Transcript Chapter 6 Powerpoint

Introduction to
Production and
Resource Use
Chapter 6
Topics of Discussion
Conditions of perfect competition
Classification of productive inputs
Important production relationships
(Assume one variable input in this chapter)
Assessing short run business costs
Economics of short run production
decisions
2
Conditions for Perfect Competition
Homogeneous products
 i.e., Corn grain, mined low-sulfur coal
No barriers to entry or exit
 No regulatory barriers
 No extremely high fixed costs
Large number of sellers
 How large is large?
Perfect information
Information cost is relatively small
No one firm has access to information that
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others don’t
Page 86
Classification of Inputs
Economists view the production process
as one where a variety of inputs are
combined to produce a single or multiple
outputs
 Cheese plant example
 Many inputs: Labor, stainless steel cheese vats,
raw milk, energy, starter cultures, cutting and
wrapping tables, water, etc.
 Multiple outputs: Cheese, dry whey, whey
protein concentrates are produced by the plant
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Pages 86-87
Classification of Inputs
Land: includes renewable (forests) and
non-renewable (minerals) resources
Labor: all owner and hired labor
services, excluding management
Capital: Manufactured goods such as
fuel, chemicals, tractors and buildings
that may have an extended lifetime
Management: Makes production
decisions designed to achieve specific
economic goals
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Pages 86-87
Classification of Inputs
Inputs can also be classified depending
on whether amount of input used changes
with production level
 Fixed inputs: The amount of input used
does not change with output level
 Up to a point the size of milking parlor does not
change with ↑ milk production/cow or for initial
↑ in herd size
 Variable Inputs: The amount of input used
changes directly with the level of output
 Usually the amount of labor supplied is a
variable input (i.e., car assembly plant that ↑ the
speed of assembly line to ↑ production/hour
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Pages 86-87
Production Function
“given the level of”
Output = f(labor | capital, land,
and management)
Start with
one variable
input
Assume remaining inputs
fixed at current levels
f(•) is general functional notation
7
 Could be any functional form
Page 88
Production Function
8
Point
Labor (hr)
Output
A
10
1.0
B
16
3.0
C
20
4.8
D
22
6.5
E
26
8.1
F
32
9.6
G
40
10.8
H
50
11.6
I
62
12.0
J
76
11.7
We can graph the
relationship between
output and amount of
labor used
 Known as the Total
Physical Product (TPP)
curve
 Purely a physical
relationship, no
economics involved
 X lbs of fertilizer/acre
generates a yield of Y
Page 89
Total Physical Product (TPP) Curve
Maximum Output
Decreasing output
Data from previous table
Variable input
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Page 89
Other Physical Relationships
The following derivations of the TPP curve
play an important role in decision-making
 Marginal Physical Product (MPP) =
 Average Physical Product (APP) =
10
 O utput
 Input
O utput Q ty
Input Q ty
Page 90
Production Function
Point
11
Labor Output ∆Labor ∆Output
[1]
[2]
[3]
[4]
MPP
[5] = [4]
÷ [3]
A
10
1.0
-----
-----
-----
B
16
3.0
6
2
0.33
C
20
4.8
4
1.8
0.45
D
22
6.5
2
1.7
0.85
E
26
8.1
4
1.6
0.40
F
32
9.6
6
1.5
0.25
G
40
10.8
8
1.2
0.15
H
50
11.6
10
0.8
0.08
I
62
12.0
12
0.4
0.02
J
76
11.7
14
-0.3
-0.02
MPP = Change
in output as you
change input use

 O u tp u t
 In p u t
↑MPP
↓MPP
Page 89
Total Physical Product (TPP) Curve
Data from previous table
4.8
 MPP = 1.8/4.0 = .45
Output
Output ↑ from 3.0 to 4.8
units = 1.8
Labor ↑ from 16 to 20
units = 4.0
3
Input
12
Page 89
Law of Diminishing
Marginal Returns
Pertains to what happens to the MPP with
increased use of a single variable input
If there are other inputs their level of use is not
changed
Diminishing Marginal Returns
The MPP ↑ with initial use of a variable input
