UNIT 6

1. UNIT 6 COSTS AND PRODUCTION: LONG AND SHORT-RUN, TOTAL, FIXED AND VARIABLE COSTS, LAW OF DIMINISHING RETURNS, INCREASING, CONSTANT AND DIMINISHING RETURNS

2. THE ROLE OF FIRM IN PRODUCTION • A firm uses resources to convert inputs into outputs. • Firm’s technology converts inputs x into outputs Y.

3. Production and Costs The Firm’s Objective: Maximizing Profit An explicit cost is a cost that is incurred when an actual payment is made. An implicit cost represents the value of resources used in production for which no actual payment is made. This is incurred as a result of a firm using its own resources that it owns or that the owners of the firm contribute to it.

4. Accounting and Economic Profit

5. Zero Economic Profit? • It is possible for a firm to earn both a positive accounting profit and a zero economic profit. • A firm that makes zero economic profit is said to be earning normal profit. • Zero economic profit means the owner has generated total revenues sufficient to cover total opportunity costs.

6. Production • A fixed input is an input whose quantity cannot be changed as output changes in the short run. • The costs associated with fixed inputs are fixed costs. A fixed cost doesn’t change as output changes. • A variable input is an input whose quantity can be changed as output changes in the short run. • The costs associated with variable inputs are variable costs. A variable cost changes as output changes.

7. Determining the Optimal Method of Production • The optimal method of production is the method that minimizes cost.

8. The Production Process • Production technology refers to the quantitative relationship between inputs and outputs. • A labor-intensive technology relies heavily on human labor instead of capital. • Acapital-intensive technologyrelies heavily on capital instead of human labor.

9. PRODUCTION FUNCTION • A mathematical expression which relates the quantity of all inputs to the quantity of outputs assuming that management employs all inputs efficiency • Q = F(I1, I2, I3……..IN)

10. The Production Function • The production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs. It shows units of total product as a function of units of inputs.

11. PRODUCTION FUNCTION

12. Marginal Product • Marginal productis the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

13. AVERAGE PRODUCT • Average productis the average amount produced by each unit of a variable factor of production.

14. Short Run & Long Run Production • The short run is a period in which some inputs are fixed. • The long run is a period in which all inputs can be varied. • The Total Cost is the sum of fixed and variable costs

15. PERIODS OF PRODUCTION, INPUTS, AND COSTS

16. PRODUCTION IN THE SHORT RUN • As more and more variable inputs, such as labor and capital, were added to a fixed input, such as land, the variable inputs would yield smaller and smaller additions to output • As ever larger amounts of a variable input are combined with fixed inputs, eventually the marginal physical product of the variable input will decline. • The marginal physical product of a variable input is equal to the change in output that results from changing the variable input by one unit, holding all other inputs fixed.

17. THE LAW OF DIMINISHING RETURNS {PRODUCTIVITY}

18. If the law of diminishing marginal returns did not hold, then it would be possible to continue to add additional units of a variable input to a fixed input, and the marginal physical product of the variable input would never decline. We could increase output indefinitely as long as we continued to add units of a variable input to a fixed input.

19. The law of diminishing marginal returns says that as more units of the variable input are added, each one has fewer units of the fixed input to work with; consequently, output rises at a decreasing rate.

20. COSTS OF PRODUCTION: TOTAL, AVERAGE, AND MARGINAL • The Average Fixed Cost (AFC) = Total fixed cost divided by quantity of output • The Average Variable Cost (AVC) = Total variable cost divided by quantity of output.

21. The Average Total Cost (ATC) or Unit Cost= Total Cost divided by quantity of output. • The Marginal Cost is the change in total cost or total variable cost that results from a change in output

24. Average and Marginal Cost Curves

25. Sunk Cost Sunk cost is a cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered. Long – Run Average Total Cost Curve Long Run Average Total Cost Curve shows the lowest unit cost at which the firm can produce any given level of output

27. Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale • Economies of Scale exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall. • Constant Returns to Scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant. • Diseconomies of Scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise. • Minimum Efficient Scale is the lowest output level at which average total costs are minimized.

28. WHEN A FIRM SHOULD CONTINUE INBUSINESS OR SHUT DOWN

29. In the short run the firm will continue to produce as long as total revenue covers total variable costs or put another way, so long as Price per unit > or equal to Average Variable Cost (AR = AVC). The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption these costs are sunk costs (i.e. they cannot be covered if the firm shuts down) then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

30. Consider the cost and revenue curves facing a business in the short run shown in the diagram below. The market equilibrium price is P1 which means that the equilibrium output for the firm (where MR=MC) is at output Q2. The business is making an economic loss at this price (AC > P1) but the price is high enough for the business to cover all of its variable costs and also make some contribution to its fixed costs. If we assume that most of the fixed costs are lost if the firm shuts down, then the firm can justify continuing to produce in the short run, losses will be greater if they close down

32. In the second example in the diagram below, the market price is so low that the firm is not covering its variable costs let alone the fixed costs. Losses can be cut if the firm shuts down some of their productive capacity. The shut down price for a business in the short run is assumed to be the price which covers average variable cost. Therefore if price < AVC then the supplier is better off closing down a plant. We can use the concept of the shut down price to derive the competitive firm’s supply curve. The supply curve is the marginal cost curve above the shut down point

33. CLASSWORK FILL IN THE VACANT SPACES