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Perfect competition
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apuntes sobre perfect competition and price and cost
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PRODUCTION AND COST1. There are several different ways to look at production and costs, just like there
are several different ways to look at a student’s learning in a course. Students
can be asked to write an essay or do a class presentation on a topic. These are
two ways of trying to assess the same thing, student learning.
2. There is an inverse relationship between production and costs. The harder it is
to produce something, for example, the more labor it takes, the higher the cost
of producing it, and vice versa.
What is production?
A firm (or business) combines inputs of labor, capital, land, and raw or finished
component materials to produce outputs. If the firm is successful, the outputs are
more valuable than the inputs. This activity of production goes beyond manufacturing
(i.e., making things). It includes any process or service that creates value, including
transportation, distribution, wholesale and retail sales. Production involves a number
of important decisions that define the behavior of firms. These decisions include, but
are not limited to:
What product or products should the firm produce?
How should the products be produced (i.e., what production process should be
used)?
How much output should the firm produce?
What price should the firm charge for its products?
How much labor should the firm employ?
The answers to these questions depend on the production and cost conditions facing
each firm, which is the subject of this module. The answers also depend on the
structure of the market for the product(s) in question. Market structure is a
multidimensional concept that involves how competitive an industry is. It is defined by
questions such as these:
How much market power does each firm in the industry possess?
How similar is each firm’s product to the products of other firms in the
industry?
How difficult is it for new firms to enter the industry?
, Do firms compete on the basis of price, advertising, or other product
differences?
The cost of the product depends on how many inputs (or factors of production) are
required to produce the product and what those inputs cost. We can determine the
costs by looking at the firm’s production function.
Production is the process (or processes) a firm uses to transform inputs (e.g. labor,
capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell.
Economists divide factors of production into several categories:
Natural Resources (Land and Raw Materials) – The ingredients for the pizza are
raw materials. These include the flour, yeast, and water for the dough, the
tomatoes, herbs, and water for the sauce, the cheese, and the toppings. If the
pizza place uses a wood-burning oven, we would include the wood as a raw
material. If the establishment heats the oven with natural gas, we would count
this as a raw material. Don’t forget electricity for lights. If, instead of pizza, we
were looking at an agricultural product, like wheat, we would include the land
the farmer used for crops here.
Labor – When we talk about production, labor means human effort, both
physical and mental. The pizzaiolo was the primary example of labor here. He
or she needs to be strong enough to roll out the dough and to insert and
retrieve the pizza from the oven, but he or she also needs to know how to
make the pizza, how long it cooks in the oven and a myriad of other aspects of
pizza-making. The business may also have one or more people to work the
counter, take orders, and receive payment.
Capital – When economists uses the term capital, they do not mean financial
capital (money); rather, they mean physical capital, the machines, equipment,
and buildings that one uses to produce the product. In the case of pizza, the
capital includes the peel, the oven, the building, and any other necessary
equipment (for example, tables and chairs).
Technology – Technology refers to the process or processes for producing the
product. How does the pizzaiolo combine ingredients to make pizza? How hot
should the oven be? How long should the pizza cook? What is the best oven to
use? Gas or wood burning? Should the restaurant make its own dough, sauce,
cheese, toppings, or should it buy them?
, Entrepreneurship – Production involves many decisions and much knowledge,
even for something as simple as pizza. Who makes those decisions? Ultimately,
it is the entrepreneur, the person who creates the business, whose idea it is to
combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital,
raw materials, and other inputs required and the price of each input to the
entrepreneur.
The production function
A production is purely an engineering concept. If you plug in the amount of labor,
capital and other inputs the firm is using, the production function tells how much
output will be produced by those inputs. Production functions are specific to the
product. Different products have different production functions. Firms in the same
industry may have somewhat different production functions, since each firm may
produce a little differently.
Fixed inputs are those that can’t easily be increased or decreased in a short period of
time. In the pizza example, the building is a fixed input. Once the entrepreneur signs
the lease, he or she is stuck in the building until the lease expires. Fixed inputs define
the firm’s maximum output capacity. This is analogous to the potential real GDP shown
by society’s production possibilities curve, i.e. the maximum quantities of outputs a
society can produce at a given time with its available resources. Fixed inputs do not
change as output changes.
Variable inputs are those that can easily be increased or decreased in a short period of
time. The pizzaiolo can order more ingredients with a phone call, so ingredients would
be variable inputs. The owner could hire a new person to work the counter pretty
quickly as well. Variable inputs increase or decrease as output changes.
Economists also differentiate between short and long run production. The short run is
the period of time during which at least some factors of production are fixed. During
the period of the pizza restaurant lease, the pizza restaurant is operating in the short
run, because it is limited to using the current building—the owner can’t choose a
larger or smaller building. The long run is the period of time during which all factors
are variable. Once the lease expires for the pizza restaurant, the shop owner can move
to a larger or smaller place.
Note that there is another important distinction between fixed and variable inputs. In
the short run, since the firm’s fixed inputs are fixed, the only way to vary a firm’s
output is by changing its variable inputs. Let’s explore production in the short run using
a specific example: tree cutting (for lumber) with a two-person crosscut saw.
Since by definition capital is fixed in the short run, our production function becomes:
Q= f [ L,K ] or Q= f [L]
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