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Introduction to Production and Resource Use. Chapter 6. Topics of Discussion. Conditions of perfect competition Classification of inputs Important production relationships (assume one variable input in this chapter) Assessing short-run business costs Economics of short-run decisions.

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topics of discussion
Topics of Discussion
  • Conditions of perfect competition
  • Classification of inputs
  • Important production relationships (assume one variable input in this chapter)
  • Assessing short-run business costs
  • Economics of short-run decisions
conditions for perfect competition
Conditions for Perfect Competition
  • Homogeneous products
  • No barriers to entry or exit
  • Large number of sellers
  • Perfect information

Page 86

classification of inputs
Classification of Inputs
  • Land:includes renewable (forests) and non-renewable (minerals) resources
  • Labor:all owner and hired labor services, excluding management
  • Capital:manufactured goods such as fuel, chemicals, tractors and buildings
  • Management:production decisions designed to achieve specific economic goal

Pages 86-87

production function
Production Function

Output = f(labor|capital, land,

and management)

Start with

one variable

input

Page 88

production function1
Production Function

Output = f(labor|capital, land,

and management)

Start with

one variable

input

assume all other inputs

fixed at their current

levels…

Page 112

slide7

Coordinates of input and

output on the TPP curve

Page 89

law of diminishing marginal returns
Law of DiminishingMarginal Returns

“As successive units of a variable

input are added to a production

process with the other inputs held

constant, the marginal physical

product (MPP) eventually declines”

Page 93

other physical relationships
Other Physical Relationships

The following derivations of the TPP curve play

An important role in decision-making:

Marginal

Physical =  Output ÷  Input

Product

Pages 90

other physical relationships1
Other Physical Relationships

The following derivations of the TPP curve play

An important role in decision-making:

Marginal

Physical =  Output ÷  Input

Product

Average

Physical = Output ÷ Input

Product

Pages 90-91

slide12

Change in output as

you increase inputs

Page 89

slide13

Total Physical Product (TPP) Curve

Marginal physical product is .45 as labor is increased from 16 to 20

output

input

Page 89

slide14

Output per unit

input use

Page 89

slide15

Total Physical Product (TPP) Curve

Average physical product is .31 if

labor use is 26

output

input

Page 89

slide16

Plotting the MPP curve

Change in output

associated with a

change in inputs

Page 91

slide17

Marginal Physical Product

Change from point A to point B on the production function is an MPP of 0.33

Page 91

slide18

Plotting the APP Curve

Level of output

divided by the level

of input use

Page 91

slide19

Average Physical Product

Output divided

by labor use is equal to 0.19

Page 91

slide20

Three Stages of Production

Average physical

product (yield) is

increasing in Stage I

Page 91

slide21

Three Stages of Production

Marginal physical

product falls below the

average physical

product in Stage II

Page 91

slide22

Three Stages of Production

MPP goes negative

in stage III…

Page 91

slide23

Three Stages of Production

Why are Stage I and

Stage III irrational?

Page 91

slide24

Three Stages of Production

Output falling

Productivity rising so why stop???

Page 91

slide25

Three Stages of Production

The question therefore is

where should I operate in Stage II?

Page 114

economic dimensions
Economic Dimensions
  • We need to account for the price of the product
  • We also need to account for the cost of the inputs
key cost relationships
Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost =  total cost ÷  output

Page 117-120

key cost relationships1
Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost =  total cost ÷  output

Average

variable = total variable cost ÷ output

cost

Page 117-120

key cost relationships2
Key Cost Relationships

The following cost derivations play a key

role in decision-making:

Marginal cost =  total cost ÷  output

Average

variable = total variable cost ÷ output

cost

Average

fixed = total fixed cost ÷ output

cost

Average

total = total cost ÷ output = AVC+AFC

cost

Pages 94-96

slide30

From TPP

curve on

page 113

Page 94

slide31

Fixed costs are

$100 no matter

the level of

production

Page 94

slide32

Column (2)

divided by

column (1)

Page 94

slide33

Costs that vary

with level of

production

Page 94

slide35

Column (2) plus

column (4)

Page 94

slide37

Column (6) divided

by column (1) or

Page 94

slide38

or column (3) plus

column (5)

Page 94

slide40

Plotted cost relationships

from table 6.3 on page 94

Plotting costs for levels of output

Page 95

slide42

Key Revenue Concepts

Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition.

