Theory of Production and cost

Week 4

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

You know you're getting old when the candles cost more than the cake.Bob Hope

Economic Cost

This is different to accounting cost

What is accounting cost?

Remember Nelum? – She made Rs. 30000 profit making ice-cream. Assume Nelum was an amazing programmer and she could earn Rs. 80000 a month programming.

Her Opportunity cost = 80000 – 30000 = Rs. 50000

Which means she is losing Rs 50000 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)

No other investment yields as great a return as the investment in education. An educated workforce is the foundation of every community and the future of every economy.Brad Henry

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

HourTotal Cost

Fixed Cost

Variable Cost

Average Fixed Cost

Average Variable Cost

Average Total Cost

Marginal Cost

0 300 300 0 0 0 0

1 330 300 30 300 30 330

2 380 300 80 150 40 190

3 450 300 150 100 50 150

4 540 300 240 75 60 135

5 650 300 350 60 70 130

6 780 300 480 50 80 130

7 930 300 630 43 90 133

8 1100 300 800 38 100 138

9 1290 300 990 33 110 143

10 1500 300 1200 30 120 150

Observations

Rising Marginal Cost

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!