Economics of Production

In this lecture, we will turn to theory of production. After this lecture, you should be able to understand the economics of production. 

What you will learn

This introductory lecture to production economics provides a thorough view of what economists know about topical issues such as profit maximisation and the Production Possibilities Frontier.

Production economics

Economic theory is to a large extent driven by money - focusing on prices, markets and costs. However, when it comes to production economics, we must also consider the technical production possibility of the business, and how this shapes economic behaviour and the choices involved with production. Production technology in its most general form will consider the relationship between inputs and outputs within a business. Essentially, how well a business can turn its inputs into outputs which can then be sold on, in turn bringing in the relationship of costs and revenue/ profit. The table below showcases how this can be visualised in a table:

Such can also be shown within a graph; displaying how the relationship between inputs and outputs change:

Figure 1 - Relationship between inputs and outputs.

The key takeaway here is that the line is not linear. At the beginning, it could be seen that output increases faster as inputs are increased, seen as efficiency gains, or economies of scale, both which will be discussed later. As inputs increase further, output growth slows, before finally falling. This could be seen as diseconomies of scale, or diminishing returns, again concepts which will be discussed later in more detail.  Essentially, the business can produce at any point on the curve; with its main aim to maximise its own return, and so its profits. It should also be mentioned that the production curve can be any shape depending on the individual business/ market.

However, when considering the production process, it is also important to consider a process whereby there is more than one input. There is then the need to showcase the numerous combinations of inputs which could be used to produce the same output. These are so-called isoquants, shown below:

Figure 2 - Production process.

Essentially, each line represents a level of output from the business, which each point on the line a combination of the two inputs which can be used to produce the given level of output. However, each graph showcases a different relationship. For instance, in ‘A’ it could be noted that line 1 shows that it is possible to produce the product/ service with just one output involved, however a combination of the two can also be used. In ‘B’, both inputs are necessary for the output, however there is no maximum, and so this could be thought of as a Cobb-Douglas production function.

Finally, it could be noted that in ‘C’ there is a maximum, with the corners of each line being seen as efficient. With this, it could be seen as a Leontief production function.

we must consider the production function of the business; shown below,

Q = f (a, b, c............ n)

Essentially, what we are saying here is that the quantity of output (Q), is determined by the given quantities of output, (a,b,c etc.). Thus, the production function expresses the technological relationship between the quantity of output and the quantities of the various inputs used for the production. Alternatively, it can be changed round to reflect the minimum quantity of each input needed for the final output.

With this, the production function has several assumptions, namely:

1. It is associated with specified period of time.

2. The state of technology is constant during the specified period of time.

3. The producer is expected to use the best and the most efficient technique.

4. The factors of production are divisible.

Production Possibility Frontier

Following on, the Production Possibilities Frontier can be considered. Although, in reality, an economy will produce thousands of goods/ services, for the simplicity of this model it is assumed that the economy can produce two goods. With this, the economy will look to use its factors of production (mentioned above) to produce the two goods, seeking to meet domestic demand. The image below showcases a graphical representation of the frontier:

Figure 3 - Production Possibility Frontier

As shown above, several points can be noted on the graph. Points A, B, and C are all on the curve, and so would be seen as efficient, with the economy able to choose production levels for Product A and Product B. Point X would be seen as inefficient given that the economy is producing a combination of goods below its maximum potential. Finally, Point Y would be seen as currently unachievable given that the production is above that of the curve, which as mentioned denotes the maximum production potential of the economy.

Cost/ Revenue Equilibrium in Businesses

When it comes to production, a business will seek to supply goods to the market whereby MC=MR; essentially where the marginal cost of producing one extra unit is equal to the marginal revenue earned from producing that one extra good. To understand the basics, a business will make a loss if its costs are higher than its revenue, while it will make a profit if its revenue is higher than its costs. Breakeven will be seen when revenue equals costs; so MC=MR would be seen as the breakeven point for production.

Businesses with a high level of fixed costs are able to reduce the total costs per unit by increasing production, known as achieving economies of scale. To provide a definition, economies of scale can be defined as cost advantages that businesses obtain due to their size, output, scale of operation etc., with the costs per unit of output generally decreasing as fixed costs are spread out over more output.

Although, remaining focused on this, the law of diminishing returns can also be considered. This law would suggest that the scale of these cost advantages would decrease as output rises. For instance, assume that after producing 1000 units, the business needed to increase the size of its manufacturing facility to produce more. In this case, fixed costs would then need to rise, reducing the cost advantages associated with economies of scale.

