Production And Cost of Production

Production

Introduction– We will focus on supply in this chapter. We will

analyze how the factors of production are combined in a firm to produce goods and services.

Definition – Production means the process of using the factors

of production to produce goods or services– Also can be stated as, ‘Transformation of inputs

into outputs’

• Factors of production Land Labour Capital Entrepeneurship

• Production functionThe functional relationship between inputs(factors of

production) and outputs ( goods and services)It is able to show maximum output that can be produce with

the given inputsIt can be represented in the form of a mathematical equation

such as :

Where Q is amount of output per unit of timeK,L,M,etc. are the various factors of production like capital,

labour, raw material, etc.Production function can be represented in the form of a table,

equation or graph

Q = f(K,L,M,etc.)

Short-run and Long Run Production function

Short run and Long Run depend on the inputs, which can be varied in production

There are two type of factor inputs :

fixed input - an input in which the quantity does not change according to output. Fro example, machinery, land, buildings, tools, equipment, etc.

Variable input – an input in which the quantity changes according to output. For example, raw materials, electricity, fuel, transportation, communication, etc.

The short run period is the time frame which at least of the inputs (factors of production) is fixed but the other inouts are varied

Example,

The long run period is the time frame in which all inout are variable. In the long run firms can alter the inputs to increase the output.

Example

Law of Diminishing Marginal Returns This law explain the behaviour of production functions in

the short run. The law states that if quantities of certain factors are

increased while the quantities of one or more factors are held constant, beyond of certain level of production, the rate of increase in output will decrease (total pruduction wil increase in decreasing rate) and eventually the marginal product declines

The law also known as the law of variable proportions because it show how output varies when the proportion of a variable input to fixed input used in production varies.

Total Product (TP) -- It is the amount of output when given amount of that input is used together with fixed input

Average Product (AP) -- It can be obtained by dividing the total product by the amount of that input used. In this case labour is used.

Average Product (APL) = Total Production Total Labour

Average Product (APK) = Total Production Total Capital

Marginal Product (MP) – It is the change in the total product of that input corresponding to an addition or unit change in its labour. Marginal product is the additional to total product when one more unit of labour is employed.

Marginal Product (MPL) = Change in Total Product Change in Labour

MPL = ∆TP ∆L

Marginal Product (MPK) = Change in Total Product Change in Capital

MPK = ∆TP ∆K

• Jadual

Capital(fixed input)

Labour(Variable input)

Total Product

Marginal Product

Average Product

Stage of Product

10 0 0 0 0

STAGE 110 1 8 8 8

10 2 20 12 10

10 3 33 13 11

10 4 44 11 11

10 5 50 6 10STAGE 210 6 54 4 9

10 7 56 2 8

10 8 56 0 7STAGE 310 9 54 -2 6

10 10 50 -4 5

Unit of Variable Factor (labour)

TP/ AP/ MP

Relationship between Total Product(TP) and Marginal Product(MP)• When MP is increasing, TP will increase at an increasing rate.• When MP is decreasing, TP will increase at a decreasing rate• When MP is zero, TP is at Maximum.• When MP is negative, TP declines

Relationship between Marginal Product(MP) and Average Product (AP)• When MP is above AP, AP is increasing• When MP equals to AP, AP is at maximum.• When MP below to AP, AP is decreasing.

Stages of Production• Stage 1: Increasing returns• Stage 2: Diminishing Returns• Stage 3: Negative Returns

• Isoquant Analysis– The term isoquant bas been derived from “iso” which

means equal, and “Quant” meaning quantity .– An isoquant represent all the possible combinations of

variable input that are used to generate the same level of output (total product).

– The isoquant analysis illustrates that there are various ways to generate a given quantity of output in one period of time

• Let us take the example of a firm roducing soymilk that used the input of labour and capital.

• Table 6.4 below lists the output that the firm can produce with various combinations of input.

Capital LABOUR

1 2 3 4 5

1 250 450 600 700 800

2 450 650 800 900 950

3 550 800 950 1050 1100

4 700 900 1050 1150 1200

5 800 950 1100 1200 1250

Labour

Capital (Machine)

The properties of isoquant are :1. Isoquant curve slopes downward from left to

right2. Isoquant curve is convex to origin3. An isoquant far away from the origin

represents a larger output4. Isoquant curve never intersect with each

other

Isoquant Map• An isoquant map is a number of isoquants that combined in a

single graph• The isoquant map can be used to estimates the maximum

attainable output from different combinations of inputs.• Figure 6.6 show four different isoquants based on data from

Table 6.3Machine

Labour

• A firm has two options of producing maximum output. The first option is that a firm can using 1 machine and 5 labours as shown in point A, Another option is by using 5 machines and 1 labour as shown in point D

• All the points on this isoquant curve represent the input combinations that can produce 800 can of soy milk per month

• A higher isoquant curve represent a higher level of output

• Marginal Rae of Technical Substitution

MRTS = - Change in Capital Change in Labour

= - ∆K ∆L

Long Run Production Function

– In the long run, all factors including plants and machinery are variable. A firm can expand its scale of productivity by increasing all inputs such as more labour, more equipment, more buildings, etc.

