Analysis of Production and

Cost
 Introduction
• In the supply process, people first
offer their factors of production to
the market.


• Then the factors are transformed by

firms into goods that consumers
want.
– Production is the name given to that
transformation of factors into goods
 What is a firm?
• A firm is an entity concerned with the purchase
and employment of resources in the production
of various goods and services


• The firm is an economic institution that

transforms factors of production into consumer
goods – it:
– Organizes factors of production.
– Produces goods and services.
– Sells produced goods and services.
•
• Assumptions:
– the firm aims to maximize its profit with the use of
resources that are substitutable to a certain
degree
 The Production Function
• The production function refers to the
physical relationship between the inputs
or resources of a firm and their output of
goods and services at a given period of
time, ceteris paribus.
•
• The production function tells the
maximum amount of output that can be
derived from a given number of inputs.
 Firm’s Inputs
• Inputs - are resources that contribute
in the production of a commodity.

• Most resources are lumped into three

categories:
– Land,
– Labor,
– Capital.
 Fixed vs. Variable Inputs
• Fixed inputs -resources used at a constant
amount in the production of a
commodity.
• Variable inputs - resources that can
change in quantity depending on the
level of output being produced.
• The longer planning the period, the
distinction between fixed and variable
inputs disappears, i.e., all inputs are
variable in the long run.
•
 The Production Process
• The production process can be
divided into the long run and the
short run.
The Long Run and the Short
Run
• A long-run decision is a decision in
which the firm can choose among
all possible production techniques.
•
• A short-run decision is one in
which the firm is constrained in
regard to what production decision
it can make.
•
 The Long Run ….
• The terms long run and short run do not
necessarily refer to specific periods of
time.
•
• They refer to the degree of flexibility
the firm has in changing the level of
output.
•
• In the long run, all inputs are variable.
•
• In the short run, some inputs are fixed.
 Production Tables and
Production Functions
• A production table shows the
output resulting from various
combinations of factors of
production or inputs.
Production Analysis with One Variable
Input
• Total product, Average product,
marginal product
• Stages of production
•
 Total product

• Total product (Q) refers to the total

amount of output produced in physical
units (may refer to, kilograms of sugar,
sacks of rice produced, etc)
•
• Total Product (TPx) = total amount of
output produced at different levels of
inputs
•
 Production Function of a Rice
Farmer
Units of L Total Product
(QL or TPL)
0 0
1 2
2 6
3 12
4 20
5 26
6 30
7 32
8 32
9 30
10 26
 QL

32
30
26 QL
Total product

20

12

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

Labor
 Marginal Product
• Marginal product is the additional
output that will be forthcoming from an
additional worker, other inputs
remaining constant
• Formula:
–
∆ TPL
M PL =
∆L
 Production Function of a Rice
Farmer
Units of L Total Product Marginal Product
(QL or TPL) (MPL)
0 0
1 2
2 6
3 12
4 20
5 26
6 30
7 32
8 32
9 30
10 26
Draw Marginal Product
Curve

MPL
 Marginal Product
• Marginal product initially increases,
reaches a maximum level, and beyond
this point, the marginal product declines,
reaches zero, and subsequently
becomes negative.
•
•
 Average Product (AP)

• Average product is a concept commonly

associated with efficiency.
• The average product measures the total
output per unit of input used.
– The "productivity" of an input is usually
expressed in terms of its average
product.
– The greater the value of average product,
the higher the efficiency in physical
terms. TPL
AP =
L
• Formula: L
Average product of labor.
Labor (L) Total product of labor Average product of
(TPL) labor (APL)
0 0
1 2
2 6
3 12
4 20
5 26
6 30
7 32
8 32
9 30
10 26
Draw Average Product
Curve

MPL
 Law of Diminishing Marginal
Returns
• As more and more of an input is
added (given a fixed amount of
other inputs), total output may
increase; however, as the additions
to total output will tend to diminish.
• Counter-intuitive proof: if the law of
diminishing returns does not hold,
the world’s supply of food can be
produced in a hectare of land.
Relationship between Average and
Marginal Curves: Rule of Thumb
• When the marginal is less than the
average, the average decreases.
• When the marginal is equal to the
average, the average does not
change (it is either at maximum or
minimum)
• When the marginal is greater than
the average, the average increases
AP,MP

At Max AP,
MP=AP

Max MPL
Max APL

APL

0 L1 L2 L3 L
MPL
 TP

TPL

0 L1 L2 L3 L
Stage I Stage II Stage III
MP>AP MP<AP
AP,MP AP increasing AP decreasing MP<0
AP decreasing
MP still positive

