Principles Of Economics - FY-B.Com(Hons.) Programme PDF

PRINCIPLES OF ECONOMICS FY-B.Com(Hons.) Programme MIT-WPU Unit 3 – Producers’ behaviour and Cost analysis i. Theory of Production- Short run and Long run ii. Concepts of Costs- Short-run and long-run costs, Average and marginal costs, Total, fixed and variable costs THEORY...

PRINCIPLES OF ECONOMICS FY-B.Com(Hons.) Programme MIT-WPU Unit 3 – Producers’ behaviour and Cost analysis i. Theory of Production- Short run and Long run ii. Concepts of Costs- Short-run and long-run costs, Average and marginal costs, Total, fixed and variable costs THEORY OF PRODUCTION- SHORT RUN AND LONG RUN We turn to the supply side and examine the behavior of producers. We see how firms can produce efficiently and how their costs of production change with changes in both input prices and the level of output. It is useful for dealing with problems that arise regularly in business. What is Production- Production is the process of transformation of inputs (like land, labour, capital, entrepreneurship) into goods and services of utility to consumers and/or producers. It is a process of creation of value or wealth through the production of goods and services that have economic value to either consumers or other producers. Such a process of adding value may occur by change in form (input to output, say steel into car), or by change in place (supply chain, say from factory to dealer/retailer), or by changing hands (exchange, say from retailer to consumer). Product and services both. THE PRODUCTION DECISIONS OF A FIRM: The production decisions of firms are analogous to the purchasing decisions of consumers, and can be understood in three steps:- 1) Production Technology: We need a practical way of describing how inputs (such as labor, capital, land and raw materials) can be transformed into outputs (such as cars and televisions). Just as a consumer can reach a level of satisfaction from buying different combinations of goods, The firm can produce a particular level of For example, an electronics firm might produce 10,000 televisions per month by using a substantial amount of labor (e.g., workers assembling the televisions by hand) and very little capital, Or by building a highly automated capital- intensive factory and using very little labor. - Different combinations of inputs. 2. Cost Constraints: Firms must take into account the prices of labor, capital, and other inputs. Just as a consumer is constrained by a limited budget, The firm concerns about its cost of production. For example, the firm that produces 10,000 televisions per month will want to do so in a way that minimizes its total production cost, which is determined in part by the prices of the inputs it uses. 3. Input Choices: Given its production technology and the prices of labor, capital, and other inputs, the firm must choose how much of each input to use in producing its output. Just as a consumer takes account of the prices of different goods when deciding how much of each good to buy, The firm must take into account the prices of different inputs when deciding how much of each input to use. If our electronics firm operates in a country with low wage rates, it may decide to produce televisions by using a large amount of labor, thereby using very little capital.  The Production Function: The basic relationship between the factors of production and the output is referred to as a production function. A production function indicates the highest output that a firm can produce for every specified combination of inputs. It depicts the physical relationship between the output and inputs. Such a basic relationship between the inputs and the output may be expressed in the functional form such as, Q = f (X1, X2, X3 …………. Xn)  Q is the level of output and Xi represents the ith input, per period of time. Q = F(K, L). This equation relates the quantity of output to the quantities of the two inputs, capital and labour. For example, the production function might describe the number of personal computers that can be produced each year with a 10,000-squarefoot plant and a specific amount of assembly-line labor. Or crop that a farmer can obtain using specific amounts of machinery and workers. The level of output, Q depends on (a) Combination of quantities of all the factors of production or inputs, (b) The quantities of different inputs available to the firm. In general, while specifying a production function, technology is held constant. Therefore, given the quantities of Xi, the production function is simply a catalogue of production possibilities. The Short Run versus the Long Run It takes time for a firm to adjust its inputs to produce its product with differing amounts of labor and capital. A new factory must be planned and built, and machinery and other capital equipment must be ordered and delivered. Such activities can easily take a year or more to complete. As a result, if we are looking at production decisions over a short period of time, such as a month or two, the firm is unlikely to be able to substitute very much capital for labor. It is important to distinguish between the short and long run when analyzing production. The short run refers to a period of time in which the quantities of one or more factors of production cannot be changed. In other words, in the short run there is at least one factor that cannot be varied; such a factor is called a fixed input. The long run is the amount of time needed to make all inputs variable. There is no specific time period, such as one year, that separates the short run from the long run. Rather, one must distinguish them on a case-by- PRODUCTION WITH ONE VARIABLE INPUT (LABOR):- The short-run production function