Production function lesson 4

BASIC ELEMENTS of Capital

• Capital goods, such as machines and tools, are used in the production of other goods. Companies acquire capital to begin or expand production or to become more productive. The term capital stock denotes all that is needed to produce goods. Labor skills are referred to as human capital.

Explicit & Implicit Costs

• A Firm’s costs of Production include the Explicit & Implicit costs.

1. Explicit Cost. Involves a direct money outlay for factors of production.

2. Implicit Cost. Do not involve a direct money outlay.

• Explicit Costs are monetary payments a firm makes to an outsider to obtain a resource. “out of pocket expenses.”

• Implicit costs are the monetary income a firm sacrifices when it uses resources it owns rather than supplying the resources on the open market. “alternative uses”

Normal profits are an implicit cost.

• Cost of Production = Explicit + Implicit Costs

• Economic Profit as differed from Accounting Profit

1. Accounting Profit = Total Revenue - Explicit Costs

2. Economic profit = total revenue - all costs

• When total revenue is greater than all costs, the entrepreneur has an economic, or pure, profit.

Short Run vs. Long Run

• Short Run – fixed plant - too brief to change plant

capacity – input of certain resources (labor, materials)

may be changed in order to alter output – ex. – UST hires 100 extra workers to work

at the newly constructed parking area.• Long Run

– variable plant - plant capacity may be changed

– firms may enter or exit the market – ex. UST puts up a branch in Sri Lanka

Law of Diminishing Returns

• Reflected in “short run” production. • As successive increments of a variable

resource are added to a fixed resource, the marginal product (MP) of the variable resource will eventually decrease.

• Assumption - units of variable resource are of equal quality

Example - Factory overcrowding

Short Run Production Relationships

• Total Product (TP) = total output of a particular good or service produced by a firm

• Marginal Product (MP) = the additional output produced when an additional unit of a resource is employed

• Average Product (AP) = the total output produced per unit of a resource employed

Total Product

• Total Product declines at the point where additional units of labor ( a variable resource) become inefficient in their use of a fixed resource.

• Total Product declines when marginal product becomes negative.

“With Great Power Comes Great Responsibilities”