Economics 10 1

2025 November

The Theory of Production and Cost

By; Samuel S., MSc in EPA and MSc in ENRE, PhD candidate at AAU

2025 Economics 101 AAU

Theory of production in the short run
 Production process

•Production is the process of transforming inputs (labor,

capital, land and entrepreneurship) into outputs.
oIts an act of creating value or utility.

•The end products are outputs which could be

otangible (goods) or

ointangible (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.
oIt shows what is technically feasible when the firm
operates efficiently.
 Production function

•It can be represented using algebra as

𝑸 = 𝒇(𝒙𝟏 , 𝒙𝟐 , … . 𝒙𝒏 )
where 𝑄 is output, 𝑓 is the technological relationship, 𝑥1 , … , 𝑥𝑛
inputs.

•The most common one is

𝑸 = 𝒇(𝑳, 𝑲)

where 𝐿 is labor and 𝐾 capital

 Input classification

• Inputs are commonly classified into: Fixed inputs and Variable

inputs
oFixed inputs are inputs whose quantity cannot readily be
changed when an immediate adjustment in output is required.

oNo input is absolutely fixed, but some are fixed in the immediate
requirement period.

oExamples: Buildings, Land, Machinery…

 Input classification

• Variable inputs are inputs whose quantity can be changed almost

instantly in response to output needs.

•Their quantities can be:

oIncreased when market demand rises

oDecreased when market demand falls

•Example: Unskilled labor (easy to hire or reduce quickly)

 Production periods

•Short run = a period in which not all input quantities can be changed.
oAt least one input remains fixed.

• It does not refer to a specific universal period of time for all firms
or industries.

oIt is unique to each firm, industry, or economic variable.

•Long run= a period in which all inputs are variable

o planning horizon
 Short-Run Production

•This section assumes:

oOne fixed input: Capital and One variable input: Labor

•Since capital is fixed in the SR, output changes only by adjusting labor.

• Given fixed capital, production depends solely on labor input:

𝑸 = 𝒇(𝑳, 𝑲)

o The production function shows different levels of output obtained by

efficiently using various units of labor with fixed capital.
 SR Production…Total product (Q)

•When the variable input increases (with fixed inputs held constant):

oTP initially increases at an increasing rate

oThen increases at a decreasing rate

oReaches a maximum, and

oEventually declines if the variable input exceeds the carrying

capacity of the fixed input
 SR Production…Marginal product (Q)

•MP = additional output generated by adding one more unit of the

variable input, holding other inputs constant.

oExample: MPL measures the change in output from hiring one

additional worker.
𝒅𝑻𝑷
𝑴𝑷𝑳 =
𝒅𝑳

(Marginal product equals the slope of the TP curve.)

 SR Production…Average product (Q)

•AP = output produced per unit of the variable input.

oIt measures the mean contribution of each unit of the variable
input.
𝑻𝑷
𝑨𝑷𝑳 =
𝑳

oAP at a given labor input equals the slope of the ray from the origin to
the TP curve.
Total, Marginal, & Average Product
MP=DTP/DQL AP=TP/QL
Total Marginal
Labour Product Product Average
(workers (sweaters (sweaters per Product
per day) per day) additional (sweaters
worker) per worker)
a 0 0
b 1 4 ………..4 4.00
c 2 10 ………..6
5.00
d 3 13 ………..3
4.33
………..2
e 4 15 3.75
………..1
f 5 16 3.20
13
•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 .

• When 𝑀𝑃𝐿 = 0 TP is
Maximum
 The Law of Variable Proportions/Law of Diminishing Returns

As successive units of a variable input are added to a fixed input the

marginal product of the variable input eventually declines.

•The law assumes:

oTechnology is fixed

oTechniques of production do not change

oAll units of labor are of equal quality

 The Law of Variable Proportions/Law of Diminishing Returns

•It begins after the marginal product curve reaches its maximum.

•It occurs because more workers are used relative to the fixed amount
of capital or land.

