Production Function

Implicit cost, explicit cost

  • Explicit Cost – Monetary payments or cash expenditures made to those who supply labor, materials, fuel, transportation, etc. “The costs of rent, wages, cheese, etc for running a pizza parlor.”
  • Implicit Cost – Opportunity costs of using self-owned, self-employed resources. Implicit costs are the money payments that self-employed resources could have earned in their best alternative use. “The $50,000 given up by quitting your job to open a pizza parlor”.

Law of Diminishing Returns

  • As successive units of a variable resource are added to a fixed resource, beyond some point the extra or marginal product that can be attributed to each additional unit of the variable resource will decline. Fourth added to the TP, but not as much as the third. Fifth added to the TP, but not as much as the fourth.
  • At some point (where TP is at a maximum and MP is at 0), adding another unit will be detrimental to the productivity, and TP and MP will begin to decline.

Normal Profit, Economic versus accounting profit

  • Normal Profit – The minimum payment that the owner of the enterprise (entrepreneur) would be willing to accept in order to stay in the business. It represents the opportunity cost.
    • Occurs when economic profit = $0
  • Economic Profit – Profit that occurs after the opportunity costs are subtracted from the accounting profit.
    • When economic profit is greater than $0, it is called Super Normal Profit.
  • Accounting Profit – Profit that occurs after accounting costs (dollar payments made) are deducted from revenue.
  • Accounting profit only takes into account the explicit costs. Economic profit includes the accounting (explicit) costs, and the opportunity (implicit) costs.
  • Economic profit will always be less than accounting profit.

TP, AP, MP

  • TP – Total Product
  • AP – Average Product (Productivity)
    • AP = TP/Variable Input
    • As AP increases, costs decrease; as AP decreases, costs increase. Inverse relationship.
    • AP line crosses the MP line at AP’s maximum point (see Avg-Marg relationship)
  • MP – Marginal Product
    • MP = ?TP/? Variable Input
    • Measure of the change in TP when adding one more unit of variable input.

Total – Marginal relationship for production

  • When MP > 0 and Variable Input increases, TP increases.
  • When MP < 0 and Variable Input increases, TP decreases.
  • When MP = 0, TP is at a maximum.

TFC, TVC, TC, AFC, AVC, ATC, MC

  • TFC – Total Fixed Cost
    • Do not vary with output
    • TFC = TC – TVC = AFC * Q
  • TVC – Total Variable Cost
    • Always increasing, but at different rates due to Law of Diminishing Returns
    • TVC = TC – TFC = AVC * Q
  • TC – Total Cost
    • The sum of the fixed and variable costs
    • TC = TFC + TVC = ATC * Q
  • AFC – Average Fixed Cost
    • The ratio of TFC to quantity of output
    • AFC = TFC / Q = ATC – AVC
  • AVC – Average Variable Cost
    • The ratio of TVC to quantity of output
    • AVC = TVC / Q = ATC – AFC
  • ATC – Average Total Cost
    • The ratio of TC to quantity of output
    • ATC = TC / Q = AFC + AVC
  • MC – Marginal Cost
    • The change in TC resulting from a unit change in outpu
    • MC = ? TC / ? Q

Short run versus long run

  • Short Run (A time period in which some inputs cannot be changed. These determine the firms capacity to produce)
    • 2 types of inputs or costs – fixed and variable
  • Long run
    • All inputs are variable

Economies/Diseconomies of Scale

  • LRATC = Long run average total cost
  • LRATC shows what costs would be like at the present time for alternative outputs using different size plant and equipment.
  • Economies of Scale – Bigger is cheaper (to the left of the long run curve)
    • LRATC declines as the size of the firm increases
      • Cheaper input costs (volume buying)
      • More efficient utilization of equipment (24 hours a day vs 11 hours a day, but paying full rent either way)
      • Utilization of byproducts (Walmart boxes example)
      • Greater specialization of resources (mailing letters, larger being able to afford a machine to do it)
      • Growth in infrastructure
  • Diseconomies of Scale – Bigger is more expensive. (to the right of the long run curve)
    • LRATC rises as production expands
      • Diminishing return sets in to management – can’t respond to changes
      • Competition for resources

Average – Marginal Relationship for production and cost

  • Average-Marginal Product Relationship
    • When AP=MP, AP is at a maximum.
    • If MP > AP and variable input increases, AP increases.
      • Margin is greater than average, and pulls average up.
    • If MP < AP and variable input increases, AP decreases.
      • Margin is less than average, and pulls average down.
  • Average-Marginal Cost Relationship
    • When ATC = MC, ATC is at a minimum. This is production efficient.
    • If ATC > MC and quantity increases, ATC declines.
      • Margin is less than average, and pulls average down.
    • When ATC < MC and quantity increases, ATC increases.
      • Margin is greater than average, and pulls average up.

Accounting cost versus economic cost

  • Outlay (accounting) cost – Money expended to carry on an activity. The explicit costs.
  • Opportunity cost – The value or benefit that you give up by choosing one alternative over another. The implicit costs.
  • Economic cost – The payments that are made to the factors of production
    • Includes both accounting and opportunity cost (implicit costs become explicit costs).
    • Land = rent; labor = wage; capital = investment; entrepreneur = profit

Production/output tables

  • Production Table

Production function/curves

  • Production function shows the relationship between inputs and output
  • Output = f(Inputs)
  • Production Curves

Short run cost curves

Long run cost

Other terms and items

  • What determines productivity
    • The education and skills of the workers
    • The technology, the capital equipment, that each worker uses
    • Infrastructure – What links together that business needs (roads, communications, banking systems)
  • Cost – A sacrifice that must be made to do or acquire something.
  • Cost function: Cost = f(outputs)
  • Inflection point = going from increasing at a decreasing rate to increasing at an increasing rate.
  • If MP increases, MC declines
  • When MP is at maximum, MC is at minimum
  • When AP increases, AVC declines; When AP is at maximum, AVC is at minimum