Production Choices and Costs
Our analysis of production and cost begins with a period economists call the short run. Theshort runin this microeconomic context is a planning period over which the managers of a firm must consider one or more of their factors of production as fixed in quantity. For example, a restaurant may regard its building as a fixed factor over a period of at least the next year. It would take at least that much time to find a new building or to expand or reduce the size of its present facility. Decisions concerning the operation of the restaurant during the next year must assume the building will remain unchanged. Other factors of production could be changed during the year, but the size of the building must be regarded as a constant.
When the quantity of a factor of production cannot be changed during a particular period, it is called afixed factor of production. For the restaurant, its building is a fixed factor of production for at least a year. A factor of production whose quantity can be changed during a particular period is called avariable factor of production; factors such as labor and food are examples.
While the managers of the restaurant are making choices concerning its operation over the next year, they are also planning for longer periods. Over those periods, managers may contemplate alternatives such as modifying the building, building a new facility, or selling the building and leaving the restaurant business. The planning period over which a firm can considerallfactors of production as variable is called thelong run.
At any one time, a firm will be making both short-run and long-run choices. The managers may be planning what to do for the next few weeks and for the next few years. Their decisions over the next few weeks are likely to be short-run choices. Decisions that will affect operations over the next few years may be long-run choices, in which managers can consider changing every aspect of their operations. Our analysis in this section focuses on the short run. We examine long-run choices later in this module.
The Short-Run Production Function
A firm uses factors of production to produce a product. The relationship between factors of production and the output of a firm is called aproduction function.Our first task is to explore the nature of the production function.
Consider a hypothetical firm, Acme Clothing, a shop that produces jackets. Suppose that Acme has a lease on its building and equipment. During the period of the lease, Acme’s capital is its fixed factor of production. Acme’s variable factors of production include things such as labor, cloth, and electricity. In the analysis that follows, we shall simplify by assuming that labor is Acme’sonlyvariable factor of production.
Total, Marginal and Average Products
Figure 8.1 “Acme Clothing’s Total Product Curve” shows the number of jackets Acme can obtain with varying amounts of labor (in this case, tailors) and its given level of capital. Atotal product curveshows the quantities of output that can be obtained from different amounts of a variable factor of production, assuming other factors of production are fixed.
Notice what happens to the slope of the total product curve in Figure 8.1 “Acme Clothing’s Total Product Curve.” Between 0 and 3 units of labor per day, the curve becomes steeper. Between 3 and 7 workers, the curve continues to slope upward, but its slope diminishes. Beyond the seventh tailor, production begins to decline and the curve slopes downward.
We measure the slope of any curve as the vertical change between two points divided by the horizontal change between the same two points. The slope of the total product curve for labor equals the change in output (ΔQ) divided by the change in units of labor (ΔL):
The slope of a total product curve for any variable factor is a measure of the change in output associated with a change in the amount of the variable factor, with the quantities of all other factors held constant. The amount by which output rises with an additional unit of a variable factor is themarginal productof the variable factor. Mathematically, marginal product is the ratio of the change in output to the change in the amount of a variable factor. Themarginal product of labor(MPL), for example, is the amount by which output rises with an additional unit of labor. It is thus the ratio of the change in output to the change in the quantity of labor (ΔQ/DL), all other things unchanged. It is measured as the slope of the total product curve for labor.
In addition we can define theaverage productof a variable factor. It is the output per unit of variable factor. Theaverage product of labor(APL), for example, is the ratio of output to the number of units of labor (Q/L).
The concept of average product is often used for comparing productivity levels over time or in comparing productivity levels among nations. When you read in the newspaper that productivity is rising or falling, or that productivity in the United States is nine times greater than productivity in China, the report is probably referring to some measure of the average product of labor.
The total product curve in Panel (a) of Figure 8.2 “From Total Product to the Average and Marginal Product of Labor” is repeated from Figure 8.1 “Acme Clothing’s Total Product Curve”. Panel (b) shows the marginal product and average product curves. Notice that marginal product is the slope of the total product curve, and that marginal product rises as the slope of the total product curve increases, falls as the slope of the total product curve declines, reaches zero when the total product curve achieves its maximum value, and becomes negative as the total product curve slopes downward. As in other parts of this text, marginal values are plotted at the midpoint of each interval. The marginal product of the fifth unit of labor, for example, is plotted between 4 and 5 units of labor. Also notice that the marginal product curve intersects the average product curve at the maximum point on the average product curve. When marginal product is above average product, average product is rising. When marginal product is below average product, average product is falling.
