Chapter Four: Theory of Production and Cost

4.1 Theory of Production

• Production:
– is a creation of any good/service that have economic
value to either consumers or producers
• Production Function:
– Presents firm’s production technology
– It represents the maximum possible output that can
be produce from a given level of input at a given
technology.
– It is a physical relationship between input and output
• Production process: Is the manner by which inputs are
transformed into output.
• In reality, there are different processes to produce a
particular output.
• Labor intensive (More labor)
• Capital incentive (more capital)
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 Theory of Production (Cont. …)
• The production technology includes only those
processes which are technically efficient
• Which processes are technically efficient ?
– If one process uses less of one of the inputs as
compared to all other process, it will be regarded as
technically efficient process
– But,
– If one process uses less of one input and more of the
other input, then such processes can not be compared
directly on the bases of technical efficiency, and hence
both will be regarded as technically efficient process
• A choice between them shall be an economic
one, based on the prices of inputs
2
 Technical Vs Economic Efficiency
• Technical Efficiency : Producing the maximum
output from a given level of input.
– It is not possible to increase output without
increasing input
• Economic efficiency: It is doing things at the
lowest possible cost
• Producing a particular good/service require
the use of different inputs such as,
– Land, Labor, capital, raw materials , technology,
• Q=( Ld, L,K,M,T, …)
3
 Theory of Production (Cont. …)
 It implies that,
• Economist reduced it as increasing output (Q)
requires increasing the
• Q=f(L,K) ……. Why? use of labor and capital
• Where, inputs.
 Is it possible to
• Q = Output
increase output by
• L = Labor inputs increasing both labor
• K = is capital inputs and capital inputs
simultaneously?
All are in physical units  In reality output can be
What does Q = f(L,K) mean? increased in two ways

4
 Theory of Production (Cont. …)
 Output can be increased by increasing one of
the two input while keeping another input fixed
 This is true in the short run
 Output can also be increased by increasing both
labor and capital input at the same times
This is possible only in the long-run
 Accordingly, we have
 Short-run production
Long-run production
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 Short run Vs. long run
Short-run: is a time period which is not
sufficient to change the level of all
inputs.
 Thus, in short run at least one input is
fixed.
 Hence in the short run, there is a
variable and fixed input
Long run: is that time period sufficient
enough to change the level of all inputs.
 Thus, in the long-run all inputs are variable
6
 Fixed Vs Variable Inputs
 Fixed Inputs: are inputs whose quantity can
not be changed with the level of out.
 The level of such input will not be affected by
the level of output produced.
 These are fixed capital assets like, Machinery,
Building, land, Management staff, etc.
 Variable Inputs: are inputs whose quantity
directly related to the level of output
produced.
 The level of such inputs is directly related to
the amount of output produced
 Raw material is a typical example
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 4.1.1. Production in the short-run/
Production with one variable input
 The generalized production function
 Q=f(L,K) will be modified as
Q = f( L, K)
 In the short run, labor is a variable input
and capital is a fixed input.
 This implies that, the level of output
depends upon the level of labor input
employed in the production process.

8
 The Concept of Total Product,
Marginal Product and Average Product
 Total product (TP): is the total amount
of output produced in physical unit.
 Increasing the variable input (while some
other inputs are fixed) can increase the
total product only up to a certain point.
This is because of the law diminishing
return
As a result The shape of the total
variable curve is nearly S-shape.
 It reflects the law of diminishing return 9
The Law of Diminishing Marginal
Rate Returns (LDMR)
The LDMR states that as the use of a
variable input increases, initially the total
output will increase, later on a point will
eventually be reached at which the level
of additional output decreases as more
and more variable inputs are added.

