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Topic 6 - Production Theory.docx

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Economics 1021A/B
Arvin Dar

Topic 6: Production Theory 1. Returns to factors of production 2. Theory of revenue 3. Theory of cost 4. Conditions for profit (TI) maximization 5. Conditions for profit (TI) maximization and production 6. Conclusions 6.1 6.2 1. Returns to factors of production  Q = f (Land, labour, capital, entrepreneurship)  Four factors of production: land (doesn’t have to be land, but water for an oil platform sits), labour, capital (anything man or woman made – like a tool or screwdriver) & entrepreneurship (the idea is if you put these 3 together, nothing will happen. You need an organizer)  Five dimensions are needed to draw all of these  Example: pick one – labour (L) o Don’t sweep the others under the rug – treat them like you do with consumer theory (the others are all fixed amounts: K (capital) is held fixed at some constant level, etc.) o Q (output) can also be Total Product/ion o Q Q (T.P) This line is where your number of people becomes crazy – if you already have a coffee guy & and a backup coffee guy and you hire someone new, you’re going to bugger production (and TP) – The marginal production of that person is negative – he’s in the way. Damned guy. L  Average Product = T.P (or Q)/ L o Looks at straight lines from 0,0 to whichever point is picked  Marginal Product: ΔQ/ΔL or ΔTP/ΔL where the denominator is taken to be 1 o The addition to output when we employ one more individual AP You can only get a certain point of production  MP Eventually, you get to a point where the next person is not as important as the one before L First section; increasing mp or labour Second section; law of diminishing MP of labour (law of diminishing returns to labour) Last section; negative MP of labour  If you don’t fix the other variables when you graph this, then output can increase forever – too much labour = bigger factory = more machines  If you fix them at some level , you will at some point, see negative marginal returns. 2. Theory of revenue TR: Total revenue (is the same as total expenditure by consumers) TR = P X Q ^-- Constrained by the demand curve (set a higher price, but you’ll sell less) Pick one, accept the other If you pick Px, then you’re only going to sell Qx OR pick Qy and have to set your price at Py AR: Average revenue AR = TR/Q but TR is P X Q so AR = P X Q / Q (Q cancels out) SO AR = P and vice versa P AR = 5-2Q (P=5-2Q) P AR = 5 D = AR = P Q Q Average revenue is given by the slope of the rays on this (the half circle up there) curve *Don’t need this+ As we increase Q, average revenue keeps falling MR: Marginal Revenue (Marginal is the change in something divided by the change in something else) The addition to our total revenue when we produce one more unit (ΔQ will always be 1) MR = ΔTR/ΔQ Marginal revenue keeps falling because slopes keep falling P= 11 - Q TR TR = P X Q (= (11-Q) Q 2 11Q – Q MR = 11-2 ∙ Q (1 and 9, 2 and 7, etc.) MR P=AR = D P = 10 TR = 10 Q MR = 10 P = AR = D = MR Q P(AR) TR MR 1 10 10 10 2 9 18 8 3 8 24 6 4 7 28 4 ^ this is not the best way to get the values because of how zero works (MR & AR are supposed to be = ) If Lyryx asks though, use this. Cause we’re silly. 3. Theory of cost More important, but more complex Accounting costs vs. Economic costs Accounting: obvious, explicit Rent, supplies, utilities (hydro, etc.), display counters, etc. TR = 50,000; TC = 45,000; TI = 5,000 Economic: equal to accounting costs + implicit costs (hidden, indirect or imputed) Owner’s salaries (even if they’re retired because of opportunity cost – the old lady could sell knitted sweaters for $40/day), paying children’s salaries (if their kids come home from university to run the shop on the weekend so the parents can rest), brother shovels snow (won’t take money) No money is exchanged TC = 45,000 + 11,500 (salaries, etc.) A chance for all the factors of production to be rewarded (at least the opportunity cost)  Short run is the length of time within which the quantity of some factors of production remains fixed (i.e., it cannot be varied) o Those factors whose quantity cannot be varied in the short run are called fixed factors of production. The costs associated with the fixed factors of production are referred to as fixed costs. o Those factors that can be varied in the short run are called variable factors of production. The costs associated with the variable factors of production are referred to as variable costs.  Long run is the length of time within which the quantity of all the factors of production can be varied  In the long run, all
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