CHAPTER 3 AND 4

THE THEORY OF PRODUCTION AND COST

Firms
 are buyers of factors of production (or resources) and
sellers of goods & services.
Firms buy factors of production & transform them into

goods & services; and this process is called Production.
Theory of production thus shows how economic resources

are combined to produce commodities/products.
Raw materials yield less satisfaction to the consumer by

themselves.
Production is basically an activity of transformation,


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which connects factor inputs and outputs.
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DIAGRAMMATIC: THE PRODUCTION
FUNCTION

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 BASIC CONCEPTS OF PRODUCTION THEORY

 An input is a good or service that goes into the production process.

As economists refer to it, an input is simply anything which a firm

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buys for use in its production process.

 An output, on the other hand, is any good or service that comes out
of a production process.

 Inputs are considered variable or fixed depending on how readily

their usage can be changed.

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 CONT….

 Fixed input– An input for which the level of usage cannot readily be
changed when market conditions indicate that an immediate adjustment
in output is required.

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 Example, capital

 Variable input are- those inputs whose quantity can be altered

almost instantaneously in response to desired changes in output.

 It is the one whose supply in the short run is elastic, example, labor, raw
materials, and the like. Users of such inputs can employ a larger quantity in the
short run.

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 SHORT RUN VS. LONG RUN PRODUCTION

 Short run
– At least one input is fixed

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– All changes in output achieved by changing usage of variable
inputs.

 Long run
– All inputs are variable
– Output changed by varying usage of all inputs

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 PRODUCTION FUNCTION
 It
   describes the technical relationship between inputs and output in physical
terms.

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 It may take the form of a schedule, a graph line or a curve, an algebraic equation
or a mathematical model.

 It refers the maximum amount of output that can be produced from any specified
set of inputs, given existing technology.

 Look the following production function:

 Where Ld = land and building; L = labour; K = capital; M = materials; T =6

technology; and, t = time.
 For sake of convenience, economists have reduced the number of
.


variables used in a production function to only two: capital (K) and
labour (L).

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 Therefore, in the analysis of input-output relations, the production
function is expressed as:

Q = f(K, L)

 Increasing production, Q, will require K and L, and whether the

firm can increase both K and L or only L will depend on the time
period it takes into account for increasing production, that is,
whether the firm is thinking in terms of the short run or in terms of
the long run.
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 .

 Economists believe that the supply of capital (K) is inelastic in the

short run and elastic in the long run.

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 Thus, in the short run firms can increase production only by
increasing labour, since the supply of capital is fixed in the
short run.
 In the long run, the firm can employ more of both
capital and labour, as the supply of capital becomes elastic
over time.

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 SHORT RUN PRODUCTION
 In the short run, capital is fixed– Only changes in the variable labor
input can change the level of output

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 Short run production function Q = f ( L,K ) = f ( L )

 ………………………………………………………...

 Total Product (Q): It gives maximum of output that can be produced at

different levels of one input (L), assuming that the other input is fixed at
a particular level.

 Marginal Product: Change in the output resulting from a very small

change in one variable input (L), keeping the other factor inputs constant.
MPL = ΔQ/ΔL

 Average Product: the ratio of total production to the number of

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variable input (L). AP = Q/L
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EXAMPLE
THE LAW OF VARIABLE PROPORTION (LDMR)

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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 (MPL declines).

As more and more of an L is added (combined with a fixed amount of K), total output

initially largely increase but eventually smaller increments; and then the additions to

total output will tend to diminish; LDMR.

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12
.
 .

Relationships b/n TP, MP & AP curves

 At the point O, all the three curves, TP, AP and MP starts from the
origin since L = 0.

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 As long as TP curve is convex, MP is increasing. When TP curve is
Concave, MP is decreasing.
 The point A on TP curve is called as point of inflexion. MP will be
maximum corresponding to this point of the TP curve.
 AP is maximum at the point B, and also AP = MP

 Corresponding to the maximum point of the TP curve, point C, MP

is equal to Zero.
 To the left of Point C, TP is increasing & MP is positive. To the right
of point C, TP curve is decreasing & MP is negative.
 Since the MP curve is must be decreasing when the AP is maximum,
the MP curve reaches maximum before the AP curve. 13
 CONT…
 When AP is rising, MP is greater than AP
 When AP is falling, MP is less than AP

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 When AP reaches it maximum, AP = MP

The Three Stages of Production

Stage I: Stage of Increasing Returns:
 AP is increasing and the MP is greater than the AP. Up to point B on the TP
curve Stage I exist.
 AP is increasing, but MP is increasing first up to point A then decreasing.

Stage II: Stage of Decreasing Returns

 Both AP and MP is decreasing. But MP is positive.

