Production Function
Inputs Land Labor Capital Process Output
Technical efficiency
Achieved when maximum amount of output is
Economic efficiency
Achieved when firm is producing a given output at
variable or Fixed
Variable input
An input for which the level of usage may be changed quite
readily
Fixed input
level of usage cannot readily be changed must be paid even if no output is produced
Quasi-fixed input
An input employed in a fixed amount for any positive level of
Q f ( L,K ) f ( L )
Marginal Product of Capital MPk = Q/ K Using Cobb-Douglas: Q =AKL MPL = dQ/dL = AKL-1 MPk = dQ/dK= AK-1L Average Product of Labor APL =TPL/L Average Product of Labor APK =TPK/K
1
2 3 4
52
112 170 220
5
6 7 8 9 10
258
286 304 314 318 314
10
4 -4
35.3
31.4
Panel A
Q0
Total product
L0
L1
L2
Panel B
Average product
L0
L1
L2
Marginal product
Combination
A
B C D
6
3 2 1
1
2 3 6
Stages of Production
Q Increasing Marginal Returns
Q=F(K,L)
AP
MP
Isoquant
The combinations of inputs (K, L) that yield the
producer the same level of output. The shape of an isoquant reflects the ease with which a producer can substitute among inputs while maintaining the same level of output.
L
Linear Isoquants
Capital and labor are perfect substitutes
K
Increasing Output
Q1
Q2
Q3
Leontief Isoquants
Capital and labor are perfect complements
Capital and labor are
K Q1
Q3
Q2
Increasing Output
used in fixedproportions
Cobb-Douglas Isoquants
Inputs are not perfectly substitutable Diminishing marginal rate of technical substitution Most production processes have isoquants of this shape
K
Q2 Q1 Q3 Increasing Output
Data Set
Marginal Revenue Product is the labor demand function for the firm
from adding successive quantities of variable factors to a fixed factor Long run Increases in capacity can lead to increasing, decreasing or constant returns to scale
TC = TVC + TFC
Average Costs
100
200 300 400
500
600
AVC is U-shaped
Equals SMC at AVCs minimum
ATC is U-shaped
Equals SMC at ATCs minimum
falling
Lies above AVC & ATC when AVC & ATC are
rising
is increasing, marginal cost (average cost) is decreasing When marginal product (average product) is decreasing, marginal cost (average variable cost) is increasing When marginal product = average product at maximum AP, marginal cost = average variable cost at minimum AVC
Isocost
The combinations of inputs that cost the
K
producer the same amount of money For given input prices, isocosts farther from the origin are associated with higher costs. Changes in input prices change the slope of the isocost line
C0 K
C1
Cost Minimization
K
Point of Cost Minimization
Slope of Isocost = Slope of Isoquant
Revenue
Total revenue the total amount received
from selling a given output TR = P x Q Average Revenue the average amount received from selling each unit AR = TR / Q Marginal revenue the amount received from selling one extra unit of output MR = TRn TR n-1 units
Profit
Profit = TR TC
The reward for enterprise Profits help in the process of directing resources to
alternative uses in free markets Relating price to costs helps a firm to assess profitability in production
Profit
Normal Profit the minimum amount
required to keep a firm in its current line of production Abnormal or Supernormal profit profit made over and above normal profit
Abnormal profit may exist in situations where firms
have market power Abnormal profits may indicate the existence of welfare losses Could be taxed away without altering resource allocation
Profit
Sub-normal Profit profit below normal profit Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs Cost of exit may be high Sub-normal profit may be temporary (or perceived as such!)
Profit
Assumption that firms aim to maximise profit
May not always hold true
Cost/Revenue
150 145 140 Total 120 added Added to Added to total profit to total profit profit 40 30 Reduces total profit by this amount
Profit
Why? MC
20 18
If Assume output is at the firm were to The firm decides to Ifproduce the 104th unit, the process continues 100 The cost of forMC units. The MC of each successive MR unit addition produce one more unit thisproducingwould cost last the ONE producingrevenue th unit produced. 100 as toto produce than total the the 101st the addition it more is 20. of unit extra unit MC a cost of toProvided the now(-105) total in revenue is 18, earns resultis production MR it less than received from the total the The MR reduce total addition to this producing one would willmorethat 100th unit be worth selling so of revenue is 140would not profit and unit the firm expanding output as 150. producing. willis output the price be add 128 to firm can worth The profit. difference it the received from isadd theexpanding of worth difference The sellingmaximising profit that extra between and the the output.costthe two is output isto received from ADDED where MR = unit. revenue total profit MC that 100th unit to profit (130) MR
100
101
102
103
104
Output
Example
A micro-entrepreneur produces caps and hats for
Estimate of Example
First we assume the cost function as
TC = c0+c1Q + c2Q2 +c3Q3 Results TC= 954.29 -2.46Q +0.02Q2 -.0002Q3 (5.9) (-0.75) (1.04) (-0.07) R2 = 0.99 F = 197.78 Comments: t-statistics are not acceptable though R2 and F are good. Second, we assume the cost function as TC = c0+c1Q + c2Q2 Results TC = 944.29 -2.24Q + 0.02Q2 t Stat (12.51) (-2.58) (8.45) R2 = 0.99 F = 394.86 Comments: t-statistics are acceptable and R2 and F are good.
the second estimation, indicate that the coefficient of each of the independent variables are significantly different from zero. The value of the co-efficient of determination means that 99 percent of the variation in total cost is explained by changes in the rate of output.
Answer (b)
The output rate that results in minimum per-unit cost
is found by taking the first derivative of the average cost function, setting it equal to zero, and solving for Q.
Answer (c)
Because the lowest possible cost is Tk. 6.45 per unit,
which is above the market price of Tk. 6.00, the production should not be continued.
Assignment
Output Total Cost
25 100 150
200 280
360 460 600
1240 1440
1940 2330 3500