Module 6

Theory of Production and Costs

Learning Outcomes

By the end of this chapter, you will be able to:

1. Define the term “production” and explain what a production function is; define the
term “production inputs,” and differentiate between labor, land, capital,
entrepreneurship, technology
2. Define and differentiate between marginal, average, and total product; compute
and graph marginal, average, and total product; explain diminishing marginal product
and diminishing marginal returns
3. Differentiate between Explicit and Implicit Costs, Accounting and Economic
Profit
4. Define and differentiate between marginal, average, and total cost; compute and
graph marginal, average, and total cost; differentiate between variable and fixed costs
5. Differentiate between short-run and long-run costs; interpret the relationship
between short-run and long-run costs
6. Define and explain long-run costs, economies of scale, diseconomies of scale, and
constant returns to scale

1 INTRODUCTION

Production is the process by which factor inputs are transformed into output. An
increase in the quantity of factor inputs will lead to an increase in output. The theory
of production is the study of how the output level changes as the quantity of factor
inputs changes. To increase output, firms need to employ more factor inputs which
will lead to an increase in costs. The theory of costs is the study of how the cost of
production changes as the output level changes. When a firm expands its scale of
production, its average cost will usually fall and this phenomenon is called internal
economies of scale, or simply known as economies of scale. However, when the
scale of production of a firm reaches a certain size, a further expansion may lead to a
rise in its average cost and this phenomenon is called internal diseconomies of scale,
or simply known as diseconomies of scale. A firm may experience a fall or rise in its
average cost when the industry expands, even though its scale of production remains
unchanged, and these phenomena are called external economies of scale and external
diseconomies of scale respectively. This chapter provides an exposition of the theory
of production and the theory of costs.

1.1 PRODUCTION FUNCTION

The production function of firm is a relationship between inputs used and output
produced by the firm. For various quantities of inputs used, it results in varied
quantities of output. Let us take an example of a manufacturer who produces steel
chairs. He employs two workers – worker1 and worker 2, two machines – machine
1 and machine 2 and 50 kilogramof raw – materials. Worker 1 is good in operating

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machine 1 and worker 2 is good in operating machine 2. If worker 1 uses machine 1
and worker 2 uses machine 2, then with 50 kilogram of raw materials, they can
produce 10 steel chairs. However, if worker 1 uses machine 2 and worker 2 uses
machine 1, which they are not good at operating, with the same 50 kilogram of
raw-materials, they can produce only 7 steel chairs. So with efficient uses of inputs,
10 steel chairs can be produced where as an inefficient use results in production of 7
steel chairs. Production function considers only the efficient use of inputs. It means
that worker 1, worker 2, machine 1 and machine 2 and 50 kilograms of
raw-materials together can produce 10steel chairs which is the maximum possible
output for this input combination.

A production function is defined for a given technology. If the technology

improves, the maximum level of output produce for different input combinations
increases. We then have a new production function.

We consider a firm that produces output (Q) using only two factorsof production
labour (L) and capital (K), and the production function will be–

Q = f (L, K)

Where,
Q= output
L= labour
K= capital
f= function

Let us express the production function numerically.

100 = f (2, 1)

The above equation implies that by using 2 units of labor and 1unit of capital
(machine), the firm can produce 100 units of the commodity.

1.2 LINEAR HOMOGENEOUS PRODUCTION FUNCTION

Production function can take several forms but a particular form of production
function enjoys wide popularity among the economists. This is a linearly
homogeneous production function. Linearly homogeneous production function
implies that if all the factors of production are increased in a given proportion, output
also increases in the same proportion.Hence, linearly homogeneous production
function represents the constant returns to scale. If there are two factors
labour (L) and capital (K), thenhomogeneous production can be
mathematically expressed as–

mQ = f (mL, mK)

Where ‘Q’ stands for output (Total product) and ‘m’ is any
realnumber.The above function means that if factor labour (L) and capital (K)are
increased by m-times, the total product ‘Q’ also increased by m times.Let us see the
example below-

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 Labor (L) Capital (K) Total Product (output)
2 1 100
4 2 200

By using 2 units of labor and 1 unit of capital, the firm can produce 100 units of
the commodity. When it makes the labor and capital double (i.e. 4 units of labour and
2 units of capital), the output also get double (i.e.200 units). This is the case of
linearly homogeneous production function.

