Chapter 4

THE THEORY OF
PRODUCTION AND COSTS
 THE THEORY OF
PRODUCTION

• Production involves
transformation of inputs
such as capital, equipment,
labor, and land into output -
goods and services
 Production Function
• A production function is purely technical
relation which connects factor inputs &
outputs.
• It describes the transformation of factor
inputs into outputs at any particular time
period. Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time

For our current analysis, let’s reduce the

inputs to two, capital (K) and labor (L):

Q = f(L, K)
 Short-Run and Long-Run
Production
• In the short run some inputs are
fixed and some variable
– e.g. the firm may be able to vary the
amount of labor, but cannot change
the amount of capital
– in the short run we can talk about
factor productivity / law of variable
proportion/law of diminishing returns
 The Organization of
Production
• Inputs
– Labor, Capital, Land
• Fixed Inputs
• Variable Inputs
• Short Run
– At least one input is fixed
• Long Run
– All inputs are variable
 Production Function
With One Variable Input
Total Product TP = Q = f(L)
TP
Marginal Product MPL =
L
Average Product TP
APL =
L
Production or MPL
EL = AP
Output Elasticity L
 Production Function
With One Variable Input
Total, Marginal, and Average Product of Labor, and Output Elasticity

L Q MPL APL EL
0
1
0
3 3
- -
3
-
1
Output Elasticity
2 8 5 4 1.25
3 12 4 4 1 MPL
4
5
14
14
2
0
3.5
2.8
0.57
0 EL = AP
6 12 -2 2 -1 L
 Production Function
With One Variable Input
 Production Function
With One Variable Input
 Short-Run Analysis of Total,
Average, and Marginal Product
• If MP > AP then
AP is rising
• If MP < AP then
AP is falling
• MP = AP when
AP is
maximized
• TP maximized
when MP = 0
 Three Stages of Production in
Short Run
AP,MP
Stage I Stage II Stage III

APX
X
•TPL Increases at •TPL Increases at
Diminshing rate.
MPX
increasing rate.
•MPL Begins to decline.
•MP Increases at • TPL begins to decline
•TP reaches maximum
decreasing rate. level at the end of
stage II, MP = 0. •MP becomes negative
•AP is increasing and
reaches its maximum at •APL declines •AP continues to decline
the end of stage I
 Production With Two
Variable Inputs
Isoquants show combinations of two inputs
that can produce the same level of output.
Firms will only use combinations of two
inputs that are in the economic region of
production, which is defined by the portion
of each isoquant that is negatively sloped.
 Marginal Rate of Technical
Substitution MRTS
• The degree of imperfection in
substitutability is measured with marginal
rate of technical substitution (MRTS-
Slope of Isoquant):

MRTS = -K/L

(in this MRTS some of K is removed from

the production and substituted by L to
maintain the same level of output)
 Production With Two
Variable Inputs
Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

 Properties of Isoquants
• Isoquants have a negative slope.

• Isoquants are convex to the origin.

• Isoquants cannot intersect or be tangent to

each other.

• Upper Isoquants represents higher level of

output
 Isoquant Map
• Isoquant map is a set
Figure : Isoquant Map
of isoquants
Y
presented on a two
dimensional plain.

Capital Y
• Each isoquant shows
IQ4
IQ3

various combinations IQ1

IQ2

of two inputs that can O Labour X X

be used to produce a
given level of output.
 Laws of Returns to Scale
• It explains the behavior of output in response
to a proportional and simultaneous change in
input.
• When a firm increases both the inputs, there
are three technical possibilities –
(i) TP may increase more than proportionately –
Increasing RTS
(ii) TP may increase proportionately – constant
RTS
(iii) TP may increase less than proportionately –
diminishing RTS
Optimal Combination of Inputs
Isocost lines represent all combinations of
two inputs that a firm can purchase with
the same total cost.

C  wL  rK C  Total Cost
w  Wage Rate of Labor ( L )
C w
K  L r  Cost of Capital ( K )
r r
Optimal Combination of Inputs
MRTS = w/r
 Returns to Scale
Production Function Q = f(L, K)

Q = f(hL, hK)

If  = h, then f has constant returns to scale.

