Chapter Four

Theory of Production and Cost

12/09/2023 1
 Presentation Outline
4.1 Theory of production in the short
run
4.1.1 Definition of production
4.1.2 Production function
4.1.3 Total, average, and marginal product
4.1.4 The law of variable proportions
4.2 Theory of costs in the short run
4.2.1 Definition and types of costs
4.2.2 Total, average and marginal costs in the short
run
4.2.3 The relationship between short run
12/09/2023
production and cost curves 2
 4.1.1 Definition of production

 In order to get better utility from raw materials, they

must be transformed into outputs.
 However, transforming raw materials into outputs
requires inputs such as land, labour, capital and
entrepreneurial ability.
 Production is the process of transforming inputs into
outputs.
 It can also be defined as an act of creating value or
utility.
 The end products of the production process are
outputs which could be tangible (goods) or intangible
(services).
12/09/2023 3
 4.1.2 Production function
Production function is a technical
relationship between inputs & outputs.
It shows the maximum output that can
be produced with fixed amount of inputs
and the existing technology.
 A production function may take the form
of an algebraic equation, table or graph
Q= f(X ,X ,X ,...,X )
where, Q is output
X1, X2, X3,…, Xn are different types of
inputs.
12/09/2023 4
 Fixed vs Variable Inputs

Fixed inputs are those inputs whose quantity

cannot readily be changed when market
conditions indicate that an immediate adjustment
in output is required.
Eg. Buildings, land and machineries
For example, if the demand for Beer rises suddenly in
a week, the brewery factories cannot plant additional
machinery overnight and respond to the increased
demand.
Variable inputs are those inputs whose quantity
can be altered almost instantaneously in response
to desired changes in output
12/09/2023 5
 Short run Vs Long run

 In economics, production period is classified as

short run and long run.
Short run refers to a period of time in which the
quantity of at least one input is fixed.
In other words, short run is a time period which is
not sufficient to change the quantities of all
inputs so that at least one input remains fixed.
Noted that short run periods of d/t firms have
d/t durations. Some firms can change the
quantity of all their inputs within a month while it
takes more than a year for other types of firms.

12/09/2023 6
 CONT’D…
This sub-section is confined to production with one
variable input and one fixed input
 For example, capital goods like building,
machinery, etc are fixed in the short run.
 Consider a firm that uses two inputs: capital
(fixed input) and labour (variable input).
 Given the assumptions of short run production,
the firm can increase output only by increasing
the amount of labor it uses. Hence, its
production function can be given by: Q = f (L)
where, Q is output & L is the quantity of labour.
12/09/2023 7
 Cont’d…
 Long run: refers to a period of time in
which all inputs are variable or there is no
fixed resource in general.
 It must be understood that when we mean
short run and long run it does not
necessarily mean a relatively short or long
period of time like one year or less than
one year or like two or five years.
 It rather refers to the nature of economic
arrangement of the inputs in response to the
changing economic environment.
12/09/2023 8
 Total, Average and Marginal product
 Total product (TP): -it is the overall
amount of output produced by the factors
of production employed over a given
period.
 It is the gross or entire output by
workers & expressed in terms of
Quantity (Q).
 In the short run production function, a
firm obtains its TP by using a combination
of variable inputs with specific amount of
fixed inputs.
12/09/2023 9
 Cont’d….
 Increasing the variable input (while some
other inputs are fixed) can increase the total
product only up to a certain point.
 Initially, as we combine more and more units
of the variable input with the fixed input,
output continues to increase, but eventually if
we employ more and more unit of the variable
input beyond the carrying capacity of the
fixed input, output tends to decline.

12/09/2023 10
 Cont’d…
 Average product (AP): - a firm’s average
product is obtained by dividing the total output
by the number of workers employed.
 This can be put in the form of AP=TP/L; Where
AP=Average Product, TP= Total Product and
L=Labor.
 The average product is a good indicator of the
productivity of labor.
 Productivity is a measure of output per unit
input (i.e. output ratio for each level of input
and the corresponding level of output).
12/09/2023 11
 Cont’d…
 Marginal Product (MP): - it is the increase in
output w/c results from using one additional or
extra unit of a single factor input, holding the
quantities of other factors constant, is called
the marginal physical product or simply MP.
 In other words the MP is the percentage
change in total output resulting from a
percentage change in variable input, all other
things being equal.
Mathematically, MP=ΔTP/ΔL
12/09/2023 12
 TP, AP and MP curve

The relationship between MPL and APL can

be stated as follows.
 When APL is increasing, MPL > APL.
 When APL is at its maximum, MPL = APL.
 When APL is decreasing, MPL < APL.

12/09/2023 13
 Stages of production
 Stage I: This stage of production covers the range of
variable input levels over w/c the average product (APL)
continues to increase.
 It goes from the origin to the point where the APL is
maximum, w/c is the equality of MPL & APL (up to L2 level
of labour employment in figure ).
 This stage is not an efficient region of production
though the MP of variable input is positive.
 The reason is that the variable input (the number of
workers) is too small to efficiently run the fixed input so
that the fixed input is under-utilized (not efficiently
utilized).

