Economic Theory of Production Economic theory of the firm begins with theory of production. What is a firm? The essence of a firm is to buy inputs, convert them to outputs, and sell these outputs to consumers, firms or government. Therefore a firm is poised between two markets. It is a demander in factor markets. It buys the inputs required for production in factor markets (markets that supply inputs for firms). It is a supplier in market for goods and services. It has to adjust its production to satisfy the demand curve of its customers at profit.
It is assumed that the firm or the owner of the firm always strives to produce efficiently, or at lowest cost. He will always attempt to produce the maximum level of output for a given dose of inputs avoiding waste whenever possible. Production function The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output. Put in other way, the function gives for each set of inputs, the maximum amount of output of a product that can be produced.
It is defined for a given state of technical knowledge (If technical knowledge changes, the amount of output will change. ) Importance of the Concept of Production Function In an economy there will be thousands and millions of production functions because each firm will have one for each of the products that it is making. From the production function, the cost curves of a firm for each of its products can be determined. Contribution of each factor of production I. E. , land, land, capital is also determined from production functions.
The price that a factor of production will command in the market will be determined by the production functions from the demand side. Total, Average and Marginal Products Total product or output is the total output produced in physical units by using a set f inputs. It is given by the product function directly. Marginal product of an input is the extra product or output produced when 1 extra unit of that input is added while other inputs are held constant at any given set of inputs. Average output is total output divided by total units of input.
It can be calculated for each input separately also. Law of diminishing marginal returns It holds that the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant. Returns to scale Returns to scale reflect the responsiveness of total product when all the inputs are increased proportionately. The scale effect can be constant returns, decreasing returns, and increasing returns. Constant returns to scale means, if inputs are doubled output also will double.
Research Paper on Economics price theory By Bid-Around Increasing returns to scale means if inputs are doubled, output is getting more than double. Time Horizon of Analysis Three different time periods are used to develop theories of production and production costs Momentary run: The period of time is so short that no change in production can take place. Short run: The period of time in which labor and material an be changed, but all inputs cannot be changed simultaneously.
Especially, equipment and machinery cannot be fully modified or increased. Long run: All fixed and variable factors employed by the firm can be changed. Technology change Technology change is said to occur when more output can be produced from the same inputs. Example: Wide-body Jets increased the number of passenger-miles per unit of input by almost 40 percent. The meaning of productivity When economists and government ministers talk about productivity they are referring to how productive labor is. But productivity is also about other inputs.
So, for example, a company could increase productivity by investing in new machinery which embodies the latest technological progress, and which reduces the number of workers required to produce the same amount of output. The government’s objective is to improve labor and capital productivity in the British economy in order to improve the supply-side potential of the country. Productivity of the variable factor labor and the law of diminishing returns In the example of productivity given below, the labor input is assumed to be the only variable factor by a firm.
Other factor inputs such as capital are assumed to be fixed in supply. The “returns” to adding more labor to the production process are measured in two ways: Marginal product (MM) Change in total output from adding one extra unit of labor Average product (AP) = Total Output divided by the total units of labor employed In the example below, a business hires extra units of labor to produce a higher quantity of wheat. The table below tracks the output that results from each level of employment.
Units of Labor Employed Total Physical Product (tons of wheat) Marginal Product (tons of wheat) Average Product (tons of wheat) 2 10 5 24 14 8 4 12 9 6 42 7 Table: 1 Diminishing returns is said to occur when the marginal product of labor starts to fall. In the example above, extra labor is added to a fixed supply of land when a farming business is harvesting wheat. The marginal product of extra workers is maximized when the 4th worker is employed. Thereafter the output from new workers is falling although total output continues to rise until the seventh worker is employed.
Notice that once marginal product falls below average product we have reached the point where average product is maximized – I. E. E have reached the point of productive efficiency. Explaining the law of diminishing returns The law of diminishing returns occurs because factors of production such as labor and capital inputs are not perfect substitutes for each other. This means that resources used in producing one type of product are not necessarily as efficient (or productive) when switched to the production of another good or service.
