CONTENT TOPIC 3: SUPPLY, PRODUCTION AND COST. The Supply Process. The Role of the Firm 10/10/2016

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1 CONTENT TOPIC 3: SUPPLY, PRODUCTION AND COST - The factors of production - Combining factors of production: The law of returns - Costs of production: Short & Long Run - Deciding whether to produce in the short & long run - Price elasticity of supply - Outsourcing & cost - Producer surplus The Supply Process In the supply process, people first offer their factors of production to the market. Firms transform the factors into goods that consumers want. Production is the transformation of factors into goods. The Role of the Firm The firm is an economic institution that transforms factors of production into consumer goods. It: Organizes factors of production. Produces and sells goods and services. A virtual firm only organizes production and subcontracts out all work. 1

2 Factors of production Resources used for production Types: Land Capital Labour Entreprenuership Natural resources Characteristics Land A gift of nature Limited in supply Land is immovable The supply of land involves no opportunity cost Capital Man-made resources used for further production Examples: machines, raw materials, tools Features: Man made Labour Entreprenuership Human Resources It raises the productivity of other factors

3 Labour Supply Measured in terms of time (man hour) Labour supply = no. of workers x no. of working hours per worker Law of Diminishing Returns Fixed factor of production An input whose quantity cannot be altered in the short run. E.g. square footage of factory space Variable factor of production An input whose quantity can be altered in the short run. E.g. labor Law of Diminishing Returns If one factor is variable and all others are fixed: the increased production of the good eventually requires ever larger increases in the variable factor The Supply Process In the supply process, people first offer their factors of production to the market. Firms transform the factors into goods that consumers want. Production is the transformation of factors into goods. Production Functions Production function a curve that describes the relationship between the inputs (factors of production) and outputs. It tells the maximum amount of output that can be derived from a given number of inputs. Marginal product is the additional output that will be produced by an additional worker, other factors remaining constant. Average product is total output divided by the number of workers. 3

4 Output Output A Production Function Both average and marginal productivities initially increase, but eventually they both decrease. The production function exhibits: Increasing marginal productivity Then diminishing marginal productivity Finally negative marginal productivity Increasing 18 1 marginal 1 productivity Diminishing marginal productivity TP Diminishing absolute productivity Number of workers MP AP Number of workers The Law of Diminishing Marginal Productivity Law of diminishing marginal productivity as more of a variable input is added to an existing fixed input, after some point the additional output from the additional input will fall. This law is also called the flower pot law. If it did not hold true, the world s entire food supply could be grown in a single flower pot. Fixed Costs, Variable Costs, and Total Costs Fixed costs are those that are spent and cannot be changed in the period of time under consideration. In the long run, there are no fixed costs since all inputs (and therefore their costs) are variable. In the short run, a number of inputs and their costs will be fixed. Fixed Costs, Variable Costs, and Total Costs Workers represent variable costs costs that change as output changes. The sum of the variable and fixed costs are total costs. TC = FC + VC

5 The Role of the Firm Firms Maximize Profit The firm is an economic institution that transforms factors of production into consumer goods. It: Organizes factors of production. Produces and sells goods and services. A virtual firm only organizes production and subcontracts out all work. Profit = total revenue total cost Economists and accountants measure profit differently. Accountants focus on explicit costs and revenues. Economists focus on both explicit and implicit costs and revenue. Firms Maximize Profit Economic profit = (explicit and implicit revenue) (explicit and implicit costs) Total revenue is the amount a firm receives for selling its good or service plus any increase in the value of its assets. Total cost is explicit payments to resources plus the opportunity cost of resources provided by the owners of the firm. The Production Process The production process can be divided into the long run and the short run. The terms long run and short run do not necessarily refer to specific periods of time. They refer to the flexibility the firm has in changing the level of output. 5

