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Principles of Economics

Principles of Economics. Production Costs Deduction of supply. 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).

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Principles of Economics

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  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. Marginalandaverageproduct • MARGINAL PRODUCT (MP) is a change in total productdue to anincreaseintheamount of inputsby 1 unit. MPL = TP(L)-TP(L-1) MPK = TP(K)-TP(K-1) • AVERAGE PRODUCT (AP) is theratio of total productandcurrentamount of inputs APL = TP/L APK = TP/K • GRANIČNI proizvod je porast ukupnog proizvoda uslijed porasta količine inputa za jednu jedinicu:

  5. Verticalcut of a productionfunction q • Verticalcut of a productionfunction – intheshortrun (theotherinputs are heldconstant) • Shortrun: at least one input is fixed • Longrun: all inputs are variable TP L 0 q AP 0 L MP

  6. Production elasticity • % change of theoutputcausedby a 1% change of theinput:

  7. Returns • LAW OF DIMINISHING RETURNS saysthateveryadditionalunit of aninput, otherinputsbeingconstant, bringseach time less of theadditionaloutput(MP decreases). • RETURNS TO A FACTOR of productionobserve how theoutputchangeswhen a singleinputchanges, otherinputskeptconstant. • RETURNS TO SCALE observe how theoutputchangeswhen all theinputsincreaseinthe same proportion.

  8. 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 stretchesproductionfunctionupwardswithoutadditional use of inputs.

  9. Technological progress q TP2 B↑ TP1 0 K, L

  10. 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, MRTSab . It tells by how much the use of b has to increase of a decreases by 1 small unit (a and b are inputs)

  11. L ISOQUANTS ΔK = 1 ΔL = MRTSKL q4 q3 q2 q1 0 K

  12. Isocost • ISOCOST is a line thatconnects all thecombinations of inputsthatcausethe same cost. • Slope of theisocostequalstheratiooftheinputprices

  13. y TC’ > TC 0 x

  14. The minimum costproductioncombination • The minimum cost of productionofcertainamountofgoodsq* is achievedwhenisocostistangent to the isoquant thatcorresponds to theamount of goodsq*.

  15. y q3 q2 q1 0 x

  16. Exercise 1 • 1) Based on thevalues of averageproductoflabourfind total andmarginalproduct!

  17. Solution:

  18. Exercise 2 • Ifmarginalproduct of labour (MPL) is 10, marginalproduct of capital (MPK) 20, andmarginalproduct of (MPN) 15, what are theprices of capital (PK) andland (PN) ifwages (PL) are 5 andcompanyhas minimum costs?

  19. solution

  20. 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 thecostsperunit of production: AC = TC/q • Averagefixedcosts (AFC) are fixedcostsperunit of production: AFC = AFC/q • Averagevariablecosts (AFC) are fixedcostsperunit of production: AFC = FC/q

  21. 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

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

  23. Productionandcostsrelation • TC(1) = wL1 + rK1 + iA1 where L1, K1, A1 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 (L1↓, K1↓, A1↓) and TC decrease

  24. Economiesofscale • Economiesofscale is a situationinwhichaveragecostsofproductionfall as quantityofproductionincreases. • Diseconomiesofscale is a situationinwhichaveragecostsofproductionfall as quantityofproductionincreases. • Costelasticity: % change ofcostscausedby a 1% change inproducedquantity MC p AC 0 q Economiesofscale AC falls ETC < 1 Diseconomiesofscale AC rises ETC > 1 ETC = 1

  25. Othertermsaboutcosts • 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 certainpoint of time)

  26. Exercise 3 • Iffixedcosts are 100 andvariablecostsincreaseby 30 kn for eachadditionalunit of outputfind all costfunctions.

  27. 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

  28. Exercise 4 • Based on the dana inthe Table find total costs (TC), averagefixedcosts (AFC), averagevariablecosts (AVC), average total costs (AC) andmarginalcosts (MC) andthenshowthemgraphically.

  29. solution

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

  31. 10000 8000 6000 4000 2000 0 MC AC AVC AFC 0 5 10 15 20 25 30 35 Q

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

  33. Supplyand profit maximization on perfectlycompetitivemarkets • Perfect competition properties: • Many small companies unable to affect prices (price takers) • Market demand is horizontal (Ed = -∞) • Marginal revenue is equal to price since price is constant • Perfect information • Homogeneous product • Freeentryandexit

  34. Assumption: companymaximizesits profit • Profit is a differencebetween total revenueandtotalcosts • TOTAL REVENUE (TR): TR = p×q • Profit maximizationcondition: • MR = MC • Since P = const.⟹ MR = P = MC • It meansthat for foreach price p suppliedquantitywillbedeterminedbyequationp = MC: MC p AC AVC MC 0 q

  35. 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

  36. MC MC p p AC AC SSR SLR BEP Z AVC AVC MC MC 0 q 0 q Supplyintheshortrun (MC above AVC) Supplyinthelongrun (MC above AC)

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

  38. Exercise 6 • Dailyoutput of a companyearns it TR = 5000$. Companymaximizesits profit. Averagecost is AC = 8$, marginalcost MC = 10$ andaveragevariablecost AVC = 5$. What is theamount of productionandfixedcost FC?

  39. 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

  40. Exercise 7 Companysells a goodwhich price is p = 62 on a perfectlycompetitivemarket. Company’s averagevariablecosts are givenwiththefollowing table. Fixedcosts are 168. Findquantity at whichcompany a) maximizesits profit, b) shutsdownand c) hasbreakevenpoint

  41. solution Shutdownpoint Breakevenpoint Optimalproductionlevel Shortrunsupply: MC for q > 5, Longrunsupply: MC for q ≥ 7

  42. Exercise 8 There are 6 situationsinthefollowing table. Givetheadvicewhat to do ineverysituation: a) Keepthecurrentlevel of output b) Increasethe price c) Increaseproduction d) Lowerthe price e) Lowerproduction f) Stop production

  43. solution 1. P=AVC -> f Stop production! 2. MC=ATC -> a Keepthecurrentproductionlevel! 3. MC>P -> e Lowerproduction! 4. P<AVC -> f Stop production! 5. P>MC -> c Increaseproduction! 6. P>MC -> c Increaseproduction!

  44. Exercise 9 • A farmer rents 10 hectares of landandpays $5,50 perhectare. Depending on theworkinghoursemployed, farmer’s wheatproductionchanges (Table). Wage is $5. Find TC Find MC, AC, FC, AFC, AVC Find APLand MPL

  45. FC = 5.5×10 = 55

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