Production Theory

Production
The process of transforming resources into goods and
services that have considerable value (utility) to
consumers.
In the production process, these resources are also
referred to as inputs while goods and services created
are called outputs.
The Behavior of Profit-Maximizing Firms
All firms must make several basic decisions to achieve
what we assume to be their primary objectivemaximum
profits.

FIGURE 7.1 The Three

Decisions That All Firms
Must Make
 Production
Two Kinds of Inputs in a Short term Production Process:
1. Fixed Inputs do not change as output increases
2. Variable Inputs changes as output increases

Producers in the market seek for profit maximization

maximize the revenue but minimize the cost of production.
The Behavior of Profit-Maximizing Firms
Short-Run Versus Long-Run Decisions

Short Run The period of time for which two conditions

hold: The firm is operating under a fixed scale (fixed
factor) of production, and firms can neither enter nor exit
an industry.

Long Run That period of time for which there are no

fixed factors of production: Firms can increase or
decrease the scale of operation, and new firms can enter
and existing firms can exit the industry.
 The Production Function
It refers to the greatest output that can be created
given an exact number of inputs.
Q = f (land, labor, capital)
Q is a function of land resources, which may also refer
to raw materials; labor, which is a manpower resource;
and capital, which includes equipment, machinery, and
other capital goods.
 Law of Diminishing Marginal Returns

It states that as more inputs are added to

production while holding other inputs fixed,
the additional inputs start to diminish at
certain point.
 Production of Tricycles
Labor (L) Units Total Product (TP) Marginal Product (MP) Average Product (AP)
1 10 10
2 19 9 9.5
3 26 7 8.7
4 30 4 7.5
5 30 0 6
6 26 -4 4.3
7 19 -7 2.7
 Summary of Returns to Scale

TP MP AP
Phase I increasing diminishing decreasing
Phase II maximum/ zero decreasing
constant
Phase III diminishing negative decreasing
Returns to Scale
 Isocosts and Isoquants
Isocost represents all the possible combinations of two
variables inputs that are of equal total cost.
Isoquants traces out the different combinations of variable
inputs that a firm can use to produce the given amounts of
output.
The least cost combination is the point where the highest
isoquant curve touches the isocost line at a point of tangency.
Isocosts and Isoquants
Theory of Costs
 Cost Analysis

TC = TFC + TVC
Where:
TC is total cost
TFC is total fixed cost
TVC is total variable cost
 Cost Analysis
ATC = AFC + AVC
ATC = TC/Q
AFC = TFC/Q
AVC = TVC/Q
Where:
ATC is average total cost
AFC is average fixed cost
AVC is average variable cost
 Cost Analysis
MC = change in TC/change in Q
Where:
Q is quantity or output
MC is marginal cost
 Revenue and Profit
Revenue is the amount of money received by firms from selling goods
and services.
Profit is the difference between total revenue and total costs.
TP = TR TC
Where:
TP is total profit
TR is total revenue
TC is total costs
 Example 1: Farmer Jacks Production Function

L Q 3,000
(no. of (bushels
workers) of wheat) 2,500

Quantity of output
0 0 2,000

1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
THE COSTS OF PRODUCTION 18
 Marginal Product
If Jack hires one more worker, his output rises by the marginal product
of labor.
The marginal product of any input is the increase in output arising
from an additional unit of that input, holding all other inputs constant.
Notation:
(delta) = change in
Examples:
Q = change in output, L = change in labor
Marginal product of labor (MPL) =
Q
L
THE COSTS OF PRODUCTION 19
 EXAMPLE 1: Total & Marginal Product
L Q
(no. of (bushels
MPL
workers) of wheat)

0 0
L = 1 Q = 1000 1000
1 1000
L = 1 Q = 800 800
2 1800
L = 1 Q = 600 600
3 2400
L = 1 Q = 400 400
4 2800
L = 1 Q = 200 200
5 3000
THE COSTS OF PRODUCTION 20
 Marginal Cost
Marginal Cost (MC) is the increase in Total Cost from producing one
more unit:

MC = TC
Q

THE COSTS OF PRODUCTION 21

 EXAMPLE 1: Total and Marginal Cost
Q
Total Marginal
(bushels
Cost Cost (MC)
of wheat)

