Production Cost

Production and Costs: The Theory of the Firm
The Circular Flow Model
Recall that in our initial discussion of the economy we identified two broad groups of economic actors (or units); they were households and firms. In our study of demand we looked at households as consumer units effecting demand for goods and services in the product market. On the supply side of the product market are the economic (or business) firms. They are the producers (and sellers) of goods and services. In this section we are going to look the behavior of an economic firm.

Production and Production Costs
Questions to be asked:
How do firms decide what to produce and how much to produce?
What factors constitute a firm�s costs?
How do firms determine what price(s) to charge
What determines a firm�s profit?
What determines the shape and the position of a (firm�s) supply curve?
Business Firm
A business firm is an economic unit engaged in the production of one of more economic goods or services.
Applying the technology available to it, a business firm combines economic resources (factors of production) to produce one or more goods for the purpose of making profits.
A business firm buys economic resources (inputs) and sells the goods it produces (outputs).
Production and Costs
To produce a good or a service a firm needs economic resources or factors of production. In economics,  the factors of production used by a firm in the production of a good or a service are generally referred to as inputs. What a firm produces is called output. A firm has to pay for the inputs it needs. Therefore, inputs, on the one hand, generate costs and, on the other hand, generate output.
We first study the relationship between inputs and the output; that is "production function". Then we look at the relationship between the output and costs; that is cost function.

Note: Studying the relationship between costs and inputs without regard to the output produced from the inputs is not useful. That is why we study the relationship between costs and output.
Inputs: Factors of Production
Factors of production:
The primary factors of production are land and labor.
Capital is another important factor of production.
In economics we distinguish between physical capital and financial capital.
Physical capital: tools,  machinery, equipment, buildings
Note: Non-physical assets such as copy rights and patent rights are functionally similar to physical capital.
Financial capital: Financial assets representing physical capital (stocks) or used to acquire physical capital are financial capital.
In addition to land, labor and capital businesses often use intermediate goods (raw materials and supplies) in the production process.
Entrepreneurial Services: In market economies the function of entrepreneurs is also very important. The function of an entrepreneur is to acquire and combine all the needed factors of production to produce a good. An entrepreneur takes chances (risks) in the hope of making profits.
Cost of production is simply the sum of the costs of all inputs used in production.
Production Costs = Costs of Inputs
Production in the Short Run versus Production in the Long Run
In the theory of the firm the distinction between short run and long run is not necessarily based on the length of time. It is rather based on the degree of the variability of inputs.
In the short run at least one of the factors of production remains unchanged (fixed).
In the long run all factors of production are variable.
In a two-input production process, in the short run, only one input is variable.
In a two-input production model, in the short run, the changes in the output (physical product) are the result of changes in the variable input.
Production in the Long Run
In the long run all inputs used in the production process by the firm are variable.
In a two-input production model, in the long run, both inputs (say, capital and labor) are variable.
In the long run the level of the output of a firm can change as a result of changes in any or all inputs.
A Short-Run Production (Function) Analysis
Our model:
A firm using two inputs:
Capital (K); Fixed Input
Labor (L);    Variable input
We examine the relationship between the variable
input (labor) and the output.
We examine how changes in labor (the variable input)
affect the out put.

Output Measures
Total (Physical) Product (output), TPP: The total amount of output produced by the firm over a certain period
Average (Physical) Product (of the variable input), APP: Total (Physical) Product divided by the number units of the variable input
Marginal (Physical) Product (of the variable input), MPP: The change in total product resulting from employing one additional unit of the variable input
 




Average (Physical) Product and Marginal Physical Product


                                                             Change in  TPP
Marginal Physical Product =  MPP =   ---------------------
                                                             Change in V. Input
                                                           Total Physical Product
Average Physical Product = APP =    -------------------------
                                                                Total V. Input

The �Law� of Diminishing Return
Increases in the amount of any one input, holding the amounts all other inputs constant, would eventually result in decreasing marginal product of the variable input.
Explanation: Unless all inputs are perfectly and infinitely substitutable, as we increase the amount of one input, while keeping other inputs constant, at some point the productive effectiveness of that input starts to decline.

Output and the Firm�s Revenue
Total Revenue (TR) = Price x Total P. Product
Marginal Revenue Product: The change (increase) in revenue resulting from the output produced by one additional unit (MPP) of the variable input
                   MRP = MPP x Price

 
 
 



Optimal Input Level:
Input Price = MRP
Wage = $5
Optimal Input= 7
Optimal Output =60
Optimal Input/Output

 


 

Plotting the Cost Measures





                     K= 10                                            K= 20                                               K= 30


Return to Scale


Optimal Input Combinations
Recall that in our short-run analysis to decide how many units of labor to employ we equalized the revenue resulted from hiring one additional unit of labor (MRP) and the price of labor (wage).
   This rule can be generalized and applied to all inputs.
        MPP_L  *  PRICE  =  MRP_L  =   Wage
      MPP_K * PRICE =   MRP_K  =   Price of Capital

