Management in the Built Environment Lesson 5 – PRODUCTION EQUILIBRIUM James Hartwell’s Supply and Demand Lecture Notes 2013. Sources and reading list – Economics, Tony Cleaver (2012); Monetary Economics, Goodley and Lavoire (2011); Modern Financial Microeconomics, Knoop (2010); A Guide to What’s Wrong with Economics, Fullbrook (2007); Microeconomics, Besanko (2004)

Learning Outcome of this lecture Understand the role on production costs Determinants in production decisions Production Equilibrium

Production Choices Every producer faces two fundamental choices:   What do they produce and how many? What combination of inputs? Costs they will incur during the act of production Revenue they expect to generate The nature of the costs will vary as level of output and the combination of inputs used to produce the product change.

PRODUCER Equilibrium The ultimate aim of any firm is to earn the maximum profit possible Producer equilibrium is the situation of PROFIT – MAXIMISATION At equilibrium, the firm has the maximum level of output being produced and earning the maximum profit out of the same It is the equilibrium level of output which the producer will produce at MINIMUM COST and sell to earn MAXIMUM PROFIT

Different Type of Producer Costs

Producer Costs Fixed costs (FC)   These costs are those that do not vary with output. They remain constant over fairly long periods of time. In economics we say that fixed costs are fixed over the short term. Examples of fixed costs include rent for land and buildings, interest on loans, and depreciation of large machinery. 2. Variable costs (VC) These costs are those that vary with the amount of output. They increase as output increases, and vice versa. Examples of variable costs include wages, energy costs, and raw materials. The sum of fixed costs and variable cost gives the total costs (TC) incurred in production, i.e. TC = FC +VC.

Difference Between Fixed and Variable Cost

Relationship between Total = Variable + Fixed Cost When output is zero then variable costs equal zero. This results in total costs being equal to fixed costs.   As output rises then total costs will increase as variable costs increase (see Figure 5.1). However, the fixed, variable and total costs tell us very little about how these costs vary as output varies. COST OUTPUT Figure 5.1

AVERAGE COST PRICING RULE The average cost pricing rule is a pricing strategy that regulators impose on certain businesses to limit what they are able to charge consumers for its products or services to a price equal to the costs necessary to create the product or service. This implies that businesses will set the unit price of a product relatively close to the average cost needed to produce it. Utilizing an average-cost pricing strategy, a producer charges, for each product or service unit sold, only the addition to total cost resulting from materials and direct labor. Businesses will often set prices close to marginal cost if sales are suffering. If, for example, an item has a marginal cost of $1 and a normal selling price is $2, the firm selling the item might wish to lower the price to $1.10, if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.

AVERAGE COST – determine the changes in output Average costs, i.e. the cost per unit, enables us to analyse the effect that changes in output have on costs. The average costs are calculated as follows:   Average fixed costs (AFC) = FC/Q Average variable costs (AVC) = VC/Q Average total costs (ATC) = TC/Q where Q is the units of output.

Video – Fixed Cost, variable cost , average and marginal cost https://youtu.be/0CHyHeNCJ30

Average Total Cost and the Law of Diminishing Returns OUTPUT Figure 5.2 shows the relationship between average variable costs and average total costs. This demonstrates how:   Average fixed costs fall as the number of units produced is increased. Average variable costs fall then rise slowly as more units are produced.

Average Total Costs and the Law of Diminishing Returns Average total costs for most producers are typically U-shaped.   The curve falls initially due to a decrease in fixed costs per unit as the overheads are spread over more units of production. The level of output is increasing as more variable factors are added to the fixed factors of production. However, there will reach a level of production when both average variable costs and average total costs start to rise. This is due to a decrease in the efficiency of labour and equipment as the producer operates closer and closer to full capacity. This observation is called the Law of Diminishing Returns.

Definition of the Law of Diminishing Returns The Law of Diminishing Returns is defined as the effect of adjusting a variable factor, or factors, in combination with one or more fixed factors. Production can be expanded up to a point by increasing the variable factors. After a certain level of production, fixed factors must be increased or the law of diminishing marginal returns will set in.

Average Total Cost and the Law of Diminishing Returns A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish. Although the marginal productivity of the workforce decreases as output increases, diminishing returns do not mean negative returns until (in this example) the number of workers exceeds the available machines or workspace. In everyday experience, this law is expressed as "the gain is not worth the pain."

