CHAPTER FOUR

THE THEORY OF PRODUCTION AND

COST
 Theory of Production in the Short Run
• Raw materials yield less satisfaction to the consumer by
themselves.
• In order to get better utility from raw materials, they must be
transformed into outputs.
• However, transforming raw materials into outputs requires
inputs such as land, labour, capital and entrepreneurial ability.
• 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).
 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.
• 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:
Q= f(X1 ,X2 ,X3,...,Xn )
where, Q is output and X1, X2, X3,…, Xn are different
types of inputs.
 Cont……
• 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.
• In fact, no input is ever absolutely fixed but may be fixed during an
immediate requirement.
• 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 because their quantity cannot be
manipulated easily in a short period of time.
• Variable inputs are those inputs whose quantity can be altered
almost instantaneously in response to desired changes in output.
• That is, their quantities can easily be diminished when the market
demand for the product decreases and vice versa.
• The best example of variable input is unskilled labour.
 Cont…..
• In economics, short run refers to a period of time in which the quantity of
at least one input is fixed.
• In other words, 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.
• Here it should be noted that short run periods of different firms have
different durations. Some firms can change the quantity of all their inputs
within a month while it takes more than a year for other types of firms.
This sub-section is confined to production with one variable input and one
fixed input.
• Consider a firm that uses two inputs: capital (fixed input) and labour
(variable input). Given 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.
• The production function shows different levels of output that the firm can
produce by efficiently utilizing different units of labour and the fixed
capital.
• In the above short run production function, the quantity of capital is fixed.
 Total, average, and marginal product
• In production, the contribution of a variable input can be
described in terms of 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.
• Increasing the variable input (while some other inputs are
fixed) can increase the total product only up to a certain point.
• Initially, as we combine more and more units of the variable
input with the fixed input, output continues to increase, but
eventually if we employ more and more unit of the variable
input beyond the carrying capacity of the fixed input, output
tends to decline.
• In general, the TP 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
 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.
• For instance, the change in total output resulting from employing
additional worker (holding other inputs constant) is the marginal
product of labour (MPL).
• In other words, MPL measures the slope of the total product
curve at a given point.

• In the short run, the marginal product of the variable input first
increases, reaches its maximum and then decreases to the extent
of being negative. That is, as we continue to combine more and
more of the variable input with the fixed input, the marginal
product of the variable input increases initially and then declines.
 Cont…..
• Average Product (AP): Average product of an input is the
level of output that each unit of input produces, on the
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.
• The average product of labour (APL), for instance, is given by:

• Average product of labour first increases, reaches its

maximum value and eventually declines.
• The AP curve can be measured by the slope of rays
originating from the origin to a point on the TP curve.
• For example, the APL at L2 is the ratio of TP2 to L2. This is
identical to the slope of ray a.
 Cont…..
Output
a

TP3

TP2 TP

TP1

Units of labour (variable input)

L1 L2 L3

APL
MPL

APL

Units of labour (variable input)

L1 L2 L3
MPL
 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-
0.6K2-0.1L2 where Q is quantity of cut-flower produced,
L is labour input and K is fixed capital input (K=5).
a. Determine the 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?
 The Law of Variable Proportions
• The law of variable proportions states that as successive units of a
variable input(say, labour) 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.
• For example, if additional workers are hired to work with a constant
amount of capital equipment, output will eventually rise by smaller
and smaller amounts as more workers are hired.
• 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 of equal quality. Each successive 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 L 1 in the
above figure). This law is also called the law of diminishing returns.
 Stages of Production
• We are not in a position to determine the specific number of the
variable input (labour) that the firm should employ because this
depends on several other factors than the productivity of labour.
• However, it is possible to determine the ranges over which the
variable input (labour) be employed. To this end, 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 labour
employment in the above figure).
• 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
 Cont….

