Introduction to Production and Resource Use

Introduction toProduction and Resource UseChapter 61Topics of DiscussionConditions of perfect competitionClassification of inputsImportant production relationships (assume one variable input in this chapter)Assessing short-run business costsEconomics of short-run decisions2Conditions for Perfect CompetitionHomogeneous productsNo barriers to entry or exitLarge number of sellersPerfect informationPage 863Classification 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 goalPages 86-874Production FunctionOutput = f(labor | capital, land, and management)Start withone variableinputPage 885Production FunctionOutput = f(labor | capital, land, and management)Start withone variableinputassume all other inputsfixed at their currentlevelsPage 1126

Coordinates of input andoutput on the TPP curvePage 897

Page 89Total Physical Product (TPP) CurveVariable input8Law of DiminishingMarginal ReturnsAs successive units of a variableinput are added to a production process with the other inputs heldconstant, the marginal physicalproduct (MPP) eventually declinesPage 939Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output InputProduct

Pages 9010Other Physical RelationshipsThe following derivations of the TPP curve playAn important role in decision-making:

MarginalPhysical = Output InputProduct

AveragePhysical = Output InputProduct Pages 90-9111

Change in output asyou increase inputsPage 8912

Page 89Total Physical Product (TPP) CurveoutputinputMarginal physical product is .45 as labor is increased from 16 to 20 13

Page 89Output per unitinput use14

Page 89outputinputAverage physical product is .31 if labor use is 26Total Physical Product (TPP) Curve15

Plotting the MPP curvePage 91Change in outputassociated with achange in inputs16

Marginal Physical ProductPage 91Change from point A to point B on the production function is an MPP of 0.3317

Page 91Plotting the APP CurveLevel of outputdivided by the levelof input use18

Page 91Average Physical ProductOutput dividedby labor use is equal to 0.1919

Page 91Three Stages of ProductionAverage physicalproduct (yield) isincreasing in Stage I20

Page 91Marginal physicalproduct falls below theaverage physicalproduct in Stage IIThree Stages of Production21

Page 91MPP goes negative in stage IIIThree Stages of Production22

Page 91Why are Stage I andStage III irrational?Three Stages of Production23

Page 91Productivity rising so why stop???Output fallingThree Stages of Production24

Page 114The question therefore is where should I operate in Stage II?Three Stages of Production25Economic DimensionsWe need to account for the price of the productWe also need to account for the cost of the inputs

26Key Cost RelationshipsThe following cost derivations play a keyrole in decision-making:

Marginal cost = total cost output

Page 117-12027Key Cost RelationshipsThe following cost derivations play a keyrole in decision-making:

Marginal cost = total cost output

Averagevariable = total variable cost output cost

Page 117-12028Key Cost RelationshipsThe following cost derivations play a keyrole in decision-making:

Marginal cost = total cost output

Averagevariable = total variable cost output cost

Averagefixed = total fixed cost output cost

Average total = total cost output = AVC+AFC cost

Pages 94-9629

From TPP curve onpage 113Page 9430

Fixed costs are$100 no matterthe level ofproductionPage 9431

Column (2)divided bycolumn (1)Page 9432

Page 94Costs that varywith level of production33

Page 94Column (4) divided by column (1)34

Page 94Column (2) plus column (4)35

Page 94Change in column (6) associated with a change in column (1)36

Page 94Column (6) divided by column (1) or 37

Page 94or column (3) pluscolumn (5)38Lets graph the cost series in this table39

Plotted cost relationshipsfrom table 6.3 on page 94Page 95Plotting costs for levels of output40Now lets assume this firm can sell its product for $45/unit41

Key Revenue ConceptsNotice 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 9842Lets see this in graphical form43

Page 99Profit maximizinglevel of output,where MR=MCP=MR=AR$45

11.244

Page 99AverageProfit = $17, or AR ATCP=MR=AR$45-$28$2845

Grey area representstotal economic profitif the price is $45Page 99P=MR=AR11.2 ($45 - $28) = $190.4046

Zero economic profitif price falls to PBE.Firm would only produceoutput OBE . AR-ATC=0Page 99P=MR=AR

47

Economic lossesif price falls to PSD.Firm would shut downbelow output OSDPage 99P=MR=AR

48

Where is the firmssupply curve?Page 99P=MR=AR49

Page 99P=MR=AR

Marginal cost curveabove AVC curve?

