Handout 3 Production & Costs ‘The problems are adapted from various textbooks: The supply side of the market is represented by firms, organisers of production. ‘The firms convert factors of production, such as land, labour and capital, imto goods and services. It is important to look at costs that arise in production, and analyse why costs are essential for profit maximisation. There arc two periods of production: Short run refers to that period of time for which at least one of the factors of production, usually land or capital is fixed. Long run is that period of time for which all factors of production are variable 1. Theory of Production A production function illustrates the relationship between the total quantity of goods and services produced 1d the quantity of factors of production used in the production ) where, L is labour, AC is physical capital (buildings, machinery), R is raw materials, T, is technology (including IT), is land o space, and F is enterprise. In the short run, Q = f(L). Marginal product of labour (FP) is the increase in total production (or output)as a result of employing ‘one more worker. Average product of labour (AP;,) is the total output produced per worker employed Diminishing Marginal Returns occur when more and more of the variable factor of production is added to the fixed factor of production in the short run. In different industries, diminishing marginal returns set in at different times Q=ILKRT.S, « Example: Consider the short-run production function Q = 15L? ~ 0.5L". Deduce the equation for marginal product and average product of labour. Calculate marginal product and average product of labour when 10 tnits of labour are employed and comment on the result Solution: @ = 15L? ~ 0.5L" — total production MP; = 42 = 15(2L) — 0.5(3L%) = 30 — 1.5L? when £10, MP; = 150 At the point where 10 units of labour are employed. production is increasing at the rate of 150 nits of output per additional unit of labour employed. AP, = $ = 15L — 0.50 when = 10, AP, = 100 The average productivity per unit of labour is 100 units of output for each of the first 10 units of labour employed. The total output can be easily calculated and it is: Q = AP, x L = 1000. * Example (Review: Revenue): The demand function is given as P = 6 — 0.5Q. Find the value of VR for Q at 1, 2,3, 4,5 & 6 Solution: The demand function is available and therefore the total revenne (TR) is: 1TR= Px Q=(6-0.5Q)Q = 6Q- 0.592 ‘The marginal revenue (MR) is obtained as MR = 02 — 6-215) =6-Q Calculate now the values of MR for different Q. RRS RNR 2 Short-run Costs The firm's costs are determined by the quantities of labour aud capital used in the production. However, we have defined the short run as that period where labour is the only factor that can be naried. apital is fired. Given these assumption, we can distinguish between variable casts and fixed costs. Costs that do not change with the output level, also referred to as overhead costs ar unavoidable costs are fixed costs. Costs that change with the output level; also referred to as direct costs or avoidable costs are called variable costs. The sum of the costs of all inputs used in producing a firin's output is called total costs, The change in total cost resulting from increasing production by ‘one unit is referred to as marginal costs (IC). Please uote, in some textbooks, the word short-run is prefixed before the above cost concepts. TC =TFC+TVC ATC MC =~ i= The total cost of producing any given output divided by the number of units produced is referred to as average variable cost (AVC). Average cost can be divided into average fixed (AFC) and average variable costs (AVC) ¢ Example: Find an expression for the MC and 7C from the following average cost funetions. 1 AC =29454+2 2. AC = 3@?-4Q +64 Solution: 1, Since the AC function is given, we derive the equation for TC: F PACK Q=TC STC = 020+ 34+ B)0- 2Q? +5Q +30 AC = MC 2. TC = 3Q* — 4Q? + 6Q + 100 and MC = 992 — 8Q +6 * Example: A firm has an average cost function : AC = Q? — 9Q + 8 475 1. Find an expression for TC and calculate TC when Q = 15 2. Write down the equations for FC and TVC. 3, Find the expression for MC and show that MC > 0 for all Q.Solution: 1, 1530 TC = ACK Q= (AC = QF 90+ F + T5)Q = TC = Q* - 9 + 150+ 75Q 5. TC = 15" = 9 x 15? + 150 + 75 x 15 = 3375 — 2025 + 150 + 1125 = 2625 150 and TVG = f(Q) = Q'—9@ + 75Q 3Q? ~ 18Q +75 Plot MC on the graph to alaaunabuagg o> 092m oe igs ‘Example: If fixed costs are 4, variable costs per unit are 1 and the demand function is ? = 10 ~2Q, obtain an expression for z (profit) in terms of Q and hence sketch a graph of = against Q. 1, For what values of Q does the firm break even”? 