1. This is a PowerPoint presentation on the production process and associated costs.
A left mouse click or the enter key will add and element
to a slide or move you to the next slide. The back space
key will take you back an element or slide. If you wish to
exit the presentation, the escape key will do it!
R. Larry Reynolds ã 1997

2. Principles of Microeconomics
Production
Production is an activity where resources are altered or changed and there is an increase in the ability of these resources to satisfy wants.
change in physical characteristics
change in location
change in time
change in ownership
Fall ‘ 97
Principles of Microeconomics

3. Principles of Microeconomics
Production and Cost
Production is a technical relationship between a set of inputs or resources and a set of outputs or goods QX = f( inputs [land, labour, capital], technology, ) [Legal and social/cultural institutions influence the production function.]
Cost functions are the pecuniary relationships between outputs and the costs of production; Cost = f(QX {inputs, technology} , prices of inputs, )
Cost functions are determined by input prices and production relationships. It is necessary to understand production functions if you are to interpret cost data.
Fall ‘ 97
Principles of Microeconomics

4. Principles of Microeconomics
Costs
Costs are incurred as a result of production. The important concept of cost is opportunity cost [marginal cost]. These are the costs associated with an activity. When inputs or resources are used to produce one good, the other goods they could have been used to produce are sacrificed.
Costs may be in real or monetary terms;
implicit costs
explicit costs
Fall ‘ 97
Principles of Microeconomics

5. Principles of Microeconomics
Implicit Costs
Opportunity costs or MC should include all costs associated with an activity. Many of the costs are implicit and difficult to measure.
A production activity may adversely affect a person’s health. This is an implicit cost that is difficult to measure.
Another activity may reduce the time for other activities. It may be possible to make a monetary estimate of the value.
Fall ‘ 97
Principles of Microeconomics

6. Principles of Microeconomics
Explicit Costs
Explicit costs are those costs where there is an actual expenditure in a market. The costs of labour or interest payments are examples.
Some implicit costs are estimated and used in the decision process. Depreciation is an example.
Fall ‘ 97
Principles of Microeconomics

7. Principles of Microeconomics
Normal Profit
In neoclassical economics, all costs should be included:
wages represent the cost of labour
interest represents the cost of Kapital
rent represents the cost of land
“normal profit [ P ]” represents the cost of entrepreneurial activity
normal profit includes risk
Fall ‘ 97
Principles of Microeconomics

8. Principles of Microeconomics
Production Function
A production function expresses the relationship between a set of inputs and the output of a good or service.
The relationship is determined by the nature of the good and technology.
A production function is “like” a recipe for cookies; it tells you the quantities of each ingredient, how to combine and cook, and how many cookies you will produce.
Fall ‘ 97
Principles of Microeconomics

9. Principles of Microeconomics
QX = f(L, K, R, technology, )
QX = quantity of output
L = labour input
K = Kapital input
R = natural resources [land]
Decisions about alternative ways to produce good X require that we have information about how each variable influences QX.
One method used to identify the effects of each variable on output is to vary one input at a time. The use of the ceteris paribus convention allows this analysis.
The time period used for analysis also provides a way to
determine the effects of various changes of inputs on the
output.
Fall ‘ 97
Principles of Microeconomics

10. Principles of Microeconomics
Technology
The production process [and as result, costs] is divided up into various time periods;
the “very long run” is a period sufficiently long enough that technology used in the production process changes.
In shorter time periods [long run, short run and market periods], technology is a constant.
Fall ‘ 97
Principles of Microeconomics

11. Principles of Microeconomics
Long Run
The long run is a period that:
is short enough that technology is unchanged.
all other inputs [labour, kapital, land, ] are variable, i.e. can be altered.
these inputs may be altered in fixed or variable proportions. This may be important in some production processes.
If inputs are altered, the output changes.
QX = f(L, K, R, ) technology is constant
Fall ‘ 97
Principles of Microeconomics

12. Principles of Microeconomics
Short Run
The short run is a period in which at least one of the inputs has become a constant and at least one of the inputs is a variable.
If kapital [K] and land [R] are fixed or constant in the short run, labour [L] is the variable input. Output is changed by altering the labour input. QX = f(L) Technology, K and R are fixed or constant.
Fall ‘ 97
Principles of Microeconomics

13. Principles of Microeconomics
Market Period
When Alfred Marshall included time into the analysis of production and cost, he included a “market period” in which inputs, technology and consequently outputs could not be varied.
The supply function would be perfectly inelastic in this case.
Fall ‘ 97
Principles of Microeconomics

