1. Principles of Economics Production Costs Deduction of supply

2. Production PRODUCTION is a process in which inputs are transformed into outputs. Outputs can be either consumed or used as an input for another production process (corn, corn flour, bread). PRODUCTION is organized in small, medium and large companies. Large companies have lower interest rates and attract more capital, while small companies are more adaptable to new circumstances

3. Total product PRODUCTION FUNCTION (TP or q) expresses the maximum amount of production (output) that can be produced using the given amount of inputs (K, L, A) q = TP(K, L, A) =B×f(K,L,A)

4. Marginal and average product MARGINAL PRODUCT (MP) is a change in total product due to an increase in the amount of inputs by 1 unit. MP L = TP(L)-TP(L-1) MP K = TP(K)-TP(K-1) AVERAGE PRODUCT (AP) is the ratio of total product and current amount of inputs AP L = TP/L AP K = TP/K GRANIČNI proizvod je porast ukupnog proizvoda uslijed porasta količine inputa za jednu jedinicu:

5. q 0 L TP q 0L MP AP Vertical cut of a production function – in the short run (the other inputs are held constant) Short run: at least one input is fixed Long run: all inputs are variable Vertical cut of a production function

6. Production elasticity % change of the output caused by a 1% change of the input:

7. Returns LAW OF DIMINISHING RETURNS says that every additional unit of an input, other inputs being constant, brings each time less of the additional output (MP decreases). RETURNS TO A FACTOR of production observe how the output changes when a single input changes, other inputs kept constant. RETURNS TO SCALE observe how the output changes when all the inputs increase in the same proportion.

8. 1 input is doubled Output is less then doubled Decreasing returns to a factor E q < 1 Output is doubled Constant returns to a factor E q = 1 Output is more than doubled Increasing returns to a factor E q > 1 All inputs are doubled Output is less then doubled Decreasing returns to scale E q,K + E q,L < 1 Output is doubled Constant returns to scale E q,K + E q,L = 1 Output is more than doubled Increasing returns scale E q,K + E q,L > 1

9. Technological progress Technological progress (B) is the improvement of production processes by improvement of the old products or invention of the new ones. Technological progress can be either a PRODUCT INNOVATION or PROCESS INNOVATION. Product innovation: development of new goods Process innovation: improvement of the production processes Technological progress stretches production function upwards without additional use of inputs.

10. Technological progress q 0 TP 1 TP 2 K, L B↑B↑

11. Isoquants Isoquants are a horizontal cut of a production function showing all the combinations of inputs with which one can produce the same amount of goods q. Slope of the isoquant is Marginal rate of technical substitution, MRTS ab. It tells by how much the use of b has to increase of a decreases by 1 small unit (a and b are inputs)

12. q2q2 L 0 K q3q3 q4q4 q1q1 Δ K = 1 Δ L = MRTS KL ISOQUANTS

13. Isocost ISOCOST is a line that connects all the combinations of inputs that cause the same cost. Slope of the isocost equals the ratio of the input prices

14. y 0 x TC’ > TC

15. The minimum cost production combination The minimum cost of production of certain amount of goods q* is achieved when isocost is tangent to the isoquant that corresponds to the amount of goods q*.

16. q2q2 y 0 x q3q3 q1q1

17. Exercise 1 1) Based on the values of average product of labour find total and marginal product!

18. Solution:

19. Exercise 2 If marginal product of labour (MP L ) is 10, marginal product of capital (MP K ) 20, and marginal product of (MP N ) 15, what are the prices of capital (P K ) and land (P N ) if wages (P L ) are 5 and company has minimum costs?

20. solution

21. Costs So far costs were expressed as a function of the amount of inputs TC(q(K,L)) Now costs will be analyzed as a function of the quantity of production TC(q) Costs are either VARIABLE (change with the quantity of production) or FIXED. Average total costs (AC or ATC) are the costs per unit of production: AC = TC/q Average fixed costs (AFC) are fixed costs per unit of production: AFC = AFC/q Average variable costs (AFC) are fixed costs per unit of production: AFC = FC/q

22. TC/Q = VC/Q + FC/Q AC = AVC + AFC Marginal costs (MC) – increase in costs when q increases by 1. MC(q) = TC(q) – TC(q-1) = VC(q) – VC(q-1) MC = ΔTC/ Δq

23. p 0q TC p 0q MC VC AVC AC AFC FC

24. Production and costs relation TC(1) = wL 1 + rK 1 + iA 1 where L 1, K 1, A 1 are the amounts of inputs needed to produce 1 unit of output. If prices of inputs (w, r, i) fall TC decrease If technology progresses (B↑) the use of inputs fall (L 1 ↓, K 1 ↓, A 1 ↓) and TC decrease

25. Economies of scale Economies of scale is a situation in which average costs of production fall as quantity of production increases. Diseconomies of scale is a situation in which average costs of production fall as quantity of production increases. Cost elasticity: % change of costs caused by a 1% change in produced quantity p 0q AC MC Diseconomies of scale AC rises E TC > 1 Economies of scale AC falls E TC < 1 E TC = 1

26. Other terms about costs Substitution rule: if an input becomes cheaper, it will be used more and the other inputs will be used less until MP/price of inputs becomes equal again. Economic costs include opportunity costs, but not sunk costs Accounting costs: Profit & Loss Statement: Π = TR – TC (in a time period) Balance sheet: Assets = Capital + Liabilities (at certain point of time)

27. Exercise 3 If fixed costs are 100 and variable costs increase by 30 kn for each additional unit of output find all cost functions.

