Product And Cost

Production  Production Is an organized activities of converting inputs into output or creation of value and utility Factors of production – Rewards  Land - rent  Labor - wages  Capital - interest  Organization - profit

Production function  Production function – The functional relationship between physical inputs and physical output

Production Function With One Variable Input Total Product Marginal Product Average Product Production or Output Elasticity

TP = Q = f(L) ∆TP MPL = ∆L TP APL = L MPL EL = APL

Production Function With One Variable Input Total, Marginal, and Average Product of Labor, and Output Elasticity

L 0 1 2 3 4 5 6

Q 0 3 8 12 14 14 12

MPL 3 5 4 2 0 -2

APL 3 4 4 3.5 2.8 2

EL 1 1.25 1 0.57 0 -1

Production Function With One Variable Input

Production Function With One Variable Input

Production function  1. Production function for a firm is Q = 100L – 0.02L2. If 10 units of labor are used, What is the maximum average productivity of labor?  2. If the average product of labor (APL) is 30L – L2, What is the maximum possible total product (TPL) ?  3. The Production function of a manufacturing unit, using only labor (L) as inputs in the production process, is estimated to be Q = 100 L2 – L3. What is the number of labor input at which the firm can maximize average productivity ? and What is the maximum average productivity at that input level?

Optimal Use of the Variable Input Marginal Revenue Product of Labor

MRPL = (MPL)(MR)

Marginal Resource Cost of Labor

∆TC MRCL = ∆L

Optimal Use of Labor MRPL = MRCL

Optimal Use of the Variable Input

Use of Labor is Optimal When L = 3.50 L 2.50 3.00 3.50 4.00 4.50

MPL 4 3 2 1 0

MR = P $10 10 10 10 10

MRPL $40 30 20 10 0

MRCL $20 20 20 20 20

Optimal Use of the Variable Input

Production With Two Variable Inputs

Isoquants show combinations of two inputs that can produce the same level of output. Firms will only use combinations of two inputs that are in the economic region of production, which is defined by the portion of each isoquant that is negatively sloped.

Production With Two Variable Inputs Isoquants

Production With Two Variable Inputs Economic Region of Production

Production With Two Variable Inputs Marginal Rate of Technical Substitution MRTS = -∆K/∆L = MPL/MPK

Production With Two Variable Inputs MRTS = -(-2.5/1) = 2.5

Production With Two Variable Inputs Perfect Substitutes

Perfect Complements

Optimal Combination of Inputs Isocost lines represent all combinations of two inputs that a firm can purchase with the same total cost. C = wL + rK

C = Total Cost w = Wage Rate of Labor ( L)

C w K= − L r r

r = Cost of Capital ( K )

Optimal Combination of Inputs Isocost Lines AB

C = $100, w = r = $10

A’B’

C = $140, w = r = $10

A’’B’’

C = $80, w = r = $10

AB*

C = $100, w = $5, r = $10

Optimal Combination of Inputs MRTS = w/r

Production function 1. Production function of a firm is Q = 4L2 + 6K2 – 2LK Budget constraint of the firm is Rs.720. The market going wage rate w = Rs.10 and cost of capital r = Rs.10 a.The optimum input quantities of Labour and Capital and the output at that input quantities b.The optimum output if both the wage rate and cost of capital increase to Rs. 15. 2.Suppose the price of labour is Rs.10 and the price of capital is Rs.2.5 Use this information to determine the isocost equations corresponding to a total cost of Rs.200 and Rs.500 Plot these two iso-cost lines on a graph If the price of labour falls from Rs.10 per unit to Rs. 8 per unit, determine the new Rs.500 iso-cost line and plot it on the same diagram used in part (b)

Optimal Combination of Inputs  Effect of a Change in Input Prices

Returns to Scale Production Function Q = f(L, K) λQ = f(hL, hK) If λ = h, then f has constant returns to scale. If λ > h, then f has increasing returns to scale. If λ < h, the f has decreasing returns to scale.