10
 The Concept of TP,AP,TP (Cont. …)

Average Product (AP): output produce

per unit of a variable input (labor input)
used in the production process.
It is the ratio of total output to the
number of variable inputs (L)

Average product of labor first increases with

the number of labor (i.e. TP increases faster
than the increase in labor), and eventually it
declines 11
Marginal Product (MP)
 Is the additional output associated with the
additional unit of a variable input (labor).
It is rate of change in the total output
associated with a unit change in the variable
input
It is the slope of the total product

TP dTP
MPL  or MPL 
L dL

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 Short-run production function
Quantity
of output

TP

APL
MPL Labor

13
 Relationship between AP, MP and TP
 When TPL is increasing at increasing rate, MPL
increases.
 When TPL increases at decreasing rate, MPL
declines but it is positive
 When TPL reaches at maximum, MPL is zero
 When TPL decline , MPL is negative.
 MPL = APL,
 AP is at maximum (Slope of APL is zero)
 When MPL>APL, APL increasing
 When MPL<APL, APL falling
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 Short-run production schedule
Labor in No Quantity in ton
workers (TP) AP MP
0 0 - -
1 24 24 24
2 72 36 48
3 138 46 66
4 216 54 78
5 300 60 84
6 384 64 84
7 462 66 78
8 528 66 66
9 576 64 48
10 600 60 24
11 600 54.5 0
12 588 49 -12 15
 Stages of Production and Efficient Region
of Production
• Stage I – Starts from the origin
• Ends when MP = AP
• Or when AP is maximum
• Stage II – starts from the point where Stage
I ends.
• ends when TP is max and
• MP = 0
• Stage III – : Area beyond stage II 16
 Stages of Production (Cont. …)
Quantity
of output
Stage I
Irrational Stage Stage II
rational
/Economic
stage
TP

Stage III
Irrational Stage

APL
MPL Labor

17
 Stages of Production (Cont. …)
Labor in No Quantity in ton
workers (TP) AP MP
0 0 - -
1 24 24 24
2 72 36 48
3 138 46 66
Stage 4 216 54 78
I
5 300 60 84
6 384 64 84
7 462 66 78
8 528 66 66
Stage 9 576 64 48
II 10 600 60 24
11 600 54.5 0
12 588 49 -12 18
• The firm should not operate in stage III
– Because in this stage additional units
of variable input are contributing
negatively to the total product (MP of
the variable input is negative).
• Stage I is also not an efficient region of
production though the MP of variable input is
positive.
– The reason is that the variable input is too
small to efficiently run the fixed input; so
that the fixed input is under utilized.

19
• Thus, the efficient region of production
is stage II.
– At this stage 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
over that range of employment of variable
input where the marginal product of the
variable input is declining but positive

20
 Example
• Suppose firm’s short-run technology is
given by:
Q =14L+20L2 -2L3.
• Where L is labor input in number of
workers.
• Determine
– Average Product of Labor (APL)
–Marginal Product of Labor (MPL) 21
 4.1.2. Long run Production: Production
with two variable inputs.

 In the long-run a firm has sufficient time to

change the level of all input. .

 The resulting production function can be

expressed as Q= F(L, K)

 Output (Q) can be increased by increasing both

labor and capital input simultaneously.

 Hence in the long-run all inputs are variable

.
22
Consider a hypothetical Iron-ore producing firm using both
labor and capital input as a variable input. Output is Iron-
ore in ton and capital is measured in horse power and labor
is in number of workers
Labor input in Capita input in horse power
number of
workers
250 500 750 1000
1 3 6 9 16

2 6 9 16 24

3 9 16 33 44

4 24 33 44 48

5 33 44 48 55

6 44 48 55 64 23
• There are different processes to produce same level of
output
• A line can be drawn to connect all processes producing the
same level of output
• This line is called Isoquant
• “Iso” comes from Greek word “Isos” meaning equal
• Quant is a short for quantity .
• Isoquant would mean a line representing equal quantity

9 tons 16 tons 44 tons

(1, 750) (1, 1000) (3, 100)

(2, 500) (2, 750) (4, 750)

(3, 250) (3, 500) (5, 500)

(6, 250)
24
 Isoquant
Capital

1000

750

500
16t

250 44t
9t

1 2 3 4 5 6
Labor

25
Isoquants
Is a line representing different combinations
of labor and capital input producing the
same level of output.
An isoquant is a curve that shows all
possible efficient combinations of inputs
that can yield equal level of output
On a given Isoquant the level of output is
constant
Isoquant maps: is a set of isoquants that
represent different level of output as we move
up and to the right.
26
• Iso-quant assumptions
– The producer is rational aiming at
maximizing profit
– Only two inputs (labor and capital) are
employed
– There is technical possibility of substituting
one input for another.
– Inputs and outputs are divisible
– State of technology is given
– Diminishing Marginal Rate of Technical
substitution
 Properties of Isoquants
[Link] is down ward slopping.

