Chapter Four

The Theory of Production and Cost

Introduction
This chapter has two major sections. The first part will introduce you to the basic concepts of
production and production function, classification of inputs, essential features of short run
production functions and the stages of short run production. The second part mainly deals with
the difference between economic cost and accounting cost, the characteristics of short run cost
functions, and the relationship between short run production functions and short run cost
functions.

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. In order to get better
utility from raw materials, they must be transformed into outputs. 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. It can also be defined 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).

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(X 1 , X 2 , X 3 ,..., X n )

where, Q is output and X1, X2, X3,…, Xn are different types of 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. In fact, no input is ever absolutely fixed but may be fixed
during an immediate requirement. 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 because their
quantity cannot be manipulated easily in a short period of time. 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.

Does a short run refer to specific period of time that is applicable to every firm or industry?
If this condition is rather unique to the firm, industry or economic variable being studied,
what is our basis to classify production as a short run?

In economics, short run refers to a period of time in which the quantity of at least one input is
fixed. In other words, 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. Here it should be noted that short
run periods of different firms have different durations. 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. This
sub-section is confined to production with one variable input and one fixed input.

Consider a firm that uses two inputs: capital (fixed input) and labour (variable input). Given
the assumptions of short run production, the firm can increase output only by increasing the
amount of labour it uses. Hence, its production function can be given by:
Q = f (L)
where, Q is output and L is the quantity of labour.

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.
 4.1.3 Total, average, and marginal product

In production, the contribution of a variable input can be described in terms of 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. Initially, as we combine 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 general, the
TP function in the short-run follows a certain trend: it initially increases at an increasing rate,
then increases at a decreasing rate, reaches a maximum point and eventually falls as the
quantity of the variable input rises. This tells us what shape a total product curve assumes.

Marginal Product (MP): it 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.
dTP Q
MPL  
dL 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. 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:
TP
APL 
L

Average product of labour first increases, reaches its maximum value and eventually declines.
The AP curve can be measured by the slope of rays originating from the origin to a point on the
TP curve (see figure 4.1). For example, the APL at L2 is the ratio of TP2 to L2. This is identical
to the slope of ray a.
Output
a

TP3

TP2 TP

TP1

Units of labour (variable input)

L1 L2 L3

APL
MPL

APL

Units of labour (variable input)

L1 L2 L3
MPL

Figure 4.1: Total product, average product and marginal product curves

The relationship between MPL and APL can be stated as follows.

 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: Q = 4KL - 0.6K 2 - 0.1L2 where Q is quantity of cut-flower produced, L is labour input and
K is fixed capital input (K=5).
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?
Solution:
Q 4KL - 0.6K 2 - 0.1L2 0.6K 2 15 20L - 15 - 0.1L2
a) APL = = = 4K - - 0.1L = 20 - - 0.1L =
L L L L L

b) When total product (Q) is maximum, MP will be zero.

Q (4KL - 0.6K 2 - 0.1L2 )
MPL = = = 4K - 0.2L = 0
L L
20
 20 - 0.2L = 0  L = = 100
0.2
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):
2
Q = 4KL - 0.6K - 0.1L2 = 4* 5* 100 - 0.6 * 5 2 - 0.1* 100 2 = 985

4.1.4 The law of variable proportions

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. For
example, if additional workers are hired to work with a constant amount of capital equipment,
output will eventually rise 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 of equal quality. Each successive worker is
presumed to have the same innate ability, education, training, and work experience. Marginal
product ultimately diminishes not because successive workers are less skilled or less energetic
rather it is because more workers are being used relative to the amount of plant and equipment
available. The law starts to operate after the marginal product curve reaches its maximum (this
happens when the number of workers exceeds L1 in figure 4.1). This law is also called the law
of diminishing returns.

4.1.5 Stages of production

We are not in a position to determine the specific number of the variable input (labour) that the
firm should employ because this depends on several other factors than the productivity of
labour. However, it is possible to determine the ranges over which the variable input (labour)
be employed. To this end, economists have defined three stages of short run production.
Stage I: This stage of production 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 AP L
is maximum, which is the equality of MPL and APL (up to L2 level of labour employment in
figure 4.1). This stage is 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 under-utilized (not efficiently
utilized).

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). Here, as the labour input increases by one unit, output
still increases but at a decreasing rate. Due to this, the second stage of production is termed as
the stage of diminishing marginal returns. The reason for decreasing average and marginal
products is due to the scarcity of the fixed factor. That is, once the optimum capital-labour
combination is achieved, employment of additional unit of the variable input will cause the
output to increase at a slower rate. As a result, the marginal product diminishes. This stage is
the efficient region of production. 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 where the marginal
product of the variable input is declining but positive.

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. This stage is also known as the stage of negative marginal returns to the
variable input. The cause of negative marginal returns is the fact that the volume of the variable
inputs is quite excessive relative to the fixed input; the fixed input is over-utilized. Obviously,
a rational firm should not operate in stage III because additional units of variable input are
contributing negatively to the total product (MP of the variable input is negative). In figure 4.1,
this stage is indicated by the employment of labour beyond L3.

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 the production of an item.

Economists use the term ―profit‖ differently from the way accountants use it. To the
accountant, profit is the firm‘s total revenue less its explicit costs (accounting costs). To 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 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.). These costs are said to be explicit costs.
Explicit costs are out of pocket expenses for the purchased inputs. If a producer calculates her
cost by considering only the costs incurred for purchased inputs, then her profit will be an
accounting profit.

