Production and cost

ECONLESSON-04

long run of production

The time period in which the production is changed by changing all types of inputs

what type of inputs are identified in long run production?

variable inputs only

long run production function

the function which shows the technological relationship between the inputs and outputs in the long run of production is identified as long run production function

Economic theory that explains the long production process

laws of returns to scale

law of returns to scale

the law of returns to scale explains the relationship between the percentage change in the inputs and the percentage change in the output when the production is changed by changing all types of inputs in the long run production process.

three types of returns to scale

1. increasing returns to scale

2. constant returns to scale

3. decreasing returns to scale

increasing returns to scale

increasing returns to scale refers to a situation where output increases at a higher percentage than the percentage increase in the inputs when the production is increased by increasing all types of inputs.

constant returns to scale

constant returns to scale refers to a situation where output increases at same percentage of increase in inputs when production is increased by increasing all types of inputs.

decreasing returns to scale

decreasing returns to scale refers to a situation where output increases at lower percentage of increase in inputs when production is increased by increasing all types of inputs.

reasons for increasing returns to scale

1. Indivisibility of some production factors

2. specialization through division of labor

3. possibility of using machineries

4. there are onetime costs

reasons for decreasing returns to scale

1. scarcity of resources/ constraints regarding the resources

2. stress

3. problems related to the management and co-ordination

production

the process of converting the factors of production into goods and services

business firms

they are the entities which organize the factors of production process by mixing the productive economic resources in order to produce and supply the goods and services demanded by different parties in an economy

5 major types of business organizations found in a market economic system according the their organization structure

1. sole proprietorships

2. partnerships

3. incorporated companies

4. cooperative societies

5. state entrepreneurships

output

the final outcome of a certain production process is identified as the output

inputs

anything which is used within the production process

two types of inputs used in the production process

1. fixed inputs

2. variable inputs

fixed inputs

Fixed inputs are inputs that do not depend on the number of units produced. They are incurred even when output is zero and remain constant as the level of output increases.

examples for fixed inputs

• buildings

• machineries

• equipment

variable inputs

Variable inputs are inputs that depend on the number of units produced. Their requirement is zero when output is zero and increases gradually as the level of output rises.

examples for variable inputs

• labor

• raw materials

production function

A production function shows the functional relationship between inputs and outputs in relation to a particular production activity.

two production times based on types of inputs which can be observed within the production process

1. short run

2. long run

short run

• The short run is the time period in which at least one input remains fixed.

• In the short run, output can be increased only by increasing the variable inputs while keeping the fixed inputs constant.

• Therefore, both fixed and variable inputs are present in the short-run production process.

Long Run

• long run is the time period in which the output is increased by increasing all types of inputs.

• all inputs become variable in the long run

• no fixed inputs are identified in the long run production process

the two types of production processes are categorized based on?

based on types of inputs used

short run production process

• short run is the time period in which at least on input remains fixed

• in the short run the output is increased by only increasing variable inputs while fixed inputs held constant.

• therefore in short run both variable inputs and fixed inputs can be seen

the three assumptions the short run production process is based on

1. Atleast one input remains fixed

2. Variable inputs are homogenous

3. Technology held constant

short run production function

• the technical relationship between the variable inputs and the total output while the fixed inputs remain constant is shown through the short run production function

• Q= f {L1,L2,L,3…,K}

• L = variable inputs

• K = fixed inputs

Concepts related to short run production process

1. Total product

2. Average product

3. Marginal product

Total product

the total output obtained by using a certain amount of variable inputs mixing with a given amount of fixed inputs is identified as the total product.

Average product

Average product refers to the average amount of output received for one unit of variable input

• AP = TP/ L (units)

Marginal product

Marginal product refers to the addition to the total product when the number of units of variable are increased by one additional unit

• MP = change in TP / change in L

law of diminishing returns

Law of diminishing returns state that in the short run when the variable inputs are increased while the fixed inputs are held constant the marginal product and the average product starts to decrease after a certain point

Another name for law of diminishing marginal returns

Law of variable factor proportions

Which theory decides the shape of the short run product curves as well as the short run cost curves?

Law of diminishing marginal returns

Which economic theory decides the behavior of short run production process

Law of diminishing marginal returns

Reason for the law of diminishing marginal returns

1. Existence of constraints (fixed inputs) within the production process

2. When only the variable inputs are increased while the fixed inputs remain constant, the efficiency of the variable inputs starts to decrease after a certain point.

understand the behavior

Study the behavior of TP, AP,MP

When MP is maximum

Total product starts to increase at a decreasing rate

MP > AP

• AP is increasing

MP = AP

AP is maximum

MP = 0

total product starts decreasing

MP < AP

AP is dec

Three stages of TP

1. Increasing at a increasing rate until MP Is maximum

2. Increasing at a decreasing rate

3. Decreasing

Cost of production

In economics, cost of production refers to the opportunity cost of all resources used in the production process of a certain good or service

Two components of economic cost

1. Explicit cost

2. Implicit cost

Another names for explicit cost

• Direct cost

• Financial cost

Another names for implicit cost

• indirect cost

Explicit cost

• Refers to the cost incurred on purchasing resources from outside of the organization in order to produce goods and services

• There is a money outflow from the organization due to the explicit cost

Eg for explicit cost

Salaries paid

Purchase Of RM

interest paid on loans

Electricity bill

Implicit cost

• Refers to the opportunity cost of resources owned by the organization itself which are used into the production activity being considered

• There is NO money outflow from the organization due to the implicit cost

Types of costs included in the indirect/ implicit cost

1. OPC of own financial capital (forgone interest income)

2. OPC of own labor (forgone salary income)

3. Normal profits (forgone entrepreneurship income)

4. Economic depreciation (reduction in FA market value)

Forgone interest income

Forgone income from the next best investment opportunity

Another name for forgone interest Income

OPC of own financial capital

Forgone salary income

Forgone income from the next best employment opportunity

AKA for forgone salary income

OPC of own labor

Normal profits

Minimum payment expected by an entrepreneur to retain his resources and perform his functions

AKA for normal profits

OPC of entrepreneurship

Economic depreciation

Reduction in market value of fixed assets used in production activity

Economic depreciation = market value of FA in the beginning of the year (-) market value of the fixed asset at the end of the year

Difference between accounting cost and economic cost

• accounting cost refers to explicit cost incurred in production process.

• That is the cost incurred to acquire resources from outsiders to carry out a certain production activity.

• This in other words is known as the direct or financial cost

• Economic cost refers to the opportunity cost of all the economic resources used in production process

• That is the total of direct and indirect costs incurred in the production process

• Economic costs includes both opportunity cost of resources acquired from outside as well as the opportunity cost of the resources owned by the organization

Economic costs = opportunity cost

Economic cost = explicit cost + implicit cost

Difference between accounting profit and economic profit

• accounting profit is obtained by deducting explicit cost from the total revenue

Accounting profit = total revenue - explicit cost

• economic profit is obtained by deducting economic cost from total revenue.

• Economic cost includes both explicit and implicit costs

• Economic profit = total revenue - economic cost

• Accordingly the difference between accounting profit and economic profit is implicit cost

• Economic profit can be obtained by deducting implicit cost from account profit

• Economic profit = accounting profit - implicit cost

Sunk cost

A cost incurred in the past and cannot be recovered at present, such costs are identified as sunk costs

Does sunk cost incur an OPC?

NO.

Ex for sunk cost

• cost incurred in installing a machine

• Cost incurred on performing market survey

Is capital OPC for economic costs?

NO. but the forgone interest from capital is an OPC.

Eg- FD interest income using the capital is forgone