2. The shape of the Isoquant is convex to the

origin

[Link] isoquant far from the origin represents

he greater the level of output.

4. Isoquants do not cross each other.

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4.3.2. Marginal Rate of Technical Substitution (MRTS)

 MRTS is slope of an isoquant.

 The MRTS shows the amount by which the quantity of

one input can be reduced when one extra unit of
another input is used, so that output remains
unchanged.

• MRTSLK : Represents the amount of capital input

that must be given up in exchange for one additional
unit of labor input without affecting the level output.
K MPL
MRTS L , K  
L MPK
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Why MRTS is Diminishing?
- No inputs are perfectly substitute
- Inputs are subjected to diminishing return

30
 Iso-cost
 The level of output produced by the firm is constrained by

 The availability financial expenditure (C)

 Prices of inputs
 This limitation is represented by Iso-cost
function/line
 Iso-cost: is a lines/function representing all labor and
capital input that costs the same.
Capital

C/r
Iso cost
line

C/w Labor

C  rK  wL , where K and L
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 Long-run Equilibrium of the Firm

A firm is at Equilibrium when he chooses

the labor and capital combination that
maximizes profit.
 This requires bringing together Iso-quant and
Iso-cost together

Equilibrium occurs at the point of

tangency between the Iso-quant and
Iso-cost
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 Long-run Equilibrium
Capital

E Q3
K*
Q2
Q1

L*
Labor

33
 4.2. Theory of Cost
What is Cost ?
Cost : is the monetary value of inputs used in
the production process.
Cost can be
– private cost
– social cost
Private cost: are costs incurred by the firm when
undertaking its economic activities.
These are cost incurred by the firms directly or
indirectly
 Cost …
• Private cost can be
– Accounting Costs ( Explicit cost): This are
direct costs paid out of the firms pocket
• These are costs paid by the firm to the resource
owners
– Implicit costs: are opportunity costs of
resources owned by the firm
Economic cost = Explicit cost + Implicit Cost

35
Social cost: is the cost of economic
activities occurred to the
society.
Social Cost=Private cost + External
cost
External cost: Are costs involuntarily
imposed up on the society .
• A firm in undertaking economic activities,
may impose costs on the third party not
related to the activity.
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Example
• A Leather industry in producing its product,
may produce hazardous wests as a by
product
– The wests may be dumped in the river
– Bad smell may be released
• The west and the smell from the industry
costs the society living around the factory.
• The cost can be both
– Physical: deterioration of physical asset
– Financial: Cost of medical expenses or cost to clean
the west
37
 Cost Function
 Cost is a function of
 Level of output (Q)
 Prices of inputs (Pi)
 Technology (T)
 This can be written as
 C = f (Q, T, Pi)
Where C- is total cost of production
Q - is the amount of output
T – is technology
Pi – is the price of input
• However, Cost is presented as a function of output
and the effect of other factors will be shown by
the shift of the cost curve. C =f(Q)
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 Short Run Vs. Long Run Costs
• Economics theory distinguishes between short
run costs and long run costs
Short run costs: are the costs over a period
during which some factors of production are fixed.
The long-run costs: are the cost over a period
long enough to permit the change of all factor of
production.
Thus, in the long-run all costs are variable

39
 Short-run costs
All costs incurred in the short run, is called
total costs (TC) .
Total cost has two components
• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
Total Fixed Cost (TFC): Are cost that will not
change with the level of output.
– It is the monetary value of fixed inputs.
– It is independent of the level of output
produced
E.G:
Salaries of admin. staff, depreciation, rent, interest
payment, etc.
40
 TFC -Curve

100 TFC

41
Total Variable Cost (TVC): Are costs that will vary
with the level of output.
• It is dependent on the level of output
• It is a monetary value of variable inputs
• E.g. Row materials cost, Fuel, energy , wage etc.