At some point, MPP reaches a maximum with
greater input use
Eventually MPP ↓ as input use continues to ↑
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Page 93
Production Function
Labor Output ∆Labor ∆Output
Point
[1]
[2]
[3]
[4]
14
MPP
[5] = [4]
÷ [3]
A
10
1.0
-----
-----
-----
B
16
3.0
6
2
0.33
C
20
4.8
4
1.8
0.45
D
22
6.5
2
1.7
0.85
E
26
8.1
4
1.6
0.40
F
32
9.6
6
1.5
0.25
G
40
10.8
8
1.2
0.15
H
50
11.6
10
0.8
0.08
I
62
12.0
12
0.4
0.02
J
76
11.7
14
0.3
-0.02
∆MPP
Plotting the MPP Curve
Change from A to B on
the production function
→ a MPP of 0.33
Change in output
associated with a
change in inputs
Data from previous table
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Page 91
Plotting the MPP Curve
Q of
Output
A
∆Q*
0
16
∆I*
MPP = Slope of the line
tangent at a
point (A) on the
TPP curve
= ∆Q*/∆I*
Q of
Input
Page 91
Plotting the MPP Curve
Q of
Output
A
At A, MPP = ∆Q/∆I
= 0/∆I* = 0
TPP is at a maximum
when MPP = 0
0
17
∆I*
Q of
Input
Page 91
Production Function
Labor Output ∆Labor ∆Output
Point
[1]
[2]
[3]
[4]
18
APP
[6] = [2] ÷
[1]
A
10
1.0
-----
-----
0.10
B
16
3.0
6
2
0.19
C
20
4.8
4
1.8
0.24
D
22
6.5
2
1.7
0.30
E
26
8.1
4
1.6
0.31
F
32
9.6
6
1.5
0.30
G
40
10.8
8
1.2
0.27
H
50
11.6
10
0.8
0.23
I
62
12.0
12
0.4
0.19
J
76
11.7
14
0.3
0.15
-----
Average Physical
Product (APP) =
Amount of
output ÷ amount
of inputs used
= Output/unit of
input used
Page 89
Total Physical Product (TPP) Curve
Data from previous table
Output
APP = .31 (= 8÷26)
with labor use = 26
Input
19
Page 89
Plotting the APP Curve
Output divided
by labor use at
B (3 ÷ 16) =0.19
APP = output level
divided by level of
input use
Data from previous table
20
Page 91
Plotting the APP Curve
Q of
Output
B
A
Q*
0
APP = Q*/I*
= Slope of the line from
the origin to the point
on the TPP curve
At I**, APP is at a maximum,
as line OB is just tangent
to the TPP curve
Q of
Input
I*
I**
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Page 91
Relationship Between APP and MPP
Q of
Output
MPP
APP is at a maximum at
input level where APP = MPP
APP*
APP
0
22
I*
Q of
Input
Page 91
Definition of the Three Stages of Production
Stage I: MPP > APP
APP is ↑
APP is increasing in Stage I
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Page 91
Definition of the Three Stages of Production
Stage II: MPP < APP
MPP > 0
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Page 91
Definition of the Three Stages of Production
Stage III: MPP < 0
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Page 91
The Three Stages of Production
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I


26
Stage II
Stage II starts at input use where APP is
at a maximum (pt A)
Stage II ends at input where MPP = 0 (or
TPP is at a maximum)
Page 91
The Three Stages of Production
Why are using the amount of input in
Stage I and Stage III of production
irrational from the producer’s perspective?
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I
27
Stage II
Page 91
The Three Stages of Production
Q of
Output
Can increase output by using
less inputs: →More output and
less cost
MPP
APP
Stage III
Q of
Input
0
Stage I
Stage II
Average productivity is increasing as more
inputs are being used so why stop if the
average return is greater than cost?
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Page 91
The Three Stages of Production
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I
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Stage II
The producer’s economic question:
What level of input amount contained in
Stage II should the I use to maximize profits?
Page 91
Economic Dimension
To answer the above question
We need to account for the price of the
product being produced
We also need to account for the cost of
the inputs used to produce the above
product
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Key Cost Relationships
 The following cost concepts play key
roles in determining where in Stage II a
producer will want to produce
 Total Variable Cost (TVC) = the total value
of costs that change with the level of output
(e.g. energy costs, labor costs, material
costs, etc.)