Page 98

slide44

$45

P=MR=AR

Profit maximizing

level of output,

where MR=MC

11.2

Page 99

slide45

Average

Profit = $17, or AR – ATC

P=MR=AR

$45-$28

$28

Page 99

slide46

Grey area represents

total economic profit

if the price is $45…

P=MR=AR

11.2  ($45 - $28) = $190.40

Page 99

slide47

P=MR=AR

Zero economic profit

if price falls to PBE.

Firm would only produce

output OBE . AR-ATC=0

Page 99

slide48

P=MR=AR

Economic losses

if price falls to PSD.

Firm would shut down

below output OSD

Page 99

slide49

Where is the firm’s

supply curve?

P=MR=AR

Page 99

slide50

Marginal cost curve

above AVC curve?

P=MR=AR

Page 99

slide51

Key Revenue Concepts

The previous graph indicated that profit is maximized at 11.2

units of output, where MR ($45) equals MC ($45). This occurs

between lines G and H on the table above, where at 11.2 units

of output profit would be $190.40. Let’s do the math….

Page 98

doing the math
Doing the math….

Produce 11.2 units of output (OMAX on p. 123)

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

doing the math1
Doing the math….

Produce 11.2 units of output

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28

Total costs = 11.2 × $28 = $313.60

Profit= $504.00 – $313.60 = $190.40

slide54

Doing the math….

Produce 11.2 units of output

Price of product = $45.00

Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28

Total costs = 11.2 × $28 = $313.60

Profit= $504.00 – $313.60 = $190.40

Average profit = AR – ATC = $45 – $28 = $17

Profit = $17 × 11.2 = $190.40

profit at price of 45
Profit at Price of $45?

$

MC

Revenue = $45  11.2 = $504.00

Total cost = $28  11.2 = $313.60

Profit = $504.00 – $313.60 = $190.40

Since P = MR = AR

Average profit = $45 – $28 = $17

Profit = $17  11.2 = $190.40

P =45

ATC

28

AVC

Q

11.2

slide56

Profit at Price of $45?

$

Revenue = $45  11.2 = $504.00

Total cost = $28  11.2 = $313.60

Profit = $504.00 – $313.60 = $190.40

Since P = MR = AR

Average profit = $45 – $28 = $17

Profit = $17  11.2 = $190.40

MC

P =45

$190.40

ATC

28

AVC

Q

11.2

price falls to 28 00
Price falls to $28.00….

Produce 10.3 units of output (OBE on p. 123)

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

price falls to 28 001
Price falls to $28.00….

Produce 10.3 units of output

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

Average total cost at 10.3 units of output = $28

Total costs = 10.3 × $28 = $288.40

Profit= $288.40 – $288.40 = $0.00

price falls to 28 002
Price falls to $28.00….

Produce 10.3 units of output

Price of product = $28.00

Total revenue = 10.3 × $28 = $288.40

Average total cost at 10.3 units of output = $28

Total costs = 10.3 × $28 = $288.40

Profit= $288.40 – $288.40 = $0.00

Average profit = AR – ATC = $28 – $28 = $0

Profit = $0 × 10.3 = $0.00

profit at price of 28
Profit at Price of $28?

$

Revenue = $28  10.3 = $288.40

Total cost = $28  10.3 = $288.40

Profit = $288.40 – $288.40 = $0

Since P = MR = AR

Average profit = $28 – $28 = $0

Profit = $0  10.3 = $0 (break even)

MC

45

ATC

P=28

AVC

Q

10.3

11.2

price falls to 18 00
Price falls to $18.00….

Produce 8.6 units of output (OSD on p. 123)

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

price falls to 18 001
Price falls to $18.00….

Produce 8.6 units of output

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

Average total cost at 8.6 units of output = $28

Total costs = 8.6 × $28 = $240.80

Profit= $154.80 – $240.80 = – $86.00

price falls to 18 002
Price falls to $18.00….

