Introduction to
Production and
Resource Use
Chapter 6
Topics of Discussion
Conditions of perfect competition
Classification of productive inputs
Important production relationships
(Assume one variable input in this chapter)
Assessing short run business costs
Economics of short run production
decisions
2
Conditions for Perfect Competition
Homogeneous products
 i.e., Corn grain, mined low-sulfur coal
No barriers to entry or exit
 i.e., Regulatory, extremely high fixed costs
Large number of sellers
 How large is large?
Perfect information
Information cost is relatively small
No one firm has access to information and
others don’t
3
Page 86
Classification of Inputs
Economists view the production process
as one where a variety of inputs are
combined to produce a single or multiple
outputs
 Cheese plant example
 Labor, cheese vats, milk, energy, starter cultures,
cutting and wrapping tables, water, etc.
 Cheese, dry whey, whey protein concentrates are
produced by the plant
Pages 86-87
4
Classification of Inputs
Land: includes renewable (forests) and
non-renewable (minerals) resources
Labor: all owner and hired labor
services, excluding management
Capital: Manufactured goods such as
fuel, chemicals, tractors and buildings
that may have an extended lifetime
Management: Makes production
decisions designed to achieve specific
economic goal
Pages 86-87
5
Classification of Inputs
Inputs can also be classified depending
on whether amount of input used changes
with production level
 Fixed inputs: The amount used does not
change with output level
 Up to a point the size of milking parlor does not
change with ↑ milk production/cow or for initial
↑ in herd size
 Variable Inputs: The amount of input used
changes with the level of output
 Usually the amount of labor supplied is a
variable input (i.e., car assembly plant that ↑ the
speed of assembly line to ↑ production/hour
6
Pages 86-87
Production Function
Output = f(labor | capital, land,
and management)
Start with
one variable
input
Assume remaining inputs
fixed at current levels
f(•) is general functional notation
 Could be any functional form
7
Page 88
Production Function
Point
Labor (hr)
Output
A
10
1.0
B
16
3.0
C
20
4.8
D
22
6.5
E
26
8.1
F
32
9.6
G
40
10.8
H
50
11.6
I
62
12.0
J
76
11.7
We can graph the
relationship between
output and amount of
labor used
 Known as the Total
Physical Product (TPP)
curve
 Purely a physical
relationship, no
economics involved
 X lbs of fertilizer/A
generates a yield of Y
Page 89
8
Total Physical Product (TPP) Curve
Maximum Output
↓ Output
Variable input
9
Page 89
Other Physical Relationships
The following derivations of the TPP curve
play an important role in decision-making
Output
 Marginal Physical Product (MPP) =
Input
Output Qty
 Average Physical Product (APP) =
Input Qty
Page 90
10
Production Function
Labor Output ∆Labor ∆Output
Point
[1]
[2]
[3]
[4]
11
MPP
[5] = [4]
÷ [3]
A
10
1.0
-----
-----
-----
B
16
3.0
6
2
0.33
C
20
4.8
4
1.8
0.45
D
22
6.5
2
1.7
0.85
E
26
8.1
4
1.6
0.40
F
32
9.6
6
1.5
0.25
G
40
10.8
8
1.2
0.15
H
50
11.6
10
0.8
0.08
I
62
12.0
12
0.4
0.02
J
76
11.7
14
0.3
-0.02
MPP = Change
in output as you
change input use

Output
Input
Page 89
Total Physical Product (TPP) Curve
 MPP = 1.8/4.0 = .45
Output ↑ from 3.0 to 4.8
units = 1.8
Labor ↑ from 16 to 20
units = 4.0
Output
Input
Page 89
12
Law of Diminishing
Marginal Returns
Pertains to what happens to the MPP with
increased use of a single variable input
If there are other inputs their level of use is not
changed
Diminishing Marginal Returns
13
The MPP ↑ with initial use of a variable input
At some point, MPP reaches a maximum with
greater input use
Eventually MPP ↓ as input use continues to ↑
Page 93
Production Function
Labor Output ∆Labor ∆Output
Point
[1]
[2]
[3]
[4]
14
MPP
[5] = [4]
÷ [3]
A
10
1.0
-----
-----
-----
B
16
3.0
6
2
0.33
C
20
4.8
4
1.8
0.45
D
22
6.5
2
1.7
0.85
E
26
8.1
4
1.6
0.40
F
32
9.6
6
1.5
0.25
G
40
10.8
8
1.2
0.15
H
50
11.6
10
0.8
0.08
I
62
12.0
12
0.4
0.02
J
76
11.7
14
0.3
-0.02
Page 89
Plotting the MPP Curve
Change from A to B on
the production function
→ a MPP of 0.33
15
Change in output
associated with a
change in inputs
Page 91
Production Function
16
APP
∆Labor ∆Output
[6] = [2]
[3]
[4]
÷ [1]
Point
Labor
[1]
Output
[2]
A
10
1.0
-----
-----
0.10
B
16
3.0
6
2
0.19
C
20
4.8
4
1.8
0.24
D
22
6.5
2
1.7
0.30
E
26
8.1
4
1.6
0.31
F
32
9.6
6
1.5
0.30
G
40
10.8
8
1.2
0.27
H
50
11.6
10
0.8
0.23
I
62
12.0
12
0.4
0.19
J
76
11.7
14
0.3
0.15
Average Physical
Product (APP) =
Amount of
output/ amount
of inputs used
= Output/unit of
input used
Page 89
Total Physical Product (TPP) Curve
Output
APP = .31 (= 8÷26)
with labor use = 26
Input
17
Page 89
Plotting the APP Curve
Output divided
by labor use at
B (3 ÷ 16) =0.19
18
APP = output level
divided by level of
input use
Page 91
Definition of the Three Stages of Production
Stage I: MPP > APP
APP is ↑
APP is increasing in Stage I
19
Page 91
Definition of the Three Stages of Production
Stage II: MPP < APP
MPP > 0
Page 91
20
Definition of the Three Stages of Production
Stage III: MPP < 0
Page 91
21
Definition of the Three Stages of Production
22
Why are Stage I and
Stage III irrational from the
producer’s perspective?
