05. economics (iii)

8/13/2019 05. Economics (III)

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CHAPTER 9

PRODUCTION COSTS

If the demand side of the market is done by the behavior of

consumers, in turn, the supply side of the market is done by the behavior of

producers. It is very important for any firm to know how to organize its

production efficiently and how their costs of productio change as input

prices, on one hand, and the level of output, on the other hand, change, too.

Therefore, the theory of production and cost is central for the companys

management.

9.1. FIRM'S THEORY

One crucial decision of the firm concerns how much to produce andoffer for sale in the market, in other words, what level of output to be done.But, further, firm has to decide how much effort is necessary in doing thisand what amount of effects is epected to be. Thus, it has to know howmuch it will cost to produce this output and how much revenue will be

earned by selling it.!or each level of output, production costs depend on the specific

technology used. In turn, technology further determines"

# what kind of and how many inputs $factors of production% arenecessary to produce it&


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# the specific input pricesthat determine what the firm will have to payfor them.

The revenue obtained from selling output depends on the demand

curvefaced by the firm. It will determines the price for which any given)uantity of output can be sold and hence the revenue the firm will earn.*onse)uently, it is the interaction of production costs and virtual revenues

that determines how much output firm wish to supply on the market$!ig.+.'%.


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Production costs ''

Fig9! Relationships "etween Firm#s Production Costs$ Revenues$ andProfits


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Profits = Revenues - Costs

The firms income (revenue) is the amount it earns "y selling itsgoods or services in a given time period. The firms costsare the e%pensesimplied in producing goods or services in a given time period.

/ll firms have the same main goal 0 to gain as much profit as possible.

Profitsare the difference "etween revenues and costs. In order to select theoutput level which maimizez its profits, the firm eamines how revenuesand costs change with the level of output produced and sold. Thats why theoutput level is one of the most important decision for any firm

Individuals, households or organizations do not always pay their billsimmediately. !rom an economic viewpoint, the correct understanding ofrevenues and costs relates to the activities carried out during the yearwhether or not payments have yet been made. This distinction betweeneconomic revenues and costs, on one side, and actual receipts andpayments, on the other side, conduces us to the important concept of cashflow. The firms cash flow is the net amount of money actually receivedduring the period. Increasing the cash flow it earns is also an important goalof any firm.

The firms profits will have three destinations"

# a part will be claimed by, and therefore flow to, government ascompany income tax;

# a part of remaining corporate profits will be paid out to theirstakeholders $shareholders% as dividends&

# the last part of remaining corporate profits will be investedcurrently or in the future in new plants, e)uipments a.s.o., as retained(undistributed) profits.

1etained earnings are the part of after0ta profits that is turned backinto the business, rather than paid out to shareholders as dividends.

9.2. THE BALANCE SHEET

/ll the aspects defined above will be summarized in the incomestatement (profit-and-loss account), that tell us about the firm#s flow ofmoney during a given year. It results from the firms balance sheet. Thebalance sheetlists the assets the firm owns and the lia"ilities for which it isresponsi"le.


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Production costs ''2

Assets are what the firm owns &cash in the "ank accounts$ accountsreceiva"le from its customers$ inventories in warehouses$ "uildings$e'uipments$ etc(& they are shown on the left side of the balance sheet&

Liabilities are what the firm owes &unpaid "ills and salaries$ long)and*or short)term mortgages for "ank loans$ etc(& they are shown on theright side of the balance sheet.

Thedifference "etween what a firm owns and what it ows is its networth, on which always depends its reputation, customer loyalty and abundle of intangibles which economists callgoodwill.

Ta"9! Corporate + , + -alance .heet at /! 0ecem"er 1222 &in monetaryunits(

ASSES L!A"!L!!ES!actorybuilding233.333Other e)uipment(23.333

Inventories42.333/ccountsreceivable23.333*ash '(2.333

/ccountspayable'33.3335alaries42.333

Bankloanmortgages42.333Insurancemortgages(2.3336et worth'.333.333

#$%%%$%%%

#$%%%$%%%

E%emple

/n hypothetical balance sheet is represented in the table 7.'. 1etained$undistributed% profits affect the balance sheet"

# if retained profits are kept as cash or used to purchase newe)uipments, they will increasethe assets side of the balance sheet&

# if retained profits are used to reducethe firms liabilities, they willreduce the right side of the balance sheet.

8ither way, the firms net worth will increase.


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9.3. PRODUCTION COSTS AND FIRM'S PROFITS

:e can now review, from another perspective, the concept earlydiscussed of opportunity cost. The firm finds a useful guide to what has tobe done in the two pieces presented above" the income statement and the

balance sheet, both processed in the accounting department of the firm.

8conomists and accountants do not always have the same perceptionof costs and profits. Accountants are mainly interested in recording theactual receipts and payments of the company. *oncerned with the firmsfinancial statement, accountants tend to take a retrospective look at a firmsfinance, because they have to keep track of assets and liabilities andevaluate past performance.

Economists, on the other hand, take a forwardlooking view of the firm.*oncerned with what costs are epected to be in the future, and with howthe firm might be able to lower its costs and improve its profitability,economists and managers are especially interested in the role of costs andprofits as determinants of the firms output $production, supply% decision andin finding the best combination of inputs $allocation of resources% toparticular activities.

/ necessary distinction has to be made between eplicit and implicitcosts. / firms explicit costscompriseall e%plicit payments to the factors of

production the firm uses. :ages paid to workers, payments to suppliers ofraw materials, and fees paid to bankers and lawyers are all included amongthe firms eplicit costs.

/ firms implicit costs, on the other hand, consist of the opportunitycosts of using the firm#s own resources without receiving any e%plicitcompensation for those resources. !or eemple, the owner of a firm, whoworks along with his employees but does not draw a salary, forgoes theopportunity to earn a wage working for someone else. Or, another eemple,a firm that uses its own building for production purposes forgoes the incomethat it might receive from renting the building out. / ll these implicit costs arenot regarded as costs in an accounting sense, but they are a part of thefirms costs of doing business, nonetheless. :hen economists discuss costs,they have in mind "othimplicit and eplicit costs.