1.3 OPTIMUM INPUT COMBINATION

An important problem facing an entrepreneur is to decide

aboutthe particular combination of factors which should be employed
forproducing a product. There are various combinations of factors which canyield a
given level of output and from among which producer has to selectone for production.
Let us first discuss two major related concepts–

Isoquant

An isoquant is the set of all possible combinations of the two inputs that yield the
same maximum possible level of output. Let us consider a production function with
two inputs.

If the inputs used are labour (L) and capital (K), then a sugar factory will be able to
produce 20 quintals of sugar by employing any four combinations of inputs–
a)5 units of L and 5 units of K
b)4 units of L and 6 units of K
c)2 units of L and 7 units of K
d)6 units of L and 4 units of K

In the diagram, labor is measured along the OX-axis and capital along the
OY-axis. Here, we have three isoquants for the three output levels, namely Q = Q1,
Q = Q2 and Q = Q3 in the inputs plane. Two input combinations (L, K) and (L/,
K/) give the same level of output Q1. If we fix capital at K/ and increase labour to
L//, output increases and we reach a higher isoquant Q = Q2. Thus higher isoquant
represents higher level of output.

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Iso-cost line

An iso-cost line illustrates all the possible combinations of two factors that can
be used at given cost and for a given producer’s budget. In simple words, an isocost
line represents a combinations of inputs which cost the same total amount. Now
suppose that a producer has a total budget of PhP 120 and for producing a certain
level of output, he has to spend this amount on two factors– labor (L) and capital
(K). Price of labor and capital are PhP15 and PhP10 respectively.

Combination Units of Units of Total

Capital (K) Labor (L) Expenditure
A 8 0 120=(8x15)+(0x10)
B 6 3 120=(6x15)+(3x10)
C 4 6 120=(4x15)+(6x10)
D 2 9 120=(2x15)+(9x10)
E 0 12 120=(0x15)+(12x10)

In the above diagram we measure laborr along OX-axis and capital along
OY-axis. The straight line AB will pass through all combinations of labor and capital
which the firm can buy with outlay of PhP 120, if it spends the entire sum on them at
the given prices. The line AB is called the iso-cost line. Higher iso-cost line
represents higher cost or outlay. To produce a given level of output, the entrepreneur
will choose the combination of factors which minimizes the cost of production and
in this way he will be maximizing his profit. Thus, a producer will try to produce a
given level of output with least cost combination of factors. This least cost
combination of factors will be optimum combination for him.
The iso-cost line combined with the isoquant map helps indetermining the
optimal production point at any given level of output. Specifically, the point of
tangency between any isoquant and an iso-cost line gives the lowest-cost
combination of inputs that can produce the level of output associated with that
isoquant. Which will be the optimum input combination can be understood from
the following figure–

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 Suppose the entrepreneur has decided to produce 100 units of output which is
represented by isoquant Q. The 100 units of output can be produced by any
combination of labour and capital such as P, S, E, K and T lying on the isoquant. But
it is clear from the figure that for producing the given level of output (100 units) the
cost will be minimum at point E at which the iso-cost line CD is tangent to the given
isoquant. At no other point such as P, S, K and T, lying on the isoquant Q, the cost is
minimum. It is seen in the figure that all other point on isoquant Q, such as P, S, K,
T lie on higher iso-cost line than CD and which will therefore mean greater total cost
for producing the given output. Therefore, the entrepreneur will not choose any of the
combinations P, S, K, and T. We, thus, see that factor combination E is the least-cost
combination of labor and capital for producing a given output. Factor combination E
is therefore an optimum combination for him under the given circumstances.

Hence, we conclude that the entrepreneur will choose factor combination E

(that is OM units of labor and OW units of capital) to produce 100 units of output.
It is thus clear that the tangency point of the given isoquant with an iso-cost line
represents the least-cost combination of factors for producing a given output.

2 THE SHORT-RUN THEORY OF PRODUCTION

2.1 Marginal Returns

If a firm wants to increase output, it can almost immediately employ more labour.
However, it will not be able to employ more capital in the same time frame as
acquisition of capital takes time. In economics, we distinguish between two types of
factor inputs: variable factor input and fixed factor input. Variable factor inputs are
factor inputs whose quantities can be changed in the short run. An example is labor.
Fixed factor inputs are factor inputs whose quantities are fixed in the short run. An
example is capital.