For example, workers employed in producing glass for use in the construction industry may not be as efficient if they have to be re-employed in producing cement or kitchen units. Likewise many items of capital equipment are specific to one type of production. They would be much less efficient in generating output if they were to be switched to other uses. We say that factors of production such as labor and capital can be “occupationally immobile”; they can be switched from one use to another, but with a consequent loss of productivity.
There is normally an inverse relationship between the productivity of the factors of production and the unit costs of production for a business. When productivity is low, the unit costs of supplying a good or service will e higher. It follows that if a business can achieve higher levels of efficiency among Economic Theory of Production Cost The content above focused on theory of production quantity. Production cost is another important attribute of firm.
Costs are important in production and supply decision making by entrepreneurs. Every dollar of cost reduces the firm’s profit. The deeper reason to study costs by an economist is that supply of an item depends upon incremental or marginal cost when the price is constant. Otherwise it depends on marginal cost as well as marginal price or revenue. In all the market structures (perfect competition to monopoly) marginal cost is key concept for understanding a firm’s production quantity behavior.
Concepts Related to Cost #Total Cost, Fixed Cost, Variable Cost #Marginal Cost #Average or Unit Cost, Average Fixed Cost, Average Variable Cost, Minimum Average Cost #opportunity Cost #J-Shaped Cost Curves Total Cost Total cost is the cost incurred to produce a quantity of output. A total cost schedule shows the total cost for various output amounts. The total cost schedule is derived from the production function of the product for a firm. As per definition of production function and assumption of a businessman’s behavior (operating at maximum efficiency and lowest cost), it will be the lowest cost for that output.
But Samuelsson clearly highlighted that there is hard work of the businessman involved to attain this lowest level of costs. The firm’s managers have to make efforts and make sure that they are paying the least possible prices for necessary materials and supplies. The wages are to be fixed or bargained so that neither they are high to raise the firms production costs nor they are so low that sufficient labor is not there to produce as ere market requirement. Also various engineering techniques are to be utilized in equipment purchase decisions, factory layout and production processes.
Countless other decisions are to be made in most economical fashion. Fixed Cost These costs relate do not vary directly with the level of output. Examples of fixed costs include: Rent paid on buildings and business rates charged by local authorities. The depreciation in the value of capital equipment due to age. Insurance charges. The costs of staff salaries e. G. For people employed on permanent contracts. Interest charges on borrowed money. The costs of purchasing new capital equipment. Marketing and advertising costs.
Variable Cost Variable cost is incurred when production is there and it varies with the level of output. Variable costs vary directly with output. I. E. As production rises, a firm will achieve an expansion of supply. Examples of variable costs for a business include the costs of raw materials, labor costs and other consumables and components used directly in the production process. We can illustrate the concept of fixed cost curves using the table below. The greater the total volume of units produced, the lower will e the fixed cost per unit as the fixed costs are spread over a higher number of units.
This is one reason why mass-production can bring down significantly the unit costs for consumers – because the fixed costs are being reduced continuously as output expands. In our example below, a business is assumed to have fixed costs of EWE,OHO per month regardless of the level of output produced. The table shows total fixed costs and average fixed costs (calculated by dividing total fixed costs by output). Output (COOS) Total Fixed costs (CHOOSE) Average Fixed Cost (AFC) 15 7. 5 4. 3 Table: 2 When we add variable costs into the equation we can see the total costs of a business.
The table below gives an example of the short run costs off firm Output Units Total Fixed Cost ETC (SEES) TV (SEES) -RCA (SEES) Average Total Cost TACT (E per unit) Marginal Cost MAC(E) 20 140 7. 0 2. 0 160 4. 0 74 174 184 0. 5 190 120 104 204 1. 7 0. 7 138 238 188 288 1. 8 2. 5 180 260 360 3. 6 200 2. 3 5. 0 Table: 3 At each output level or at any output level, marginal cost of production is the additional cost incurred in producing one extra unit of output. Marginal cost can be calculated as the difference between the total costs or reducing two adjacent output levels.
