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Production Theory And Theory Of Costs Essay Sample

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Production Theory And Theory Of Costs Essay Sample

Production and Production Theory
Production refers to the transformation of inputs into outputs (or products) An input is a resource that a firm uses in its production process for the purpose of creating a good or service.

Most resources are lumped into three categories:
– Land
– Labor
– Capital

The two kinds of inputs: Fixed vs. Variable Inputs
Fixed inputs -resources used at a constant amount in the production of a commodity. Variable inputs – resources that can change in quantity depending on the level of output being produced. The longer planning the period, the distinction between fixed and variable inputs disappears, i.e., all inputs are variable in the long run.

The Production Function and the Law of Diminishing Marginal Returns The production function refers to the physical relationship between the inputs or resources of a firm and their output of goods and services at a given period of time, ceteris paribus. The production function is dependent on different time frames. Firms can produce for a brief or lengthy period of time. Law of Diminishing Marginal Returns

All other things remaining constant, if only one input is increased a point will be reached where each additional input produces less output than the previous input. Law of Diminishing Returns: After a certain point, when additional units of a variable input are added to a fixed input, the marginal product of each additional variable input is less than the previous input. Diminishing returns always apply in the short run, and in the short run every firm will face diminishing returns. This means that every firm finds it progressively more difficult to increase its output as it approaches capacity production.

Production Analysis with One Variable Input
Total product (Q) refers to the total amount of output produced in physical units (may refer to, kilograms of sugar, sacks of rice produced, etc) The marginal product (MP) refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant.

Total vs. Marginal Product
Total Product (TPx) = total amount of output produced at different levels of inputs Marginal Product (MPx) = rate of change in output as input X is increased by one unit, ceteris paribus.

Marginal Product
The marginal product refers to the rate of change in output as an input is changed by one unit, holding all other inputs constant. Formula:

Marginal Product
Law of diminishing returns states that “as the use of an input increases (with other inputs fixed), a point will eventually be reached at which the resulting additions to output decrease”

Law of Diminishing Marginal Returns
As more and more of an input is added (given a fixed amount of other inputs), total output may increase; however, as the additions to total output will tend to diminish. Counter-intuitive proof: if the law of diminishing returns does not hold, the world’s supply of food can be produced in a hectare of land. Average Product (AP)

Average product is a concept commonly associated with efficiency. The average product measures the total output per unit of input used. The “productivity” of an input is usually expressed in terms of its average product. The greater the value of average product, the higher the efficiency in physical terms. Formula:

Relationship between Average and Marginal Curves: Rule of Thumb

When the marginal is less than the average, the average decreases. When the marginal is equal to the average, the average does not change (it is either at maximum or minimum) When the marginal is greater than the average, the average increases Long Run and Short Run Adjustments

Long run
In the long run, firms change production levels in response to (expected) economic profits or losses, and the land, labor, capital goods and entrepreneurship vary to reach associated long-run average cost. In the simplified case of plant capacity as the only fixed factor, a generic firm can make these changes in the long run: enter an industry in response to (expected) profits

leave an industry in response to losses
increase its plant in response to profits
decrease its plant in response to losses.

Long-run average-cost curve with economies of scale to Q2 and diseconomies of scale thereafter.

The long run is associated with the long-run average cost (LRAC) curve in microeconomic models along which a firm would minimize its average cost (cost per unit) for each respective long-run quantity of output. Long-run marginal cost (LRMC) is the added cost of providing an additional unit of service or commodity from changing capacity level to reach the lowest cost associated with that extra output. LRMC equalling price is efficient as to resource allocation in the long run. The concept of long-run cost is also used in determining whether the long-run expected to induce the firm to remain in the industry or shut down production there. In long-run equilibrium of an industry in which perfect competition prevails, the LRMC = Long run average LRAC at the minimum LRAC and associated output. The shape of the long-run marginal and average costs curves is determined by economies of scale.

The long run is a planning and implementation stage.[2][3] Here a firm may decide that it needs to produce on a larger scale by building a new plant or adding a production line. The firm may decide that new technology should be incorporated into its production process. The firm thus considers all its long-run production options and selects the optimal combination of inputs and technology for its long-run purposes. The optimal combination of inputs is the least-cost combination of inputs for desired level of output when all inputs are variable. Once the decisions are made and implemented and production begins, the firm is operating in the short run with fixed and variable inputs. Short run

All production in real time occurs in the short run. The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount. Costs that are fixed, say from existing plant size, have no impact on a firm’s short-run decisions, since only variable costs and revenues affect short-run profits. Such fixed costs raise the associated short-run average cost of an output leveong-run average cost if the amount of the fixed factor is better suited for a different output level. In the short run, a firm can raise output by increasing the amount of the variable factor(s), say labor through overtime. A generic firm already producing in an industry can make three changes in the short run as a response to reach a posited equilibrium: increase production

decrease production
shut down.
In the short run, a profit-maximizing firm will:
increase production if marginal cost is less than marginal revenue (added revenue per additional unit of output; decrease production if marginal cost is greater than marginal revenue; continue producing if average variable cost is less than price per unit, even if average total cost is greater than price; shut down if average variable cost is greater than price at each level of output.

