Principles of Economics Chapter 5 PDF

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 1  CHAPTER 5 THEORY OF PRODUCTION PRINCI...

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 1  CHAPTER 5 THEORY OF PRODUCTION PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 2  DEFINITION OF PRODUCTION  Definition – Production means the process of using the factor of production to produce goods and services. – Production is the process of transforming inputs into outputs. INPUTS OUTPUTS Inputs refers to the factors of Refers to what we production get at the end of the Processing that a firm use in production process the that is finished production process. products. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 3  LAND LABOUR All natural resources Physical or mental or gift of nature activities of human beings CLASSIFICATION OF FACTORS OF PRODUCTION CAPITAL ENTREPRENEUR Part of man-made wealth A person who combines the different used for further production factors of production, and initiates the process of production and also bears the risk PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 4  PRODUCTION FUNCTION  A production function is a statement of the functional relationship between inputs and outputs, where it shows the maximum output that can be produced with given inputs. Q = (K, L, M, etc.)  Where: Q = Output K = Capital L = Labour M = Raw Material PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 5  SHORT-RUN AND LONG-RUN PRODUCTION FUNCTION  Two Types of Factor Inputs – Fixed Input An input which the quantity does not change according to the amount of output. Example: Machinery, land, buildings, tools, equipment, etc. – Variable Input An input which the quantity changes according to the amount of output. Example: Raw materials, electricity, fuel, transportation, communication, etc.  Short-run and Long-run Periods – Short run period is the time frame, which at least one of the inputs (factor of production) is fixed and other inputs can be varied. – Long run period is the time frame which all inputs are variable. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 6  SHORT-RUN PRODUCTION FUNCTION  In the short run, we assume that at least one of the inputs is fixed that is capital.  Therefore, in the short run the production function can be written as: Q = ( K , L) Where: Q = Output L = Labour K = Capital (fixed) PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 7  SHORT-RUN PRODUCTION FUNCTION (cont.)  LAW OF DIMINISHING MARGINAL RETURNS – It states that if the quantities of certain factors are increased while the quantities of one or more factors are held constant, beyond a certain level of production, the rate of increase in output will decrease. OR – “Law of diminishing marginal returns states that as more of a variable input is used while other input and technology are fixed, the marginal product of the variable input will eventually decline”. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 8  SHORT-RUN PRODUCTION FUNCTION (cont.) TOTAL PRODUCT (TP) The amount of output produced when a given amount of That input is used along with fixed inputs. AVERAGE PRODUCT (AP) Divide the total product by the amount of that input used in the production Average Product (AP L) = Total Product Total Labour AP L = TP/ L PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 9  SHORT-RUN PRODUCTION FUNCTION (cont.) MARGINAL PRODUCT (MP) Change in the total product of that input corresponding to an addition unit change in its labour assuming other factors that is capital fixed. Marginal Product (MP L) = Change in Total Product Change in Total Labour MP L =  TP/ L  PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 10  SHORT-RUN PRODUCTION FUNCTION (cont.) MP = 54 - 56 AP = 56 9-8 8 = -2 = 7 PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 11  SHORT-RUN PRODUCTION FUNCTION (cont.) Stage I Stage II Proportion of fixed factors are Called law of diminishing returns   greater than variable factors The most efficient stage of production  Under utilization of fixed factor because the combinations of inputs are fully  Operation involves a waste of resources utilized  STAGES OF PRODUCTION Stage III Proportion of fixed factors is lower than variable factors  Increase in variable factors decline the TP because of overcrowding  A producer would not like to operate at this stage  PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 12  SHORT-RUN PRODUCTION FUNCTION (cont.) RELATIONSHIP BETWEEN TP AND MP RELATIONSHIP BETWEEN AP AND MP When MP is increasing, TP increase at an increasing rate. When MP is above AP , AP is increasing When MP is decreasing, TP increase at a decreasing rate. When MP is below AP, AP is decreasing. When MP is zero, TP at its maximum. When MP equals to AP, AP is at maximum. When MP is negative, TP declines. 