introduction to production and resource use

Introduction toProduction and

Resource Use

Chapter 6

Topics of Discussion

Conditions of perfect competition

Classification of productive inputs

Important production relationships (Assume one variable input in this chapter)

Assessing short run business costs

Economics of short run production decisions

2

Conditions for Perfect CompetitionHomogeneous products

i.e., Corn grain, mined low-sulfur coal

No barriers to entry or exit i.e., Regulatory, extremely high fixed costs

Large number of sellersHow large is large?

Perfect informationInformation cost is relatively smallNo one firm has access to information and

others don’t Page 863

Classification of InputsEconomists view the production process

as one where a variety of inputs are combined to produce a single or multiple outputs Cheese plant example

Labor, cheese vats, milk, energy, starter cultures, cutting and wrapping tables, water, etc.

Cheese, dry whey, whey protein concentrates are produced by the plant

Pages 86-874

Classification of InputsLand: includes renewable (forests) and

non-renewable (minerals) resourcesLabor: all owner and hired labor

services, excluding managementCapital: Manufactured goods such as

fuel, chemicals, tractors and buildings that may have an extended lifetime

Management: Makes production decisions designed to achieve specific economic goal

Pages 86-875

Classification of InputsInputs can also be classified depending

on whether amount of input used changes with production level Fixed inputs: The amount used does not

change with output level Up to a point the size of milking parlor does not

change with ↑ milk production/cow or for initial ↑ in herd size

Variable Inputs: The amount of input used changes with the level of output Usually the amount of labor supplied is a

variable input (i.e., car assembly plant that ↑ the speed of assembly line to ↑ production/hour

Pages 86-876

Production Function

Output = f(labor | capital, land, and management)

Page 88

Start withone variable

input

Start withone variable

input

f(•) is general functional notation Could be any functional form

Assume remaining inputsfixed at current levels

Assume remaining inputsfixed at current levels

7

9

Point Labor (hr) Output

A 10 1.0

B 16 3.0

C 20 4.8

D 22 6.5

E 26 8.1

F 32 9.6

G 40 10.8

H 50 11.6

I 62 12.0

J 76 11.7

Production FunctionWe can graph the

relationship between output and amount of labor usedKnown as the Total

Physical Product (TPP) curve

Purely a physical relationship, no economics involved X lbs of fertilizer/A

generates a yield of Y

8

Total Physical Product (TPP) Curve

Variable inputVariable input

Maximum Output

↓ Output

9

Other Physical Relationships

The following derivations of the TPP curve play an important role in decision-making

Marginal Physical Product (MPP) =

Average Physical Product (APP) =

Page 90

Output

Input

Output Qty

Input Qty

10

MPP = Change in output as you change input use

Page 89

Production Function

Output

Input

PointLabor

[1]Output

[2]∆Labor

[3]∆Output

[4]

MPP [5] = [4]

÷ [3]

A 10 1.0 ----- ----- -----

B 16 3.0 6 2 0.33

C 20 4.8 4 1.8 0.45

D 22 6.5 2 1.7 0.85

E 26 8.1 4 1.6 0.40

F 32 9.6 6 1.5 0.25

G 40 10.8 8 1.2 0.15

H 50 11.6 10 0.8 0.08

I 62 12.0 12 0.4 0.02

J 76 11.7 14 0.3 -0.0211


Input

MPP = 1.8/4.0 = .45Output ↑ from 3.0 to 4.8

units = 1.8Labor ↑ from 16 to 20

units = 4.0

Output

12

Law of DiminishingMarginal Returns

Pertains to what happens to the MPP with increased use of a single variable input If there are other inputs their level of use is not

changed

Diminishing Marginal ReturnsThe MPP ↑ with initial use of a variable inputAt some point, MPP reaches a maximum with

greater input useEventually MPP ↓ as input use continues to ↑

Page 9313

PointLabor

[1]Output

[2]∆Labor

[3]∆Output

[4]

MPP [5] = [4]

÷ [3]

A 10 1.0 ----- ----- -----

B 16 3.0 6 2 0.33

C 20 4.8 4 1.8 0.45

D 22 6.5 2 1.7 0.85

E 26 8.1 4 1.6 0.40

F 32 9.6 6 1.5 0.25

G 40 10.8 8 1.2 0.15

H 50 11.6 10 0.8 0.08

I 62 12.0 12 0.4 0.02

J 76 11.7 14 0.3 -0.02

Production Function

14

Plotting the MPP Curve

Page 91

Change in outputassociated with achange in inputs

Change from A to B on the production function → a MPP of 0.33

15

PointLabor

[1]Output

[2]∆Labor

[3]∆Output

[4]

APP[6] = [2]

÷ [1]

A 10 1.0 ----- ----- 0.10

B 16 3.0 6 2 0.19

C 20 4.8 4 1.8 0.24

D 22 6.5 2 1.7 0.30

E 26 8.1 4 1.6 0.31

F 32 9.6 6 1.5 0.30

G 40 10.8 8 1.2 0.27

H 50 11.6 10 0.8 0.23

I 62 12.0 12 0.4 0.19

J 76 11.7 14 0.3 0.15

Production Function

Average Physical Product (APP) = Amount of output/ amount of inputs used= Output/unit of input used

