Principals of Economics Law class By Edward Gatwaza 12/03/2018 Lesson five

PRODUCERS DECISION MAKING The theory of Production is the statement of technical and technological relationships between inputs and outputs. Production, in microeconomics in the convention of inputs into outputs. Some economists define productivity broadly as all economic activity other than consumption. They see every commercial activity other than the final purchase as some form of production.

Total, Average and Marginal Products

Total, Average and Marginal Products The average product typically varies as more of the input is employed, so this relationship can also be expresses as a chart or as a graph. A typical average physical product curve is shown (APP). The marginal physical product of a variable input is the change in total output due to a one unit change in the variable input or alternatively the rate of change in total output due to an infinitesimally small change in the variable input (called the continuous marginal product). The discrete marginal product of capital is the additional output resulting from the use of an additional unit of capital (assuming all other factors are fixed).

Total, Average and Marginal Products

6.2. Costs of production Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable. Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the rate of output, for example, labour, fuel, power and cost of raw material. Average total cost is the total cost divided by the quantity of output (AC). Average fixed cost is the fixed cost divided by the quantity of output (AFC). Average variable cost are variable costs divided by the quantity of output (AVC). Marginal cost is the increase in total cost that arise when the quantity produced (or purchased) increases by one unit (MC).

Costs of production In terms of equations. Total Cost– the sum of all costs incurred in production TC = FC + VC Average Total Cost - the cost per unit of output AC = TC/Output AC = AFC + AVC Marginal Cost – the cost of one more or one fewer units of production MC = TCn –TCn-1 units

6.3. Revenue and profits Total revenue – the total amount received from selling a given output R = P x Q Average Revenue – the average amount received from selling each unit AR = TR/Q Marginal revenue – the amount received from selling one extra unit of output MR = TRn – TR n-1 units Profit = TR-TC

Revenue and profits *Profits help in the process of directing resources to alternative uses in free markets *Relating price to costs helps a firm to assess profitability in production Normal Profit – the minimum amount required to keep a firm in its current line of production Abnormal or Supernormal profit – profit made over and above normal profit Profit maximizing output would be where MC = MR

Graphical relations – Total, Marginal and Average Products

Total, average, and marginal product Diagrammatically, the Total product starts to decline when the marginal product is equal to zero. The diagram if well drawn should show that the MPP cuts the APP where APP is maximum. From the diagram we can revisit the law of diminishing returns again.

Diminishing marginal returns These curves illustrate the principle of diminishing marginal returns to a variable input. This states that as you add more and more of a variable input, you will reach a point beyond which the resulting increase in output starts to diminish. This point is illustrated as the maximum point on the marginal physical product curve. It assumes that other factors inputs (if they are used in the process) are held constant.

Inputs and outputs Inputs are the factors of production classified as: Land – all natural resources of the earth - Price paid to acquire land = Rent Labour – all physical and mental human effort involved in production - Price paid to labour = Wages Capital – building, machinery and equipment not used for its own sake but for the contribution it makes to production - Prince paid for capital = Interest

Inputs and outputs A production function expresses the relationship between on organization’s inputs and its outputs. It indicates, in mathematical or graphical form, what outputs can be obtained from various amounts and combinations of factor inputs. Alternatively, a production function can be defined as the specification of the minimum input requirement needed to produce designated quantities of outputs, given available technology.

5.2. Long run and short run In the short run at least one factor fixed in supply but all other factors capable of being changed. Reflects ways in which firms respond to changes in output (demand). Can increase or decrease output using more or less of some factors but some likely to be easier to change than others. Increase in total capacity only possible in the long run

Long run and short run In the long run all factors of production can vary; By doing this, the firm is able to increase its total capacity – just short term capacity. Associated with a change in the scale of production The period of time varies according to the firm and the industry In coffee production, the time taken to grow coffee trees could be many years; for a market stall holder the “long run” could be as little as a few weeks or months.

5.3. Fixed and variable inputs Fixed inputs like machinery cannot change in the short run. Costs of buying fixed inputs are called fixed costs as is defined later. Variable inputs change in the short run. They vary with output. These are for example labour raw materials. Costs of buying variable inputs are called variable costs.

5.4. Law of diminishing returns It is can be stated as follows: Successive addition of variable inputs on fixed in puts in production, will result in increased output only to a point. After point, further increase will result in less than proportionate increase in marginal output.

Law of diminishing returns Fixed input (say 1 has of land) Variable input (say tonnes manure) Total output (say bags of maize) Marginal Output Average Output 1 10 2 22 12 11 3 36 14 4 48 5 59 11.4 6 68 9 11.3 7 73 10.4 8 9.1 72 -1

Law of diminishing returns In the example above the law of diminishing returns starts to operate after the third person. The marginal output falls from 14 to 12. In fact there can be a point where the marginal output from an addition of labour will be 0. This is at the 8th unit of labour. After that point even total output will start to decline. We shall show this diagrammatically in the next topic. Note also, that after the marginal product has started to decline, the average output also follows suit. Ideally it starts to fall shortly after the falling of the marginal product.

5.5. Isoquants There are many ways of producing a given level of output. You can use a lot of labour with a minimum amount of capital. This is what we call labour intensive techniques. Alternatively you could invest heavily In capital equipment that requires a minimum amount of labour to operate. This we called capital intensive techniques. An isoquant, in a two input case, is a curve that shows all the ways of combining two inputs so as to produce a given level of output (see diagram, Movement along an isoquant depicts a constant rate of output (iso is Latin for same and quant for quantity).

Isoquants

Isoquants An isoquant such as QQ slopes from the left downwards to the right. It is convex to the origin. Any two isoquants do not cross each other. The slope of an isoquant changes at every point. The slope is called the Marginal Rate of Technical Substitution (MRST).

Isoquants maps

5.6. Isocosts An isocost shows all the combinations of inputs that can be purchased, at given prices, for single amount of money. Iso is Latin for the same Isocost is a straight line joining same cost that can purchase different combinations of inputs to produce the same level of output. It is similar but not the same as a budget line we saw under indifference curves.

Isocosts

5.7. Producers Equilibrium The goal is of a producer either to produce as much output as is possible with a given amount of money or to produce a given amount of output with as little money as possible. Both goals can be represented by a diagram showing the interaction of isocosts and isoquants (analogous to, but not the same as, the diagram showing budget lines and indifferences curves).

Producers Equilibrium

Producers Equilibrium At point E the slope of the isoquant is its MRST which is equal to the ratio of the marginal product of the input on the horizontal axis to the marginal product of the input to the vertical axis.

5.8. Expansion Path A curve that connects points of equilibria between isocosts and isoquants gives an expansion path. EE4. This would happen if for instance a production unit expanded its production, and as a result sought different equilibrium points

Expansion Path