c6 production and cost

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PRODUCTION AND COST

THE CONCEPT OF PRODUCTION

Production – the creation of any good or service for the purpose of selling to buyers.

– the creation of utility.

TRANSFORMING INPUTS INTO OUTPUTS

Classifications of Inputs

Capital – including raw material ingredients, supplies, tools, machineries, equipment,

and physical facilities;

Labor – this combines and processes the various materials;

Land – where the space allotted for processing is located;

Entrepreneurial or managerial talent – performs function like supervision, planning,control, coordination and leadership.



Categories of Production Activities

1. Unique-product production – its output is “made-to-order” products and services.

Education as a Production Activity

Inputs Production Activity Outputs

the means of transforming inputs into outputsteachers

administrators

buildings

suppliesequipment

– like actual classroom activity – educated children

2. Rigid mass production – involves the manufacturing of uniform products in large

quantities using a well-defined, proven, and usually inflexible

technology.

Standardization makes the tools (as well as materials andparts) interchangeable which minimizes disruptions in

processing.



3. Flexible mass production

2 Stages of Processing

Mass production of standardized components.

Components are assembled into final products that appear different from one another.

e.g. A book with a single master copy can be produced in two editions: the

clothbound and the paperbound.

4. Process or flow production – a continuous flow of output .

PRODUCTION FUNCTION – the relationship between the amounts of input

(resources) required and the amount of outputs (goods

and services) that can be obtained.

The production function is really a schedule (a table or mathematical equation) showing

the maximum of outputs that can be produced from any specified set of inputs given the

existing technology.

Production Time Periods

Short-run – a period of time in which producers are able to change the quantities of

some but not all of the resources they employ ;

– a period in which some resources (usually plant) are fixed and some are

variable.



Long-run – a period of time long enough to enable producers of a product to change

the quantities of all the resources they employ;

– a period in which all resources or costs are variable and no resources or

costs are fixed.

PRODUCTION WITH ONE VARIABLE INPUT

Total product ( TP ) – the total quantity, or total output, of a particular good produced.

Average product ( AP ) – also called labor productivity, is output per unit of labor input.

total product

Average product =

units of labor

TP AP =

L

Marginal product ( MP ) – is the extra output or added product associated with adding

a unit of variable resources ( in this case labor ) to the

production process.

change in total product

Marginal product =

change in labor input

( TP2 – TP1 )

MP =

L2 – L1



Law of Diminishing Returns – as successive units of a variable resource ( say, labor ) are

added to a fixed resource ( say, capital or land ) beyond

some point the extra, or marginal, product that can be

attributed to each additional unit of the variable

resource will decline. Table 1 Total, Marginal, and Average Product in the Law of Diminishing Return

(3) (4)

(1) Marginal Product (MP) Average

Units of the Variable (2) Change in (2) ÷ Product (AP),

Resource (Labor) Total Product (TP) Change in (1) (2) ÷ (1)

0

1

2

3

4

5

6

7

8

0

10

25

45

60

70

75

75

70

10

15

20

15

10

5

0

–5

Increasing

marginal

returns

Diminishingmarginal

returns

Negative

marginal

returns

10.00

12.50

15.00

15.00

14.00

12.50

10.71

8.75



Stages of Diminishing Returns

Stage 1: Increasing Returns

TP increase, AP increase and reaches maximum, MP increase and reaches

maximum and decrease, MP is greater than AP.

Stage 2: Diminishing Returns

TP increase and reaches maximum, AP begins to decline, MP decrease and

becomes zero.

Stage 3: Negative Returns

TP decrease, AP decrease, and MP negative.

Total Product

75

TP

Total product (TP) 50

25

0 1 2 3 4 5 6 7 8 9 Quantity of labor



As a variable resource (labor) is added to fixed amounts of other resources (land or capital),

the total product that results will eventually increase by diminishing amounts, reach a

maximum, and then decline.

Marginal and Average Product

Marginal product (MP) 20

10

0 1 2 3 4 5 6 7 8 9

Quantity of labor

Marginal product is the change in total product associated with each new unit of labor.Average product is simply output per labor unit. Note that marginal product intersects

average product at the maximum average point.

