CHAPTER FOUR

THE THEORY OF PRODUCTION AND COSTS

4.1 THEORY OF PRODUCTION IN THE SHORT RUN

Definition of Production
Production may be defined as the act of creating those goods/services which have
exchange value for sale. Raw materials yield less satisfaction to the consumer by
themselves. In order to get utility from raw materials, first they must be transformed into
output. However, transforming raw materials into final products require factor inputs
such as land, labor, and capital and entrepreneurial ability. Thus, no production can take
place without the use of inputs.

Factors of production
These are the production resources or the economic resources used to produce goods and
services which include:
Land: The economy’s NRs such as land, trees, and minerals.
Labor: The mental and physical skills of individuals
Capital: Goods-such as tools, machines, and factories-used in production or to facilitate
production.
Management/entrepreneurship/: Consists special types of human talent that helps to
organize and manage other factors of production like land, labor and capital.

Production function
Production function is a mathematical statement used to describe the technological r/ship
b/n inputs & outputs in physical terms. It is purely technical relation, which connects
factor inputs and outputs. It can be expressed in many ways: written form, tabular, and
graphical. It expresses the functional r/ship b/n quantities of inputs and outputs. This can
also be expressed in mathematical equation form in which output the dependent variable
and inputs are the independent variables.

Assumptions of short run production analysis

In order to simplify the analysis of short run production, the classical economist assumed
the following points:
1. Perfect divisibility of inputs and outputs
This assumption implies that factor inputs and outputs are so divisible that one can hire,
for example a fraction of labor, a fraction of manager and we can produce a fraction of
output, such as a fraction of automobile.
2. Limited substitution between inputs
Factor inputs can substitute each other up to a certain point, beyond which they cannot
substitute each other

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3. Constant technology
They assumed that level of technology of production is constant in the short run.
Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is
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 is
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain by
efficiently utilizing different units of labor and the fixed capital. In the above short run
production function, the quantity of capital is fixed. Thus output can change only when
the amount of labor used for production changes. Hence, Q is a function of L only in the
short run.

TOTAL PRODUCT (TPP)

Total product: is the total amount of output that can be produced by efficiently utilizing
a specific combination of labor and capital. The total product curve, thus, represents
various levels of output that can be obtained from efficient utilization of various
combinations of the variable input, and the fixed input. It shows the output produced for
different amounts of the variable input, labor. 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, increasing the unit of the variable input may not
help output increase. Even as we employ more and more unit of the variable input beyond
the carrying capacity of a fixed input, output may tends to decline. Thus increasing the
variable input can increase the level of output only up to a certain point, beyond which
the total product tends to fall as more and more of the variable input is utilized. This tells
us what shape a total product curve assumes. The shape of the total variable curve is
nearly S-shape (see fig 2.1 Panel A)

MARGINAL PRODUCT (MPP)

The marginal product of variable input is the addition to the total product attributable to
the addition of one unit of the variable input to the production process, other inputs being
constant (fixed). The change in total output resulting from using this additional worker
(holding other inputs constant) is the marginal product of the worker. If output changes
by q when the number of workers (variable input) changes by ∆L, the change in output
per worker or marginal product of the variable input, denoted as MPL is found as
MPL =

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Thus, MPL measures the slope of the total product curve at a given point. In the short
run, the MP of the variable input first increases reaches its maximum and then tends to
decrease to the extent of being negative. That is, as we continue to combine more and
more of the variable inputs with the fixed input, the marginal product of the variable
input increases initially and then declines.

AVERAGE PRODUCT (APP)

The AP of an input is the ratio of total output to the number of variable inputs.

The average product of labor first increases with the number of labor (i.e. TP increases
faster than the increase in labor), and eventually it declines.

Graphing the short run production curves

The following figures shows how the TP, MP and AP of the variable (labor) input vary
with the number of the variable input.
Output a

TP3
TP2 TP

TP1

Units of labor (variable input)

L1 L2 L3
APL, MPL

APL
Units of labor (variable input)
L1 L2 L3
MPL
Fig 3.1 Total product, average product and marginal product curves:

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 As the number of the labor hired increases (capital being fixed), the TP curve first
rises, reaches its maximum when L3 amount of labor is employed, beyond which it
tends to decline.
 Marginal product curve increases until L1 number of labor reaches its maximum at
L1, and then it tends to fall. The MPL is zero at L3 (when the TP is maximal); beyond
which its value assumes zero indicating that each additional worker above L3 tends to
create over crowded working condition and reduces the total product. Thus, in the
short run (where some inputs are fixed), the marginal product of successive units of
labor hired increases initially, but not continuously, resulting in the limit to the total
production. Geometrically, the MP curve measures the slope of the TP.
 The average product curve increases up to L2, beyond which it continuously
declines. The AP curve can be measured by the slope of rays originating from the
origin to a point on the TP curve.