Marginal Product and the Input Price
Each time a firm wants to increase its  output it would have to buy (hire) additional inputs.
Additional input generates costs, on the one hand, and generates output, on the other hand.
If the inputs are added one unit at a time,
            Change in cost = the price of input
                Change in output = MPP
The cost of each additional unit of out put will be:
 Change in cost           or                Input Price
Change in output                               MPP
MPP, Input Price and Marginal Cost
Recall our definition for marginal cost:
                      Change in Cost
     MC    =  -------------------
                    Change in Output
When we increase our input one input/one unit at a time:
                                         Change in cost  =  Input price
                                        Change in Output = MPP
Choosing the Optimal Mix of Inputs
One approach to choosing the optimal (least costly) mix of inputs is to compare the (marginal) cost of producing one extra unit of out put across different inputs.
The firm would likely use the input that increases its output at the lowest cost by comparing
Input Price
    --------------       across all available inputs.
       MPP

Introduction to Economics

Introduction:

Economics is a field of study that has become increasingly relevant in our globalized, financialized society. The economy is part of our collective conscious and a buzzword that links personal finances to big business and international trade deals. Economics deals with individual choice, but also with money and borrowing, production and consumption, trade and markets, employment and occupations, asset pricing, taxes and much more. What then is the definition of economics? One way to think of it is the study of what constitutes rational human behavior in the endeavor to fulfill needs and wants given a world with scarce resources. In other words, economics tries to explain how and why we get the stuff we want or need to live. How much of it do we get? Who gets to have more? Who makes all this stuff? How is it made? These are the questions and decisions that economics concerns itself with.

As an individual, for example, you constantly face the problem of having limited resources with which to fulfill your wants and needs. As a result, you must make certain choices with your money – what to spend it on, what not to spend it on, and how much to save for the future. You'll probably spend part of your paycheck on relative necessities such as rent, electricity, clothing and food. Then you might use the rest to go to the movies, dine out or buy a smartphone. Economists are interested in the choices you make, and investigate why, for instance, you might choose to spend your money on a new Xbox instead of replacing your old pair of shoes. They would want to know whether you would still buy a carton of cigarettes if prices increased by $2 per pack. The underlying essence of economics is trying to understand how individuals, companies, and nations as a whole behave in response to certain material constraints.

Adam Smith (1723 - 1790), is often considered the "father of modern economics." His book "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776) was the first fully elaborated attempt to understand why some nations prospered while others suffered widespread poverty. He famously argued that individuals working for their own self-interest could nonetheless create a stable and well-provisioned society through a mechanism he called  the invisible hand of the market. (See also: 'Adam Smith and 'The Wealth Of Nations.')

Smith, however, was not the first to write on economic matters. Other scholars of what was then known as political economy wrote prior to "The Wealth of Nations," but Adam Smith was one of the first to identify the unique economic changes that accompanied the birth of industrialization and capitalist production. Smith’s work was followed by David Ricardo’s "Principles of Political Economy and Taxation" (1817) and later by Karl Marxin "Capital" (1867). Each of these authors sought to explain how capitalism worked and what it meant for producers and workers in the capitalist system. (See also: What is the difference between Communism and Socialism?)

In the late 19^th century, the discipline of economics became its own distinct field of study. Alfred Marshall, author of "The Principles Of Economics" (1890) defined economics as a social science that examines people's behavior according to their individual self-interests. He wrote, "Thus it is on one side the study of wealth; and on the other, and more important side, a part of the study of man." In the early 20^th century, however, there was a push toward legitimizing economics as a rigorous science alongside the physical sciences like chemistry and physics. As a result, mathematical models and statistical methods were brought to the forefront along with a number of strong assumptions that are needed to make those models work. For example, modern mainstream economics makes the assumption that human beings will always aim to fulfill their individual self-interests. It also assumes that individuals are rational actors in their efforts to fulfill their unlimited wants and needs. It also makes the claims that firms exist to maximize profit and that markets are efficient. This school of economics, which has come to dominate both the academic field of economics as well as the practical application of economic theory in policy and business, is known as neoclassical economics.

Kinds of Economic Systems:

Traditional Economic System

The traditional economic system is the most traditional and ancient types of economies in the world. Vast portions of the world still function under a traditional economic system. These areas tend to be rural, second- or third-world, and closely tied to the land, usually through farming. In general, in this type of economic system, a surplus would be rare. Each member of a traditional economy has a more specific and pronounced role, and these societies tend to be very close-knit and socially satisfied. However, they do lack access to technology and advanced medicine.

Command Economic System

In a command economic system, a large part of the economic system is controlled by a centralized power. For example, in the USSR most decisions were made by the central government. This type of economy was the core of the communist philosophy.

Since the government is such a central feature of the economy, it is often involved in everything from planning to redistributing resources. A command economy is capable of creating a healthy supply of its resources, and it rewards its people with affordable prices. This capability also means that the government usually owns all the significant industries like utilities, aviation, and railroad.