• 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 the
above figure). 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
average and marginal products is due to the scarcity of the fixed
factor.
• That is, once the optimum capital-labour 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
 Cont……

• 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 labour becomes negative.
• This stage 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 the above figure, this stage
is indicated by the employment of labour beyond L3.
 Theory of Costs in the Short Run

• To produce goods and services, firms need factors of production or

simply inputs. To acquire these inputs, they have to buy them from
resource suppliers.
• Cost is, therefore, the monetary value of inputs used in the
•
production of an item.
• Economists use the term ―profit‖ differently from the way
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.
• 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
 Cont…..

• 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.
Accounting profit = Total revenue – Accounting cost = Total
revenue – Explicit cost
• In the real world economy, entrepreneurs may use some
resources which may not have direct monetary expense
since the entrepreneur can own these inputs himself or
herself.
• 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
 Cont…..

• 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 labour 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.
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.
– If all inputs are purchased from the market, accounting and economic
profit will be the same.
– However, if implicit costs exist, then accounting profit will be larger than
economic profit.
 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).
• By fixed costs we mean costs which do not vary with the level of
output. They are regarded as fixed because these costs are
unavoidable regardless of the level of output.
• The firm can avoid fixed costs only if he/she stops operation
(shuts down the business).
• The 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.
 Cont…..

• Variable costs, on the other hand, include all costs which

directly vary with the level of output. For example, 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.
• 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
• Based on the definition of the short run cost functions,
let‘s see what their shapes look like.
• 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.
 Cont…….

• 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. At the initial stage of production with a
given plant, as more of the variable factor is employed, its
productivity increases.
• Hence, the TVC increases at a decreasing rate. This continues until
the optimal combination of the fixed and variable factor is
reached.
• Beyond this point, as increased quantities of the variable factor
are combined with the fixed factor, the productivity of the variable
factor declines, and the TVC increases at an increasing rate.
• Total Cost (TC): The total cost curve is obtained by vertically
adding TFC and 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.
• It should be noted that when the level of output is zero, TVC is
also zero which implies TC = TFC.
 Cont……
TC

TVC

TFC

Output

Figure 4.2: Short run TC, TFC and TVC curves

 Per Unit Costs

• From total costs functions we can derive per-

unit costs. These are even more important in
the short run analysis of the firm.
• Average fixed cost (AFC) - Average fixed cost is
total fixed cost per unit of output.
• It is calculated by dividing TFC by the
corresponding level of output. The curve
declines continuously and approaches both
axes asymptotically.
 Cont…..

• Average variable cost (AVC) - Average variable

cost is total variable cost per unit of output.
• It is obtained by dividing total variable cost by
the level 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.
 Cont…..

• Average total cost (ATC) or simply Average

cost (AC) - Average total cost is the total cost
per unit of output. It is calculated by dividing
the total cost by the level of output.

• Thus, AC can also be given by the vertical sum

of AVC and AFC.
 Cont……

• Marginal Cost (MC) - Marginal cost is defined as the

additional cost that a firm incurs to produce one
extra unit of output.
• In other words, it is the change in total cost which
results from a unit change in output.
• Graphically, MC is the slope of TC function.

• In fact, MC is also a change in TVC with respect to a

unit change in the level of output.
 Cont……

• Given inverse S-shaped TC and TVC curves, MC initially decreases, reaches

its minimum and then starts to rise.
• From this, we can infer that the reason for the 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.

AFC
AVC
AC
AC
MC MC

AVC

AFC

Q
Q1 Q2
 Cont…..

• In the above figure, the AVC curve reaches its minimum

point at Q1 level of output and AC reaches its minimum
point at Q2 level of output.
• The vertical distance between AC and AVC, that is, AFC
decreases continuously as output increases.
• It can also be noted that the MC curve passes through
the minimum points of both AVC and AC curves.
• Example: Suppose the short run cost function of 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
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.
 Cont…..

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 and when finally MP L declines, MC
 Cont……

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 and
when finally APL declines, AVC increases.
• We can also sketch the relationship between these
production and cost curves using graphs.
 Cont…..

• From the above figure, we can conclude that

– the MC curve is the mirror image of MPL curve and
AVC curve is the mirror image of AP curve.