Theory of Production and cost

1. Theory of Production and cost Class 3

2. 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

3. 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 Profit = Total Revenue – Total Cost

4. Economic Cost • This is different to accounting cost • What is account 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.

5. 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)

7. 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.

8. Production Function

9. 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.

10. 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.

13. Observations • Rising Marginal Cost • Chatura’s 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

14. 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.

15. Break Time!