Chapter Four: The Theory of Production and Cost

 This chapter has two major sections:

i) The first part will introduce
 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.
ii) The second 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.
4.1 Theory of production in the short run
4.1.1 Definition of production
 Raw materials yield less satisfaction to the consumer by themselves.
 For a better utility, raw materials has to 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.
 The end products of the production process are outputs which
could be tangible (goods) or intangible (services).
4.1.2 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:

Where, Q is output and 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.
 In fact, no input is ever absolutely fixed but may be fixed during an
immediate requirement.
Examples: Buildings, land and machineries etc.
 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.
 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.
 Note: 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.
 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:

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.
 Thus, output can change only when the amount of labour
changes.
4.1.3 Total, average, and marginal product
 In production, the contribution of a variable input can be described
in terms of total, average and marginal product.
A) Total product (TP)
 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 what shape a total product curve assumes.
B) 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.
C) Average Product (AP)
 is the level of output that each unit of input produces, on the
average(mean contribution of each variable input to the TP).
 Mathematically, the average product of labour (APL), is given by:

 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 (see figure 4.1).
 For example, the at is the ratio of to = Slope of ray a.
 The RELATIONSHIP between and can be stated as follows.
 When APL is increasing,
 When APL is at its maximum,
 When APL is decreasing, .
EXAMPLE: Suppose that the SRPF 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
a) Determine the function.
b) At what level of labour does Q reach the maximum ?
c) What will be the maximum achievable Q ?
Solution:
A) =
B) The total product level(Max Q) occurs when .

Hence, total output will be the maximum when 100 workers are
employed.
C) Substituting the optimal values of labor and capital into the original
production function (Q):
Practice Question
TP= 100L+5L2−L3

1. Find MP,AP.
2. Show the relationship between MP and AP
3. Show on a graph the stages of production
4.1.4 The law of variable proportions/LDMR
 This law 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.
 Assumptions of LDMR
 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.
  MP 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 MP curve reaches its maximum
(this happens when the number of workers exceeds in figure 4.1).
 This law is also called the LDMR.
4.1.5 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 level of labour
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: It ranges from the point where is at its maximum
(MPL=APL) to the point where MPL is zero (from to in figure 4.1).
 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.
Note: 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.
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
returnsto 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 labour
beyond .
4.2 Theory of costs in the short run
4.2.1 Definition and types of costs
 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, 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 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.

 In the real world economy, entrepreneurs may use some resources

which may not have direct monetary expensesince 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 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 (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 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.
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; can be described using equations, tables or curves.
 A cost function can be represented using an equation as follows:

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).
1) Fixed Costs: are 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( avoidable only if firms 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.
2) Variable costs: are all costs which directly vary with the level of
output.
 if the firm produces zero output, the variable cost is zero.
Example: 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.
A) 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.
B) 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.

C) 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 .
Per unit costs
 From total costs functions we can derive per-unit costs.
 more important in the short run analysis of the firm.
a) Average Fixed Cost (AFC)
 is total fixed cost per unit of output.
 It is calculated by dividing TFC by the corresponding level of Q.
 The curve declines continuously and approaches both axes
asymptotically.

b) Average Variable Cost (AVC)

 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.
c) Average total cost (ATC) or (AC)
 is the total cost per unit of output.
 It is calculated by dividing the total cost by the level of
output.

 Equivalently,
 Thus, AC can also be given by the vertical sum of AVC and
AFC.
Practice (HW) : Fill the missing
D) 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.

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

the level of output.
, since
 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.
 In the above figure, the AVC curve reaches its minimum point at
level of output and AC reaches its minimum point at 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:

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
Solution:
Given
A) TFC = 10; and
B)




C) To find the minimum value of MC, = 12Q - 4 = 0

 Thus, MC is minimized when Q = 0.33

 The minimum value of MC will be:
MC = =

 To find the minimum value of AVC,

 AVC is minimized at .
 The minimum value of AVC will be:

 AVC =
AVC = = 0.5 – 1 + 1 = 0.5
 Practice questions
1. Given: TC=2q2+5q+1800. Find AC,AVC,AFC,MC. Also find minimum TC,
minimum MC and minimum AVC and AC.
2. Given the TC =Q3-10Q2+60Q, what will be the minimum average cost.
At what level of output minimum cost will occur.3. Suppose that a firm's
total cost equation is TC=10000+100Q+0.25Q2 where TC is total cost and
Q is the level of output.
a. What output level will minimize the firm's average total cost?
b. Calculate the average total cost and marginal cost at the average cost
minimizing output level.

4. Given the short run cost function of a firm under TC= 200+5Q+2Q²,
what will be the level of output which AC and MC will be equal?

5. Given a short run cost function as TC=1/3 Q3 -2Q2 + 60Q + 100, what is
the minimum value of MC and AVC?
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) MC and MP of Labour
, Where
Thus, ; but =
 Therefore,
 This expression shows that MC and are inversely related.
 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.
II) AVC and AP of Labour
AV, Where
Thus, ; but =
 Therefore,
 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.
 Graphically,

 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 APL curve.
END!