TVC Q TVC
TVC 0 0
5 20
10 30
15 60
20 100

42
Total Cost (TC)
 The total cost curve is obtained by vertically adding the TFC and the
TVC i.e., by adding the TFC and the 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.
 But the TC curve doesn’t start from the origin as that of the TVC
curve.
 The TC curve starts from the point where the TFC curve intersects the
cost axis. The vertical distance between them (TFC) is constant.

Q TFC TVC TC
C
0 100 0 100
TC
5 20 120
TVC
10 30 130
TFC
TFC 15 60 160
20 100 200
Q
43
 Unit cots
• Average fixed cost (AFC): It is fixed cost per unit of
output TFC
AFC 
Q
As the level of output increase AFC decreases.

Thus, AFC curve is continuously decreasing but it can never be

zero.
Q TFC AFC
0 100 -
5 20
10 10
15 6.67
20 5

44
 Average variable cost (AVC)
• AVC: It is a variable cost per unit of output
• AVC is similarly obtained by dividing the TVC
with the corresponding level of output.

TVC
AVC 
Q Q TVC AVC
Cost 0 0
AVC 5 20 4
10 30 3
15 60 4
20 100 5

Q=3
Out put (Q) 45
Average total cost (ATC) or Average cost (AC)
 It is a total cost per unit of output

 It shows the amount of cost incurred to produce each unit of

successive outputs.
AC = AVC + AFC Q TFC TVC TC AFC AVC ATC
0 100 0 100 - - -
5 20 120 20 4 24
TC TVC TFC
AC    10 30 130 10 3 13
Q Q Q 15 60 160 6.67 4 10.67
20 100 200 5 5 10

46
• Average Total Cost (ATC): Has U-shape due to
the law of variable proportion

Cost ATC
AVC

Out put (Q)

 Marginal Cost (MC)
 The marginal cost
 is defined as the additional cost associated with
additional unit of output
 MC is the rate of change in TC with respect to output,
 MC is the slope of TC
 MC is also the rate of change of TVC with respect to
the level of output.

dTC dTFC  dTVC dTVC

MC  MC  
dQ dQ dQ
48
Marginal Cost curve

49
 Hypothetical total, average and marginal costs
Q TFC TVC TC=TFC+TVC AFC=TFC/Q AVC=TVC/Q ATC=TC/Q = MC=∆TC/Q
AFC+AVC
0 60 0 60 - - - -
1 60 30 90 60 30 90 30
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13.75 28.75 10
5 60 75 135 12 15 27 20
6 60 120 180 10 20 30 45

Exercise
Given the cost function, find FC,VC,AFC,AVC,ATC
and MC functions?
TC  3Q  2Q  10Q  100
3 2
50
[Link] relationship between average costs
• Both AVC and ATC are u – shaped, reflecting the
law of variable proportions
• the minimum of ATC occurs to the right of the
minimum point of the AVC ( see the above figure)
• Because, ATC includes AFC which
continuously decreases as the level of output
increases.
• After the AVC has reached its lowest point and
starts rising, its rise is over a certain range is
more than off set by the fall in the AFC, so that
the ATC continues to fall (over that range)
despite the increase in AVC.
51
Relationship among Short-run
average cost Curves cost
MC AC
 When MC is below AVC and
ATC, both AVC and ATC are AVC
falling
 When MC is above AVC and
ATC, both of them are rising
AFC
 The MC curve passes through
the minimum point of both AC output
and AVC
 AVC=MC, when AVC is at
minimum
 ATC=MC, when ATC is at
minimum 52
 Relationship between short run average costs and
average products
Short run AVC and MC curves are the mirror image of average
and marginal product.

L=3 L=4
Long run Cost
• In the long term the firm can expand its business
• So, in the long run all inputs are variable
• Due to this only variable costs are exist (TFC=0)
• TC=TVC
• The long run AC and MC has the shape they have in
the short run

The simple meaning of

economies of scale is
doing things more
efficiently with increasing