SHORT RUN

PRODUCTION AND
COST THEORIES
PRODUCTION THEORY
Definition

Goods & Services

Creation
&
Transformation

Inputs of Production – labour,

capital, machinery, capital
equipments, land
Production function
 Schedule showing the maximum amount of output
that can be produced from any specified set of
inputs, given the existing technology or state of the
art.
 Mathematically denoted as
Q= f(X1, X2, X3 …Xn)
Where Q is the output level, Xi is the ith input level.
Technical Efficiency & Economic Efficiency

 Technical efficiency – production function gives

maximum output. Therefore TE is implicitly
assumed in any production function
 Economic Efficiency – production of a given
amount at least cost. Therefore it is the matter of
constrained optimization
Fixed Input & Variable Input
 Fixed Input – Level cannot be altered rapidly with
production in a specified time point. E.g. –
Building/Plant
 Variable Input – Level can be altered according to
the changes in production level. E.g. – Labour,
Raw Material
Different Production Functions
 Short Run – some inputs of production are fixed. Q=f(L,K*),
where L remains variable factor, but K becomes fixed.
 Long Run – All inputs are variable. Q=f(L,K), where both L &
K are variable factors
 Variable Proportion Production Function – production
functions that allow some substitution of one input for another
to reach an output target. Variable proportion is possible in the
short run when the variable factor changes but the fixed factor
remains unchanged. Proportion can also be variable in long
run
 Fixed Proportion Production Function- there is one & only
one ratio or mix of factors to produce a particular input.
Short run Production function
 Q=f(L,K*)
 Total Product – in short run when the capital input
is fixed, output can be increased by increasing
labour input. This is termed as TP of labour. TP
increases at an increasing rate at first, then
increases at a diminishing rate. Eventually TP falls
with more employment.
Average & Marginal Products
 Average Product, APL = TP/L
 Marginal Product – Additional output obtained by
increasing an unit of labour input, combined with
other fixed factors of production. In other words,
MPL = ∆TP/∆L
 When TP of labour increases at an increasing
(decreasing) rate, MPL also rises (falls). When TP
of labour falls, MPL<0
Table showing TP, AP & MP
L Q AP MP
K=2
0 0 - -
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
Diagrammatic Representation
TP

TP

O St
a L
AP,MP g
e
II
Stage I Stage III

AP
O MP L
Law Of Diminishing MP
 As the number of units of the variable input
increases, other inputs remaining constant, there
exists a point beyond which MP of the variable
input declines.
 Lesser the amount of variable input as compared to
fixed input, higher is the intensity of utilization of
fixed factor, thus MP increases initially but starts
falling with the rise in variable input.
Stages of Production
 The relationship between AP & MP is mainly
indicated by three different stages of production
 Stage I: When MP>AP, AP of labour rises
 Stage II: When MP<AP, AP of labour falls
 Stage III: When MP<0, Negative Returns
COST FUNCTIONS
Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
 Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
Q TFC TVC TC AFC AVC ATC MC
0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
 Average Variable Cost
AVC = TVC/Q = w/APL

Marginal Cost
TC/Q = TVC/Q = w/MPL
OPTIMAL USE OF THE
VARIABLE INPUT
Optimal Labour Employment in the short run

 Capital being fixed, labour employment can be

increase to a point where Marginal Revenue
Product of Labour (MRPL)= Marginal Resource
Cost of Labour (MRCL)
 MRPL = (MPL)(MR) (Defined as extra revenue
generated by an extra unit of labour)
 MRCL=ΔTC/ΔL=W (WAGE RATE)