Topic 3: Production Theory
Chapter Objectives
Learn about:
Explicit and Implicit Costs, Accounting and Economic Profit
Production in the Short Run
Costs in the Short Run
Production in the Long Run
Costs in the Long Run
Introduction to Production, Costs, and Industry Structure
Amazon Overview: An American international electronic commerce company primarily selling books and more, with a shift towards online services.
Impact on Book Selling Industry: Transformation of consumer purchasing habits and decline of independent bookstores and bigger retailers like Borders and Barnes & Noble due to online sales.
Amazon's Success
Reasons for Success:
Effective production model
Competitive cost structure enabling lower prices.
Behavior of Firms: Firms determine outputs and pricing based on internal production costs and market structures.
Defining a Firm
A firm combines inputs of labor, capital, land, and materials to produce outputs. Successful firms generate outputs of greater value than inputs.
Production encompasses manufacturing and includes all processes creating value.
Decisions In Production
Decisions defining a firm’s behavior:
What products to produce?
How to produce?
How many outputs?
Pricing strategy?
Labor employment?
Decisions must factor in production and cost conditions.
Market Structure
Market structure defined by:
Market power of firms
Product similarity among firms
Barriers to entry for new firms
Competitive strategies (price, advertising)
Spectrum of Competition:
Perfect Competition: Many firms selling identical products
Monopoly: One firm dominating with no competition
Monopolistic Competition and Oligopoly: Intermediate structures with varying product similarities.
Size Distribution of Firms
Private enterprise characterizes the U.S. economy; firms can be grouped as:
Sole proprietorships
Partnerships
Corporations
Firm Size Statistics: As of 2010, approximately 5.7 million firms employed around 112 million workers, with a significant proportion employed in small businesses (fewer than 100 employees).
7.1 Explicit and Implicit Costs, Accounting and Economic Profit
Profit Motivation: Each business seeks profit; calculated as Total Revenue - Total Costs.
Total Revenue Calculation:
Total Revenue = Price x Quantity Sold
Total Cost: Sum of all expenditures for producing output.
Cost Distinction:
Explicit Costs: Direct payments (e.g., wages, rent).
Implicit Costs: Opportunity costs for using owned resources (e.g., owner’s time without formal salary).
Types of Profit
Accounting Profit:
Accounting Profit = Total Revenue - Explicit Costs
Economic Profit:
Economic Profit = Total Revenue - Total Costs (including implicit costs)
Example: Implicit Costs
Scenario: Eryn considers leaving a corporate law job for her practice, earning $200,000 with explicit costs of $85,000.
Calculating Costs:
Total explicit costs = Office rent + clerk salary
Economic profit considers lost income from current job as implicit cost,
Eryn's decision reflects understanding opportunity costs.
7.2 Production in the Short Run
Production Function Concepts
Production Function: Relationship between inputs and outputs (e.g., number of workers and pizza produced).
Input Categories:
Natural Resources: Raw ingredients for products.
Labor: Human effort, physical and mental.
Capital: Physical assets; not monetary
Technology: Processes for production.
Entrepreneurship: Decision-making and management of resources.
Fixed and Variable Inputs
Fixed Inputs: Difficult to adjust in the short run (e.g., factory size, lease).
Variable Inputs: Easily adjustable (e.g., labor hours, raw materials).
Production and Diminishing Returns
Short Run Production Overview: Output depends on labor employed when capital is fixed.
Marginal Product: Additional output from an additional worker. First increases, then diminishes due to fixed capital constraints.
Law of Diminishing Marginal Product: Adding labor eventually leads to smaller increases in output.
Production Example: Lumberjacks
Table Representation: Data shows output versus labor. Marginal products vary with number of workers.
Graphical Representation: Total product and marginal product curves demonstrate production behavior.
7.3 Costs in the Short Run
Short Run Cost Calculations
Cost Function: Mathematical representation of cost relative to output level.
Factor Payments: Payments associated with production factors (e.g., wages, rent).
Total Costs Calculation: Sum of fixed and variable costs.
Types of Costs Overview
Average Cost: Total cost per unit of output.
Marginal Cost: Cost of producing an additional unit.
Fixed Costs: Unchanging regardless of output (e.g., lease).
Variable Costs: Change with the level of production (e.g., material costs).
Average and Marginal Costs
Average Total Cost Calculation: Total costs / Quantity produced.
Marginal Cost Calculation: Change in total cost / Change in output.
Analysis of Cost Patterns: Understanding marginal cost helps firms in pricing and output decisions.
7.4 Production in the Long Run
Long Run Definition: All factors variable, allowing firms to adjust fully.
Production Technology Choices: Adaptation of production based on varying demands and technology.
Economies of Scale: Cost per unit falls with increased production.
Diseconomies of Scale: Increasing production leads to higher per-unit costs due to complexity.
Long Run Cost Curves
LRAC vs. SRAC: LRAC is derived from the least cost combinations of SRAC curves, allowing any level of output.
Graphical Interpretation: Downward slope indicates economies of scale; flat refers to constant returns; upward indicates diseconomies.
Key Terms
Explicit Costs: Out-of-pocket expenses incurred by a firm.
Implicit Costs: Opportunity costs of resources owned but used in business.
Economic Profit: Total revenue less total costs (explicit + implicit).
Marginal Cost: Cost incurred when one more unit is produced.
Key Concepts and Summary
Profit calculations must include both explicit and implicit costs to understand true profitability.
Production function shows the max output with varying levels of input, facilitating cost and pricing decisions.
Economies of Scale fosters competitive advantages through lower per-unit costs with larger production levels, while Diseconomies of Scale signals inefficiencies at higher operational scales.