Average Physical Product (APP) = Amount of output/ amount of inputs used= Output/unit of input used

16


APP = .31 (= 8÷26) with labor use = 26

Output

Input

17

Plotting the APP Curve

APP = output leveldivided by level of input use

Output dividedby labor use at B (3 ÷ 16) =0.19

18

Definition of the Three Stages of Production

APP is increasing in Stage IAPP is increasing in Stage I

Stage I: MPP > APP APP is ↑

19


Stage II: MPP < APP MPP > 0

20


Stage III: MPP < 0

21

Why are Stage I andStage III irrational from the producer’s perspective?


22

Productivity is increasing as more inputs are being used so why stop if the average return is greater than cost?

Can increase output by using less inputs: →More output and less cost


23

The question for the producer is: What level of input amount represented by Stage II should the I use?

The question for the producer is: What level of input amount represented by Stage II should the I use?


24

Economic DimensionTo answer the above question

We need to account for the price of the product being produced

We also need to account for the cost of the inputs used to produce the above product

25

Key Cost Relationships The following cost concepts play key

roles in determining where in Stage II a producer will want to produce Marginal Cost (MC) = total cost of

production ÷ output produced as output level changes = variable cost of production ÷

output produced given that total fixed costs by definition do not change with output Average Variable Cost (AVC) = total

variable cost of production ÷ total amount of output produced

Page 94-9626

Key Cost Relationships The following cost concepts play key roles

in determining where in Stage II a producer will want to produce Average Fixed Cost (AFC) = total fixed

cost of production ÷ total amount of output produced

Average Total Cost (ATC) = total cost of production ÷ total amount of output produced = AVC + ATC

Page 94-9627

From TPP curve onpage 113

From TPP curve onpage 113

Page 94

28

Fixed costs are$100 no matter

the level ofproduction

Fixed costs are$100 no matter

the level ofproduction Page 94

29

Total fixed costs (Col. 2)÷ by total output (Col. 1)

Total fixed costs (Col. 2)÷ by total output (Col. 1)

Page 94

30

Costs that varywith level of production

Costs that varywith level of production

31

Total variable cost (Col. 4) ÷ by total output

(Col. 1)

Total variable cost (Col. 4) ÷ by total output

(Col. 1)32

Total Fixed Cost (Col. 2) + Total Variable

Cost (Col.4)

Total Fixed Cost (Col. 2) + Total Variable

Cost (Col.4)33

Change in Total Cost (Col. 4 or 6) associated with a change in output (Col. 1)

Change in Total Cost (Col. 4 or 6) associated with a change in output (Col. 1)

34

[Total Cost (Col. 6) ÷ by Total Output (Col. (1)] or [Avg. Variable Cost + Avg. Fixed Cost]

35

Let’s Graph the Above Cost Items Contained

in this Table

36

Table 6.3 Cost Relationships

0

10

20

30

40

50

60

70

3.0 4.8 6.5 8.1 9.6 10.8 11.6

MC ATC

AVC AFC

MC=min(ATC) and min(AVC)

Vertical distance between ATC and AVC = AFC

Input Use

Cos

t ($

)

37

Key Revenue ConceptsThe following revenue concepts play key roles

in determining where in Stage II a producer will want to produceTotal Revenue (TR) =Multiplication of total

amount of output produced by the sale priceAverage Revenue (AR) = Total revenue ÷

total amount of output producedMarginal Revenue (MR) = ∆ total revenue ÷

∆ total amount of output produced How much revenue is generated by one additional

unit of output? Under perfect competition, it is the per unit price

38

Now let’s assume this firm can sell its

product for $45/unit

39

Remember we are assuming perfect competition The firm takes price as given Price (Col. 2) = MR (Col. 7) What is the AR value?

Key Revenue Concepts

40

With perfect competition, where would the firm maximize profit in the above example?

Profit Maximization

41

Let’s see this in graphical form

42

Profit Maximization

0

10

20

30

40

50

60

70

1 3 4.8 6.5 8.1 9.6 10.8 11.6

MC ATCAVC MR

P=MR=AR

$45

11.2

Profit maximizingOutput where MR=MC

43

The previous graph indicated thatProfit is maximized at 11.2 units of outputMR ($45) equals MC ($45) at 11.2 units of outputProfit maximizing output occurs between points G and HAt 11.2 units of output profit would be $190.40. Let’s do the math….

The previous graph indicated thatProfit is maximized at 11.2 units of outputMR ($45) equals MC ($45) at 11.2 units of outputProfit maximizing output occurs between points G and HAt 11.2 units of output profit would be $190.40. Let’s do the math….

Profit Maximization

44

Profit at Price of $45?

