CHAPTER FOUR
THEORY OF PRODUCTION AND COST
OUTLINE
This chapter has two major sections
First:
The basic concepts of production and production function,
Classification of inputs,
Essential features of short run production functions
The stages of short run production.
Second
The difference between economic cost and accounting cost,
The characteristics of short run cost functions
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
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.
It can be expressed in tabular or graphic form or by a
mathematical formula
INPUTS (TYPES OF INPUTS IN Z SHORT
RUN PRODUCTION PERIOD)
Inputs are commonly classified as fixed inputs or variable
inputs.
Fixed inputs are inputs whose quantity cannot readily be
changed when market conditions indicate that an immediate
adjustment in output is required.
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.
VARIABLE INPUTS
Variable inputs are inputs whose quantity can be altered
almost instantaneously in response to desired changes in
output.
The best example of variable input is unskilled labour.
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
SHORT RUN….
Consider a firm that uses two inputs: capital (fixed input) and
labour (variable input).
In 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.
In short run, output can change only when the amount of
labour changes.
4.1.3 TOTAL, AVERAGE, AND MARGINAL
PRODUCT
Total product (TP) is the total amount of output that
can be produced by efficiently utilizing combinations
of the variable input and fixed input.
Increasing the variable input can increase the total
product only up to a certain point.
TP 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.
MARGINAL PRODUCT (MP):
Marginal Product (MP) is the change in output attributed to
the addition of one unit of the variable input to the production
process, other inputs being constant
MPL measures the slope of the total product curve at a given
point.
The marginal product of the variable input first increases,
reaches its maximum and then decreases to the extent of
being negative
AVERAGE PRODUCT (AP)
Average product of an input is the level of output that each
unit of input produces, on 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.
Average product of labour first increases, reaches its
maximum value and eventually declines.
MPL and TP.
When TP is increasing, MPL is positive .
When TP reaches maximum, MPL = 0
When TP is decline, MPL is negative.
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.
EXERCISE
4.1.4 THE LAW OF VARIABLE PROPORTIONS
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 equal quality.
Each successive worker is presumed to have the same innate
ability, education, training, and work experience.
Marginal product ultimately diminishes 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 law is also called the law of diminishing returns.
4.1.5 STAGES OF PRODUCTION
Economists have defined three stages of short run production.
Stage I: This stage covers the range from the origin to the
APL is maximum where APL is equal to MPL. In this stage:
APL is continues to increase
This stage is not an efficient region of production though the
MP of variable input is positive.
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.
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 AP and MP is due to the scarcity of
the fixed factor
Additional inputs are contributing positively to the total
product and MP of successive units of variable input is
declining.
Hence, the efficient region of production is where the MPL is
declining but positive.
Stage III: an increase in the variable input is accompanied by
decline in the total product.
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. Because volume of the variable
inputs is quite excessive relative to the fixed input; the fixed
input is over-utilized.
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).
4.2 THEORY OF COSTS IN THE SHORT RUN
4.2.1 Definition and types of costs
Cost is the monetary value of inputs used in the production of
goods and services.
Economists use the term “profit” differently from the way
accountants use it.
Accountant profit is the firm‘s total revenue less its explicit
costs (accounting costs).
Economic profit is total revenue less economic costs
(explicit and implicit costs).
ACCOUNTING COST
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
Accounting profit = Total revenue- explicit cost/accounting cost
ECONOMIC COST
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.
This estimated monetary cost called implicit 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.
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.
C = f (Q),
Technical R/n b/n Tc & output
where C is the total cost of production
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).
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 include all costs which directly vary with the level
of output.
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.
TC = TFC + TVC
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.
Total Cost (TC): The total cost curve is obtained by
vertically adding TFC and TVC at each level of output.
The TC has also an inverse S-shape
When the level of output is zero, TVC is also zero which
implies TC = TFC.
PER UNIT COSTS
From total costs functions we can derive per-unit costs.
A) Average fixed cost (AFC) - Average fixed cost is total
fixed cost per unit of output.
B) Average variable cost (AVC) - Average variable cost is
total variable cost per unit of output.
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.
MARGINAL COST (MC)
Marginal cost is defined as the additional cost that a firm
incurs to produce one extra unit of output.
It is the change in total cost which results from a unit change
in output.
Graphically, MC is the slope of TC function.
MC initially decreases, reaches its minimum and then starts
to rise.
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.
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
The above expression shows that MC and MPL are inversely
related.
When initially MPL increases, MC decreases;
When MPL is at its maximum, MC must be at a minimum
When finally MPL declines, MC increases.
ii) Average Variable Cost and Average Product of Labour
This expression also shows inverse relation between AVC and
APL.
When APL increases, AVC decreases
when APL is at a maximum, AVC is at a minimum
when finally APL declines, AVC increases.
• TP
• APL
E • MPL
• TC, TVC, TFC
• AFC, AVC, ATC, MC
N
• APL Vs AVC
• MPL Vs MC
D