PRODUCTION AND COST IN THE

SHORT RUN

VICTORIA NYARKOAH SAM-ABAIDOO (PHD)

UPSA
 Learning outcomes
 At the end of the course, students should be able to:
 Describe the relationship between inputs and outputs
 Derive the total product, marginal product and average
products and show the relationship between them
 Determine the optimal input usage by a firm in the short
run.
 Derive the short run cost curves and show the
relationship between them and the product curves.
 Show how a firm maximize output in the short run.
 Production Function

 A production function describes the relationship between

a flow of inputs and the resulting flow of outputs in a
production process during a given period of time.

 Q = f(L, K, M, …)
 where,
 Q = quantity of output
 L = quantity of labor input
 K = quantity of capital input
 M = quantity of materials input
 It is necessary to obtain estimates of production
function for practical decision making purposes.

Forms of production are:

1. Linear production function: Q = βo + 𝐵1 L

2. Quadratic production function: Q = βo + 𝐵1 L + 𝐵2 𝐿2

3. Cubic production function: Q = βo + 𝐵1 L + 𝐵2 𝐿2 + 𝐵3 𝐿3

4. Cobb-Douglas production function: Q = A𝐿α 𝐾 β

In the process of production, managers need to
be concerned with the efficiency with which they
use inputs.

Efficiency is the act of achieving good result

with little waste of efforts: A firm can be:
1. Technical efficiency
2. Allocative efficiency
3. Economic efficiency

The firm attempts either to minimize the cost of

producing a given level of output or maximize
output attainable with a given level of cost
 Fixed and Variable Inputs

 A fixed input is an input whose quantity a

manager cannot change during a given period of
time.
 e.g. machinery and equipment

 A variable input is an input whose quantity a

manager can change during a given period of
time.
 eg. Labour and raw material

 Short-Run vs. Long-Run
 Two dimensions of time are used to describe production
functions: short run and long run.

 These periods do not refer to specific calendar periods of

time, such as month or a year, they are defined in terms
of the use of fixed and variable inputs.

 The short-run is a period of time during which at least

one input is fixed, while the long-run is a period of time
during which all inputs are variable.
 Short-Run Production Analysis
 Three measures of productivity or the relationship
between inputs and output in the short run.

 Total Product - The total quantity of output produced

with given quantities of fixed and variable inputs.
 TP or Q = f(L, K ),
 where
 TP or Q = total product or total quantity produced
 L = quantity of labor input (variable)
 K = quantity of capital (fixed)
 Average Product (AP) - The amount of output per unit
of variable input.

APL = TP÷L or Q÷L,

where APL = average product of labor

 Marginal Product - The additional output produced

with an additional unit of variable input.

MPL = ΔTP÷ΔL or ΔQ÷ΔL

where MPL = marginal product of labor

Mathematically, the three productivity measures
can be obtained by differentiating the total
product functions.

Suppose the production function of a firm is

given as:

TP = 10L + 4.5𝐿2 – 0.3333𝐿3

the average and marginal products can be

derived
 Relationship among TP, AP and MP

 Stage I: increasing marginal returns, TP is

increasing at an increasing rate.

 Stage II: MP is falling but AP is rising, TP is

increasing at a decreasing rate.

 Stage III: both MP and AP are falling, but AP>MP

 Beyond stage III, there is negative marginal

returns
 Law of Diminishing Marginal Returns
 The phenomenon illustrated by that region
of the marginal product curve where the
curve is positive, but decreasing, so that
total product is increasing at a decreasing
rate.

 Asmore and more of a variable input is

added to a fixed input, addition to total
output increases reaches a maximum and
begins to decline
 Cost Function
 We now analyze how a firm’s costs of
production vary in the short run.

A mathematical or graphic expression that

shows the relationship between the cost of
production and the level of output, all
other factors held constant.
 Opportunity Cost

 The economic measure of cost that

reflects the use of resources in one activity,
such as a production process by one firm, in
terms of the opportunities forgone in
undertaking the next best alternative
activity
 Explicit and Implicit Costs

 A cost is explicit if it is reflected in a payment to

another individual, such as a wage paid to a
worker, that is recorded in a firm’s bookkeeping
or accounting system.