VARIABLE costs versus Fixed costs Total Fixed Costs (TFC) are fixed at all level of output Total Variable Costs (TVC) and, therefore, Total Costs (TC) rise as output increases Average Fixed Cost (AFC) decline continuously as the fixed costs are distributed across more and more output, until at very large output, they may be negligible. The ACF curve is a rectangular hyperbola, i.e. the area under the curve remains constant as the output changes. Average Variable Cost (AVC) may fall initially but after a certain level of output they begin to rise. This is due to the Law of Diminishing Returns – the gain is no longer worth the pain

Video on Law of Diminishing Returns https://youtu.be/-g-HY5oPpTA

Marginal Cost Marginal cost is the incremental cost involved in producing one more unit of output in a given period.   Marginal costs are an important element of a producer’s costs. When applied to production costs, marginal cost refers to the addition to total costs incurred by producing an extra unit of output. Figure 5.3 plots marginal costs with average total costs. Figure 5.3: Average total costs and marginal costs

Average Total Cost, Marginal Cost and Optimum Output Figure 5.3: Average total costs and marginal costs Observe the Average Total Cost curve in Fig 5.3 below. The cost per unit falls initially because marginal cost is lower than average total cost. When marginal cost is less than average total cost, it pulls average total cost down.   When marginal cost becomes greater than average total cost, it pulls average total cost up. At the point of intersection of the Average Total Cost curve and the Marginal Cost curve, Average Total Cost = Marginal Cost This is the point as well where Average Total Cost is at the lowest.  As marginal cost rises, it cuts the average total cost curve at its lowest point. The point of intersection is the ideal output level for the producer. It represents the optimum output.

https://youtu.be/C3m9FC3T3vw Video : Marginal Cost and Average Total Cost https://youtu.be/C3m9FC3T3vw

Breakeven Production Point If the producer operates below this output level then the marginal revenue for each unit of output is greater than it costs to produce. It will be more profitable for the producer to increase the production level as long as the marginal cost of producing the last unit of output is equal to the marginal revenue.   If the marginal revenue is lower than the marginal cost then the average total cost for producing one unit is greater than the revenue generated. It would be more profitable for the producer to reduce output. At the break-even point, where the average total cost equals price, the firm makes zero profit on the last unit produced and optimizes the production capacity.

Optimum Production At this optimum production point, producing any more units would increase the per-unit production cost. In other words, the additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level may involve paying prohibitively high amounts of overtime pay to workers, or the maintenance costs for machinery may significantly increase To recap, the optimum production will be at the lowest point of average total cost and where the marginal cost is equal to the average total cost

Profit Maximum Rule The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is rising. In other words, it must produce at a level where MC = MR. The profit maximization formula is MC = MR Marginal Cost is the increase in cost by producing one more unit of the good. Marginal Revenue is the change in total revenue as a result of changing the rate of sales by one unit. Marginal Revenue is also the slope of Total Revenue.

Profit Maximum Rule Profit = Total Revenue – Total Costs Therefore, profit maximization occurs at the most significant gap or the biggest difference between the total revenue and the total cost. At A, Marginal Cost < Marginal Revenue, then for each additional unit produced, revenue will be higher than the cost so that you will generate more. At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will be higher than revenue so that you will create less. Thus, optimal quantity produced should be at MC = MR

Maximizing Profit Practice Profit = TR - TC Sale Price = $30 = MR Profit = TR - TC OUTPUT Variable Cost Fixed Cost Total Cost Marginal Cost Marginal Revenue Total Revenue Profit $0 $20 NA 1 $12 $32 $30 -$2 2 $22 $42 $10 $60 $18 3 $27 $47 $5 $90 $43 4 $40 $13 $120 5 $80 $150 $70 6 $100 $180 What is the profit maximization quantity ? 5 What is the total revenue at that quantity ? $150 How much is the profit ? $70

Video on Profit Maximization https://youtu.be/vhArqwE9We4

SUMMARY Production costs determine the producers’ production levels, and subsequently, the amount they are willing and able to supply on the market. Fixed costs are costs that do not change with the output of the producers, whereas variable costs vary with the level of output chosen. Fixed costs plus variable costs equal total costs.  

SUMMARY Average fixed costs are total fixed costs divided by the quantity of output. Average fixed costs decline as output rises. Average variable costs are total variable costs divided by the quantity of output. Average fixed costs plus average variable costs are equal to average total costs. Average total costs curves are typically U shaped. This is due to the law of diminishing returns. Marginal cost is the increase in total costs that result from producing one more unit of output. Since fixed costs do not change when output changes, marginal costs reflect changes in variable costs.  

Key takeaways in Lesson 5 Profit maximization is not just a number or equation PROFIT MAXIMIZATION Social and Economical welfare Measurement Standard Economical Survival It Involves : Economical Survival Measurement Standards Social And Economical Welfare