THEORY OF COSTS
Production and Production Theory
Production refers to the transformation of inputs into outputs (or products) An input is a resource that a firm uses in its production process for the purpose of creating a good or service.
Most resources are lumped into three categories:
The two kinds of inputs: Fixed vs. Variable Inputs
Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs - resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.
The Production Function and the Law of Diminishing Marginal Returns The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time. Law of Diminishing Marginal Returns
All other things remaining constant, if only one input is increased a point will be reached where each additional input produces less output than the previous input. Law of Diminishing Returns: After a certain point, when
additional units of a variable input are added to a fixed input, the marginal product of each additional variable input is less than the previous input. Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approaches capacity production.
Production Analysis with One Variable Input
Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.
Total vs. Marginal Product
Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus.
The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula:
Law of diminishing returns states that "as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease"
Law of Diminishing Marginal Returns
As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish. Counter-intuitive proof: if the law of diminishing returns does not hold, the world’s supply of food can be produced in a hectare of land. Average Product (AP)
Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used. The "productivity" of an input is usually expressed in terms of its average product. The greater the value of average product, the higher the efficiency in physical terms. Formula:
Relationship between Average and Marginal Curves: Rule of Thumb
When the marginal is less than the average, the average decreases. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum) When the marginal is greater than the average, the average increases Long Run and Short Run Adjustments
In the long run, firms change production levels in response to (expected) economic profits or losses, and the land, labor, capital goods and entrepreneurship vary to reach associated long-run average cost. In the simplified case of plant capacity as the...