14. Principles of Microeconomics
Production in the Short Run
Consider a production process where K, R and technology are fixed: As L is changed, the output changes, QX= f(L)
Production of Good X L
APL
MPL
TPL
L = labour input
TPL = QX = output of good X
APL = average product [TP/L]
MPL = Marginal product [DTP/ DL] --
DTPL=4
DL = 1 1 4 4 4 2 10 5 6
APL =
TPL L
APL =
TPL L
APL =
TPL L 3 20
6.67 10
MPL =
DTPL DL
MPL =
DTPL DL 4 25
6.25 5 5 6 7 9 8 29 32 34 35
5.8
5.3
4.87
4.37
3.89 4 3 2 1
APL =
TPL L =
output
input
= Efficiency
Maximum of APL is at the 3 input of labour.
Fall ‘ 97
Principles of Microeconomics

15. Principles of Microeconomics
Production in the Short Run
APL =
TPL L =
output
input
Efficiency of labour
Production of Good X L
APL
MPL
TPL 5 6 7 9 8 -- 1 4 2 10 3 20
6.67 25
6.25 29 32 34 35
5.8
5.3
4.87
4.37
3.89
Notice that the APL increases as the first three units of labour are added to the fixed inputs of K and R. The maximum efficiency of Labour or maximum APL , given our technology, plant and natural resources is with the third worker.
As additional units of labour are added beyond the third worker the output per worker [APL ] declines.
Fall ‘ 97
Principles of Microeconomics

16. Principles of Microeconomics
Graphically TPL can be shown:
TPL initially increases at an increasing rate; it is convex from below. L 5 6 7 9 8 1 2 3 4
TPL 10 20 25 29 32 34 35 . . . .
TPL .
Labour
Output, QX 5 10 15 20 25 30 35 .
Maximum output .
After some point it
then increases at a
decreasing rate and
reaches a maximum
level of output, . . .
and declines
Fall ‘ 97
Principles of Microeconomics

17. Principles of Microeconomics
Given the TP , the APL can calculated:
TPL 4 10 20 25 29 32 34 35 L 5 6 7 9 8 1 2 3 4
APL 4 5
6.67
6.25
5.8
5.3
4.87
4.37
3.89
APL =
TPL L =
output
input
Efficiency of labour
APL
Labour 2 4 6 8 10 . . . . . . . . . .
APL
Fall ‘ 97
Principles of Microeconomics

18. Principles of Microeconomics. . .
Labour
Output, QX 5 10 15 20 25 30 35 Z Z W . .
TPL
The APL is the slope of a ray from the origin to the TPL . .
Graphically the relationship between APL and TPL can be shown: . M
1 unit of L produces 4Q,
APL is 4/1 = 4 or the slope of line 0H. H .
rise/run = 5
2 units of L produces 10Q,
rise/run = 4
APL is 10/2 = 5 or the slope of line 0M. . .
3 units of L produces 20Q, 4
APL is 20/3 = 6.67 or the slope of line 0Z.
APL .
4 units of L produces 25Q,
Labour 2 4 6 8 10 . .
APL is 25/4 = 6.25 or
the slope of line 0W. . . . . . .
As additional units of L are added, the AP falls. .
The maximum AP is where
the ray with the greatest
slope is tangent to the TP.
APL
Fall ‘ 97
Principles of Microeconomics

19. Principles of Microeconomics4 .
Labour
Output, QX 5 10 15 20 25 30 35 2 6 8
TPL
APL
Given TPL , the APL was calculated and graphed.
MPL was calculated as the change in TPL given a change in L. L 5 6 7 9 8 1 2 3 4
MPL -- 4 6 10 5 3 2 1
APL 4 5
6.67
6.25
5.8
5.3
4.87
4.37
3.89
TPL 4 10 20 25 29 32 34 35
4-0
The first unit of labour added 4 units of output.
“Between” the 1st and 2cd units of labour, Q increases by 6. . .
Note: Where MPL = APL, APL is a maximum. .
MPL = APL . . . . . .
MPL
Remember: MP is graphed
at “between” units of L.
Fall ‘ 97
Principles of Microeconomics

20. Principles of Microeconomics4 .
Labour
Output, QX 5 10 15 20 25 30 35 2 6 8
TPL
APL
MPL Z
Useful things to notice:
1. MPL is the slope of TPL.
2. When TPL increases at an increasing rate, MPL increases. At the inflection point in the TPL , MPL is a maximum. When TPL increases at a decreasing rate, MPL is decreasing.
3. The APL is a maximum when:
a. MPL = APL , b. the slope of the ray from origin is tangent to TPL .
4. When MPL > APL the APL is increasing.
When MPL < APL the APL is decreasing.
5. When MPL is 0, the slope of TPL is 0, and TP is a maximum.
Fall ‘ 97
Principles of Microeconomics

