Chapter Four

The Theory of Production and Cost

4.1. Theory of production in the short run
4.1.1. Definition of production
 Raw materials yield less satisfaction to the consumer by
themselves.
 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.
Production is 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).
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 4.1.2. Production Function
 Production function is a technical relationship between
inputs and 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.
 A general equation for production function can, (for
instance), be described as:
Q = f (X1,X2,X3, . . . , Xn)
where, Q is output and X1, X2, X3,…, Xn are different
types of inputs.

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Cont…
Inputs are commonly classified in to two;
Fixed inputs are those inputs whose quantity cannot readily be
changed when market conditions indicate that an immediate
adjustment in output is required.
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. Buildings, land and machineries
are examples of fixed inputs.
 Variable inputs are those inputs whose quantity can be altered
almost instantaneously in response to desired changes in output. That
is, their quantities can easily be diminished when the market demand
for the product decreases and vice versa.
The best example of variable input is unskilled labour.

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Cont…
In economics, short run refers to a period of time in which the
quantity of at least one input is fixed.
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.
 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.
oHence, its production function can be given by:
Q = f (L,𝐾 )
Where, Q is output, L is the quantity of labour which is variable
input and ,𝐾 is fixed capital in the short run.
The production function shows different levels of output that the firm
can produce by efficiently utilizing different units of labour 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
labour changes.
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 4.1.3. Total, Average and Marginal Product
In production, the contribution of a variable input can be described in
terms of: -
Total product (TP): is the total amount of output that can be produced
by efficiently utilizing specific combinations of the variable input and
fixed input.
An increase in variable input can increase the total product.
 Marginal Product (MP): is the change in output attributed to the
addition of one unit of the variable input to the production process, other
inputs being constant.
For instance, the change in total output resulting from employing
additional worker (holding other inputs constant) is the marginal
product of labour (MPL).
In other words, MPL measures the slope of the total product curve at a
given point.
MPL= ∂TP/∂L = ∆Q/∆L
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Cont…
 In the short run, the marginal product of the variable input first
increases, reaches its maximum and then decreases to the extent
of being negative.
 That is, as we continue to combine more and more of the
variable input with the fixed input, the marginal product of the
variable input increases initially and then declines.
Average Product (AP): Average product of an input is the level
of output that each unit of input produces, on the average. It tells
us the mean contribution of each variable input to the total
product.
Mathematically, it is the ratio of total output to the number of the
variable input.
The average product of labour (APL), for instance, is given by:
APL =TP/L
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Cont…
Output
 The relationship between MPL and TPL can be stated
TP3 a as follows.
 When TPL is increasing, MPL is positive
TP2 TP  When TPL is reaches maximum, MPL is zero
 When TPL is declining, MPL is negative
 The relationship between MPL and APL can be stated
as follows.
TP1  When APL is increasing, MPL>APL.
 When APL is at its maximum, MPL=APL.
L1 L2 L3 labour
 When APL is decreasing, MPL<APL.

APL
MPL

APL
Units of labour (Variable input)
L1 L2 L3
MPL

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Cont…
 Numerical 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). Hint: Q is Total output
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?

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Cont…
Solution
a) APL = Q/L = (4KL - 0.6K2-0.1L2)/L = 4K – (0.6K2/L -
0.1L = (20 – 15/L - 0.1L)
b) When total product (Q) is @maximum, MPL will be Zero.
MPL = 0  MPL=∂Q/∂L  4K – 0.2L = 0  L = 100
Hence, total output will be the maximum when 100
workers are employed.
c) Substituting the optimal values of labor (L=100)
and capital (K=5) into the original production
function (Q): Q = 4KL - 0.6K2 - 0.1L2 where K=5 &
L=100
Q = 4*5*100 – 0.6(52) – 0.1*1002

 Q = 985
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4.1.4. The law of variable proportions
 This law is also called the law of diminishing returns.
 As the producer invests more and more variable inputs (Unskilled
labour), the marginal productivity ultimately declines.
 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), 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
(Capital is declined) by smaller and smaller amounts as more
workers are hired.
 This law assumes that technology is fixed and thus the techniques
of production do not change. Moreover, all units of labour are
assumed to be equal quality.
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 4.1.5. Stages of Production
 Economists have defined three stages of short run production: -
o Stage I: This stage of production covers the range of variable
input levels over which the average product (APL) continues to
increase. This stage is not an efficient region of production
though the MP of variable input is positive.
o 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 4.1).
o Here, as the labour input increases by one unit, output still increases but at a
decreasing rate.
o The stage is called diminishing marginal returns.
o The reason for decreasing average and marginal products is due to the scarcity of the
fixed factor.
o Stage III: In this stage, an increase in the variable input is
accompanied by decline in the total product. Thus, the total
product curve slopes downwards, and the marginal product of
labour becomes negative.
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Three Phases of Production
StageI: Stage of Increasing Returns
StageII: Stage of Decreasing Returns
Stage III :Stage of Negative
Returns

