Transcript Chapter 6

Introduction to
Production and
Resource Use
Chapter 6
Topics of Discussion
Conditions of perfect competition
Classification of inputs
Important production relationships
(assume one variable input in this
chapter)
Assessing short run business costs
Economics of short run decisions
Conditions for Perfect Competition
Homogeneous products
No barriers to entry or exit
Large number of sellers
Perfect information
Page 109
Classification of Inputs
Land: includes renewable (forests) and nonrenewable (minerals) resources
Labor: all owner and hired labor services,
excluding management
Capital: manufactured goods such as fuel,
chemicals, tractors and buildings
Management: production decisions designed to
achieve specific economic goal
Page 110
Production Function
Output = f(labor | capital, land,
and management)
Start with
one variable
input
Page 112
Production Function
Output = f(labor | capital, land,
and management)
Start with
one variable
input
assume all other inputs
fixed at their current
levels…
Page 112
Coordinates of input and
output on the TPP curve
Page 112
Total Physical Product (TPP) Curve
Variable input
Page 113
Law of Diminishing
Marginal Returns
“As successive units of a variable
input are added to a production
process with the other inputs held
constant, the marginal physical
product (MPP) eventually declines”
Page 113
Other Physical Relationships
The following derivations of the TPP curve play
An important role in decision-making:
Marginal
Physical =  Output ÷  Input
Product
Pages 114-115
Other Physical Relationships
The following derivations of the TPP curve play
An important role in decision-making:
Marginal
Physical =  Output ÷  Input
Product
Average
Physical
Product
= Output ÷ Input
Pages 114-115
Change in output as
you increase inputs
Page 112
Total Physical Product (TPP) Curve
Marginal physical
product is .45 as labor is
increased from 16 to 20
output
input
Page 113
Output per unit
input use
Page 112
Total Physical Product (TPP) Curve
Average physical
product is .31 if
labor use is 26
output
input
Page 113
Plotting the MPP curve
Change in output
associated with a
change in inputs
Page 114
Marginal Physcial Product
Change from point A
to point B on the
production function
is an MPP of 0.33
Page 114
Plotting the APP Curve
Level of output
divided by the level
of input use
Page 114
Average Physical Product
Output divided
by labor use is
equal to 0.19
Page 114
Three Stages of Production
Average physical
product (yield) is
increasing in Stage I
Page 114
Three Stages of Production
Marginal physical
product falls below the
average physical
product in Stage II
Page 114
Three Stages of Production
MPP goes negative
as shown on Page 112…
Page 114
Three Stages of Production
Why are Stage I and
Stage III irrational?
Page 114
Three Stages of Production
Productivity rising
so why stop???
Output
Page
114
falling
Three Stages of Production
The question therefore is
Page 114
where should I operate in Stage II?
Economic Dimension
We need to
account for the
price of the
product
We also need to
account for the
cost of the inputs
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Page 117-120
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Average
variable = total variable cost ÷ output
cost
Page 117-120
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Average
variable = total variable cost ÷ output
cost
Average
total = total cost ÷ output
cost
Page 117-120
From TPP
curve on
page 113
Page 118
Fixed costs are
$100 no matter
the level of
production
Page 118
Column (2)
divided by
column (1)
Page 118
Costs that vary
with 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) plus
column (5)
Page 118
Let’s graph the cost
series in this table
Plotted cost relationships
from table 6.3 on page 118
Plotting costs for levels of output
Page 119
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
$45
P=MR=AR
Profit maximizing
level of output,
where MR=MC
11.2
Page 123
Average
Profit = $17,
or AR – ATC
P=MR=AR
$45-$28
$28
Page 123
Grey area represents
total economic profit
if the price is $45…
P=MR=AR
11.2  ($45 - $28) = $190.40
Page 123
P=MR=AR
Zero economic profit
if price falls to PBE.
Firm would only produce
output OBE . AR-ATC=0
Page 123
P=MR=AR
Economic losses
if price falls to PSD.
Firm would shut down
below output OSD
Page 123
Where is the firm’s
supply curve?
P=MR=AR
Page 123
Marginal cost curve
above AVC curve?
P=MR=AR
Page 123
Key Revenue Concepts
The previous graph indicated that profit is maximized at 11.2
units of output, where MR ($45) equals MC ($45). This occurs
between lines G and H on the table above, where at 11.2 units
of output profit would be $190.40. Let’s do the math….
Page 122
Doing the math….
Produce 11.2 units of output (OMAX on p. 123)
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Doing the math….
Produce 11.2 units of output
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Average total cost at 11.2 units of output = $28
Total costs = 11.2 × $28 = $313.60
Profit = $504.00 – $313.60 = $190.40
Doing the math….
Produce 11.2 units of output
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Average total cost at 11.2 units of output = $28
Total costs = 11.2 × $28 = $313.60
Profit = $504.00 – $313.60 = $190.40
Average profit = AR – ATC = $45 – $28 = $17
Profit = $17 × 11.2 = $190.40
Profit at Price of $45?
$
MC
P =45
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
ATC
28
AVC
11.2
Q
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
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
ATC
28
AVC
11.2
Q
Since P = MR = AR
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
Price falls to $28.00….