6 Total cost Cost The Long Run and the Short Run A long-run decision is a decision in which the firm can choose among all possible production techniques. In the long run, all inputs are variable. A short-run decision is one in which the firm is constrained in regard to what production decision it can make. In the short run, some inputs are fixed. Average Costs Average fixed costs AFC = FC/Q Average variable cost AVC = VC/Q Average total cost ATC = TC/Q or ATC = AFC + AVC Marginal cost is the increase in total cost of increasing output by one unit. Total Cost Curves Per Unit Output Cost Curves $ TC VC TC = VC + FC L O M FC $ MC ATC AVC AFC Quantity of earrings Quantity of earrings

7 Output per worker Costs per unit Average and Marginal Cost Curves The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. The average fixed cost curve slopes down continuously because as output increases, the same fixed cost is spread out over more output. The Relationship Between Productivity and Costs A MC AVC Output AP of workers MP of workers Output The Relationship Between Productivity and Costs Costs are generally divided into fixed costs, variable costs, and marginal costs. TC = FC + VC MC = change in TC AFC = FC/Q AVC = VC/Q ATC = AFC + AVC Production in the Short Run Factors of Production An input used in the production of a good or service Short Run A period of time sufficiently short that at least some of the firm s factors of production are fixed Long Run A period of time of sufficient length that all the firm s factors of production are variable 7

8 Production in the Short Run Perfectly competitive firms should produce where MR (P) = MC, unless price is very low If total revenue falls below variable cost, the best the firm could do is shut down in the short run Price Elasticity of Supply Elasticity of Supply (Es) Determinants of Price Elasticity of Supply When Government Taxes Products For Next Time Price Elasticity of Supply A measure of the extent to which the quantity supplied of a good changes when the price of the good changes, and all other influences on seller s plans remain the same (cateris paribus) Price Elasticity of Supply (Es) = % Change in Qs % Change in Price Computing Price Elasticity of Supply Percentage change in quantity supplied Percentage change in price If Price Elasticity of Supply > 1, Supply is elastic If Price Elasticity of Supply = 1, Supply is unit elastic If price elasticity of supply< 1, Supply is inelastic 8

9 Price Elasticity of Supply Perfectly Elastic Supply When the quantity supplied changes by a very large percentage in response to an almost zero increase in price Elastic Supply When the % change in the quantity supplied > the % change in the price Unit Elastic Supply When the % change in the quantity supplied = the % change in price Inelastic Supply When the % change in the quantity supplied is < the % change in price Perfectly Inelastic Supply When the quantity supplied remains the same as the price changes Perfectly Elastic Supply Curve S Quantity Perfectly Inelastic Supply Curve S Quantity Relative Elasticities of Supply The Short Run S 1 S In the short run a firm has an essentially fixed productive capacity but labor flexibility A firm has some ability to increase output A firm could go from two 8-hour shifts to three 8- hour shifts Store hours could probably be extended And so, an increase in demand will result in more output Quantity 9

10 The Long Run What is Outsourcing? In the long run there is sufficient time for a firm to alter its productive capacity The firm can leave the industry New firms can enter the industry When a rise in demand is considered to be long lasting, some existing firms will add to their plant and equipment If demand falls, some or all firms will cut back on their plant and equipment, while others may leave the industry Outsourcing - the strategic use of outside resources to perform activities traditionally handled by internal staff and resources Dave Griffiths Why Outsource? Provide services that are scalable, secure, and efficient, while improving overall service and reducing costs Reasons for Outsourcing Traditional role - reaction to problem Reduction and control of costs Avoid large capital investment costs Insufficient resources available Modern role business strategy Allows company to focus on their core competencies Keeping up with cutting-edge technology Creating value for the organization and its customers Building partnerships Producer Surplus Producer Surplus (PS) is the difference between the firm s minimum willingness to accept (MC) and what they actually accept (P), summed over all units produced.

11 Producer Surplus and Supply Graphically then, PS is the area below the price line and above the supply curve, up to Q* Here, PS = $0 =½(base)(height) = ½(0)() P 30 PS 0 Quantity S D 11