STAGES OF PRODUCTION
It is possible to determine ranges over which the variable input (labor) be employed. To
do best with this, let’s divide it into three ranges called stages of production.
 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point
where MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.

Now, which stage of production is efficient and preferable?

Obviously, a firm should not operate in stage III because in this stage additional units of
variable input are contributing negatively to the total product (MP of the variable input
is negative) because of over crowded working environment i.e., the fixed input is over
utilized.
Stage I is also 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 underutilized (not efficiently
utilized). Thus, the efficient region of production is stage II. At this stage additional
inputs are contributing positively to the total product and 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 over that range of employment of variable
input where the marginal product of the variable input is declining but positive.

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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 production of an item.
We can identify two types of cost of production: social cost and private cost.
Social cost: is the cost of producing an item to the society. This cost is realized due to the
fact that most resources used for production purpose are scarce and some production
process, by their nature, emit dangerous chemicals, bad smell, etc to surrounding society.
For example, when a certain beer factory wants to produce beer in Ethiopia, the society
as a whole also incurs a cost. Because, the next- best alternative of the raw material (such
as barely) used for the production of beer is sacrificed. When the beer factories buy
barley from the market, the amount of barely available for consumption by society may
be reduced and the price may become dearer. Hence, the production of beer imposes an
indirect cost on the society, moreover, by its nature; the production of beer emits bad
chemicals to the environment, which pollutes waters, air, etc. To control the
understandable consequences of the production process on the environment and their
property, the society incurs cost.
Private cost: This refers to the cost of producing an item to the individual producer. It is
the cost that the beer factory incurs to produce the beer, in our example:
Private cost of production can be measured in two ways:
i) Economic cost
In economics the cost of production to the individual producer includes the cost of all
inputs used for the production of the item.
The producer may buy part of the inputs from the market. For example, he/ she hire
workers, buy raw materials, the necessary machines, etc. the actual or out- of- pocket
expenditures that the firm incurs to purchase these inputs from the market are called
explicit costs.
But, the producer can also use his/ her own inputs which are not purchased from the
market for the production purpose. For example, the producer may use his/ her own
building as a production place, he/she may also manage his firm by himself instead of
hiring another manager, etc. since these inputs are used for the purpose production, their
value has to be estimated and included in the total cost of production. As to how to
estimate the cost of these non- purchased inputs is concerned, we usually estimate their
cost from what these inputs could earn in their best alternative use. For instance, if the
firm uses his own building for production purpose, the cost of using this building for
production is estimated by the rent income foregone. If the producer is a teacher with

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salary of 1000 birr per month and fruits his job to manage his factory, then the next best
alternative of his labor is the salary that he sacrificed to be the manager of his factory.
The estimated costs of the non- purchased inputs are called implicit costs.
Thus, in economics the cost of production includes the costs of all inputs used in the
production process whether the inputs are purchased from the market or owned by the
firm himself that is:
Economic cost: Explicit cost plus Implicit cost
ii) Accounting Cost
For accountant, the cost of production includes the cost of purchased inputs only.
Accounting cost is the explicit cost of production only. Moreover, accountant’s doesn’t
consider the cost of production from the opportunity cost of the resources point of view.
TOTAL, AVERAGE AND MARIGIAL COSTS IN THE SHORT RUN
In the traditional theory of the firm, total costs are split into two groups: total fixed costs
and total variable costs:
TC = TFC + TVC
Where – TC is short run total cost
TFC is short run total fixed cost
TVC is short run total variable cost
By fixed costs, we mean a cost which doesn’t vary with the level of output. The fixed
costs include: salaries of administrative staff, expenses for building depreciation and
repairs, expenses for land maintenance, and the rent of building used for production, etc.
All the above costs are regarded as fixed costs because whether the firm produces much
output or zero output, these costs are unavoidable, and the firm can avoid fixed costs only
if he / she shut down the business stops operation. Variable costs, on the other hand,
include all costs which directly vary with the level of output. The variable costs include:
the cost of raw materials, the cost of direct labor, and the running expenses of fixed
capital such as fuel, electricity power, etc. All these costs are regarded as variable costs
because their amount depends on the level of output. For example, if the firm produces
zero output, the variable cost is zero.
Graphical presentation of short run costs.
Total fixed cost (TFC)
Graphically, TFC is denoted by a straight line parallel to the output axis. The point of
intersection of the TFC line with the cost axis (vertical axis) shows the amount of the
fixed. For example if the level of fixed cost is $ 100, it can be shown as.