APL

0 L1 L2 L3 L
MPL
 Three Stages of Production
• In Stage I
– APL is increasing so MP>AP.
– All the product curves are increasing
– Stage I stops where APL reaches its
maximum at point A.
– MP peaks and then declines at point C
and beyond, so the law of
diminishing returns begins to
manifest at this stage
•
 Three Stages of Production
• Stage II
– starts where the APL of the input
begins to decline.
– QL still continues to increase,
although at a decreasing rate, and
in fact reaches a maximum
– Marginal product is continuously
declining and reaches zero at point
D, as additional labor inputs are
employed.
 Three Stages of Production
qStage III starts where the MPL has
turned negative.
– all product curves are decreasing.
– total output starts falling even as the
input is increased
 COSTS OF PRODUCTION
• Opportunity Cost Principle- the economic
cost of an input used in a production
process is the value of output sacrificed
elsewhere. The opportunity cost of an
input is the value of foregone income in
best alternative employment.
• Implicit vs. Explicit Costs
– Explicit costs – costs paid in cash
– Implicit cost – imputed cost of self-owned or
self employed resources based on their
opportunity costs.
7 Cost Concepts (Short-run)
1.Total Fixed Cost (TFC)
2.Total Variable Cost (TVC)
3.Total Cost (TC=TVC+TFC)
4.Average Fixed Cost (AFC=TFC/Q)
5.Average Variable Cost (AVC=TVC/Q)
6.Average Total Cost (AC=AFC+AVC)
7.Marginal Cost (MC= ∆AVC/∆Q
 Short Run Analysis

• Total fixed cost (TFC) is more

commonly referred to as "sunk
cost" or "overhead cost."
– Examples: include the payment or
rent for land, buildings and
machinery.
– The fixed cost is independent of the
level of output produced.
– Graphically, depicted as a
horizontal line
 Short Run Analysis
• Total variable cost (TVC) refers to
the cost that changes as the
amount of output produced is
changed.
– Examples - purchases of raw
materials, payments to workers,
electricity bills, fuel and power
costs.
– Total variable cost increases as the
amount of output increases.
• If no output is produced, then total
variable cost is zero;
• the larger the output, the greater the
 Short Run Analysis
• Total cost (TC) is the sum of total
fixed cost and total variable cost

– TC=TFC+TVC

– As the level of output increases, total

cost of the firm also increases.
 Total Costs of Production
Units of Total Total Total Total Marginal Average
Labor Product Fixed Variable Cost Cost Cost
L TPL
Cost
TFC
Cost
TVC
0 0 100 0
1 6 100 30
2 10 100 50
3 12 100 60
4 13 100 65
5 15 100 75
6 19 100 95
7 25 100 125
8 33 100 165
9 43 100 215
10 55 100 275
Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 Q
“TOTAL” COST CURVES
Pesos

AFC=TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

0 Q
Pesos The Average Variable
Cost at a point on the
TVC curve is measured
by the slope of the line
from the origin to that
point. TVC
(Total Variable Cost)

AVC=TVC/Q

Minimum AVC

0 q1 Q
Average Costs of Production
(Q) (TC)
0 100
1 130
2 150
3 160
4 165
5 175
6 195
7 225
8 265
9 315
10 375
Average Costs of Production
Total Total Average
Product Variable Variable
(Q)
0 Cost
0 (AVC) Cost (AVC)
1 30
2 50
3 60
4 65
5 75
6 95
7 125
8 165
9 215
10 275
Pesos
TVC
Inflection (Total Variable Cost)

point

0 q1 Q
MC
AVC

q1
Pesos

The Average Variable Cost is U

shaped. First it decreases, reaches a
minimum and then increases.

AVC
(Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos The Marginal Cost curve passes
through the minimum point of
the AVC curve.
MC (Marginal Cost)
It is also U-shaped. First it
decreases, reaches a minimum AVC
and then increases. (Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos MC

AC

AVC

AFC

0 q1 Q

The “PER UNIT” COST CURVES

 LTC LTC
All inputs are variable in the long
run. There are no fixed costs.
Long Run Total Cost

Q
Total Product

LONG-RUN TOTAL COST CURVE

 The LAC
• The LAC curve is an envelop curve of
all possible plant sizes. Also known
as “planning curve”
• It traces the lowest average cost of
producing each level of output.
• It is U-shaped because of
– Economies of Scale
– Diseconomies of Scale
COST

LAC

SAC1

SAC2

0 Q

LONG-RUN AVERAGE COST CURVE

COST

LAC
SAC1

0 Q
q0
 Building a larger sized plant (size
2) will result in a lower average
COST cost of producing q0

LAC
SAC1

SAC2

0 Q
q0
 Likewise, a larger sized plant
COST (size 3) will result to a lower
average cost of producing q1

SAC1 LAC
SAC2
SAC3

0 Q
q0 q1
 Economies and Diseconomies of
Scale
• Economies of Scale- long run
average cost decreases as output
increases.
– Technological factors
– Specialization

• Diseconomies of Scale: - long run

average cost increases as output
increases.
– Problems with management –
becomes costly, unwieldy
COST

