CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Chapter 3
Production-Revenue and Cost

3.1 Production and Efficiency

Production is a process through which resources and/or other products are
transformed into different products either for final use or use in another
production process. Production also includes services, such as transportation.

Production Function – given the current state of technology, the production

function is a physical relationship between a firm’s inputs and its output, for
example:
( ) (1)

Production possibility is the maximum output from given inputs with a given
level of technology.

Technological efficiency – given the current state of technology,

technological efficiency is the production process that requires the least
amount of inputs in order to produce a particular level of output.

Economic efficiency – the goal here is the least-cost production. For a

specific rate of output, economic efficiency is the production process that
utilized the lowest per unit cost, for that rate of output. In a competitive
market, firms that continue to exist mst be economically efficient. Economic
efficiency is closely tied to technological efficiency.

Efficient production does not assume that perfect knowledge exists, but that
whatever knowledge does exist is being used.

Productivity – the amount of output that is produced by one unit of input. It

is measured by units of output per unit of input.
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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Determinants of Productivity Growth

Economies of Scale – cases in which the percentage increase in output

is greater than the precentage increase of inputs used to produce that
output.
Factor Substitution – substitution of a less productive input for a more
productive input.
Technological Change – technological change in one industry generally
results in improved ability to obtain more of all goods.
Improved Quality of Inputs – e.g., education of labor.

Factors of Production

Four Major Factors of Production: Land (L), Labor (N), Capital (K),
Entrepreneurial ability.

Labor – considered to be the single most important input.

High Labor Productivity is due to: capital, natural resources, technology, labor
quality (health, morale, training, education, and aptness), intangibles
(management, market size, environment).

Human Capital – investment in education, training, health, etc.

Division of Labor – creates efficiency and productivity. A task is broken into

specialized tasks, allowing each worker to become more skilled in a paticular
job.

Benefits: greater output with less hours worked.

Cost: work perceived as dull, insignificant part of a whole.

Capital Widening – the duplication of capital goods to meet the increased

labor force (capital per worker remains constant).

Capital Deepening – each worker is given more capital inputs in order to raise
productivity (capital per worker increases).

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

3.2 Isoquants, Isocost, and Ridge Lines

Returns to Scale and the Production Function – Homogeneity

A graph of a production function with one input is given below:

𝑦 𝑓 (𝐾) The production

function shows
diminishing returns
to scale because
output is increasing
at a decreasing rate
and eventually falls
as the input
increases.

Figure 3.2.1 Production function with one input K

𝒚 𝒇 (𝑲) IRS
CRS

DRS

Figure 3.2.2 Return to Scale

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Return to scale (See Chapter 1.6, page 5) can be determined by looking at the
degree of homogeneity of the production function. Given a production
function:

( ) if ( ) ( ) (1)

where X is a positive number and n is constant. It is said that ( ) is a

homogeneous function of degree n. The production function shows constant
return to scale (CRS) if , increasing returns to scale (IRS) if , and
decreasing returns to scale (DRS) if .

The Production or Output Isoquant

Output Isoquants are curves showing all the combinations of inputs that will give
the same output. The curves Q1, Q2, and Q3 below are isoquants. Each isoquant
corresponds to a given output level. Movements along an isoquant show different
input combinations for a given level of output. The ray T from the origin shows
increasing output as you move farther from the origin (Q1 < Q2 < Q3). These
isoquants reflect a single production process. Different production processes may
require different combinations of inputs to produce a given level of output.
Capital

Q3
Q2
Q1

Labor

Figure 3.2.3 Isoquants

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Substitution Among Inputs

The slope of the isoquant is given by the Marginal Rate of Technical Substitution
(MRTS). The marginal rate of technical substitution of b for a MRTSba is the
amount of b can be given up for one unit of a in order to keep output constant:

(2)

The isoquant is shaped in such a way that eventually a great deal of one input is
needed to compasate for a small decrease in other input. This is due to the
principal of diminishing marginal rate of substitution.

Isoquants reflect complementarity and substitutability between the input factors.