21. Principles of Microeconomics
Summary: TPL , MPL and APL Z
In many production processes Q initially increases at an increasing rate. This is due to
division of labour and a “better”
mix of the variable input with the
fixed inputs.
TPL
TPL
At the inflection point
Diminishing marginal product
As Q [TPL ]increases at an increasing rate, MP increases. L
As Q [TPL ]increases at a decreasing rate, MPL decreases.
MPL
APL
MPL is
a max
{MP< AP, AP falls}
Where 0Z is tangent to TPL , APL is a maximum; APL = MPL .
When TPL is a maximum, MPL is zero.
APL
When TPL is decreasing, MPL is negative.
MPL
{MP> AP, AP rises} L1 L2 L3 L
Fall ‘ 97
Principles of Microeconomics

22. Principles of Microeconomics
PRODUCTION
LABOUR
KAPITAL
OUTPUT MP AP 5 1 8 2 23 3 42 4 57 67 6 74 7 79 82 9 83 10
To calculate AP:
APL =
TPL L
AP is a maximum when L = 4.
0 ¸ = ?
DTPL = 8
DL= 1 8
8.0
8 ¸ = 8
DTPL = 15
DL= 1 15
11.5
23 ¸ 2 = 11.5
DTPL = 19
Note that MP is
15 between 3rd & 4th
units of L, it is 10
between 4th & 5th,
so it equals
AP = at L=4.
DL= 1 19
42 ¸ 3 = 14
14.0
DTPL = 15
DL= 1
57¸4 = 15
14.25
DTPL = 10
DL= 1
67 ¸ 5 = 13.4 10
13.4
DTPL = 7
DL= 1 7
12.33 5
11.28 3
10.25
To calculate MP: 1
9.22
MPL =
DTPL DL -1
8.2
MP is a maximum between 2cd and 3rd unit of L.
Fall ‘ 97
Principles of Microeconomics

23. Principles of Microeconomics
PRODUCTION
LABOUR
KAPITAL
OUTPUT MP AP 5 1 8 2 23 3 42 4 57 67 6 74 7 79 82 9 83 10
8.0
11.5
14.0
14.25
13.4
12.33
11.28
10.25
9.22
8.2 15 19 -1
As L is added to production process, output per worker [AP] increases. to a maximum “efficiency” [output/input which occurs at L = 4.
MP increases to a max between the 2cd & 3rd units of L.
When MP > AP the output per
worker is increasing.
Division of Labour and a more efficient mix of L, K & R causes AP to increase.
Output per worker decreases
after the 4th worker. “Too
many” workers for K, R & tech, MP< AP.
Diminishing Marginal Productivity begins
with the 4rth unit of L.
Fall ‘ 97
Principles of Microeconomics

24. Principles of Microeconomics
The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
TFC = PK x K = $6K = 6 x5 = $30, This cost does not change in the short run.
TVC = PL x L = $4L, as L changes TVC and Output change.
PRODUCTION AND COST
LABOUR
KAPITAL
OUTPUT AP MP
TFC
TVC TC
AFC
AVC
ATC 5 -- 1 8 2 23
11.5 15 3 42 14 19 4 57
14.25 67
13.4 10 6 74
12.33 7 79
11.28 82
10.25 9 83
9.22
8.2 -1
TC = TVC+TFC
x $4 =
$30
=$30
$ 0
x $4 =
=$34
$ 4
x $4 =
=$38
$ 8
x $4 =
=$42
$12
x $4 =
=$46
$16
x $4 =
=$50
$20
=$54
$24
=$58
$28
=$62
$32
=$66
$36
=$70
$40
Fall ‘ 97
Principles of Microeconomics

25. Principles of Microeconomics
PRODUCTION AND COST
LABOUR
KAPITAL
OUTPUT AP MP
TFC
TVC TC
AFC
AVC
ATC 5 -- 1 8 2 23
11.5 15 3 42 14 19 4 57
14.25 67
13.4 10 6 74
12.33 7 79
11.28 82
10.25 9 83
9.22
8.2 -1
The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
$30
$ 0
$ 4
$ 8
$12
$16
$20
$24
$28
$32
$36
$40
$38
$42
$46
$50
$54
$58
$62
$66
$70
$34
AFC = TFC¸Q = $30¸Q
ATC = AVC + AFC = TC¸Q
AVC = TVC ¸ Q
$3.75
$ .50
$4.25
$1.30
$ .35
$1.65
$ .71
$ .29
$1.00
$ .53
$ .28
$.81
$ .45
$ .30
$.75
$ .41
$ .32
$.729
$ .38
$ .35
$.734
$ .37
$ .39
$.76
$ .36
$ .43
$.79
$ .37
$ .49
$.86
Fall ‘ 97
Principles of Microeconomics

