profits, costs and factor of production costs and factor of pro… · returns to the variable...

PROFITS, COSTS AND FACTOR OF PRODUCTION

Economists normally assume that the goal of a firm is to maximize

profit, and they find that this assumption works well in most cases.

Profit = Total revenue - Total cost

• total revenue: the amount a firm receives for the sale of its output

• total cost : the market value of the inputs a firm uses in production Condition for profit maximisation: MR=MC

Goonjan Kumar, IES 2015 batch 9/16/2016 1

• All firms work to keep their costs as low as possible.

• For given prices and levels of output, a firm maximizes its profits by finding the least costly way of producing its output. Thus, profit-maximizing firms are also cost-minimizing firms.


PRODUCTION

• Production involves using inputs to produce an output

• Inputs include resources

• Labor

• Capital

• Land

• Raw materials

• Other goods and services provided by other firms

• Way in which these inputs may be combined to produce output is the firm’s technology


The Firm’s Production Function

the relationship between quantity of inputs used to make a good and the

quantity of output of that good

Alternative Input Combinations

Different Quantities of Output

Production Function


The Short Run and the Long Run

Short Run Long Run

Some inputs can’t be changed due to time constraint

All the inputs are variable

Returns to a variable factor Returns to scale


Production in the Short Run

• Fixed inputs • An input whose quantity must remain constant, regardless

of how much output is produced

• Variable input • An input whose usage can change as the level of output

changes


PRODUCTION WITH ONE VARIABLE INPUT

Assumptions: There are only two factors of production,

• one fixed(say capital) and

• one that varies with the level of production (say labour)


Marginal product of labour

• Marginal product of labor (MPL) is the change in total product (ΔQ) divided by the change in the number of workers hired (ΔL)

• It tells us the rise in output produced when one more worker is hired, leaving all other inputs unchanged


30

90

130

161

184 196 Total Product

DQ from hiring fourth worker

DQ from hiring third worker

DQ from hiring second worker

DQ from hiring first worker

increasing marginal returns

diminishing marginal returns

Units of Output

Number of Workers 6 2 3 4 5 1

Total and Marginal Product

(Production function with diminishing Returns)


Diminishing Returns

As more and more of one input is added, while other inputs remain unchanged, the marginal product of the added input diminishes. E.g. Diminishing returns to labour (eg Rangoli)


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


COSTS

• Fixed costs : costs that do not vary with the quantity of output produced

• Variable costs : costs that do vary with the quantity of output produced

• Total cost : Cost of all inputs—fixed and variable

TC = TFC + TVC


TC

0

Rupees

135

195

255

315

375

435

30 90 130 161

Units of Output

184 196

TFC

TFC

TVC

The Firm’s Total Cost Curves


AVERAGE AND MARGINAL COST

• average total cost: total cost divided by the quantity of output AC= TC/Q

• average fixed cost: fixed costs divided by the quantity of output

• average variable cost: variable costs divided by the quantity of output

• marginal cost: the increase in total cost that arises from an extra unit of production MC= δTC/ δQ


Average And Marginal Costs

MC

AVC

ATC AFC

Units of Output

Rupees

4

3

2

1

30 90 130 161 196 0


Average And Marginal Costs

• At low levels of output, the MC curve lies below the AVC and ATC curves • These curves will slope downward

• At higher levels of output, the MC curve will rise above the AVC and ATC curves • These curves will slope upward

• As output increases; the average curves will first slope downward and then slope upward • Will have a U-shape

• MC curve will intersect the minimum points of the AVC and ATC curves


U-shaped Average cost Curve

• It reflects the law of variable proportions or the law of diminishing returns to the variable factor of production.

• According to law of variable proportions, at the initial stages of production, with a given plant, as more of the variable factor(s) is employed, its productivity increases and the AVC falls. This continues until the optimal combination of the fixed and variable factors is reached. Beyond this point, increase in variable factors of production combined with fixed factors, the productivity of the variable factor(s) declines and the AVC rises.


Production And Cost in the Long Run

• In the long run, there are no fixed inputs or fixed costs - All inputs and all costs are variable

• Cost-minimizing input choice: This simply means choice of inputs to produce a given output at minimum cost.


ECONOMIES AND DISECONOMIES OF SCALE

• economies of scale: the property whereby long-run average total cost falls as the quantity of output increases

• diseconomies of scale: the property whereby long-run average total cost rises as the quantity of output increases

• constant returns to scale: the property whereby long-run average total cost stays the same asthe quantity of output changes


Specialization and Economies of Scale

Lessons from a pin factory “One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business; to whiten it is another; it is even a trade by itself to put them into paper.” - Adam Smith Because of specialization, a large pin factory could achieve higher output per worker and lower average cost per pin than a small pin factory.


Production with Many Factors of production

• COST MINIMIZATION: Producing a level of output with a mix of inputs such that the cost is minimized.

• THE PRINCIPLE OF SUBSTITUTION


Economies of Scope

• If it is less expensive to produce a set of goods together than separately, economists say there are economies of scope.

• Economies of scope is an economic theory stating that the average total cost of production decreases as a result of increasing the number of different goods produced. For example, McDonald's can produce both hamburgers and French fries at a lower average expense than what it would cost two separate firms to produce each of the goods separately. This is because McDonald's hamburgers and French fries are able to share the use of food storage, preparation facilities and so forth during production.

• It helps us understand why certain activities are often undertaken by the same firm. Goonjan Kumar, IES 2015 batch 9/16/2016 22

THANK YOU!


profits, costs and factor of production costs and factor of pro… · returns to the variable...

Documents