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 4.2. Theory of costs in the short run
4.2.1. Definition and Types of Costs
 Cost is the monetary value of inputs used in the production of
an item thus cost is a derived function from production.
 Cost =Social(external) cost +Producer’s(private) cost.
 In this chapter concerns about the cost incurred by
the firm (Producer’s cost).
 There is no uniformity in measuring private cost.
This will lead us to the discussion on accounting
and economic cost.
 Private cost = accounting cost +economic cost
 Accounting cost is the monetary value of all purchased
inputs used in production; it ignores the cost of non-
purchased (self-owned) inputs
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 ..cost
 Explicit costs are out of pocket expenses for the purchased
inputs. Explicit costs 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.).
 Accounting profit = Total revenue – Accounting cost
= Total revenue – Explicit cost
 Economic cost = explicit cost +implicit cost
Implicit-costs are the cost of self owned (self-employed)
resources. Example: salary of the owner of firm, rent on own
building etc are called implicit costs.
 Economic profit=Total Revenue –(explicit cost +implicit cost)

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 4.2.2. Total, Average and Marginal costs in the short run

 In the short run, total cost (TC) can be broken down in to

two: total fixed cost (TFC) and total variable cost (TVC).
That is, TC = TVC + TFC
 Total fixed cost (TFC): is denoted by a straight line
parallel to the output axis. This is 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.
 Total Cost (TC) has also an inverse S-shape.

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Cont….
.
TC

TVC

TFC

Output
Figure 4.2: Short run TC, TFC and TVC curves

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 Per unit costs
From total costs functions we can derive per-unit costs.
a) Average fixed cost (AFC) - is total fixed cost per
unit of output. AFC = TFC/Q
b) Average variable cost (AVC) - is total variable
cost per unit of output. AVC =TVC/Q. The short run
AVC falls initially, reaches its minimum, and then
starts to increase. Hence, the AVC curve has U-
shape and due to the law of variable proportions.
c) Average total cost (ATC) or simply Average
cost (AC). That is AC = TC/Q
Equivalently, AC= (TVC +TFC) / Q = (AVC + AFC) / Q
 Thus, AC can also be given by the vertical sum of AVC
and AFC.

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 Marginal Cost (MC)
 Marginal cost is the additional cost that a firm incurs to produce one
extra unit of output. In other words, it is the change in total cost per
change in output. Graphically, MC is the slope of TC function.
MC = ∂TC/ ∂Q
 In fact, MC is also a change in TVC with respect to a unit change in
the level of output.
MC = (∂TFC + ∂TVC) / ∂Q = ∂TVC/ ∂Q, Since, ∂TFC/ ∂Q = 0
 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.

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Cont…
 In the figure 4.3: 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.

MC AC
AFC

AVC AVC

AC

MC AFC

Q1 Q2 Q
Figure 4.3: Short run AFC, AVC, AC and MC Curves

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 Numerical Example
Suppose the short run cost function of a firm is given by:
TC = 2Q3 –2Q2 + Q + 10.
a) Find the expression of TVC & TFC
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
Solution:
 Given TC=2Q3 – 2Q2 + Q + 10
 Where TC= TVC + TFC
a) TFC=10 and TVC = 2Q3 – 2Q2 + Q
b) AFC = TFC/Q = 10/Q
AVC = TVC/Q = (2Q3 – 2Q2 + Q)/Q = 2Q2 – 2Q + 1

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Cont….
 AC =TC/Q = (2Q3 – 2Q2 + Q + 10)/Q
◦ = 2Q2 – 2Q + 1 + 10/Q
 MC = ∂TC/ ∂Q= 6Q2 – 4Q + 1
c) To find the minimum value of MC
 ∂MC/∂Q
12Q - 4 = 0 Q=1/3
 MC is minimized when Q = 0.33
The minimum value of MC will be:
MC = 6Q2–4Q+1
= 6(1/3)2 -4(1/3) + 1 MC is minimum @0.33
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Cont….
 To find the minimum value of AVC
 ∂AVC/ ∂Q = 4Q - 2= 0 Q=0.5
 AVC is minimized at Q =0.5
 The minimum value of AVC will be:
 AVC = 2Q2– 2Q +1
 AVC = 2 (0.5) 2 - 2(0.5) +1 = 0.5–1+1 = 0.5

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 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
MC = ∆TVC/ ∆Q, where TVC = w.L
MC = ∆(w,L)/ ∆Q = w (∆L/∆Q), but ∆L/∆Q = 1/MPL
Therefore, MC = w/MPL
ii. Average Variable Cost and Average Product of Labour
AVC = TVC/Q, Where, TVC = w.L = w.L/Q = w.(1/ APL)
Therefore, AVC = w/ APL
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.
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Cont…
We can also sketch the relationship between these production
and cost curves using graphs.
- From the 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.
MPL
APL
APL
Labor (L)

MPL

MC MC

AVC
AVC

Figure 4.4: relationship between short run production and cost curves

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