVC decreases.

Since AFC declines, it will pull the ATC down as Q increases beyond the minimum of the AVC.

PRODUCTION AND COST

TVC TC AFC AVC ATC

5 5 5 5 5 5 5 5

0 8 23 42 57 67 74 79

0 8 11.5 14 14.25 13.4 12.33 11.28

1 2 3 4 5 6 7 8 9 10
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8 15 19 15 10 7 5

$30
$30 $30

$0 $4 $8 $12 $16 $20 $24 $28 $32 $36 $40

$30 $34 $3.75 $ .50 $4.25 $38 $1.30 $ .35 $1.65 $42 $ .71 $ .29 $1.00 $46 $ .53 $ .28 $.81 $50 $ .45 $ .30 $.75 $54 $ .41 $ .32 $.729 $58 $62 $66 $70
$ .38 $ .37 $ .36 $ .37 $ .35 $.734 $ .39 $.76 $ .43 $.79 $ .49 $.86
Slide -- 26

$30
$30 $30 $30 $30 $30 $30 $30

5
5 5

82
83 82

10.25
9.22 8.2

1
-1

Principles of Microeconomics

TPL is Q TPL
When TP or Q increases at an increasing rate,

Z
L2 x PL

TVC = L x PL
TVC increases at a decreasing rate.

TVC

TPL

L2 x PL L1 x PL

Q* is the output with the lowest AVC! [Max AP]

At L1 [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. At L2 the AP is a maximum; output per worker is a maximum, maximum efficiency; additional units of labour are less productive. At L3 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.
Fall 97 Principles of Microeconomics Slide -- 27

L1 L2

L3

Q*

MPL APL APL

The average variable cost [AVC] and marginal cost [MC] are mirror images of the AP and MP functions.

APL

APL

MPL
L1 L2
MC =

MPL

L3

1 AVC = x PL AP

AVC APL x L2 Q
Slide -- 28

Fall 97

Principles of Microeconomics

APL

MPL

1 x PL MP

L $

The maximum of the AP is consistent with the minimum of the AVC.

MC AVC

MC will intersect the AVC at the minimum of the AVC [always].

ATC
ATC* AVC* R

AVC
MC will intersect the ATC at the minimum of the ATC. The vertical distance between ATC and AVC at any output is the AFC. At Q** AFC is RJ.

TC = ATC* x Q**
TVC = AVC* x Q*

Q* Q** Q At Q* output, the AVC is at a minimum AVC* [also max of APL]. At Q** the ATC is at a MINIMUM.

Fall 97

Principles of Microeconomics

Slide -- 29

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 97

Principles of Microeconomics

Slide -- 30

LONG RUN COSTS

MC1

ATC! MC2

Plant ATC* is the optimal size!

LRMC ATC5 ATC6

ATC2

ATC3

ATC* ATC*

Cmin

For Plant size 1, the costs are ATC1 and MC1 : For a bigger Plant 2, the unit costs move out and down. It is more cost effective. As bigger plants are built the ATC moves out and down. Eventually, the plant size is too large, the ATC moves out but also up! An envelope curve is constructed to represent the long run AC [LRAC].

Q*

There is a long run marginal cost function. At Q* the cost per unit are minimized [the least inputs used].

LRAC

Fall 97

Principles of Microeconomics

Slide -- 31

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 97

Principles of Microeconomics

Slide -- 32

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.
Fall 97 Principles of Microeconomics Slide -- 33