Ch-4

Theory of Production and Cost

Theory of production in short run:

Definition of production:
 Production is the process of transforming inputs into
outputs. Q = f(x1,x2,….xn); Q- output, and x1,x2,…xn are
inputs
 The end products of the production process are outputs
which could be tangible (goods) or intangible (services).
 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 general equation for production function can be described
as;
• Q = f(X1 , X2 , X3 ,..., Xn )
• where, Q is output and X1, X2, X3,…, Xn are different types of
inputs.
 Inputs
 Inputs are commonly classified as fixed inputs or 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
 Buildings, land and machineries are examples of fixed
inputs because their quantity cannot be manipulated easily
in a short period of time
 Variable inputs are those inputs whose quantity can be
altered (changed) almost instantaneously in response to
desired changes in output
 The best example of variable input is unskilled labour
 Cont…

Periods of production
Short run vs long run
 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
 Cont…
 Long run: it is a period of time at which the quantity of all
inputs can be changed. In long run all inputs become variable
inputs

Total, average, and marginal product

 Total product (TP): it is the total amount of output that can be
produced by efficiently utilizing specific combinations of the
variable input and fixed input
 Increasing the variable input (while some other inputs are
fixed) can increase the total product only up to a certain point.
 Cont..
 When 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
 In short run, TP function initially increases at an increasing
rate, then increases at a decreasing rate, reaches a maximum
point and finally decrease.
 Cont…
 Marginal Product (MP): it is the change in output attributed
to the addition of one unit of the variable input to the
production process.
 The change in total output resulting from employing
additional worker (holding other inputs constant) is the
marginal product of labour (MPL)
 =∆TP/∆L
 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
 Cont..
 Average Product (AP): Average product of an input is the
level of output that each unit of input produces, on the
average
 It indicates the mean contribution of each variable input to
the total product
 APL= TP/L
Average product of labour first increases, reaches its maximum
value and eventually declines
 Cont..
Output
a
@ TP3
TP
TP2
TP

TP1

Units of labour (variable input)

L1 L2 L3

APL
MPL

APL

L1 L2 L3
MPL
 Cont…
The relationship between TP and MP
 When TP increase @ increasing rate, MPl increase
 When TP increase @ decreasing rate, MPL decrease but positive
 When TP maximum, MPL become zero
 When TP decline, MPL negative
The relationship between MPL and APL;
– When APL is increasing, MPL > APL.
– When APL is at its maximum, MPL = APL.
– When APL is decreasing, MPL < APL.
• Example: Suppose that the short-run production function
of certain cut-flower firm is given by:
-0.1 :where Q is quantity of cut-flower produced, L is labour
input and K is fixed capital input (K=5).
• Determine the average product of labour (APL) function.
• At what level of labour does the total output of cut-flower
reach the maximum?
• What will be the maximum achievable amount of cut-
flower production?
 Law of variable proportion

 It states that as successive units of a variable input are added

to a fixed input, beyond some point the extra, or marginal
product that can be attributed to each additional unit of the
variable resource will decline
 The law starts to operate after the marginal product curve
reaches its maximum
 This law is also called the law of diminishing returns.
 Stages of production

There are 3 stages of production

Stage I: It covers the range of variable input levels over which
the average product (APL) continues to increase.

 It goes from the origin to the point where the APL is

maximum ( MPL =APL)

 It is not an efficient region of production though the MP of

variable input is positive
 The fixed input is under-utilized (not efficiently utilized).
 Cont....
• Stage II: It ranges from the point where APL become

maximum (MPL=APL) to the point where MPL is zero.