The curvature of the isoquant may give us a measure of substitutability. If the
isoquants were straight negatively sloped lines, then the two inputs would be
perfect substitute. If the isoquants were right angled, that is they have to be used
in fixed quantities, then the two inputs would be not be substitutes.

The measure of substitutability can be expressed by the elasticity of technical

substitution and is measured by the following formula:

(3)

( )
( )
( )
(4)
( )

Note: if , inputs used in fixed proportions.

If , factors are perfect substitutes.

Ridge Lines

Ridge Lines are locus points on isoquants where those isoquants turn back on
themselves.

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

CAPITAL K2 L

K
Q3
Q2
K1

Q1

O L2 L1
LABOR

Figure 3.2.4a Ridge Lines

Ridge line OK shows the minimum amount of capital for different

quantities of output, where at all points along OK, .
Ridge line OL shows the minimum amount of labor for different quantities
of output; where at all points along OL, .
If you have K, amount of capital, then no matter how much more labor over
L1 you have, you cannot produce more than Q3 amount of output; in fact,
output will actually decline due to the law of diminishing returns.
Therefore, any more labor L1, given capital endowment of K1, will have
. Any amount of labor less than L1, given capital endowment of K1,
will have .
The area between the ridge lines is the economical area of production.

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

L
CAPITA K2
K
Q3

K1 Q2

Q1

O L2 L1
LABOR

Figure 3.2.4b Economical Area of Production

The Isocost Curve

The Isocost Curve shows different combination of two given inputs that can be
purchased for a certain amount of money, given the nominal of these two inputs.

𝑤 = wage rate
𝑇𝐶
𝑟 = interest rate
𝑟
𝑇𝐶
𝑟
= Maximum amount of
𝑤 capital that can be purchased
Slope = 𝑇𝐶
Capital

𝑟
𝑤
= maximum amount of
labor that can be purchased

𝑇𝐶
𝑤 Labor

Figure 3.2.5 Isocost = the slope of the isoquant

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

The Least Cost Combination

The firm wants to reach its highest isoquant given its isocost. This is where the
isocost is tangent to an isoquant, where (see equation 2):

(the least cost combinaton) (5)

Point e is where
𝑀𝑃𝐿 𝑤
𝑻𝑪
𝑀𝑃𝐾 𝑟
𝒓
CAPITAL

e Q3

Q2

Q1

𝑻𝑪
LABOR
𝒘

Figure 3.2.6 The least cost

3.3 Product Curves

Total Physical Product (TP) – the total physical output that is produced in any
given production process.

Average Physical Product (AP):

Marginal Physical Product (MPa) – is the change in input for a unit change of
the input a.
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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Law of Diminishing Marginal Physical Product

Holding fixed inputs constant

and just increasing the one
𝑀𝑃𝐿
variable input beyond a certain
point will result in a decreasing 𝑀𝑃𝐿
marginal product. For instance,
increasing the labor force while
holding capital at a constant
level will produce higher output, Quantity of Labor
but the additional output per Figure 3.3.1 Marginal
man-hour will become smaller Product of Labor
and smaller as more labor added.

The Geometry of the TP, MP, and AP Relationship

P The AP is the measurement of the slope

K connecting a given point on the TP curve
Product A

TP with the origin;

The MP is the measurement of the slope
of TP at any point on that curve;
T The first stage of production is from the
point O to T. At point T, MP changes from
O increasing to decreasing;
VARIABLE INPUT The second stage of production is from
point T to point K. Point K is where MP =
1 2 3 AP;
The third stage is from point K to point P.
T K Point P is where TP is at maximum point,
that is MP=0;
Stage 1 and 3 are called uneconomic
AP regions of production. Stage 2 is the
P economic region of production.

VARIABLE INPUT MP Figure 3.3.2 The TP, MP, and AP curves

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

3.4 Revenue

Total Revenue (TR) : Maximum receipts obtainable by selling a given quantity of

output per unit of time.
(measured in dollars) (6)

Average Revenue (AR):

(7)

Marginal Revenue (MR): Change in TR caused by one unit change in output sold.