Page 91
Definition of the Three Stages of Production
Productivity is increasing as more
inputs are being used so why stop if the
average return is greater than cost?
23
Can increase output by
using less inputs: →More
output and less cost
Definition of the Three Stages of Production
The question for the producer is:
What level of input amount represented by
Stage II should the I use?
24
Economic Dimension
To answer the above question
We need to account for the price of the
product being produced
We also need to account for the cost of
the inputs used to produce the above
product
25
Key Cost Relationships
 The following cost concepts play key
roles in determining where in Stage II a
producer will want to produce
 Marginal Cost (MC) =  total cost of
production ÷  output produced as output
level changes
=  variable cost of production ÷ 
output produced given that total
fixed costs by definition do not
change with output
 Average Variable Cost (AVC) = total variable
cost of production ÷ total amount of output
produced
26
Page 94-96
Key Cost Relationships
 The following cost concepts play key roles
in determining where in Stage II a
producer will want to produce
 Average Fixed Cost (AFC) = total fixed
cost of production ÷ total amount of
output produced
 Average Total Cost (ATC) = total cost of
production ÷ total amount of output
produced = AVC + ATC
27
Page 94-96
From TPP
curve on
page 113
Page 94
28
Fixed costs are
$100 no matter
the level of
production
29
Page 94
Total fixed costs (Col. 2)
÷ by total output (Col. 1)
Page 94
30
Costs that vary
with level of
production
31
Page 94
Total variable
cost (Col. 4) ÷
by total output
(Col. 1)
32
Page 94
Total Fixed
Cost (Col. 2) +
Total Variable
Cost (Col.4)
33
Page 94
Change in Total Cost
(Col. 4 or 6) associated
with a change in output
(Col. 1)
34
Page 94
[Total Cost (Col. 6) ÷ by Total
Output (Col. (1)] or [Avg. Variable
Cost + Avg. Fixed Cost]
35
Page 94
Let’s Graph the Above
Cost Items Contained
in this Table
36
Table 6.3 Cost Relationships
MC=min(ATC) and
70
60
MC
ATC
AVC
AFC
min(AVC)
Vertical distance between
ATC and AVC = AFC
50
Cost ($)
40
30
20
10
0
3.0
4.8
6.5
8.1
9.6
10.8
11.6
Input Use
37
Page 95
Key Revenue Concepts
 The following revenue concepts play key roles
in determining where in Stage II a producer
will want to produce
Total Revenue (TR) =Multiplication of total
amount of output produced by the sale price
Average Revenue (AR) = Total revenue ÷ total
amount of output produced
Marginal Revenue (MR) = ∆ total revenue ÷
∆ total amount of output produced
 How much revenue is generated by one additional
unit of output?
 Under perfect competition, it is the per unit price
38
Now let’s assume this
firm can sell its
product for $45/unit
39
Key Revenue Concepts
Remember we are assuming perfect competition
40
 The firm takes price as given
 Price (Col. 2) = MR (Col. 7)
 What is the AR value?
Page 98
Profit Maximization
With perfect competition, where would the
firm maximize profit in the above example?
Page 98
41
Let’s see this in
graphical form
42
Profit Maximization
70
MC
AVC
60
ATC
MR
Profit maximizing
Output where MR=MC
P=MR=AR
50
$45
40
30
20
10
11.2
0
43
1
3
4.8
6.5
8.1
9.6
Page 9911.6
10.8
Profit Maximization
The previous graph indicated that
Profit is maximized at 11.2 units of output
MR ($45) equals MC ($45) at 11.2 units of output
Profit maximizing output occurs between points G and H
At 11.2 units of output profit would be $190.40. Let’s do the math….
44
Profit at Price of $45?
$
P =45
MC
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
ATC
28
AVC
11.2 Q
45
Since P = MR = AR
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
Profit at Price of $45?