Figure 8.2 From Total Product to the Average and Marginal Product of Labor.The first two rows of the table give the values for quantities of labor and total product from Figure 8.1 “Acme Clothing’s Total Product Curve.”Marginal product, given in the third row, is the change in output resulting from a one-unit increase in labor. Average product, given in the fourth row, is output per unit of labor. Panel (a) shows the total product curve. The slope of the total product curve is marginal product, which is plotted in Panel (b). Values for marginal product are plotted at the midpoints of the intervals. Average product rises and falls. Where marginal product is above average product, average product rises. Where marginal product is below average product, average product falls. The marginal product curve intersects the average product curve at the maximum point on the average product curve.
As a student you can use your own experience to understand the relationship between marginal and average values. Your grade point average (GPA) represents the average grade you have earned in all your course work so far. When you take an additional course, your grade in that course represents the marginal grade. What happens to your GPA when you get a grade that is higher than your previous average? It rises. What happens to your GPA when you get a grade that is lower than your previous average? It falls. If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains unchanged.
The relationship between average product and marginal product is similar. However, unlike your course grades, which may go up and down willy-nilly, marginal product always rises and then falls, for reasons we will explore shortly. As soon as marginal product falls below average product, the average product curve slopes downward. While marginal product is above average product, whether marginal product is increasing or decreasing, the average product curve slopes upward.
As we have learned, maximizing behavior requires focusing on making decisions at the margin. For this reason, we turn our attention now toward increasing our understanding of marginal product.
Increasing, Diminishing and Negative Marginal Returns
Adding the first worker increases Acme’s output from 0 to 1 jacket per day. The second tailor adds 2 jackets to total output; the third adds 4. The marginal product goes up because when there are more workers, each one can specialize to a degree. One worker might cut the cloth, another might sew the seams, and another might sew the buttonholes. Their increasing marginal products are reflected by the increasing slope of the total product curve over the first 3 units of labor and by the upward slope of the marginal product curve over the same range. The range over which marginal products are increasing is called the range ofincreasing marginal returns. Increasing marginal returns exist in the context of a total product curve for labor, so we are holding the quantities of other factors constant. Increasing marginal returns may occur for any variable factor.
The fourth worker adds less to total output than the third; the marginal product of the fourth worker is 2 jackets. The data in Figure 8.2 “From Total Product to the Average and Marginal Product of Labor” show that marginal product continues to decline after the fourth worker as more and more workers are hired. The additional workers allow even greater opportunities for specialization, but because they are operating with a fixed amount of capital, each new worker adds less to total output. The fifth tailor adds only a single jacket to total output. When each additional unit of a variable factor adds less to total output, the firm is experiencingdiminishing marginal returns. Over the range of diminishing marginal returns, the marginal product of the variable factor is positive but falling. Once again, we assume that the quantities of all other factors of production are fixed. Diminishing marginal returns may occur for any variable factor. Panel (b) shows that Acme experiences diminishing marginal returns between the third and seventh workers, or between 7 and 11 jackets per day.
After the seventh unit of labor, Acme’s fixed plant becomes so crowded that adding another worker actually reduces output. When additional units of a variable factor reduce total output, given constant quantities of all other factors, the company experiencesnegative marginal returns. Now the total product curve is downward sloping, and the marginal product curve falls below zero. Figure 8.3 “Increasing Marginal Returns, Diminishing Marginal Returns, and Negative Marginal Returns” shows the ranges of increasing, diminishing, and negative marginal returns. Clearly, a firm will never intentionally add so much of a variable factor of production that it enters a range of negative marginal returns.