 Total Fixed Cost (TFC) = total value of costs
that do not changed with the level of output
(e.g. property taxes)
 Total Costs (TC) = the sum of total variable
and fixed costs
 TC = TVC + TFC
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Page 94-96
Key Cost Relationships
 The following cost concepts play key roles in
determining where in Stage II a producer
will want to produce
 Marginal Cost (MC) =  total cost of
production ÷  output produced as output level
changes
=  variable cost of production ÷  output
produced given that total fixed costs by
definition do not change with output =
∆TC/∆Q = ∆TVC/∆Q
 Average Variable Cost (AVC) = total variable
cost of production ÷ total amount of output
produced = TVC/Q
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Page 94-96
Key Cost Relationships
 The following cost concepts play key roles
in determining where in Stage II a
producer will want to produce
 Average Fixed Cost (AFC) = total fixed
cost of production ÷ total amount of
output produced = TFC/Q
 Average Total Cost (ATC) = total cost of
production ÷ total amount of output
produced = TC/Q = AVC + ATC
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Page 94-96
From TPP
curve on
page 113
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Page 94
Fixed costs are
$100 no matter
the level of
production
35
Page 94
Total fixed costs (Col. 2)
÷ by total output (Col. 1)
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Page 94
Costs that vary
with level of
production
37
Page 94
Total variable
cost (Col. 4) ÷
by total output
(Col. 1)
38
Page 94
Total Fixed
Cost (Col. 2) +
Total Variable
Cost (Col.4)
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Page 94
Change in Total Cost
(Col. 4 or 6) associated
with a change in output
(Col. 1)
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Page 94
[Total Cost (Col. 6) ÷ by Total
Output (Col. (1)] or [Avg. Variable
Cost + Avg. Fixed Cost]
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Page 94
Let’s Graph the Above
Cost Items Contained
in the Previous Table
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Table 6.3 Cost Relationships
MC = min(ATC) and
70
60
MC
A TC
AVC
AFC
min(AVC)
Vertical distance between
ATC and AVC = AFC
50
Cost ($)
40
30
20
AFC
10
0
3.0
4.8
6.5
8.1
9.6
10.8
11.6
Input Use
43
Page 95
Key Revenue Concepts
 The following revenue concepts play key roles in
determining where in Stage II a producer will
want to produce
Total Revenue (TR) =Multiplication of total
amount of output produced by the sale price ($)
Average Revenue (AR) = Total revenue ÷ total
amount of output produced ($/unit of output) =
TR/Q
Marginal Revenue (MR) = ∆ total revenue ÷ ∆
total amount of output produced = ∆TR ÷ ∆Q
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 How much revenue is generated by one additional
unit of output?
 Under perfect competition, it is the per unit price
Now let’s assume this
firm can sell its
product for $45/unit
45
Key Revenue Concepts
Remember we are assuming perfect competition
46
 The firm takes price as given
 Price (Col. 2) = MR (Col. 7)
 What is the AR value?
Page 98
Profit Maximization
With perfect competition, where would the
firm maximize profit in the above example?
47
Page 98
Let’s see this in
graphical form
48
P rofit M axim ization
70
60
MC
AT C
AVC
MR
Profit maximizing
Output where MR=MC
P=MR=AR
50
$45
40
30
20
10
11.2
0
49
1
3
4 .8
6 .5
8 .1
9 .6
Page
1 0 .8
991 1 .6
Profit Maximization
The previous graph indicated that
Profit is maximized at 11.2 units of output
MR ($45) equals MC ($45) at 11.2 units of output
Profit maximizing output occurs between points G and H
At 11.2 units of output profit would be $190.40. Let’s do the math….
50
Profit at Price of $45?
$
MC
P =45
ATC
28
AVC
11.2 Q
51
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
Since P = MR = AR
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
Profit at Price of $45?
$
MC
P =45
$190.40
28
ATC
AVC
11.2 Q
52
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
Since P = MR = AR
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
P=MR=AR
Zero economic profit if price
falls to PBE
Firm would only produce output
OBE where AR (MR) ≥ ATC
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Page 99
Profit at Price of $28?
Revenue = $28  10.3 = $288.40
Total cost = $28  10.3 = $288.40
Profit = $288.40 – $288.40 = $0
$
MC
45
ATC
P=28
AVC
10.3 11.2
54
Q
Since P = MR = AR
Average profit = $28 – $28 = $0
Profit = $0  10.3 = $0 (break even)
P=MR=AR
Firm can just cover
variable cost if price
falls to PSD.
