Chapter 6
Introduction to
Production and
Resource Use
Topics of Discussion
• Conditions of perfect competition
• Classification of inputs
• Important production relationships
(assume one variable input in this
chapter)
• Assessing short-run business costs
• Economics of short-run decisions
Conditions for Perfect
Competition
Homogeneous products
No barriers to entry or exit
Large number of sellers
Perfect information
Page 86
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
Management: production decisions
designed to achieve specific economic
goal
Pages 86-87
Production Function
Output = f(labor | capital, land,
and management)
Start with
one
variable
input
Page 88
Production Function
Output = f(labor | capital, land,
and management)
Start with
one
variable
input
assume all other
inputs
fixed at their current
levels…
Page 112
Coordinates of input and
output on the TPP curve
Page 89
Total Physical Product (TPP) Curve
Variable input
Page 89
Law of Diminishing
Marginal Returns
“As successive units of a variable
input are added to a production
process with the other inputs held
constant, the marginal physical
product (MPP) eventually declines”
Page 93
Other Physical
Relationships
The following derivations of the TPP curve play
An important role in decision-making:
Marginal
Physical =  Output ÷  Input
Product
Pages 90
Other Physical
Relationships
The following derivations of the TPP curve play
An important role in decision-making:
Marginal
Physical =  Output ÷  Input
Product
Average
Physical
Product
= Output ÷ Input
Pages 90-91
Change in output as
you increase inputs
Page 89
Total Physical Product (TPP) Curve
Marginal physical product
is .45 as labor is
increased from 16 to 20
output
input
Page 89
Output per unit
input use
Page 89
Total Physical Product (TPP) Curve
Average physical
product is .31 if
labor use is 26
output
input
Page 89
Plotting the MPP curve
Change in output
associated with a
change in inputs
Page 91
Marginal Physical Product
Change from
point A to point
B on the
production
function is an
MPP of 0.33
Page 91
Plotting the APP Curve
Level of output
divided by the level
of input use
Page 91
Average Physical Product
Output divided
by labor use is
equal to 0.19
Page 91
Three Stages of Production
Average physical
product (yield) is
increasing in Stage I
Page 91
Three Stages of Production
Marginal physical
product falls below the
average physical
product in Stage II
Page 91
Three Stages of Production
MPP goes negative
in stage III…
Page 91
Three Stages of Production
Why are Stage I and
Stage III irrational?
Page 91
Three Stages of Production
Page 91
Productivity rising
so why stop???
Output
falling
Three Stages of Production
Page 114
The question therefore is
where should I operate in Stage II?
Economic Dimensions

We need to account for the
price of the product

We also need to account
for the cost of the inputs
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Page 117-120
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Average
variable = total variable cost ÷ output
cost
Page 117-120
Key Cost Relationships
The following cost derivations play a key
role in decision-making:
Marginal cost =  total cost ÷  output
Average
variable = total variable cost ÷ output
cost
Average
fixed = total fixed cost ÷ output
cost
Average
total = total cost ÷ output = AVC+AFC
cost
Pages 94-96
From TPP
curve on
page 113
Page 94
Fixed costs are
$100 no matter
the level of
production
Page 94
Column (2)
divided by
column (1)
Page 94
Costs that vary
with level of
production
Page 94
Column (4)
divided by
column (1)
Page 94
Column (2)
plus
column (4)
Page 94
Change in column (6)
associated with a
change in column (1)
Page 94
Column (6) divided
by column (1) or
Page 94
or column (3) plus
column (5)
Page 94
Let’s graph the
cost series in this
table
Plotted cost relationships
from table 6.3 on page 94
Plotting costs for levels of output
Page 95
Now let’s assume
this firm can sell
its product for
$45/unit
Key Revenue Concepts
Notice the price in column (2) is identical to marginal revenue in
column (7). What about average revenue, or AR? What do you
see if you divide total revenue in column (3) by output in column
(1)? Yes, $45. Thus, P = MR = AR under perfect competition.
Page 98
Let’s see this in
graphical form
$45
P=MR=AR
Profit maximizing
level of output,
where MR=MC
11.2
Page 99
Average
Profit = $17,
or AR – ATC
P=MR=AR
$45-$28
$28
Page 99
Grey area represents
total economic profit
if the price is $45…
P=MR=AR
11.2  ($45 - $28) = $190.40
Page 99
P=MR=AR
Zero economic profit
if price falls to PBE.
Firm would only produce
output OBE . AR-ATC=0
Page 99
P=MR=AR
Economic losses
if price falls to PSD.
Firm would shut down
below output OSD
Page 99
Where is the firm’s
supply curve?
P=MR=AR
Page 99
Marginal cost curve
above AVC curve?
P=MR=AR
Page 99
Key Revenue Concepts
The previous graph indicated that profit is maximized at 11.2
units of output, where MR ($45) equals MC ($45). This occurs
between lines G and H on the table above, where at 11.2 units
of output profit would be $190.40. Let’s do the math….
Page 98
Doing the math….
Produce 11.2 units of output (OMAX on p. 123)
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Doing the math….
Produce 11.2 units of output
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Average total cost at 11.2 units of output = $28
Total costs = 11.2 × $28 = $313.60
Profit = $504.00 – $313.60 = $190.40
Doing the math….