If  > h, then f has increasing returns to scale.
If  < h, the f has decreasing returns to scale.
 Returns to Scale

Constant Increasing Decreasing

Returns to Returns to Returns to
Scale Scale Scale
 Empirical Production
Functions
Cobb-Douglas Production Function
Q = AKaLb

Estimated using Natural Logarithms

ln Q = ln A + a ln K + b ln L
 Theory of Cost
To produce goods and services, firms
need factors of production or simply
inputs.
Cost is, therefore, the monetary value of
inputs used in the production of an item.
Cost means the amount of expenditure
(actual or estimated) which is to be
incurred for obtaining any particular
commodity or factor of production or
facility.
 Theory of costs
• Costs are derived from the production function,
• Short-run and long-run costs.
• Short-run costs are the costs over a period during
which some factors of production (usually
capital equipment and management) are fixed.
• The long-run costs are those cost over a period
long enough to permit the change of all factors of
production.
• In the long-run all factors become variable.
SHORT-RUN COSTS
The short run is the period during which some factor(s) is
fixed.
Total costs are split into two groups: total fixed costs and
total variable costs:
TC = TFC + TVC
The fixed costs include:
 Salaries of administrative staff
 Depreciation (wear and tear) of machinery
 Expenses for building depreciation and repairs
 Expenses for land maintenance and depreciation
 SHORT-RUN COSTS
The variable costs include:
 The raw materials
 The cost of direct labor
 The running expenses of fixed capital, such as fuel
ordinary repairs and routine maintenance.
• Total fixed cost is graphically denoted by a straight line
parallel to the output axis .
• The total variable cost has broadly an inverse – S
shape, which reflects the law of variable proportions.
• According to this law, at the initial stages of production
with a given plant, as more of the variable factor(s) is
employed, its productivity increases and the average
variable cost falls.
 Total, average and marginal costs in the
short run
• A cost function shows the total cost of producing a given 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).
• Fixed costs means a 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).
Total Cost (TC): The total cost curve is
obtained by vertically adding TFC and
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
 Total cost
⚫ Total cost (TC) is the cost of all
the factor inputs needed to
produce an amount of output.
⚫ In the short run, total cost is the

sum of total fixed cost (TFC)

and total variable cost (TVC)
and is positively related to the
output level.
 Per unit costs

From total costs functions we can derive per-unit costs.

These are even more important in the short run
analysis of the firm.

•a) Average fixed cost (AFC) - Average fixed cost 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= TFC/Q
 Cont..
Average variable cost (AVC) - Average variable cost is
total variable cost per unit of output. It is obtained by
dividing total variable cost by the level of output.
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.
Average total cost (ATC) or simply Average cost (AC)
- Average total cost is the total cost per unit of output. It
is calculated by dividing the total cost by the level of
output. Is also U shape due to LVP
The ATC at any level of output is the slope of the
straight line from the origin to the point on the TC curve
corresponding to that particular level of output.
 Cont.…
TC TFC  TVC
ATC    AFC  AVC
X X
Thus, AC can also be given by the vertical sum of AVC and
AFC.
Marginal Cost (MC) is defined as the additional cost that a
firm incurs to produce one extra unit of output. In other
C
words, it is the change in total cost whichMC 
results from a unit
X
change in output.
MC is the slope of TC function.
In fact, MC is also a change in TVC with respect to a unit
change in the level of output
Average And Marginal Costs

Dollars MC
$4

3
AFC ATC
2 AVC
1

0 30 33 90 130 161 196

Units of Output
Relationship between Short run Production
and Cost curve
 Suppose a firm in the short run uses labour as a variable input and
capital as a fixed input.
 Let the price of labor 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
 MC= dTVC/dQ, where TVC=w.L
 MC=d(w.L)/dQ= w dL/dQ, but dL/dQ = 1/MP
Therefore MC = w/MP
 The above expression shows that MC and MPL are inversely
related.
 When initially MPL increases, MC decreases; when MPL is at its
ii ) Average Variable Cost and Average
Product of Labour
AVC = TVC/Q, where TVC = w.L
AVC = w.L/Q = w. L/Q, but L/Q = 1/AP
Therefore AVC = w/AP
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
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
Short-Run Cost Functions

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
Short-Run Cost Functions

Average Variable Cost

AVC = TVC/Q = w/APL

Marginal Cost
TC/Q = TVC/Q = w/MPL