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    Chapter 4

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    l4

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    Chapter 4

    Uploaded by

    seyoum shimels
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    l4

    Copyright:

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    Download as pptx, pdf, or txt
    11 views26 pages

    Chapter 4

    Uploaded by

    seyoum shimels
    l4

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 26

    LECTURE FOUR

    THEORY OF PRODUCTION AND


    COST

    Demelash H (Assistant Professor)


    Email: [email protected]

    1
    Introduction: Production Theory
     Raw materials yield less satisfaction to the consumer
    by themselves.
     In order to get better utility from raw materials, they
    must be transformed into outputs.
     Transforming raw materials into outputs requires inputs
    such as land, labor, capital and entrepreneurial
    ability.
     Production is the process of transforming inputs into
    outputs (an act of creating value or utility).
     The end products of the production process are
    outputs which could be tangible (goods) 2
    or
    Production Function
    • Shows the relationship between inputs and the
    resulting output.
    • Production function displays different levels of output
    that the firm can produce by efficiently utilizing different
    units of labor and the fixed capital.
    • Assume that there are only two inputs, labor (L) and
    capital (K).
    – We can then write the production function as; Q =
    F (K, L)
     There Are Two Types of Inputs
    • Fixed inputs: inputs that cannot vary overtime or inputs
    3
    Short Run Production Function
    • Short run refers to a period of time in which the
    quantity of at least one input is fixed.
     Short run periods of different firms have different
    durations.
     The production with one variable input and one fixed
    input.
     A firm that uses two inputs: capital (fixed input) and
    labor (variable input).
     The firm can increase output only by increasing the
    amount of labor it uses.
    4
     Long run: refers to a period of time in which all factors
    Total, Average, and Marginal Product
    • Total product (TP): It is the total amount of output that can be
    produced by a combinations of the variable input and fixed input.

    • Marginal Product (MP): It is the change in output attributed to the


    addition of one unit of the variable input.

    • Average Product (AP): Average product of an input is the level of


    output that each unit of input produces, on the average.

    5
    Cont.…..

    6
    Amount of Labor Amount of Capital Average Product Marginal Product
    Total Output (Q)
    (L) (K) (Q/L) (∆Q/∆L)

    0 10 0 -

    1 10 10 10 10

    2 10 30 15 20

    3 10 60 20 30

    4 10 80 20 20

    5 10 95 19 15

    6 10 108 18 13

    7 10 112 16 4

    8 10 112 14 0

    9 10 108 12 -4

    10 10 100 10 -8 7
     Example: Suppose that the short-run production function of certain cut-
    flower firm is given by: fixed capital input (K=5).
    a) Determine the average product of labor (APL) function.
    b) At what level of labor does the TP of cut-flower reach the maximum?
    c) What will be the maximum achievable amount of cut-flower production?

    8
    Law of Variable Proportions

     The law states that as successive units of a variable


    input(labor) are added to a fixed input (capital or
    land), beyond some point the extra, or marginal,
    product that can be attributed to each additional unit of
    the variable resource will decline.

    9
    Stage of Production in the Short
    Run
    • Accordingly, we divide this production function into three
    stages as:
    – Stage I (starting from zero TPL up to the
    maximum of APL),
    – Stage II (starting from the maximum of APL to
    zero MPL), and
    – Stage III (starting from zero MPL onwards).
    • In summary, the production theories concentrate only on
    the efficient part of the production function, that is, on
    the ranges of output over which the marginal
    10
    productivities are positive but declining.
    Cont’d

    11
    Cont’d

    • The second stage of production in the above analysis


    corresponds to this efficient stage in the short run.
    • Short summery;
    – If MPL > APL, the latter will be rising as labor input
    (L) increases. This is in stage I of production.
    – If MPL = APL, the latter will be at its maximum. This
    is in stage II of production.
    – If MPL < APL the latter will be declining as labor
    input (L) increases. This is the case in stages II and
    III of production. 12
    THEORY OF COST