28

P =45

$

Q11.2

MC

ATC

AVC

Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40

Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40

45


28

P =45

$

Q11.2

MC

ATC

AVC





$190.40

46

P=MR=AR

Zero economic profit if price falls to PBE

Firm would only produce output OBE where AR (MR) ≥ ATC

Zero economic profit if price falls to PBE

Firm would only produce output OBE where AR (MR) ≥ ATC

47


P=28

45

$

Q11.210.3

MC

ATC

AVC

Revenue = $28 10.3 = $288.40Total cost = $28 10.3 = $288.40Profit = $288.40 – $288.40 = $0

Since P = MR = ARAverage profit = $28 – $28 = $0Profit = $0 10.3 = $0 (break even)

48

P=MR=AR

Firm can just cover variable cost if price falls to PSD.

Firm would shut down if price falls below PSD

Firm can just cover variable cost if price falls to PSD.

Firm would shut down if price falls below PSD

49


28

P=18

45

$

Q11.210.38.6

MC

ATC

AVC

Revenue = $18 8.6 = $154.80Total cost = $28 8.6 = $240.80Profit = $154.80 – $240.80 = $0

Since P = MR = ARAverage profit = $18 – $28 = –$10Profit = –$10 8.6 = –$86 (Loss)

50


28

P=10

19

45

$

Q11.210.38.6

MC

ATC

AVC

7.0

Revenue = $10 7.0 = $70.00Total cost = $30 7.0 = $210.00Profit = $70.00 – $210.00 = – $140.00

Since P = MR = ARAverage profit = $10 – $30 = –$20Profit = –$20 7.0 = –$140

Average variable cost = $19Variable costs = $19 7.0 = $133.00Revenue – variable costs = –$63Not covering variable costs!!!!!!

51

The Firm’s Supply Curve

28

10

18

45

$

Q11.210.38.6

MC

ATC

AVC

7.0

52

We know that so long as P (= MR) > AVC some of the fixed costs can be coveredBetter economic position then shutting down

altogether, WHY?We know that when P (= MR)=MC, the

firm maximizes profitPortion of MC curve defined by output

level that generates the minimum AVC is referred to as the firm’s supply curve


53


28

18

45

$

Q11.210.38.6

ATC

AVC

Firm Supply CurveMC

54

Now let’s look at the demand for a single

input: Labor

55

Key Input RelationshipsThe following input-related derivations play

key roles in determining amount of variable input to use to maximize profitsMarginal Value Product (MVP) =

MPP × Product Price MPP → ∆Output ÷ ∆Input Use Product Price → ∆$ ÷ ∆Output MVP → ∆$ ÷ ∆Input Use (Additional

output value generated by the last increment in input use)

Marginal Input Cost (MIC) = wage rate, rental rate, seed cost, etc. Page 100

56

5

BC

E

F

G

H

J

MVP=MPP x Output Price

Wage rate islabor’s MIC

I

D

57

5

B

C

D

E

FG

HI

J

Profit maximizing input use ruleUse a variable input up to the point where

Value received from another unit of input

Equals cost of another unit of input→ MVP=MIC

58

5

B

C

D

E

FG

HI

J

The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit

The area below the green lined MVP curve and above the green lined MIC curve represents cumulative net benefit

59

MVP = MPP × $45MVP = MPP × $4560

Profit are maximized where MVP = MICor where MVP =$5 and MIC = $5

Profit are maximized where MVP = MICor where MVP =$5 and MIC = $5

61

Marginal net benefit (Col. 5) = MVP (Col. 3) – labor MIC (Col. 4) = Value of additional output from last unit of input net of the cost of that input

Marginal net benefit (Col. 5) = MVP (Col. 3) – labor MIC (Col. 4) = Value of additional output from last unit of input net of the cost of that input

=–

62

The cumulative net benefit (Col. 6) of input use = the sum of successive marginal net benefits (Col. 5) = the grey area in previous graph.

The cumulative net benefit (Col. 6) of input use = the sum of successive marginal net benefits (Col. 5) = the grey area in previous graph.

63

For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25

For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25

64

=–

Cumulative net benefit is maximized where MVP=MIC at $5

Cumulative net benefit is maximized where MVP=MIC at $565

5

B

C

D

E

FG

HI

J

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

66

5

B

C

D

E

FG

HI

J

If you use labor beyond the point where MVP =MIC, you begin incurring losses as the return to another unit of labor is < $5.00, its per unit cost

If you use labor beyond the point where MVP =MIC, you begin incurring losses as the return to another unit of labor is < $5.00, its per unit cost

67

A Final ThoughtOne final relationship needs to be made. The levelof profit-maximizing output (OMAX) in the graph on page 99 where MR = MC corresponds directly withthe variable input level (LMAX) in the graph on page 101 where MVP = MIC.

Going back to the production function on page 88,this means that:

OMAX = f(LMAX | capital, land and management)

68

In Summary…Features of perfect competitionFactors of production (Land, Labor,

Capital and Management)Key decision rule: Profit maximized at

output MR=MCKey decision rule: Profit maximized

where MVP=MIC

69

Chapter 7 focuses on the choice of inputs to use and products to produce….

70

introduction to production and resource use

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