THEORY OF PRODUCTION AND COST Class 3 Theory

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THEORY OF PRODUCTION AND COST Class 3

THEORY OF PRODUCTION AND COST Class 3

Theory of Production and Cost Short and Long run production functions Behavior of Costs

Theory of Production and Cost Short and Long run production functions Behavior of Costs Law of Diminishing Returns Law of Returns to scale in theory of production Fixed Costs and Variable Costs Explicit Costs and Implicit Costs

What are Costs? “The Market Value of the inputs a firm uses in production”

What are Costs? “The Market Value of the inputs a firm uses in production” Total Revenue – the amount a firm receives for the sale of its outputs. Eg: Each Ice-Cream takes Rs. 10 to make and it is sold at Rs. 25 – Nelum sells 2000 icecreams

Economic Cost This is different to accounting cost What is account cost? Remember Nelum?

Economic Cost This is different to accounting cost What is account cost? Remember Nelum? – She made Rs. 30000 profit making ice-cream. Assume Nelum was an amazing programmer and she could earn Rs. 80000 a month programming. Her Opportunity cost = 80000 – 30000 = Rs. 50000 Which means she is losing Rs 50000 by making ice-cream.

Implicit and Explicit Costs – input costs that require an outlay of money by

Implicit and Explicit Costs – input costs that require an outlay of money by the firm. Implicit costs – input costs that do not require an outlay of money by the firm. Accounting Profit = TR – Explicit Costs Economic Profit = TR – (Implicit Costs+ Explicit Costs)

35 30 25 10 20 20 Profit Implicit Cost Explicit Cost 15 10 30

35 30 25 10 20 20 Profit Implicit Cost Explicit Cost 15 10 30 10 5 10 10 0 Economic Profit Total Revenue Accounting Profit

The production functions Output per Marginal Cost of Hour 0 1 2 3 4

The production functions Output per Marginal Cost of Hour 0 1 2 3 4 5 6 product of labour Two Assumptions factory (FC) � Short Total Cost workers (VC) Number of Workers Run 0 0 30 � Size of Nelum’s factory is fixed 50 only vary 50 the amount 30 10 40 � She can of ice-cream by increasing workers 90 40 30 20 50 � Long run – She can build a new factory. 120 30 30 30 60 140 20 40 70 The production function 30 150 10 30 quantity 50 of inputs 80 The relationship between the used to 155 make a good and 30 he quantity of outputs for 5 60 90 that good.

Production Function 180 160 140 120 100 Output per Hour 80 60 40 20

Production Function 180 160 140 120 100 Output per Hour 80 60 40 20 0 0 2 4 6 8

Total Cost Curve 100 80 60 Marginal Product � The increase in output that

Total Cost Curve 100 80 60 Marginal Product � The increase in output that arises from an additional unit of output Diminishing Marginal Product Total Cost property whereby the marginal product of an input declines as the quantity of the input increases. � The 40 20 0 0 50 100 150 200

Fixed and Variable Costs Fixed Costs � Variable Costs � Costs that do not

Fixed and Variable Costs Fixed Costs � Variable Costs � Costs that do not vary with the quantity of output produced Costs that vary with the quantity of output produced. Average Total Cost – Total cost divided by the quantity of output Average Fixed Cost – Fixed cost divided by the quantity of output Average Variable Cost – Variable cost divided by the quantity of output Marginal Cost – The increase in total cost that arises from an extra unit of production.

Cups Per Total Hour Cost Fixed Cost Variable Average Fixed Average Total Marginal Cost

Cups Per Total Hour Cost Fixed Cost Variable Average Fixed Average Total Marginal Cost Variable Cost 0 300 0 0 1 330 300 30 330 2 380 300 80 150 40 190 3 450 300 150 100 50 150 4 540 300 240 75 60 135 5 650 300 350 60 70 130 6 780 300 480 50 80 130 7 930 300 630 43 90 133 8 1100 300 800 38 100 138 9 1290 300 990 33 110 143 10 1500 300 1200 30 120 150

350 300 250 200 150 100 50 0 0 1 2 3 4 Average

350 300 250 200 150 100 50 0 0 1 2 3 4 Average Fixed Cost Average Total Cost 5 6 7 8 9 10 Average Variable Cost

Observations Rising Marginal Cost � Chatura’s MC rises with the quantity of out produced.

Observations Rising Marginal Cost � Chatura’s MC rises with the quantity of out produced. This reflects the property of diminishing marginal product. U-Shaped Average Total Cost � Average fixed costs always reduces � Average variable costs typically rises as output increases because of diminishing marginal product The bottom of the U shaped curve occurs at the quantity that minimizes average total cost

Long run costs curves In the short term you cannot increase the number of

Long run costs curves In the short term you cannot increase the number of factories, only the number of workers In the long run this is not an issue. Economies of Scale – (Specialization) – When long run average total costs falls as the quantity of output increases Diseconomies of Scale – (Coordination Issue) – When LRATC increase as the output increases Constant returns of scale – When LRATC stays the same as the quantity of output changes.

Break Time!

Break Time!