CHAPTER 9(B)

The theory of production and cost

Dr Jacques de Jongh
Jacques.dejongh@nwu.ac.za
(016) 910 3524
Learning Outcomes
• Define all concepts
• Distinguish between concepts
• Explain how the law of diminishing returns relate to product curves in the short
run production costs
• Explain the relationship between the production and costs
o Short run
o Long run
• Calculate and graph
o TP, AP, MP,
o TC, AC, MC,
o TVC, TFC, AVC, AFC

2
Recap
• Short run vs. Long run
• Econ profit vs. Acc profit
• The Law of Diminishing Returns (MAT)
• Fixed costs vs. Variable costs
• Other costs (AFC, AVC, AC, MC)
• Relationship between the short run production and costs (Figure 9-6 handbook
pg. 157)
Test your knowledge

Q TC TVC TFC MC AC AVC AFC

1 45 5
2 30
3 13
4 105 10
5 110
6 200 50 33
Answers

Q TC TVC TFC MC AC AVC AFC

1 45,0 5,0 40,0 5,0 45,0 5,0 40,0
2 60,0 20,0 40,0 15,0 30,0 10,0 20,0
3 79,0 39,0 40,0 19,0 26,3 13,0 13,3
4 105,0 65,0 40,0 26,0 26,3 16,3 10,0
5 150,0 110,0 40,0 45,0 30,0 22,0 8,0
6 200,0 160,0 40,0 50,0 33,3 26,7 6,7
Long Run (LR)
 Long Run Production & Costs
 LR - Period long enough for the firm to change the quantity of all the inputs in the
production process as well as the process itself.
 NO fixed inputs
 NO fixed costs
 NO law of diminishing returns
 When inputs are variable, there is flexibility in the firm:
 Building a new factory
 Installing new machinery or equipment
 However, adjusting inputs is determined by:
 Characteristics of the firm
 Firms production process &
 Firms institutional environment
Returns to scale
 Compares the long-run relationship between inputs and output (vary all inputs by a certain
percentage)
 Variation or change in productivity that is the outcome from a proportionate increase of all inputs.
Three situations can be distinguished:
 Constant Returns to scale:
─ % inputs = % output
─ Doubling inputs = doubling output
 Increasing Returns to scale:
– % inputs = larger % output
– Doubling of inputs = trebling of output
 Decreasing Returns to scale:
– % inputs = smaller % output
– 100% ↑ in inputs = 50% ↑ in output
 Economies of scale (EOS)
 When increase in returns to scale occur it results in economies of scale
 Cost savings realised from an increase in the volume of production.
 Relationship between costs and output, specifically a decline in unit costs as output
expands
 Cost per unit produced decreases as production increases
 Gets cheaper per unit the more you produce
 EOS occur for various reasons such as:
─ Bulk buying - If you buy a large quantity then the average costs will be lower.
 Diseconomies of scale
 Occurs when unit cost increases as output increases.
 Cost per unit produced increases as production increases
 Diseconomies of scale can occur for the following reasons:
─ Lack of control: when there is a large number of workers it is easier to escape with not working very hard
because it is more difficult for managers to notice shirking, i.e. neglect.
─ See textbook page 159

Note difference between

returns to scale (input vs. output) and economies of scale (cost vs. output)
 Economies of Scope
 Refers to the cost savings achieved by producing related goods in one firm rather
than producing those goods in two separate firms.
 Arises when unit costs are lower when a business produces wider range of
products rather than specialise in one of fewer products.
 Use same capital intensive inputs for production of both products
 Dairy factory– milk, butter & cheese
 Automobile factory/manufacturer – cars, mini-vans & trucks
 Long Run Average Cost Curve
 Note: Due to the fact that all inputs in the LR are variable, economies and
diseconomies of scale can occur.
 Therefore the LRAC curves can be in different shapes.
 Three Basic possibilities (see page 159):
Complete Long-Run Average Cost (Figure 9-8)

Economies Constant costs Diseconomies

Average Total Costs Of Scale Of Scale
Long-Run
ATC

AC AC
q1 q2
Output

Long-Run ATC Curve

 LRAC is based on three assumptions
1. Prices of Production Functions (PFs) are given
2. State of technology & quality of PFs are given
3. Firm choose the lowest cost combination of PFs to produce each level of output

 General wage increases, ceteris paribus – costs to increase or decrease? LRAC curve
to shift upwards or downwards?
 New cost saving production techniques – costs to increase or decrease? LRAC curve
to shift upwards or downwards?
SUMMARY – CHAPTER 9[10]