The difference between eplicit and implicit costs is crucial tounderstanding the difference between accounting profits and economicprofits.Accountin& profitsarethe firm#s total revenues from sales of itsoutput$ minus the firm#s e%plicit costs.

Accountin& profits ' otal revenues - Explicit costs


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Production costs ''4

Economic profitsaretotal revenues minus e%plicit and implicit costs.

Economic profits ' otal revenues - (Explicit costs !mplicitosts)

/lternatively stated, economic profits are accounting profits minusimplicit costs.

Economic profits ' Accountin& profits - !mplicit costs

Thus, the difference between economic profits and accounting profits isthat economic profits include the firms implicit costs, while accountingprofits do not. Ignoring the opportunity costs and economic profits, andrelying only on accounting costs and accounting profits, this way can beseriously misleading. 3t is the core phylosophy of the "usiness.

/ firm is said to make normal profitswhen its economic profits are

4ero. This fact implies that the firms reserves are enough to cover the firmseplicit costs and all of its implicit costs. These implicit costs add up to theprofits the firm would normally receive if it were properly compensated forthe use of its own resources 0 hence the name, normal profits.

9.4. TYPES OF COSTS

8conomists distinguishe between two types of costs, depending ontheir relationship with output change" fied costs and variable costs.

9.4.1. Fixed, !"i!#$e !%d T&!$ C&((

The fixed costs are those not affected "y the firm#s level ofproduction. They eist and do not change no matter how much or how littlethe firm produces. Being independentof the level of production, the fiedcosts include only those epenses that do not change as production change"

rent payments for facilities, e)uipments&

debt payments on loans, mortgages&


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salaries of permanent personnel who remain employed regardless ofproduction level $managers, accountants, etc.%&

insurance premiums, licence fees&

different taes $property taes, privilege taes, a.s.o.%.

The company*s fixed costs (+) are the sum of all of the firm#sdifferent fi%ed costs incurred. It can be represented graphically as a

horizontal line since, at all levels of production $;%, fied costs remainrelativelyconstant $!ig.+.(%. The only way the firm can avoid paying fiedcosts is to go out of business altogether.

The variable costs are those affected "y the firm#s level ofproduction. They eist and change depending on how much or how little thefirm produces. !or instance, as production increases, more labor must behired to make it, and more raw materials must be purchased to make it with.Being dependentof the level of production, the variable costs include thoseepenses that change as production change"

Fig91 Fi%ed Costs


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Production costs ''+

Fig 9/ 5aria"le Cost

payments for labor $salaries for employees direct implied in the

production process%&

raw materials&

utilities $energy, fuel, technological water%&

advertising epenses&

waste disposal&

taes which vary with production level $income taes, sales taes,

ecise taes, a.s.o.%.

The company*s variable cost (,( is the sum of all the firm#sdifferent varia"le costs incurred $!ig.+.%. The variable cost has a morecomplicated behavior" they increases as output increases, but at different

rates.

# /t first, variable cost rises rapidly, because many resources are notbeing fully used $buildings and e)uipments are to be bought or rented,people hired, etc.%. The production level is not great enough to employ themin the most efficient combinations.

# In the second stage, most resources are used efficiently, variablecosts rise more slowlyand its level off.

# In the third stage, finally, when production is high, diminishingreturns cause variable costs to accelerate and they increase rapidlyagain.


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The company*s total costs ()is the sum of fi%ed cost and varia"lecost $!ig.+.-%.

TC = FC + VC

In the graph showing the costs vertically and the output horizontally,

the total cost is represented as a sum of"

# fi%ed cost, a straight line, because it never change, regardless theamount of output&

# varia"le cost, which increases as output increases.

The shape of the total cost curve is similarto the shape of the variablecost curve, but it is a"ovethe fied cost"

# when output is4ero, then total cost is done by the fied cost as output grows, total cost increases rapidly at first, then more

slowly, because of the diminishing returns when output become very large, total cost starts to increase rapidly

again.

Fig96 Total Cost


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9.4.3. S*&"-"% !%d L&%+-"%

The costs which a firm needs in producing any given output dependupon the type of ad7ustments it is able to make in the amounts of the

various inputs it employs. 5ome of them $labor, raw materials, fuel, power%generally can be varied easily and )uickly. 5ome of others $plant capacity ofmanufacturing, for instance% re)uire more time for ad=ustments. Talkingabout production and cost, the economists then distinguishe between short0run and long0run, depending upon the time involved.

$'% The short-runrefers to a period of time too "rief to allow a firm tochange &adapt( all its resources, in which one or more factors of productioncannot be changed. In the short0run, some costs are fied. !actors thatcannot be varied over this period are called fi%ed inputs.

8isting plant capacity, for instance, can be used more or lessintensively in the short0run. / firms capital usually re)uires time to change >a new factory must be planned and built, and machinery or other e)uipmentmust be ordered and delivered. It takes at least one year.

$(% The lon&-run, in turn,refers to a period of time e%tensive enoughto permit a firm to alter the 'uantity of all resources employed. In the long0

run, all costs are varia"lebecause this time eisting firms can even d issolveand leave the industry or new firms can be created and enter the industry.

There are strong relationships between firms short0 and long0rundecisions"

# if in the short0run firms vary the intensity with which they utilize agiven plant, machinery or other e)uipment, in the long0run, in turn, firmsvary the size of the p lant $capacity of production%&

# in the short0run, all fied inputs represents the outcomes of previouslong0run decisions, based on the firms estimates of what they couldprofitable produce and sell&

# firms continually make production decisions in the short0run, whilesimultaneously planning how to alter their inputs in the long0run.

The analisys of the firm in microeconomics tends to consider the short0

run, but the long0run will be further also described.

