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8/8/2019 Production, Cost Analysis & Decision Making
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PRODUCTION, COST ANALYSIS &
DECISION MAKING
Contents :Production:
Hemant Shetty (40) & Kamakhya Narayan (19)
Cost Analysis:
Hetal Desai (10) & Gohil Jayesh (13)
Decision Analysis:
Kuntal Rastogi (33)
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PRODUCTION :
Theory of Firm
- Production technologies
- Cost Constraints
- Input Choices
Factors of Production
Production function
q = F(K,L)
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PRODUCTION: ONE VARIABLE
INPUTWe will begin looking at the short run whenonly one input can be variedW
e assume capital is fixed and labor isvariable
Output can only be increased byincreasing labor
Must know how output changes as theamount of labor is changed
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Production: One Variable
Input Average product of Labor - Output per unit of
a particular product
Measures the productivity of a firms labor interms of how much, on average, each workercan produce
Avg Prod of Labor = output/Labor Input
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Production: One Variable
Input Marginal Product of Labor additional
output produced when labor increases by one
unit Change in output divided by the change in
labor Marg Prod of Labor = change in output/change in labor input
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Production: One Variable
Input
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Product Curves
We can show a geometric relationship
between the total product and the average
and marginal product curves Slope of line from origin to any point on the total
product curve is the average product
At point B, AP = 60/3 = 20 which is the same as the
slope of the line from the origin to point B on thetotal product curve
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Production: One Variable
Input
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Product Curves
Geometric relationship between total
product and marginal product
The marginal product is the slope of the linetangent to any corresponding point on the totalproduct curve
For 2 units of labor, MP = 30/2 = 15 which is slope
of total product curve at point A
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Production: Two Variable
Inputs Firm can produce output by combining
different amounts of labor and capital
In the long run, capital and labor are bothvariable
We can look at the output we can achieve
with different combinations of capital andlabor Table 6.4
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Production: Two Variable
Inputs
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Production: Two Variable
Inputs The information can be represented
graphically using isoquants
Curves showing all possible combinations ofinputs that yield the same output
Curves are smooth to allow for use of
fractional inputs
Curve 1 shows all possible combinations of laborand capital that will produce 55 units of output
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Production: Two Variable
Inputs As labor increases to replace capital
Labor becomes relatively less productive
Capital becomes relatively more productive Need less capital to keep output constant
Isoquant becomes flatter
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A Production Function for
Wheat Farmers can produce crops with different
combinations of capital and labor
Crops in US are typically grown with capital-intensive technology
Crops in developing countries grown with labor-intensive productions
Can show the different options of cropproduction with isoquants
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A Production Function for
Wheat Manager of a farm can use the isoquant to
decide what combination of labor and capital
will maximize profits from crop production A: 500 hours of labor, 100 units of capital
B: decreases unit of capital to 90, but mustincrease hours of labor by 260 to 760 hours
This experiment shows the farmer the shape ofthe isoquant
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Isoquant Describing the
Production of Wheat
Capital
Labor250 500 760 1000
40
80
120
100
90
A
10-K!(B
260L !(
Point A is more
capital-intensive, and
B is more labor-intensive.
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There are following types of costs:
Classification of costs into
- Direct costs
- Indirect costs
- Finance costs
Types of Costs
1) Opportunity cost
2) Money cost
- Explicit
- Implicit3) Sunk costs
4) Accounting Cost
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Categorisation of costs (important for decision making process)
Fixed costs (also known as Period costs, constant costs)
Variable costs (also known as marginal costs)
semi variable costs (split into Variable & fixed portion)
Incremental costs (can be variable cost and / or fixed costs)
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Relevant costs & irrelevant costs(used for short term decision making)
All variable costs associated to a decision are relevant
All historical costs irrelevant
All existing fixed costs (being sunk costs) irrelevant
All future fixed costs associated to decisionmaking relevant
Opportunity costs (arising due to decisionmaking) relevant
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Cost in Short Run and Long Run How the COST & DECSION can be change
in Short Run and Long Run
How the same costs are Fixed / Variable inshort Run / Long Run
How the Law of Diminishing Marginal
Returns works only in Short run & useful to
Long run Decision
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PROFIT LOSSES & BREAKEVEN Break Even Analysis
Minimum out put the firm need to produce its costs
TOTAL COST = TOTAL REVENUE
WhereP Price
Q Output in unitsTFC Total fixed cost
AVC Average Variable cost Assumptions:
1. The cost and revenue functions are linear functions.
2. The firm can estimate the cost and revenues in advance.
3. Price remains uniform at all levels of out put.
4.The costs are made up of fixed and variable costs.
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PROFIT LOSSES & BREAKEVENCase 1:
Price is P0 or aFor profit
maximisation
output is y0( refer the intersection
point of MC )
ATC (Average Total
Cost) is b
Profit per unit would be ab
and the TOTAL PROFIT would be the total area
marked with dotted lines
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PROFIT LOSSES & BREAKEVENCase 2:
Price is P1 or c(Point touching the
ATC curve)
Optimal output is y1
(refer the intersectionpoint of MC )
ATC (Average Total Cost)
is C
Profit per unit would be ZERO
And the firm is at BREAK EVEN
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PROFIT LOSSES & BREAKEVENCase 3:
Price is P2 or d(Point touching the
ATC curve)
Optimal output is y2
(refer the intersectionpoint of MC )
ATC (Average Total Cost)
is e
Loss per unit would be ed
And the TOTAL LOSSES would be the total area
marked
d
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PROFIT LOSSES & BREAKEVENCase 4:
Price is P3 or f(i.e. min point of AVC)
output is y3( refer the intersection
point of MC )
And P3 = AVC
Total Loss=Total Cost Total Revenue
= (TFC + TVC) TR
= TFC + AVC*y3 - p3*y3= TFC (as P3 = AVC)
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PROFIT LOSSES & BREAKEVENContd..
Case 5:
Price falls below P3 orf output is less than y3(i.e. doesnot touch min point (refer the intersection point
of AVC) of MC )
i.e. If p3 < Min AVC (market price is less than Min AVC)
Total Loss=Total Cost Total Revenue
= (TFC + TVC) TR
= TFC + AVC*y3 - p3*y3= TFC + (AVC - p3)*y3
Then the losses would start exceeding the TFC ,
Hence reaches to SHUT DOWN CONDITION