Firm would shut down
if price falls below PSD
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Page 99
Profit at Price of $18?
$
MC
45
ATC
28
AVC
P=18
8.6 10.3 11.2
56
Q
Revenue = $18  8.6 = $154.80
Total cost = $28  8.6 = $240.80
Profit = $154.80 – $240.80 = –$86
Since P = MR = AR
Average profit = $18 – $28 = –$10
Profit = –$10  8.6 = –$86 (Loss)
Profit at Price of $10?
$
MC
45
ATC
30
28
Revenue = $10  7.0 = $70.00
Total cost = $30  7.0 = $210.00
Profit = $70.00 – $210.00 = – $140.00
Since P = MR = AR
Average profit = $10 – $30 = –$20
Profit = –$20  7.0 = –$140
AVC
19
P=10
7.0 8.6 10.3 11.2
57
Q
Average variable cost = $19
Variable costs = $19  7.0 = $133.00
Revenue – variable costs = –$63
Not covering variable costs!!!!!!
The Firm’s Supply Curve
Profit Maximizing Output Levels
$
MC
45
ATC
AVC
28
18
10
7.0 8.6 10.3 11.2
58
Q
The Firm’s Supply Curve
We know that so long as P (= MR) > AVC
some of the fixed costs can be covered
Better economic position then shutting down
altogether, WHY?
We know that when P (= MR)=MC, the
firm maximizes profit
Portion of MC curve defined by output
level that generates the minimum AVC is
referred to as the firm’s supply curve
Page 99
59
The Firm’s Supply Curve
$
Firm Supply Curve
MC
45
ATC
AVC
28
18
8.6 10.3 11.2
60
Q
Now let’s look at the
demand for a single
input: Labor
61
Key Input Relationships
The following input-related derivations play
key roles in determining amount of variable
input to use to maximize profits
Marginal Value Product (MVP) =
MPP × Product Price
 MPP → ∆Output ÷ ∆Input Use
 Product Price → ∆Revenue ÷ ∆Output
 MVP → ∆Revenue ÷ ∆Input Use
(Additional output value generated by
the last increment in input use)
Marginal Input Cost (MIC) = wage rate,
rental rate, seed cost, etc.
Page 100
62
D
MVP=MPP x Output Price
Wage rate is
labor’s MIC
C
B
E
F
5
G
H
I
J
63
Page 101
 Profit maximizing input use rule
 Use a variable input up to the
point where
 Value received from another
unit of input (MVP)
 Equals cost of another unit of
input (MIC)
 → MVP=MIC
D
C
B
E
F
G
5
H
I
J
64
Page 101
D
The area below the green lined
MVP curve and above the red
lined MIC curve represents
cumulative net benefit
C
B
E
F
G
5
H
I
J
65
Page 101
MVP = MPP × $45
66
Page 100
67
Profit are maximized where MVP = MIC
or where MVP =$5 and MIC = $5
Page 100
–
68
=
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor
MIC (Col. 4) = Value of additional output from last
unit of input net of the cost of that input
Page 100
69
The cumulative net benefit (Col. 6) of input use
= the sum of successive marginal net benefits (Col. 5)
= the grey area in previous graph.
Page 100
70
For example…
$25.10 = $9.85 + $15.25
$58.35 = $25.10 + $33.25
Page 100
–
Cumulative net benefit is maximized
71 where MVP=MIC at $5
=
Page 100
D
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.
C
B
E
F
G
5
H
I
J
72
Page 101
D
If you use labor beyond the
point where MVP =MIC, you
begin incurring losses as the
return to another unit of
labor is < $5.00, its per unit
cost
C
B
E
F
G
5
H
I
J
73
Page 101
A Final Thought
One final relationship needs to be made. The level
of profit-maximizing output (OMAX) in the graph on
page 99 where MR = MC corresponds directly with
the 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)
74
In Summary…
Features of perfect competition
Factors of production (Land, Labor,
Capital and Management)
Key decision rule: Profit maximized at
output MR=MC
Key decision rule: Profit maximized
where MVP=MIC
75
Chapter 7 focuses on the choice
of inputs to use and products to
produce….
76