Marginal and Average Costs

For any business seeking to decide on production, two main questions can be asked. The first would refer to the average cost of producing one unit of the good/ service, while the second will consider the marginal cost which will be occurred from producing one more of that good. Initially, it could be considered that the marginal costs of an extra unit may be low, especially if the business has spare capacity in the production process. So, if production was increased, the business could utilise this spare capacity, benefitting from economies of scale and keeping the marginal cost low, representative of the variable costs of production, variable costs which could then be helped by cost savings associated with efficiency and bulk buying of raw materials. However, as this spare capacity is eroded, then the marginal cost may increase. For instance, there could be longer waiting times to use equipment, or the need to hire more staff, making the marginal cost of increasing output by one expensive.

Considering the above, the average cost curve is U-Shaped. Initially, a business can reduce the average cost by increasing production, benefitting from economies of scale, however this is only applicable up to a point. As production increases, the business can then suffer from diseconomies of scale, leading to the average cost rising, which could be brought about by the business needing to expand, i.e. larger factory, more employees. A graph is shown below which plots both the marginal, and average costs.

Image result for marginal and average cost

Figure 4 - Marginal and Average Costs

As shown, the point at which the MC curve and AC curve cross is the minimum for average costs. As mentioned above, a business will maximise their own production to a point when MC = MR, shown below in graphical form:

Image result for marginal and average cost

Figure 5 - MC = MR; Business will maximise their own production at the point where MC = MR.

  • Elasticity of demand:definition

Short-Run Costs/ Revenue

In the short-run the business will look to maximise profits; be it where total revenue is greater than total costs.

The graph below represents a single firm in a perfectly competitive market. You can tell it is a perfectly competitive market in this example with the demand curve, shown as being perfectly elastic, suggesting that the business can supply as much of the good/ service to the market at the price point ‘P’ (displayed below):

As mentioned above, the MC curve initially falls before rising. In the short-term, the business will look to produce at QH, where the MC line crosses the price line; essentially where MC = MR. However, at this price point, the business can make profits shown by the shaded area, given that the MC crosses the average cost line (here AC) at point B. Points A and J show the breakeven points, suggesting two points at which the business can produce and breakeven. Although, as shown by the shaded area, the business is earning above normal profits at point H, known as abnormal profits. Considering this in a perfectly competitive market, the long-run argument would be that new businesses enter the market, increasing total output and pushing the price lower.

Marginal cost

To provide a definition, the marginal cost could be seen as the change in total cost that arises when the quantity produced is increased by an increment of one. So, if the business currently produced 100 units with total costs of £1,000; and increasing this to 101 increased total costs to £1,008 then the marginal cost would be £8. This in turn will impact on revenue, and profit. For example, consider that the business sold each unit for £15, then the total revenue would increase by £15, and the profit would increase by a further £7. So, in this example it is beneficial for the business to increase production as it increases profit. Furthermore, the marginal revenue (MR) is greater than the marginal cost (MC).

Image result for marginal and average cost

Figure 6 - Visualisation of marginal costs

Long-run costs/revenue

When it comes to the long-run, new variables must be considered in terms of production. For instance, costs could increase which are out of the control of the business. Again, consider the airline industry and Ryanair’s business model. In the short term (<1 year), Ryanair can control its costs, be it signing purchase agreements for aviation fuel, setting airport fee’s or offering its employee’s a set wage rate. However, in the long-run, these costs can become variable. For instance, crude oil prices move daily on global markets; meaning that businesses may see a different price when it comes to re-negotiating contracts. So, the price being paid by Ryanair for fuel would vary between 2016 and 2013 given the major differences in oil prices. Furthermore, wages could be impacted on by increases the minimum wages, or be negotiations from trade unions. Finally, airport fee’s and other costs may increase for the airline given changes in the supply chain, and inflationary pressures. Ultimately, what is being mentioned here is that long-run costs are more variable to change; even fixed costs. For instance, a landlord may put up the rent on the buildings rented by the business.

The Relationship of LR and SR costs

Considering the graph above we can consider the following points:

  • The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is drawn on the assumption of there being an infinite number of plant sizes
  • Points of tangency between the LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. This is shown in the graph below. To provide a definition, the MES is seen as the lowest point at which the plant can produce such that its long-run average costs are minimised.
  • If LRAC is falling when output is increasing, then the firm is experiencing economies of scale. For example, a doubling of factor inputs might lead to a more than doubling of output.
  • Conversely, When LRAC eventually starts to rise then the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale
  • The working assumption is that a business will choose the least-cost method of production in the long run.

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