THEORY OF PRODUCTION AND COST Class 3

Theory of Production and Cost  Short and Long run production functions  Behavior of Costs  Law of Diminishing Returns  Law of Returns to scale in the theory of production  Fixed Costs and Variable Costs  Explicit Costs and Implicit Costs

What are Costs?  “The Market Value of the inputs a firm uses in production”  Total Revenue – the amount a firm receives for the sale of its outputs.  Eg: Each Ice-Cream takes Rs. 10 to make and it is sold at Rs. 25 – Nelum sells 2000 ice-creams

Economic Cost  This is different to accounting cost  What is account cost?  Remember Nelum? – She made Rs profit making ice-cream. Assume Nelum was an amazing programmer and she could earn Rs a month programming.  Her Opportunity cost = – = Rs  Which means she is losing Rs by making ice- cream.

Implicit and Explicit Costs  Explicit Costs – input costs that require an outlay of money by the firm.  Implicit costs – input costs that do not require an outlay of money by the firm.  Accounting Profit = TR – Explicit Costs  Economic Profit = TR – (Implicit Costs+ Explicit Costs)

The production functions  Two Assumptions  Short Run  Size of Nelum’s factory is fixed  She can only vary the amount of ice-cream by increasing workers  Long run – She can build a new factory. The production function The relationship between the quantity of inputs used to make a good and he quantity of outputs for that good.

Production Function

Total Cost Curve  Marginal Product  The increase in output that arises from an additional unit of output  Diminishing Marginal Product  The property whereby the marginal product of an input declines as the quantity of the input increases.

Fixed and Variable Costs  Fixed Costs  Costs that do not vary with the quantity of output produced  Variable Costs  Costs that vary with the quantity of output produced.  Average Total Cost – Total cost divided by the quantity of output  Average Fixed Cost – Fixed cost divided by the quantity of output  Average Variable Cost – Variable cost divided by the quantity of output  Marginal Cost – The increase in total cost that arises from an extra unit of production.

Cups Per Hour Total Cost Fixed Cost Variable Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost

Observations  Rising Marginal Cost  Chatura’s MC rises with the quantity of out produced. This reflects the property of diminishing marginal product.  U-Shaped Average Total Cost  Average fixed costs always reduces  Average variable costs typically rises as output increases because of diminishing marginal product The bottom of the U shaped curve occurs at the quantity that minimizes average total cost

Long run costs curves  In the short term you cannot increase the number of factories, only the number of workers  In the long run this is not an issue.  Economies of Scale – (Specialization) – When long run average total costs falls as the quantity of output increases  Diseconomies of Scale – (Coordination Issue) – When LRATC increase as the output increases  Constant returns of scale – When LRATC stays the same as the quantity of output changes.

Break Time!