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4 Productionandcost 121207091754 Phpapp02
4 Productionandcost 121207091754 Phpapp02
1. Each good or service produced requires inputs of time, materials, and capital. These
resource inputs produce an output. If we listed the greatest output possible for any set of
inputs, we would have described a production schedule, table, or function.
2. A production function is a schedule of maximum output from any set of inputs, Xi. Q = f
(X1,X2,...,Xn)
3. Production is real. It is visible either in a large scale factory assembly line or in smaller scale
in an artist's workshop. Production can be measured in the number of cars assembled or
the number of paintings completed.
4. Yet even in something as real as production, it is vital to a manager to have methods to
measure efficiency and ways to think about improving the production process. Theory is
useful when it helps organize thought in constructive ways.
6. A production function with two inputs: Q =f(K, L), where K is the amount of capital, and
L is the amount of labor is used to illustrate issues in production.
0 1 2 3 4 5 6 7 Units
Economic Efficiency
Occurs at only one point – At the Level of output where MR = MC
Price MC
P = D = MR = AR = MC MR = MC
Economic efficiency
occurs at 5 units of
output only
0 1 2 3 4 5 6 7 8 Output Q
Production Function, Q = f (L, K)
Law of Diminishing Returns
Output (Q)
Total Product Curve
Increases in one factor of production such as, holding one
12
or other factors fixed such as capital and
11 entrepreneurship, after some point, lead to diminishing
9 marginal increases in total product. i.e. the marginal
product diminishes.
0 1 2 3 4 5 6 7 Units
Cost Structure of a Firm (p60-61)
1 2 3 4 5 6 7 8
O utput FC VC TC A FC A VC A TC MC
(Q )
(2+ 3) (2/1) (3/1) (4/1) ΔTC
1 30 40 70 30.0 40.0 70.0 -
2 30 60 90 15.0 30.0 45.0 20
3 30 90 120 10.0 30.0 40.0 30
4 30 130 160 7.5 32.5 40.0 40
5 30 180 210 6.0 36.0 42.0 50
6 30 250 280 5.0 41.7 46.7 70
7 30 350 380 4.3 50.0 54.3 100
Relationship between the Cost Curves
1. When the marginal cost is below the average cost (MC < AC), your average costs are falling.
2. When the marginal cost is equal to the average cost (MC = AC), your average cost stays the same.
3. When the marginal cost is above the average cost (MC > AC), your average costs are rising.
Note: MC curve always cut both the AVC and the ATC at their minimum points.
C
o
st MC
’s
/
u
n
it
ATC
AVC
0
Quantity (Q)
Short-Run Average Cost Curves
Cost’
s
/unit
AC
Fixed Costs are spread over a larger output – Law of Diminishing Returns set-in
Increasing returns to scale – Decreasing returns to scale
Better use of
specialisation
0
Quantity (Q)
Long-Run Average Cost Curves
Long-Run Average Cost Curves are downward
sloping due to:
1.Product-specific economies which include Long-Run Average Cost Curves
specialization and learning curve effects.
2.Plant-specific economies, such as economies in
overhead, required reserves, investment, or
interactions among products
3.Firm-specific economies which are economies in
distribution and transportation of a
geographically dispersed firm, or economies in
marketing, sales promotion, or R&D of multi-
product firms.
Economies of Scale: These include purchasing
economies – a large firm can benefit from bulk
purchases of inputs, construction economies
– building costs do not increase with the size of
the firm, economies – greater specialisation
and division of – greater productivity,
financial economies- better interest rate terms
and advertising economies – advertising costs
per unit of output are lower for a large firm.
Long-Run Average Cost Curves
Envelope of Short-Run ATC Curves
Sample Exam Question: Describe and illustrate the three stages of production.
Relationship between Inputs and Output
Production Functions and Returns to Scale
1. Constant Returns to Scale (CRS) increasing all inputs by lambda (λ) percent,
increases output by lambda percent.
∆AVC
Minimum AVC, is where =0
∆Q
VC 0.5Q 3 − 10Q 2 + 150Q
1.where AVC = Q Q = 0.5Q 2 - 10Q + 150
∆AVC
2. = ∆Q Q -10 = 0, So Q = 10, AVC minimised at Q =10
∆TC
3. MC function = = 1.5Q 2 − 20Q + 150
∆Q
Sample Question 2
Consider the following variable cost function: VC = 120Q - 9Q 2 + 0.25Q3.
Fixed costs = 180 and Q = output.
a. Determine the average variable cost (AVC) function?
AVC = VC = 120Q − 9Q 2 + 0.25Q 3 = 120Q – 9Q +0.25Q2
Q Q
b. Find the level of output Q that minimises average variable costs?
∆VC
AVC are minimised when =0 -9 + 0.5Q = 0, so Q = 4.5
∆Q
∆TC
MC function = = 120 − 18Q + 0.75Q 2
∆Q
Sample Question 3
Suppose: Q = 1.4 L0.70 K0.35