9.4.4. Ae"!+e Fixed, !"i!#$e !%d T&!$ C&((

5uppliers are particularly interested in their average $per unit% costs.This information is more usable for making comparisons with product price,which always is epressed on a per unit basis. There are three types of


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Production costs '(

average costsaverage fied cost, average variable cost, and average totalcost. ?raphically, each of them provides a @0shaped curve $!ig.+.2%.

Fig98 Average Fi%ed$ 5aria"le$ and Total Costs

$'%Avera&e fixed cost (A+)is calculated "y dividing total fi%ed cost&TFC( "y the corresponding output &(:

AFC = TFC/Q

/s specific behavior, average fied cost declines so long as outputdecreases

$(% Avera&e variable cost (A,( is calculated "y dividing totalvaria"le cost &T5C( "y the corresponding output &(:

AVC = TVC/Q

/s specific behavior, average varia"le cost initially declines$ reaches aminimum$ and then increases again

$%Avera&e total cost (A( is calculated "y dividing total cost &TC("y corresponding output &(:

ATC = TC/Q = AFC + AVC


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/verage total cost is found by adding vertically the average fied costand average variable cost curves. Thus, the verticale distance between theaverage total cost and the average variable cost curves reflects averagefied cost at any level of output.

9.4./. T*e M!"+i%!$ C&(

The last type of cost concept discussed here, but the most important, isthe marginal cost.

.ar&inal cost (.)is the additional cost of producing one more unitof output. In fact, the marginal cost of producing any unit of output is onlythe additional variable cost that will be incurred for the production of thatone unit.

Q

TCMC

= ,

were"

; means Achange in ;A always by one unit, so that marginal cost will be theincrease in total cost incurred to produce one more unit of output

/s specific behavior"

# at very low levels of production, the marginal cost declinessharply,then, depending upon the behavior of the firms variable cost, it decreasesmore slowly, reaches a minimum, and finally risesagain, rather sharply&

# as output continues to increase, diminishing returns set in. ariablecost begins to rise more rapidly. Therefore, marinal cost begins to riseandcontinue to do so as output increases further $!ig.+.9%.


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Production costs '(2

Fig9;


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Fig9= Relationship "etween "eyondthis point, marginal cost is greater than average variable cost$./A,% and, therefore, average variable cost will begin to increase asoutput increases.

The same eplanation also shows that"# as long as marginal cost is "elowthe average cost, the average cost

will fall&

# beyond the point where marginal cost e)ualize the average totalcost, average cost will begin to rise.*onse)uently, we can understand why the rising marginal cost curve

always intersects the average varia"le cost curve at its lowest (minimum)point

The same logic leads us to the conclusion that the rising marginal costcurve also intersects the average total cost curve at the lowest &minimum(point on the average total cost curve. This is because whenever the etra or


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Production costs '(4

marginal amount added to total cost $or variable cost% is less than theaverage of that cost, the average will necessarly fall.

*onversely, whenever the marginal amount added to total $or variable%cost, the average unit must rise.

Table +.( summarize this important relationship.

Ta"91 Relationship "etween


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The lon&-run avera&e total cost curve (LA) is made up ofsegments of the short)run cost curve &.ATC!$ .ATC1$ aso( of the various)si4ed plants from which the firm might choose. 8ach short0run average costcurve $5/T*% in the graph is a short0run average total cost $/T*% curve withthe firm using the optimum amount of plant e)uipment for that level ofoutput. The long0run average cost curve $G/T*% AenvelopesA the short0runcost curves $5/T*% that the firm eperiences at various levels of output.

The long0run average total cost curve shows the least per unit cost atwhich any output can "e produced after the firm has had time to make allappropriate ad7ustments in its plant si4e $capacity of production%.

Fig9? The @ong)run Average Total Cost Curve


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Production costs '(+

9./.2. E&%&)ie( !%d Di(e&%&)ie( & S!$e

The @0shaped long0run average cost curve is eplained in terms ofeconomies and diseconomies of scale"

# the long0run average cost curve $G/T*% usually falls over a

considerable first portion of its length due to economies of scale&

# at higher levels of output, the long0run average cost remainsconstant, and the firm is said to eperience constant returns to scale&

# at very high output levels, the long0run average cost curve may risedue to diseconomies of scale

8conomies of scale $economies of mass production% are caused bymany factors, such as"

increased specialization in the use of labor&

better utilization of, and greater specialization in, management&

affordability and efficiently operating of the best available

e)uipment&

effective utilization of by0products.

/ll these considerations will contribute to lower unit costs for theproducer who is able to epand its scale of operations.

Economies of scale "ehave differently in different industries. !orinstance, some heavy industries $autos, steel, etc.% show economies of scaleup to very great size because they use large plants and heavy investmentsin fied e)uipment. They also benefit from use of specialized inputs.

In some industries there may not be enough demand to warrant largeplant or firm sizes. In other, such as those where personal service tocustomers is significant, large size may not increase efficiency.

The main factorcausing diseconomies of scale has to do with certainmanagerial problems involved in efficiently controlling and coordinating afirms operations as it become a large0scale producer $bureaucracy,difficulties in circulating the information etc.%. ?eographical problems mayalso eplain dieconomies of scale. :e say, the firm is too big.

The firms optimum plant si1e&minimum efficient scale($ operates atthe optimum rate of the output. It occurs at the lowest point on the long0runaverage total cost $G/T*% curve. This is the level of output at whicheconomies of scale end and constant returns to scale "egin$!ig.+.7%.

The lowest point on the long0run average total cost is the single onewhere G/T* curve is tangent to the lowest point on a short0run average totalcost $5/T*% curve $the one marked with OHT.%. /t all other points on G/T*,


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the tangency with 5/T* curves occurs somewhere otherthan the lowestpoints on these other 5/T* curves.

The shapeof the long0run average cost curve depends on two things"# how long the economies of scale persist how )uickly the diseconomies of scaleoccur as output is

increased.The balance of these two forces is an empirical )uestion of fact whichwill vary from industry to industry and from firm to firm.

