Economic
Rawan ageeli
Module_5_-_Firms_Production_Decisionsnew2.pptxECONOMICS 1 (ECON101)
Firm’s Production Decisions
MODULE 5 : Textbook Chapter 5
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
1
Nature and Goal of the firm
Firms may have different and many goals at the same time.
They can be as follows,
Maximize profit
Maximize sales
Rate of growth of sales
Product differentiation
Market leadership
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Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN THEORY OF PRODUCTION
Factors of production :
a) Fixed factor – an input that cannot be increased in supply within a given time period. Example: buildings.
b) Variable factor – an input that can be increased in supply within a given time period. Example: raw material, Labour.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN THEORY OF PRODUCTION
Long-run and short-run production:
The distinction between fixed and variable factors allows us to distinguish between the short-run and long-run production.
a) Short-run – the period of time over which at least one factor is fixed.
In short-run output can increased only by using more variable factors. For example: if an airline wanted to carry more passengers in response to a rise in demand, it could possibly accommodate more passengers on existing flights if there was space. It could possibly increase the number of flights with its existing fleet, by hiring more new crew and by using more fuel. But in short-run it could not buy more planes.
b) Long-run – the period of time long enough for all factors to be varied.
In long-run a firm can build additional factories and install new machines.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN THEORY OF PRODUCTION
The short-run production function:
Total Physical Product (TPP) – the total output of a product per period of time that is obtained from a given amount of inputs.
Average Physical Product (APP) – the total output (TPP) per unit of the variable factor (QV)/input in question
APP = TPP/QV
Marginal Physical Product (MPP) – the extra output(TPP) gained by the employment of one more unit of the variable factor/input
MPP = TPP/QV
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
Wheat production per year from a particular farm (tonnes)
6
Wheat production per year from a particular farm (tonnes)
7
Wheat production per year from a particular farm (tonnes)
8
Wheat(Qamah) production per year from a particular farm (tonnes)
9
Number of farm workers
Wheat production per year from a particular farm
Tonnes of wheat produced per year
Number of
workers
0
1
2
3
4
5
6
7
8
TPP
0
3
10
24
36
40
42
42
40
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Number of farm workers
Wheat production per year from a particular farm
Tonnes of wheat produced per year
Number of
workers
0
1
2
3
4
5
6
7
8
TPP
0
3
10
24
36
40
42
42
40
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Wheat production per year from a particular farm
Number of farm workers
Tonnes of wheat produced per year
TPP
b
Diminishing returns
set in here
d
Maximum output
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Prepared by Ms.Farha Zeba Ibrahim
12
Wheat production per year from a particular farm
Number of
farm workers (L)
Tonnes of wheat per year
TPP
Tonnes of wheat per year
Number of
farm workers (L)
DTPP = 7
DL = 1
MPP = DTPP / DL = 7
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Prepared by Ms.Farha Zeba Ibrahim
13
Wheat production per year from a particular farm
Tonnes of wheat per year
TPP
Tonnes of wheat per year
MPP
Number of
farm workers (L)
Number of
farm workers (L)
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Wheat production per year from a particular farm
Tonnes of wheat per year
TPP
Tonnes of wheat per year
APP
MPP
APP = TPP / L
Number of
farm workers (L)
Number of
farm workers (L)
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Prepared by Ms.Farha Zeba Ibrahim
15
SHORT-RUN THEORY OF PRODUCTION
Law of diminishing returns:
When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
This can be illustrated by taking a simplest case where there are just two factors i.e., one fixed and one variable.
Take the case of a farm. Assume the fixed factor is land and the variable factor is labour.
Since the land is fixed in supply, output per period of time can be increased only by increasing the amount of workers employed.