In a command economy, it is theoretically possible for the government to create enough jobs and provide goods and services at an affordable rate. However, in reality, most command economies tend to focus on the most valuable resources like oil.

Advantages of Command Economic Systems

• If executed correctly, the government can mobilize resources on a massive scale. This mobility can provide jobs for almost all of the citizens.
• The government can focus on the good of the society rather an individual. This focus could lead to a more efficient use of resources.

Disadvantages of Command Economic Systems

• It is hard for the central planners to provide for everyone’s needs. This forces the government to ration because it cannot calculate demand since it sets prices.
• There is a lack of innovation since there is no need to take any risk. Workers are also forced to pursue jobs the government deems fit.

 Market Economic System

In a free market economy, firms and households act in self-interest to determine how resources get allocated, what goods get produced and who buys the goods. This is opposite to how a command economy works, where the central government gets to keep the profits.

There is no government intervention in a pure market economy (“laissez-faire“). However, no truly free market economy exists in the world. For example, while America is a capitalist nation, our government still regulates (or attempts to control) fair trade, government programs, honest business, monopolies, etc.

In this type of economy, there is a separation of the government and the market. This separation prevents the government from becoming too powerful and keeps their interests aligned with that of the markets.

Hong Kong has been seen as an example of a free market society.

Advantages of a Free Market Economy

• Consumers pay the highest price they want to, and businesses only produce profitable goods and services. There is a lot of incentive for entrepreneurship.
• This leads to the most efficient use of the factors of production since businesses are very competitive.
• Businesses invest heavily in research and development. There is an incentive for constant innovation as companies compete to provide better products for consumers.

Disadvantages of a Free Market Economy

• Due to the fiercely competitive nature of a free market, businesses will not care for the disadvantaged like the elderly or disabled. This leads to higher income inequality.
• Since the market is driven solely by self-interest, economic needs have a priority over social and human needs like providing healthcare for the poor. Consumers can also be exploited by monopolies.

Mixed Economic System

A mixed economy is a combination of different types of economic systems. This economic system is a cross between a market economy and command economy. In the most common types of mixed economies, the market is more or less free of government ownership except for a few key areas like transportation or sensitive industries like defense and railroad.

However, the government is also usually involved in the regulation of private businesses. The idea behind a mixed economy was to use the best of both worlds – incorporate policies that are socialist and capitalist.

To a certain extent, most countries are mixed economic system. For example, India and France are mixed economies.

Advantages of Mixed Economies

• There is less government intervention than a command economy. This means that private businesses can run more efficiently and cut costs down than a government entity might.
• The government can intervene to correct market failures. For example, most governments will come in and break up large companies if they abuse monopoly power. Another example could be the taxation of harmful products like cigarettes to reduce a negative externality of consumption.
• Governments can create safety net programs like healthcare or social security.
• In a mixed economy, governments can use taxation policies to redistribute income and reduce inequality.

Disadvantages of Mixed Economies

• There are criticisms from both sides arguing that sometimes there is too much government intervention and sometimes there isn’t enough.
• A common problem is that the state run industries are often subsidized by the government and run into large debts because they are uncompetitive.

Production Possibility Frontier

A production–possibility frontier (PPF) or production possibility curve (PPC) is the possible tradeoff of producing combinations of goods with constant technology and resources per unit time. One good can only be produced by diverting resources from other goods, and so by producing less of them. This tradeoff is usually considered for an economy, but also applies to each individual, household, and economic organization.

Graphically bounding the production set for fixed input quantities, the PPF curve shows the maximum possible production level of one commodity for any given production level of the other, given the existing state of technology. By doing so, it defines productive efficiencyin the context of that production set: a point on the frontier indicates efficient use of the available inputs (such as points B, D and C in the graph), a point beneath the curve (such as A) indicates inefficiency, and a point beyond the curve (such as X) indicates impossibility.

The PSU represented by the point on the PPF where an efficient economy operates (which is obtained by tangency with the highest individual or social indifference curve, not shown in the graph) presents the priorities or choices of the modeled agent, such as the choice of having more butter produced and fewer guns, or vice versa.

An example PPF with illustrative points marked

PPFs are normally drawn as bulging upwards or outwards from the origin ("concave" when viewed from the origin), but they can be represented as bulging downward (inwards) or linear (straight), depending on a number of assumptions. A PPF illustrates several economic concepts, such as scarcity of resources (the fundamental economic problem that all societies face), opportunity cost (or marginal rate of transformation), productive efficiency, allocative efficiency, and economies of scale.

An outward shift of the PPF results from growth of the availability of inputs, such as physical capital or labour, or from technological progress in knowledge of how to transform inputs into outputs. Such a shift reflects, for instance, economic growth of an economy already operating at its full productivity (on the PPF), which means that more of both outputs can now be produced during the specified period of time without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.

However, most economic contractions reflect not that less can be produced but that the economy has started operating below the frontier, as typically, both labor and physical capital are underemployed, remaining therefore idle.