+.2.. E&%&)ie( !%d Di(e&%&)ie( & S&e

ery often, firms produce more than one product. These two or moreproducts can be closely related, slightly related, or totally unrelated.1egardless the degree of connection between its products, a firm is likely toen=oy production or cost advantages when it produces two or more productsrather than producing only one. The eplanation could consists in"

# the =oint use of inputs or production facilities&

# the utilization of by0products from one output as input for another the =oint implementation of marketing programs cost savings of having a common management.

E%emple

/ construction firm could produce, for eemple, two types of products"# construction of buildings interior decorations.Both products use capital $buildings, machinery and e)uipments% and

labor as inputs. Both products rely on similar machinery, use similarly skilledworkers, and share the firms management resources. Organizationsmanagement must choose how much of each product to produce.

The product transformation curve describes the variouscom"inations of two outputs that could "e produced with a fi%ed amount of

production inputs. !igure +.+ represents the two product transformationcurve, C!and C1. 8ach curve shows the different combinations of buildingsand interior decorations that can be produced with a given input of capitaland labor.


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Production costs ''

!ig.+.+. Product Transformation Curves

In our eemple"

# curve C! describes all combinations of buildings and interiordecorations that can be produced with a relatively low level of inputs&

# curve C1 describes all combinations of buildings and interiordecorations that can be produced with twice the level of inputs.

Hroduct transformation curves described in figure +.+ do have followingcharacteristics"

# their slope is a negative onebecause, to get more of one output, the

firm must give up some of the other output they are a concave ones $bowed outward% because =oint productionusually has advandages that enable a single organization to produce morebuildings and interior decorations with the same resources than would twoorganizations producing each product separately.

Organizations production process involves"

# economies of scope, if its =oint output is greaterthan the outputthat could be achieved by two different separate firms, each producing asingle product, with e)uivalent production inputs allocated between them&

# diseconomies of scope, if its =oint output is lessthan the outputthat could be achieved by two different separate firms.

It is important to mention that there is no direct relationshipbetweenincreasing return to scale and economies of scope"

# a two0output company can obtain economies of scope even if itsproduction process involves decreasing returns to scale&

# a =oint0product firm can have increasing returns to scale for eachindividual product,yet notobtains economies of scope.

In the companys practice, it is important to know the etent to which

there are economies of scope. There is the degree of economies of scope


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that meeasures the percentage of the cost of production which is savedwhen two or more products are produced =ointly rather than separately.

9.5. THE LEARNIN6 CURE

Over time, a firm learnsJ as cumulative output increases andmanagers use this eperience process in planning and forecasting futurecosts.

Gong0run average costs may declineover time in some companies dueto the absorbtion of new technological information and the gaining of more

=ob eperiencefor its employes. /s the economic practice demonstrates, theassertion that firms en=oying lower average costs over time are growingcompanies with increasing returns to scale is not always true. Increasingreturns to scale is not the only reason for a large company to have lowerlong0run average costs than a smaller company. There are othereplanations, too.

Over time, gaining eperience for its workers and managers, thecompany will eperience falling marginal and average cost of producing agiven level of output because of fourth reasons"

# a s managers gain more eperience in scheduling the processes,planning and forecasting will become more and more effective as engineersgain more eperience in designing and manufacturing

products, the costs and defects will lower as workersgain more eperience in the accomplishment of a specific

task, the time necessary to do this will be more and more shorter and laborproductivity increases&

# as suppliers themselves gain more eperience in effectivelyprocessing the materials offered, then these advantages will be transferred,at least a part of them, in lower costs of materials for the company.

/ learnin& curve shows the relationship "etween a companyscumulative output and the amount of inputs necessary to produce a unit ofoutput !or an eemple, figure +.'3 represents a learning curve for theproduction of bungalows by a construction company. The two ais measure"

# the cumulative number of bungalow units produced by theconstruction company, on the horizontal ais&

# the number of hours of labor necessary to produce the correspondingnumber of bungalows.


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!ig. +.'3. The @earning Curve

The learning curve describes the etent to which the hours of laborneeded per unit of output $a bungalow% falls as the cumulative output$number of bungalows% produced increases. /s we can see, the fewer thehours of labor necessary, the lower the marginal and average cost ofproduction. *onse)uently, la"or input per unit of output directly affects thecompanys cost of production.

To represent the learning curve, we use the relationship"

L ' A "23 ,

where"

@ is the labor input per units of output&Bis the cumulative units of output produced&

A$ -$ and K are constants, withA and -positive, and K between 3 and '.The larger is $ the more important is the learning effect.

The learning curve effects can be important for a company decisionregarding the penetration of a particular industry andLor launching a newproduct.

The per0unit labor re)uirement falls with increased production dueto the learning curve. *onse)uently, the total labor re)uirement forproducing more and more output increases in smaller and smallerincrements. Thats why, looking at the higher initial labor re)uirement, acompany could have a pessimistic perception over its business. Over time, inturn, once the learning effects has taken place, production costs will belower, and the company could en=oy increasing profits.

7EY CONCEPTS

3ncome &revenue(CostProfitCash flowFirms income ta%.tockholder.hareholder

Fi%ed costs5aria"le costsTotal cost


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0ividendRetained &undistri"uted( profit3ncome statement-alance sheet

Assets@ia"ilitiesBet worthE%plicit cost3mplicit cost

Accounting profitEconomic profitBormal profit

Average cost


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CHAPTER!2

SELECTIN6 THE PRODUCTION TECHNI8UE

1.1. THE EFFICIENCY

Efficiency is the goal of getting the most out of the firms productiveefforts. *onversely, inefficiency occurs when there is wastw.

8conomists recognize several types of efficiency of production"economic efficiency& technical efficiency& allocative efficiency.