28. solution FC = 100 VC = 30Q TC = FC + VC = 100 + 30Q AFC = FC/Q = 100/Q AVC = VC/Q = 30 AC = 100/Q + 30 MC = 30

29. Exercise 4 Based on the dana in the Table find total costs (TC), average fixed costs (AFC), average variable costs (AVC), average total costs (AC) and marginal costs (MC) and then show them graphically. QVC 00 515000 1025000 1532500 2042000 2554500 3071500 3596500

30. solution QVCFCTCAFCAVCACMC 0040000 ---- 515000400005500080003000110003000 102500040000650004000250065002000 153250040000725002667216748331500 204200040000820002000210041001900 255450040000945001600218037802500 3071500400001115001333238337173400 3596500400001365001143275739005000

31. 0 5 10 15 20 25 30 35 Q 140000 120000 100000 80000 60000 40000 20000 0 FC VC TC

32. 0 5 10 15 20 25 30 35 Q 10000 8000 6000 4000 2000 0 AFC AVC AC MC

33. Exercise 5: Marginal costs and fixed costs are known and given in the following table. Find FC, VC, TC, AFC, AVC and AC.

35. Supply and profit maximization on perfectly competitive markets Perfect competition properties: 1.Many small companies unable to affect prices (price takers) 2.Market demand is horizontal (Ed = -∞) 3.Marginal revenue is equal to price since price is constant 4.Perfect information 5.Homogeneous product 6.Free entry and exit

36. p 0q MC AVC AC Assumption: company maximizes its profit Profit is a difference between total revenue and total costs TOTAL REVENUE (TR): TR = p×q Profit maximization condition: MR = MC Since P = const. ⟹ MR = P = MC It means that for for each price p supplied quantity will be determined by equation p = MC: MC

37. Shutdown and breakeven point If p = AVC then only variable costs are covered. Then company has to close immediately ⟹ SHUTDOWN POINT (SDP) Π = TR – TC = p×q – AVC×q – FC Π = q(p – AVC) – FC, p = AVC ⟹ Π = - FC If p = AC then revenues match the costs covering both VC and FC (Π = 0) ⟹ BREAKEVEN POINT(BEP) Π = p×q – AC×q Π = q(p – AC), p = AC ⟹ Π = 0

38. p 0q MC AVC AC MC S SR BEP Z p 0q MC AVC AC MC S LR Supply in the long run (MC above AC)Supply in the short run (MC above AVC)

39. Profit in perfect competition p 0q MC AC p MC p 0q AC p MC Extra profits (short run) Normal profits (long run)

40. Exercise 6 Daily output of a company earns it TR = 5000$. Company maximizes its profit. Average cost is AC = 8$, marginal cost MC = 10$ and average variable cost AVC = 5$. What is the amount of production and fixed cost FC?

41. solution TR = 5000 (TR=P*Q) P = MC = 10 => Q = 500 AC = AVC + AFC AFC = 8 – 5 = 3 FC = AFC*Q = 3*500 = 1500 kn

42. Exercise 7 Company sells a good which price is p = 62 on a perfectly competitive market. Company’s average variable costs are given with the following table. Fixed costs are 168. Find quantity at which company a) maximizes its profit, b) shuts down and c) has breakeven point qAVC 0- 120 214 310 48 58 6 714 820 928 1038

43. solution Short run supply: MC for q > 5, Long run supply: MC for q ≥ 7 qFCAVCVCMCTCAC 0168-0- - 1 20 188188,00 21681428819698,00 31681030219866,00 4168832220050,00 5168840820841,60 616810602022838,00 716814983826638,00 8168201606232841,00 9168282529242046,67 101683838012854854,80 Shut down point Break even point Optimal production level

44. Exercise 8 There are 6 situations in the following table. Give the advice what to do in every situation: a) Keep the current level of output b) Increase the price c) Increase production d) Lower the price e) Lower production f) Stop production

45. solution 1. P=AVC -> f Stop production! 2. MC=ATC -> a Keep the current production level! 3. MC>P -> e Lower production! 4. P f Stop production! 5. P>MC -> c Increase production! 6. P>MC -> c Increase production!

46. Exercise 9 A farmer rents 10 hectares of land and pays $5,50 per hectare. Depending on the working hours employed, farmer’s wheat production changes (Table). Wage is $5. Q (tons of wheat)L (working hours) 00 16 211 315 421 531 645 a)Find TC b)Find MC, AC, FC, AFC, AVC c)Find AP L and MP L

47. QLVCTCMCAFCAVCACAP L MP L 00055------ 163085405530850,17 211551102527,5 550,180,20 315751302018,332543,330,200,25 4211051603013,7526,25400,190,17 531155210501131810,160,10 645225280709,1737,5107,50,130,07 FC = 5.5×10 = 55