$
MC
P =45
$190.40
28
ATC
AVC
11.2 Q
46
Revenue = $45  11.2 = $504.00
Total cost = $28  11.2 = $313.60
Profit = $504.00 – $313.60 = $190.40
Since P = MR = AR
Average profit = $45 – $28 = $17
Profit = $17  11.2 = $190.40
P=MR=AR
Zero economic profit if price
falls to PBE
Firm would only produce output
OBE where AR (MR) ≥ ATC
47
Page 99
Profit at Price of $28?
Revenue = $28  10.3 = $288.40
Total cost = $28  10.3 = $288.40
Profit = $288.40 – $288.40 = $0
$
MC
45
ATC
P=28
AVC
10.3 11.2
48
Q
Since P = MR = AR
Average profit = $28 – $28 = $0
Profit = $0  10.3 = $0 (break even)
P=MR=AR
Firm can just cover
variable cost if price
falls to PSD.
Firm would shut down
if price falls below PSD
49
Page 99
Profit at Price of $18?
$
MC
45
ATC
28
AVC
P=18
8.6 10.3 11.2
50
Q
Revenue = $18  8.6 = $154.80
Total cost = $28  8.6 = $240.80
Profit = $154.80 – $240.80 = $0
Since P = MR = AR
Average profit = $18 – $28 = –$10
Profit = –$10  8.6 = –$86 (Loss)
Profit at Price of $10?
$
MC
45
ATC
28
Revenue = $10  7.0 = $70.00
Total cost = $30  7.0 = $210.00
Profit = $70.00 – $210.00 = – $140.00
Since P = MR = AR
Average profit = $10 – $30 = –$20
Profit = –$20  7.0 = –$140
AVC
19
P=10
7.0 8.6 10.3 11.2
51
Q
Average variable cost = $19
Variable costs = $19  7.0 = $133.00
Revenue – variable costs = –$63
Not covering variable costs!!!!!!
The Firm’s Supply Curve
$
MC
45
ATC
AVC
28
18
10
7.0 8.6 10.3 11.2
52
Q
The Firm’s Supply Curve
We know that so long as P (= MR) > AVC
some of the fixed costs can be covered
Better economic position then shutting down
altogether, WHY?
We know that when P (= MR)=MC, the
firm maximizes profit
Portion of MC curve defined by output
level that generates the minimum AVC is
referred to as the firm’s supply curve
Page 99
53
The Firm’s Supply Curve
$
Firm Supply Curve
MC
45
ATC
AVC
28
18
8.6 10.3 11.2
54
Q
Now let’s look at the
demand for a single
input: Labor
55
Key Input Relationships
The following input-related derivations play
key roles in determining amount of variable
input to use to maximize profits
Marginal Value Product (MVP) =
MPP × Product Price
 MPP → ∆Output ÷ ∆Input Use
 Product Price → ∆$ ÷ ∆Output
 MVP → ∆$ ÷ ∆Input Use (Additional
output value generated by the last
increment in input use)
Marginal Input Cost (MIC) = wage rate,
rental rate, seed cost, etc.
Page 100
56
D
MVP=MPP x Output Price
Wage rate is
labor’s MIC
C
B
E
F
5
G
H
I
J
57
Page 101
Profit maximizing input use rule
Use a variable input up to the point where
 Value received from another unit of
input
 Equals cost of another unit of input
→ MVP=MIC
D
C
B
E
F
G
5
H
I
J
58
Page 101
D
The area below the green lined
MVP curve and above the green
lined MIC curve represents
cumulative net benefit
C
B
E
F
G
5
H
I
J
59
Page 101
MVP = MPP × $45
60
Page 100
61
Profit are maximized where MVP = MIC
or where MVP =$5 and MIC = $5
Page 100
–
62
=
Marginal net benefit (Col. 5) = MVP (Col. 3) – labor
MIC (Col. 4) = Value of additional output from last
unit of input net of the cost of that input
Page 100
63
The cumulative net benefit (Col. 6) of input use
= the sum of successive marginal net benefits (Col. 5)
= the grey area in previous graph.
Page 100
64
For example…
$25.10 = $9.85 + $15.25
$58.35 = $25.10 + $33.25
Page 100
–
Cumulative net benefit is maximized
65 where MVP=MIC at $5
=
Page 100
D
If you stopped at point E on the MVP curve,
for example, you would be foregoing all of the
potential profit lying to the right of that point
up to where MVP=MIC.
C
B
E
F
G
5
H
I
J
66
Page 101
D
If you use labor beyond the
point where MVP =MIC, you
begin incurring losses as the
return to another unit of
labor is < $5.00, its per unit
cost
C
B
E
F
G
5
H
I
J
67
Page 101
A Final Thought
One final relationship needs to be made. The level
of profit-maximizing output (OMAX) in the graph on
page 99 where MR = MC corresponds directly with
the variable input level (LMAX) in the graph on page
101 where MVP = MIC.
Going back to the production function on page 88,
this means that:
OMAX = f(LMAX | capital, land and management)
68
In Summary…
Features of perfect competition
Factors of production (Land, Labor,
Capital and Management)
Key decision rule: Profit maximized at
output MR=MC
Key decision rule: Profit maximized
where MVP=MIC
69
Chapter 7 focuses on the choice
of inputs to use and products to
produce….
70