$'% Economic efficiency e%ists when the firm$ at a given level ofoutput$ is using the one technically efficient com"ination of resources thatresults in the lowest cost to the firm of producing that amount of output.

$(% echnical efficiency e%ists within the firm whenever using alower 'uantity of any input will re'uire using more of at least one other inputin order to maintain the same level of output. Technical efficiency refers tothe different ways in which a firm can combine inputs in order to produce acertain )uantity of output.

$%Allocative efficiencyrefers to the one level of output at which thefirm#s average cost &ATC( is lowest. The firm is able to be economicallyefficient at many levels of output& however, the average total cost $/T*% will

vary among them. The allocatively efficient one is the one at which theaverage total cost is lowest. The result is that if the firms production isallocativelly efficient it is producing output at the lowest possible cost.

/ll of these depend upon many factors:

# input prices market price of output&


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# the production function.

If any of these change, then the points at which any of these kinds ofefficiency occurs may change as well.

1.2. EFFICIENCY OF A PRODUCTION TECHNI8UE

One of the most important )uestions rised by the economic life of thefirm concerns the optimum production techni)ue recomended to be adoptedby this company. In order to answer, the firm has to analyse the relationshipbetween the choice of production techni)ue 0 say, the use of robots 0 and itsown costs of production. This problem leads us to the concept of A function ofproduction A.

'3.(.'. P"&di&% F%i&%(

!irms turn inputs, also called factors of production, into outputs, alsocalledproduction. Inputs can be further divided into the broad categories oflabor, materials, and capital, each of them including more narrowsubdivisions. !or instance"

# la"or inputs include skilled and unskilled workers, as well as theentrepreneurial efforts of the firms managers&

# materials include steel, plastics, electricity, water, and any othergoods that the firm buys and transforms into a final product&

# capitalincludes buildings, e)uipments, and inventories.

The firm uses these inputs to produce output. This rises manyengineering and management problems that have to be solved.Theproduction function specifies the ma%imum output level that can "eproduced from any given amount of inputs

Hroduction function usually are shown as mathematical epressionsrelating combinations of variable inputs and the maimum output they canproduce"

Q = f(a,b,c,...),

wherea,b,cetc. are inputs.

For instance, if there are two inputs, labor L and capital C, the implied function of production will


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.electing the Production Techni'ue '4

Q = F(,!)

This e)uation states that the )uantity of output depends on the)uantities of the two inputs, capital and labor. It is a formal way of sayingthat if the amounts of variable inputs used in a production process arechanged, the )uantity of output will change in a certain way.

Hroduction function can be very comple or very simple. The simplestshows the changes in ; due to varying the amount of the single variableinput.

E%emple

Table '3.'. summarizes the technically efficient productiontechni)ue listed by the corresponding production function.

Ta"!2! The production function

O@TH@T G88G$unitsLyear% */HIT/G I6H@T$number of machines% G/BO1 I6H@T$number of workers%

73 - -

73 ( 972 ( 4

'23 - '(

The table could be enlarged to include other combinations of labor andcapital that are also technically efficient.

The )uestion is" how does the firm find its as complete as possi"le listof technically efficient production techni'ue In part, it will use the epertiseof its engineers, designers or time0and0motion eperts. These ones analyseindustrial or work procedures to determine the most efficient methods ofproduction. In part, the firm may eperiment different techni)ues andobserve the results.

'3.(.(. Me!("i%+ *e P"&di&% F%i&%

/ firm can obtain the necessary information regarding its productionfunctions either from" engineering approaches and statistical approaches.


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'7 Economics

$'% En&ineerin& approaches, ask e%perts to descri"e a particularproduction capa"ilities of the firm. The engineering approach is most usefulwhen a firm whishes to eamine its own production relationship.

/pplyed to a particular firm, data are well understood, however, theyoften describe only one technical aspect of the production process.*onse)uently, the firm can have little if anything information aboutdiseconomies of scale in the management of the entire production process.

$(% Statistical approaches investigate the production processes ofone firm over time$ or the production processes of a num"er of differentfirms. The statistical approach is valuable if the manager wishes to eamineproduction relationships that go beyond a particular plant or operation withinthe firm.

There are two general ways of using statistical approach here"

# cross-section data method, describing the production ofdifferent firms of a specific industry at one point in time&

# time-series data method$ describing the production ofone firm or an entire industry over time.

The widely used algebraic form of the function of production is theobb-4ou&las production function"

5 ' A6 L,

where"

A is a constant that depends on the units in which inputs and output aremesured& is the capital employed&@is the labor employed&M is a constant representing the relative importance of capital in theproduction process&M is a constant representing the relative importance of labor in theproduction process.

'3.(.. echnical and economical efficiency

The production function summarizes the technically efficientmethods of combining inputs to produce output. / production method istechnically inefficientif, to produce a given output, it uses more inputs thansome other methods that could produce the same output. Hrofit0maimizingfirms are not interested in wasteful $inefficient% production methods, thatswhy we will focus only those that are technically efficient.


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.electing the Production Techni'ue '+

The e)uation applies to a given technology, for instance, to a givenstate of knowledge concerning the various methods that might be used totransform inputs into outputs. /s the technology becomes more advanced,the firm can obtain more output for a given set of inputs.

Hresuming that the firm are technically efficient > it can use eachcombination of inputs as effectively as possible 0, the function of productiondo not allow for inefficient or wasteful production processes. This is the wayto corectly understand the epresion maimum outputJ in the definition ofa production function.

Because production functions involve attaining a maimum output for agiven set of inputs, they will never be used if a decreasing output will follow.It is reasonable to epect that profit0seeking firms will not waste theirresources.

E%emple

5uppose, there are two methods available"

# method Aproduces ' bungalow by 42 hours of labor and -3 hours ofmashine time&

# method -produces ' bungalow by 42 hours of labor and 23 hours ofmashine time.

Cethod B is less efficient than method / because it uses the sameamount of labor, but more mashine time to produce the same output asmethod /.

