CHAPTER FOUR

THE THEORY OF PRODUCTION AND COST

 Firms are buyers of factors of production (or resources)

and sellers of goods & services.
 Firms buy factors of production & transform them into
goods & services; and this process is called Production.
 Theory of production thus shows how economic
resources are combined to produce
commodities/products.
 Raw materials yield less satisfaction to the consumer by
themselves.

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 Production is basically an activity of transformation,
which connects factor inputs and outputs.
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
DIAGRAMMATIC: THE PRODUCTION FUNCTION

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 BASIC CONCEPTS OF PRODUCTION THEORY

 An input is a good or service that goes into the

production process. As economists refer to it, an input
is simply anything which a firm buys for use in its
production process.

 An output, on the other hand, is any good or service

that comes out of a production process.

 Inputs are considered variable or fixed depending on

how readily their usage can be changed.
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 CONT….
 Fixed input– An input for which the level of usage cannot
readily be changed when market conditions indicate that an
immediate adjustment in output is required.

 Example, capital

 Variable input are- those inputs whose quantity can be

altered almost instantaneously in response to desired
changes in output.

It is the one whose supply in the short run is elastic,

example, labor, raw materials, and the like. Users of such
inputs can employ a larger quantity in the short run.

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 SHORT RUN VS. LONG RUN PRODUCTION
 Short run
– At least one input is fixed

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– All changes in output achieved by changing usage of variable
inputs.

 Long run
– All inputs are variable
– Output changed by varying usage of all inputs

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 PRODUCTION FUNCTION
 It describes the technical relationship between inputs and output in
physical terms.

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 It may take the form of a schedule, a graph line or a curve, an algebraic
equation or a mathematical model.

 It refers the maximum amount of output that can be produced from any
specified set of inputs, given existing technology.

 Look the following production function:

𝑸 = 𝒇(𝑳𝒅, 𝑳, 𝑲, 𝑴, 𝑻, 𝒕)

 Where Ld = land and building; L = labour; K = capital; M = materials;

T = technology; and, t = time.
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 .
 For sake of convenience, economists have reduced the number of
variables used in a production function to only two: capital (K)
and labour (L).

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 Therefore, in the analysis of input-output relations, the production
function is expressed as:

Q = f(K, L)

 Increasing production, Q, will require K and L, and whether the

firm can increase both K and L or only L will depend on the time
period it takes into account for increasing production, that is,
whether the firm is thinking in terms of the short run or in terms
of the long run.
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 .
 Economists believe that the supply of capital (K) is inelastic in the
short run and elastic in the long run.

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 Thus, in the short run firms can increase production only
by increasing labour, since the supply of capital is fixed
in the short run.
 In the long run, the firm can employ more of both
capital and labour, as the supply of capital becomes
elastic over time.

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 SHORT RUN PRODUCTION
 In the short run, capital is fixed– Only changes in the variable labor
input can change the level of output

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 Short run production function Q = f ( L,K ) = f ( L )
 ………………………………………………………...
 Total Product (Q): It gives maximum of output that can be produced at
different levels of one input (L), assuming that the other input is fixed
at a particular level.

 Marginal Product: Change in the output resulting from a very small

change in one variable input (L), keeping the other factor inputs
constant.
MPL = ΔQ/ΔL

 Average Product: the ratio of total production to the number of

variable input (L). AP = Q/L
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EXAMPLE

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THE LAW OF VARIABLE PROPORTION (LDMR)
 The law of variable proportions states that as successive units of a variable

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input(say, labour) are added to a fixed input (say, capital or land), beyond
some point the extra, or marginal, product that can be attributed to each
additional unit of the variable resource will decline (MPL declines).

 As more and more of an L is added (combined with a fixed amount of K),

total output initially largely increase but eventually smaller increments; and
then the additions to total output will tend to diminish; LDMR.

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.
 .
Relationships b/n TP, MP & AP curves
 At the point O, all the three curves, TP, AP and MP starts from the
origin since L = 0.

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 As long as TP curve is convex, MP is increasing. When TP curve
is Concave, MP is decreasing.
 The point A on TP curve is called as point of inflexion. MP will
be maximum corresponding to this point of the TP curve.
 AP is maximum at the point B, and also AP = MP

 Corresponding to the maximum point of the TP curve, point C,

MP is equal to Zero.
 To the left of Point C, TP is increasing & MP is positive. To the
right of point C, TP curve is decreasing & MP is negative.
 Since the MP curve is must be decreasing when the AP is
maximum, the MP curve reaches maximum before the AP curve. 13
CONT…
 When AP is rising, MP is greater than AP
 When AP is falling, MP is less than AP
 When AP reaches it maximum, AP = MP

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The Three Stages of Production
Stage I: Stage of Increasing Returns:
 AP is increasing and the MP is greater than the AP. Up to point B on the
TP curve Stage I exist.
 AP is increasing, but MP is increasing first up to point A then
decreasing.
Stage II: Stage of Decreasing Returns

 Both AP and MP is decreasing. But MP is positive.

Stage III: Stage of Negative Returns
 The portion of TP is diminishing and the MP is negative.
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 IN WHICH STAGE WOULD THE RATIONAL PRODUCER LIKE TO
OPERATE?
 In Stage I, MP and AP both are rising, and the MP is

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more than AP.
 A given increase in variable factor leads to a more than
proportionate increase in the output.
 The producer is not making the best possible use of the
fixed factor. A particular portion of fixed factor remains
unutilized.
 In Stage III, MP of variable factor is negative and the TP
is also decreasing.
 MP is negative because of overcrowded working environment i.e.,
the fixed input is over utilized.
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 .
 In Stage II, MP and AP both are falling and MP through
positive, is less than AP. This is efficient region. B/se:
 There is less than proportionate change in output due to

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change in labor force.
 Hence at this stage the producer will employ the variable
factor in such a manner that the utilization of fixed factor
is most efficient.
• Hence, the efficient region of production is where the
marginal product of the variable input is declining but
positive.