The Analysis of Isocosts and Isoquants
A firm’s production function specifies the relationship between resource use and output, given pre- vailing technology. An isoquant is a curve that illustrates the possible combinations of resources that will produce a particular level of output. An isocost line presents the combinations of resources the firm can employ, given resource prices and the amount of money the firm plans to spend. For a given level of output – that is, for a given isoquant – the firm minimises its total cost by choosing the lowest isocost line that just touches, or is tangential to, the isoquant. The least- cost combination of resources will depend on the productivity of resources and the relative cost of resources. Cost Analysis

Cost analysis (also called economic evaluation, cost allocation, efficiency assessment, cost-benefit analysis, or cost-effectiveness analysis by different authors) is currently a somewhat controversial set of methods in program evaluation. One reason for the controversy is that these terms cover a wide range of methods, but are often used interchangeably. At the most basic level, cost allocation is simply part of good program budgeting and accounting practices, which allow managers to determine the true cost of providing a given unit of service. At the most ambitious level, well-publicized cost-benefit studies of early intervention programs have claimed to show substantial long-term social gains for participants and cost savings for the public. Because these studies have been widely cited and credited with convincing legislators to increase their support for early childhood programs, some practitioners advocate making more use of cost-benefit analysis in evaluating social programs Others have cautioned that good cost-benefit or cost-effectiveness studies are complex, require very sophisticated technical skills and training in methodology and in principles of economics, and should not be undertaken lightly. Whatever position you take in this controversy, it is a good idea for program evaluators to have some understanding of the concepts involved, because the cost and effort involved in producing change is a concern in most impact evaluations. THREE TYPES OF COST ANALYSIS IN EVALUATION:

Cost allocation, cost-effectiveness analysis, and cost-benefit analysis represent a continuum of types of cost analysis which can have a place in program evaluation. They range from fairly simple program-level methods to highly technical and specialized methods. However, all have specialized and technical aspects. If you are not already familiar with these methods and the language used, you should plan to work with a consultant or read some more in-depth texts (see some suggested references at the end of this discussion) before deciding to attempt them. COST ALLOCATION: Cost allocation is a simpler concept than either cost-benefit analysis or cost-effectiveness analysis. At the program or agency level, it basically means setting up budgeting and accounting systems in a way that allows program managers to determine a unit cost or cost per unit of service. This information is primarily a management tool.

However, if the units measured are also outcomes of interest to evaluators, cost allocation provides some of the basic information needed to conduct more ambitious cost analyses such as cost-benefit analysis or cost-effectiveness analysis. For example, for evaluation purposes, you might want to know the average cost per child of providing an after-school tutoring program, including the costs of staff salaries, snacks, and other overhead costs. Besides budget information, being able to determine unit costs means that you need to be collecting the right kind of information about clients and outcomes. In many agencies, the information recorded in service records is based on reporting requirements, which are not always in a form that is useful for evaluation. If staff in a prenatal clinic simply report the number of clients served by gender, for example, you might know only that 157 females were served in March. For an evaluation, however, you might want to be able to break down that number in different ways. For example, do young first-time mothers usually require more visits than older women? Do single mothers or women with several children miss more appointments?

Is transportation to appointments more of a problem for women who live in rural areas? Are any client characteristics commonly related to important outcomes such as birth weight of the the baby? Deciding how to collect enough client and service data to give useful information, without overburdening staff with unnecessary paperwork requirements, requires a lot of planning. Larger agencies often hire experts to design data systems, which are called MIS or management-and-information-systems. If you are working for an existing agency, your ability to separate out unit costs for services or outcomes may depend on the systems that are already in place for budgeting, accounting, and collecting service data. However, if you are in a position to influence these functions, or need to supplement an existing system, there are a number of texts that discuss the pros and cons of different ways of budgeting, accounting, and designing MIS or management-and-information-systems. COST-EFFECTIVENESS AND COST-BENEFIT STUDIES

Most often, cost-effectiveness and cost-benefit studies are conducted at a level that involves more than just a local program (such as an individual State Strengthening project). Sometimes they also involve following up over a long period of time, to look at the long-term impact of interventions. They are often used by policy analysts and legislators to make broad policy decisions, so they might look at a large federal program, or compare several smaller pilot programs that take different approaches to solving the same social problem. People often use the terms interchangeably, but there are important differences between them. COST-EFFECTIVENESS ANALYSIS: Cost-effectiveness analysis assumes that a certain benefit or outcome is desired, and that there are several alternative ways to achieve it. The basic question asked is, “Which of these alternatives is the cheapest or most efficient way to get this benefit?” By definition, cost-effectiveness analysis is comparative, while cost-benefit analysis usually considers only one program at a time.

Another important difference is that while cost-benefit analysis always compares the monetary costs and benefits of a program, cost-effectiveness studies often compare programs on the basis of some other common scale for measuring outcomes (eg., number of students who graduate from high school, infant mortality rate, test scores that meet a certain level, reports of child abuse). They address whether the unit cost is greater for one program or approach than another, which is often much easier to do, and more informative, than assigning a dollar value to the outcome.

COST-BENEFIT ANALYSIS: One important tool of cost-benefit analysis is the benefit-to-costs ratio, which is the total monetary cost of the benefits or outcomes divided by the total monetary costs of obtaining them. Another tool for comparison in cost-benefit analysis is the net rate of return, which is basically total costs minus the total value of benefits. The idea behind cost-benefit analysis is simple: if all inputs and outcomes of a proposed alternative can be reduced to a common unit of impact (namely dollars), they can be aggregated and compared. If people would be willing to pay dollars to have something, presumably it is a benefit; if they would pay to avoid it, it is a cost. In practice, however, assigning monetary values to inputs and outcomes in social programs is rarely so simple, and it is not always appropriate to do so. Revenue and Profit

Revenue is the money the company receives for selling their product or service. It is calculated by taking the selling price and multiplying it by the number of units sold. Profit is the amount of money left over after costs have been covered. It is therefore calculated by: total revenue minus total costs. Profit can be used as a measure of the businesses success, attracting investors and reinvesting back into the business. The quality of profit can also be measured. Low quality profit is gaining money from an event which is unlikely to occur again in the future but high quality profit is from normal trading activities which should continue to occur in the future. It is important when told a company’s profit, that it is clear what type of profit it is (gross, operating, pre-tax or after tax).

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