The production function links amounts of inputs with amounts ofoutput.


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'-3 Economics

Techi)ue < 2 - '73 '23 +33 933 '.233

Techi)ue B ( 9 '73 '23 93 +33 '.(93Techi)ue P 2 '73 '23 2-3 423 '.(+3

/ll these three techni)ues can be used to produce 73 units ofbungalows per year. The firm knows the cost of "

# renting a machine 0 '73 monetary units per year hiring the necessary labor 0 '23 monetary units per year.

!rom the production function the firm knows the )uantities of labor andcapital re)uired to produce 73 units of bungalows per year using eachtechni)ue.

The total costs implied are"

N '.(3 monetary units per year by using productiontechni)ues


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.electing the Production Techni'ue '-'

!irms production technology can vary because of changes madeseparately in its labor inputs, capital inputs, or simoultaneusly in both thesefactors of production.

'3..'. Ae"!+e !%d M!"+i%!$ P"&d( & L!#&"

In order to study the behavior of labor as factor of production, we willconsider the capital as being fi and labor as a variable one. In this case, thefirm can produce more output by increasing the labor inputs used.

The information about the production functions are shown in the table'3.. It contains data about the amount of output that can be produced withdifferent amounts of labor $between 3 and '3%, by maintaining a fiedamount of capital input $(3 units%.

Ta"le !2/ Production with 5aria"le @a"or and Fi%ed capital 3nputs

Gabor $units%$@%

*apital$units% $%

Total output$%

/verageproduct $L@%

Carginalproduct

$ L @% 3 2 3 0 0

' 2 '3 '3 '3 ( 2 3 '2 (3

2 93 (3 3

- 2 73 (3 (3

2 2 +2 '+ '2 9 2 '37 '7 '

4 2 ''( '9 -

7 2 ''( '- 3

+ 2 '37 '( 0- '3 2 '33 '3 07

Qata contained in table '3. are plotted in figure '3.'.


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'-( Economics

!ig.'3.'. Production with Dne 5aria"le 3nput &@a"or(

he avera&e product of laboris the output per unit of la"or input.

7 ' 5 8 L$ L

where"

G is the average product of labor, is total output,@ istotal input of labor.

/s we can see in the table '3., the average product"

# increasesinitially fallswhen the labor input becomes greater than - units.

?enerally speaking, from a geometric point of view, the averageproduct at a point on a total product curve is given by the slope of the linefrom the origin to that point. In our case, the average product of labor ismeasured by the slope of the line running from the origin to on the totalproduct curve. The average product of labor"

# increasesand reaches its maimum value where the line from theorigin has the greatest slope,


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.electing the Production Techni'ue '-

The marginal product is always"

#positivewhen output is increasing,# negativewhen output is decreasing.

?enerally speaking, from a geometric point of view, the marginalproduct at a point on a total product curve is given by the slope of the totalproduct curve at that point. The line drawn tangent to the curve give the

slope of a total product curve.

E%emple

!igure '3.' shows that output increases until it reaches the maimumoutput of ''( units, diminishing thereafter. Beyond that point, the marginalproduct becomes negative. That portion of the total output is dashed todenote that production past an output of 7 is not technically efficient.

Therefore, it is not part of the production function" technical efficency rulesout the possibility of negative marginal products.

The marginal product curve crosses the horizontal ais of the graph atthe point of maimum total product. The eplanation is" adding a worker to aproduct line in a manner that slows up the line and actually decreases totaloutput, implying a negative marginal product for that worker.

There is a close relationshipbetween the average product of labor andthe marginal product of labor $fig.'3.'%"

# when the marginal product is greaterthan the average product, theaverage product isincreasing $in our figure, between outputs ' and -%&

# when the marginal product e'ualsthe everage product, the averageproduct curve reaches its ma%imum$ point


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'-- Economics

In any particular year, the aggregate value of goods and servicesproduced by an economy is e)ual to the payments made to all factors ofproduction, including wages, rental payments to capital, and profit to firms.*onsumers ultimately receive these factor payments in different forms.*onse)uently, consumers in the aggregate can increase their rate ofconsumption in the long0run only by increasing the total amount theyproduce. /s we can see, there is a strong relationship "etween standard ofliving and the la"or productivity

'3... P"&di&% i* T& !"i!#$e I%(. T*e I(&:!% !%d I(&:!%( M!

:e can now consider the firms production technology varying becauseof its "oth inputs > labor and capital. Table '3.-. tabulates the maimumoutput obtainable for different combinations of outputs.

Ta" !26 Production with Two 5aria"le 3nputs

1 ( - 2 ' '3 3 -2 22 92

( 3 23 92 42 73

-2 92 73 +3 +2

- 22 42 +3 '33 '32 2 92 73 +2 '32 ''3

The information contained in tables can also be represented graphicallyusing curves named iso)uants. /n iso0uantis a curve that shows all thecom"inations of inputs that yield the same level of output

Iso)uants show the fle%i"ility of the firm in making productiondecisions. Because in most cases, a firm can obtain a particular output usingvarious combinations of inputs, the manager of that firm must understandthe nature of this fleibility" their knowledge allows him to choose inputcombinations that minimize costs and maimize profit.

The set of iso'uants$ each of which represents the ma%imum outputthat can "e achieved for any corresponding set of inputs$ is namediso0uants map. The set of iso)uants $iso)uants map% corresponding toinformation contained in table '3. is represented in figure '3.(.

In our picture"


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.electing the Production Techni'ue '-2

# iso)uant ! represents all combinations of inputs that combine toyield -2 units of output&

# iso)uant 1 represents all combinations of inputs that combine toyield 92 units of output&

# iso)uant / represents all combinations of inputs that combine toyield 73 units of output.

Iso)uant nI!lies above and to the right of nbecause it takes more

of either labor or capital or both to obtain a higher level o f output.