The short run is the time period during which at least one of the factor inputs
used in the production process is fixed. It does not correspond to any specific number
of weeks, months or years as it varies from firm to firm and from industry to industry.
For example, a web hosting firm may take only a few weeks or even days to increase
its production capacity by purchasing more servers. However, an oil refining firm

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may take many years to increase its production capacity due to the long time period
needed to build oil refineries.

Suppose that a firm employs two factor inputs: capital and labor. In this case, the
fixed factor input is capital and the variable factor input is labor. As the quantity of
capital is fixed in the short run, the firm can increase output only by employing more
labor.

Example

Capital Labor Total Output Additional Output

5 0 0 —
5 1 3 3
5 2 7 4
5 3 12 5
5 4 18 6
5 5 22 4
5 6 24 2
5 7 24 0
5 8 23 -1
5 9 20 -3

In the above table, from the first unit of labor to the fourth, each additional unit
of labor is adding more to total output than the previous additional unit and hence the
firm is experiencing increasing marginal returns. Increasing marginal returns occur
when each additional unit of a variable factor input (e.g. labor) is adding more to total
output than the previous additional unit. This occurs due to under-utilisation of the
fixed factor inputs (e.g. capital). However, from the fifth unit of laborr onwards, each
additional unit of labor is adding less to total output than the previous additional unit
and hence the firm is experiencing diminishing marginal returns. Diminishing
marginal returns occur when each additional unit of a variable factor input (e.g.
labour) is adding less to total output than the previous additional unit. This occurs
due to over-utilization of the fixed factor inputs (e.g. capital). Diminishing marginal
returns set in when the fifth unit of labor is employed. Furthermore, the seventh unit
of labor is actually redundant. Total output even falls when the eighth unit of labor is
employed.

The law of diminishing marginal returns states that if an increasing quantity of a

variable factor input is used with a constant quantity of fixed factor inputs, an output
level point will be reached beyond which each additional unit of the variable factor
input will add less to total output than the previous additional unit. To put it
somewhat differently, the law of diminishing marginal returns states if a firm
increases output continually in the short run, it is a matter of time that diminishing
marginal returns will set in. If the firm starts with a small quantity of fixed factor
inputs, diminishing marginal returns will set in earlier. If the firm starts with a large
quantity of fixed factor inputs, diminishing marginal returns will set in later.

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STAGE I: INCREASING RETURNS

TP increases at increasing rate, indicated by increasing MP.

There is intermediary constant stage between Stage 1 & Stage 2. TP increases at a

constant rate indicated by constant MP

STAGE II: DIMINISHING RETURNS

TP continues to increase but at diminishing rate, indicated by declining MP

STAGE III: NEGATIVE RETURNS

TP begins to decline, indicated by negative MP

Total Product Marginal Product Average Product

Stage I
First increases at increasing Increases in the beginning First increases, continues to
rate then at diminishing rate then reaches a maximum and increase and becomes
begins to decrease. maximum.
Stage II
Continues to increase at Continues to diminish and Becomes equal to MP and
diminishing rate and becomes equal to zero. then begins to diminish.
becomes maximum.
Stage III
Diminishes Becomes negative. Continues to diminish but
will always be grater than
zero.

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2.2 Total Product, Marginal product and Average product (Optional but
good to know)

Total Product

Total product (TP) is the total output produced with a given amount of factor inputs.

The total product curve is S-shaped.

Total Product Curve

In the above diagram, the TP curve shows how total output varies with the
quantity of labour, given the quantity of capital. From the first unit of labor to QL0,
the firm is experiencing increasing marginal returns and hence total output is rising at
an increasing rate when the quantity of labor increases. After QL0, the firm is
experiencing diminishing marginal returns and hence total output is rising at a
decreasing rate when the quantity of labor increases. After QL2, the problem of

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diminishing marginal returns becomes so severe that additional units of labour
actually lead to a fall in total output.

Marginal Product

Marginal product (MP) is the additional output resulting from employing one more
unit of labour.

Marginal product is calculated by dividing the change in total output by the change in
the quantity of labour.

ΔTP
MP = ——–
ΔQL

The marginal product curve is inverted-U-shaped.

In the above diagram, from the first unit of labor to QL0, the firm is experiencing
increasing marginal returns and hence MP is rising. After QL0, the firm is
experiencing diminishing marginal returns and hence MP is falling. After QL2, the
problem of diminishing marginal returns becomes so severe that additional units of
labour actually lead to negative MP.

