Managerial Economics Lesson 2 – Theory of Production PDF

MANAGERIAL ECONOMICS Lesson 2 – Theory of Production Overview The theory of production is an analysis of output-input relationship. As such, discussions touch on the relation of output to the size, combination, and efficiency of resources. The fundamental concepts in this lesson...

MANAGERIAL ECONOMICS Lesson 2 – Theory of Production Overview The theory of production is an analysis of output-input relationship. As such, discussions touch on the relation of output to the size, combination, and efficiency of resources. The fundamental concepts in this lesson are the Law of Diminishing Returns which explain the output function in different resources conditions. As a practical model and tool of analysis, its one-variable resource assumption basically reflects on the dynamics of a multi-resource condition. Specifically, after completion of this lesson, the students will have a thorough understanding about the following:  Production function  The Law of Diminishing Returns  Productivity  Resource efficiency Desired Learning Outcomes 1. Explain the production function and its ways to improve production. 2. Describe the concept of Law of Diminishing Returns 3. Discuss the basic ways on how to improve resource efficiency 4. Show how productivity is measured via formula 5. Solve exercises involving production function.  Lesson 2 Theory of Production Content-Discussion Terms to remember Production-basically means act of manufacturing a product Productivity-the efficiency and therefore the power of inputs to produce Marginal product-product due to the additional or last unit of the variable resource input Economic efficiency-profitable improvement in overall resource efficiency Resource mix or combination-defined as how much of one resources is used per unit Production function Plant size and the efficiency of its resources (land, labor, and capital) determine plant capacity (maximum output). Resources are fixed in the short run, which is generally described as a period when conditions have not changed yet. But as plant size and resource efficiency change in the long run, so is production capacity. PRODUCTION FUNCTION LABOR TOTAL PRODUCT MARGINAL AVERAGE PRODUCT STAGE Man Hours OR OUTPUT PRODUCT(units) (units) 1 5 5 5 STAGE 1 2 10 5 5 3 16 6 5.3 4 21 5 5.2 STAGE 2 5 24 3 4.5 6 24 0 4 7 21 -3 3 STAGE 3 8 16 -5 2 9 10 -6 1.1 10 5 -5 0.5 STAGE 4 11 2 -3 0.2 12 0 -2 0 The production function illustrates how variations in a certain resource (e.g., labor) change the total product (TP) or output, assuming the other resource (e.g., capital) to be fixed. The TP or output rises with more labor inputs in the first two stages but eventually declines in the last stage. The marginal product influences this trend and is defined as the product due to the additional or last unit of the variable resource input and measured as follows: MP = ∆Q ∆I Where: MP = Marginal product or output QP = Total product/output I = Resource Input ∆ = Change The table shows that the 2nd unit of labor yields an additional output of 5 which is actually the MP of using 2 units of the resource. In turn, this additional product (MP) increases TP from 5 to 10 because of that 2nd or last unit of labor. But the 7th unit of labor has a negative product or an MP of - 3, which decreases TP from 24 to 21. At stage 1, every additional input of labor churns out a bigger chunk with a higher MP to accelerate the TP. At stage 2, additional input churns out a smaller chunk with a lower MP to still increase but decelerates TP. MP continues to decline to negative levels at stage 3 where additional labor input has negative returns and decreases TP. The law of diminishing returns The production function shows that stretching the use of variable resources against the limits of fixed resources decreases additional product (MP). This is the Law of Diminishing Returns, which is basically due to the limits of a fixed plant size. Having too much of one resource and too little of another can even result in a resource imbalance that decreases production capacity stretching resource use to the point of imbalance or overusing breeds counter-productive conditions which directly cause diminishing or even negative returns. The saying “Too many cooks spoil the broth” applies to production. It also states that the use of variable resources against the limits of fixed resources or describes the tendency at some point for each succeeding addition to output to become smaller as the firms add succession units of variable input to some fixed inputs.  