PRODUCTION AND COST THEORY SHORT RUN PRODUCTION

Production means the process of using the factor of  In the short run, we assume that at least one of
production to produce goods and services. the inputs is fixed that is capital.
Production is the process of transforming inputs into  Therefore, in the short run the production
outputs. function can be written as: Q = ƒ( K , L)
Where: Q = Output
L = Labour
K = Capital (fixed)

LAW OF DIMINISHING MARGINAL RETURNS

 It states that if the quantities of certain factors
CLASSIFICATION OF FACTORS OF PRODUCTION are increased while the quantities of one or
 Land - All natural resources or gift of nature more factors are held constant, beyond a
 Labor - Physical or mental activities of human certain level of production, the rate of increase
beings in output will decrease.
 Capital - Part of man-made wealth used for  “Law of diminishing marginal returns states that
further production as more of a variable input is used while
 Entrepreneur - A person who combines the other input and technology are fixed, the
different factors of production, and initiates the marginal product of the variable input will
process of production and also bears the risk. eventually decline”.
PRODUCTION FUNCTION AVERAGE PRODUCT (AP)
 a statement of the functional relationship  Divide the total product by the amount of that
between inputs and outputs, where it shows the input used in the production.
maximum output that can be produced with  Average Product (APL) = Total Product over
given inputs. Q = ƒ(K, L, M, etc.) Total Labour APL = TP/ L
Where: Q = Output MARGINAL PRODUCT (MP)
K = Capital  Change in the total product of that input
L = Labour corresponds to an additional unit change in its
M = Raw Material labour assuming other factors that is capital
fixed.
SHORT RUN AND LONG RUN PRODUCTION  Marginal Product (MPL = Change in Total
FUNCTION Product / Change in Total Labour)
 Two Types of Factor Inputs  MPL = Δ TP/ Δ L
Fixed Input
 An input which the quantity does not change
according to the amount of output.
Example: Machinery, land, buildings, tools,
equipments, etc.

Variable Input
 An input which the quantity changes according
to the amount of output.
Example: Raw materials, electricity, fuel,
transportation, communication, etc.

Short Run and Long Run Period

 Short run period is the time frame, which at  Long run is a period where there are only
least one of the inputs (factor of production) is variable factors and no fixed cost involved.
fixed and other inputs can be varied.  Long run total cost (LRTC) starts from origin
 Long run period is the time frame which all because of the absence of total fixed cost.
inputs are variable.
LONG RUN AVERAGE COST CURVE (LRAC)
 Shows the minimum cost of producing any given
output when all of the inputs are variable.
 Long run is a period where firms plan how to  Marketing economies, financial economies,
minimize average cost. labour economies, technical economies,
TOTAL VARIABLE COST (TVC) managerial economics.
 The cost of inputs that changes with output. Ex.
Raw materials, labours, etc DISECONOMIES OF SCALE
TOTAL COST (TC)  Problems faced by a firm as it becomes larger
 The sum cost of all inputs used to produce and larger.
goods and services  Increase long run average cost (LRAC).
 Total cost (TC) is also defined as total fixed cost  Mismanagement, competition, labour
(TFC) plus total variable cost (TVC) diseconomies.
 TC = TFC + TVC
MARGINAL COST (MC)
 The change in total production that comes from
making or producing one additional unit
AVERAGE TOTAL COST (ATC)
 The total cost per unit of output.
 The formula for average total cost (ATC) is the
total cost (TC) divided by the output (Q).
AVERAGE FIXED COST (AFC)
 Total fixed cost (TFC) divided by total output:
 AFC = TFC/Q
AVERAGE VARIABLE COST (AVC)
 Total variable cost (TVC) divided by total output:
 AVC = TVC/ Q
MARGINAL COST (MC)
 The change in total cost that results from a
change in output; the extra cost incurred to
produce another unit of output:
 MC = ΔTC / Δ Q

LONG RUN AVERAGE COST

 Long run is a period where there are only
variable factors and no fixed cost involved.
 Long run total cost (LRTC) starts from origin
because of the absence of total fixed cost.

LONG RUN AVERAGE COST CURVE (LRAC)  Economies of scope appear when an individual
 Shows the minimum cost of producing any given firm’s output for two different products is higher
output when all of the inputs are variable. than the output reached by two different firms
 Long run is a period where firms plan how to each produce a single product.
minimize average cost.  The diseconomies of scope appear in the
LONG RUN PRODUCTION COST productions of an individual firm’s because the
 Long run average cost curve (LRAC) is “U– production of one product might inconsistent
Shaped” due to the Law of Returns to Scale. with the production of another product.

