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.
 Thesecond 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.
Chapter objectives
 After successful completion of this chapter, you will be able
to:
 define production and production function
 differentiate between fixed and variable inputs
 describe short run total product, average product and
marginal product
 compare and contrast the three stages of production in the
short run
 explain the difference between accounting cost and
economic cost
 describe total cost, average cost and marginal cost functions
 explain the relationship between short run production
functions and short run cost
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.
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:

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.
 Variableinputs are those inputs whose
quantity can be altered almost instantaneously
in response to desired changes in output.
 Ineconomics, short run refers to a period of
time in which the quantity of at least one input
cont.
 Consider a firm that uses two inputs: capital
(fixed input) and labor (variable input).
 Given the assumptions of short run production,
the firm can increase output only by increasing
the amount of labor it uses. Hence, its
production function can be given by: Q = f (L)
where, Q is output and L is the quantity of labor.
 In the above short run production function, the
quantity of capital is fixed. Thus, output can
change only when the amount of labor changes.
 4.1.3 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.
 TheTP 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.`
 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, other inputs being constant.
 MPLmeasures 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.
cont.
 Average Product (AP): Average product of an input
is the level of output that each unit of input
produces, on the average. APL =
 Average product of labor first increases,
reaches its maximum value and eventually
declines.
CONT.
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 -0.1L 2 where Q is
quantity of cut-flower produced, L is labor
input and K is fixed capital input (K=5).
 CONT.
 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:
CONT.
 4.1.4 The law of variable
proportions
The law of variable proportions states that as
successive units of a variable input(say, labor)
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.
 This law assumes that technology is fixed and
thus the techniques of production do not
change.
 cont.
 Eachsuccessive 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).
4.1.5 Stages of production
 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 APL is
maximum, which is the equality of MPL and APL (up to L2
level of labor 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
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 labor 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
 That is, once the optimum capital-labor
cont.
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
 Stage III:
 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 labor becomes negative.
 Thisstage 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 labor beyond L3.
 4.2 Theory of costs in the
short run
4.2.1 Definition and types of
 Cost is monetary value of inputs used in the production of an
item.
costs use the term ―profit differently from the way
 Economists
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.
 Explicit costs
 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.

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. 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 labor 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.
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).
fixed costs
 Byfixed costs we mean costs which do not vary
with the level of output.
 Theyare regarded as fixed because these costs
are unavoidable regardless of the level of output.
 Thefirm can avoid fixed costs only if he/she stops
operation (shuts down the business).
 Thefixed 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
 Variablecosts, on the other hand, include all costs
which directly vary with the level of output.
 Forexample, if the firm produces zero output, the
variable cost is zero.
 These costs may include the cost of raw materials,
the cost of direct labor 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
let‘s see what their shapes
look like.
Per unit costs

a) Average fixed cost (AFC) - AFC =
 The curve declines continuously and
approaches both axes asymptotically.
 b) Average variable cost (AVC) - AVC =
 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.
cont.
 c) Average total cost (ATC) or simply Average
cost (AC)
 AC = Equivalently, AC =