Theory of production and cost microeconomics pdf
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Production can be defined as the transformation of resources into commodities. The production function is the relationship between the output and the factors of production. Students can refer to the Class 12 Economics Chapter 3 Notes to revise the formula that defines the production function. Production function can be classified into short term and long term based on the variables used.
Theory of Production
Each business, regardless of size or complexity, tries to earn a profit:. Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:. Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs.
Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs. We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns.
Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate.
We will cover an example shortly. These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit.
Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
Consider the following example. To run his own firm, he would need an office and a law clerk. First, let us calculate revenue.
This is simple as it is given to us. Next, let us calculate the explicit costs. These are the actual outlays of money. However, we are ignoring the fact that Fred has to leave his job to start his own firm. This is where implicit costs come in to play. Fred does not have to pay to leave. Instead, he is giving up the ability to earn his salary. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost.
The cost of producing pizza or any output depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs:.
Where N is the level of natural resources, L is the quantity of labor, K is the amount of capital, t is the level of technology, and E is the degree of entrepreneurship. The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs? Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile.
Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently. One pizza restaurant may make its own dough and sauce, while another may buy those pre-made. A sit-down pizza restaurant probably uses more labor to handle table service than a purely take-out restaurant. In the pizza example, the building is a fixed input.
Once the entrepreneur signs the lease, he or she is stuck in the building until the lease expires. Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well.
The short run is the period of time during which at least some factors of production are fixed. The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
This equation simply indicates that since capital is fixed, the amount of output e. We can express this production function numerically as the table below shows. Note that we have introduced some new language. We also call Output Q Total Product TP , which means the amount of output produced with a given amount of labor and a fixed amount of capital.
In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour. We should also introduce a critical concept: marginal product. Marginal product is the additional output of one more worker. Mathematically, Marginal Product is the change in total product divided by the change in labor:. In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day.
Why might that be the case? A two-person saw works much better with two persons than with one. Suppose we add a third lumberjack to the story. What will that person contribute to the team? What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product.
In fact, there may eventually be no effect or a negative effect on output. Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice.
Both concepts are examples of the more general concept of diminishing marginal returns. Why does diminishing marginal productivity occur? We will see this more clearly when we discuss production in the long run. We can show these concepts graphically as the figures below illustrate. The first figure is the total product curve while the second figure is the marginal product curve.
However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost. For every factor of production or input , there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production.
Factor payments include:. A cost function is a mathematical expression or equation that shows the cost of producing different levels of output. What we observe is that the cost increases as the firm produces higher quantities of output.
This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire. What is the origin of these cost figures? They come from the production function and the factor payments. Let us use a new example to explore why costs seems to be increasing at an increasing rate.
Suppose that the number of pizzas we can produce in the short-run is dependent on the number of employees we hire. The production function is given below. From the table, we see what was mentioned earlier…decreasing marginal returns. As we hire more and more employees, the additional production, in this case pizzas, decreases.
But how does that relate to the cost of production? Imagine that the only cost is labor. While this is unrealistic, it does allow us to focus in on the main idea of the argument.
Let us re-examine the table above, but this time we will add two new rows. First, we will add a row for the cost of the extra labor. Second, we will add the cost per extra pizza. So how much does each of those additional pizzas cost? Therefore we divide the cost of hiring the new employee by the number of new pizzas they produce. We can decompose costs into fixed and variable costs.
Fixed costs are the costs of the fixed inputs e. Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same.
Theory of production
Costs of production relate to the different expenses that a firm faces in producing a good or service. These are costs that do not vary with output. However many goods are produced, fixed costs will remain constant. These are costs that do vary with output. As output increases, there will be more variable costs. For example, as you produce more cars, you will have to pay for more raw materials, such as metal, tyres and plastic.
In economics, production theory explains the principles in which the business has to take decisions on how much of each commodity it sells and how much it produces and also how much of raw material ie. It defines the relationships between the prices of the commodities and productive factors on one hand and the quantities of these commodities and productive factors that are produced on the other hand. Production is a process of combining various inputs to produce an output for consumption. It is the act of creating output in the form of a commodity or a service which contributes to the utility of individuals. The Production function signifies a technical relationship between the physical inputs and physical outputs of the firm, for a given state of the technology.
Everything has a cost, and that is true for firms as well as consumers. When firms produce goods, they incur costs that vary depending on how much they are producing. In this lecture, we will analyze firms' cost functions. Building factory infrastructure is a producer cost. Image courtesy of AndreasPraefcke on Wikipedia. Keywords : Productivity; food production; costs; marginal costs; long run costs; short run costs.
Production and Costs roduction and Costs. A Firm Effort. In the previous chapter, we have discussed the behaviour of the consumers. In this chapter as well as in.
The theory involves some of the most fundamental principles of economics. These include the relationship between the prices of commodities and the prices or wages or rents of the productive factors used to produce them and also the relationships between the prices of commodities and productive factors, on the one hand, and the quantities of these commodities and productive factors that are produced or used, on the other. The various decisions a business enterprise makes about its productive activities can be classified into three layers of increasing complexity. The first layer includes decisions about methods of producing a given quantity of the output in a plant of given size and equipment.
In economics the long run is a theoretical concept in which all markets are in equilibrium , and all prices and quantities have fully adjusted and are in equilibrium. The long run contrasts with the short run , in which there are some constraints and markets are not fully in equilibrium. More specifically, in microeconomics there are no fixed factors of production in the long run, and there is enough time for adjustment so that there are no constraints preventing changing the output level by changing the capital stock or by entering or leaving an industry.
Each business, regardless of size or complexity, tries to earn a profit:. Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:.
Long run and short run
Variable costs change according to the quantity of goods produced; fixed costs are independent of the quantity of goods being produced. In economics, the total cost TC is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.
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ECON Theory of the Firm: Production, Costs and Profit. 1 Introduction. There are millions of businesses and firms in the world and the U.S., and they are all.