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
 No regulatory barriers
 No 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 that
3
others don’t
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
 Many inputs: Labor, stainless steel cheese vats,
raw milk, energy, starter cultures, cutting and
wrapping tables, water, etc.
 Multiple outputs: Cheese, dry whey, whey
protein concentrates are produced by the plant
4
Pages 86-87
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 goals
5
Pages 86-87
Classification of Inputs
Inputs can also be classified depending
on whether amount of input used changes
with production level
 Fixed inputs: The amount of input 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 directly 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
“given the level of”
Output = f(labor | capital, land,
and management)
Start with
one variable
input
Assume remaining inputs
fixed at current levels
f(•) is general functional notation
7
 Could be any functional form
Page 88
Production Function
8
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/acre
generates a yield of Y
Page 89
Total Physical Product (TPP) Curve
Maximum Output
Decreasing output
Data from previous table
Variable input
9
Page 89
Other Physical Relationships
The following derivations of the TPP curve
play an important role in decision-making
 Marginal Physical Product (MPP) =
 Average Physical Product (APP) =
10
 O utput
 Input
O utput Q ty
Input Q ty
Page 90
Production Function
Point
11
Labor Output ∆Labor ∆Output
[1]
[2]
[3]
[4]
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

 O u tp u t
 In p u t
↑MPP
↓MPP
Page 89
Total Physical Product (TPP) Curve
Data from previous table
4.8
 MPP = 1.8/4.0 = .45
Output
Output ↑ from 3.0 to 4.8
units = 1.8
Labor ↑ from 16 to 20
units = 4.0
3
Input
12
Page 89
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
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 ↑
13
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
∆MPP
Plotting the MPP Curve
Change from A to B on
the production function
→ a MPP of 0.33
Change in output
associated with a
change in inputs
Data from previous table
15
Page 91
Plotting the MPP Curve
Q of
Output
A
∆Q*
0
16
∆I*
MPP = Slope of the line
tangent at a
point (A) on the
TPP curve
= ∆Q*/∆I*
Q of
Input
Page 91
Plotting the MPP Curve
Q of
Output
A
At A, MPP = ∆Q/∆I
= 0/∆I* = 0
TPP is at a maximum
when MPP = 0
0
17
∆I*
Q of
Input
Page 91
Production Function
Labor Output ∆Labor ∆Output
Point
[1]
[2]
[3]
[4]
18
APP
[6] = [2] ÷
[1]
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
Data from previous table
Output
APP = .31 (= 8÷26)
with labor use = 26
Input
19
Page 89
Plotting the APP Curve
Output divided
by labor use at
B (3 ÷ 16) =0.19
APP = output level
divided by level of
input use
Data from previous table
20
Page 91
Plotting the APP Curve
Q of
Output
B
A
Q*
0
APP = Q*/I*
= Slope of the line from
the origin to the point
on the TPP curve
At I**, APP is at a maximum,
as line OB is just tangent
to the TPP curve
Q of
Input
I*
I**
21
Page 91
Relationship Between APP and MPP
Q of
Output
MPP
APP is at a maximum at
input level where APP = MPP
APP*
APP
0
22
I*
Q of
Input
Page 91
Definition of the Three Stages of Production
Stage I: MPP > APP
APP is ↑
APP is increasing in Stage I
23
Page 91
Definition of the Three Stages of Production
Stage II: MPP < APP
MPP > 0
24
Page 91
Definition of the Three Stages of Production
Stage III: MPP < 0
25
Page 91
The Three Stages of Production
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I


26
Stage II
Stage II starts at input use where APP is
at a maximum (pt A)
Stage II ends at input where MPP = 0 (or
TPP is at a maximum)
Page 91
The Three Stages of Production
Why are using the amount of input in
Stage I and Stage III of production
irrational from the producer’s perspective?
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I
27
Stage II
Page 91
The Three Stages of Production
Q of
Output
Can increase output by using
less inputs: →More output and
less cost
MPP
APP
Stage III
Q of
Input
0
Stage I
Stage II
Average productivity is increasing as more
inputs are being used so why stop if the
average return is greater than cost?
28
Page 91
The Three Stages of Production
Q of
Output
MPP
APP
Stage III
Q of
Input
0
Stage I
29
Stage II
The producer’s economic question:
What level of input amount contained in
Stage II should the I use to maximize profits?
Page 91
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
30
Key Cost Relationships
 The following cost concepts play key
roles in determining where in Stage II a
producer will want to produce
 Total Variable Cost (TVC) = the total value
of costs that change with the level of output
(e.g. energy costs, labor costs, material
costs, etc.)