There are similarities and differences between iso)uants and theindifference curves of the consumer theory"

# they are similarbecause where indifference curves order levels ofsatisfaction from low to high, iso)uants order levels of output&

# they are however differentbecause the numerical labels attached toindifference curves are meaningful only in an ordinal way > higher levels ofutility are associated with higher indifference curves, but cannot estimate aspecific level of utility the way we can estimatea specific level of outputwithan iso)uant.

1emember, it is important to distinguish between short and long0runwhen talking about production and costs, on a case0by0case basis.

!ig.'3.(. 3so'uants with Ttwo 5aria"le 3nputs

1.4. FACTOR INTENSITY

!rom the viewpoint of the factor intensity, production techni)ues can beclassified in two categories"

$'% capital-intensive techni0ue, when it uses a lot of capital andrelatively smaller amounts of la"or&

$(% labor-intensive techni0ue, when it uses a lot of la"or andrelatively smaller amounts of capital.


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'-9 Economics

In the table '3.("

# techni)ue C is more capital0intensive and less labor0intensive techni)ues 6 and H which are more labor0intensive comparing with

techni)ue C.

/n useful indicator necessary to do this comparisons is the ratio of

the units of capital input to labor input5uppose a firm chooses the more labor0intensive techni)ue because it

is cheaper. /fter a time, the wage rate rises" labor has become moreepensive, while the rental on capital remains unchanged. :e say, therelativeprice of labor has risen.

The firm now faces with two new )uestions"

# what happens to the total cost of producing the planned level of outputin a given timeR

# is this necessary any change in the preffered production techni)ueR

/ny input whose amount used can be changed in the short0run is avaria"le input?enerally, after the wage increases, the higher price of laborrelative to capital leads the firm to substitute capital for labor.

6E


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CHAPTER !!

FIRM'S LON6-RUN OUTPUT DECISION

In any market, firm looks after maimizing their profits. This implieslong0run output decision" how production costs and demand conditions mustinteract to determine the optimum level of production$ which allow to thefirm ma%imi4ing its profit.

11.1. COMPETITION

11.1.1. M!";e M&de$(

*ompetition eists in any market in which more than a single firmoperates. It re)uires firm to consider and be affected by the actions of theother firms in the industry.

*ompetition for scarce resources eists in every economy. In all but themost centrally0controlled economies, there are private property rights toscarce resources. These rights are recognized, enforced, and defended bysocietys legal system. :ithout such rights, the ac)uisition and allocation ofresources would be chaotic.

!rom the viewpoint of the competition, economists distinguish fourrelatively distinct market situations in terms of"

# the number of firms in the industry&

# whether the product is homogeneous $standardized% or differentiated how easy or difficult it is for new firms to enter in and for the eistingones to eit from the industry.

The four basic mar=et competitive situationsare $Tab.''.'%"


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'-7 Economics

Ta"!!! Characteristics of the Four -asic


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Firm#s @ong)run Dutput 0ecision '-+

To the buyer, the only possible reason for prefering one firms productto anothers is to lower price. *onversely, to the seller, the only possibledevice to face the competition in the market is to lower its price.

Hroduct homogeneity eists in some industries and it is a characteristicof perfect $pure% competition.

4ifferentiated productseists in an industry when there isat leastone difference "etween different firms# products. Hroduct differentiation is a

nonprice competition. !irms try to develop customer loyalty by creatingdifferentiated products, that offer superior advantages for their customers.

5trong customer loyalty makes the demand for such products lesselastic. The firm loses fewer customers when new firms enter the market andit is less vulnerable to their competition.

On the other hand, through nonprice competition, the firm attempts toshift the demand curve of its product to the right $to increase demand%,when customers are attracted by the firms improved product or service.!urthermore, nonprice competition is improved by establishing a strong"rand name for the product. This way, product cannot be duplicated$copied%. Advertising also creates customer loyalty through productdifferentiation, especially for establishing and supporting brand0nameidentification of the product.

Hroduct differentiation is a characteristic of monopolistic competitionand, sometimes, oligopoly.

11.1.3. B!""ie"( & E%"?@Exi

The degree to which firms can enter or leave an industry is a significantaspect of that industry, and the competitiveness within it. :hen entry andeit are easy, the industry are likely to be very competitive. *onversely,when eists some barriers to entry, firms faces with difficulties to

penetrate that market. It will be a less competitive market.8asy of entry is, in economics, much more significant, since it affects

the ability of new competition to arise within an industry or market. 8ntryinto a market is easy when there are few or no effective barriers to newfirms wishing to enter. 8asy of entry is a condition for perfect $pure%competition.

On the other hand, exit from most mar=ets is relatively easy,anyway, especially because there is anytime possible for a firm to closedown.

/ market with difficult entry has "arriersof some kinds to new firm.The barriers, to some degree, insulate firms in the market from newcompetitors and tend to make the market less competitive. Barriers are"

ine%istentin perfect competition&

a fewin monopolistic competition&


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'23 Economics

strongin o ligopolistic competition&

insurmounta"lein markets with monopol.

Barriers are economic and noneconomic.There are many economic barriersto entry an industry. The most

important are"

# high startup costs, simply insurmountable for newcomers who cantafford entering $costs of design, engineering, factories, sales outletsa.s.o.%&

# large economies of scalefurther lead to higher startup costs.

There are also many noneconomic barriersto entry an industry. Themost important are"

# government franchise, which grants a firm the eclusive right tooperate within a certain area and effectively keeps all other firms out&

#private franchise, which protects a firm against local competition fromthe same brand0name franchisor, but cannot protect against otherfirms selling similar products of another brand.

# licensing$ 4oning$ and other government action$which can keep outcompetition.

11.2. PROFIT MAIMIATIONIN A PERFECT COMPETITION

11.2.1. T&!$ Ree%e !%d M!"+i%!$ Ree%e

The prfectly competitive firm is aprice)taker& that means it receivesthe same market price $H% for every unit of its output. The perfectlycompetitive firm is so small that it cannot influence market price in any way,and it accepts the market price as a given condition.

