Introduction to Production and Resource Use

Introduction toProduction and

Resource Use

Chapter 6

Topics of Discussion

Conditions of perfect competitionClassification of inputsImportant production relationships

(assume one variable input in this chapter)

Assessing short run business costsEconomics of short run decisions

Conditions for Perfect Competition

Homogeneous productsNo barriers to entry or exitLarge number of sellersPerfect information

Page 109

Classification of InputsLand: includes renewable (forests) and non-

renewable (minerals) resourcesLabor: all owner and hired labor services,

excluding managementCapital: manufactured goods such as fuel,

chemicals, tractors and buildingsManagement: production decisions designed to

achieve specific economic goal

Page 110

Production Function

Output = f(labor | capital, land, and management)

Start withone variable

input

Page 112

Production Function

Output = f(labor | capital, land, and management)

Start withone variable

input

assume all other inputsfixed at their currentlevels…

Page 112

Coordinates of input andoutput on the TPP curve

Page 112

Page 113

Total Physical Product (TPP) Curve

Variable input

Law of DiminishingMarginal Returns

“As successive units of a variableinput are added to a production process with the other inputs heldconstant, the marginal physicalproduct (MPP) eventually declines”

Page 113

Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output ÷ InputProduct

Pages 114-115

Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output ÷ InputProduct

AveragePhysical = Output ÷ InputProduct

Pages 114-115

Change in output asyou increase inputs

Page 112

Page 113


output

input

Marginal physical product is .45 as labor is increased from 16 to 20

Page 112

Output per unitinput use

Page 113


output

input

Average physical product is .31 if labor use is 26

Plotting the MPP curvePlotting the MPP curve

Page 114

Change in outputassociated with achange in inputs

Marginal Physcial ProductMarginal Physcial Product

Page 114

Change from point A to point B on the production function is an MPP of 0.33

Page 114

Plotting the APP CurvePlotting the APP CurveLevel of outputdivided by the levelof input use

Page 114

Average Physical ProductAverage Physical Product

Output dividedby labor use is equal to 0.19

Page 114

Three Stages of ProductionThree Stages of Production

Average physicalproduct (yield) is

increasing in Stage I

Page 114


Marginal physicalproduct falls below the

average physicalproduct in Stage II

Page 114


MPP goes negativeas shown on Page 112…

Page 114


Why are Stage I andStage III irrational?

Page 114


Productivity rising so why stop???

Output falling

Page 114


The question therefore is where should I operate in Stage II?

Economic DimensionWe need to

account for the price of the product

We also need to account for the cost of the inputs

Key Cost RelationshipsThe following cost derivations play a keyrole in decision-making:

Marginal cost = total cost ÷ output

Page 117-120



Averagevariable = total variable cost ÷ output cost

Page 117-120



Averagevariable = total variable cost ÷ output cost

Average total = total cost ÷ output cost

Page 117-120

From TPP curve onpage 113

Page 118

Fixed costs are$100 no matter

the level ofproduction Page 118

Column (2)divided bycolumn (1)

Page 118

Page 118

Costs that varywith level of production

Page 118

Column (4) divided by column (1)

Page 118

Column (2) plus

column (4)

Page 118

Change in column (6) associated with a

change in column (1)

Page 118

Column (6) divided by column (1) or

Page 118

or column (3) pluscolumn (5)

Let’s graph the cost series in this table

Plotted cost relationshipsfrom table 6.3 on page 118

Page 119Plotting costs for levels of output

Now let’s assume this firm can sell its

product for $45/unit

Key Revenue Concepts

Notice the price in column (2) is identical to marginal revenue in column(7). What about average revenue, or AR? What do you see if you divide total revenue in column (3) by output in column (1)? Yes, $45. Thus, P = MR = AR under perfect competition.

Page 122

Let’s see this in graphical form

Page 123

Profit maximizinglevel of output,where MR=MC

P=MR=AR $45

11.2

Page 123

AverageProfit = $17, or AR – ATC

P=MR=AR

$45-$28$28

Grey area representstotal economic profitif the price is $45…

Page 123

P=MR=AR

11.2 ($45 - $28) = $190.40

Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0 Page 123

P=MR=AR

Economic lossesif price falls to PSD.Firm would shut downbelow output OSD Page 123

P=MR=AR

Where is the firm’ssupply curve?

Page 123

P=MR=AR

Page 123

P=MR=AR

Marginal cost curveabove AVC curve?

Key Revenue Concepts

Page 122

The previous graph indicated that profit is maximized at 11.2units of output, where MR ($45) equals MC ($45). This occursbetween lines G and H on the table above, where at 11.2 unitsof output profit would be $190.40. Let’s do the math….

Doing the math….Produce 11.2 units of output (OMAX on p. 123)Price of product = $45.00Total revenue = 11.2 × $45 = $504.00

Doing the math….Produce 11.2 units of outputPrice of product = $45.00Total revenue = 11.2 × $45 = $504.00

Average total cost at 11.2 units of output = $28Total costs = 11.2 × $28 = $313.60Profit = $504.00 – $313.60 = $190.40

Doing the math….Produce 11.2 units of outputPrice of product = $45.00Total revenue = 11.2 × $45 = $504.00


Average profit = AR – ATC = $45 – $28 = $17Profit = $17 × 11.2 = $190.40

Profit at Price of $45?

