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Cost of Production

Cost of Production - Costs of Production Supplementary...

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Costs of Production Supplementary Notes to Chapter 13 In chapter 21 we explored the maximizing behavior of the consumer which we used to derive the demand curve. Consumers’ behavior is directed by their desire to maximize satisfaction. From the consumer behavior we derived the demand curve. In this chapter we will turn our attention to the behavior of firms. Firms are institutions that produce and supply the goods and services that individuals demand. We will examine the firms’ behavior for which we use to derive the supply curve. Producers’ behavior is directed by their desire to maximize profit , which is revenue minus cost . First we will discuss production. Production is the process of turning inputs to outputs. The physical relationship between input and output can be simply summarized by what is called production function . Second the concept of production function is then used to discuss costs of production. Firms seek to produce their output at the lowest possible cost. Cost varies over time and therefore we will consider what is called short-run and long-run cost. We then investigate the firm’s supply decision; that is, we examine the factors that determine how much output a firm will produce. This will be done in later chapter. In doing so, we assume that the firms produce to achieve the maximum profit possible. 1. Production In the process of production, firms turn inputs , such labor of workers and machines, into outputs (or products). We will divide inputs into two broad categories, labor L (services provided by workers) and capital K (machines and equipments). The relationship between the inputs and output can be described by a production function . A production function indicates the amount of output Q that firms can produce for every specified combinations of L and K . We can write the production function as Q = F(K,L) This equation relates the quantity of output to the quantities of the two inputs, capital and labor. For example, the production function may describe the crop that a farmer can produce with a specific amount of workers and machinery. It describes the maximum output that can be produced given that inputs are used technically efficient manner. It is important to distinguish between the short and long run when analyzing production. The short run refers to a period of time in which one or more factors of production cannot be changed. Factors that cannot be varied over this period are called fixed inputs . The long run is the amount of time needed to make all inputs variable.
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Production with One Variable (Short Run) Let us consider a case where the firm, when it increases or decreases production, it can do so only by varying labor. In other words, let us say that capital is fixed in short run.
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