Chapter 3

Theory of Production and Costs

The Theory and Estimation of Production
The Production Function
The Cost Function
The Production Function
A production function defines the relationship between
inputs and the maximum amount that can be produced
within a given time period with a given technology.
 Mathematically, the production function can be
expressed as
Q=f(K, L)
Q is the level of output
K = units of capital
L = units of labour
f( ) represents the production technology
 The Production Function

When discussing production, it is important

to distinguish between two time frames.
The short-run production function describes
the maximum quantity of good or service that
can be produced by a set of inputs, assuming
that at least one of the inputs is fixed at some
level.
The long-run production function describes
the maximum quantity of good or service that
can be produced by a set of inputs, assuming
that the firm is free to adjust the level of all
inputs
Production in the Short Run
When discussing production in the short run,
three definitions are important.
•TotalProduct
•Marginal Product
•Average Product
Total product(TP) is another name for output in
the short run.
The marginal product(MP) of a variable input
is the change in output (or TP) resulting from a
one unit change in the input.
MP tells us how output changes as we change
the level of the input by one unit.
 Cont…d
The average product (AP) of an input is the
total product divided by the level of the input.

AP tells us, on average, how many units of output

are produced per unit of input used.
Consider the two input production function
Q=f(X,Y) in which input X is variable and input Y is
fixed at some level.
The marginal product of input X is defined as
holding input Y constant.
The table below represents a firm’s
production function, Q=f(X,Y):
In the short run, let Y=2. The row highlighted
below represents the firm’s short run
production function.
Cont..
 Production in the Short Run
The figures illustrate TP, MP, and AP
graphically.
•If MP is positive then
TP is increasing.
•If MP is negative
then TP is decreasing.
•TP reaches a
maximum when
MP=0
•If MP > AP then AP
is rising.
•If MP < AP then AP
is falling.
•MP=AP when AP is
maximized.
The Law of Diminishing Returns
Definition
As additional units of a variable input are
combined with a fixed input, at some point
the additional output (i.e., marginal product)
starts to diminish.
The Three Stages of Production
Stage I
From zero units of the variable input to
where AP is maximized
Stage II
From the maximum AP to where MP=0
Stage III
From where MP=0 on
The 3 stages of Production
Optimal Level of Variable Input Usage
Consider the following short run production
process. Where is Stage II?
 Optimal Level of Variable Input Usage

e II
ag
St
Optimal Level of Variable Input Usage
 What level of input usage within Stage II is best
for the firm?
 The answer depends upon how many units of
output the firm can sell, the price of the product,
and the monetary costs of employing the variable
input.
 In order to determine the optimal input usage we
assume that the firm operates in a perfectly
competitive market for its input and its output.
 Product price, P=$2
 Variable input price, w=$10
 Define the following
 Total Revenue Product (TRP) = Q•P
 Marginal Revenue Product (MRP) =

Total Labor Cost (TLC) = w•X

Marginal Labor Cost (MLC) =
Optimal Level of Variable Input Usage
A profit-maximizing firm operating in
perfectly competitive output and input
markets will be using the 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.
Where MRP=MLC.
When the firm employs multiple variable
inputs, the firm should choose the level of the
inputs which equates the marginal product per
dollar across each of the inputs.
Mathematically,
Production in the Long Run

 In the long run, all inputs are variable.

Isoquant defines combinations of inputs that yield the same level of
product. Isoquant
K
The long run production process is described by
the concept of returns to scale.
Returns to scale describes what happens to total
output as all of the inputs are changed by the
same proportion.
If all inputs into the production process are
doubled, three things can happen:
output can more than double
◦ increasing returns to scale (IRTS)
output can exactly double
◦ constant returns to scale (CRTS)
output can less than double
◦ decreasing returns to scale (DRTS)
Returns to Scale
Returns to scale can be generalized to a
production function with n inputs

q= f(X1,X2,…,Xn)
If all inputs are multiplied by a positive constant
m, we have

If k=1, we have constant returns to scale

If k<1, we have decreasing returns to scale
If k>1, we have increasing returns to scale
The Linear Production Function
 Suppose that the production function is
 q= f(K,L) = aK+ bL
 This production function exhibits constant returns to scale
 f(mK,mL) = amK+ bmL= m(aK+ bL) = mf(K,L)
 All isoquants are straight lines
 MRTS is constant

Cobb-Douglas Production Function

 Suppose that the production function is

 This production function can exhibit any returns to scale

 if a+ b= 1 constant returns to scale

 if a+ b> 1 increasing returns to scale
Cobb-Douglas Production Function
Suppose that a product is produced according
to the Cobb-Douglas function
Production in the Long Run
Economists hypothesize that a firm’s long run
production function may exhibit at first increasing
returns, then constant returns, and finally
decreasing returns to scale.
THE THEORY AND ESTIMATION OF
COST
 The Theory and Estimation of Cost

The Short Run Relationship Between

Production and Cost
The Short Run Cost Function
The Long Run Relationship Between
Production and Cost
The Long Run Cost Function
Economies of Scope
Other Methods to Reduce Costs
SR Relationship Between Production and Cost
A firm’s cost structure is intimately related to
its production process.
Costs are determined by the production
technology and input prices.
Assume the firm is a “price taker” in the input
market.
 SR Relationship Between Production and
Cost
In order to illustrate
the relationship,
consider the
production process
described in the table.

