Introduction to Production and Resource Use

Introduction toProduction and Resource Use Chapter 6

Topics of Discussion • Conditions of perfect competition • Classification of inputs • Important production relationships (assume one variable input in this chapter) • Assessing short-run business costs • Economics of short-run decisions

Conditions for Perfect Competition • Homogeneous products • No barriers to entry or exit • Large number of sellers • Perfect information Page 86

Classification of Inputs • Land:includes renewable (forests) and non-renewable (minerals) resources • Labor:all owner and hired labor services, excluding management • Capital:manufactured goods such as fuel, chemicals, tractors and buildings • Management:production decisions designed to achieve specific economic goal Pages 86-87

Production Function Output = f(labor|capital, land, and management) Start with one variable input Page 88

Production Function Output = f(labor|capital, land, and management) Start with one variable input assume all other inputs fixed at their current levels… Page 112

Coordinates of input and output on the TPP curve Page 89

Total Physical Product (TPP) Curve Variable input Page 89

Law of DiminishingMarginal Returns “As successive units of a variable input are added to a production process with the other inputs held constant, the marginal physical product (MPP) eventually declines” Page 93

Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Pages 90

Other Physical Relationships The following derivations of the TPP curve play An important role in decision-making: Marginal Physical =  Output ÷  Input Product Average Physical = Output ÷ Input Product Pages 90-91

Change in output as you increase inputs Page 89

Total Physical Product (TPP) Curve Marginal physical product is .45 as labor is increased from 16 to 20 output input Page 89

Output per unit input use Page 89

Total Physical Product (TPP) Curve Average physical product is .31 if labor use is 26 output input Page 89

Plotting the MPP curve Change in output associated with a change in inputs Page 91

Marginal Physical Product Change from point A to point B on the production function is an MPP of 0.33 Page 91

Plotting the APP Curve Level of output divided by the level of input use Page 91

Average Physical Product Output divided by labor use is equal to 0.19 Page 91

Three Stages of Production Average physical product (yield) is increasing in Stage I Page 91

Three Stages of Production Marginal physical product falls below the average physical product in Stage II Page 91

Three Stages of Production MPP goes negative in stage III… Page 91

Three Stages of Production Why are Stage I and Stage III irrational? Page 91

Three Stages of Production Output falling Productivity rising so why stop??? Page 91

Three Stages of Production The question therefore is where should I operate in Stage II? Page 114

Economic Dimensions • We need to account for the price of the product • We also need to account for the cost of the inputs

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Page 117-120

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Page 117-120

Key Cost Relationships The following cost derivations play a key role in decision-making: Marginal cost =  total cost ÷  output Average variable = total variable cost ÷ output cost Average fixed = total fixed cost ÷ output cost Average total = total cost ÷ output = AVC+AFC cost Pages 94-96

From TPP curve on page 113 Page 94

Fixed costs are $100 no matter the level of production Page 94

Column (2) divided by column (1) Page 94

Costs that vary with level of production Page 94

Column (4) divided by column (1) Page 94

Column (2) plus column (4) Page 94

Change in column (6) associated with a change in column (1) Page 94

Column (6) divided by column (1) or Page 94

or column (3) plus column (5) Page 94

Let’s graph the cost series in this table

Plotted cost relationships from table 6.3 on page 94 Plotting costs for levels of output Page 95

Now let’s assume this firm can sell its product for $45/unit

Key Revenue Concepts Notice the price in column (2) is identical to marginal revenue in column (7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition. Page 98

Let’s see this in graphical form

$45 P=MR=AR Profit maximizing level of output, where MR=MC 11.2 Page 99

Average Profit = $17, or AR – ATC P=MR=AR $45-$28 $28 Page 99

Grey area represents total economic profit if the price is $45… P=MR=AR 11.2  ($45 - $28) = $190.40 Page 99

P=MR=AR Zero economic profit if price falls to PBE. Firm would only produce output OBE . AR-ATC=0 Page 99

P=MR=AR Economic losses if price falls to PSD. Firm would shut down below output OSD Page 99

Where is the firm’s supply curve? P=MR=AR Page 99

Marginal cost curve above AVC curve? P=MR=AR Page 99

Introduction to Production and Resource Use