The difference in variable cost of two adjacent output levels also gives marginal cost, as fixed cost is constant for the two levels. Marginal cost is a central economic concept with a crucial important role to play in resource allocation decisions by organizations. Average Costs or Units Costs Average cost or unit cost is the total cost divided by number of units produced. Average fixed cost is total fixed cost divided by number of units produced. It keeps on decreasing as output increases. Average variable cost is total variable cost divided by number of units produced.
In the average cost curve, it is normally seen that average cost initially comes down (as average fixed cost comes down) as output increases, reaches a lowest point and then starts rising. Hence on this curve there is a minimum average cost point or output level. Hence average cost curves have ‘U’ shape. Least-cost Rule: To produce a given level of output at least cost, a firm will hire factors until it has equalized the marginal product per dollar spent on each factor of production. This implies that Marginal product of labor/price of labor = Marginal Product of Capital Equipment/ Price of capital equipment =
Thus the firm will choose a factor combination or resource combination that minimizes the total cost of production. Average Total Cost (TACT) is the cost per unit of output produced. TACT = ETC divided by output Marginal cost (MAC) is defined as the change in total costs resulting from the production of one extra unit of output. In other words, it is the cost of expanding production by a very small amount. Long run costs of production The long run is a period of time in which all factor inputs can be changed. The firm can therefore alter the scale of production.
If as a result of such an expansion, the rim experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if average total cost rises as the firm expands, discomposes of scale are happening. The table below shows a simple example of the long run average cost of a business in the long run when average costs are falling, then economies of scale are being exploited by the business. Long Run Output (units per month) Total Costs (Sees) Long Run Average Cost (Sees per unit) 1 ,oho 8,500 8. 2,000 1 5,000 5,000 36,000 7. 2 10,oho 65,000 6. 5 20,000 120,000 6. 0 280,000 5. 6 1 o,oho 490,000 4. 9 500,000 4. 6 Table: 4 Choice of Inputs by the Firm Every firm or entrepreneur has to decide how much of each input it should employ: how much labor, capital, land, energy, various materials and services. The fundamental assumption that economists make in this context is that of cost minimization. Firms are assumed to choose their combination of inputs so as to minimize the total cost of production.
Market Analysis in Microeconomics A market is any place where the sellers of a particular good or service can meet with the buyers of that goods and service where there is a potential for a transaction to take place. The buyers must have something they can offer in exchange for there to be a potential transaction. Markets in the most literal and immediate sense are places in which things are bought and sold. In the modern industrial system, however, the market is not a place; it has expanded to include the whole geographical area in which sellers compete with each other for customers.
Alfred Marshall, whose Principles of Economics (first published in 1890) was for long an authority for English-speaking economists, based his definition of the market on that of the French economist Court: Economists understand by the term Market, not NY particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality easily and quickly.
To this Marshall added: The more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same thing at the same time in all parts (200 of 3,900 words) Economics Basics: Monopolies, Oligopolies and Perfect Competition Economists assume that there are a number of different buyers and sellers in the racetrack. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead.
In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price. In some industries, there are no substitutes and there is no competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control total utility and has have very little influence over the price of goods. Monopoly Market: A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry.
Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a trial resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market.
Pfizer, for instance, had a patent on Vicarage. Oligopoly Market: In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolies firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets.
Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. Perfect Competition Market: There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many reduces that are similar in nature and, as a result, many substitutes.
Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can Just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.
These four characteristics mean that a given perfectly competitive firm is unable to exert any control whatsoever over the market. The large number of small firms, all producing identical products, means that a large (very, very large) number of perfect substitutes exists for the output produced by any given firm. This makes the demand curve for a perfectly competitive firm’s output perfectly elastic. Freedom of entry into and exit out of the industry means that capital and other resources are perfectly mobile and that it is not possible to erect barriers to entry. Perfect knowledge means