Figure 8.3 Increasing Marginal Returns, Diminishing Marginal Returns, and Negative Marginal Returns.This graph shows Acme’s total product curve from Figure 8.1 “Acme Clothing’s Total Product Curve” with the ranges of increasing marginal returns, diminishing marginal returns, and negative marginal returns marked. Acme experiences increasing marginal returns between 0 and 3 units of labor per day, diminishing marginal returns between 3 and 7 units of labor per day, and negative marginal returns beyond the 7th unit of labor.
The idea that the marginal product of a variable factor declines over some range is important enough, and general enough, that economists state it as a law. Thelaw of diminishing marginal returnsholds that the marginal product of any variable factor of production will eventually decline, assuming the quantities of other factors of production are unchanged.
It is easy to confuse the concept of diminishing marginal returns with the idea of negative marginal returns. To say a firm is experiencing diminishing marginal returns is not to say its output is falling. Diminishing marginal returns mean that the marginal product of a variable factor is declining. Output is still increasing as the variable factor is increased, but it is increasing by smaller and smaller amounts. As we saw in Figure 8.2 “From Total Product to the Average and Marginal Product of Labor” and Figure 8.3 “Increasing Marginal Returns, Diminishing Marginal Returns, and Negative Marginal Returns,” the range of diminishing marginal returns was between the third and seventh workers; over this range of workers, output rose from 7 to 11 jackets. Negative marginal returns started after the seventh worker.
To see the logic of the law of diminishing marginal returns, imagine a case in which it does not hold. Say that you have a small plot of land for a vegetable garden, 10 feet by 10 feet in size. The plot itself is a fixed factor in the production of vegetables. Suppose you are able to hold constant all other factors—water, sunshine, temperature, fertilizer, and seed—and vary the amount of labor devoted to the garden. How much food could the garden produce? Suppose the marginal product of labor kept increasing or was constant. Then you could grow anunlimitedquantity of food on your small plot—enough to feed the entire world! You could add an unlimited number of workers to your plot and still increase output at a constant or increasing rate. If you did not get enough output with, say, 500 workers, you could use 5 million; the five-millionth worker would add at least as much to total output as the first. If diminishing marginal returns to labor did not occur, the total product curve would slope upward at a constant or increasing rate.
The shape of the total product curve and the shape of the resulting marginal product curve drawn in Figure 8.2 “From Total Product to the Average and Marginal Product of Labor” are typical ofanyfirm for the short run. Given its fixed factors of production, increasing the use of a variable factor will generate increasing marginal returns at first; the total product curve for the variable factor becomes steeper and the marginal product rises. The opportunity to gain from increased specialization in the use of the variable factor accounts for this range of increasing marginal returns. Eventually, though, diminishing returns will set in. The total product curve will become flatter, and the marginal product curve will fall.
Self Check:Marginal, Average, and Total Product
Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz doesnotcount toward your grade in the class, and you can retake it an unlimited number of times.
You’ll have more success on the Self Check if you’ve completed the Reading in this section.
Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.
A planning period over which the managers of a firm must consider one or more of their factors of production as fixed in quantity. A factor of production whose quantity cannot be changed during a particular period. A factor of production whose quantity can be changed during a particular period.What is the difference between cost and production? ›
Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost.What are production and costs in the short run? ›
Short-run production costs are the total of fixed and variable costs incurred by the production of a good or service where factors such as land and heavy machinery cannot change in the short term.What are examples of short run costs? ›
Short Run Costs
Examples of variable costs include employee wages and costs of raw materials. The short run costs increase or decrease based on variable cost as well as the rate of production.
There are four main types of production processes used by businesses. The production processes include batch, unit, mass, and continuous production.What are the three 3 types of production? ›
There are three types of production - primary production, secondary production, and tertiary production.What are examples of production costs? ›
Production cost factors typically include labor, raw materials, equipment, rent, and other supplies or overhead. Although production costs are generally associated with businesses like manufacturers with high inventory levels, they affect all types of businesses.What is a simple example of cost of production? ›
Employee salary, rent, and leased equipment are some examples of fixed costs of production.How do you explain production cost? ›
Production costs refer to the costs a company incurs from manufacturing a product or providing a service that generates revenue for the company. Production costs can include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead.What are the 7 short run costs? ›
There are seven cost curves in the short run: fixed cost, variable cost, total cost, average fixed cost, average variable cost, average total cost, and marginal cost. The fixed cost (FC ) of production is the cost of production that does not vary with output level.