0 $1,000
Q = 1000 TC = $2000 $2.00
1000 $3,000
Q = 800 TC = $2000 $2.50
1800 $5,000
Q = 600 TC = $2000 $3.33
2400 $7,000
Q = 400 TC = $2000 $5.00
2800 $9,000
Q = 200 TC = $2000 $10.00
3000 $11,000
THE COSTS OF PRODUCTION 22
 EXAMPLE 1: The Marginal Cost Curve
$12
Q
(bushels TC MC $10 MC usually rises
of wheat) as Q rises,

Marginal Cost ($)

$8 as in this example.
0 $1,000
$2.00
$6
1000 $3,000
$2.50
1800 $5,000 $4
$3.33
2400 $7,000 $2
$5.00
2800 $9,000 $0
$10.00
0 1,000 2,000 3,000
3000 $11,000 Q
THE COSTS OF PRODUCTION 23
 Fixed and Variable Costs
Fixed costs (FC) do not vary with the quantity of
output produced.
For Farmer Jack, FC = $1000 for his land
Other examples:
cost of equipment, loan payments, rent

Variable costs (VC) vary with the quantity produced.

For Farmer Jack, VC = wages he pays workers
Other example: cost of materials

Total cost (TC) = FC + VC

THE COSTS OF PRODUCTION 24

 EXAMPLE 2: Costs
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500

Costs
2 100 120 220
$400
3 100 160 260
$300
4 100 210 310
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 25
 EXAMPLE 2: Marginal Cost

Q TC MC $200 Marginal Cost (MC)

Recall,
is $175
the change in total cost from
0 $100
$70 producing
$150 one more unit:
1 170
50 $125 TC

Costs
2 220 MC =
$100 Q
40
3 260 Usually,
$75
MC rises as Q rises, due
50 to diminishing marginal product.
4 310 $50
70 Sometimes (as here), MC falls
5 380 $25
100 before rising.
6 480 $0
140 (In other0 examples,
1 2 3 MC 4 may
5 6be 7
7 620 constant.) Q
THE COSTS OF PRODUCTION 26
 EXAMPLE 2: Average Fixed Cost

Q FC AFC Average
$200 fixed cost (AFC)
0 $100 n/a
is$175
fixed cost divided by the
quantity
$150
of output:
1 100 $100
AFC
$125 = FC/Q

Costs
2 100 50
$100
3 100 33.33
Notice
$75 that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed
$50
5 100 20 costs over a larger and larger
$25
number of units.
6 100 16.67
$0
7 100 14.29 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 27
 EXAMPLE 2: Average Variable Cost

Q VC AVC Average
$200 variable cost (AVC)
is$175
variable cost divided by the
0 $0 n/a
quantity of output:
$150
1 70 $70
AVC
$125 = VC/Q

Costs
2 120 60
$100
3 160 53.33 As$75
Q rises, AVC may fall initially.
4 210 52.50 In most cases, AVC will
$50
eventually rise as output rises.
5 280 56.00
$25
6 380 63.33 $0
7 520 74.29 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 28
 EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost

(ATC) equals total
0 $100 n/a n/a n/a
cost divided by the
1 170 $170 $100 $70 quantity of output:
2 220 110 50 60 ATC = TC/Q
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29

THE COSTS OF PRODUCTION 29

 EXAMPLE 2: Average Total Cost

Q TC ATC $200
Usually,
$175
as in this example,
0 $100 n/a
the ATC curve is U-shaped.
$150
1 170 $170
$125

Costs
2 220 110
$100
3 260 86.67
$75
4 310 77.50
$50
5 380 76 $25
6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57
Q
THE COSTS OF PRODUCTION 30
 EXAMPLE 2: The Various Cost Curves Together

$200
$175
$150
ATC
$125

Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 31
 Q L MPL FC VC TC ATC AFC AVC MC
0 0 100 0
180 1 100 55
270 2 100 105
390 3 100 153
450 4 100 204
570 5 100 262
680 6 100 331
770 7 100 415
895 8 100 518
956 9 100 645
1078 10 100 800
1125 11 100 986
1245 12 100 1209