PRODUCTION THEORY: SHORT RUN & LONG RUN

Firms are not black boxes that mysteriously transform inputs (economic resources) into outputs. Economic theory explains
how firms make decisions about production processes, types of inputs to use, and the volume of output to produce.

In this lesson, we examine how a firm chooses its inputs so as to produce efficiently; how a firm chooses the least costly
among all possible efficient processes; and how this two prior information are combined to produce at optimal.
ECON 2043: PRODUCTION THEORY

Firms, in making production decisions, must determine the technologically and economically efficient combination of inputs to utilize. In transforming
inputs to outputs, a firm can use many (possible) different ways (i.e. technological efficiency) and likewise, must determine which among these ways will
allow them to incur least cost or which will allow them to maximize output given a specific cost (i.e. economic efficiency).

♦ Production Function→ relates the output of a firm to the amount of inputs used, typically labor and capital.
Let us have a simple production function Q= f (K, L) which suggests that output depends upon the amount of capital and labor used in production.
The production function shows only the maximum amount of output that can be produced given levels of inputs because production function includes only
efficient processes.
There are differences in the ease into which resources can be varied. Some resources can be changed easily while some others may take considerable
time to alter. The more time a firm has to adjust its inputs, the more factors of production it can adjust. Hence, there are two conceptual (meaning periods do
not pertain to calendar periods) production periods:

♦ Production Periods:
1. Short run → a conceptual period in which some factors of production are variable while some others are fixed. (In the production function where Q
= f (K, L, we can assume K to be the fixed input while L is the variable one – so that, changes in output depend only on changes in L)
2. Long run → a conceptual period in which there are no fixed factors of production, i.e. all inputs are variable including the firm’s plant capacity.(In
the production function where Q = f (K, L), both K and L are considered variable – so that, changes in output depend on changes in both K and L.)
SHORT RUN PRODUCTION

Tabular Example: Short run Production

In the short run, firms can for a time increase its output by adding units of labor to its fixed plant. But by how much will output rise when it adds the
labor? (Let us look at the shaded portion of the table below.) Law of Diminishing Marginal Productivity/Returns
Short run Production Relationships
Php100 Php200
TR Profit/Loss
MR = (Total = TR – TC
Fixed Input Variable Price = revenue)
(K) Input (L) TP (Q) MP AP TFC TVC TC MC AFC AVC ATC 15.38 = Q*P
1 0 0 0 100 0 100 0 0 0 15.38 0 -100
1 1 13 13 13 100 200 300 15.38 7.69 15.38 23.07 15.38 199.94 -100.06
1 2 28 15 14 100 400 500 13.33 3.57 14.29 17.86 15.38 430.64 -69.36
1 3 46 18 15.33 100 600 700 11.11 2.17 13.04 15.21 15.38 707.48 7.48
1 4 61 15 15.25 100 800 900 13.33 1.64 13.11 14.75 15.38 938.18 38.18
1 5 74 13 14.8 100 1000 1100 15.38 1.35 13.51 14.86 15.38 1138.12 38.12
1 6 74 0 12.33 100 1200 1300 undefined 1.35 16.21 17.56 15.38 1138.12 -161.88
1 7 67 -7 9.57 100 1400 1500 1.49 22.39 23.88 15.38 1030.46 -469.54

Condition for maximum profit or it all is at a loss, minimum loss: MC = P = MR MR = Marginal Revenue, MC = Marginal Cost Price = Market price.

Conclusion: At the price of 15.38 per unit, the production level should be 74 units, using one unit of capital and 5 units of labor, yielding a profit of 38.12
pesos.

MR = P = MC (optimization condition) maximum profit or loss minimization

Notice that as the firm adds up units of variable input, i.e. labor, the total product rises but the extra output being added, i.e. the marginal product,
declines, beyond some point. The reason behind is the law of diminishing marginal returns. This law assumes that technology is fixed and thus, the
techniques of production do not change. It states that as successive units of a variable resource are added to a fixed resource, eventually, the marginal
product that can be attributed to each additional unit of a variable resource will decline. For example, if additional workers are hired to work with a constant
amount of capital equipment, output will eventually rise by smaller and smaller amounts as more workers are hired.