MP

AP

Increasing

marginal

returns

Diminishing

marginal

returns

Negative

marginal

returns



COST OF PRODUCTION

Implicit cost – refers to the value of inputs being owned by the firm and use in its own

production process.

Explicit cost – refers to the actual expenses of the firm in purchasing or hiring theinputs it needed.

Types of Explicit Cost

1. Fixed cost ( FC ) – those costs that do not change as output change.

e.g. rental payments, interest on a firm’s debt, a portion of depreciation

on equipment and buildings, insurance premiums are generally

fixed cost; they do not increase even if a firm produces more.

2. Variable cost ( VC ) – those costs that change with the level of output.

e.g. payments for materials, fuel, power, transportation services,

most labor, and similar variable resources.



4. Average fixed cost ( AFC ) – a firm’s total fixed cost divided by output.

AFC = TFC ÷ Q

5. Average variable cost ( AVC ) – a firm’s total variable cost divided by output.

AVC = TVC ÷ Q

6. Average Total cost ( ATC ) – a firm’s total cost divided by output.

TC TFC

ATC = = = AFC + AVC

Q AVC

7. Marginal cost ( MC ) – the extra, or additional, cost of producing 1 more unit of output.

change in TC ( TC 2 – TC 1 )

MC =

change in Q ( Q2 – Q1 )

Other Explicit Costs

3. Total cost ( TC ) – is the sum of fixed cost and variable cost.

TC = FC + VC



Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run

Average-Cost Data Marginal Cost

Total-Cost Data (5) (6) (7)

(1) (2) (3) (4) Average Average Average (8)

Total Total Total Total Fixed Cost Variable Cost Total Cost Marginal Cost

Product Fixed Cost Variable Cost Cost TFC TVC TC change in TC (Q) (TFC) (TVC) TC = TFC + TVC AFC = AVC = ATC = MC =

Q Q Q change in Q

0 P100 P 0 P100 P 90

1 100 90 190 P100.00 P90.00 P190.00 80

2 100 170 270 50.00 85.00 135.00 70

3 100 240 340 33.33 80.00 113.33 60

4 100 300 400 25.00 75.00 100.00 705 100 370 470 20.00 74.00 94.00 80

6 100 450 550 16.67 75.00 91.67 90

7 100 540 640 14.29 77.14 91.43 110

8 100 650 750 12.50 81.25 93.75 130

9 100 780 880 11.11 86.67 97.78 150

10 100 930 1030 10.00 93.00 103.00

change in TC ( TC2 – TC1 )

MC = -------------------------------

change in Q ( Q2 – Q1 )



P 1100

1000

900

800

700

Cost

600

500

400

300

200

100

0 1 2 3 4 5 6 7 8 9 10 Q

TC

TVC

TFC

Fixed cost

Variable cost

Total cost



Long-run Cost

Fixed inputs that cannot be changed in the short run, can be increased (or decreased)

in the long run. To increase capacity, additions to building, land, machinery, or even

managerial talents may be made.

Economies of Scale – reductions in the average total cost of producing a product as the

firm expands the size of plant (its output) in the long run;

– the economies of mass production.

Diseconomies of Scale – increases in the average total cost of producing a product as the

firm expands the size of its plant (its output) in the long run.

PRODUCTION WITH TWO VARIABLE INPUTS

Isoquant – a curve or locus of points showing all possible combinations of inputs physically

capable of producing at a given level of output.

Isocost – it shows the different combinations of capital (K) and labor (L) that a producer can

purchase or hire given his total outlay and factor price.



Example:

If the price of capital ( K ) is P2/unit, labor ( L ) is P4/unit, and the total outlay is P20,

we can draw the isocost line in this manner. We can have 10 units of capital (P20 ÷ 2), and

5 units of labor (P20 ÷ 4). By joining the 2 points we can get the isocost line AB.

K

10

8

6

4

2

0 1 2 3 4 5 L

A

B

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