•Hence
othe average worker has less of the fixed input to work with and
will be less productive.
Three Stages of Production in Short Run

AP,MP
Stage I Stage II Stage III

APL

•TPL Increases at L
•TPL Increases at Diminishing MPL
increasing rate. rate.
•MP Increases at •MPL Begins to decline. • TPL begins to decline
decreasing rate.
•TP reaches maximum level at •MP becomes negative
•AP is increasing and the end of stage II, MP = 0.
reaches its maximum at •AP continues to decline
•APL declines
the end of stage I
17
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).
a) Determine the 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 −𝟎.𝟔𝑲𝟐 −𝟎.𝟏𝑳𝟐 𝟎.𝟔𝑲𝟐 𝟏𝟓
a) 𝑨𝑷𝑳 = =
𝑳 𝑳
= 𝟒𝑲 −
𝑳
− 𝟎. 𝟏𝑳 = 𝟐𝟎 −
𝑳
−
𝟐𝟎𝑳−𝟏𝟓−𝟎.𝟏𝑳𝟐
𝟎. 𝟏𝐋 =
𝑳
b) The total product level(Max Q) occurs when 𝑴𝑷𝑳 = 0.
𝑑𝑇𝑃 𝑑(20𝐿 − 15 − 0.1𝑳𝟐 )
𝑴𝑷𝑳 = = = 20 − 0.2𝐿 = 0
𝑑𝐿 𝑑𝐿
0.2𝐿 = 20; 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):
𝑸𝒎𝒂𝒙 = 𝟒𝑲𝐿∗ − 𝟎. 𝟔𝑲𝟐 − 𝟎. 𝟏𝐿∗ 𝟐
𝟐
= 𝟒 𝟓 100 ∗ − 𝟎. 𝟔 𝟓 𝟐 − 𝟎. 𝟏 100 ∗
= 𝟐𝟎𝟎𝟎 − 𝟏𝟓 − 𝟏𝟎𝟎𝟎 = 𝟗𝟖𝟓
𝑸𝒎𝒂𝒙 = 𝟗𝟖𝟓
Theory of Cost in the short run
Cost

Accounting Cost
◦ Consider only explicit cost, the out of pocket cost for such items as
wages, salaries, materials, and property rentals

Economic Cost
◦ Considers explicit and opportunity cost (implicit cost).

◦ Opportunity cost is the cost associated with opportunities that are

foregone by not putting resources in their highest valued use.

Sunk Cost
◦ An expenditure that has been made and cannot be recovered--they
should not influence a firm’s decisions.
Cost in the short run

•Total output is a function of variable inputs and fixed inputs.

•Therefore, the total cost of production equals the fixed cost (the
cost of the fixed inputs) plus the variable cost (the cost of the
variable inputs), or
𝑻𝑪 = 𝑻𝑭𝑪 + 𝑻𝑽𝑪
o Fixed costs do not change with changes in output

o Variable costs increase as output increases.

 A Firm’s Short-Run Costs ($)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

0 50 0 50 --- --- --- ---

1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Cost Curves for a Firm
Price 400
($ per
year)

300

200

100

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
Cost Curves for a Firm
Price 400
($ per
year)

300
Fixed costs are
the same at all
200 levels of output.

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
Cost Curves for a Firm VC
Price 400
($ per
year)

300
Variable cost
increases with
production and
200
the rate varies with
increasing &
decreasing returns.
100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
Cost Curves for a Firm TC

Price 400
VC
($ per
year)

300
Total cost
is the vertical
sum of FC
200
and VC.

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
Cost in the short run

•Marginal Cost (MC) is the cost of expanding output by one unit.

• Since fixed cost have no impact on marginal cost, it can be written

as:

𝑑𝑇𝐶 𝑑𝑉𝐶
𝑀𝐶 = =
𝑑𝑄 𝑑𝑄

• Slop of the total cost curve

Cost in the short run

•Average Total Cost (ATC) is the cost per unit of output, or average
fixed cost (AFC) plus average variable cost (AVC). This can be
written:

𝑇𝐶 𝑇𝑉𝐶 𝑇𝐹𝐶
𝐴𝐶 = = + = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
𝑄 𝑄 𝑄

• Drown using ray from the origin

Cost Curves for a Firm TC

Price 400
VC
($ per
year)

300

200
A

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
Cost Curves for a Firm TC

Price 400
VC
($ per
year)

300
B

200
A

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
 Cost Curves for a Firm
The line drawn from the origin
to the tangent of the variable P TC

cost curve: 400 VC

◦ Its slope equals AVC 300 B

◦ The slope of a point on VC
200
equals MC A

◦ Therefore, MC = AVC at 7 100

F
units of output (point A) C
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output
Cost Curves for a Firm
Price 100
($ per
unit)

75

50

25

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
Cost Curves for a Firm
Price 100
($ per
unit)
Average fixed
75 cost fall
continuously