There is an inverse relationship between production and costs. The harder it is to produce something, for example, the more labor it takes, the higher the cost of producing it, and vice versa.What are the three stages of production theory? ›
However, there are three key stages that take place in the production of any film: pre-production (planning), production (filming), and post-production (editing, color-grading, and visual effects).What is an example of a long run production? ›
An example of a long run can be of the same company, ABC, permanently looking to expand production capacity of cars instead of only during the season. It requires new land, labour, and equipment in addition to the existing infrastructure.What are 4 examples of running cost? ›
The running costs of a business are the amount of money that is regularly spent on things such as salaries, heating, lighting, and rent.What is the long run production cost? ›
Long-run production costs refer to the costs over the length of time in which all the costs of the firm are variable costs.What are the categories of production? ›
The five main types of production are Mass production, Batch production, job production and just-In-Time production, and flexible manufacturing system.What are the five different production process types? ›
- Repetitive manufacturing.
- Discrete manufacturing.
- Job shop manufacturing.
- Process manufacturing (continuous)
- Process manufacturing (batch)
An entrepreneur is a person who combines the other factors of production - land, labor, and capital - to earn a profit.What are the 3 main means of production? ›
The elements needed to produce goods and services: land, labour, and capital.What are the 4 types of cost of production? ›
- fixed cost.
- variable cost.
- total costs.
- average cost.
- marginal cost.
Examples of fixed costs are rent and lease costs, salaries, utility bills, insurance, and loan repayments.What are the 3 basic elements of production cost? ›
The three general categories of costs included in manufacturing processes are direct materials, direct labor, and overhead.How do you calculate production? ›
It consists of three main expenses: raw materials, direct labor, and overhead. These costs may be fixed (most overhead) or variable (raw materials and labor). The total product cost formula is Total Product Cost = Cost of Raw Materials + Cost of Direct Labor + Cost of Overhead.How do you calculate cost of production of finished goods? ›
COGM = Beginning WIP inventory + total manufacturing costs - ending WIP inventory. To find the total manufacturing costs, add direct materials, labour, and other overhead manufacturing costs.How do production costs impact profit? ›
Impact of Production Cost on Business
In general, the lower your production cost, the higher your profit, or the amount you have leftover after you subtract your expenses from your sales revenue. However, low production costs do not necessarily guarantee a high profit.
A straightforward and easy-to-use procedure, the total-cost formula is calculated by dividing the total production cost by the number of products manufactured.How do you calculate variable cost? ›
Variable Cost Formula. To calculate variable costs, multiply what it costs to make one unit of your product by the total number of products you've created. This formula looks like this: Total Variable Costs = Cost Per Unit x Total Number of Units.How do you find total cost? ›
The most simple way to calculate the total cost for a product is to add its fixed costs and the variable costs. It is the basic total cost formula. When we add these together, we find the total amount of money the business spends to make the product.Why do we calculate cost of production? ›
Why calculate cost of production? The cost of production is an important factor for businesses to consider when assessing their financial health. If a product's cost of production is consistently higher than the profits it earns, the company may cease production to stay within budget.What are costs and factors of production? ›
- What are the ingredients in your cost of production? For manufacturing companies, it's critical to understand your production costs. ...
- Raw materials. Raw materials are the physical materials needed to produce the product. ...
- Labor. ...
- Overhead. ...
- Outside Services.