 Law of Returns to Scale states that as the firm Factors of Production and Factor Markets
expand its size or scale of production, its long Factors of production:
run average cost (LRAC) will decrease and  Inputs used to produce goods and services
increase at later stage. Labor
Land
ECONOMIES OF SCALE Capital: the equipment and structures used to
 Advantages and benefits of a firm as it becomes produce goods and services
larger and larger.  Prices and quantities are determined by supply
 Reduce long run average cost (LRAC). & demand in factor markets.
Derived Demand Things that Shift the Labor Demand Curve
Markets for the factors of production  Changes in the output price, P
 Are like markets for goods & services  Technological change (affects MPL)
 Except the demand for a factor of production is a  The supply of other factors (affects MPL)
derived demand Example:
Derived from a firm’s decision to supply a If firm gets more equipment (capital), then workers
good in another market will be more productive; MPL and VMPL rise, labor
demand shifts upward.
Two Assumptions
1. All markets are competitive Input Demand & Output Supply
The typical firm is a price taker
 In the market for the product it produces Marginal Cost (MC)
 In the labor market  Cost of producing an additional unit of Output
2. Firms care only about maximizing profits  MC = ∆TC/∆Q, where TC = total cost
Each firm’s supply of output and demand  In general: MC = W / MPL
for inputs are derived from this goal To produce additional output
Hire more labor.
Marginal Product of Labor (MPL) As L rises, MPL falls…
 Marginal product of labor, MPL= ΔQ / ΔL causing W/MPL to rise…
 The increase in the amount of output from an causing MC to rise.
additional unit of labor
where Hence:
∆Q = change in output  Diminishing marginal product and increasing
∆L = change in labor marginal cost are two sidesof the same coin
 The competitive firm’s rule for demanding
The Value of the Marginal Product  labor: P x MPL = W
Problem:  Divide both sides by MPL: P = W/MPL
 Cost of hiring another worker (wage) is  Substitute MC = W/MPL from previous slide:
measured in dollars  P = MC
 Benefit of hiring another worker (MPL) is This is the competitive firm’s rule for supplying
measured in units of output output.
Solution: convert MPL to dollars
Value of the marginal product, VMPL=Px MPL Hence
 The marginal product of an input times the  Input demand and output supply are two sides of
price of the output the same coin.
VMPL and LABOR DEMAND
Labor Supply
Trade-off between work and leisure:
 The more time you spend working, the less time
you have for leisure.
Wage
 Is the opportunity cost of leisure

THE LABOR SUPPLY CURVE

SHIFTS IN LABOR DEMAND

Things that Shift the How the Rental Price of Land Is Determined
Labor Supply Curve
Changes in tastes or attitudes regarding
the labor–leisure trade-off

Changes in alternative opportunities

Immigration

Movement of workers from region to

region, or country to country

EQUILIBRIUM IN THE LABOR MARKET

How the Rental Price of Capital Is Determined

Monopsony:
Rental and Purchase Prices
A market with one buyer
Buying a unit of capital or land
A monopsony employer can use its
market power to increase its profits by Yields a stream of rental income.
paying lower wages
The rental income in any period
As with monopoly, economic activity under
monopsony is below the socially optimal Equals the value of the marginal product
level, causing a deadweight loss (VMP)

Monopsonies are rare in the real world Hence, the equilibrium purchase price of
Land and Capital a factor

With land and capital, must distinguish Depends on both the current VMP and the
between: VMP expected to prevail in future periods.
Linkages Among the
Purchase price: the price a person pays to Factors of Production
own that factor indefinitely
Factors of production are used together
Rental price: the price a person pays to
use that factor for a limited period of time In a way that makes each factor’s
productivity dependent on the quantities of
The wage is the rental price of labor the other factors