– The law of returns to scale applies in the long run– The law refers to the effects of changes in the scale of

production– The responsiveness of output to a given proportionate change

in quantities of all inputs is called returns to scale– We will look into how proportion output changes when there

is some proportionate change in the amount of all inputs.

There are three possibilities1. Increasing Returns to Scale -

Quantity of all inputs < Outputs double (labour and capital) doubles

2. Constant Returns to Scale

Quantity of all inputs = Output doubles (labour and capital) doubles

3. Decreasing return to Scale

Quantity of all inputs > Outputs double (labour and capital) doubles

Cost of Production

Introduction• In this chapter, we will explain the relationship between

costs and output• We will also define the cost of production, identify various

types of costs and analyze short-run costs and long run costs.

Cost concepts• Cost of production refers to the expenses incurred by the

producer in producing a particular quantity of output. • There are different concepts of cost such as implicit and

explicit costs, opportunity costs and social costs

o Implicit Cost and Explicit Cost

Implicit costs – the value of input service that are used in production which are nor purchased in the market.

It is the value self owned, self employed resources utilized in production

Implicit is included in economic cost but excluded in accounting costs

Example of implicit costs would be the opporturnity cost of the owner’s wife providing (labour) service in production, a self-owned factory and the interest saved because the capital is one’s own.

Explicit Cost - the value of resources purchased for production.

Explicit both included in both economic and accounting costs Examples of explicit cost are wages and salaries to workers,

payment for fuel, transportation, electricity and power and expenditure in machinery and equipment

Therefore economic cost, which included both implicit and explicit cost, is higher than accounting cost.

ACCOUNTING COST < EONOMIC COST

o Opportunity Cost The value of the next best use of a resource. In other words, opportunity costs of a particular oroduct is

the value of the forgone alternative product.

o Social Cost The total cost of production of a product and includes direct

ad indirect costs incurred by society Examples of social costs are water pollution from industrial

waste contaminating rivers, and air pollution from mining activities, factory smoke and exhaust fumes from a lare number of vehicles.

o Sunk Cost The cost that a firm cannot recover from the expenditure it

has been made is called as sunk costs. Only counted in accounting costs and not in economic costs Example, a firm purchased specialized machinery for the

purpose of production. The equipment that firm purchased was design only to do specific work with no alternative use. Then the purchase of such equipment is sunk cost for a firm because it has no alternative use and has zero opportunity costs

Therefore, sunk cos not included in economic cost because it has no opportunity costs

IN conclusion, sunk cost is irrelevant to firm when making future economic decisions.

Cost Curves in the Short Run• Total Fixed cost• Total Variable Cost

• Total Cost

• Graf

• Avaraged fixed Cost

• Average Variable Cost

• Averaged Total Cost

• Marginal Cost

• Short run Average Total Cost Curve• Graf

• Stage I• Stage II• Stage III

• Relationship between Productivity Curve and Cost Curve

• The cost minimizing Technique

• Cost curves in the long Run

• Relationship between Avarage Total Cost (ATC) and Marginal Costs (MC)

• Graph

The isocosts Analysis

Isocost Map

• Cost minimizing technique

Graph

• Explanation of graph

• Cost Curves in the Long Run

• Economies of Scales

Internal economies of scales 1 Labour economies 2 Managerial Economies 3Marketing Economies 4 Technical Economies 5 Financial Economies 6 Risk bearing Economies 7 Transport and Storage Economies

• External Economies of Scale 1 Economies of government action 2 Economies of Concentration 3 Economies of Information 4 Economies of Marketing

• Diseconomies of Scale• Internal Diseconomies of scale 1 Labor diseconomies 2 Management economies 3 Technical Difficulties

• External diseconomies of scale 1 Scarcity of raw material 2 Wage Differential 3 Concentration Problems

• Economies and diseconomies of scope

Concept of RevenueTotal Revenue (TR)

• Average Revenue

• Marginal Revenue

Relationship between Price, Average Revenue and Marginal Revenue In Perfect Market

Graph

• In an Imperfect Market

• Graf