Two important lessons: a. Size of a resource, given the rest as fixed, should not go beyond its product-maximizing point. b. Plant capacity can only increase with more resources combined unless technology changes. Productivity It is the efficiency and therefore the power of inputs to produce. It confines discussions to resource inputs which are basic to production. Productivity is measured as output per unit of input which is illustrated below. Productivity = Q I Where: Q = Output I = Input The foregoing, which is average productivity, is the efficiency of inputs taken as a whole and is measured as their average output (as in the above formula). On the other hand, marginal productivity is the efficiency of additional inputs and it is measured as their marginal output which is also illustrated below. Marginal Productivity = ∆Q ∆I Where additionally: ∆ = Change In the production function, the average product (AP) of labor measures its average efficiency, while marginal product (MP) measures its marginal efficiency. Advantages Productivity improvement means more output per unit of input as the increase in the efficiency ratio indicates. It also means less input for output as the decrease in the ratio’s inverse indicates. Therefore, efficiency is not a matter of size. A bigger plant is not necessarily more efficient than its smaller counterparts. For example: a class may best the rest in a school fund drive by the sheer number of soliciting members. But the most efficient class has the biggest amount solicited by every member which reflects on individual initiative. However, productivity is not an end, but a means to compete and survive in the free market. Resource efficiency Production resources are complementary not only in function but also in efficiency. A better machine also enables its operator to work faster or the other way around. Resources do not become more internally efficient at the same time, but every improvement contributes to the overall productivity picture. In addition, the time lag between productivity improvements can alter the optimum combination of resources. For example: Replacing old machines with modern and more efficient ones improves work and shifts the TP, AP, and MP upward. But plant expansion favors the use of more efficient capital than less efficient labor. The shift is economically efficient since every peso of labor given up, which is additional spent for capital, yields a net increase in output. Basic ways to improve resource efficiency 1. Change the nature of the resource through innovation. Example, a worker in a car assembly plant does more in tightening bolts than with other jobs like mounting wheels. 2. Change the external condition of resources. Example, increasing the number of customers served in a drug store by temporarily reassigning resources to augment the sales group during peak hours. This set-up minimize imbalance in work distribution and labor idle time. 3. More balanced resource combination. Example, investment in an irrigation system (capital) enables the rice farmer to plant and harvest three times a year with the same land area. But without irrigation, capital is at minimum and land is only productive once a year. 4. Using resource-saving technology Example, computers have become more powerful and cost efficient and resource combination in industrialized economies favors their use to save on scarce and costly labor resources. Progress check: Briefly answer the following To be submitted/placed in your portfolio in our Google classroom. 1. Cite some successful businesses in the Philippines that uses resource efficiency (20 points) 2. Cite your own examples as regards ways to improve resource efficiency (20 points) Exercises A. Complete the table below. (30 points) Labor Input TP MP AP 1 6.00 2 9.00 3 14.00 4 17.00 5 22.00 6 27.00 7 29.00 8 25.00 9 16.00 10 10.00 11 6.00 12 3.00 13 1.00 14 0.00  Self-evaluation: Quiz B. Write T if the statement is true. If the statement is false, underline the wrong word and write the correct answer on the blank before each number. (2 points each) 1. Productivity is the output produced by a unit of factor input during a given span of Factor input during a given span of time. 2. The theory of production describes the functional relationships of output and economic resources, assuming these are of fixed size. 3. A production function illustrates the varied combinations of inputs at the same level of plant capacity. 4. The AP and MP of a production function may shift downward or upward only because the overall productivity level of that firm may also change. 5. Computers and computerized machineries are means of improving overall efficiency by utilizing resource-saving technology. Rubrics for essay Assessment: 20 points 30 points Present ideas in an original manner 5 8 Organization of thought (strong and organized) 5 7 Understanding (writing shows clear understanding) 4 7 Word choice (use of nouns and verbs make the essay very informative) 3 4 Sentence structure is evident; sentences mostly flow 3 4 20 points 30 points References for further readings Arnold, Roger A. (2019) Microeconomics 13th Edition Mc Eachern, William A. (2017) Microeconomics Bato, Ma. Jesusa Avila (2016) Microeconomics Simplified Marcelo Jr. Danilo F. (2016) Microeconomics Theories and Applications OBE Approach Pagaso, Cristobal M. (2015) Introducing Microeconomics Online Sources:  https://www.researchgate.net/publication/47804534_Basic_microeconomics  https://www.researchgate.net/publication/236784560_modern_microeconomics MANAGERIAL ECONOMICS Lesson 3 – Pricing and Output Under Pure Competition Overview Competition has always been part of human motivation and activity. This lesson shows how the price system operates in a purely competitive market. Competition can make wonders in the economy. Fair competition can make wonders both in human activities and in the market system, say, the best shoes can be produced in the market if there is fair competition among the shoe producers. Needles to say, perverted and unbridled competition can lead to undesirable ends. After the completion of this lesson, the students will have a thorough knowledge about the following:  Pure and Perfect Competition  A Note on Profits  Profit Maximizing Output: Pure Competition Total Revenue-Total Cost Approach  Profit Maximizing Output: Pure Competition Marginal Revenue=Marginal Cost Approach Desired Learning Outcomes 1. Define a perfectly competitive market and explain its effect on demand. 