C
$100
TFC
X

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Fig 4.1
Total variable cost (TVC)
The total variable cost of a firm has an inverse s- shape. It increases at a decreasing rate.
This continues until the optimal combination of the fixed and variable factors is reached.
TVC
Beyond this point, as increased quantities of the variable factors(s) are combined with the
fixed factor (s) the productivity of the variable factor(s) declined, and the TVC increases
by an increasing rate. Graphically, the TVC looks the following.

X
Fig 4.2
Total Cost (TC)
The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding
the TFC and the 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. But the TC curve
doesn’t start from the origin as that of the TVC curve. The TC curve starts from the point
where the TFC curve intersects the cost axis.
C

TC

TVC

TFC

Q
Fig 4.3 the TC and TVC curves has an inverse S- shape. The vertical distance between
them (TFC) is constant.

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AVERAGE COSTS
From total costs we can derive per-unit costs. These are even more important in the short
run analysis of the firm. Average fixed cost (AFC) - is found by dividing the TFC by the
level of output.
Graphically, the AFC is a rectangular hyper parabola. The AFC curve is continuously
decreasing curve, but decreases at a decreasing rate and can never be zero. Thus, AFC
gets closer and closer to zero as the level of output increases, because a fixed amount of
cost is being divided by increasing level of output.

Average variable cost (AVC)

The AVC is similarly obtained by dividing the TVC with the corresponding level of
output.
TVC
AVC 
X
It is clear from this figure that the slope of a ray through the origin declines continuously
until the ray becomes tangent to the TVC curve at C. To the right of this point (Point c)
the slope of the rays through the origin starts increasing. Thus, the short run AVC (SAVC
now on) falls initially, reaches its minimum and then start to increase. Hence, the SAVC
curve has a U-shape and the reason behind is the law of variable proportions. Had the
TVC not been inverse S-shaped, the SAVC would never assume a U-shape.
Generally, at initial stage of production, the productivity of each additional unit a variable
input increases, thus, the variable input requires to produce each successive units of
output decreases at this stage, implying that the AVC (Variable Cost Incurred to produce
a unit of output) decreases. This process continues until the point of optimal combination
between the fixed input and the variable input is reached. Beyond this point, the
productivity of each additional unit of the variable combined with the existing fixed input
decreases because the fixed input is over utilized. As the productivity of such variables
decreases, more and more of the variables are required to produce successive units of the
output, implying that the VC incurred to produce each successive unit (AVC) increases.
Average total cost (ATC) or simply, Average cost (AC)
ATC (or AC, now on) is obtained by dividing the TC by the corresponding level of
output. It shows the amount of cost incurred to produce each unit of successive outputs.
TC
AC 
Q
TVC  TFC
Or equivalently, AC 
Q
TVC TFC
 
Q Q
= AVC + AFC
Thus, AC can also be given as the vertical sum of AVC and AFC.
Graphically, AC curve can be obtained by vertically adding the AVC and AFC for each
level of successive outputs. Alternatively, the AC curve can also be derived in the same

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way as the SAVC curve. The AC curve is U-shaped because of the law of variable
proportions. Observe the figure that follows.
MARGINAL COST (MC)
The marginal cost is defined as the additional cost that the firm incurs to produce one
extra unit of the output. One thing to be noted here is that, the additional cost that the firm
incurs to produce the 10th unit of output is not equal to the additional cost of producing
the 1000th unit. They would be equal if the TC curve is straight line.

To sum up, the MC is the change in total cost which results from a unit change in output
i.e. MC is the rate of change of TC with respect to output, Q or simply MC is the slope of
TC function and given by:
dTC
MC 
dQ
In fact MC is also the rate of change of TVC with respect to the level of output.
dTFC  dTVC dTVC dTFC
MC   , since 0
dQ dQ dQ

THE RELATIONSHIP BETWEEN SHORT RUN PRODUCTION AND COST

CURVES
Earlier in this chapter we have said that cost function is derived from production
function. Now, let’s see the important relation that per unit production curves (i.e. AP and
MP of the variable input) and per unit cost curves (i.e. AVC and MC) have. The
relationship is that the short run per unit costs is the mirror reflection (against the x-axis)
of the short run production curves. That is the short run AVC is the mirror reflection of
the short run AP of the variable input. When AP variable input increases, AVC decreases;
when AP variable input reaches its maximum, the AVC reaches its maximum point, and
finally when AP variable input starts to fall, the AVC curve starts to rise. The same
relationship exists between the short run MP of variable input curve the MC curve. This
can be shown algebraically by using a linear short run cost function.

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