26. Principles of Microeconomics
PRODUCTION AND COST
LABOUR
KAPITAL
OUTPUT AP MP
TFC
TVC TC
AFC
AVC
ATC 5 -- 1 8 2 23
11.5 15 3 42 14 19 4 57
14.25 67
13.4 10 6 74
12.33 7 79
11.28 82
10.25 9 83
9.22
8.2 -1
$30
$ 0
$ 4
$ 8
$12
$16
$20
$24
$28
$32
$36
$40
$38
$42
$46
$50
$54
$58
$62
$66
$70
$34
$3.75
$1.30
$ .71
$ .53
$ .45
$ .41
$ .38
$ .37
$ .36
$ .50
$ .35
$ .29
$ .28
$ .30
$ .32
$ .39
$ .43
$ .49
$4.25
$1.65
$1.00
$.81
$.75
$.729
$.734
$.76
$.79
$.86
Things to note . . .
As AP increases,
AVC decreases.
Since AFC declines, it will “pull” the ATC down as Q increases beyond the minimum of the AVC.
When AP is a maximum, AVC is a minimum.
AFC declines so long as Q or output increases.
{Up to the point where TP becomes negative.}
Fall ‘ 97
Principles of Microeconomics

27. Principles of Microeconomics
L x PL = TVC
TPL is Q
L x PL = TVC Z
TVC = L x PL
TVC
TPL = Q
TPL
TPL
When TP or Q increases at an increasing rate, Z’
L2 x PL
TVC
TVC increases at a decreasing rate.
TPL
[a mirror image]
L2 x PL
L1 x PL
[a mirror image]
Q* is the output with the lowest
AVC! [Max AP]
TPL = Q Q L1 L2 L3 L Q*
At L1 [inflection point] the MP is a maximum; the point of Diminishing Marginal productivity begins, each additional worker increases output, but at a smaller and smaller amount.
At L2 the AP is a maximum; output per worker is a maximum, “maximum efficiency;” additional units of labour are less “productive.”
At L3 the TP is a maximum; this is the maximum amout of output [Q] that can be produced given the size of the plant [fixed input K]. Additional [marginal] L is negative.
Fall ‘ 97
Principles of Microeconomics

28. Principles of Microeconomics
The average variable cost [AVC] and marginal cost [MC] are “mirror” images of the AP and MP functions.
MPL
APL
APL
APL
MPL
APL
MPL L1 L2 L3 L3 L
The maximum of the AP is consistent with
the minimum of the AVC. $
MC = 1 MP
x PL
APL
MPL MC
AVC
AVC = 1 AP
x PL
AVC Q
APL x L2
Fall ‘ 97
Principles of Microeconomics

29. Principles of Microeconomics$
MC will intersect the AVC at the minimum of the AVC [always]. MC
ATC
AVC
ATC* R J
MC will intersect the ATC at the minimum of the ATC.
TC = ATC* x Q**
AVC*
The vertical distance between ATC and AVC at any output is the AFC. At Q** AFC is RJ.
TVC = AVC* x Q* Q*
Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.
Fall ‘ 97
Principles of Microeconomics

30. Principles of Microeconomics
The Long Run
The long run is a period of time where:
technology is constant
All inputs are variable
The long run period is a series of short run periods. [For each short run period there is a set of TP, AP, MP, MC, AFC, AVC, ATC, TC, TVC & TFC for each possible scale of plant]
Fall ‘ 97
Principles of Microeconomics

31. Principles of Microeconomics
LONG RUN COSTS
Plant ATC* is the optimal size!
MC1
LRMC $
ATC!
LRAC
MC2
ATC6
ATC2
ATC5
ATC3
ATC*
ATC*
There is a long run
marginal cost function.
Cmin
At Q* the cost per unit are minimized [the least inputs used]. Q* Q
For Plant size 1, the costs are ATC1 and MC1 :
For a bigger Plant 2, the unit costs move out and down. It is more cost effective.
As bigger plants are built the ATC moves out and down.
Eventually, the plant size is “too large,” the ATC moves out but also up!
An “envelope curve” is constructed to represent the long run AC [LRAC].
Fall ‘ 97
Principles of Microeconomics

32. Principles of Microeconomics
The LRAC
LRAC is “U-Shaped”
The LRAC initially decreases due to “economies of scale”
economies of scale are due to division of labour.
Eventually, “diseconomies of scale” begin
usually lack of adequate information to manage the production process
Fall ‘ 97
Principles of Microeconomics

33. Principles of Microeconomics
Calculation of LRAC
With a little mathematics, the long run cost functions can be calculated.
It is easier to use equations rather than tables and graphs.
If consumer behavior, production and cost is understood, you can then think about how to achieve your objectives.
Fall ‘ 97
Principles of Microeconomics