L6 Production and Cost

• An entity concerned with the purchase and employment of resources in the production of various goods and services.

  Firm
• May be a sole proprietorship, partnership or corporation.

  Firm
• Forms of Business Organizations (3)

  1.Sole proprietorship

  2.Partnership

  3.Corporation
• -Easy to set up and organize

  -All profits and all costs assumed by the owner.  -Unlimited liability.

  Sole proprietorship
• -Easy to organize; less legal expense and paperwork viz. corporation; greater specialization possible.

  -dissolved when partner dies. -Unlimited liability.

  Partnership
• -Most dominant form of business enterprise.

  -Most effective for raising financial capital.

  When any of its owners dies, it is not dissolved. -Substantial legal expense in setting up. 

  Corporation
• Principal - owners may want maximum profit
• Agent - managers may go for power and prestige
• The production function is a physical relationship between the inputs of a firm and its output of goods and services
• Production function is a purely technological relationship – no economics!
• inputs of a firm are resources that contribute to the production of a good/service.
• Examples of inputs (3):

  1.land

  2. labor 

  3. capital
• Fixed inputs are resources that are used at a constant amount in the production of a commodity.
• Variable inputs are resources that can change in quantity depending on the level of output being produced.
• Fixed inputs will exist over short planning period.
• All inputs are variable in the long run.
• Only one input used in production, say labor (L).
• Only one input (labor) is variable and all other inputs are fixed.
• Total product (TP or Q) refers to the total amount of output produced by the firm. This is measured in physical units (e.g., kilograms of sugar, sacks of rice produced).
• Marginal product - The change in output for a one unit change in the quantity of an input, holding all other inputs constant.
• The principle of diminishing marginal product states that “as the use of an input increases with other inputs fixed, a point will eventually be reached.
• The average product measures the total output per unit of input used.
• productivity" of an input is usually expressed in terms of its average product.
• Stage I

  • AP is increasing so MP > AP

  • Stage I stops where AP reaches its maximum point (MP = AP)
• Stage II

  • starts where the AP begins to decline

  • Q continues to increase, although at a decreasing rate, and in fact reaches a maximum.

  • MP declines, until it reaches zero, as additional labor inputs are employed.
• Stage III

  • starts where the MPL has turned negative.

  • Q falls as more inputs are used in production

  • TP, AP and MP curves are decreasing

  • The firm will produce in Stage II.
• Opportunity Cost Principle - the economic cost of an input used in a production process is the value of output sacrificed elsewhere.
• opportunity cost of an input is the value of foregone income in best alternative employment.
• Costs of production include those items which are explicit and implicit.
• Explicit costs

  • These are payments made by one entity or individual to another - “out of pocket” costs.
• Implicit cost

  • These are imputed costs of self-owned or self employed resources based on their opportunity costs; no actual payment made from one entity to another.
• Short run: (7)

  1.Total Fixed Cost (TFC)

  2. Total Variable Cost (TVC)

  3. Total Cost (TC=TVC+TFC)

  4. Average Fixed Cost (AFC=TFC/Q) 

  5. Average Variable Cost (AVC=TVC/Q) 

  6. Average Total Cost (AC=AFC+AVC) 

  7. Marginal Cost (MC= ∆TC/∆Q)
• Long run: (3) all costs are variable 

  1.TFC=AFC=0

  2. TVC=TC

  3. AVC=AC
• Total fixed cost (TFC)

  Aka sunk cost or overhead cost. This component of cost is independent of the level of output produced.
• Total variable cost (TVC) - Component of cost that changes with the level of output.
• Total cost (TC) - sum of total fixed cost and total variable cost.
• Average fixed cost - this declines as Q increases. However for TFC>0, it never becomes zero.
• Average variable cost - as Q increases, AVC declines initially and then rises. This generates U shaped curve
• Average cost - sum of AFC and AVC.
• Marginal cost - shows the change in total cost for a unit change in output.