Total variable cost(TVC)

is the cost associated with
the variable input, in this
case labor. Assume that
labor can be hired at a price
of w=$500 per unit. TVC
has been added to the table.
SR Relationship Between Production and Cost
Plotting TP and TVC illustrates that they are mirror
images of each other.
When TP increases at an increasing rate, TVC
increases at a decreasing rate.
 Cont…
Total fixed cost(TFC) is the cost associated with
the fixed inputs.
Total cost(TC) is the cost associated with all of
the inputs. It is the sum of TVC and TFC.
TC=TFC+TVC
Marginal cost (MC) is the change in total cost
associated a change in output.

MC can also be expressed as the change in TVC

associated with a change in output.
The Short Run Cost Function
 A firm’s short run cost function tells us the minimum cost necessary
to produce a particular output level.
 For simplicity the following assumptions are made:
 the firm employs two inputs, labor and capital
 labor is variable, capital is fixed
 the firm produces a single product
 technology is fixed
 the firm operates efficiently
 the firm operates in competitive input markets
 the law of diminishing returns holds
 The following average cost functions will be useful in our analysis.
 Average total cost(AC) is the average per-unit cost of using all of
the firm’s inputs.
 Average variable cost(AVC) is the average per-unit cost of using the
firm’s variable inputs.
 Average fixed cost(AFC) is the average per-unit cost of using the
TheShort Run Cost Function
Mathematically,
AVC = TVC/Q
AFC = TFC/Q
ATC=TC/Q=(TFC+TVC)/Q=AFC+AVC
The Short Run Cost Function
 The Short Run Cost Function
 Graphically, these results are be depicted in the figure below.
 Important Observations
 AFC declines steadily over the range of production.
 In general, AVC, AC, and MC are u-shaped.
 MC measures the rate of change of TC
 When MC<AVC, AVC is falling
 When MC>AVC, AVC is rising
 When MC=AVC, AVC is at its minimum
 The distance between AC and AVC represents AFC

The LR Relationship Between Production and Cost

 In the long run, all inputs are variable.
 In the long run, there are no fixed costs
 The long run cost structure of a firm is related to the
firm’s long run production process.
 The firm’s long run production process is described by
the concept of returns to scale.
Economists hypothesize that a firm’s long-run
production function may exhibit at first increasing
returns, then constant returns, and finally
decreasing returns to scale.
When a firm experiences increasing returns to scale
◦ A proportional increase in all inputs increases output by
a greater percentage than costs.
◦ Costs increase at a decreasing rate
When a firm experiences constant returns to scale
◦ A proportional increase in all inputs increases output by
the same percentage as costs.
◦ Costs increase at a constant rate
When a firm experiences decreasing returns to scale
◦ A proportional increase in all inputs increases output by
a smaller percentage than costs.
 The LR Relationship Between Production and Cost

This graph
illustrates the
relationship
between the long-
run production
function and the
long-run cost
function.
The Long-Run Cost Function
 Long run marginal cost(LRMC) measures the change
in long run costs associated with a change in output.
 Long run average cost(LRAC) measures the average
per-unit cost of production when all inputs are
variable.
 In general, the LRAC is u-shaped.
When LRAC is declining we say that the firm is
experiencing economies of scale.
Economies of scale implies that per-unit costs are
falling.
When LRAC is increasing we say that the firm is
experiencing diseconomies of scale.
Diseconomies of scale implies that per-unit costs are
rising.
 The Long-Run Cost Function
The figure
illustrates the
general shape of
the LRAC.
LRAC
LRAC with
decrease with diseco
output.. size at
Economies of of
size at ever
level of output

LRAC remains as output

increases: all sizes of firm produce
output at the same average cost
 The Long-Run Cost Function
 In the short run, the
firm has a fixed level
of capital equipment
or plant size.
The figure illustrates
the SRAC curves for
various plant sizes.
 Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve.
The Long-Run Cost Function
In the long run the firm is able to adjust its
plant size.
LRAC tells us the lowest possible per-unit
cost when all inputs are variable.
What is the LRAC in the graph?
The LRAC is the lower envelope of all of the
SRAC curves.
PROFIT MAXIMIZATION AND
COMPETITIVE SUPPLY
Do Firms Maximize Profits
profit is likely to dominate decisions in owner
managed firms
managers in larger companies may be more
concerned with goals such as
◦ revenue maximization
◦ dividend pay-out
◦ on the long run they must have profit as one of
their highest priorities
Competitive Firm
Competitive Firm Incurring Losses
Adequate Condition for Profit Maximization:
P >=AVCmin
Variation of Short-Run Cost with Output
Iso-cost curves
 Various combinations of inputs that a firm can buy with the
same level of expenditure
 PLL + PKK = M
 where M is a given money outlay.
Maximization of output for given cost
MPL/PL= MPK/PK
 Application of various cost concepts
in Decision making
TC: useful in breakeven analysis and in
determining whether a firm is making profit or
loss
ATC: used for calculating profit to be obtained
from per unit of output produced
MC: useful in deciding whether a firm can
expand its output further or not of a particular
enterprise
Long-run cost: useful in making decision about
investment for expanding firm size in the future