Also, observe that as long as marginal product is higher than the average product, average product is increasing (and if it falls below average product,
average product declines).

To maximize profit or minimize loss : MR=MC

 Profit or Loss = TR – TC = ___

Definition of Terms:

Fixed Input – is aresource which cannot be altered in the short run.

Variable Input – is aresourcewhichcan vary in the short run.
Total Product (TP) – is the totalquantity or total output of a particular good produced.
Marginal Product (MP) –is the extra output or added product associated with a unit of variable resource, in this case labor, to the production process.
Average Product (AP) –here, also called labor productivity, is output per unit of variable resource, that is, labor input.
Total Fixed Cost (TFC) – arethose costs that in total, do not vary with changes in output.
Total Variable Cost (TVC) – are those costs that change with the level of output.
Total Cost (TC) – is the sum of total fixed cost and total variable cost at each level of output.
Marginal Cost (MC) –is the extra or additional cost of producing one more unit of output.
Average Fixed Cost (AFC) – is the fixed cost per unit of output.
Average Variable Cost (AVC) – is the variable cost per unit of output.
Average Total Cost (ATC) – is the totality of cost incurred per unit of output produced.

List of Formulas used

MP change in TP/ Change in Variable Inputs
AP TP/ VI
TC TVC + TFC
MC change in TC/change in Q
AFC TFC/ Q
AVC TVC/ Q
ATC AFC + AVC
GRAPHICAL ILLUSTRATIONS:

I II III Notes:
I. Stage of Increasing Returns
TP a. TP, AP & MP are increasing
b. TP increases at increasing rate because MP is increasing
c. MP is greater than AP, that is why AP is also increasing
d. At the end of stage I, MP reaches its maximum.
e. The economic efficiency of VI is maximized.
II. Stage of Diminishing Marginal Returns
a. TP is increasing at decreasing rate. (increasing because MP is still positive;
decreasing rate because MP is declining)
AP
b. MP is decreasing and upon intersection with AP, it declines faster than AP
c. When MP is decreasing, AP is still rising since the economic efficiency of
variable input is offset by the increasing economic efficiency of fixed input.
MP d. MP intersects AP when AP is at its maximum.
e. At the end of stage II, TP reaches its maximum (because MP reaches zero)
III. Stage of Negative Returns
a. TP & AP are decreasing
b. MP is less than zero (negative)

Economic Costs are payments a firm must make, or the incomes it must provide, to attract the resources it needs away from alternative production
opportunities.
 Implicit Costs→ are the opportunity costs of using its self-owned, self-employed resources. To the firm, implicit costs are the money
payments that self-employed resources could have earned in their best alternative use. 50,000/month
 Explicit Costs → are the monetary payments (or cash expenditures) it makes to those who supply labor services, materials, fuel,
transportation, services and the like. Such money payments are for the use of resources owned by others.
In accounting, only explicit costs are considered. Hence, accounting profit can be said to be overstated. On the other hand, economics takes also into
account the forgone incomes or the implicit costs in computing economic profit. (This suggests that accounting profit is greater than economic profit).
(Refer to the shaded portion of the table.)
A firm’s cost of producing a specific output depends on the prices of the needed resources and the quantities of resources (inputs) needed to produce
that output. Below, given the price of K and L, costs of production are computed. (Exercise: Please scrutinize the behavior of the different cost functions).
 Short run Production Relationships
Php100 Php200
Fixed Input Variable Input TP
(K) (L) (Q) MP AP TFC TVC TC MC AFC AVC ATC
1 0 0 0 100 0 100 0 0 0
1 1 13 13 13 100 200 300 15.38 7.69 15.38 23.07
1 2 28 15 14 100 400 500 13.33 3.57 14.29 17.86
1 3 46 18 15.33 100 600 700 11.11 2.17 13.04 15.21
1 4 61 15 15.25 100 800 900 13.33 1.64 13.11 14.75
1 5 74 13 14.8 100 1000 1100 15.38 1.35 13.51 14.86
1 6 74 0 12.33 100 1200 1300 _ 1.35 16.21 17.56
1 7 67 -7 9.57 100 1400 1500 _ _ 22.39 23.88

GRAPHICAL ILLUSTRATIONS:
 Figure 1 Figure 2

Figure 1 shows the TC, TVC and TFC curves. Initially, TVC and TC are increasing at a decreasing rate (because initially, marginal returns are increasing, so
fewer inputs are needed to come up with a specific level of output). Eventually, when decreasing returns are encountered, both TVC and TC are increasing at
an increasing rate.