But imagine what would happen as more and more workers crowd on to a fixed area of land. The land cannot go on yielding more and more output. After a point the additions to output from each extra worker will begin to diminish.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
LONG-RUN THEORY OF PRODUCTION
Economies of scale : when increasing the scale of production leads to a lower cost per unit of output
Diseconomies of scale : where costs per unit of output increases as the scale of production increases
The scale of production
Constant return of scale
This is where a given percentage increase in inputs will lead to the same percentage increase in output
(increase in input = increase in output)
Increasing return of scale
This is where a given percentage increase in inputs will lead to a larger percentage increase in output
(increase in input < increase in output)
Decreasing return of scale
This is where a given percentage increase in inputs will lead to a smaller percentage increase in output
(increase in input > increase in output)
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
Cost
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN COST
Measuring costs of production:
a) Opportunity costs – cost measured in terms of the next best alternative forgone.
b) Explicit costs – the payments to outside suppliers of inputs (factors not owned by the firm).
c) Implicit costs – costs that do not involve a direct payment of money to a third party, but which nevertheless involve a sacrifice of some alternative (factors already owned by the firm).
Fixed costs and variable costs
a) Fixed costs – total costs that do not vary with the amount of output produced (rent, insurance, accounting). Also known as sunk costs.
b) Variable costs – total costs that do vary with the amount of output produced (cost of raw materials, labour).
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN COSTS
Total Cost (TC):
The total cost (TC) of production is the sum of Total Fixed Costs (TFC) and Total Variable Costs (TVC).
TC = TFC + TVC
The TC curve is simply vertically upwards.
Average Cost (AC):
Average cost (AC) is cost per unit of production.
AC = TC/Q
OR
Average cost (AC) is the Total Cost (fixed plus variable) per unit of output.
AC = AFC + AVC
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN COSTS
Marginal Cost (MC):
Marginal cost is the cost of producing one more unit of output.
MC = TC/Q
The shape of MC curve follows directly from the law of diminishing returns. As more of the variable factor is used, extra units of output cost less than previous units, MC falls. Beyond a certain level of output, diminishing returns set in and thereafter MC rises. Additional units of output cost more and more to produce, since they require ever increasing amounts of the variable factor.
If MC<AC, AC must be falling : as long as new units of output cost less than the average, their production must pull the AC down
If MC>AC, AC must be rising : if new units cost more than the average , their production must drive the AC up
MC crosses the AC and AVC at their minimum point
The output level at which MC = lowest AVC is the most efficient level of production. In this example it is at output level 4
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN COSTS
Total Fixed Cost (TFC):
The TFC does not vary with output, it is shown by a horizontal straight line.
Total Variable Cost (TVC):
With a zero output, no variable factors will be used. Thus, TVC = 0. The TVC curve, therefore starts from the origin.
The shape of the TVC curve follows from the law of diminishing returns. Initially, before diminishing returns set in, TVC rises less and less rapidly as more variable factors are added. As output increase, diminishing returns set in. Thus, TVC rises more and more rapidly, TVC curve gets steeper.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
SHORT-RUN COSTS
Average Fixed Cost (AFC):
Total fixed cost per unit of output.
AFC = TFC/Q
The shape of AFC is downward slopping since TFC are being spread over a greater and greater output.
Average Variable Cost (AVC):
AVC is the total variable cost per unit of output.