shows the maximum output a firm can produce when only one input can be varied. When deciding how much of a particular input to buy, a firm has to compare the benefit that results with the cost of that input. When capital is fixed but labor is variable, the only way the firm can produce more output is by increasing its labor input. For example, that you are managing a clothing factory. Although you have a fixed amount of equipment, you can hire more or less labor to sew and to run the machines. You must decide how much labor to hire and how much clothing to produce. To make the decision, you will need to know how the amount of output q increases (if at all) as the input of labor L increases. TABLE: PRODUCTION WITH ONE VARIABLE INPUT. Amount of Amount of Output (Q) Average Marginal labour (L) Capital (K) Product Product (Q/L) (ΔQ/ΔL) 0 10 0 - 1 10 10 10 10 2 10 30 15 20 3 10 60 20 30 4 10 80 20 20 5 10 95 19 15 6 10 108 18 13 7 10 112 16 4 8 10 112 14 0 9 10 108 12 -4 10 10 100 10 -8 The table shows- The first three columns show the amount of output that can be produced in one month with different amounts of labor and capital fixed at 10 units. When labor input is zero, output is also zero. Output then increases as labor is increased up to an input of 8 units. Beyond that point, total output declines. Although initially each unit of labor can take greater and greater advantage of the existing machinery and plant, after a certain point, additional labor is no longer useful and indeed can be counterproductive. Five people can run an assembly line better than two, but ten people may get in one another’s way. TOTAL, AVERAGE AND MARGINAL PRODUCT OF A VARIABLE INPUT Total Product: The firm uses a number of inputs to produce its output. If the firm varies the quantity of only one input, keeping the other input quantities unchanged, then the quantity of its output obtained at any quantity of the variable input is called the total product of the input. For example, if the said variable input is labour and if it is obtained that the firm produces 112 units of output when it uses 7 units of labour along with the fixed inputs, then we say that the total product of labour is 112units when 7 units of labour are used. Average and Marginal Products:- Average product of labour (APL ), which is the output per unit of labor input. The average product is calculated by dividing the total output q by the total input of labour L. APL= TP/ L The average product of labor measures the productivity of the firm’s workforce in terms of how much output each worker produces on average. In our example, the average product increases initially but falls when the labour input becomes greater than four. Marginal product of labor (MPL)- Marginal product of labour (MPL) is the additional output produced as the labour input is increased by one unit. MPL = Δ TP/ Δ L For example, with capital fixed at 10 units, when the labor input increases from 2 to 3, total output increases from 30 to 60, creating an additional output of 30 (60– 30) units. The marginal product of labour written as Δ TP/ Δ L= Δ q/ Δ L—in other words, the change in output q resulting from a 1-unit increase in labour input L.  LAW OF VARIABLE PROPORTIONS: THE THREE STAGES. Production Function with one variable input A production function with one variable input may be expressed as: Q = f (X1/ X2, X3 …… Xi) In this function output, Q varies directly with X1 whereas other inputs such as X2, X3…, Xn are held constant at certain level(s). All the inputs except X1 are, fixed and X1 alone may be deemed as the decision variable. In other words, the firm optimize the use of X1 in producing the given product, Q. This kind of a production function describe in terms of the Law of Variable Proportions, also called the Law of Proportionality. It explains the behaviour of production in the short run. In the short run at least one factor is fixed, while other factors are variable. “This law analyses the behaviour of total output, when to a fixed quantity of one factor, more and more units of a variable factor are added.” Prof. Samuelson defines this law as “An increase in some varying inputs relative to other fixed inputs will, in a given state of technology, make total output increase; but after a point the extra output resulting from the same additions of extra inputs is likely to become smaller and smaller.” Professor Benham states that “As the proportion of one factor in a combination of factorsis increased, after a point, first the marginal and then the average product of that factor will diminish.” Assumptions of the Law of Variable Proportions 1. It is assumed that the state of technology remains unaltered. 2. Of the various inputs employed in production some at least must be kept constant. 3. All units of variable factors are homogeneous in size and quality. 4. The addition of variable input is made in equal increments. This law has special application to agriculture. Fix factor Units of Total Product Avg Product Marginal Three Product K variable (TP) (AP) (Q/L) Product (MP) Stages factor L (ΔQ/ΔL) 5 0 0 - - 5 1 20 20 20 5 2 60 30 40 5 3 120 40 60 Up to 1st Stage MP>AP 5 4 160 40 40 AP=MP 5 5 190 38 30 5 6 216 36 26 5 7 224 32 8 5 8 224 28 0 Upto 2nd Stage MP=0 and TP is max. 5 9 216 24 -8 5 10 200 20 -16 Upto 3nd In the table the Fixed Factor is K-Capital and the variable Factor is L-Labour. As L is increased to a fixed amount of K- T.P increases, reaches a maximum and then decreases. AP increases, reaches a maximum and then decreases. MP increases, reaches a maximum, decreases and finally becomes negative. LAW OF VARIABLE PROPORTIONS In the figure, the behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the other divided