It is the total cost sustained by a business to produce a specific quantity of a product. It includes all direct and indirect costs of manufacturing the product. Or in simple words, the cost of production is the original cost of the product without adding profits of wholesalers, shopkeepers, and other intermediaries.What are the 4 factors of production and give an example of each? ›
theory of production, in economics, an effort to explain the principles by which a business firm decides how much of each commodity that it sells (its “outputs” or “products”) it will produce, and how much of each kind of labour, raw material, fixed capital good, etc., that it employs (its “inputs” or “factors of ...What is considered to be the most efficient stage of production? ›
The second stage of production is the most rational stage to produce for the producer because, in the first stage , the production tends to increase at an increasing rate, which means the producer will tend to increase the total output at a increasing rate.What is Isocost and Isoquant? ›
An isoquant shows all combinations of factors that produce a certain output. An isocost show all combinations of factors that cost the same amount.What is the marginal cost curve? ›
The marginal cost (MC) curve is defined as the change in total cost divided by the change in energy output. Under perfectly competitive markets, the MC curve is the same as the firm's supply curve.What is the difference between short run cost and long run cost? ›
What is the difference between long run and short run cost? In long run cost, all the factors of production are variable, whereas, in the short run cost, at least one factor of production is fixed.What are the two main types of operating costs? ›
A business's operating costs are comprised of two components, fixed costs and variable costs, which differ in important ways.What are four cost systems? ›
The four cost accounting standards are: (1) consistency in estimating, accumulating and reporting costs; (2) consistency in allocating costs incurred for the same purpose; (3) accounting for unallowable costs; and (4) cost accounting period (note: OSU uses its fiscal year for its cost accounting period).What are 3 examples of start up costs of a business? ›
What are examples of startup costs? Examples of startup costs include licensing and permits, insurance, office supplies, payroll, marketing costs, research expenses, and utilities.
The term “short-run production” refers to a production cycle in which at least one factor is fixed. Most companies have multiple factors that they use to produce goods or services. Also known as input factors, they can consist of labor, materials, equipment, capital and real property.What is an example of a short run and a long-run? ›
The short run is the period during which some inputs are fixed and unchangeable, while others are variable. The long run is the period during which all inputs are variable. For example, imagine a company, Best Bats, that makes wooden baseball bats. In the short run, Best Bats has fixed as well as variable inputs.What is the difference between short run production and long-run production? ›
Short run production function alludes to the time period, in which at least one factor of production is fixed. Long run production function connotes the time period, in which all the factors of production are variable. No change in scale of production. Change in scale of production.What does production mean on a job application? ›
Production workers, specifically, are responsible for making the actual products. That could mean that they work at individual stations to put parts together. Others may work along a conveyor belt line where each worker performs their own specific task.What are the factors of production choice? ›
There are four factors of production—land, labor, capital, and entrepreneurship.What are the different types of production options? ›
- Mass production,
- Batch production,
- Job production,
- Service production, and.
- Customised production.
Objects, models, molds, tools, samples, drawings, plans, and documents of all kinds (hereinafter referred to as "Production Items") remain the property of the Client.What is considered production work? ›
Production Workers typically work for factories or manufacturing plants to help assemble products and monitor manufacturing equipment for product defects. They work closely with other Production Workers to check product quality and complete assembly tasks by set deadlines.Is production work hard? ›
Production line work is tough. It's fast-paced and can be challenging at times, but it can also be very rewarding.How does job production work? ›
Job production concentrates on producing one product from start to finish. Once one product is complete, another can begin. It is highly specialised and very labour intensive.
They called these the three factors of production: land, labor, and capital. Later economists added a fourth factor called enterprise (or entrepreneurship).What is the most costly factor of production in most businesses? ›
Labor costs can account for as much as 70% of total business costs; this includes employee wages, benefits, payroll and other related taxes.What are the five 5 important areas under production plan? ›
- Forecast market expectations. To plan effectively, you will need to estimate potential sales with some reliability. ...
- Inventory control. ...
- Availability of equipment and human resources. ...
- Standardized steps and time. ...
- Risk factors.
The five main types of the production process are Mass production, Batch production, job production, Just-In-Time production, and flexible manufacturing system.What are the two main types of production techniques? ›
- (i) Job Production:
- (ii) Batch production:
- (iii) Mass or flow production:
- Job Production. Manufacturing a custom part for an infrastructure project.
- Batch Production. A bakery that produces a batch of 1200 blueberry muffins.
- Mass Production. A factory that produces lightweight bicycle tires on a continuous flow production line.
- Mass Customization.
- Production »
- Job Production »
- Batch Production »
- Batch »
- Mass Production »
- Continuous Production »
Production is the process of making or manufacturing goods and products from raw materials or components. In other words, production takes inputs and uses them to create an output which is fit for consumption – a good or product which has value to an end-user or customer.