60 TP MAX STAGE I STAGE II STAGE III 50 40 30 TP MP 20 AP MAX; AP =MP AP 10 MP=0 0 1 2 3 4 5 6 7 8 9 10 -10 PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 13  3 PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 14  COST CONCEPTS 1. Implicit cost Implicit cost is not an accounting cost and is only viewed as an economic cost. It is the opportunity cost of using resources owned by the firm and is not shown or reported. The examples: Business firm owning a warehouse and using the same warehouse for its operations. Hence, the implicit cost for this firm is the rental income if the warehouse is rented out to other firms. 2. Explicit cost Explicit cost is the real payment for any transactions which are purchased for production purposes and will be documented accordingly. Examples: Payments for wages, fuel, electricity and expenditure in purchasing raw materials. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 15  COST OF PRODUCTION SHORT RUN A production period in which at least on of the input is fixed*. LONG RUN A production period in which all the inputs are variable**. * A fixed input is an input which the quantity does not change according to the amount of output. E.g. machinery ** A variable input is an input which the quantity varies according to the amount of output. E.g. labour PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 16  SHORT-RUN PRODUCTION COST TOTAL COST (TC) The sum of cost of all inputs used to produce goods and services.  Total cost (TC ) also defined as total fixed cost (TFC) plus  total variable cost (TVC). TC = TFC + TVC TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)  The cost of inputs that are  The cost of inputs that changes independent of output. with output.  Examples: Factory, machinery  Example: Raw materials, labours, and etc. etc. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 17  SHORT-RUN PRODUCTION COST (cont.) AVERAGE TOTAL COST (ATC)  The total cost per unit of output.  The formula for average total cost (ATC) is the total cost (TC) divided by the output (Q). ATC = TC Q TC = TVC + TFC PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 18  SHORT-RUN PRODUCTION COST (cont.) AVERAGE FIXED COST (AFC) Total fixed cost (TFC) divided by total output: AFC = TFC Q AVERAGE VARIABLE COST (AVC) Total variable cost (TVC) divided by total output: AVC = TVC Q MARGINAL COST (MC) The change in total cost that results from a change in output; the extra cost incurred to produce another unit of output: MC = TC Q PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 19  SHORT-RUN COST CURVES TOTAL COST (TC) COST TC The sum of cost of all inputs used to produce goods and services. Also defined as TFC plus TVC TVC TC = TVC + TFC TOTAL VARIABLE COST (TVC) The cost of inputs that changes with output. TFC TOTAL FIXED COST (TFC) The cost of inputs that is independent of output. QUANTITY PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 20  SHORT-RUN COST CURVES (cont.) when ATC is falling, MC is falling and then rising, but is below ATC when ATC is rising, MC is above ATC when MC cuts ATC from below, it IS at ATC minimum point: MC= ATC, ATC is at its miniinum when MC cuts AVC from below, it IS at AVC MARGINAL COST (MC) COST minimum point: Change in total cost that results from a change in output MC= AVC, AVC is at its minimum MC = TC   MC ATC Q AVERAGE TOTAL COST (ATC) Total cost per output AVC ATC = TC ATC = AFC + AVC Q AVERAGE VARIABLE COST (AVC) Total variable cost (TVC) divided by total output AVC = TVC Q AVERAGE FIXED COST (AFC) Total fixed cost (TFC) divided by total output AFC = TFC AFC Q QUANTITY PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 21  Total costs Average costs (1) (2) (3) (4) (5) (6) (7) (8) Quantity Total Total Total Average Average Average Marginal (Q) fixed variable cost fixed cost variable total cost cost (MC) cost cost (TC) (AFC) cost (AVC) (ATC) (TFC) (TVC) TC=TFC AFC = AVC = ATC = MC = +TVC TFC/Q TVC/Q TC/Q TC/Q (2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1) (5)+(6) 0 20 0 20 - - - - 1 20 15 35 20 15 35 15 2 20 25 45 10 12.50 22.50 10 3 20 30 50 6.67 10 16.67 5 4 20 35 55 5 8.75 13.75 5 5 20 45 65 4 9 13 10 PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 22  SHORT-RUN COST CURVES (cont.) COST STAGE III STAGE STAGE II I SATC STAGE I AFC begins to fall with an increase in output and AVC decreases. As long as the falling effect of AFC is higher than the rising effect of AVC, the ATC tends to decrease. SAVC STAGE II AFC continuous to decline and SATC will become minimum. ATC remains constant at this stage since the falling effect of AFC and rising effect of AVC is balanced.. STAGE III The falling effect of AFC is lower than rising effect of AVC, therefore ATC begins to increase. SAFC QUANITTY ATC curve is “U-Shaped” because of the combined influences of AFC and AVC. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 23  RELATIONSHIP BETWEEN MC AND ATC Cost MC ATC Quantity ATC falling, MC curve lies below ATC curve. ATC is at minimum point, ATC curve and MC curve are equal. ATC starts to increase, MC curve lies above ATC curve. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 24  RELATIONSHIP BETWEEN PRODUCTIVITY AND COST Production When its AP is equal to MP, MP AP curve is at maximum. AP When its AVC is equal to MC, AVC curve is at minimum. Labour Cost MC AVC Quantity PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 25  COST CURVES IN THE LONG RUN  Long run is a period where there are only variable factors and no fixed cost involved.  Long run total cost (LRTC) starts from origin because of the absence of total fixed cost. LONG RUN AVERAGE COST CURVE (LRAC)  Shows the minimum cost of producing any given output when all of the inputs are variable.  Long run is a period where firms plan how to minimize average cost. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 26  LONG-RUN PRODUCTION COST LRAC curve are derived by a series of short run average cost curves COST SRAC1 SRAC5 SRAC2 SRAC4 LRAC SRAC3 Tangential point of the SAC are joined and made up the LRAC. QUANTITY PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 27  LONG-RUN PRODUCTION COST (cont.)  Long run average cost curve (LRAC) is “U–Shaped” due to the Law of Returns to Scale.  Law of Returns to Scale states that as the firm expand its size or scale of production, its long run average cost (LRAC) will decrease and increase at later stage. Cost LRAC Increasing Constant Decreasing Return to Return to Return to Scale Scale Scale Quantity PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 28  LONG-RUN PRODUCTION COST (cont.) ECONOMIES OF SCALE  Advantages and benefits of a firm as it becomes larger and larger.  Reduce long run average cost (LRAC).  Marketing economies (bulk buying &selling), financial economies (large firm with high capital), labour economies (efficiency), technical economies (quality technology), managerial economics (different departments). DISECONOMIES OF SCALE  Problems faced by a firm as it becomes larger and larger.  Increase long run average cost (LRAC).  Mismanagement, competition, labour diseconomies. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 29  ECONOMIES OF SCALE Economies of scale are benefits and advantages of a firm as it expands its production. Reduce the average cost. INTERNAL EXTERNAL Internal economies happen inside an organization Advantages of the industry as a whole PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 30  ECONOMIES OF SCALE (cont.) Diseconomies of scale are problems and disadvantages faced by a firm when it expands production. Increase the average cost. INTERNAL EXTERNAL Raise the cost of production of a firm as The disadvantages faced by the industry the firm expands as a whole PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 31  ECONOMIES AND DISECONOMIES OF SCOPE  Economies of scale refer to the cost advantages of large-scale production. Output increases, long-run average cost will decrease, and return increase.  The diseconomies of scale appear in when an increase in the output causes a firm’s long-run average cost to rise. PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 32  CONCEPT OF REVENUE TOTAL REVENUE (TR) The total amount received from the sale of a firm’s goods and services Total Revenue (TR) = Price (P) x Quantity (Q) AVERAGE REVENUE (AR) Average revenue is the total revenue per unit output sold. Average revenue (AR) is also equal to the price (P) of the good.  Average Revenue (AR) = Total Revenue (TR) Quantity (Q) AR = PxQ = PRICE Q PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 33  CONCEPT OF REVENUE (cont.) MARGINAL REVENUE (MR) The change in total revenue resulting from one unit increase in quantity sold. Marginal Revenue (MR) = Change in Total Revenue Change in Quantity MR = TR/ Q   PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 34  THANK YOU PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 35