2. Distinguish an accountant’s view from an economist’s view as regards a corporation’s net income or profit and economic profits. 3. Identify how concepts of efficiency are used to judge market performance 4. Compute for the profits with the given data on the following approaches: a. Total Revenue-Total Cost Approach b. Marginal Revenue=Marginal Cost Approach Lesson 3 Pricing and output under pure competition Content/Discussion Terms to remember  Pure competition-a market wherein there is a large number of buyers and seller of a commodity  Profits-pure surplus or an excess of total receipts over all costs of production incurred by a firm.  Marginal cost-the additional cost incurred when additional units of output are produced.  Marginal revenue-the additional revenue obtained by putting the additional units of output in the market.  Economic profits-the difference between the net income of the firm and the opportunity cost of the inputs used; also known as economic value added.  Pure and perfect competition Economists make a distinction between pure and perfect competition. A market is said to be perfectly competitive if it contains all the characteristics of pure competition plus an additional characteristics, i.e., consumers, resource owners, and firms in the market have perfect knowledge of present and future prices and costs. Perfect knowledge means that a person knows the price of a commodity being charged in the markets. Based on this knowledge, he can make his decision whether to buy from one market or the other based on price differences. A market is said to be purely competitive if: 1. There is a large number of sellers and buyers of the commodity, each too small to affect the price of the commodity. 2. The outputs of all firms in the market are homogeneous, i.e., the product of any seller is considered exactly alike in all respects to the product of any other seller. 3. There is perfect mobility of resources, i.e., there is freedom of entry into and exit from the industry. When there is a large number of seller and buyers of a commodity, each would be too small to affect the price of the commodity. For example, a typical rice farmer, since he is only one of the millions of farmers in the Philippines, his individual decision regarding the pricing of his product would not significantly affect the price of rice in the market. This means that both the producers and the seller are price takers. Given this condition, the demand curve under a purely competitive market is shown below. Price Firm P Demand Output As can be seen from the graph above, the firm faces an infinitely elastic demand curve. The firm can sell any amount it can produce at the price. However, while each individual firm faces a horizontal demand curve, the industry demand curve is still downward sloping. The demand and supply curves in the industry are subject to various influences which generally make the demand curve downward sloping and the supply curve positively sloped. A note on profit The term profit can sometimes be ambiguous. To avoid this, let us make explicit definitions on profit. Profit-is a pure surplus or an excess of total receipts over all costs of production incurred by a firm. Included as cost are obligations incurred for all resources used, which include opportunity costs. These costs include returns to the owners of capital used equivalent to what they could get. Let us look at how an accountant would look at a corporation’s net income or profit compared with an economist’s view of economic profits. Assuming that corporate income taxes are ignored, corporate profits are determined by the accountant as follows:  Gross Income-Expenses=Net Income or Profits The economist would view profit from a slightly different light. Obligations incurred to the owners of the corporation’s capital (its stockholders) are as much cost of production as those incurred for labor or for raw materials. This means that a company has to make payments to capital owners in the form of dividends from the corporation’s profits. To arrive at economic profits, dividends payments equal to what investors could earn, should be subtracted from the corporation’s net income as follows: Gross Income - Expenses = Net Income or Profit Net Income of Profit-Average Dividends = Economic Profits Given the market price of a product, the producer in a competitive market is faced with the following questions: 1. Should I produce? 2. If so, what will I produce and how much? 3. Will profit be realized (or loss)? 