Some Notes on Production Theory

Short-Run – A period of time in which there is at least one resource that is fixed and can not be changed in the current production process.

Long Run – A period of time sufficiently long so that producers are able to change the quantities of all the resources they employ.  It is the “planning horizon” for the firm.

Variable Inputs – Inputs that vary in quantity employed with the level of output.  Labor and raw materials are frequently raw materials.

Fixed Inputs – Inputs that do not vary with the level of output in the short-run.  Salaries, insurance, and rent are some examples.

Production Function or Total Product Function – shows the relationship between a firm’s inputs or resources and the amount of output produced.

Law of Diminishing Returns – As more and more of a variable resource is added to a production process that has at least one fixed input, eventually the additional output the firm gets from that variable input is going to fall.

                                        Change In Total Product

Marginal Product  =     --------------------------------

                                        Change in the Variable Input

                                    Total Product

Average Product =    -------------------

                                 Variable Input

Worksheet assignment #2

An Introduction to Costs and Review of the Marginal Product

Date Due:  Right Now

Remember N. P. Maplewood and her birdhouse factory in the shed out back.  She has just come to the realization that her friends will not work for free and her parents have informed her that she must pay rent to use the shed, tools, and the lumber.  Producing goods involves costs.  We will explore her marginal product in relation to her marginal costs in this worksheet.

N. P. must pay her friends $20 per day to build birdhouses and she must pay her parents $100 for rent to be allowed to use the shed, the tools, and wood pile in the back yard.  Fill in the blanks below.

Answer the following questions:

1.     The law of marginal productivity (law of diminishing returns) begins with worker ___

2.     Define Marginal Costs in everyday language.

3.     Marginal costs first __________ and then __________.  This pattern occurs because marginal productivity (returns) first _________ and then __________.

Worksheet assignment #3

The Fixed Cost, Variable Cost, and Total Cost Curves.

Date Due:  Right Now

N. P. Maplewood is still trying to understand the costs in her birdhouse factory in the shed out back.  We will explore the shapes of her cost curves in this worksheet.

Remember that N. P. must pay her friends $20 per day to build birdhouses and she must pay her parents $100 for rent to be allowed to use the shed, the tools, and wood pile in the back yard.  Fill in the banks below.

Use this information to complete the graphs and questions on the follow pages.

Graph the Fixed Cost, Variable Cost, and Total Cost on the graph below.

              5        10     15     20      25     30       35     40      45    50      55      60     65     70

1.     The fixed cost curve (increases, decreases, does not change) ________________.

2.     The total cost curves starts by increasing at an (increasing, decreasing) _________ rate and continues increase but at an (increasing, decreasing) ____________ rate.

3.     What causes the pattern described in problem 2?

Worksheet assignment 4

The Average Cost Curves and the Marginal Cost Curves

Date Due:  Right Now

N. P. Maplewood has just learned about average costs and marginal costs and is trying to relate them to her birdhouse factory in the shed out back.  We will explore her average costs in relation to her marginal costs in this worksheet.

Remember that N. P. must pay her friends $20 per day to build birdhouses and she must pay her parents $100 in rent to be allowed to use the shed, the tools, and wood pile in the back yard.  Fill in the banks below.

Use this information to complete the graphs and questions on the follow page.

Marginal Cost on the graph below.  Notice the scale on the Y-axis.  Some of the values are too great to be included on the graph, but you can estimate the shape of the curves after you have obtained some points on the graph

              5        10     15     20      25     30       35     40      45    50      55      60     65     70

1.     Describe the shape of the average fixed cost.

2.     Describe the shape of the average variable cost and the average total cost.

3.     Approximately where do the marginal cost and average total cost curves cross.

4.     What is the relationship between the marginal cost curve and the total cost curve.

When the marginal cost curve is (above, below) ___________ the average total cost, average total cost is (increasing, decreasing) ___________  and when the marginal cost curve is (above, below) _________ the average total cost, average total cost is (increasing, decreasing) ___________.

Worksheet assignment #

Profit Maximization Part II

Date Due:  Right Now

The assignment will be graded out of a possible of XX points.

Maplewood, shed, the birds.  N.P  was overwhelmed with the graphs so she asked her economics teacher if there was another way to find the profit maximizing point.  She was given a handout  on marginal cost and marginal revenue.  We will explore another method for profit maximization in this worksheet.

Just like before, her friends are $20 per day and she must pay her parents $100 for rent to be allowed to use the shed, the tools, and wood pile in the back yard.  The improved situation with the power tools is below.  The current price for birdhouses is $10.  Fill in the blanks below.