Figure 2shows the MC, AFC, AVC and ATC curves. MC is a U-shaped curve because of the law of diminishing marginal returns. As long as MC is below
ATC and AVC, both of these curves are declining. If MC exceeds ATC and AVC, these curves are rising. AFC, on the contrary, is consistently declining as
output increases.

(Exercise: Try to compare MP against MC; and AP against ATC – Graphically, you will see that they are mirror images of each other.)

LONG RUN PRODUCTION (With two variable inputs)

With both factors of production, K and L, variable, a firm can usually produce a given level of output by using more of K and less of L, less of K and
more of L or moderate of both – that is, a firm can substitute one input for another while continuing to produce same level of output. (Much the same way
that consumer can maintain a given level of utility by substituting a good for another).
 Long run: Output Produced With Two Variable Inputs
K L
1 2 3 4 5 6
1 10 14 17 20 22 24
2 14 20 24 28 32 35
3 17 24 30 35 39 42
4 20 28 35 40 45 49
5 22 32 39 45 50 55
6 24 35 42 49 55 60

At 24 units of output

K (100) L (200) Total Cost Total Revenue Total Profit or

at price = 15.38 Loss (TR-TC)
6 1 600 + 200 = 800 369.12 -430.88
2 3 200 + 600 = 800 369.12 -430.88
3 2 300 + 400 = 700 369.12 -330.88
1 6 100 + 1200 = 1,300 369.12 -930.88

Conclusion: In the long run, if you intend to produce 24 units of output, you must employ 3 units of Capital and 2 units of Labor to yield a total minimal loss
of 330.88.

At 35 units of output

K (100) (X) L (200) (Y) Total Cost Total Revenue Total Profit or
at price = 55.00 Loss (TR-TC)
Pt. B 6 (X2) 2 (Y2) 600 + 400 = 1000 1,925 925
Pt. A 4 (X1) 3 (Y1) 400 + 600 = 1000 1,925 925
3 4 300 + 800 = 1,100 1,925 825
2 6 200 + 1200 = 1,400 1,925 525

MRTS (Marginal Rate of Technical Substitution) (Tradability or irreplaceability of K with Labor) = slope of the two points of combinations of L & K to
produce the same output Y2- Y1 / x2 – x1 = 2 – 3 / 6 – 4 = -1 / 2 = this means that from Pt A to Pt. B, we need to replace 1 unit of labor with 2 units
of capital to maintain the same output of 35 units.
We illustrate a firm’s ability to substitute between inputs in the table above, which shows the amount of output per day the firm produces with various
combinations of K and L per day. The table shows four combinations of capital and labor that the firm may use to produce 24 units of output. The firm may
employ a) 1 worker & 6 units of capital b) 2 workers & 3 units of capital c) 3 workers and 2 units of capital or d) 6 workers and 1 unit of capital.

GRAPHICAL ILLUSTRATION:

Approximately, by plotting the different combinations of L & K that will yield an

output of 24 units, we will a curve just like the one labeled q = 24 in Figure 3.
We call such a curve an isoquant, which is a curve that shows the efficient
combinations of L and K that can produce a single (iso) level of output
(quantity).

An isoquant shows the flexibility that a firm has in producing a given level of
output. Figure 3 further shows isoquants corresponding to different levels of
output.

Figure 3

Properties of Isoquants:
1. The farther the isoquant from the origin, the higher is the level of output.
2. Isoquants do not cross (why?)
3. Isoquants slope downward.