12/09/2023 14
 Cont’d…
• Stage II: It ranges from the point where APL is at its
maximum (MPL=APL) to the point where MPL is zero
(from L2 to L3 in figure).
• Here, as the labour input increases by one unit, output
still increases but at a decreasing rate.
• Due to this, the second stage of production is termed
as the stage of diminishing marginal returns.
• The reason for decreasing AP & MP is due to the
scarcity of the fixed factor.
• That is, once the optimum capital-labour combination is
achieved, emp’t of additional unit of the variable input
will cause the output to increase at a slower rate.
12/09/2023 15
 Cont’d…
 As a result, the marginal product diminishes.
 This stage is the efficient region of
production.
 Additional inputs are contributing positively
to the TP & MP of successive units of
variable input is declining (indicating that the
fixed input is being optimally used).
 Hence, the efficient region of production is
where the marginal product of the variable
input is declining but positive.
12/09/2023 16
 Cont’d…
 Stage III: In this stage, an increase in the variable input
is accompanied by decline in the TP. Thus, the TP curve
slopes downwards, & the MP of labour becomes negative.
 This stage is also known as the stage of negative
marginal returns to the variable input.
 The cause of negative marginal returns is the fact that
the volume of the variable inputs is quite excessive
relative to the fixed input; the fixed input is over-utilized.
 Obviously, a rational firm should not operate in stage III
b/c additional units of variable input are contributing
negatively to the to TP (MP of the variable input is
negative).
 In figure above this stage is indicated by the employment
of labour beyond L3.
12/09/2023 17
 Self check test
Example: Suppose that the short-run production
function of certain cut-flower firm is given by:
Q= 4KL -0.6K2 -0.1L2 where Q is quantity of cut-
flower produced, L is labour input and K is fixed
capital input (K=5).
a) Determine the average product of labour (APL)
function.
b) At what level of labour does the total output of
cut-flower reach the maximum?
c) What will be the maximum achievable amount of
cut-flower production?
12/09/2023 18
 4.1.4 The law of variable proportion
 The law of variable proportions states that as
successive units of a variable 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.
 For example, if additional workers are hired to work
with a constant amount of capital equipment, output will
eventually rise by smaller and smaller amounts as more
workers are hired.
 This law assumes that technology is fixed & thus the
techniques of production do not change. Moreover, all
units of labour are assumed to be of equal quality.

12/09/2023 19
 Cont’d…
 Each successive worker is presumed to have the
same ability, education, training, and work
experience.
 Marginal product ultimately diminishes not because
successive workers are less skilled or less energetic
rather it is because more workers are being used
relative to the amount of plant and equipment
available.
 The law starts to operate after the marginal product
curve reaches its maximum (this happens when the
number of workers exceeds L1 in figure ).
 This law is also called the law of diminishing returns.
12/09/2023 20
 4.2 Theory of costs in the short run
4.2.1 Definition and types of costs
 To produce goods and services, firms need factors of
production or simply inputs.
 To acquire these inputs, they have to buy them from
resource suppliers.
 Cost is, therefore, the monetary value of inputs
used in the production of an item.
 Economists use the term ―profit‖ differently from the
w ay accountants use it.
 To the accountant, profit is the firm‘s total revenue
less its explicit costs (accounting costs).
 To the economist, economic profit is total revenue less
economic costs (explicit and implicit costs).
12/09/2023 21
 Types of costs:
 To produce goods & services, we need factors
of production. These factors of production
(resources) are bought through monetary
outlays from factor markets.
 Explicit and implicit costs
 Explicit costs: - are the actual monetary
payments or cash outlays that business firms
make to suppliers of inputs or resources.
 For example; the rewards of labor, land,
capital & entrepreneur are all costs for a
business firm employing them in certain
production process.
12/09/2023 22
 Cont’d…
Accounting cost is another name for Explicit
costs:
 Accounting/Explicit cost is the monetary value
of all purchased inputs used in production; it
ignores the cost of non-purchased (self-owned)
inputs.
 It considers only direct expenses such as
wages/salaries, cost of raw materials,
depreciation allowances, interest on borrowed
funds and utility expenses (electricity, water,
telephone, etc.).
12/09/2023 23
 Cont’d…
 Accounting profit = Total revenue – Accounting cost
= Total revenue – Explicit cost.
 In the real world economy, entrepreneurs may use
some resources which may not have direct monetary
expense since the entrepreneur can own these inputs
himself or herself.
 Economic cost of producing a commodity considers the
monetary value of all inputs (purchased and non-
purchased).
 The monetary value of these inputs is obtained by
estimating their opportunity costs in monetary terms.
 The estimated monetary cost for non-purchased
inputs is known as implicit cost.
12/09/2023 24
 Cont’d…
 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.
 If all inputs are purchased from the market,
accounting and economic profit will be the same.
 However, if implicit costs exist, then accounting
profit will be larger than economic profit.
12/09/2023 25
Short Run Total Costs: Total Fixed Cost,
Total Variable Cost and Total Cost
 A cost function shows the total cost of producing a given
level of output.
 It can be described using equations, tables or curves.
 A cost function can be represented using an equation as
follows. C = f (Q), where C is the total cost of production
and Q is the level of output.
 In the short run, total cost (TC) can be broken down in to
two – total fixed cost (TFC) and total variable cost (TVC).
 By fixed costs we mean costs which do not vary with the
level of output.
 They are regarded as fixed because these costs are
unavoidable regardless of the level of output.
 The firm can avoid fixed costs only if he/she stops
operation (shuts down the business).
12/09/2023 26
 Cont’d…
 The fixed costs may include salaries of administrative staff,
expenses for building depreciation and repairs, expenses for
land maintenance and the rent of building used for production.
 Variable costs, include all costs which directly vary with the
level of output.
 For example, if the firm produces zero output, the variable cost
is zero.
 These costs may include the cost of raw materials, the cost of
direct labour and the running expenses of fuel, water,
electricity, etc.
 In general, the short run total cost is given by the sum of total
fixed cost and total variable cost.
That is, TC = TFC + TVC

