PRODUCTION AND COST

THE CONCEPT OF PRODUCTION

Production the creation of any good or service for the purpose of selling to buyers.
the creation of utility.

TRANSFORMING INPUTS INTO OUTPUTS

Classifications of Inputs
Capital including raw material ingredients, supplies, tools, machineries, equipment,
and physical facilities;

Labor this combines and processes the various materials; Land where the space allotted for processing is located; Entrepreneurial or managerial talent performs function like supervision, planning,
control, coordination and leadership.

Categories of Production Activities

1. Unique-product production its output is made-to-order products and services.

Education as a Production Activity

Inputs
teachers administrators buildings supplies equipment Production Activity the means of transforming inputs into outputs like actual classroom activity educated children Outputs

2. Rigid mass production involves the manufacturing of uniform products in large

quantities using a well-defined, proven, and usually inflexible technology. Standardization makes the tools (as well as materials and parts) interchangeable which minimizes disruptions in processing.

3. Flexible mass production 2 Stages of Processing

Mass production of standardized components. Components are assembled into final products that appear different from one another. e.g. A book with a single master copy can be produced in two editions: the clothbound and the paperbound.

4. Process or flow production a continuous flow of output.

PRODUCTION FUNCTION

the relationship between the amounts of input (resources) required and the amount of outputs (goods and services) that can be obtained.

The production function is really a schedule (a table or mathematical equation) showing the maximum of outputs that can be produced from any specified set of inputs given the existing technology.

Production Time Periods

Short-run a period of time in which producers are able to change the quantities of some but not all of the resources they employ ;

a period in which some resources (usually plant) are fixed and some are variable.

 Long-run a period of time long enough to enable producers of a product to change

the quantities of all the resources they employ;
a period in which all resources or costs are variable and no resources or costs are fixed.

PRODUCTION WITH ONE VARIABLE INPUT

Total product (TP) the total quantity, or total output, of a particular good produced.
Average product (AP) also called labor productivity, is output per unit of labor input.
total product Average product = units of labor AP = TP

Marginal product (MP) is the extra output or added product associated with adding
a unit of variable resources (in this case labor) to the production process.
change in total product Marginal product = change in labor input MP = L2 L1 (TP2 TP1)

Law of Diminishing Returns

as successive units of a variable resource (say, labor) are added to a fixed resource (say, 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.

Total, Marginal, and Average Product in the Law of Diminishing Return (3) (4) (1) Marginal Product (MP) Average Units of the Variable (2) Change in (2) Product (AP), Resource (Labor) Total Product (TP) Change in (1) (2) (1)
Table 1 0 1 2 3 4 0 10 25 45 60 70 75 75 70 10 15 20 15 10 5 0 5 Negative marginal returns Increasing marginal returns 10.00 12.50 15.00

5
6 7

Diminishing marginal returns

15.00 14.00

12.50
10.71 8.75

Stages of Diminishing Returns

Stage 1: Increasing Returns
TP increase, AP increase and reaches maximum, MP increase and reaches maximum and decrease, MP is greater than AP.

Stage 2: Diminishing Returns

TP increase and reaches maximum, AP begins to decline, MP decrease and becomes zero.

Stage 3: Negative Returns

TP decrease, AP decrease, and MP negative.
Total Product
75

TP Total product (TP) 50

25

Quantity of labor

As a variable resource (labor) is added to fixed amounts of other resources (land or capital), the total product that results will eventually increase by diminishing amounts, reach a maximum, and then decline.
Marginal and Average Product
Increasing marginal returns Diminishing marginal returns Negative marginal returns

Marginal product (MP) 20

10

AP

8
MP

Quantity of labor

Marginal product is the change in total product associated with each new unit of labor. Average product is simply output per labor unit. Note that marginal product intersects average product at the maximum average point.

COST OF PRODUCTION
Implicit cost refers to the value of inputs being owned by the firm and use in its own
production process.

Explicit cost refers to the actual expenses of the firm in purchasing or hiring the
inputs it needed.

Types of Explicit Cost 1. Fixed cost (FC) those costs that do not change as output change.
e.g. rental payments, interest on a firms debt, a portion of depreciation on equipment and buildings, insurance premiums are generally fixed cost; they do not increase even if a firm produces more.

2. Variable cost (VC) those costs that change with the level of output.
e.g. payments for materials, fuel, power, transportation services, most labor, and similar variable resources.

Other Explicit Costs

3. Total cost (TC) is the sum of fixed cost and variable cost.
TC = FC + VC

4. Average fixed cost (AFC) a firms total fixed cost divided by output.
AFC = TFC Q

5. Average variable cost (AVC) a firms total variable cost divided by output.
AVC = TVC Q

6. Average Total cost (ATC) a firms total cost divided by output.

TC ATC = Q = AVC TFC = AFC + AVC

7. Marginal cost (MC) the extra, or additional, cost of producing 1 more unit of output.

change in TC (TC2 TC1)

MC = change in Q (Q2 Q1)

Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run
Average-Cost Data Marginal Cost
(7)

Total-Cost Data
(1) (2) (3) (4)

(5)

(6)

Total Total Total Product Fixed Cost Variable Cost

(Q) (TFC) (TVC)

Total Cost
TC = TFC + TVC

Average Fixed Cost TFC

AFC =

Average Variable Cost TVC

AVC =

Average Total Cost TC

ATC = MC =

(8)

Marginal Cost change in TC change in Q P 90 80 70 60 70 80 90 110 130 150

Q 0 1 2 3 4 5 6 7 8 9 10 P100 100 100 100 100 100 100 100 100 100 100 P 0 90 170 240 300 370 450 540 650 780 930 P100 190 270 340 400 470 550 640 750 880 1030

P100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00

P90.00 85.00 80.00 75.00 74.00 75.00 77.14 81.25 86.67 93.00

P190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00

change in TC (TC2 TC1) MC = ------------------------------change in Q (Q2 Q1)

P 1100
1000 900 800 700

TC
TVC

Cost
600
500 400 300

Fixed cost

Variable cost 200 Total cost

100

TFC
0 1 2 3 4 5 6 7 8 9 10

Long-run Cost
Fixed inputs that cannot be changed in the short run, can be increased (or decreased) in the long run. To increase capacity, additions to building, land, machinery, or even managerial talents may be made.

Economies of Scale reductions in the average total cost of producing a product as the
firm expands the size of plant (its output) in the long run; the economies of mass production.

Diseconomies of Scale increases in the average total cost of producing a product as the
firm expands the size of its plant (its output) in the long run.

PRODUCTION WITH TWO VARIABLE INPUTS

Isoquant a curve or locus of points showing all possible combinations of inputs physically
capable of producing at a given level of output.

Isocost it shows the different combinations of capital (K) and labor (L) that a producer can
purchase or hire given his total outlay and factor price.

Example:

If the price of capital (K) is P2/unit, labor (L) is P4/unit, and the total outlay is P20, we can draw the isocost line in this manner. We can have 10 units of capital (P20 2), and 5 units of labor (P20 4). By joining the 2 points we can get the isocost line AB. K
10 8
A

6
4

2
B