1.     Provide a mathematical definition for marginal cost.

2.     Define marginal costs in “everyday” language.

3.     Provide a mathematical definition for marginal revenue.

4.  Define marginal revenue in “everyday”  language.

5.  At what level of output is profit maximized?

THE COSTS OF PRODUCTION

I.    What Are Costs?

A.   Total Revenue, Total Cost, and Profit

1.   The goal of a firm is to.......

             2.   Definition of total revenue:.........

3.   Definition of total cost:.................

4.   Definition of profit:................. 

B.   Costs as Opportunity Costs

1.   Principle #2: The cost of something is what you give up to get it.

 2.   Total opportunity costs include both implicit and explicit costs.

 a.   Definition of explicit costs:.............

 b.   Definition of implicit costs:..............

   Accountants focus on explicit costs, while economists examine both explicit and implicit costs.

D.   Economic Profit versus Accounting Profit

   Definition of economic profit:

   Definition of accounting profit:

   If implicit costs are greater than zero, accounting profit will always exceed economic profit.

II.  Production and Costs

A.   The Production Function

1.   Definition of production function: .........

.   Definition of marginal product:

   Definition of diminishing marginal product..........
 

   We can draw a graph of the firm's production function by plotting the level of labor (x-axis) against the level of output (y-axis).

  Diminishing marginal product can be seen from the fact that the slope falls as the amount of labor used increases.

B.   From the Production Function to the Total-Cost Curve

1.   We can draw a graph of the firm's total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis).

a.   The total cost curve eventually gets steeper and steeper as output rises.

b.   This increase in the slope of the total cost curve is also due to diminishing marginal product:

III. The Various Measures of Cost

1.   Definition of fixed costs: ...............

2.   Definition of variable costs:............

C.   Average and Marginal Cost

1.   Definition of average total cost: ...................

2.   Definition of average fixed cost: ..................

3.   Definition of average variable cost:.............

4.   Definition of marginal cost: the increase in total cost that arises from an extra unit of production.

5.   Average total cost tells us the cost of a typical unit of output and marginal cost tells us the cost of an additional unit of output.

D.   Cost Curves and Their Shapes

1.   Rising Marginal Cost

a.   This occurs because of diminishing marginal product.

b.   At a low level of output, there are few workers and a lot of idle equipment. But as output increases, the coffee shop gets crowded and the cost of producing another unit of output becomes high.

2.   U-Shaped Average Total Cost

a.   Average total cost is the sum of average fixed cost and average variable cost.                                        

b.   AFC declines as output expands and AVC typically increases as output expands. AFC is high when output levels are low. As output expands, AFC declines pulling ATC down. As fixed costs get spread over a large number of units, the effect of AFC on ATC falls and ATC begins to rise because of diminishing marginal product.

3.   The Relationship between Marginal Cost and Average Total Cost

a.   Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.

b.   The marginal-cost curve crosses the average-total-cost curve at minimum average total cost (the efficient scale).

4.   Typical Cost Curves

a.   Marginal cost eventually rises with output.

b.   The average-total-cost curve is U-shaped.

c.    Marginal cost crosses average total cost at the minimum of average total cost.

I.    What Is a Competitive Market?

1.   Definition of perfectly competitive market:

B.   The Revenue of a Competitive Firm is equal to ......

2.   Definition of average revenue:....... 

3.   Definition of marginal revenue:.... 

II.  Profit Maximization and the Competitive Firm's Supply Curve

1.   In this example, profit is maximized if the farm produces four or five gallons of milk (see the fourth column).

2.   The profit-maximizing quantity can also be found by comparing marginal revenue and marginal cost.

a.   As long as marginal revenue exceeds marginal cost, increasing output will raise profit.

b.   If marginal revenue is less than marginal cost, the firm can increase profit by decreasing output.

c.    Profit-maximization occurs where marginal revenue is equal to marginal cost.

1.   Cost curves have special features that are important for our analysis.

a.   The marginal-cost curve is upward sloping.

b.   The average-total-cost curve is U-shaped.

c.    The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

2.   Marginal and average revenue can be shown by a horizontal line at the market price.

3.   To find the profit-maximizing level of output, we can follow the same rules that we discussed above.

a.   If marginal revenue is greater than the marginal cost, the firm should increase its output.

b.   If marginal cost is greater than marginal revenue, the firm should decrease its output.

c.    At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.