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.
 The second part mainly deals with the cost ,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.

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 cont…
 Definition of production
=Production is the process of transforming inputs
into outputs.


= It can also be an act of creating value or
utility.
= The end products of the production process
are outputs which could be tangible
(goods) or intangible (services).
=transforming raw materials into outputs
requires inputs such as land, labour, capital
and entrepreneurial ability

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 Cont….
 Production function
 is a technical relationship between
input

and outputs.
 It shows the maximum output that can be
produced with fixed amount of inputs
and the existing technology.
 may take the form of an algebraic equation, table or
graph.
 A general equation for production function can, for
instance, be described as:

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 Fixed InputVs.Variable Input

 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. Atlabachew A..
March 17, 2025 4
Buildings, land and machineries are examples of
 Cont`d…
 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.

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 Short Run vs. Long Run

 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.
 Long run refers to a period of time in which all the inputs
are variable.

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 Cont`d…
 Theory of production in the short run
 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 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.

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 Cont…
 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.
 Thus, output can change only when the amount of
labour changes.

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 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 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.

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 Cont…
 The TP function in the short-run follows a certain trend:
 it initially increases at an increasing rate,


 then increases at a decreasing rate, then
 It 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.
 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.
 The change in total output resulting from
employing additional worker (holding other
inputs constant) is the marginal product of labour
(MPL).

March 17, 2025 Atlabachew A.. (Yardstick international college) 10

 Cont…
 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 means, 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.
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 Cont…
 Average Product (AP):
o 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:

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 Cont…

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 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.
 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. Why?
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 Cont…
 Example: Suppose that the short-run production
function of certain cut-flower firm is given by:


 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?

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 Cont…
 The law of variable proportions
o This law is also called the law of diminishing
returns. 
o This law states that as successive units of a
variable input(say, labour) are added to a fixed
input, beyond some point the extra, or marginal,
product that can be attributed to each additional
unit of the variable resource will decline.
o 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.

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 Cont…
 Assumptions of the law
 Technology is fixed and thus the techniques of
production do not change.

 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.

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 Cont…
 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.
 But, it is possible to determine the ranges
over which the variable input (labour) be
employed.
 For that purpose, economists have defined three
stages of short run production.
 Stage I
 Stage II
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 Stage III
 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.
 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).

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 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. 

diminishing marginal returns. T
 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 product of the
variable input is declining but positive.
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March 17, 2025 20
 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).
Atlabachew A.
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 Theory of costs in the short run
Definition and types of costs
 Cost is, therefore, the monetary value of inputs used

in the production of an item.
 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.
Explicit and implicit costs
 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)
Atlabachew A.
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 Cont…
 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.
 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
March 17, 2025 profit. Atlabachew A..
23
 Cont…
 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.
 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.
Atlabachew A..
March 17, 2025 24
 Cont…
 Therefore, economic cost is given by the sum
of implicit cost and explicit cost.


 Economic profit =Total revenue –
Economic cost (Explicit cost +
Implicit cost)
 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

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March 17, 2025 25
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.
March 17, 2025 Atlabachew A.. 26
 The firm can
operation (shuts
Cont…
avoiddown
fixed the
costs only if he/she stops
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.
• 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
In general, the expenses
short run of fuel,
total cost water,
is electricity,
given by the sumetc.of
total fixed cost and total variable cost.
• That is, TC = TFC + TVC

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March 17, 2025 27
 Graphical Nature of These Costs
 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.
 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.
Atlabachew A..
March 17, 2025 28
 Cont…
 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.

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 CONT…


Atlabachew A..
March 17, 2025 30
 Cont…
Per unit costs
 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.

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
Atlabachew A..
March 17, 2025 31
 Cont…
The short run AVC falls initially, reaches itsminimum,
and then starts to increase. Hence, the AVC curve has

U-shape and the reason behind is the law of variable
proportions.
 Average total cost (ATC)
• It is simply called Average Cost (AC)
• It is the total cost per unit of output.
• It is calculated by dividing the total cost by the level
of output
AC = AVC + AFC

Atlabachew A..
March 17, 2025 32
 Cont…
Marginal Cost (MC)
• 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.

 MC is also a change in TVC with respect to a

unit change in the level of output.
• Also, MC is the slope of TVC. Why?

March 17, 2025 Atlabachew A.. 33

 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.
o In summary, AVC, AC and MC curves are all U-
shaped due to the law of variable proportions.

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 Graphical r/p b/n ATC, AVC, And MC

Atlabachew A..
March 17, 2025 35
 Cont…
Example: Consider the total cost function:
TC = 1/3Q3 – 2Q2 + 60Q + 100

A) Identify the FC and VC function?
B) Calculate AVC, AFC, ATC, and MC functions
C) Find the levels of output that minimize MC and
then find the minimum values of MC.
D) Find the levels of output that minimize AVC and
then find the minimum values of AVC

The relationship between short run production

and cost curves
Let the price of labour be given by w, which is
constant.
Atlabachew A..
March 17, 2025 36
)
 Cont…
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
When initially MPL
increases, MC decreases;
when MPL is at its
maximum, MC must be at
a minimum and when
finally MPL declines, MC
increases

March 17, 2025 37

Atlabachew A.
 Cont…
ii) Average Variable Cost and Average Product of lobour

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.
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 Cont…

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 End of 

Chapter Four
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