 Total Fixed Cost (TFC) = total value of costs
that do not changed with the level of output
(e.g. property taxes)
 Total Costs (TC) = the sum of total variable
and fixed costs
 TC = TVC + TFC
31
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
 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 =
∆TC/∆Q = ∆TVC/∆Q
 Average Variable Cost (AVC) = total variable
cost of production ÷ total amount of output
produced = TVC/Q
32
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 = TFC/Q
 Average Total Cost (ATC) = total cost of
production ÷ total amount of output
produced = TC/Q = AVC + ATC
33
Page 94-96
From TPP
curve on
page 113
34
Page 94
Fixed costs are
$100 no matter
the level of
production
35
Page 94
Total fixed costs (Col. 2)
÷ by total output (Col. 1)
36
Page 94
Costs that vary
with level of
production
37
Page 94
Total variable
cost (Col. 4) ÷
by total output
(Col. 1)
38
Page 94
Total Fixed
Cost (Col. 2) +
Total Variable
Cost (Col.4)
39
Page 94
Change in Total Cost
(Col. 4 or 6) associated
with a change in output
(Col. 1)
40
Page 94
[Total Cost (Col. 6) ÷ by Total
Output (Col. (1)] or [Avg. Variable
Cost + Avg. Fixed Cost]
41
Page 94
Let’s Graph the Above
Cost Items Contained
in the Previous Table
42
Table 6.3 Cost Relationships
MC = min(ATC) and
70
60
MC
A TC
AVC
AFC
min(AVC)
Vertical distance between
ATC and AVC = AFC
50
Cost ($)
40
30
20
AFC
10
0
3.0
4.8
6.5
8.1
9.6
10.8
11.6
Input Use
43
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 ($)
Average Revenue (AR) = Total revenue ÷ total
amount of output produced ($/unit of output) =
TR/Q
Marginal Revenue (MR) = ∆ total revenue ÷ ∆
total amount of output produced = ∆TR ÷ ∆Q
44
 How much revenue is generated by one additional
unit of output?
 Under perfect competition, it is the per unit price
Now let’s assume this
firm can sell its
product for $45/unit
45
Key Revenue Concepts
Remember we are assuming perfect competition
46
 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?
47
Page 98
Let’s see this in
graphical form
48
P rofit M axim ization
70
60
MC
AT C
AVC
MR
Profit maximizing
Output where MR=MC
P=MR=AR
50
$45
40
30
20
10
11.2
0
49
1
3
4 .8
6 .5
8 .1
9 .6
Page
1 0 .8
991 1 .6
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….
50
Profit at Price of $45?
$
MC
P =45
ATC
28
AVC
11.2 Q
51
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
Profit at Price of $45?
$
MC
P =45
$190.40
28
ATC
AVC
11.2 Q
52
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
53
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
54
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
55
Page 99
Profit at Price of $18?
$
MC
45
ATC
28
AVC
P=18
8.6 10.3 11.2
56
Q
Revenue = $18  8.6 = $154.80
Total cost = $28  8.6 = $240.80
Profit = $154.80 – $240.80 = –$86
Since P = MR = AR
Average profit = $18 – $28 = –$10
Profit = –$10  8.6 = –$86 (Loss)
Profit at Price of $10?
$
MC
45
ATC
30
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
57
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
Profit Maximizing Output Levels
$
MC
45
ATC
AVC
28
18
10
7.0 8.6 10.3 11.2
58
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
59
The Firm’s Supply Curve
$
Firm Supply Curve
MC
45
ATC
AVC
28
18
8.6 10.3 11.2
60
Q
Now let’s look at the
demand for a single
input: Labor
61
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 → ∆Revenue ÷ ∆Output
 MVP → ∆Revenue ÷ ∆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
62
D
MVP=MPP x Output Price
Wage rate is
labor’s MIC
C
B
E
F
5
G
H
I
J
63
Page 101
 Profit maximizing input use rule
 Use a variable input up to the
point where
 Value received from another
unit of input (MVP)
 Equals cost of another unit of
input (MIC)
 → MVP=MIC
D
C
B
E
F
G
5
H
I
J
64
Page 101
D
The area below the green lined
MVP curve and above the red
lined MIC curve represents
cumulative net benefit
C
B
E
F
G
5
H
I
J
65
Page 101
MVP = MPP × $45
66
Page 100
67
Profit are maximized where MVP = MIC
or where MVP =$5 and MIC = $5
Page 100
–
68
=
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
69
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
70
For example…
$25.10 = $9.85 + $15.25
$58.35 = $25.10 + $33.25
Page 100
–
Cumulative net benefit is maximized
71 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
72
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
73
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)
74
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
75
Chapter 7 focuses on the choice
of inputs to use and products to
produce….
76