Accounting profit = Total revenue – Accounting cost = Total revenue – Explicit cost

In the real world economy, entrepreneurs may use some resources which may not have direct
monetary expense since the entrepreneur can own these inputs himself or herself. Economic
cost of producing a commodity considers the monetary value of all inputs (purchased and non-
purchased). Calculating economic costs will be difficult since there are no direct monetary
expenses for non-purchased inputs. The monetary value of these inputs is obtained by
estimating their opportunity costs in monetary terms. The estimated monetary cost for non-
purchased inputs is known as implicit cost. For example, if Mr. X quits a job which pays him
Birr 10, 000.00 per month in order to run a firm he has established, then the opportunity cost of
his labour is taken to be Birr 10,000.00 per month (the salary he has forgone in order to run his
own business). Therefore, economic cost is given by the sum of implicit cost and 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.
If all inputs are purchased from the market, accounting and economic profit will be the same.
However, if implicit costs exist, then accounting profit will be larger than economic profit.

4.2.2 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. A cost function can be represented using an equation as
follows.
C = f (Q), where C is the total cost of production and Q is the 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). By fixed costs we mean 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).
The fixed costs may include salaries of administrative staff, expenses for building depreciation
 and repairs, expenses for land maintenance and the rent of building used for production.
Variable costs, on the other hand, include all costs which directly vary with the level of output.
For example, if the firm produces zero output, the variable cost is zero. These costs may
include the cost of raw materials, the cost of direct labour and the running expenses of fuel,
water, electricity, etc.

In general, the short run total cost is given by the sum of total fixed cost and total variable cost.
That is,
TC = TFC + TVC
Based on the definition of the short run cost functions, let‘s see what their shapes look like.

Total fixed cost (TFC): Total fixed cost 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): The total variable cost of a firm has an inverse S-shape. The shape
indicates the law of variable proportions in production. At the initial stage of production with a
given plant, as more of the variable factor is employed, its 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.

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.

TC
Cost

TVC

TFC

Output

Figure 4.2: Short run TC, TFC and TVC curves

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.
TFC
AFC 
Q
b) 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.
TVC
AVC 
Q
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.

c) 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.

TC
AC 
Q

TVC  TFC TVC TFC

Equivalently, AC    = AVC + AFC
Q Q Q
Thus, AC can also be given by the vertical sum of AVC and AFC.

Marginal Cost (MC)

Marginal cost is defined as the additional cost that a firm incurs to produce one extra unit of
output. In other words, it is the change in total cost which results from a unit change in output.
Graphically, MC is the slope of TC function.
dTC
MC 
dQ
In fact, MC is also a change in TVC with respect to a unit change in the level of output.

dTFC dTVC dTVC dTFC

MC   , since 0
dQ dQ dQ

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.
 AFC
AVC
AC AC
MC MC

AVC

AFC

Q
Q1 Q2

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

In the above figure, 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.

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

Solution:
Given TC=2Q3 – 2Q2 + Q + 10
a) TFC = 10 , TVC = 2Q3 – 2Q2 + Q

b) AFC = TFC/Q = 10/Q

AVC = TVC/Q = (2Q3 – 2Q2 + Q)/Q = 2Q2 – 2Q + 1
AC = TC/Q = (2Q3 – 2Q2 + Q + 10)/Q= 2Q2 – 2Q + 1 + 10/Q
MC = dC/dQ= 6Q2 – 4Q + 1

c) To find the minimum value of MC,

dMC/dQ = 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=0.33

To find the minimum value of AVC

dAVC/dQ = 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

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

TVC
MC  , where TVC  w.L
Q

w.L  L L 1
MC   w. , but 
Q Q Q MPL

w
Therefore, MC 
MPL

The above expression shows that MC and MPL are inversely related. When initially MP L
increases, MC decreases; when MPL is at its maximum, MC must be at a minimum and
when finally MP L declines, MC increases.

ii) Average Variable Cost and Average Product of Labour

TVC
AVC  , where, TVC  w.L
Q
w.L L L 1
AVC   w. , but 
Q Q Q APL
 Therefore, AVC  w
APL
This expression also shows inverse relation between AVC and AP L. When APL increases,
AVC decreases; when APL is at a maximum, AVC is at a minimum and when finally AP L
declines, AVC increases.

We can also sketch the relationship between these production and cost curves using graphs.

MPL
APL

APL

Labor (L)
MPL

MC MC

AVC
AVC

Output

Figure 4.4: relationship between short run production and cost curves

From the above figure, we can conclude that the MC curve is the mirror image of MP L curve
and AVC curve is the mirror image of AP L curve.
Chapter summary

Production is the act of creating those goods or services that have exchange values. The
process of production requires inputs such as land, labor, capital and entrepreneurial ability.
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. 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 change in output is required while variable inputs are those inputs whose quantity
can be changed almost instantaneously in response to desired changes in output.

In economics, short run refers to a period of time in which the quantity of at least one input is
fixed. In the short run, the efficient stage of production where marginal product of the variable
input is positive but declining.

The law of diminishing returns describes what happens to output as a fixed plant is used more
intensively. As successive units of a variable resource such as labor are added to a fixed plant,
beyond some point, the marginal product associated with each additional unit of a resource
declines.

Costs are the monetary values of inputs used for production purpose. Costs of production may
involve explicit costs (costs of purchased inputs) and/or implicit costs (estimated costs of
inputs self-owned inputs). Accounting cost is the monetary value of all purchased inputs used
in production. Economic cost includes the monetary value of both purchased and non-
purchased inputs. Thus, economic cost is the sum of implicit cost and explicit cost.

In the short run, one or more of a firm‘s inputs are fixed. Fixed costs are constant irrespective
of the level output. A firm cannot avoid these costs even by producing zero level of output.
Variable costs, on the other hand, vary with the level of output directly. In the short run, the
AC, AVC and MC curves assume a U- shape due to the law of variable proportions. Short run
marginal and average variable cost curves are a mirror reflection of the marginal product and
average product of the variable input respectively.