50

25

AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
Cost Curves for a Firm
Price 100
($ per
unit)
Average variable
75 cost decreases
initially
then increases.
50

AVC

25

AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
Cost Curves for a Firm
Price 100
($ per
unit)
Average total
75 cost decreases
initially
then increases.
50 ATC
AVC

25

AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
Cost Curves for a Firm
Price 100 MC
($ per
unit)
Marginal cost
75 decreases
initially then
increases.
50 ATC
AVC

25

AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
 Cost Curves for a Firm
Unit Costs
P
◦ AFC falls continuously 100 MC
◦ When MC < AVC or MC <
75
ATC, AVC & ATC decrease
50 ATC
◦ When MC > AVC or MC > AVC
ATC, AVC & ATC increase 25
AFC
0 1 2 3 4 5 6 7 8 9 10 11
Output
 Cost Curves for a Firm
Unit Costs
P
◦ MC = AVC and ATC at 100 MC
minimum AVC and ATC
75
◦ Minimum AVC occurs at a
50 ATC
lower output than
AVC
minimum ATC due to FC 25
AFC
0 1 2 3 4 5 6 7 8 9 10 11
Output
Example:

Suppose the short run cost functionof 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 2𝑸𝟑 –2𝑸𝟐 + Q + 10
A) TFC = 10; and 𝐓𝐕𝐂 = 2𝑸𝟑 –2𝑸𝟐 + Q
𝑻𝑭𝑪 𝟏𝟎
B) 𝐀𝐅𝐂 = 𝑸
=
𝑸
𝑻𝑽𝑪 2𝑸𝟑 –2𝑸𝟐 + Q
𝐀𝐕𝐂 = = = 2𝑸𝟐 –2𝑸 + 1
𝑸 𝑸
𝑻𝑪 2𝑸𝟑 –2𝑸𝟐 + Q + 10 𝟐
𝟏𝟎
𝐀𝐂 = = = 2𝑸 –2𝑸 + 1 +
𝑸 𝑸 𝑸
𝒅𝑻𝑪 𝒅(2𝑸𝟑 –2𝑸𝟐 + Q + 10)
𝐌𝐂 = = = 6𝑸𝟐 –𝟒𝑸 + 1
𝒅𝑸 𝒅𝑸
𝒅𝑴𝑪
C) To find the minimum value of MC, = 𝟎 = 12Q - 4 = 0
𝒅𝑸
𝑸 = 𝟏/𝟑
 Thus, MC is minimized when Q = 0.33
Solution:
•The minimum value of MC will be:
𝟏 𝟏
MC = 6𝑸𝟐 –𝟒𝑸 + 1 = 6( )𝟐 –𝟒( ) + 1 = 0.33
𝟑 𝟑

𝒅𝑨𝑽𝑪
•To find the minimum value of AVC, = 𝟎=4𝑄 − 2= 0
𝒅𝑸
𝑸 = 𝟎. 𝟓
oAVC is minimized at 𝑸 = 𝟎. 𝟓.
oThe minimum value of AVC will be:

oAVC =2𝑸𝟐 –2𝑸 + 1

AVC = 2 𝟎. 𝟓 𝟐 –2(𝟎. 𝟓) + 1= 0.5 – 1 + 1 = 0.5
 The relationship between SR production and cost
curves

•Let the price of labour be given by w, which is constant.

I) MC and MP of Labour

𝒅𝑻𝑪 ∆𝑻𝑽𝑪
𝐌𝐂 = = , Where𝑻𝑽𝑪 = 𝒘 ∗ 𝑳
𝒅𝑸 ∆𝑸

∆(𝒘∗𝑳) ∆𝑳 ∆𝑳 𝟏
Thus, 𝐌𝐂 = =𝒘 ; but =
∆𝑸 ∆𝑸 ∆𝑸 𝑴𝑷𝑳

𝒘
𝑴𝑪 =
𝑴𝑷𝑳
 The relationship between SR production and cost
curves

II) AVC and AP of Labour

𝑻𝑽𝑪
AV𝐂 = , Where𝑻𝑽𝑪 = 𝒘 ∗ 𝑳
𝑸

(𝒘∗𝑳) 𝑳 𝑳 𝟏
Thus, 𝐀𝐕𝐂 = = 𝒘 ; but =
𝑸 𝑸 𝑸 𝑨𝑷𝑳

𝒘
𝐀𝐕𝐂 =
𝑨𝑷𝑳
Relationship between short run production and cost curves