A. The most efficient production method
Companies, before starting to manufacture their products or provide their services, must define how they are going to do it, that is, determine the how, one of the 3 fundamental problems to solve in economics -the others are what and what for. who-.
In this way, they have to evaluate between alternative production methods and choose one, the most efficient.
We can divide the problem of choosing the most efficient method into 2 parts:
Technical efficiency: a production method is technically efficient when it minimizes all the requirements of production factors compared to alternative methods, for the same level of production. That is, if, for example, the Zanella motorcycle factory uses several alternative techniques to manufacture the same model, it will choose the one that uses the least amount of man hours, machine hours and inputs.
Economic efficiency: a production method is economically efficient when it minimizes production costs compared to alternative methods, for the same level of production. That is, if the Zanella motorcycle factory has several alternative techniques for making the same model, it will choose the one that has the lowest cost per unit.
The entrepreneur will first analyze technical efficiency: if he finds a method that minimizes all factor requirements, the problem will be solved, since if it is technically efficient it will also be economically efficient. Why? Because in the face of lower man-hour, machine-hour and input requirements than alternative methods, for unit costs per factor equal to all methods, I obtain the lowest cost. But it turns out that sometimes the analysis of technical efficiency is not enough, it may happen that there is no method that minimizes all the factor requirements at the same time -in some of it is exceeded by an alternative method-, then it is necessary to calculate the cost total of all methods and choose the least cost, that is, we must explicitly make the economic efficiency analysis.
Finally, the entrepreneur will always end up choosing, among all the alternatives to manufacture the same product, the method that minimizes the cost per unit, that is, the most economically efficient. As the prices of the factors change: wages, inputs, etc., the most efficient method may vary, but the selection process is always the same.
B. Production structure
Once the most efficient method has been chosen, the entrepreneur is now in a position to project his possible production structure. In this way you will be able to determine, from the requirements of variable and fixed factors -see definition below-, the resulting total production levels and 2 new variables: the average product and the marginal product, also for each production level. -see table 2 in class notes-
Average product: it is the average of units produced by each worker -of the production section of the company-; It is calculated by dividing total production by number of workers.
Marginal product: it is the increase in product units that the company obtains when it adds an additional worker in the production section; it can be increasing, constant or decreasing, although always positive; if it were negative, it would not be rational from the economic point of view, the additional worker, in addition to not producing anything, would cause those already employed to produce less.
Two related important concepts are:
Fixed production factors: these are those that remain constant or relatively constant as more units are produced, it is generally the case of industrial manufacturing machines or administrative employees, which must be purchased / hired whether the company produces a lot or little. From here come the fixed costs -maintenance cost of the machines, salary costs in administrative employees, respectively-.
Variable production factors: they are those that vary as more units are produced, in the case of raw materials or the number of workers in the production area; Without hiring more workers or buying more raw materials, production cannot be increased. From here come the variable costs - raw material costs, salary costs in the production area, respectively.
In Table 2 of the class notes we observe how as the amount of the only supposed variable factor -workers production section- increases, given a certain previous endowment of fixed factors -machines, etc.-, total production grows and also can be calculating the average and marginal products by level of production.
C. Cost structure
Once the production structure has been determined, that is, the relationship between the production factors used and the quantities produced, we are one step away from obtaining the company's total production costs. The quantity used of each one of the variable factors of production is multiplied by its unit price and the total variable cost is obtained; the same procedure is done with the fixed production factors, the total fixed cost is obtained, and from the sum of both we have the total cost for all the units manufactured -see table 3 in class notes- Later, if I want to know how much I it cost to manufacture each unit on average, the total average cost, I divide the total cost by the number of units for which I want to know the average cost; this may vary as production increases.I can also find out the cost I must incur to make an additional product, the marginal cost, which is the increase in total cost when I produce an additional unit.
In table 3 of the class notes we see how, multiplying the number of workers for each level of production by the unit salary, we obtain the variable cost for each quantity of motorcycles produced, which added to the fixed cost of $ 15,000 in force for all levels of production, gives us the total cost of the motorcycles produced. Subsequently, we can also obtain the costs per average unit - total average cost - and per additional unit - marginal cost.
Other useful cost variables for business decision making are:
Variable average cost: equal to variable cost divided by the number of products; it indicates the average variable cost per unit.
Fixed average cost: equal to the fixed cost divided by the number of products; it indicates the average fixed cost per unit.
EXTENDING THE USE OF MARGINAL PRINCIPLES BEYOND THE COMPANY
Once the concepts of costs and marginal products in the company have been explained, both concepts can easily be extended to decisions that go beyond the business environment, such as those that humans make in our daily affairs.
People are constantly trying to make the best use of our scarce resources: especially time and our salary income. For most of the decisions that we must make, we are always comparing the additional -marginal- cost that it will imply and the product or additional income or benefit -marginal- that it will provide us, in this way we use both concepts -without giving ourselves account- permanently.
For example, when we must decide how to distribute the scarce 48 hours of our weekend between studying for an exam and having fun or playing sports, each additional hour we dedicate to study has a marginal cost and an associated marginal product: the marginal cost is the satisfaction that I lose by not playing sports or going to bed early on Saturday night instead of going out to dance at a bowling alley, the marginal product will be what the person values that the additional hours of study give them; In this way, the decision to study these additional hours will be made only if the person considers that the marginal product or benefit is greater than the marginal cost of doing so.
