Theory of Production and Cost

Theory of Production and CostEconomic and Accounting CostsEconomic cost: total cost of choosing one action over another. (Explicit + Implicit costs)

Accounting costs: the actual expenses incurred in the production process (explicit costs).

Explicit costs: the monetary payments for the factors of production and other inputs bought or hired by the firm. Eg. rent, raw materials, wages, electricity.

Implicit costs: those opportunity costs which are not reflected in monetary payments.Eg. salary that could have been earned.

A quick story to explain accounting and economic costsBob is a teacher who earns R100000 a year (this includes his salary, medical aid and pension benefits). He also has R50000 in a savings account. Bob decides to retire from teaching and start his own business making bean bags. He uses R50000 from his savings account to purchase the machinery and equipment required to start his business.

What are the accounting (explicit) costs involved in this decision?What are the economic (explicit + implicit) costs involved in this decision?

PROFITSProfit: revenue cost of producing it.

Total (accounting) profit: total revenue total explicit costs

Normal profit: equal to the best return that the firms resources could earn elsewhere Economic profit: total revenue - total explicit and implicit costs (including normal profit).

Total revenue R320 000Raw material costs R30 000Wages and salaries R85 000Interest paid on bank loan R30 000Salary that the owner could have earned elsewhere R32 000Interest forgone on capital invested in the business R20 000Calculatea) Normal Profit b) Economic Profit

Production in the Short Run

Production: the physical transformation of inputs into output. Short run production: a period of time when there isat least one fixed factor input. Fixed factor usually quantity of plant / machinery

Long run production: a time period in which all of the factors of production can change.

Fixed input: input whose quantity cannot be altered in the short run.

Variable input: input whose quantity can be changed in the short run (as well as the long run).

Assumptions when analysing production in the short run

The firm produces only one product. units of input are identical/homogeneous.Inputs can be used in infinitely divisible amounts.Prices of the product and of inputs are given.Firm uses fixed inputs and one variable input.Length of time between the short and the long run will vary from industry to industry.

Maize Farm ExampleFixed quantity of land = 20 units

Variable input = labourProduction schedule for maize farmerUnits of landUnits of LabourTotal Product (tons of maize)20002015202162033020456205852061142071402081602091712010180Relationship between Total Product and Units of Labour

Units of labourLaw Of Diminishing ReturnsACTIVITY: investigate relationship between output (total product) and quantities of variable factors of production used.

Learning ObjectivesBy the end of this simulation you must understandThe law of diminishing returns The difference between total, average and marginal concepts The difference between 'production' and 'productivity' The difference between short run and long run The simulationYou have an imaginary factory. You have to move hockey balls from one bucket to another.On successful transfer of a ball from one bucket to the other, your firm generates one unit of output. Fixed factors (capital) - 2 buckets, batch of hockey balls & land. Variable factor labour (thats where you come in!) At the end of each production run, the firm will add an extra unit of labour to production. Production levels will be recorded at the end of each production run. Your must monitor the output levels with each different combination of inputs. RULES!!!You may not throw the balls. Balls must not be dropped into the bucket - if they are, they are counted as damaged goods and do not count towards final output. Any balls dropped between the buckets also become damaged goods. Each production run lasts for 30 seconds - you must keep strictly to this time limit.

Units of Labour (L)Total Product (TP)Average Product (AP)TP/LMarginal Product(MP)TPFixed Costs (TFC)Variable Costs (TVC)Total Costs (TC)Average Cost (AC)Marginal Cost (MC)12345678910111213141521

Maize Farm ExampleCan you explain the law of diminishing returns using our maize farmer example?Marginal product: the number of additional units of output produced by adding one additional unit of the variable input.

Average product: the average number of total output produced by each unit of variable input.