Average Product

Average product (AP) is the output per unit of labour.

Average product is calculated by dividing total output by the quantity of labour.

TP
AP = ——–
QL

The average product curve is inverted-U-shaped.

To understand the shape of the average product curve, we need to understand the
relationship between average value and marginal value which can be illustrated with
the following example.

Assume that the average height of a particular class of students is 1.7 metres.
Further assume that a new student joins the class. If the height of the new student,
which is the marginal height, is higher than the average height of 1.7 metres, the
average height of the class will rise. However, if the height of the new student is
lower than the average height, the average height of the class will fall. Therefore,
when the marginal value is higher than the average value, the average will rise and
vice versa. This applies to the relationship between average product and marginal
product.

In the above diagram, from the first unit of labour to QL1, MP is higher than AP
and hence AP is rising. After QL1, MP is lower than AP and hence AP is falling. The

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above analysis does not only explain why the AP curve is inverted-U-shaped, it also
explains why the MP curve cuts the AP curve at the maximum point.

3 THE LONG-RUN THEORY OF PRODUCTION

3.1 The Least-cost Combination of Factor Inputs (Optional but good to

know)

The long run is the time period after which all the factor inputs used in the
production process are variable. In the long run, if a firm wants to increase output,
not only can it employ more labour, it can also employ more capital whose quantity
is fixed in the short run. Like the short run, the long run does not correspond to a
specific number of weeks, months or years as it varies from firm to firm and from
industry to industry.

The least-cost combination of factor inputs is used when the last dollar of each
factor input employed produces the same additional output. If a firm employs two
factor inputs, labour (L) and capital (K), the least-cost condition can be expressed as
MPL/PL = MPK/PK, where MP denotes marginal product and P denotes price.

Suppose that MPL/PL is twice MPK/PK. In other words, the additional output
produced by the last dollar of labour employed is twice the additional output
produced by the last dollar of capital employed. In this case, the firm can reduce the
total cost of producing the same amount of output by employing more labour and less
capital. For example, if the firm employs one more dollar of labour and two dollars
less of capital, although total cost will fall by one dollar, total output will remain
constant which will lead to a fall in the total cost of producing the same amount of
output. However, as the quantity of labour increases, MPL will fall due to diminishing
marginal returns. Similarly, as less capital is employed, MPK will increase. This
process will continue until MPL/PL = MPK/PK. In other words, the additional output
resulting from employing the last dollar of labour is equal to the additional output
resulting from employing the last dollar of capital.

3.2 Returns to Scale

When the quantities of all the factor inputs used in the production process are
increased by the same proportion in the long run, the scale of production expands. An
increase in the scale of production will lead to one of three scenarios: increasing
returns to scale, constant returns to scale or decreasing returns to scale.

Increasing Returns to Scale

Increasing returns to scale occur when the same percentage/proportionate

increase in the quantities of all the factor inputs used in the production process leads
to a larger percentage/proportionate increase in total output.

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Decreasing Returns to Scale

Decreasing returns to scale occur when the same percentage/proportionate

increase in the quantities of all the factor inputs used in the production process leads
to a smaller percentage/proportionate increase in total output.

Constant Returns to Scale

Constant returns to scale occur when the same percentage/proportionate increase

in the quantities of all the factor inputs used in the production process leads to the
same percentage/proportionate increase in total output.

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Example

Percentage
Percentage
increase in the Returns to
Capital Labour Total output increase in
quantities of all scale
total output
factor inputs
20 4 — 100 — —
40 8 100 250 150 IRS
60 12 50 420 68 IRS
80 16 33.33 560 33.33 CRS
100 20 25 672 20 DRS
120 24 20 780 16 DRS

From the output level 100 to the output level 420, the firm is experiencing
increasing returns to scale (IRS). Increasing returns to scale occur due to division of
labour and the use of larger machines. Division of labour is the process whereby each
job is broken up into its component tasks and each worker is assigned one or a few
component tasks of the job. An expansion of the scale of production may enable the
firm to engage in greater division of labour and hence greater specialisation which
will lead to higher labour productivity resulting in increasing returns to scale.
Furthermore, larger machines are often more efficient than smaller machines as they
generally make more efficient use of materials and labour. Therefore, an expansion of
the scale of production may enable the firm to use larger machines that are often
more efficient than smaller machines which will also lead to higher labour
productivity resulting in increasing returns to scale. From the output level 420 to the
output level 560, the firm is experiencing constant returns to scale (CRS). From the
output level 560 to the output level 780, the firm is experiencing decreasing returns to
scale (DRS). Decreasing returns to scale occur due to division of labour. When
division of labour increases to a high degree, workers may become demotivated as
performing the same task all the time may lead to boredom. This is especially true if
the task is mundane. If this happens, labour productivity will fall which will lead to
decreasing returns to scale.