into 3 distinct stages: Stage I: Stage of Increasing Returns TP at first increases at an increasing rate till point E. MP also rises. The point E where TP stops increasing at an increasing rate and begins increasing at a decreasing rate is called the point of inflexion. Then TP increases at a diminishing rate. Point E is the point where TP stops rising at an increasing rate and starts increasing at a diminishing rate. Corresponding to point E is point H on MP curve which is its point of maximum. MP rises till point H (maximum of MP) and then starts falling. AP increases throughout stage I but AP < MP. Stage I ends where AP is at its maximum at point J and where MP=AP (maximum), at 4 units of labour. In the 1st stage, the quantity of the fixed factor is too much relative to the quantity of the variable factor, so that if some of the fixed factor is withdrawn, the TP would increase i.e. MP of the fixed factor is negative (MPK < O) (MPL > 0). Stage I occurs when labour is employed from 1 to 4 units. Rationale behind Increasing Returns - (Stage I) (a) In the beginning, the quantity of the fixed factor is abundant relative to the quantity of the variable factor. Therefore, when more and more units of a variable factor are added to the constant quantity of the fixed factor, the fixed factor is more intensively and effectively utilised. This causes the production to increase at a rapid rate. When, in the beginning the variable factor is relatively smaller in quantity, some amount of the fixed factor may remain unutilised and therefore when the variable factor is increased fuller utilisation of the fixed factor becomes possible with the result that increasing returns are obtained.  The question is why the fixed factor is not initially taken in an appropriate quantity which suits the available quantity of the variable factor. Answer to this question is provided by the fact that generally those factors are taken as fixed which are indivisible. Indivisibility of a factor means that due to technological requirements a minimum amount of that factor must be employed whatever the level of output. Thus, as more units of variable factor are employed to work with an indivisible fixed factor, output greatly increases in the beginning due to fuller and more effective utilisation of the latter. Thus, we see that it is the indivisibility of some factors which causes increasing returns to the variable factor in the beginning. (b) With an increase in the employment of the variable factor, efficiency of the variable factor itself increases due to the possibility of division of labour and specialisation.  2. Stage II: Stage of Diminishing Returns. TP continues to increase at a diminishing rate, till it reaches a maximum (point G), where stage II ends. TP reaches a maximum at 224 units when 8 units of labour are used. The use of an additional unit of labour input at this stage does not lead to any increase in TP. In other words, MP is 0 when the 8th unit of labour is used. Hence when TP reaches a maximum at point G, MP becomes 0 at point K. This is the end of Stage II. In this stage, AP remains positive but continues to diminish. Both AP and MP are diminishing (both are > 0). In this stage, AP > MP. Stage II is very crucial and important because the firm will seek to produce in its range. (MPK > 0) (MPL > 0). Stage II ranges from 4 to 8 units of labour. Rationale behind Diminishing Returns- A) Once the point is reached at which the amount of the variable factor is sufficient to ensure the efficient utilisation of the fixed factor, then further increase in the variable factor will cause a fall in MP and AP because the fixed factor then becomes inadequately relative to the quantity of the variable factor The contributions to production made by the variable factor after a point becomes less because the additional units of the variable factors have less and less of the fixed factors to work with. B) According to Joan Robinson “diminishing returns occur because the factors of production are imperfect substitutes for one another, which means there is a limit to the extent to which one factor of production can be substituted for another.” i.e. even if one of the variable factors which we add to the fixed factor were a perfect substitute of the fixed factors, then, in stage II, when the fixed factor becomes relatively deficient, its deficiency would have been made up on account of the increase in the variable factor which is its perfect substitute. Thus, Joan Robinson says, “What the Law of Diminishing Returns really states is that there is a limit to the extent to which one factor of production can be substituted for another” 3. Stage III: Stage of Negative Returns. TP declines i.e. MP < 0 (but AP > 0). The variable factor is too much relative to the fixed factor (MPL < 0) (MPK > 0). Stage III occurs when labour is employed in excess of 8 units. Rationale behind Negative Returns The phenomenon of negative returns in state III is because the number of the variable factor becomes too excessive relative to the fixed factor so that they get in each other’s way with the result that the total output falls, instead of rising. Besides, too large a number of the variable factor also impairs the efficiency of the fixed factor. The next question is in which stage will a rational producer seek to produce? Producer will not produce in stage III because MPL < 0. In this stage less output is produced by using more of the variable input which means that production costs would be high. A rational producer avoid such inefficiencies in the use of production inputs.  A rational producer will also not choose to produce in stage 1 where the marginal product of the fixed factor is negative. MPk