50

Key Revenue ConceptsPage 98

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. Lets do the math.51Doing the math.Produce 11.2 units of output (OMAX on p. 123)Price of product = $45.00Total revenue = 11.2 $45 = $504.00

52Produce 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.53Produce 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

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

Doing the math.54Profit at Price of $45?28P =45$Q11.2MCATCAVC

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 = $190.405528P =45$Q11.2MCATCAVC

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$190.40Profit at Price of $45?56

57Price 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

58Price falls to $28.00.Produce 10.3 units of output Price of product = $28.00Total revenue = 10.3 $28 = $288.40

Average total cost at 10.3 units of output = $28Total costs = 10.3 $28 = $288.40Profit = $288.40 $288.40 = $0.00

59Price falls to $28.00.Produce 10.3 units of outputPrice of product = $28.00Total revenue = 10.3 $28 = $288.40

Average total cost at 10.3 units of output = $28Total costs = 10.3 $28 = $288.40Profit = $288.40 $288.40 = $0.00

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

60Profit at Price of $28?P=28 45$Q11.210.3MCATCAVC

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)61

62Price 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

63Price falls to $18.00.Produce 8.6 units of outputPrice 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

64Price falls to $18.00.Produce 8.6 units of outputPrice 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

65Profit at Price of $18?28P=18 45$Q11.210.38.6MCATCAVC

Revenue = $18 8.6 = $154.80Total cost = $28 8.6 = $240.80Profit = $154.80 $240.80 = -$86

Since P = MR = ARAverage profit = $18 $28 = $10Profit = $10 8.6 = $86 (Loss)66Price 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

67Price falls to $10.00.Produce 7.0 units of output Price of product = $10.00Total revenue = 7.0 $10 = $70.00

Average total cost at 7.0 units of output = $30Total costs = 7.0 $30 = $210.00Profit = $70.00 $210.00 = $140.00

Average variable costs = $19 Total variable costs = $19 7.0 = $133.00 Revenue variable costs = $63.00 !!!!!(not covering variable costs)

68Profit at Price of $10?28P=101845$Q11.210.38.6MCATCAVC

7.0Revenue = $10 7.0 = $70.00Total cost = $30 7.0 = $210.00Profit = $70.00 $210.00 = $140.00

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

Average variable cost = $19Variable costs = $19 7.0 = 133.00Revenue variable costs = $63Not covering variable costs!!!!!!69The Firms Supply Curve28P=101845$Q11.210.38.6MCATCAVC

7.070Now lets look at the demand for a single input: Labor71Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product price product

Page 10072Key Input RelationshipsThe following input-related derivations also play a key role in decision-making:

Marginal value = marginal physical product price product (MVP)

Marginal input = wage rate, rental rate, etc. cost (MIC) Page 10073

Page 1015 BC D E FG HIJWage rate representsthe MIC for labor74Page 101

5 BC D E FG HIJUse 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

75

Page 1015The area below thegreen lined MVPcurve and above thered lined MICcurve representscumulative net benefit. BC D E FG HIJ76

Page 100MVP = MPP $4577

Page 100Profit maximized where MVP = MICor where MVP =$5 and MIC = $578

Page 100=Marginal net benefit in column (5)is equal to MVP in column (3) minusMIC of labor in column (4)79

Page 100The cumulative net benefit in column (6) is equal to the sumof successive marginal net benefitin column (5)80

Page 100For example$25.10 = $9.85 + $15.25$58.35 = $25.10 + $33.2581

Page 100

=Cumulative net benefitis maximized whereMVP=MIC at $582

Page 1015If 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. BC D E FG HIJ83Page 101

5 BC D E FG HIJIf you went beyond the point where MVP=MIC, you begin incurring losses.84A Final ThoughtOne final relationship needs to be made. The levelof profit-maximizing output (OMAX) in the graph on page 99 where MR = MC corresponds directly withthe variable input level (LMAX) in the graph on page 101 where MVP = MIC.

Going back to the production function on page 88,this means that:

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

85In SummaryFeatures of perfect competitionFactors of production (Land, Labor, Capital and Management)Key decision rule: Profit maximized at output MR=MCKey decision rule: Profit maximized where MVP=MIC

86