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4 THEORY OF COST

In this unit we will analyze the concepts of cost. Cost indicates the total money
expenditure incurred by a firm in the production of goods and services. There are
several concepts of cost of production used in economics. When we talk about the
cost of a firm, generally, we refer to money cost. However, there are some other
concept of costs which draws the attention of the economists. In this unit, we will
discuss the different concept of costs. In case of production cost, time period is very
important. We have previously mentioned about the short-run and long-run. In the
short-run, some of the factors of production cannot be varied, and therefore, remain
fixed. But all the factors become variable in th long-run. In this unit you will gain
knowledge about the short-run and long-run concepts of cost.

4.1 MEANING OF COST

In order to produce output any firm needs to employ inputs or factors of

production like land, labor, capital and organization. The factors of production are
not free goods but economic goods. They are to be paid when their services are
utilized in the production process. Land gets rent, labor gets wages/salaries, capital
gets interest and organization gets profits. Cost of production, therefore, is the
payment made to the factors of production for rendering their services in the
production process.

4.2 COST FUNCTION

Cost function means the functional relationship between cost and output. It
shows total cost at each level of output. Cost function can be expressed in the
following way–

C = f (Q)

Where, C= total cost Q= output

For every level of output, the firm chooses the least-cost input combination i.e. the
combination of inputs which is least expensive.

4.3 THE SHORT-RUN THEORY OF COSTS

4.3.1 Fixed Costs, Variable Costs, Explicit Costs and Implicit Costs

Fixed costs are costs that do not vary with the output level. Examples of fixed
costs include rent and interest payments on loans. An increase in the output level will
not lead to an increase in fixed costs. Fixed costs will be incurred even if the firm
shuts down production. Variable costs are costs that vary directly with the output
level. Examples of variable costs include the cost of labour and the costs of materials.
An increase in the output level will lead to an increase in variable costs as more
variable factor inputs are needed to produce more output. Variable costs will not be
incurred if the firm shuts down production.

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 Explicit costs are costs that involve monetary payments. Examples of explicit
costs include the cost of labour and the costs of materials. Implicit costs are costs that
do not involve monetary payments. Examples of implicit costs include the cost of the
owner’s labour and the cost of the owner’s financial capital. Profit is the excess of
total revenue over total cost. Accounting profit is the excess of total revenue over
accounting costs. Accounting costs are costs computed by accountants which include
only explicit costs. Economic profit is the excess of total revenue over economic
costs. Economic costs are costs computed by economists which include both explicit
costs and implicit costs. As economic costs are higher than accounting costs,
economic profit, which is the profit that economists are concerned with, is lower than
accounting profit.

A. Fixed Cost

Fixed costs are costs that do not vary with different levels of production and fixed
costs exist even if the output is zero. Example: rent or salaries.

In the above diagram, the fixed cost remains constant regardless of the quantity
produced.

B. Variable Cost

Variable Costs are costs that vary with the level of output. Ex: electricity

In the above diagram, the variable cost curve starts from zero. It means when
output is zero, the variable cost is zero, but as production increases the variable cost

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increases. It keeps rising to the point that economies of scale cannot lower the per
unit cost anymore hence the steep incline.

Difference between Fixed and Variable Costs

This distinction is important in cost theory. Every firm has the object to maximize
profits or minimize losses if losses are unavoidable. At times the price of the product
may not cover the average total cost. Then the firm will have to decide whether to
shut down or produce some output.

1. The Decision to Shut Down the Firm

The producer may not cover the total costs if the price of the product is less than the
short-run average cost. Then the distinction between fixed cost and variable cost is
important.

If the price does not cover average variable costs, the firm prefers to shut down. In
other words, if the total revenue (total sale proceeds) does not include total variable
costs, the business must shut down. Otherwise, its total loss will be higher than the
fixed costs. It will produce something only when the price covers the average
variable cost and part of the average fixed costs. The output at which marginal cost is
equal to marginal revenue keeps losses minimum.