(8)

Marginal Revenue Product (MRP): A change in total revenue (TR) that results
from a one unit change in some variable input with other inputs held constant.

(9)

3.5 Cost

Some definitions

Economic Cost: Value of the alternative that is being given up in order to

obtain some specific item. Economic Cost is the same as Opportunity Cost.
Explicit Cost: Monetary payments going out of the firm.
Implicit Cost (non-expenditures): Cost associated with th usage of the
resources that the firm owns.
Depreciation: Decrease in the value of a capital good due to wear or
obsolescesnce
Private Cost: All implicit and explicit cost encountered by a person or a firm.
Social Cost: Private Cost plus any other extraneous cost (externality)
accrued by the members of the society which are infringed on by some
trading parties. An example of an externality is pollution.

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Short Run (SR): Time period too short to change all inputs (i.e., plant size),
but long enough to change some inputs(i.e., labor).
Long Run (LR): All inputs are variable.
Fixed Cost (FC): “Sunk Cost,” cost not varying with the rate of output. Fixed
costs occur even when output is zero (e.g., contracts, rent, etc.). Disregard
FC when deciding what quantity to produce in the short run since FC’s
between two production levels cancel out.
Variable Cost (VC): Costs that vary with the quantity produced (i.e., wages,
materials, etc.).
Total Cost (TC): All costs associated with producing a given quantity.

(10)

(see equation 5) (11)

Cost
TC
TVC

TFC

Rate of Output

Figure 3.5.1 Total Cost (TC), Total Fixed

Cost (TFC), Total Variable Cost (TVC).

 Note:
i.e. (Latin id est): ‘that is.”
e.g. (Latin exempli gratia): for or as example
etc. (Latin et cetera): and so on

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Marginal Cost (MC): The change in the TC due to a one unit change in the rate of
output:
(12)
There is a direct relation between the marginal product of an input and the
marginal cost. For example, let r is rental price of capital, and K is quantity of
capital used per unit of time. As we increase the amount of capital, total increase
as well as total output:

( ⁄
) (13)

⁄ is the marginal product of capital, . Therefore ⁄ . Due to

the law of diminishing marginal productivity, we have increasing marginal cost in
the short run (SR). This is why the marginal cost curve must eventually rise in the
short run (SR). However, at first the marginal cost curve can decline due to
increasing returns to scale.

Cost 𝑴𝑷 ↑ 𝑴𝑪 ↓ 𝑴𝑷 ↓ 𝑴𝑪 ↑

Increasing Decreasing
Returns are Returns are
reflected in reflected in
decreasing increasing
marginal cost. marginal cost.
MC

Quantity
Figure 3.5.2 The Marginal Cost (MC) Curve

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

Average Total Cost: (14)

Average Variable Cost: ⁄

(15)

The TC Curve is S-shaped and

continually rises.
Cost TC The AFC continually falls as
output rises.
MC The AVC falls and eventually
ATC rises because of the changes
in marginal cost (MC).
AVC The distance between ATC
and AVC decreases as output
grows.
AFC The geometric relationship
between TC, ATC, and MC is
essesntialy the same as the
Rate of Output
geometric relationship
between TP, AP, and MP.
Figure 3.5.3 The Long Run Cost Curves

The Short Run Cost Curves

In the long run all inputs are variable, but in the short run some inputs are
fixed. An example of a fixed input is plant size. For each different plant size
we have a different short run average cost (SRAC) curve that goes with it.
Each SRAC curve in Figure 3.5.4 corresponds to a different plant size. The
Long Run Average Cost (LRAC) curve “envelops” the SRAC curves.
The point where one of the SRAC curves is tangent to the LRAC curve at its
lowest point is the optimum scale of the plant. This is the point where the
LRAC curve is also at its lowest. The LRAC curve shows the least cost of
producing a given level of output, thus, it reflects every point where:

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CHAPTER 3 The Essentials of Microeconomics, Dr Max Fogel, Director of REA, Research & Education Association

(16)

Cost

SRAC5
SRAC2
SRAC1

SRAC4
SRAC3

Output per time period

Figure 3.5.4 SRAC and LRAC curves

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