To investigate further we also need to look atMarginal product of 1st unit of labour 16 0 = 16 tons

Total product of first 2units of labour = 44 tonsMarginal product of 2nd unit of labour 44 16 = 28 tonsHighest marginal product 113 78 = 35 tons (N = 4) Once maximum MP reached - it keeps on declining.9th unit of labour adds nothing 200 200 = 0 tons The marginal product of labour The average product (AP) of labour

AP of 1st unit of labour 16 1 = 16 tonsHighest AP145 5 = 29 tons

Comparison of total, average and marginal product

TP will continue to increase as long as MP is positiveAP & MP shaped like inverted Us rise at declining rates - reach max - decrease at increasing ratesAP increases when MP > APAP decreases when MP < AP MP equals AP at its maximum point.MP equals zero where TP reaches its maximum.

HOMEWORKBOX 6-1 TOTAL, AVERAGE AND MARGINAL MAGNITUDES

Costs of production

Costs: expenses faced by a businesswhen producing a good or service for a market.

Short run - fixedandvariable costs.

Fixed Costs

Fixed costs: cost that remains constant irrespective of the quantity of output produced.

Examples of fixed costs include:Rent Insurance charges.Salaries Interest charges on borrowed money.The costs of purchasing new capital equipment.Marketing and advertising costs.

Variable CostsVariable costs: costs thatvary directly with output.

As production rises - higher total variable costs as extra resources purchased.

Examples of variable costs for a business include:The costs of raw materialsLabour costsConsumables and components used directly in the production process.

Total product

Average and marginal cost

Calculation of Marginal Cost (MC)

AFC is L-shaped starts very high - declines till max TP reached

AVC, AC & MC are U-shaped start high - decline at decreasing rates - reach minimum points - increase at increasing ratesAC lies above AFC and AVCbecause it includes them both MC equals AVC and AC at their respective minimum pointsMarginal and Average cost curves

The relationship between production and cost in the short run

The shape of the unit cost curves is determined by the shape of the unit product curves.

Output Q1 is the total output produced by N1 units of labour.

Output Q2 is the total output produced by N2 units of labour

Production and costs in the long run

Long run: a time period where there are no fixed inputs all the inputs (including all the factors of production) are variable.

Enough time to build a new factory, install new machines, use new techniques of production etc

Law of diminishing returns does not apply - all the costs are variable.

Marginal product has no meaning - can only be calculated if all the other inputs are held constant.

Returns to scale

Returns to scale: long-run relationship between inputs and output.

Measured by varying all inputs by a certain % and comparing resulting percentage in production.

Three possible situations can result

Constant returns to scaleGiven % increase in inputs = same % increase in output

Increasing returns to scaleGiven % increase in inputs = larger % increase in output

Decreasing returns to scaleGiven % increase in inputs = smaller % increase in output

Decreasing Returns to ScalevsDiminishing Marginal ReturnsDecreasing returns to scale (long run concept) ALL inputs increase by the same proportion.

Diminishing marginal returns (short-run concept) - only the variable input increases.

Economies and Diseconomies of Scale

Economies of scale: occur when costs per unit of output fall as the scale of production increases.

Diseconomies of scale: occur when unit costs rise as output increases.

Both can be internal and external Internal: specific to a firm can be controlled. External: outside the firms control affects entire industry/economy.

Internal economies of scale

Technical economies: modern technology suited to mass production

Managerial, organisational or administrative economies: specialisation and division of labour

Marketing economies: bulk discounts & CPT decreases

Financial economies: easier/cheaper to raise. Average fixed charges decline.

Spreading overheads: Average fixed costs lower as firm grows.

Internal diseconomies of scale

Managerial diseconomies: longer lines of communication, management less directly involved.

Worker alienation: specialised, boring and repetitive jobs motivation & productivity affected.Deteriorating industrial relations: increased work stoppages and strikes.

Internal diseconomies of scale

Industry economies: Specialised markets benefits raw materials, selling finished product; specialised labour skills

General economies: general infrastructural development & better workers and may lower the effective cost of labour.

External economies of scale

Shortage: raw materials, skilled labour unit costs riseCongestion: land prices, traffic, pollution.

External diseconomies of scale

Economies of scope

Economies of scope: the cost savings achieved by producing related goods in one firm rather than in two.

Long Term Average Costs

Long-run marginal cost

The relationship between long-run and short-run average cost curves

All inputs variable in long run therefore no total or average fixed costs.

The long run can be seen as a set of alternative short-run situations between which the firm can choose.