Produce 8.6 units of output

Price of product = $18.00

Total revenue = 8.6 × $18 = $154.80

Average total cost at 8.6 units of output = $28

Total costs = 8.6 × $28 = $240.80

Profit= $154.80 – $240.80 = – $86.00

Average profit = AR – ATC = $18 – $28 = – $10

Profit = – $10 × 8.6 = – $86.00

profit at price of 18
Profit at Price of $18?

$

MC

Revenue = $18  8.6 = $154.80

Total cost = $28  8.6 = $240.80

Profit = $154.80 – $240.80 = -$86

Since P = MR = AR

Average profit = $18 – $28 = –$10

Profit = –$10  8.6 = –$86 (Loss)

45

ATC

28

AVC

P=18

Q

8.6

10.3

11.2

price falls to 10 00
Price falls to $10.00….

Produce 7.0 units of output (below OSD on p. 123)

Price of product = $10.00

Total revenue = 7.0 × $10 = $70.00

price falls to 10 001
Price falls to $10.00….

Produce 7.0 units of output

Price of product = $10.00

Total revenue = 7.0 × $10 = $70.00

Average total cost at 7.0 units of output = $30

Total costs = 7.0 × $30 = $210.00

Profit = $70.00 – $210.00 = – $140.00

Average variable costs = $19

Total variable costs = $19 × 7.0 = $133.00

Revenue –variable costs = –$63.00 !!!!!

(not covering variable costs)

profit at price of 10
Profit at Price of $10?

$

Revenue = $10  7.0 = $70.00

Total cost = $30  7.0 = $210.00

Profit = $70.00 – $210.00 = $140.00

Since P = MR = AR

Average profit = $10 – $30 = –$20

Profit = –$20  7.0 = –$140

Average variable cost = $19

Variable costs = $19  7.0 = 133.00

Revenue – variable costs = –$63

Not covering variable costs!!!!!!

MC

45

ATC

28

AVC

18

P=10

Q

8.6

10.3

11.2

7.0

the firm s supply curve
The Firm’s Supply Curve

$

MC

45

ATC

28

AVC

18

P=10

Q

8.6

10.3

11.2

7.0

key input relationships
Key Input Relationships

The following input-related derivations also play a key role in decision-making:

Marginal

value = marginal physical product × price

product

Page 100

key input relationships1
Key Input Relationships

The following input-related derivations also play a key role in decision-making:

Marginal

value = marginal physical product × price

product (MVP)

Marginal

input = wage rate, rental rate, etc.

cost (MIC)

Page 100

slide74

D

Wage rate represents

the MIC for labor

C

E

B

F

G

5

I

H

J

Page 101

slide75

Use a variable input like

labor up to the point where the value received from the market equals the cost of another unit of

input, or MVP=MIC

D

C

E

B

F

G

5

I

H

J

Page 101

slide76

D

The area below the

green lined MVP

curve and above the

red lined MIC

curve represents

cumulative net benefit.

C

E

B

F

G

5

I

H

J

Page 101

slide78

Profit maximized where MVP = MIC

or where MVP =$5 and MIC = $5

Page 100

slide79

=

Marginal net benefit in column (5)

is equal to MVP in column (3) minus

MIC of labor in column (4)

Page 100

slide80

The cumulative net benefit in

column (6) is equal to the sum

of successive marginal net benefit

in column (5)

Page 100

slide81

For example…

$25.10 = $9.85 + $15.25

$58.35 = $25.10 + $33.25

Page 100

slide82

=

Cumulative net benefit

is maximized where

MVP=MIC at $5

Page 100

slide83

D

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

C

E

B

F

G

5

I

H

J

Page 101

slide84

D

If you went beyond the point where MVP=MIC, you begin incurring losses.

C

E

B

F

G

5

I

H

J

Page 101

a final thought
A Final Thought

One final relationship needs to be made. The level

of profit-maximizing output (OMAX) in the graph on

page 99 where MR = MC corresponds directly with

the variable input level (LMAX) in the graph on page

101 where MVP = MIC.

Going back to the production function on page 88,

this means that:

OMAX = f(LMAX|capital, land and management)

in summary
In Summary…
  • Features of perfect competition
  • Factors of production (Land, Labor, Capital and Management)
  • Key decision rule: Profit maximized at output MR=MC
  • Key decision rule:Profit maximized where MVP=MIC