PRODUCTION and COSTS

Economics 11
University of the Philippines
Los Banos

Econ 11-UPLB
 Note:
The contents of this presentation
are found in Chapter 5 of the
textbook.
 Theory of Production and Costs
Focus- mainly on the the firm.
We will examine
Its 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.

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

32
30
26 QL
Total product

20

12

2
L
0 1 2 3 4 5 6 7 8 9 10

Labor

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 Product

35

30

25

20
TPL

15

10

5
MPL
0
0 1 2 3 4 5 6 7 8 9
-5

-10
 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.
Counter-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. Average product of labor.
Total product of Average product of
Labor (L) labor (TPL) labor (APL)
0 0 0
1 2 2
2 6 3
3 12 4
4 20 5
5 26 5.2
6 30 5
7 32 4.5
8 32 4
9 30 3.3
10 26 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

L1 L2 L
0 Run = L
Total
Product The average product at b is highest.
Q AP at c is less than at a.
AP at d is less than at c.

c
b
d
QL

0 L
Q Highest Slope of Line
from Origin
Max APL

Inflection point
Max 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 L3 L
MPL
 TP

TPL

0 L1 L2 L3 L
Stage I Stage II Stage III
MP>AP MP<AP
AP,MP AP increasing AP decreasing
MP<0
AP decreasing
MP still positive

APL

0 L1 L2 L3 L
MPL
 Three Stages of Production
In Stage I
APL is increasing so MP>AP.
All the product curves are increasing

Stage I stops where APL reaches its maximum at

point A.
MP peaks and then declines at point C and beyond,
so the law of diminishing returns begins to manifest
at this stage
 Three Stages of Production
Stage II
starts where the APL of the input begins to decline.
QL still continues to increase, although at a
decreasing rate, and in fact reaches a maximum
Marginal product is continuously declining and
reaches zero at point D, as additional labor inputs
are employed.
 Three Stages of Production
Stage III starts where the MPL has turned
negative.
all product curves are decreasing.
total output starts falling even as the input is
increased
 COSTS OF PRODUCTION
Opportunity Cost Principle - the economic cost of an
input used in a production process is the value of
output sacrificed elsewhere. The opportunity cost of an
input is the value of foregone income in best 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 their opportunity costs.
 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
 Short Run Analysis

Total fixed cost (TFC) is more commonly

referred to as "sunk cost" or "overhead cost."
Examples: include the payment or rent for land,
buildings and machinery.
The fixed cost is independent of the level of
output produced.
Graphically, depicted as a horizontal line
 Short Run Analysis
Total variable cost (TVC) refers to the cost
that changes as the amount 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 larger the output, the greater the total variable cost.
 Short Run Analysis
Total cost (TC) is the sum of total fixed cost
and total variable cost

TC=TFC+TVC

As the level of output increases, total cost of the

firm also increases.
 Total Costs of Production
Total Total
Units of Total Fixed Variable Total Marginal Average
Labor Product Cost Cost Cost Cost Cost
L TPL TFC TVC TC MC AC
0 0 100 0 100 - -
1 6 100 30 130 30 130
2 10 100 50 150 20 75
3 12 100 60 160 10 53.3
4 13 100 65 165 5 41.25
5 15 100 75 175 10 35
6 19 100 95 195 20 32.5
7 25 100 125 225 30 32.14
8 33 100 165 265 40 33.12
9 43 100 215 315 50 35
10 55 100 275 375 60 37.5
Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 Q
TOTAL COST CURVES
Pesos

AFC=TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

0 Q
Pesos The Average Variable
Cost at a point on the
TVC curve is measured by
the slope of the line from
the origin to that point. TVC
(Total Variable Cost)
AVC=TVC/Q

Minimum AVC

0 q1 Q
Pesos
TVC
Inflection (Total Variable Cost)

point

0 q1 Q
MC
AVC

q1
Pesos
The Average Variable Cost is U
shaped. First it decreases, reaches a
minimum and then increases.

AVC
(Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos The Marginal Cost curve passes
through the minimum point of
the AVC curve.
MC (Marginal Cost)
It is also U-shaped. First it
decreases, reaches a minimum AVC
and then increases. (Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos MC

AC

AVC

AFC

0 q1 Q

The PER UNIT COST CURVES

Table 5.4 Average Cost of Production

(Q) (TC) (AC)

0 100 -
1 130 130.00
2 150 75.00
3 160 53.33
4 165 41.25
5 175 35.00
6 195 32.50
7 225 32.14
8 265 33.13
9 315 35.00
10 375 37.50
 Table 5.5 Average Variable Costs of Production

Total Product Total Variable Cost Average Variable Cost

(Q) (AVC) (AVC)
0 0 0
1 30 30.0
2 50 25.0
3 60 20.0
4 65 16.3
5 75 15.0
6 95 15.8
7 125 17.9
8 165 20.6
9 215 23.9
10 275 27.5
 LTC LTC
All inputs are variable in the long
run. There are no fixed costs.
Long Run Total Cost

Q
Total Product

LONG-RUN TOTAL COST CURVE

 The LAC
The LAC curve is an envelop curve of all
possible plant sizes. Also known as planning
curve
It traces the lowest average cost of producing
each level of output.
It is U-shaped because of
Economies of Scale
Diseconomies of Scale
COST

LAC
SAC1

SAC2

0 Q

LONG-RUN AVERAGE COST CURVE

COST

LAC
SAC1

0 Q
q0
 Building a larger sized plant (size 2)
will result in a lower average cost of
COST producing q0

LAC
SAC1

SAC2

0 Q
q0
 Likewise, a larger sized plant (size
COST 3) will result to a lower average
cost of producing q1

SAC1 LAC
SAC2
SAC3

0 Q
q0 q1
 Economies and Diseconomies of Scale

Economies of Scale- long run average cost

decreases as output increases.
Technological factors
Specialization

Diseconomies of Scale: - long run average cost

increases as output increases.
Problems with management becomes costly,
unwieldy
COST

LAC
SAC1

SAC2

Economies of Scale Diseconomies of Scale

0 Q1 Q

LONG-RUN AVERAGE COST CURVE

 LONG-RUN AVERAGE and MARGINAL COST CURVES

LMC
COST

SMC2
LAC

SAC2
SMC1 SAC1

0 Q1 Q
 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 minimum point.