BEC 30325 Managerial Economics Fundamental questions How can production be optimized How can cost be minimized How does output behave when quantity of inputs is increased How can the leastcost combination of inputs be achieved ID: 1028252
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1. Theory of Production & CostBEC 30325Managerial Economics
2. Fundamental questions…How can production be optimized?How can cost be minimized?How does output behave when quantity of inputs is increased?How can the least-cost combination of inputs be achieved?What does happen to the rate of return when more plants are added? How does technology matter in reducing the cost of production?2
3. Why production and cost???Profit through managing the revenue is more interesting and exciting.Managers may enjoy time spent on revenue decisions.In a competitive market scenario;Profitability fairly depends on optimization of production and minimization of costs.Managers may find internalization of profitability is easier than externalization. 3
4. Some basic concepts of production theory…Fixed and variable inputsFixed inputs (Ex: buildings, machinery)Economic sense – supply is inelastic in the short runTechnical sense – remains constant for a certain level of outputQuasi-fixed inputs - unlike the fixed inputs, this can be avoided and cost is zero if the firm chooses to produce nothingVariable inputs (Ex: raw materials, labour, fuel)Economic sense – supply is elastic in the short runTechnical sense – changes with the change in output4
5. Some basic concepts of production theory…Short run and long runShort run Refers to a period of time in which the level of usage of at least one input is fixedChanges in the output must be accomplished by changes in variable inputsShort run production function;Other variable inputs (such as materials, fuel) are omitted in the production function. (Why?) 5
6. Some basic concepts of production theory…Short run and long runLong runRefers to the time in the future when all inputs are variableOutput changes with changes in both labour and capitalLong run production function;Long run consists of all possible short run situations (all possible choices of capital usage)What is the ‘very long run’? 6
7. Some basic concepts of production theory…Technical and economic efficiencyTechnical efficiencyProduction of the maximum level of output that can be obtained from a given combination of inputsEconomic efficiencyProduction of a given amount of output at the lowest possible cost7
8. Production in the short run0123456789100000000000001025527490100108114118120121205511216219822424225225826226430831702473033423693843944004034010822032540045348851152753554050125258390478543590631653663670601372864255235986557047327447537014130445355964370876680081482580143314474587679753818857873885901413184886097087898619059229351001373144926177228098879359539678Units of capital (K)Units of labour (L)
9. Total, Average & Marginal Product of Labour (with capital fixed at 2 units)No. of workers (L)Total product (TP)Average product (AP = Q/L)Marginal product(MP = ∆Q/∆L)00--152525221125660317056.75842205550525851.638628647.728730443.418831439.310931835.341031431.4-49
10. Average & Marginal ProductsAverage product of laborMarginal product of laborWhen AP is rising, MP is greater than APWhen AP is falling, MP is less than APWhen AP reaches it maximum, Law of diminishing marginal productAs usage of a variable input increases, a point is reached beyond which its marginal product decreases 10
11. 11Total, average and marginal product curves (with capital fixed at 2 units)
12. Law of Diminishing Marginal ProductNumber of units of the variable input increases, a point will be reached beyond which the marginal product decreasesOther inputs held constantIncreasing, diminishing and negative marginal product situations 12
13. Short run cost of productionEconomic cost of using resources;Total economic (opportunity) cost = Explicit costs of market supplied resources + Implicit costs of owner supplied resourcesTotal cost consists of total fixed and variable costs 13
14. Short run total costsOutput(Q)Total fixed cost (TFC)Total variable cost (TVC)Total cost(TC = TFC + TVC)0 $ 6,000 $ 0 $ 6,0001006,0004,00010,0002006,0006,00012,0003006,0009,00015,0004006,00014,00020,0005006,00022,00028,0006006,00034,00040,00014TVC changes with the output but depends on the usage of variable inputs (labour).
15. Short run average and marginal costsOutput(Q)Average fixed cost (AFC = TFC/Q)Average variable cost (AVC = TVC/Q)Average total cost(ATC = TC/Q)Short run marginal cost(SMC = ∆TC/∆Q)0----100 $ 6040 $ 100 $ 40200303060203002030503040015355050500124456806001056.766.712015
16. Short run average and marginal cost curves16SMC curve crosses AVC and ATC curves at their respective minimum points.So, AVC and ATC falling when SMC is less than those.
17. Relationship between short run production and costsShort run productionShort run costsLabour(L)Output(Q)Total variable cost(TVC = wL)Total fixed cost(TFC = rK)Total cost(TC = wL + rK)000 $ 6,000 $ 6,0004100 $ 4,0006,00010,00062006,0006,00012,00093009,0006,00015,0001440014,0006,00020,0002250022,0006,00028,0003460034,0006,00040,00017Assumptions Wage rate (w) = $ 1,000 per worker, Cost of capital (r) = $ 2,000 per unit
18. Average and marginal relations between cost and productionShort run productionShort run costsLQAPMPAVCSMC00----41002525 $ 40 $ 40620033.33503020930033.3333.3330301440028.572035502250022.7312.5044803460017.658.3356.6712018
19. AVC and APConsider the 100 units of output…AVC is calculated by dividing the wage rate by AP 19
20. SMC and MPConsider increase in output from 100 to 200 units…SMC is calculated by dividing the wage rate by MP 20
21. 21Assume a wage rate of $21 First consider the product and cost curves over the range of 0 to 500 units of labour.MP lies above AP, so AP is rising. Because, SMC is inversely related to MP (SMC = w/MP) and AVC is inversely related to AP (AVC = w/AP)MP is maximized (9 units of output) and SMC is minimized to $ 2.33 (21/9) at the usage of 500 units of labour and 3,250 units (6.5 x 500) of output. Now consider the product and cost curves over the range of 500 to 800 units of labour.As MP falls SMC rises. But, AP rises as MP is still greater than AP and AVC falls as SMC is still less than AVC.
22. Implications for managers…Relations between production and cost curves in the short run involves the effect of the law of diminishing marginal product on the marginal cost of production.In the above example;At 800 units of labour and 5,600 units of output, both SMC and AVC are equal ($3) and AVC reaches its minimum. Beyond this point AP begins to decrease but never becomes negative. However, MP eventually becomes negative.So…what’s your decision? 22
23. Production and cost in the long runIncrease in the scale of operationsNeed to increase the amount of capital employedVariability of all factors of production with the output changeEconomies of scaleEconomies of scope Reduce the cost of one good by becoming the producer of other related goods in productionRelated diversificationMergers and acquisitions23
24. Production IsoquantsA curve showing all possible combinations of inputs physically capable of producing a given fixed level of output.24
25. Marginal Rate of Technical SubstitutionMRTSThe rate at which one input is substituted another along an isoquantRelation of MRTS to marginal productsEx: , 25
26. Isocost CurvesShows various combinations of inputs that may be purchased for a given level of expenditure at given input prices .Slope of the isocost curve is the negative of the input price ratio Intercept is Represents amount of capital that may be purchased if zero labor is purchased 26
27. Isocost Curves27
28. Optimal combination of inputsMinimize total cost of producing by choosing the input combination on the isoquant for which is just tangent to an isocost curve.Two slopes are equal in equilibriumImplies marginal product per dollar spent on last unit of each input is the same = or = 28
29. Output optimization and cost minimization29
30. Optimization and costExpansion path gives the efficient (least-cost) input combinations for every level of outputDerived for a specific set of input pricesAlong expansion path, input-price ratio is constant & equal to the MRTS30
31. Expansion path31