Stage III: Stage of Negative Returns
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 The portion of TP is diminishing and the MP is negative.
 IN WHICH STAGE WOULD THE RATIONAL PRODUCER LIKE TO
OPERATE?
 In Stage I, MP and AP both are rising, and the MP is more

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than AP.
 A given increase in variable factor leads to a more than
proportionate increase in the output.
 The producer is not making the best possible use of the
fixed factor. A particular portion of fixed factor remains
unutilized.
 In Stage III, MP of variable factor is negative and the TP
is also decreasing.
 MP is negative because of overcrowded working environment i.e.,
the fixed input is over utilized. 15
 .

 In Stage II, MP and AP both are falling and MP through

positive, is less than AP. This is efficient region. B/se:
 There is less than proportionate change in output due to

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change in labor force.
 Hence at this stage the producer will employ the variable
factor in such a manner that the utilization of fixed factor
is most efficient.

• Hence, the efficient region of production is where the marginal product of

the variable input is declining but positive.


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17
TIPS;
3.2. Theory of Costs

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 THE DIFFERENT COST TYPES
 Cost: is the monetary value of inputs used in the production
 Two types of cost of a product
 Social cost: is the cost of producing an item to the society
 Private cost: is the cost of producing an item to the individual
producer.

 Private
cost of production can be measured in two ways:
 Economic cost and accounting cost

A. Economic cost: the cost of all inputs used to produce the item.
Economic cost = Explicit costs + opp. cost + other Implicit cost
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 CONT.
 Explicit costs – are out of pocket expenses for the
purchased inputs.
 Implicit cost – The estimated monetary cost for non-
purchased inputs (or imputed cost of self-owned or self
employed resources based on their opportunity costs;)
 Opportunity Cost - the economic cost of an input used in a
production process is the value of output sacrificed elsewhere.
The principle of opportunity cost of an input is the value of
foregone income in best alternative employment.

B. Accounting cost: refers to the cost of purchased inputs

only. It is the explicit cost or outlay of production only. 20
 ECONOMIC VS. ACCOUNTING
PROFIT
 Economic cost = Explicit costs + Implicit cost

 Accounting cost = Explicit costs

 Accounting profit = Total revenue – Accounting cost
= Total revenue – Explicit cost
 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.
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TOTAL, AVERAGE AND MARGINAL COSTS IN THE
SHORT RUN
 A cost function shows the total cost of producing a given
level of output. It can be described using equations, tables
or curves, as follows:
 C = f (Q)

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

two – total fixed cost (TFC) and total variable cost (TVC).

 TFC is those costs that do not vary as the firm change its
output level.
• Examples: salaries of administrative staff, expenses for
building, expense for depreciation and repairs, rent for land
and rent of building. 23
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COSTS OF PRODUCTION
 Total  Total
Fixed Variable  Total Marginal Average
Q Cost Cost Cost Cost  Cost 
0 100 0 100 - -
1 100 30 130 30 130
2 100 50 150 20 75
3 100 60 160 10 53.3
4 100 65 165 5 41.25
5 100 75 175 10 35
6 100 95 195 20 32.5
7 100 125 225 30 32.14
8 100 165 265 40 33.12
9 100 215 315 50 35
10 100 275 375 60 37.5
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… CONCEPTS … CONT’D

 TVC refers to the cost that changes as the amount of

output produced is changed.
 Examples - purchases of raw materials, payments to
workers, electricity bills, fuel and power costs.
 Total variable cost increases as the amount of output
increases.
 If no output is produced, then total variable cost is zero

 In general, the short run total cost is given as:

 TC = TFC + TVC
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… CONCEPTS … CONT’D
 As the level of output increases, total cost of the firm also increases.

 The TVC has an inverse S-shape. The shape indicates the law of
variable proportions in production, (MP);
 At the initial stage of production 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.
 Finally, the shape of the TC curve follows the shape of the TVC
curve.
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TC
TVC
TFC
TC
(Total Cost)

TVC
(Total Variable
Cost)

TFC
(Total Fixed Cost)

0 Q
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Fig. COST CURVES
AFC Per unit costs

AFC = TFC/Q.
As more output is produced, the Average Fixed
Cost continuously decreases.

AFC
(Average Fixed Cost)

0 Q29
TVC The Average Variable Cost at a point
on the TVC curve is measured by the
AVC
slope of the line from the origin to that
point.
AVC=TVC/Q
The short run AVC falls initially, TVC
(Total Variable Cost)
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.

Minimum AVC

0 q1 Q30
 CONT.

 Average total cost is the total cost per unit of output.

ATC = TC/Q
 ATC= AVC + AFC

 Marginal cost is defined as the additional cost that a firm

incurs to produce one extra unit of output.
 MC = dTC/dQ = dTVC/dQ

 Given inverse S-shaped TC and TVC curves, MC initially

decreases, reaches its minimum and then starts to rise.

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 EXAMPLE

 Suppose the short run cost function of a firm is given by:

TC=2Q3 –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

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THANK YOU!!!!!!