CHAPTER FOUR
THEORY OF PRODUCTION AND COST
Kumlachew Gebeyehu
kume1188@[Link]
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.
INPUTS
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 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 input. Hence, its production
function can be given by:
Q = f (L)
where, Q is output and L is 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.
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
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.
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
Decline in the total product.
The total product curve slopes downwards,
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.
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 accounting costs (explicit 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 is monetary value of all inputs
(purchased and non purchased).
Calculating economic costs will be difficult because
there 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),
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)
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