Economic Theory of Production and Production Cost

Economics Revision Article Series





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.


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 Total, Average and Marginal Products


Total product or output is the total output produced in physical units by using a set of 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.
Decreasing returns to scale means if inputs are doubled output is not doubling.
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 can 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.


UC Berkeley Lecture

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Analysis of Production Costs


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
U-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 Samuelson 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 per 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
Fixed and variable cost are categorized based on a period. Firms have to commit costs for production capacity at the start of a period and they have to incur these costs irrespective of the production output. Such committed capacity costs are termed fixed cost for a period.

Variable Cost
Variable cost is incurred when production is there and it varies with the level of output.

Marginal Cost
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 producing 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.

Minimum Average Cost
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.



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.

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.


References 

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition,  McGraw-Hill, 1989, Chapters 21 and 22

Online Books to be added
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Related Knols

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Related Web pages

Theory of Production and Cost - Class Presentation - Stamford

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