12/09/2023 27
 Cont’d…
 Total fixed cost (TFC): is denoted by a straight line parallel
to the output axis.
 because such costs do not vary with the level of output.
 Total variable cost (TVC): has an inverse S-shape. The shape
indicates the law of variable proportions in production.
 At the initial stage of production with a given plant, as more of
the variable factor is employed, its 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.
12/09/2023 28
 TC, TVC ,and TFC
 Total Cost (TC): The total cost curve is obtained by vertically
adding TFC & TVC at each level of output. The shape of the TC
curve follows the shape of the TVC curve, i.e. the TC has also an
inverse S-shape.
 It should be noted that when the level of output is zero, TVC is
also zero which implies TC = TFC.

12/09/2023 29
 Per unit costs
a) Average fixed cost (AFC) - is total fixed cost per unit of output.
• It is calculated by dividing TFC by the corresponding level of
output.
• The curve declines continuously and approaches both axes
asymptotically.
AFC=
b) Average variable (AVC) - is total variable cost per unit of
output.
• It is obtained by dividing total variable cost by the level of
output. 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.

12/09/2023 30
 Cont’d…
c) Average total cost (ATC) or simply Average cost (AC) - is
the total cost per unit of output.
It is calculated by dividing the total cost by the level of output.
ATC = TFC/Q + TVC/Q;
AFC=TFC/Q & AVC =TVC/Q
= AFC + AVC
 Marginal Cost (MC): - it is the extra or additional total cost
that results from producing one more unit of output; or it is
the change in total cost resulting from a percentage change in
output i.e. MC = TC/Q or
 TFC/Q +TVC/Q
or MC=TVC/Q, when TFC=0 (in the short run)

12/09/2023 31
 Cont’d…
 Given inverse S-shaped TC and TVC
curves, MC initially decreases, reaches
its minimum and then starts to rise.
 From this, we can infer that the reason
for the MC to exhibit U shape is also
the law of variable proportions.
 In summary, AVC, AC and MC curves are
all U-shaped due to the law of variable
proportions.
12/09/2023 32
 AFC, AVC, AC , and MC Curve

12/09/2023 33
 Cont’d…
>In the above figure, the AVC curve reaches its
minimum point at Q1 level of output and AC
reaches its minimum point at Q2 level of output.
>The vertical distance between AC and AVC,
that is, AFC decreases continuously as output
increases.
>It can also be noted that the MC curve passes
through the minimum points of both AVC and AC
curves.

12/09/2023 34
Example: Suppose the short run cost
function of a firm is given by: TC=2Q 3 –
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

12/09/2023 35
 4.2.3 The relationship between short run
production and cost curves
 Suppose a firm in the short run uses labour as a
variable input and capital as a fixed input. Let the
price of labour be given by w, which is constant.
Given these conditions, we can derive the relation
between MC and MPL as well as the relation
between AVC and APL.
 i) Marginal Cost and Marginal Product of Labour

12/09/2023 36
 4.4. Production and Costs
 The above expression shows that MC and MPL are
inversely related. When initially MPL increases, MC
decreases; when MPL is at its maximum, MC must
be at a minimum and when finally MPL declines, MC
increases.
 ii) Average Variable Cost and Average Product of
Labour

12/09/2023 37
 Cont’d…
 This expression also shows inverse relation
between AVC and APL. When APL increases,
AVC decreases; when APL is at a maximum,
AVC is at a minimum and when finally APL
declines, AVC increases.
 We can also sketch the relationship between
these production and cost curves using
graphs.
From this figure we can conclude that, the MC
curve is the mirror image of MPL curve and AVC
curve is the mirror image of APL curve
12/09/2023 38
𝑨𝑷 𝑳, 𝑴 𝑷 𝑳, 𝑨𝑽𝑪 ,𝒂𝒏𝒅 𝑴𝑪

12/09/2023 39
 End of Chapter Four

12/09/2023 40