The firms total revenue (?)is the total sum for which it is a"le to

sell its supplied output in the market. The firms total revenue always risesby the market price H for each additional unit produced. Therefore, a graphof the perfectly competitive firms total revenue curve is a continually risingstraight line$!ig.''.'%.


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Firm#s @ong)run Dutput 0ecision '2'

Fig!!! Total Revenue

Fig!!1


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'2( Economics

/ firms mar&inal revenue (.?) is the increase in total revenue"rought a"out "y an increase of one unit of output in the firm#s 'uantitysupplied. It is calculated starting from the change in total revenue divided bythe change in the )uantity of the product sold $demand%.

The firms marginal revenue is always the market price"

MR = P,

Where:

MRis the marginal revenue;

Pis the price.

The firm considers market demand for its output asperfectly elastic. Itcan sell all it can for price H. Because H E C1, it results for the perfectlycompetitive firm $!ig.''.(%"

" = MR = P,

Where:

Dis the market demand;

MRis the marginal revenue;

Pis the price.


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Firm#s @ong)run Dutput 0ecision '2

11.2.2. P"&i M!xi)i=!i&%

/s we already stated, the firms primarly economic goal is to maimizeits profit. 8conomists do this by maimizing the difference between firmstotal revenue and its total cost.

Profit maximi1ation occurs at that output level &


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'2- Economics

Fig!!/ Profit


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# succesive price reductions reduce the revenue earned from eistingunits of output.

:hen the firms demand curve slopes down, we have thus establishedtwo propositions"

# marginal revenue falls as output rises marginal revenue must be less than price for which the last unit is sold.

!or all firms, not =ust those in perfectly competitive markets, at theprofit maximi1ation point$in !ig.''.a or !ig.''.b%, it has no incentiveto increase or decrease output. /t this point firms output is in e'uili"rium.

If the firm produces at any otheroutput level, profit can be increasedby moving to the profit maimization point $!ig.''.-%.

Fig!!6 Dutput 0ecisions Around the Profit


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'29 Economics

# If the firm produces less than;C, then marginal cost will be less thanmarginal revenue $C*DC1% for additional units produced up to ;C. Thefirm can make marginal profiton these units and so increase total profitby producing them. !irms output decision will be to increase profit byincreasing production to ;C.

11.2.3. A% Exe)$e

5uppose a construction firm that produces and offers in the market asoutput bungalows. Information concerning its output are gathered in table''.(.

Ta"!!1 Firm#s Dutput 0ecisions &Profit


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# /t a price of '+ monetary units firm can sell only one bungalow. Thelower the price, the more units it can sell" its demand curve slopes down.

# /t low levelsof output, profits are negative.# /t the highest levelof output $'3 units%, profits are again negative.# / t intermediate levels of output, the firm is making profits. The

highest level of profits is (' monetary units on week, and the correspondingoutput level is 2 bungalows per week.

/s we saw, ma%imi4ing profit is not the same as ma%imi4ing revenue.The firm calculates the level of profit associated with each possible outputlevel. To do this, it must know both the revenue received at each outputlevel and the cost of producing each output level. !rom revenues and costs itthen calculates profit at each output level and selects the level of output thatmaimizez total economic profit.


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'27 Economics

Fig!!8 3mpact of .hift in 0emand Curve


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Firm#s @ong)run Dutput 0ecision '2+

Fig!!; 3mpact of Changing Cost on Dutput

11.3.2. I)! & C*!%+i%+ C&( &% O

5uppose the firm agrees to pay a higher wage rate or faces a priceincrease for a raw material. /t each output level, marginal cost will rise$!ig.''.9%. Higher marginal costs reduce profit)ma%imi4ing output from ;'to;(.

11.4. FIRM'S LON6-RUN OUTPUT DECISION

11.4.1. L&%+-"% M!";e E:i$i#"i)

@ong)run competitive e'uili"rium deals with the profit0maimizingreasons why firms enter and leave markets. Gong0run market e)uilibriumoccurs in perfectly competitive markets when no firms enter or leave theindustry.

P#= MR = MC = ATC,


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'93 Economics

where"

H8is the long0run market e)uilibrium price for the output.

This relationship applies to all firms in the industry in long0rune)uilibrium. :hen market price is at H8, firms earn normal profit. Qeterminedin the market by market supply and market demand, for competitive firms,

H8is the same as marginal revenue $!ig.''.4%.

The graph from figure ''.4 shows"

# on the left, marginal cost and average total cost curves for anindividual firm&

# on the right, market demand $Q% curve and different market supply $5%curves 0 5/, 58, and 5B.The curve 5 is the long0run e)uilibrium market supply curve, which

yields the e)uilibrium market price of H8.

:e have to work with some specific assumptions"

input prices do not change&

production methods, the production function, does not change&

market demand does not change.

?iven these assumptions, the only way a market supply curve can shiftin or out is if the number of firms in the market decreases $an inward shift%or increases $an outward shift%.

It results three possible situations" short0run profits, long0run markete)uilibrium, and short0run losses.

$'% If market supply curve is at SA, market price will be H/, which ishigher than H8. *onse)uently, firms will be able to sell their output for morethan their average total cost. This means that their profit will ecees normalprofit and they will have short-run profits

The ecess profit is graphically represented by the shaded area.


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Firm#s @ong)run Dutput 0ecision '9'

Fig!!= @ong)run


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The point where

.? ' minimum A,

is called the shut-down point.


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'9- Economics

Fig!!? Firm#s @ong)run Dutput 0ecision &Close)down Point(

# if LA%@ P% , the firm is making long0run profits and should stay in"usinessJ

# if LA%' P%, the firm =ust covers its costs and has no losses, but alsono profitsJ

# if LA%/ P%, the firm is making looses even in the long0run and shouldclose)down &going out of "usiness(


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These are the alternatives for the firms long0run output decision.

6E

05. economics (iii)

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