 Assumptions
– LR vs. SR
 Profit Concepts
– Profit = Revenue – Costs
– Costs: Implicit vs. Explicit
– Profit to an Economist vs. Profit to an Accountant
 Production (N)
– Marginal Product
– Average Product
– Total Product
– Law of Diminishing Returns
 Costs (C)
– TFC, TVC, TC, ATC, AFC, AVC, MC
– MAT
 The relationship between production and costs in the short-run
 Long Run
– Returns to scale
– Economies of scale
– Economies of scope
– Long-run average costs
Practice Questions
Task

1) In economics, the short-run is a period of time:

a) Of one year or less
b) In which all inputs are fixed
c) In which all inputs are variable
d) In which the quantity of at least one input is fixed and the quantities of the
other inputs can be varied
2) A firm has fixed costs:
e) In the short run and in the long run.
f) In the short run but not in the long run.
g) In the long run but not in the short run.
h) Neither in the long run nor in the short run.
i) When the price of its product is fixed.
3) Suppose a firm produces 50 units of output per month. The
firm’s average variable costs and average fixed costs per month
are R200 and R500, respectively. What is the firm’s total cost per
unit?
a) R700
b) R30 000
c) R10 500
d) R35 000
e) R25 700
4) The following diagram shows a total product curve for a small
firm. Use this diagram to answer the following questions.

At what level of labour inputs do

diminishing marginal returns
occur?
a) 10
b) 12
c) 15
d) 30
e) More than 30
5) The table below describes the production of bread in the short run. Each
oven used to produce the bread costs R5000. The wage rate is R225 per
week. Using the information in the table, answer the question below.

5.1) What is the total cost of

producing 1350 loaves of bread
per week?
a) R900
b) R30 000
c) R30 900
d) R5 400
e) R5 225
6) The following table reports the input cost (in Rands) of producing different units of
output. Complete the table below.

Output Total Total Total Average Average Average Marginal

(Q)/ Fixed Variable Cost Fixed Variable Cost (AC Cost
Total Cost Cost (TC) Cost Cost or ATC) (MC)
Product (TFC) (TVC) (AFC) (AVC)
(TP)
0 100 ---- ---- ----
10 190
20 170
30 240
40 400
50 100 550
60 600
Answer

Output Total Total Total Average Average Average Marginal

(Q)/ Total Fixed Variable Cost Fixed Variable Cost (AC Cost
Product Cost Cost (TC) Cost Cost or ATC) (MC)
(TP) (TFC) (TVC) (AFC) (AVC)

0 100 0 100 ---- ---- ----

10 100 90 190 10 9 19 9
20 100 170 270 5 8.50 13.50 8
30 100 240 340 3.33 8 11.33 7
40 100 300 400 2.50 7.50 10 6
50 100 450 550 2 9 11 15
60 100 600 700 1.67 10 11.67 15
Typical test question
Answers
Q TC TFC TVC AC AFC AVC MC

0 150 150 0

10 800 150 650 80.00 15.00 65.00 65.00

20 1400 150 1250 70.00 7.50 62.50 60.00

30 1900 150 1750 63.33 5.00 58.33 50.00

40 2300 150 2150 57.50 3.75 53.75 40.00

50 2800 150 2650 56.00 3.00 53.00 50.00

60 3400 150 3250 56.67 2.50 54.17 60.00

70 4098 150 3948 58.54 2.14 56.40 69.80

80 4850 150 4700 60.63 1.88 58.75 75.20

90 5700 150 5550 63.33 1.67 61.67 85.00

100 6600 150 6450 66.00 1.50 64.50 90.00

 TEST YOUR KNOWLEDGE
The following table indicated the different quantities of apricot jam which
consumers will demand (and thus a producer will sell) at different prices.
Fill in the table by calculating total revenue, average revenue and
marginal revenue

Total Average Marginal

Price
Quantity Revenue Revenue Income
(Rand)
(Rand) (Rand) (Rand)
20 96 -
18 97
16 98
14 99
12 100
Answer
Total Average
Marginal Income
Price Revenue Revenue
Quantity (Rand)
(Rand) (Rand) (Rand)
MR = ∆TR/∆Q
TR = PxQ AR = TR/Q
20 x 96 = R1 920/96 =
20 96 R20
-
R1 920
(1 746 – 1 920) / (97-
18 97 R1 746 R18 96) = - R174/1
= - R174
16 98

14 99

12 100