 Implicit cost is a cost that represents the value of

using a resource that is not explicitly paid out and
is often difficult to measure because it is typically
not recorded in a firm’s accounting system.
 Profit

 The difference between the total revenue

a firm receives from the sale of its output
and the total cost of producing that output.

 π = TR – TC
 where TR is Total Revenue for the sale of
the product and TC is total cost of
production.
 Accounting vs. Economic Profit

 Accounting profit is the difference

between total revenue and total cost
where cost includes only the explicit costs
of production.

 Economic profit is the difference between

total revenue and total cost where cost
includes both the explicit and any implicit
costs of production.
 Short Run Cost Function
 A cost function for a short-run production process in which
there is at least one fixed input of production.

 Fixed cost is the total cost of using the fixed input, which
remains constant regardless of the amount of output
produced.

 Variable cost is the total cost of using the variable input,

which increases as more output is produced.

 See class notes for diagrams and equations

 The profit maximization rule

 Profits are maximized where marginal cost (MC) equals

marginal revenue (MR).

 It is possible that over the firm’s full potential range of

outputs there are two points where MC = MR.

 Producing at point X would not maximize profit because

outputs up to X are produced where MC > MR.

 Technically, profits are maximized where MC = MR and

the MC curve is rising (not falling), as at q* output
 Question

 Suppose a firm’s demand function as Q = 55 – 0.5P,

where P is price and Q is rate of output and the
total cost function TC = 20 + Q + 0.2𝑄 2 , where TC
is total cost.
 Determine the,
 a. Total revenue and profit functions for the firm.
 b. Level of output that maximizes total profit
 c. Maximum profit for this company
 Normal and Supernormal Profit

 Normal profit is the minimum profit which must

be earned to ensure that a firm will continue to
supply the existing good or service.

 Supernormal profit is any profit earned above

normal profit and is a form of economic rent.

 These are measured relative to ATC

 Optimal Labour usage

 In the short run, managers are confronted with determining

how much of a variable input such as labour to use in order to
maximize profits.

 A firm should employ labour or any other variable input as long

as the extra revenue generated from the sale of the output
produced exceeds the extra cost of hiring the unit of labour.

 Therefore, a profit maximizing firm operating in a perfectly

competitive output and input markets will be using an optimal
amount of an input at the point at which the monetary value of
the input’s marginal product is equal to the additional cost of
using that input
 Suppose the short-run production function for a
restaurant producing a pack of food is given by:
Q = 3L - 0.3𝐿2
Where Q is the number of packs of food produced and L is
the amount of labour used. If the cost of a unit of labour
is GH¢6.00 and the unit price of a pack of food produced is
GH¢10.00, what is the amount of labour the restaurant
should employ in order to maximize profit. How much
profit is made?
 Practice Question 1
 You were recently hired to replace the manager of a
roller manufacturing company, despite the manager’s
strong external sales record. The manufacturing company
is relatively simple, requiring only labour and a machine
that cuts and crimps rollers. As you begin reviewing the
company’s production information, you learn that labour
is paid GH¢8.00 per hour and the last worker hired
produced 100 rollers per hour. The company rents roller
cutters and crimping machines for GH¢16.00 per hour and
the marginal product of capital is 100 rollers per hour.
What do you think the previous manager could have done
to keep his job?
 Practice Question 2
 A consultancy firm, focusing on capacity building in Research
Methodology has a demand function 100 – 10Q – P = 0 and cost
per unit function as Q – 8 + 400/Q, where Q = number of
capacity building hours and P = fees charged per hour.

 a. Determine the number of capacity building hours which

maximizes the company’s profit.
 b. How much should the firm charge for the capacity
building?
 c. Find the total profit at the profit maximizing level of
consultancy.
 d. Using the own price elasticity of demand, Comment on the
firm’s pricing policy options.