• It is production stage of diminishing marginal returns

• It is the optimum capital-labour combination is achieved.
• This stage is the efficient region of production
• The efficient region of production is where the marginal
product of the variable input is declining but positive
 Cont…
Stage III: An increase in the variable input is accompanied by
decline in the total product.
 The marginal product of labour becomes negative
 The stage of negative marginal returns to the variable input
 The fixed input is over-utilized
 A rational firm should not operate in stage III
 Theory of cost

Theory of costs in the short run

Definition and types of costs

 Cost is the monetary value of inputs used in the production
of an item.
 The accountant, profit is the firm‘s total revenue less its
explicit costs (accounting costs).
 The economist, economic profit is total revenue less
economic costs (explicit and implicit costs).
• Accounting cost is the monetary value of all purchased
inputs used in production; it ignores the cost of non-
purchased (self-owned) inputs. It is c/d explicit cost
• 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 of producing a commodity considers the monetary value
of all inputs (purchased and non- purchased)
• The monetary value of these inputs (non-purchased) is obtained by
estimating their opportunity costs in monetary terms
• The estimated monetary cost for non- purchased inputs is known as
implicit cost.
• Economic profit =Total revenue – Economic cost (Explicit
cost + Implicit cost)

• Accounting profit of a firm will be greater than economic

profit by the amount of implicit cost
• if implicit costs exist, then accounting profit will be larger
than economic profit
 Total, average and marginal costs in the short run

 C = f (Q), where C is the total cost of production and Q is the

level of output
 Total cost (TC) can be categorized in to – total fixed cost
(TFC) and total variable cost (TVC).
Fixed costs do not vary with the level of output
 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
 Cont..
• Examples of fixed costs; salaries of administrative staff,
expenses for building depreciation and repairs, expenses for
land maintenance and the rent of building
• Variable costs include all costs which directly vary with the
level of output
• if the firm produces zero output, the variable cost is zero
• EX: cost of raw materials, the cost of direct labour and the
running expenses of fuel, water, electricity, etc.
• Total fixed cost (TFC): cost of all fixed inputs
• Total variable cost (TVC): cost of variable inputs. The total
variable cost of a firm has an inverse S-shape.
• Total Cost (TC): The total cost curve is obtained by vertically
adding TFC and TVC at each level of output
• TC has also an inverse S-shape
• When out put become zero, tvc become zero and TC=TFC
TC, TFC,& TVC
• Per unit costs
 Average fixed cost (AFC) - Average fixed cost is total fixed cost per unit of
output
AFC=TFC/Q
 Average variable cost (AVC) - Average variable cost is total variable cost per
unit of output
 AVC= TVC/Q

 Average total cost (ATC) or Average cost (AC) - Average total cost is the total
cost per unit of output
 AC= TC/Q =AVC+AFC
• Marginal cost is defined as the additional cost that a firm incurs to produce one
extra unit of output
• MC =∆TC/∆Q ===
Figure: AFC, AVC, AC & MC

AFC
AVC
AC
AC
MC MC

AVC

AFC

Q
Q1 Q2
• AVC curve reaches its minimum point at Q1 level of output

• 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.
• MC curve passes through the minimum points of both AVC
and AC curves.
 Suppose the short run cost function of a firm is given by:
TC=2Q3 –2Q2 + Q + 10.
 Find the expression of TFC & TVC
 Derive the expressions of AFC, AVC, AC and MC
 Find the levels of output that minimize MC and AVC and
then find the minimum values of MC and AVC
 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
 Marginal Cost and Marginal Product of Labour
MC=∆TVC/∆Q, TVC = W*L
MC= ∆(WL)/∆Q = W*∆L/∆Q; ∆L/∆Q =1/MPL
MC= W*1/MPL = W/MPL;
MC =W/MPL,
 when MPL increase, MC decrease
 When MPL max, MC min
 When MPL decrease, MC increase
 Cont..
 Average Variable Cost and Average Product of Labour
AVC =TVC/Q; TVC =W*L
AVC= W*L/Q: L/Q =1/APL
AVC= W*1/APL
AVC= W/APL
 When APL increase, AVC decreasse
 When APL max, AVC min
 When APL decrease, AVC increase
Graphically
END