Produce 10.3 units of output (OBE on p. 123)
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Price falls to $28.00….
Produce 10.3 units of output
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Average total cost at 10.3 units of output = $28
Total costs = 10.3 × $28 = $288.40
Profit = $288.40 – $288.40 = $0.00
Price falls to $28.00….
Produce 10.3 units of output
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Average total cost at 10.3 units of output = $28
Total costs = 10.3 × $28 = $288.40
Profit = $288.40 – $288.40 = $0.00
Average profit = AR – ATC = $28 – $28 = $0
Profit = $0 × 10.3 = $0.00
Profit at Price of $28?
$
MC
45
Revenue = $28  10.3 = $288.40
Total cost = $28  10.3 = $288.40
Profit = $288.40 – $288.40 = $0
ATC
P=28
AVC
10.3 11.2
Q
Since P = MR = AR
Average profit = $28 – $28 = $0
Profit = $0  10.3 = $0 (break even)
Price falls to $18.00….
Produce 8.6 units of output (OSD on p. 123)
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Price falls to $18.00….
Produce 8.6 units of output
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Average total cost at 8.6 units of output = $28
Total costs = 8.6 × $28 = $240.80
Profit = $154.80 – $240.80 = – $86.00
Price falls to $18.00….
Produce 8.6 units of output
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Average total cost at 8.6 units of output = $28
Total costs = 8.6 × $28 = $240.80
Profit = $154.80 – $240.80 = – $86.00
Average profit = AR – ATC = $18 – $28 = – $10
Profit = – $10 × 8.6 = – $86.00
Profit at Price of $18?
$
MC
45
Revenue = $18  8.6 = $154.80
Total cost = $28  8.6 = $240.80
Profit = $154.80 – $240.80 = $0
ATC
28
AVC
P=18
8.6 10.3 11.2
Q
Since P = MR = AR
Average profit = $18 – $28 = –$10
Profit = –$10  8.6 = –$86 (Loss)
Price falls to $10.00….
Produce 7.0 units of output (below OSD on p. 123)
Price of product = $10.00
Total revenue = 7.0 × $10 = $70.00
Price falls to $10.00….
Produce 7.0 units of output
Price of product = $10.00
Total revenue = 7.0 × $10 = $70.00
Average total cost at 7.0 units of output = $28
Total costs = 7.0 × $28 = $196.00
Profit = $70.00 – $196.00 = – $126.00
Price falls to $10.00….
Produce 7.0 units of output
Price of product = $10.00
Total revenue = 7.0 × $10 = $70.00
Average total cost at 7.0 units of output = $30
Total costs = 7.0 × $30 = $210.00
Profit = $70.00 – $210.00 = – $140.00
Average variable costs = $19
Total variable costs = $19 × 7.0 = $133.00
Revenue – variable costs = –$63.00 !!!!!
Profit at Price of $10?
$
MC
45
Revenue = $10  7.0 = $70.00
Total cost = $30  7.0 = $210.00
Profit = $70.00 – $210.00 = $140.00
ATC
28
AVC
18
P=10
7.0 8.6 10.3 11.2
Q
Since P = MR = AR
Average profit = $10 – $30 = –$20
Profit = –$20  7.0 = –$140
Average variable cost = $19
Variable costs = $19  7.0 = $133.00
Revenue – variable costs = –$63
Not covering variable costs!!!!!!
The Firm’s Supply Curve
$
MC
45
ATC
28
AVC
18
P=10
7.0 8.6 10.3 11.2
Q
Now let’s look at the
demand for a single
input: Labor
Key Input Relationships
The following input-related derivations also
play a key role in decision-making:
Marginal
value
= marginal physical product × price
product
Page 124
Key Input Relationships
The 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
D
Wage rate represents
the MIC for labor
C
B
E
F
G
5
H
I
J
Page 125
Use a variable input like
labor up to the point
where the value received
from the market equals
the cost of another unit of
input, or MVP=MIC
D
C
B
E
F
G
5
H
I
J
Page 125
D
The area below the
green lined MVP
curve and above the
green lined MIC
curve represents
cumulative net benefit.
C
B
E
F
G
5
H
I
J
Page 125
MVP = MPP × $45
Page 125
Profit maximized where MVP = MIC
or where MVP =$5 and MIC = $5 Page 125
–
=
Marginal net benefit in column (5)
is equal to MVP in column (3) minus
MIC of labor in column (4)
Page 125
The cumulative net benefit in
column (6) is equal to the sum
of successive marginal net benefit
in column (5)
Page 125
For example…
$25.10 = $9.85 + $15.25
$58.35 = $25.10 + $33.25
Page 125
–
=
Cumulative net benefit
is maximized where
MVP=MIC at $5
Page 125
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
Page 125
D
If you went beyond the
point where
MVP=MIC, you begin
incurring losses.
C
B
E
F
G
5
H
I
J
Page 125
A Final Thought
One final relationship needs to be made. The level
of profit-maximizing output (OMAX) in the graph on
page 123 where MR = MC corresponds directly with
the 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
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
Chapter 7 focuses on the choice
of inputs to use and products to
produce….