4. If so, how much profit (or loss)? One of the approaches in answering these questions and arriving at the break-even point and maximum profit is through the total revenue minus total cost approach. The break-even point is arrived at when total revenue equals total cost. This is a very important concept in economics. Total profits equal total revenue minus total cost. So long as revenues are greater than costs, the firm receives profits; if costs are greater than revenues, the firm is operating at a loss. The following table will illustrate the concept. PROFIT MAXIMIZING OUTPUT: PURE COMPETITION TOTAL REVENUE-TOTAL COST APPROACH QUANTITY TOTAL REVENUE FIXED COST VARIABLE COST TOTAL COST PROFITS 0 Php0 Php200 Php0 Php200 Php-200 2 262 200 180 380 -118 4 524 200 340 540 -18 6 786 200 480 680 106 8 1,048 200 600 800 248 10 1,310 200 740 940 370 12 1,572 200 900 1,100 472 14 1,834 200 1,080 1,280 554 16 2,096 200 1,300 1,500 596 18 2,358 200 1,560 1,760 598 20 2,620 200 1,860 2,060 560 Based on the table above, Total revenue (TR) is derived by multiplying price by quantity (TR=P X Q). Assuming a market price of PHP131, the total revenue curve (column 2) is obtained by multiplying the value under quantity (column 1) by price. Total cost (TC) is obtained by adding fixed cost (column 3) and variable cost (column 4). Thus, we have the question: Total cost (TC)=Fixed cost (FC) + Variable cost (VC) Question: At what output would the firm maximize profit? Answer: From the table, we can see that profit is maximized at output 18. The size of profit at this point is Php598, the highest profit that be possibly obtained from the profit column. Profit is obtained by subtracting total cost (column 5) from total revenue (column 2). Thus, we have the equation: Profit = Total Revenue – Total Cost PROFIT MAXIMIZING OUTPUT: PURE COMPETITION MARGINAL REVENUE = MARGINAL COST APPROACH QUANTITY P = MR MC AC PROFIT/UNI TOTAL PROFIT T 0 2 Php131 Php90 Php190 Php-59 Php-118 4 131 80 135 -4 -16 6 131 70 113.33 17.67 106 8 131 60 100 31 248 10 131 70 94 37 370 12 131 80 91.67 39.33 472 14 131 90 91.43 39.57 554 16 131 110 93.75 37.25 596 18 131 130 97.78 33.22 598 20 131 150 103 28.00 560 Another way of determining profits in a competitive firm is through the marginal revenue (MR) = marginal cost (MC) approach. Marginal revenue is the additional revenue obtained by putting the additional units of output in the market. This is obtained in the equation. MR = ∆TR ∆Q Marginal cost is the additional cost incurred when additional units of products are produced. It is computed as the change in total cost divided by the change in units produced. Thus, we have the equation: MC = ∆TC ∆Q Question: At what output will the firm maximize profit? Answer: Profit is maximized where MR = MC. This is obtained at output 18. At this point, total profit is Php598, the highest in all profit columns. Total profit is obtained by multiplying profits per unit by quantity. Any point outside output 18 will give the firm lesser profit. Price competition induces sellers/producers to find the most efficient resources and use them most efficiently. An example of resource misallocation that eventually self-corrects toward collective efficiency is the mushrooming of Internet cafes in contrast to the rarity of gift shops in the market. Overinvestment in Internet cafes leaves behind idle resources that only add to cost. However, these idle resources could otherwise be profitable investments in fixtures and stocks of additional gift shops. Thus in the long run, more and more will invest in gift shops as attracted by resources, technology, and size, so are consumers in taste and preference. That they are identical and many also explains why everybody is a price taker in the market. Reinforcing equity and equality is the competitive environment that not only drives the same production efficiency but also keeps every market actor in check. The latter means that perfect mobility and information clear the market of barriers that diversify it in product and taste. In other words, mobility and information enable producers (sellers) and consumers to imitate, and therefore, neutralize one another toward homogeneity and equality. Progress check: To be submitted/placed in your portfolio in our Google classroom Exercises A. Draw the demand curve of a firm under pure competition. (20 points) B. Complete the following table. (25 points) Answer the questions that follow PRICE Qd TC TR AC MR MC PROFIT Php3.00 5 10 3.00 10 25 3.00 15 30 3.00 20 33 3.00 25 45 3.00 30 66 1. At which quantity above is profit maximized? (5 points) 2. Is this extra ordinary or normal profit? Why? (5 points) Rubrics for essay Assessment: 20 points 30 points Present ideas in an original manner 5 8 Organization of thought (strong and organized) 5 7 Understanding (writing shows clear understanding) 4 7 Word choice (use of nouns and verbs make the essay very informative) 3 4 Sentence structure is evident; sentences mostly flow 3 4 20 points 30 points References for further readings Arnold, Roger A. (2019) Microeconomics 13th Edition Mc Eachern, William A. (2017) Microeconomics Bato, Ma. Jesusa Avila (2016) Microeconomics Simplified Marcelo Jr. Danilo F. (2016) Microeconomics Theories and Applications OBE Approach Pagaso, Cristobal M. (2015) Introducing Microeconomics Online Sources:  https://www.researchgate.net/publication/47804534_Basic_microeconomics  https://www.researchgate.net/publication/236784560_modern_microeconomics