1. How can you formulate the Law of Variable Proportions?
2. In what way is the output of final product affected by adding more units of production?
3. How does total cost of production differ from marginal cost?
4. Where is marginal analysis used?

Production and Costs

Garry Clayton

Whether they are film producers of multimillion-dollar epics or small firms that market a single product, suppliers face a difficult task.

Producing an economic good or service requires a combination of land, labour, ёрЁ│- tal, and entrepreneurs. The theory of production deals with the relationship between the factors of production and the output of goods and services.

The theory of production is generally based on the short run, a period of production that allows producers to change only the amount of the variable input called labour. This contrasts with the long run, a period of production long enough for producers to adjust the quantities of all their resources, including capital.

The Law of Variable Proportions state that, in the short run, output will change as one input is varied while the others are held constant.

The Law of Variable Proportions deals with the relationship between the input of productive resources and the output of productive resources and the output of final products. The law helps answer the question: How is the output of the final product affected as more units of one variable input or resource are added to fixed amount of other resources? Of course, it is possible to vary all the inputs at the same time. Economists do not like to do this, however, because when more than one factor of production is varied, it becomes harder to gauge the impact of a single variable on total output.

When it comes to determining the optimal number of variable units to be used in production, changes in marginal product are of special interest. There are three stages of production Ч increasing returns, diminishing returns, and negative returns Ч that are based 011 the way marginal product changes as the variable input of labour is changed.

In stage one, the first workers hired cannot work efficiently because there are too many resources per worker. As the number of workers increases, they make better use of their machinery and resources. This results in increasing returns (or increasing marginal products) for the first five workers hired. As long as each new worker hired contributes more to total output than the worker before, total output rises at an increasingly faster rate. This stage is known as the stage of increasing returns.

In stage two, the total production keeps growing, by smaller and smaller amount. This stage illustrates the principle of diminishing returns, the stage where output increases at a diminishing rate as more units of variable input are added.

The third stage of production begins when the eleventh worker is added. By this time, the firm has hired too many workers, and they are starting to get in each otherТs way. Marginal product becomes negative and total plant output decreases.

Measures of Costs

Because the cost of inputs influences efficient production decision, a business must analyze costs before making its decision. To simplify decision making, cost is divided into several different categories.

The first category is fixed cost Ч the cost that a business incurs even if the plant is idle and output is zero. Total fixed cost, or overhead, remains the same whether a business produces nothing, very little, or a large amount. Fixed costs include salaries paid to executives, interest charges on bonds, rent payments on leased properties, and local and state property taxes. Fixed costs also include deprecation, the gradual wear and tear on capital goods over time and through use.

Another kind of cost is variable cost, a cost that changes when the business rate of operation or output changes. Variable costs generally are associated with labour and raw materials.

The total cost of production is the sum of the fixed and variable costs.

Another category of cost is marginal cost Ч the extra cost incurred when a business produces one additional unit of a product. Because fixed costs do not change from one level of production to another, marginal cost is the per-unit increase in variable costs that stems from using additional factors of production.

The cost and combination, or mix, of inputs affects the way businesses produce. The following examples illustrate the importance of costs to business firms.

Consider the case of a self-serve gas station with many pumps and a single attendant who works in an enclosed booth. This operation is likely to have large fixed costs, such as the cost of the lot, the pumps and tanks, and the taxes and licensing fees paid to state and local governments.

The variable costs, on the other hand, are relatively small.

As a result, the owner may operate the station 24 hours a day, seven days a week for a relatively low cost. As a result, the extra wages, the electricity, and other costs are minor and may be covered by the profits of the extra sales.

Measures of Revenue

Businesses use two key measures of revenue to find the amount of output that will produce the greatest profits. The first is total revenue, and the second is marginal revenue.

The total revenue is the number of units sold multiplied by the average price per unit.

The marginal revenue is determined by dividing the change in total revenue by the marginal product.

Keep in mind that whenever an additional worker is added, the marginal revenue computation remains the same. If a business employs, for example, five workers, it produces 90 units of output and generates \$ 1,350 of total revenue.

If a sixth worker is added, output increases by 20 units, and total revenues increase to \$ 1,600. To have increased total revenue by \$ 300, each of the 20 additional units of output must: have added \$ 15.

If each unit of output sells for \$ 15, the marginal or extra revenue earned by the sale of one more unit is \$ 15 for every level of output.

Marginal revenue can remain constant but businesses often find that marginal revenues start high and then decrease as more units are produced and sold.

Marginal Analysis

Economists use marginal analysis, a type of cost-benefit decision making that compares the extra benefits to the extra costs of an action. Marginal analysis is helpful in a number of situations, including break-even analysis and profit maximization. In each case the costs and benefits of decisions that are made in small, incremental steps.

The break-even point is the total output or total product the business needs to sell in order to cover its total costs. A business wants to do more than break even, however. It wants to make as much profits as it can. But, how many workers and what level of output are needed to generate the maximum profits?

The owner of the business can decide by comparing marginal costs and marginal revenues. In general, as long as the marginal cost is less than the marginal revenue, the business will keep hiring workers.

When marginal cost is less than marginal revenue, more variable inputs should be hired to expand output.

The profit-maximizing quantity of output is reached when marginal cost and marginal revenue are equal.

1. 2. Decide whether these statements are True (T) or False (F).

L The theory of production deals with a period of production that allows producers to change the amount of labour used.

1. The law helps answer the question: How is the output of final product affected as more units of one variable input or resource are added to fixed amount of other resources?
2. In stage one of production the more workers are hired the less are the returns.
3. When an additional worker is added, the marginal revenue computation changes according to the stage of production.
4. When marginal cost is less than marginal revenue, more variable inputs should be hired to expand output.