Produce 11.2 units of output
Price of product = $45.00
Total revenue = 11.2 × $45 = $504.00
Average total cost at 11.2 units of output = $28
Total costs = 11.2 × $28 = $313.60
Profit = $504.00 – $313.60 = $190.40
Average profit = AR – ATC = $45 – $28 = $17
Profit = $17 × 11.2 = $190.40
Profit at Price of $45?
$
MC
P =45
ATC
28
AVC
11.2
Q
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?
$
Revenue = $45  11.2 =
$504.00
MC
Total cost = $28  11.2 =
$313.60
ATC Profit = $504.00 – $313.60 =
$190.40
P =45
$190.40
28
AVC
Since P = MR = AR
Average profit = $45 – $28 =
$17
Profit = $17  11.2 = $190.40
11.2
Q
Price falls to $28.00….
Produce 10.3 units of output (OBE on p. 123)
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Price falls to $28.00….
Produce 10.3 units of output
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Average total cost at 10.3 units of output = $28
Total costs = 10.3 × $28 = $288.40
Profit = $288.40 – $288.40 = $0.00
Price falls to $28.00….
Produce 10.3 units of output
Price of product = $28.00
Total revenue = 10.3 × $28 = $288.40
Average total cost at 10.3 units of output = $28
Total costs = 10.3 × $28 = $288.40
Profit = $288.40 – $288.40 = $0.00
Average profit = AR – ATC = $28 – $28 = $0
Profit = $0 × 10.3 = $0.00
Profit at Price of $28?
$
Revenue = $28  10.3 =
$288.40
Total cost = $28  10.3 =
$288.40
ATC Profit = $288.40 – $288.40 =
$0
AVC
MC
45
P=28
10.3 11.2
Q
Since P = MR = AR
Average profit = $28 – $28 =
$0
Profit = $0  10.3 = $0 (break
even)
Price falls to $18.00….
Produce 8.6 units of output (OSD on p. 123)
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Price falls to $18.00….
Produce 8.6 units of output
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Average total cost at 8.6 units of output = $28
Total costs = 8.6 × $28 = $240.80
Profit = $154.80 – $240.80 = – $86.00
Price falls to $18.00….
Produce 8.6 units of output
Price of product = $18.00
Total revenue = 8.6 × $18 = $154.80
Average total cost at 8.6 units of output = $28
Total costs = 8.6 × $28 = $240.80
Profit = $154.80 – $240.80 = – $86.00
Average profit = AR – ATC = $18 – $28 = – $10
Profit = – $10 × 8.6 = – $86.00
Profit at Price of $18?
$
MC
45
Revenue = $18  8.6 = $154.80
Total cost = $28  8.6 = $240.80
Profit = $154.80 – $240.80 = -$86
ATC
AVC Since P = MR = AR
28
Average profit = $18 – $28 = –$10
Profit = –$10  8.6 = –$86 (Loss)
P=18
8.6 10.3 11.2
Q
Price falls to $10.00….
Produce 7.0 units of output (below OSD on p. 123)
Price of product = $10.00
Total revenue = 7.0 × $10 = $70.00
Price falls to $10.00….
Produce 7.0 units of output
Price of product = $10.00
Total revenue = 7.0 × $10 = $70.00
Average total cost at 7.0 units of output = $30
Total costs = 7.0 × $30 = $210.00
Profit = $70.00 – $210.00 = – $140.00
Average variable costs = $19
Total variable costs = $19 × 7.0 = $133.00
Revenue – variable costs = –$63.00 !!!!!
(not covering variable costs)
Profit at Price of $10?
$
MC
45
ATC
28
AVC
18
P=10
7.0 8.6 10.3 11.2
Q
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
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
28
AVC
18
P=10
7.0 8.6 10.3 11.2
Q
Now let’s look at
the demand for a
single input: Labor
Key Input Relationships
The following input-related derivations also
play a key role in decision-making:
Marginal
value
= marginal physical product × price
product
Page 100
Key Input Relationships
The following input-related derivations also
play a key role in decision-making:
Marginal
value
= marginal physical product × price
product (MVP)
Marginal
input = wage rate, rental rate, etc.
cost (MIC)
Page 100
D
Wage rate represents
the MIC for labor
C
B
E
F
G
5
H
I
J
Page 101
Use a variable input like
labor up to the point
where the value received
from the market equals the
cost of another unit of
input, or MVP=MIC
D
C
B
E
F
G
5
H
I
J
Page 101
D
The area below the
green lined MVP
curve and above the
red lined MIC
curve represents
cumulative net
benefit.
C
E
B
F
G
5
H
I
J
Page 101
MVP = MPP × $45
Page 100
Profit maximized where MVP = MIC
or where MVP =$5 and MIC = $5
Page 100
–
=
Marginal net benefit in column (5)
is equal to MVP in column (3) minus
MIC of labor in column (4)
Page 100
The cumulative net benefit in
column (6) is equal to the sum
of successive marginal net benefit
in column (5)
Page 100
For example…
$25.10 = $9.85 + $15.25
$58.35 = $25.10 + $33.25
Page 100
–
=
Cumulative net benefit
is maximized where
MVP=MIC at $5
Page 100
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.
D
C
B
E
F
G
5
H
I
J
Page 101
D
If you went
beyond the point
where MVP=MIC,
you begin
incurring losses.
C
B
E
F
G
5
H
I
J
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)
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