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TIPS;

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4.2. Theory of Costs

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THE DIFFERENT COST TYPES
 Cost:is the monetary value of inputs used in the
production
 Two types of cost of a product
 Social cost: is the cost of producing an item to the society
 Private cost: is the cost of producing an item to the
individual producer.

 Private cost of production can be measured in two ways:

 Economic cost and accounting cost
A. Economic cost: the cost of all inputs used to produce the
item.
Economic cost = Explicit costs + opp. cost + other Implicit 19
cost
CONT.
 Explicit costs – are out of pocket expenses for
the purchased inputs.
 Implicit cost – The estimated monetary cost for non-
purchased inputs (or imputed cost of self-owned or self
employed resources based on their opportunity costs;)
 Opportunity Cost - the economic cost of an input used
in a production process is the value of output sacrificed
elsewhere. The principle of opportunity cost of an input
is the value of foregone income in best alternative
employment.

B. Accounting cost: refers to the cost of purchased inputs

only. It is the explicit cost or outlay of production only.20
ECONOMIC VS. ACCOUNTING PROFIT
 Economic cost = Explicit costs + Implicit cost

 Accounting cost = Explicit costs

 Accounting profit = Total revenue – Accounting cost

= Total revenue – Explicit cost

 Economic profit =Total revenue – Economic cost

=(Explicit cost + Implicit cost)

 Economic profit will give the real profit of the firm since all
costs are taken into account. Accounting profit of a firm will
be greater than economic profit by the amount of implicit cost.
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 TOTAL, AVERAGE AND MARGINAL COSTS IN THE SHORT
RUN
A cost function shows the total cost of producing a
given level of output. It can be described using
equations, tables or curves, as follows:
 C = f (Q)
 In the short run, total cost (TC) can be broken down in to
two – total fixed cost (TFC) and total variable cost
(TVC).

 TFC is those costs that do not vary as the firm

change its output level.
• Examples: salaries of administrative staff, expenses for
building, expense for depreciation and repairs, rent for land
and rent of building. 23
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 COSTS OF PRODUCTION
Total Total
Fixed Variable Total Marginal Average
Q Cost Cost Cost Cost Cost
0 100 0 100 - -
1 100 30 130 30 130
2 100 50 150 20 75
3 100 60 160 10 53.3
4 100 65 165 5 41.25
5 100 75 175 10 35
6 100 95 195 20 32.5
7 100 125 225 30 32.14
8 100 165 265 40 33.12
9 100 215 315 50 35
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10 100 275 375 60 37.5
 … CONCEPTS … CONT’D
 TVC refers to the cost that changes as the amount
of output produced is changed.

 Examples - purchases of raw materials, payments to

workers, electricity bills, fuel and power costs.

 Total variable cost increases as the amount of output

increases.
If no output is produced, then total variable cost is zero

 In general, the short run total cost is given as:

 TC = TFC + TVC
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 … CONCEPTS … CONT’D
 As the level of output increases, total cost of the firm also increases.

 The TVC has an inverse S-shape. The shape indicates the

law of variable proportions in production, (MP);

 At the initial stage of production productivity increases.

Hence, the TVC increases at a decreasing rate. This
continues until the optimal combination of the fixed and
variable factor is reached.

 Beyond this point, as increased quantities of the variable

factor are combined with the fixed factor, the productivity
of the variable factor declines, and the TVC increases at an
increasing rate.

 Finally, the shape of the TC curve follows the shape of the

TVC curve. 27
TC
TVC
TFC
TC
(Total Cost)

TVC
(Total Variable
Cost)

TFC
(Total Fixed
Cost)

0 Q
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Fig. COST CURVES
AFC Per unit costs
AFC = TFC/Q.
As more output is produced, the Average Fixed
Cost continuously decreases.

AFC
(Average Fixed Cost)

0 Q29
 The Average Variable Cost at a point on the TVC curve is measured by the slope of the
line from the origin to that point.
TVC
AVC=TVC/Q
AVC The short run AVC falls initially, reaches its minimum, and then starts to increase. Hence,
the AVC curve has U-shape and the reason behind is the law of variable proportions.

TVC
(Total Variable Cost)

Minimum AVC

0 q1 Q30
 CONT.
 Average total cost is the total cost per unit of output.
𝑨𝑻𝑪 = 𝑻𝑪/𝑸
 𝑨𝑻𝑪 = 𝑨𝑽𝑪 + 𝑨𝑭𝑪

 Marginal cost is defined as the additional cost that a firm

incurs to produce one extra unit of output.
 𝑀𝐶 = 𝑑𝑇𝐶/𝑑𝑄 = 𝑑𝑇𝑉𝐶/𝑑𝑄

 Given inverse S-shaped TC and TVC curves, MC

initially decreases, reaches its minimum and then starts
to rise.

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THE RELATIONSHIP BETWEEN SHORT RUN PRODUCTION
AND COST CURVES
A. Marginal Cost and Marginal Product of Labour

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 RELATIONSHIP CONT…
B. Average Variable Cost and Average Product of Labour

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RELATIONSHIP CONT…

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 EXAMPLE
 Suppose the short run cost function of a firm is given
by:

 𝑻𝑪 = 𝟐𝑸𝟑 − 𝟐𝑸𝟐 + 𝑸 + 𝟏𝟎

A. Find the expression of TFC & TVC

B. Derive the expressions of AFC, AVC, AC and MC
C. Find the levels of output that minimize MC and AVC and then find the
minimum values of MC and AVC

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