Returns to Scale Constant Returns to Scale

Increasing Returns to Scale

Decreasing Returns to Scale

Returns to Scale Constant Returns to Scale

Increasing Returns to Scale

Decreasing Returns to Scale

Innovations and Global Competitiveness       

Product Innovation Process Innovation Product Cycle Model Just-In-Time Production System Competitive Benchmarking Computer-Aided Design (CAD) Computer-Aided Manufacturing (CAM)

Economies of scale and scope  Internal economies  External economies

Internal economies     

Labor economies Managerial economies Financial economies Marketing economies Technical economies

External economies  Economies of localization  Economies of marketing intelligence and information  Economies of vertical disintegration  Economies of byproducts

Basic cost concepts       

Explicit cost and Implicit cost Opportunity cost Marginal cost and incremental cost Real cost Controllable cost Traceable cost and common costs Fixed cost and variable cost

Short-Run Cost Functions    

Total Total Total TC =

Cost = TC = f(Q) Fixed Cost = TFC Variable Cost = TVC TFC + TVC

Short-Run Cost Functions  Average Total Cost = ATC = TC/Q  Average Fixed Cost = AFC = TFC/Q  Average Variable Cost = AVC = TVC/Q  ATC = AFC + AVC  Marginal Cost = ∆TC/∆Q = ∆TVC/∆Q

Short-Run Cost Functions

Q 0 1 2 3 4 5

TFC $60 60 60 60 60 60

TVC $0 20 30 45 80 135

TC $60 80 90 105 140 195

AFC $60 30 20 15 12

AVC $20 15 15 20 27

ATC $80 45 35 35 39

MC $20 10 15 35 55

Long-Run Cost Curves  Long-Run Total Cost = LTC = f(Q)  Long-Run Average Cost = LAC = LTC/Q  Long-Run Marginal Cost = LMC = ∆ LTC/∆Q

Long-run average cost curve

Learning and costs  Job familiarization and less time to instruct workers  More skillful movements of workers  Better operation sequences, machine-feeds and speeds  Less rejection and rework  Manufacturing lots are larger, cutting down the set-up time proportion  Improved coordination and management controls

Learning Curves

Minimizing Costs Internationally  Foreign Sourcing of Inputs  New International Economies of Scale  Immigration of Skilled Labor

Logistics or Supply Chain Management  Merges and integrates functions     

Purchasing Transportation Warehousing Distribution Customer Services

 Source of competitive advantage

Logistics or Supply Chain Management  Reasons for the growth of logistics  Advances in computer technology  Decreased cost of logistical problem solving  Growth of just-in-time inventory management  Increased need to monitor and manage input and output flows  Globalization of production and distribution  Increased complexity of input and output flows

Tools of cost control    

Budgetary control Standard Costing Ratio analysis Value analysis

Areas of cost control    

Material cost Labour cost Overhead cost Selling cost

Approaches to cost reduction

     

Budgetary Input reduction Input cost Input substitution “Not made here” Suggestions box

George Stigler’s Survivorship Technique  Classify various firms in an industry under study by size groups or classes  Determine which size groups or classes are increasing or decreasing their share of the total output  If the share of a given size-class falls, that size class is relatively inefficient and in general, more inefficient the size group, more rapidly the share falls. Likewise, the size-class whose share in industry grows the most, is regarded as most efficient size- class or group  The technique gives the optimum size of a firm only and that too in terms of output range or the size group. Butit does not yield the cost function

Cost-Volume-Profit Analysis Total Cost-Volume-Profit Analysis Revenue = TR = (P)(Q) Breakeven Volume TR = TC (P)(Q) = TFC + (AVC)(Q) QBE = TFC/(P - AVC)

Cost-Volume-Profit Analysis

Operating Leverage

Break Even Analysis  TR = TC In units  BEP = TFC/CM In value  BEP = TFC/ P.V.Ratio

Managerial Applications of BEP       

Price and Cost decision Target Profit Margin of safety Product mix decision Selection of technology Decision on promotional expenditure Make or buy decisions