The determination of the rental prices Example: an increase in the quantity of

capital
Analogous to the determination of wages
The marginal product and rental price of
capital fall
Having more capital makes workers more Recession: Is when an economy slows down for a
productive, MPL and W rise long time. Businesses make less money, people lose
Conclusion jobs, and overall spending drops. It's like the
economy taking a step back instead of growing. Rent
Neoclassical theory of income distribution Rent - price paid for land services. - Income derived
from the ownership of land and other free gifts of
Theory developed in this chapter nature. RENT = MAXIMUM EARNINGS FROM A
PIECE OF LAND - TRANSFER EARNINGS
Factor prices are determined by supply Maximum Earnings from a piece of land - is the
and demand maximum amount of money that a land can have
from a rent Ex. 9,000 from a monthly rent in the land,
Each factor is paid the value of its 9,000 is the maximum amount including the needed
marginal product budget from maintenance and all the expenses of
land TRANSFER EARNINGS - Is the prot you gain
Used by most economists as a starting from the MAXIMUM amount of price of the land. Ex.
point for understanding the distribution of The 9,000 rent + 1,000 = 10,000, 10,000 pesos is
Income your total gain while 9,000 is your gain from the land
for the maintenance etc. and the added 1,000 is for
INTEREST Interest: Prof. Meyers asserts that the owner's capital. RICARDIAN THEORY OF RENT
interest is the cost associated with using loanable - developed by David Ricardo in the early 19th
money. Because certain loans include greater risk, century - dened rent as "that portion of the produce
discomfort, and incidental eort, dierent interest rates of the Earth which is paid to the landlord for the use
are applied to the same loan amount for the same of the original and indestructible powers of the soil" -
length of time. Types of Interest Pure interest: is the two ideas for rent: a. land is xed in supply b. it diers
payment for the use of money as capital when there in fertility - rent is surplus - rent arises from both
is neither inconvenience, risk nor any other farming techniques: intensive cultivation and
management problem. Gross interest: is the gross extensive cultivation a. intensive cultivation -
payment which the lender gets from the borrower. increase in agricultural production is due to the
Elements of Gross Interest 1. Payment for Risk usage of more labor and capital on the same piece of
Every loan involves the risk of non-payment. Lenders land b. extensive cultivation - increase in agricultural
charge extra to compensate for this risk. 2. Payment production is due to the extension of land of area
for Inconvenience Additional charges for any Prot TYPES OF PROFIT Gross Prot -the surplus prot
inconvenience caused to the lender. Microeconomics which accrues to a rm when it subtracts its total
Interest, Rent & Profit Examples: Borrower repays at expenditure from its total revenue. Formula: Gross
inconvenient times. Borrower invests capital longer Prot = Total Revenue - Total Cost Gross Prot = Total
than agreed. 3. Payment for Management Covers Revenue - Cost of Goods Sold (COGS) Pure Prot
the lender's eort in managing loans. Examples: and Net Prot Pure Prot: Pure prot reects the prot a
Maintaining records. Sending notices or reminders. company makes from its core business activities
4. Payment for Exclusive Use of Money (Pure before accounting for other expenses like taxes,
Interest) Compensation for the exclusive use of interest, and overhead costs. Formula : Total
borrowed money. Added to other payments for risk, Revenue - Cost of Goods Sold (COGS). Net Prot:
inconvenience, and management. Economic Also known as Net Income or Net Earnings. -Net prot
Conditions: Global events, such as geopolitical represents the actual prot available to shareholders
tensions or international nancial crises, can inuence after all expenses have been deducted. Formula:
interest rates by aecting investor sentiment and Total Revenue - Total Expenses •Pure Prot focuses
capital ows. Monetary Policy: Central banks, like the on the prot derived from core business activities,
Federal Reserve, adjust interest rates to control while Net Prot accounts for all expenses, including
ination, stabilize the economy, and promote operating costs, taxes, and interest. Business Prot
employment. Changes in benchmark rates directly and Economic Prot: The excess of revenue receipts
impact market interest rates. Ination: Higher ination over the explicit costs of production. Formula:
expectations often lead to higher interest rates as Business Prot = Total Revenue - Explicit Cost.
lenders demand greater compensation for the Economic Prot: Includes both explicit and implicit
reduced purchasing power of future repayments costs of production. Formula: Economic Prot = Total
Global liquidity: Refers to the availability of nancial Revenue - Explicit and Implicit Cost The business
resources worldwide that can be easily accessed to Prot focuses solely on direct costs, while Economic
fund economic activities, investments, and trade. Prot considers opportunity costs and the overall
economic environment. Normal Prot and Super
Normal Prot Normal Prot: The prot that accrues to an
entrepreneur in the long run when the price of the
product equals the average cost (MC = MR and AR =
AC). It is included in the cost of production. Super
Normal Prot: The surplus prot that accrues to super
marginal entrepreneurs when the price of the product
is higher than the average cost (Price > AC). It is not
included in the cost of production. •Normal Prot
indicates a break-even point for the entrepreneur,
while Super Normal Prot signies above-average
returns and competitive advantage in the market.
THEORY OF PROFIT Risk Theory: Frederick
Barnard Hawley
• Risk Theory of Prot was advocated by an American
Economist – Prof. Hawley.
• Prot arise because the entrepreneur undertakes the
risk of the business.
• If the entrepreneur is not rewarded, he will not be
prepared to undertake risks. •Higher the risk, greater
is the possibility of prot.
Risk Theory of Prot: Two Types of Risk Insurable
Risks - These are predictable/measurable and which
are insurable for – re, theft, ood, accident etc. (which
are the risks in business). Non Insurable Risks-
These are unforeseeable risks or cannot be
measured/identied. For instance, competitive risks,
technical risks, risk of government risk arising out of
business cycle. Schumpeter's Theory: • The theory
propounded by Schumpeter explains the changes
caused by innovation in the productive process. •
According to this theory, prot is the reward of
innovations. • Innovations refers to all those changes
in the production process with an objective of
reducing the cost of production. • Innovation always
reduces cost of production. Marginal Theory: Prof.
Syndney Chapman • It was developed by Prof.
Chapman – Prots are equal to marginal worth of the
entrepreneur and are determined by marginal
productivity of the entrepreneur. • When the marginal
productivity is high, prots will also be high and vice-
versa. Keynesian Theory: Jhon Maynard Keynes •
Relates money supply variability and uncertainty to
ination and deation. • Variability of prices is a major
cause of business cycles. • Wages and other costs
of production adjust more slowly than prices. •
Therefore price variability aects prots and therefore
investment. • Investment cycles cause business
cycles.