    • Cost is the monetary value of inputs used in the


    production of an item.
    • Economists use the term profit differently from the
    way accountants use it.
    – To the accountant, profit is the firm‘s total revenue
    less its explicit costs (accounting costs).
    – To the economist, economic profit is total revenue
    less economic costs (explicit and implicit costs).
     Accounting cost is the monetary value of all
    purchased inputs used in production; it ignores the cost
    13
    of non-purchased (self-owned) inputs.
    Cont’d
     Explicit costs: are out of pocket expenses for the
    purchased inputs.
     Implicit Cost: the estimated monetary cost for non-
    purchased or the cost of non-purchased (self-owned)
    inputs.
     If a producer calculates her cost by considering only the
    costs incurred for purchased inputs, then her profit will
    be an accounting profit.
     Accounting profit = Total revenue – Accounting
    cost = Total revenue – Explicit cost, where as;
    14
     Economic profit =Total revenue – Economic cost
    Cont’d
     Accounting profit of a firm will be greater than
    economic profit by the amount of implicit cost.
     If all inputs are purchased from the market, accounting
    and economic profit will be the same.
     If implicit costs exist, then accounting profit will be
    larger than economic profit.

    15
    Analysis of Costs In The Short-run
     In the short run, some of the firm’s inputs to production
    are fixed, while others can be varied as the firm
    changes its output.
     Various measures of the cost of production can be
    distinguished on this basis
     Total Cost (TC): The total cost of production has two
    components:
     Fixed cost (FC): costs do not vary with the level of
    output.
     Variable cost (VC): which varies with the level of
    16
    Cont’d

    17
    Cont’d

    18
    • Average cost (ATC): is the firm’s total cost divided by
    its level of output.
    ATC = TC/Q
    • Average fixed cost (AFC) is the fixed cost divided by
    the level of output.
    AFC = FC/Q
    • Average Variable Cost (AVC): is variable cost divided
    by the level of output.
    AVC = VC/Q
    • Average total cost (ATC): is the firm’s total cost
    divided by its level of output. ATC = TC/Q
    19
    Cont’d

    20
    Cont’d

     In summary, AVC, AC and MC curves are all U-shaped


    due 21
    Table for Cost Measurements

    Rate of Average Average


    Fixed Variable Marginal Average
    Total Cost Fixed Variable
    Output Cost Cost Cost
    Cost Cost
    Total Cost

    (FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)


    0 50 0 50 - - - -
    1 50 50 100 50 50 50 100
    2 50 78 128 28 25 39 64
    3 50 98 148 20 16.7 32.7 49.3
    4 50 112 162 14 12.5 28 40.5
    5 50 130 180 18 10 26 36
    6 50 150 200 20 8.3 25 33.3
    7 50 175 225 25 7.1 25 32.1
    8 50 204 254 29 6.3 25.5 31.8
    9 50 242 292 38 5.6 26.9 32.4
    10 50 300 350 58 5 30 35
    22
    11 50 385 435 85 4.5 35 39.5
    Example: Suppose the short run cost function of a firm is given by:
    a) Find the expression of TFC & TVC
    b) Derive the expressions of AFC, AVC, AC and MC
    c) Find the levels of output that minimize MC and AVC and then find the minimum
    values of MC and AVC

    23
    The relationship between short run production and cost curves

    • Let the price of labor be given by w, which is constant.


    • Given these conditions, we can derive the relation between
    MC and MPL as well as the relation between AVC and APL.
    • • This expression shows that MC
    and MPL are inversely related.
    • When initially MPL increases, MC
    decreases;
    • When MPL is at its maximum, MC
    must be at a minimum
    • When finally MPL declines, MC
    increases.
    • This expression also shows inverse
    relation between AVC and APL.
    • When APL increases, AVC
    decreases;
    • When APL is at a maximum, AVC is
    at a minimum and
    • When APL declines, AVC increases.
    24
    The r/n ship b/n these production and cost curves using
    graphs.

     MC curve is the mirror image of MPL curve and


    25
     AVC curve is the mirror image of APL curve.
    THANKS!!!

    END!!!

    THANKS!!!
    26

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