Shape of Isoquants (the shape of isoquants shows how readily a firm can substitute one input for another)
1. Perfect Substitutability between Inputs – This means that capital and labor are perfect substitutes. (Why?)

2. Cannot be substituted at all – This means that L cannot be substituted for K and vice versa.

3. Imperfect Substitutability between Inputs – This means that K & L are substitutes but not perfect one.
  The slope of the isoquant, which is called the Marginal rate of technical substitution (MRTS), shows the ability of a firm to replace one input
with another while holding output constant. The MRTS LK tells us how many units of K the firm can replace with extra unit of labor while holding
output constant. Technically, MRTS is declining (thus, explaining the convexity of a typical isoquant) – the more labor the firm has, the harder it
becomes to replace capital with labor. Basically, MRTS = ΔK / ΔL.

Returns to Scale

In the long run, the decision to build a new plant successively depends upon whether its output increases less than in proportion, in proportion or more than in
proportion to its inputs. When inputs are changed, say, increased, change in output may vary in proportion:

a. Constant Returns to Scale –When inputs are increased by a certain percentage, output increases by that same percentage. 20% increase in inputs (K
&L) increase in output is also 20%.
b. Increasing Returns to Scale – When inputs are increased by a certain percentage, output increases by more than that percentage increase. Ex. 20%
increase in inputs (K &L), output increases by 40% or 50%.
c. Decreasing Returns to Scale – When inputs are increased by a certain percentage, output rises by less than that percentage. Ex. 20% increase in inputs
(K &L), output increases by 10% or 5%.

Exercise: Please have a graphical portrayal of these kinds of returns to scale.

LONG RUN COSTS

 In the long run, the firm adjusts all its inputs so that its costs of production are as low as possible. The firm can alter its capital/plant size and adjust
inputs that were fixed in the short run. Although firms may incur fixed cost in the long run, it is avoidable. Hence, we assume in this analysis that there are
only variable costs in a long run period.
A firm can produce a given level of output using many different technologically efficient combinations of inputs, as summarized by isoquant. From
among the technologically efficient combinations of inputs, a firm wants to choose the particular bundle with the lowest cost, which is economically efficient.

Isocost Line.The cost of producing a given level of output depends on the price of labor and capital. The firm hires L hours of labor services at a wage w per
hour, so its labor cost is wL. The firm rents K hours of machine services r per hour, so its capital cost is rK. The firm’s total cost, therefore, is C = wL + rK.
The firmcan use many combinations of K and L that cost the same amount. Consider the table below:

Bundles of L & K that Cost the Firm PhP100

Bundle Labor (L) Capital (K) Labor Cost (wL=PhP5L) Capital Cost (rK = PhP10K) Total Cost
a 20 0 100 0 100
b 14 3 70 30 100
c 10 5 50 50 100
d 6 7 30 70 100
e 0 10 0 100 100

GRAPHICAL ILLUSTRATION:

Approximately, plotting the data above for a total cost of PhP100, the isocost
line wouldbe somewhat the same as in Figure 4. An isocost line shows all
combinations of inputs that require the same (iso-) total expenditure (cost).

Figure 4 further shows two more isocost lines representing different levels of
cost.
 Figure 4

Properties of Isocost Line:

1. The intercepts, i.e. both x & y, depend upon on the level of C and prices of inputs.(Please study graphical pivoting and shifts of the isocost curve)
2. The farther the isocost from the origin, the higher the cost.
3. The slope is constant. (Slope is equal to ΔK/ΔL = -w/r --- Why?)

Combining Cost and Production Information

By combining the information about costs contained in the isocost lines with information about efficient production summarized by an isoquant, a
firm chooses the lowest-cost way to produce a given level of output.
The firm can choose any of three equivalent approaches to minimize cost:
1) Lowest Isocost rule – Pick the bundle where the lowest isocost line touches the isoquant.
2) Tangency rule – Pick the bundle of inputs where the isoquant is tangent to the isocost line.
3) Last-peso rule – Pick the bundle of inputs where the last dollar spent on one input gives as much extra output as the last dollar spent on any other
input.

Producer’s Equilibrium