2. What is the maximum profit? Solution:1, We begin by obtaining expressions for the total cost and total revenue, For this problem, FC =4 and TVC = 1, s0 TC = FC +(TVC)Q=4+Q The given demand function is: P = 10 ~ 2Q, therefore, TR = PQ = (W2Q)Q = 10Q2Q? Hence the profit is given hy, TR-TC = (10Q — 2Q*) - (4+ Q) = -2Q° +9Q-4 ‘The firm breaks even when 7 = 0. Therefore, -2Q? + 9Q— 4 =0 Q=0.5 nd Q=4 2. For finding ont profit max., solve 4 0. OR, by symmetry, the parabola reaches its maxinmm halfway between 0.5 and 4: that is, at Q = (0.5 +4) = 2.25 ‘The corresponding profit is given by m= 2(2.25)? + 9(2.25) — 4 = 6.125 3 Long-run Costs ‘The long-run production of output, Q, depends on capital, and labour, L., so we ean write: Q= (LK) The partial derivatives gives the rate of change of output with respeet to capital amd is called che marginal product of capital, MPx. If capital changes by a small amount AK, with labour held constant, then the corresponding change in Q is given by: Similarly, the rate of change of output with respect to labour and is called the marginal product of labour, MP, If labour changes by a stnall amount AL, with capital held constant. then the corresponding change in Q is given by 6Q AQ GpAlIf K and L both change simultaneously, then the net change in Q can be found from the small increments formula: 4Q 5Q AQ= aoe + ok The contours of a production function are called isoquants. In Greek iso means ‘equal’, so the word isoquant literally translates as equal quantity. Points on an isoquant represent all possible combinations of inputs (KL) which produce a constant level of output, Qo. If capital continues to decrease, the rate of substitution of labour for capital goes up. We quantify this exchange of inputs by defining the marginal@ate opmechnical Substitution; ns i'be: —4, so that MRTS is the positive value of the slope of an isoquant. As in the case of a utility function, the formula for implicit differentiation shows that: 19. MRTS = 4 ae Example: Find an expression for MTS for the general CobbDouglas produetion function: Q= AKL O} where A, a and 3 are positive constants. Solution: We begin by finding the marginal products. Partial differentiation of Q = AKL? MP, = aAK'L? and MP = 3AKOLS MP, _ @AK®18 MP = BAKeL® MRTS = Example (output Maximisation): A firm's unit capital and labour costs are Rupee 1 and Rs, 2 respectively. If the production function is given by: Q = 4LK + 12, find the maximum output and the levels of A’ and L at which it is achieved when the total input costs are fixed at Rs. 105. Verily that the ratio of marginal product to price is the same for both inputs at the optimum, Solution:We are told that 1 unit of capital costs Rupee 1 and that 1 unit of labour costs Rs.2. If the fir uses K units of capital and L units of labour then the total input costs are, +21 This is fixed at Rs. 105, 0: K 421 = 105 ‘The mathematical problem is to maximise the objective fmction: Q = 4LK + L? subject to the con- straint A’ +2L = 105. Constrained optimisation was introduced in consumer behaviour. Therefore, following the steps alter construction of the Lagrangian funetion we find that the firm should use 30 units of labour and 45 units of capital to produce a maximum output of 6300. We are asked to check that the ratio of marginal product to price is the same for both inputs. From the formula Q= 4LK + L?, we see that the marginal products are given by 10 se ie MP, = Wn =4K+2L and MPx = ix 74h So at the optimun, MP, = 4(45) + 2(30 and MP = 4(30) = 120 ‘The ratios of marginal products to prices are thenMPK 120 = Yay Pe 1 which are seen to be the Example (Cost. Minimisation): firms production function is given by: Q = 2KY?1'2. Unit capital and labour costs are Rs.4 and Rs.3 respectively. Find the values of K and L which n total inpnt costs if the firm is contracted to provide 160 units of output Solution: Given that capital and labour costs are Rs4 and Rs.3 per un units of capital and Z units of labour is: TC = 4K +31 ‘The firms production quota is 160, so . the total cost of using K 2K LM? = 160 ‘The mathematical problem is to minimize the objective function TC =4K +3L subject to the constraint ane pve 160) The Lagrangian funetion in this case is L= (4K + 3b) + A(160 ~ 2K? L") ‘There are three first order conditions: dk Sol ig the above equations we obtain at the cost minimum point, L = 92.38 and K’ = 69.28, Problems for Practice 1 4 6 Given that fixed costs are 1000 and that variable costs are 4 per unit, express TC and AC as functions of Q. Hence sketeh their graphs, If fixed costs are 25, variable costs per unit are 2 and the demand function is P = 20~Q, obtain an expression for x in terms of Q and hence sketch its graph. (a) Find the levels of output which give a profit of 31, (b) Find the maximum profit and the value of Q at which it is achieved. Find an expression for the profit function given the demand function: 2Q+ P = 25 and the average cost function AC = 32/Q +5. Find the values of Q for which the firm (a) breaks even, (b) makes a Joss of 432 units, (e) maximizes profit Given the production function: Q = K?+2L?. Write down the expressions for the marginal products and MRT. A firms production function is given by: Q = 10K'?L4, Unit capital and labour costs are Rs and Rs.5 respectively and the firm spends a total of Rs.60 on these imputs. Find the values of A and L which maxinize output A firms production function is given by: Q = 50#L. Unit capital and labour costs are Rs.2 and Rs.3 respectively. Find the values of K’ and L which minimize total input costs if the produetion quota is 1200.