LAC

SAC1

SAC2

Economies of Diseconomies of Scale

Scale
0 Q1 Q

LONG-RUN AVERAGE COST CURVE

 LONG - RUN AVERAGE and MARGINAL COST CURVES

LMC
COST

SMC2
LAC

SAC2
SMC1 SAC1

0 Q1 Q
 LAC and LMC
• Long-run Average Cost (LAC) curve
– is U-shaped.
– the envelope of all the short-run
average cost curves;
– driven by economies and
diseconomies of size.
• Long-run Marginal Cost (LMC) curve
– Also U-shaped;
– intersects LAC at LAC’s minimum
point.
 Perfectly Competitive
Market
•A p e rfe ctly co m p e titive m a rke t h a s th e
fo llo w in g ch a ra cte ristics:
–There are many buyers and sellers in the market.
–The goods offered by the various sellers are largely the
same.
–Firms can freely enter or exit the market.
–Firms are price takers
Revenue of a competitive firm
• TR = (P × Q)
•
• AR = TR = P x Q = Price
 Q Q


• MR =∆ TR/∆ Q = Price
•
•
•
Revenue of a competitive firm

Quantity Price Total revenue Average Marginal

(Q) (P) (TR = P X Q) revenue revenue
(AR = TR/Q) (MR =
Δ TR / ΔQ )

1 lawn $20 $ 20

2 20 40

3 20 60

4 20 80

5 20 100

6 20 120

7 20 140

8 20 160
 Profit maximisation
• Profit maximisation occurs at the
quantity where marginal revenue
equals marginal cost.
•
• When MR > MC, increase Q
• When MR < MC, decrease Q
• When MR = MC, profit is maximised
•
 Profit maximisation
Quantity Total Total cost Profit Marginal Marginal
(Q) revenue (TC) (TR – TC) revenue cost
(TR) (MR = (MC =
Δ TR / ΔQ ) ∆TC/∆Q)

0 lawns $0 $ 10
1 20 14
2 40 22
3 60 34
4 80 50
5 100 70
6 120 94
7 140 122
8 160 154
 Profit maximisation
Costs
and The firm maximises
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
MC 2

ATC
P = MR 1= MR 2 P = AR = MR
AVC

MC 1

0 Q1 Q MAX Q2 Copyright © 2004 Quantity

South - Western
 The firm’s short-run
decision to shut down
• A shutdown refers to a short-run
decision not to produce anything
during a specific period of time
because of current market
conditions.


- Shut down if TR < VC

- Shut down if TR/Q < VC/Q
- Shut down if P < AVC
•
The competitive firm’s short
run supply curve
Costs
Firm’s short-run
If P > ATC, the supply curve MC
firm will
continue to
produce at a
profit.
ATC
If P > AVC, firm
will continue to AVC
produce in the
short run.

Firm
shuts
down if
P < AVC
0 Quantity
The firm’s long-run decision to
exit or enter a market
• In the long run, the firm exits if the
revenue it would get from
producing is less than its total
cost.
 Exit if TR < TC
 Exit if TR/Q < TC/Q
 Exit if P < ATC
 A firm will enter the industry if such an
action would be profitable.

The firm’s long-run decision to
exit or enter a market
In the long run, the firm exits if A firm will enter the industry if
the revenue it would get from such an action would be
producing is less than its total profitable.
Exit
cost. if TR < TC Enter if TR > TC

Exit if TR/Q < TC/Q Enter if TR/Q > TC/Q

Exit if P < ATC Enter if P > ATC

The competitive firm’s long-run
supply curve
Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity
 Supernormal Profit
( a ) A firm with profits

Price

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximising quantity)
Copyright © 2004 South - Western
 Subnormal Profit
( b ) A firm with losses

Price

MC ATC

ATC
P P = AR = MR

Loss

0 Q Quantity
(loss-minimising quantity)
Copyright © 2004 South - Western
 The competitive firm’s
long-run equilibrium
• At the end of the process of entry
and exit, firms that remain must
be making zero economic profit.
• The process of entry and exit ends
only when price and average
total cost are driven to equality.
• Long-run equilibrium must have
firms operating at their efficient
scale.
Question: In perfectly competitive industry
the goods demand function D = 7000 – 500P
and supply function S = 4000 + 250P. Given
the following Q and TC, find out the break
even point.
Quantity Total Cost
0 40
10 100
20 130
30 150
40 160
50 170
60 185
70 210
 Question
• In a perfectly competitive market,


 Demand function Qd = 20000 – 400P

 Supply function Qs = 14000 + 200P
 What is the price charged by a member
firm having a cost function TC = 100
+ 50Q?
 Question
• There are 100 firms, with identical
cost functions, in a perfectly
competitive industry. The demand
function for the industry is
estimated to be Qd = 2000 – 200P.
 If the cost function of a firm is TC
= 200 – 50Q+2Q2
 Find out the equilibrium price.

 Question
• The market supply and demand
functions for a product are given by
 Qs = 3000 + 20P
 Qd = 13500 – 50P
 The industry supplying the product is
perfectly competitive. An individual
firm has Fixed cost of Rs. 500 per
period. Its average variable cost
function is AVC = 150 – 18Q + Q2.
What is the maximum profit that can
be earned by the firm?