AVC = TVC/Q
AVC is U shaped.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
Example: Total costs for firm X
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24
TFC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
Example: Total costs for firm X
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TFC
Example: Total costs for firm X
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
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TVC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TFC
Example: Total costs for firm X
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TVC
TFC
Example: Total costs for firm X
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TC
(£)
12
22
28
33
40
52
72
103
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Prepared by Ms.Farha Zeba Ibrahim
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TC
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(£)
12
12
12
12
12
12
12
12
TVC
(£)
0
10
16
21
28
40
60
91
TC
(£)
12
22
28
33
40
52
72
103
TVC
TFC
Example: Total costs for firm X
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29
TC
TVC
TFC
Example: Total costs for firm X
Diminishing marginal
returns set in here
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Prepared by Ms.Farha Zeba Ibrahim
30
Output
(Q)
0
1
2
3
4
5
6
7
TFC
(SR)
12
12
12
12
12
12
12
12
TVC
(SR)
0
10
16
21
28
40
60
91
TC
(SR)
12
22
28
33
40
52
72
103
Example : Total costs for firm X
AC
(SR)
0
22
14
11
10
10.4
12
14.7
AFC
(SR)
0
12
6
4
3
2.4
2
1.7
AVC
(SR)
0
10
8
7
7
8
10
13
MC
(SR)
0
10
6
5
7
12
20
31
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
31
Output (Q)
Costs (SR)
MC
x
Diminishing marginal
returns set in here
Marginal cost
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Prepared by Ms.Farha Zeba Ibrahim
32
Output (Q)
Costs (SR)
AFC
AVC
MC
x
AC
z
y
Average and marginal costs
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
33
LONG-RUN COSTS
All costs in long run are variable costs as there are no fixed factors in the long run.
Long-run average cost (LRAC):
A curve that shows how average cost varies with output on the assumption that all factors are variable.
It will initially experience economies of scale and thus face a downward sloping LRAC curve. After a point, all such economies of scale will have been achieved and thus the curve will flatten out. Then, the firm will get so large that it will start experiencing diseconomies of scale and thus a rising LRAC. Result is a ‘U’ shape curve.
Assumptions :-
1) Factor prices are given.
2) The state of technology and factor quality are given.
3) Firm choose the least-cost combination of factors for each
output.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
LONG-RUN COSTS
Long-run marginal cost (LRMC):
The extra cost of producing one more unit of output assuming that all factors are variable.
If there are economies of scale : LRMC curve must be below LRAC.
If there are diseconomies of scale : LRMC curve must be above LRAC.
If no economies or diseconomies of scale : LRAC curve is horizontal.
Envelope Curve:
A long-run average cost curve drawn as the tangency points
of a series of short-run average cost curves.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
A typical long-run average cost curve
Output
O
Costs
LRAC
Economies
of scale
Constant
costs
Diseconomies
of scale
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Prepared by Ms.Farha Zeba Ibrahim
36
Output
O
Costs
Long-run average and marginal costs
LRMC
LRAC
Initial economies of scale,
then diseconomies of scale
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
37
Deriving long-run average cost curves: factories of fixed size
SRAC3
Costs
Output
O
SRAC4
SRAC5
5 factories
4 factories
3 factories
2 factories
1 factory
SRAC1
SRAC2
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SRAC1
SRAC3
SRAC2
SRAC4
SRAC5
LRAC
Costs
Output
O
Deriving long-run average cost curves: factories of fixed size
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
39
LRAC
Costs
Output
O
Deriving a long-run average cost curve: choice of factory size
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40
Economic Cost and Accounting Cost
Accounting costs - Accounting costs are the costs most often associated with the costs of producing.
Economic cost: Economic costs are not only the costs of producing a good, it also includes the opportunities forgone by producing this product.
Example:
If a firm is producing Computers then the accounting costs are the costs incurred for producing the computers. Economic costs include the cost of producing the computers as well as opportunity cost. Suppose, If this firm could lease its office and the plant for say $100,000 then that is the opportunity cost.
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
Reference : Basic Text : John Sloman; Economics; 2009; 7th Edition; Pearson Prentice Hall
End of Module 5
4/8/2018
Prepared by Ms.Farha Zeba Ibrahim
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=
D
TPP/
D
Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
Number of
Workers (Lb)
TPP
APP
(=TPP/Lb)
MPP
(=(TPP/(Lb)
(a)
0
0
-
3
1
3
3
7
2
10
5
(b)
14
3
24
8
12
(c)
4
36
9
4
5
40
8
2
6
42
7
(d)
0
7
42
6
-2
8
40
5
0
10
20
30
40
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