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    Theory of Production and Cost

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    Sharmila Zackie
    The document defines key concepts in production theory including the production function, technical efficiency, economic efficiency, variable inputs, fixed inputs, quasi-fixed inputs, short run vs long run, sunk costs, avoidable costs, total product, average product, marginal product, total costs, average costs, marginal costs, and the relationships between costs and production in the short run. It provides examples and graphs to illustrate these concepts.

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    Theory of Production and Cost

    Uploaded by

    Sharmila Zackie
    227 views24 pages
    The document defines key concepts in production theory including the production function, technical efficiency, economic efficiency, variable inputs, fixed inputs, quasi-fixed inputs, short run vs long run, sunk costs, avoidable costs, total product, average product, marginal product, total costs, average costs, marginal costs, and the relationships between costs and production in the short run. It provides examples and graphs to illustrate these concepts.

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    Theory of Production and Cost

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    The document defines key concepts in production theory including the production function, technical efficiency, economic efficiency, variable inputs, fixed inputs, quasi-fixed inputs, short run vs long run, sunk costs, avoidable costs, total product, average product, marginal product, total costs, average costs, marginal costs, and the relationships between costs and production in the short run. It provides examples and graphs to illustrate these concepts.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    227 views24 pages

    Theory of Production and Cost

    Uploaded by

    Sharmila Zackie
    The document defines key concepts in production theory including the production function, technical efficiency, economic efficiency, variable inputs, fixed inputs, quasi-fixed inputs, short run vs long run, sunk costs, avoidable costs, total product, average product, marginal product, total costs, average costs, marginal costs, and the relationships between costs and production in the short run. It provides examples and graphs to illustrate these concepts.

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    © All Rights Reserved
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    Download as pptx, pdf, or txt
    of 24

    Nihal Hennayake

    Basic Concepts of Production Theory

    Production function
    Maximum amount of output that can be produced
    from any specified set of inputs, given existing
    technology
    Technical efficiency
    Achieved when maximum amount of output is
    produced with a given combination of inputs
    Economic efficiency
    Achieved when firm is producing a given output at
    the lowest possible total cost
    Basic Concepts of Production Theory
    Inputs are considered variable or fixed depending on
    how readily their usage can be changed
    Variable input
    An input for which the level of usage may be changed quite
    readily
    Fixed input
    An input for which the level of usage cannot readily be
    changed and which must be paid even if no output is produced
    Quasi-fixed input
    A lumpy or indivisible input for which a fixed amount must
    be used for any positive level of output
    None is purchased when output is zero
    Basic Concepts of Production Theory

    Short run
    At least one input is fixed
    All changes in output achieved by changing usage of
    variable inputs
    Long run
    All inputs are variable
    Output changed by varying usage of all inputs
    Sunk Costs
    Sunk cost
    Payment for an input that, once made, cannot be
    recovered should the firm no longer wish to employ that
    input
    Not part of the economic cost of production
    Should be ignored for decision making purposes
    Avoidable Costs
    Avoidable costs
    Input costs the firm can recover or avoid paying should
    it no longer wish to employ that input
    Matter in decision making and should not be ignored
    Reflect the opportunity costs of resource use
    Short Run Production
    In the short run, capital is fixed
    Only changes in the variable labor input can change the
    level of output
    Short run production function

    Q = f (L, K) = f (L)
    Average & Marginal Products
    Average product of labor
    AP = Q/L
    Marginal product of labor
    MP = Q/L
    When AP is rising, MP is greater than AP
    When AP is falling, MP is less than AP
    When AP reaches it maximum, AP = MP
    Law of diminishing marginal product
    As usage of a variable input increases, a point is reached
    beyond which its marginal product decreases
    Total, Average, & Marginal Products of Labor,
    K=2
    Number of Total product (Q) Average product Marginal product
    workers (L) (AP=Q/L) (MP=Q/L)
    0 0 -- --
    1 52 52 52
    2 112 56 60
    3 170 56.7 58
    4 220 55 50
    5 258 51.6 38
    6 286 47.7 28
    7 304 43.4 18
    8 314 39.3 10
    9 318 35.3 4
    10 314 31.4 -4
    Total, Average, & Marginal Products K = 2
    Total, Average, & Marginal Product Curves
    Q2

    Q1 Total
    product
    Panel A
    Q0

    L0 L1 L2

    Panel B

    Average product

    L0 L1 L2
    Marginal product
    Short Run Production
    Total variable cost (TVC)
    Costs
    Total amount paid for variable inputs
    Increases as output increases
    Total fixed cost (TFC)
    Total amount paid for fixed inputs
    Does not vary with output
    Total cost (TC)
    TC = TVC + TFC
    Short-Run Total Cost Schedules

    Output (Q) Total fixed cost Total variable cost Total Cost
    (TFC) (TVC) (TC=TFC+TVC)
    0 $6,000 $ 0 $ 6,000
    100 6,000 4,000 10,000
    200 6,000 6,000 12,000
    300 6,000 9,000 15,000
    400 6,000 14,000 20,000
    500 6,000 22,000 28,000
    600 6,000 34,000 40,000
    Total Cost Curves
    Average Costs
    Average variable cost (AVC)
    TVC
    AVC
    Q
    Average fixed cost (AFC)
    TFC
    AFC
    Q
    Average total cost (ATC)
    TC
    ATC AVC AFC
    Q
    Short Run Marginal Cost
    Short run marginal cost (SMC) measures rate of
    change in total cost (TC) as output varies

    TC TVC
    SMC
    Q Q
    Average & Marginal Cost Schedules

    Output Average Average Average total Short-run


    (Q) fixed cost variable cost cost marginal cost
    (AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
    AFC+AVC)
    0 -- -- -- --
    100 $60 $40 $100 $40
    200 30 30 60 20
    300 20 30 50 30
    400 15 35 50 50
    500 12 44 56 80
    600 10 56.7 66.7 120
    Average & Marginal Cost Curves
    Short Run Average & Marginal Cost Curves
    Short Run Cost Curve Relations
    AFC decreases continuously as output increases
    Equal to vertical distance between ATC & AVC
    AVC is U-shaped
    Equals SMC at AVCs minimum
    ATC is U-shaped
    Equals SMC at ATCs minimum
    Short Run Cost Curve Relations
    SMC is U-shaped
    Intersects AVC & ATC at their minimum points

    Lies below AVC & ATC when AVC & ATC are
    falling
    Lies above AVC & ATC when AVC & ATC are
    rising
    Relations Between Short-Run Costs &
    Production
    In the case of a single variable input, short-run costs
    are related to the production function by two
    relations

    w w
    AVC and SMC
    AP MP
    Where w is the price of the variable input
    Short-Run Production & Cost Relations
    Relations Between Short-Run Costs &
    Production
    When marginal product (average product)
    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

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