Economics

1. PRODUCTION and COSTS
Economics 11
University of the Philippines
Los Banos
Econ 11-UPLB

2. Note:
The contents of this presentation
are found in Chapter 5 of the
textbook.

3. Theory of Production and Costs


Focus- mainly on the the firm.
We will examine
Its production capacity given available resources
 the related costs involved


4. 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.

5. 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.

6. Firm’s Inputs

Inputs - are resources that contribute in the
production of a commodity.

Most resources are lumped into three categories:
Land,
 Labor,
 Capital.


7. 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.

8. 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

9. 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

10. Production Function of a Rice Farmer
Units of L
Total Product
(QL or TPL)
Marginal Product
(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

11. QL
32
30
Total product
26
QL
20
12
6
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.

12. 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

13. 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"

14. Total and Marginal Product
35
30
25
TPL
20
15
10
5
MPL
0
0
-5
-10
1
2
3
4
5
6
7
8
9

15. 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 world’s
supply of food can be produced in a hectare of
land.

16. 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

17. TABLE 5.2.
Average product of labor.
Labor (L)
Total product of
labor (TPL)
Average product of
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

18. The slope of the line from the origin
is a measure of the AVERAGE
Y
Slope =
rise Y
=
run L
b
a
Y
Rise = Y
0
Run = L
L1
L2
L

19. Total
Product
Q
The average product at b is highest.
AP at c is less than at a.
AP at d is less than at c.
b
c
d
QL
a
0
L

20. Q
Highest Slope of Line
from Origin
Max APL
Inflection point
TPL
Max MPL
0
L1
L2
L3
L

21. 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

22. 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.

23. AP,MP
At Max AP,
MP=AP
Max MPL
Max APL
APL
0
L1
L2
L3
L
MPL

24. TP
TPL
0
L1
L2
L3
Stage I
MP>AP
AP increasing
AP,MP
Stage II
MP<AP
AP decreasing
MP still positive
L
Stage III
MP<0
AP decreasing
APL
0
L1
L2
L3
L
MPL

25. Three Stages of Production

In Stage I

APL is increasing so MP>AP.
All the product curves are increasing
 Stage I stops where AP reaches its maximum at
L
point A.
 MP peaks and then declines at point C and beyond,
so the law of diminishing returns begins to manifest
at this stage


26. 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.


27. 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


28. 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.

29. 7 Cost Concepts (Short-run)
1.
2.
3.
4.
5.
6.
7.
Total Fixed Cost
Total Variable Cost
Total Cost
Average Fixed Cost
Average Variable Cost
Average Total Cost
Marginal Cost
(TFC)
(TVC)
(TC=TVC+TFC)
(AFC=TFC/Q)
(AVC=TVC/Q)
(AC=AFC+AVC)
(MC= ∆AVC/∆Q

30. 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


31. 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.


32. 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.

33. Total Costs of Production
Units of
Labor
Total
Fixed
Cost
Total
Product
Total
Variable
Cost
Total
Cost
TC
Marginal
Cost
Average
Cost
MC
AC
L
TPL
TFC
TVC
0
0
100
0
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
100 -
-

34. Pesos
TC
(Total Cost)
TVC
(Total Variable Cost)
TFC
(Total Fixed Cost)
Q
0
“TOTAL” COST CURVES

35. Pesos
AFC=TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.
AFC
(Average Fixed Cost)
0
Q

36. 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

37. Pesos
TVC
Inflection
point
0
q1
q1
(Total Variable Cost)
MC
Q
AVC

38. 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

39. 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
and then increases.
AVC
(Average Variable Cost)
Minimum AVC
0
q1
Q

40. MC
Pesos
AC
AVC
AFC
0
q1
The “PER UNIT” COST CURVES
Q

41. 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

42. Table 5.5
Average Variable Costs of Production
Total Product
(Q)
Total Variable Cost
(AVC)
Average Variable Cost
(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

43. LTC
LTC
Long Run Total Cost
All inputs are variable in the long
run. There are no fixed costs.
Total Product
LONG-RUN TOTAL COST CURVE
Q

44. 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


45. COST
LAC
SAC1
SAC2
0
Q
LONG-RUN AVERAGE COST CURVE

46. COST
SAC1
0
LAC
Q
q0

47. Building a larger sized plant (size 2)
will result in a lower average cost of
producing q0
COST
SAC1
LAC
SAC2
0
Q
q0

48. Likewise, a larger sized plant (size
3) will result to a lower average
cost of producing q1
COST
SAC1
LAC
SAC2
SAC3
0
Q
q0
q1

49. 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

50. COST
LAC
SAC1
SAC2
Diseconomies of Scale
Economies of Scale
0
Q1
LONG-RUN AVERAGE COST CURVE
Q

51. LONG-RUN AVERAGE and MARGINAL COST CURVES
LMC
COST
SMC2
SMC1
0
LAC
SAC2
SAC1
Q1
Q

52. 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 LAC’s minimum point.