28

P =45

$

Q11.2

MC

ATC

AVC

Revenue = $45 11.2 = $504.00Total cost = $28 11.2 = $313.60Profit = $504.00 – $313.60 = $190.40

Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40


28

P =45

$

Q11.2

MC

ATC

AVC


Since P = MR = ARAverage profit = $45 – $28 = $17Profit = $17 11.2 = $190.40

$190.40

Price falls to $28.00….Produce 10.3 units of output (OBE on p. 123)Price of product = $28.00Total revenue = 10.3 × $28 = $288.40

Price falls to $28.00….Produce 10.3 units of output Price of product = $28.00Total revenue = 10.3 × $28 = $288.40


Price falls to $28.00….Produce 10.3 units of outputPrice of product = $28.00Total revenue = 10.3 × $28 = $288.40


Average profit = AR – ATC = $28 – $28 = $0Profit = $0 × 10.3 = $0.00


P=28

45

$

Q11.210.3

MC

ATC

AVC

Revenue = $28 10.3 = $288.40Total cost = $28 10.3 = $288.40Profit = $288.40 – $288.40 = $0

Since P = MR = ARAverage profit = $28 – $28 = $0Profit = $0 10.3 = $0 (break even)

Price falls to $18.00….Produce 8.6 units of output (OSD on p. 123)Price of product = $18.00Total revenue = 8.6 × $18 = $154.80


Average total cost at 8.6 units of output = $28Total costs = 8.6 × $28 = $240.80Profit = $154.80 – $240.80 = – $86.00



Average profit = AR – ATC = $18 – $28 = – $10Profit = – $10 × 8.6 = – $86.00


28

P=18

45

$

Q11.210.38.6

MC

ATC

AVC

Revenue = $18 8.6 = $154.80Total cost = $28 8.6 = $240.80Profit = $154.80 – $240.80 = $0

Since P = MR = ARAverage profit = $18 – $28 = –$10Profit = –$10 8.6 = –$86 (Loss)

Price falls to $10.00….Produce 7.0 units of output (below OSD on p. 123)Price of product = $10.00Total revenue = 7.0 × $10 = $70.00





Average variable costs = $19 Total variable costs = $19 × 7.0 = $133.00 Revenue – variable costs = –$63.00 !!!!!


28

P=10

18

45

$

Q11.210.38.6

MC

ATC

AVC

7.0


Since P = MR = ARAverage profit = $10 – $30 = –$20Profit = –$20 7.0 = –$140

Average variable cost = $19Variable costs = $19 7.0 = $133.00Revenue – variable costs = –$63Not covering variable costs!!!!!!

The Firm’s Supply Curve

28

P=10

18

45

$

Q11.210.38.6

MC

ATC

AVC

7.0

Now let’s look at the demand for a single

input: Labor

Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Page 124

Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product × price product

Marginal input = wage rate, rental rate, etc. cost

Page 124

Page 125

5

B

C

D

E

FG

H I

J

Wage rate representsthe MIC for labor

Page 125

5

B

C

D

E

FG

H I

J

Use a variable input likelabor up to the point where the value received from the market equals the cost of another unit of input, or MVP=MIC

Page 125

5

The area below thegreen lined MVPcurve and above thegreen lined MICcurve representscumulative net benefit.

B

C

D

E

FG

H I

J

Page 125

MVP = MPP × $45

Page 125

Profit maximized where MVP = MICor where MVP =$5 and MIC = $5

Page 125

=–

Marginal net benefit in column (5)is equal to MVP in column (3) minusMIC of labor in column (4)

Page 125

The cumulative net benefit in column (6) is equal to the sumof successive marginal net benefitin column (5)

Page 125

For example…$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.25

Page 125

=–

Cumulative net benefitis maximized whereMVP=MIC at $5

Page 125

5

If you stopped at point E on the MVP curve, for example, you would be foregoing all of the potential profit lying to the right of that point up to where MVP=MIC.

B

C

D

E

FG

H I

J

Page 125

5

If you went beyond the point where MVP=MIC, you begin incurring losses.

B

C

D

E

FG

H I

J

A Final ThoughtOne final relationship needs to be made. The levelof profit-maximizing output (OMAX) in the graph on page 123 where MR = MC corresponds directly withthe variable input level (LMAX) in the graph on page 125 where MVP = MIC.

Going back to the production function on page 112,this means that:

OMAX = f(LMAX | capital, land and management)

In Summary…Features of perfect

competitionFactors of production

(Land, Labor, Capital and Management)

Key decision rule: Profit maximized at output MR=MC

Key decision rule: Profit maximized where MVP=MIC

Chapter 7 focuses on the choice of inputs to use and products to produce….

Documents

Introduction to Production and Resource Use