2. Break-Even Point

At times the firm may not make any profit. It just pays to produce a given output.
Total revenue is only equal to the total cost. The company has crossed the losses zone
and is about to enter the zero profit zone. The output at which total revenue becomes
equal to total cost represents the break-even point.

4.3.2 Total Cost, Marginal Cost, Average Cost, Average Variable Cost
and Average Fixed Cost

Total Cost

Total cost (TC) is the cost of the factor inputs required for the production of an
amount of output.

In the short run, total cost is the sum of total fixed cost (TFC) and total variable
cost (TVC) and is positively related to the output level. The total cost curve is
inverse-S-shaped.

Total Cost Curve

Total Cost = Fixed Cost + Variable Cost

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 When the output is zero, variable costs are also zero. But we have fixed costs
which is where the Total Costs start. The Total Cost remains parallel to the Variable
Cost, and the distance between the two curves is the Fixed Cost.

In the above diagram, as fixed costs do not vary with the output level, the TFC
curve is horizontal. However, as more variable factor inputs are needed to produce
more output, the TVC curve is upward-sloping. As TC is the sum of TFC and TVC,
the TC curve is geometrically similar to the TVC curve, except that the former is
higher than the latter by TFC at each output level. From the first unit of output to Q 0,
the firm is experiencing increasing marginal returns. Recall that this means each
additional unit of the variable factor input is adding more to total output than the
previous additional unit. Therefore, each additional unit of output requires fewer
units of the variable factor input to produce and this makes the TC curve and the
TVC curve rise at a decreasing rate. After Q0, the firm is experiencing diminishing
marginal returns. Recall that this means each additional unit of the variable factor is
adding less to total output than the previous additional unit. Therefore, each
additional unit of output requires more units of the variable factor input to produce
and this causes the TC curve and the TVC curve to rise at an increasing rate.

Marginal Cost

Marginal cost (MC) is the additional cost resulting from producing one more unit
of output.

Marginal cost is calculated by dividing the change in total cost by the change in
total output.

ΔTC
MC = ——–
ΔQ

The marginal cost curve is U-shaped or Nike-shaped which some like to call it.

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 Marginal Cost Curve

The Marginal Cost curve is U shaped because initially when a firm increases its
output, total costs, as well as variable costs, start to increase at a diminishing rate. At
this stage, due to economies of scale and the Law of Diminishing Returns, Marginal
Cost falls till it becomes minimum. Then as output rises, the marginal cost increases.

In the above diagram, from the first unit of output to Q0, the firm is experiencing
increasing marginal returns and hence MC is falling. After Q0, the firm is
experiencing diminishing marginal returns and hence MC is rising.

Average Cost

Average cost (AC) is the cost per unit of output.

Average cost is calculated by dividing total cost by total output.

TC
AC = ——–
Q

The average cost curve is U-shaped.

Recall from Section 2.2 that to understand the shape of the average cost curve,
we need to understand the relationship between average value and marginal value
which can be illustrated with the following example.

Assume that the average height of a particular class of students is 1.7 metres.
Further assume that a new student joins the class. If the height of the new student,
which is the marginal height, is higher than the average height of 1.7 metres, the
average height of the class will rise. However, if the height of the new student is
lower than the average height, the average height of the class will fall. Therefore,
when the marginal value is higher than the average value, the average will rise and
vice versa. This applies to the relationship between average cost and marginal cost.

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 Average Cost Curve

In the above diagram, from the first unit of output to Q2, MC is lower than AC
and hence AC is falling. After Q2, MC is higher than AC and hence AC is rising. The
above analysis does not only explain why the AC curve is U-shaped, it also explains
why the MC curve cuts the AC curve at the minimum point.

Average Variable Cost

Average variable cost (AVC) is the variable cost per unit of output.

Average variable cost is calculated by dividing total variable cost by total output.

TVC
AVC = ——–
Q

The average variable cost curve is U-shaped.

The relationship between average value and marginal value applies to average
variable cost and marginal cost.

Average Variable Cost Curve

In the above diagram, from the first unit of output to Q1, MC is lower than AVC
and hence AVC is falling. After Q1, MC is higher than AVC and hence AVC is rising.

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The above analysis does not only explain why the AVC curve is U-shaped, it also
explains why the MC curve cuts the AVC curve at the minimum point.

Average Fixed Cost

Average fixed cost (AFC) is the fixed cost per unit of output.

Average fixed cost is calculated by dividing total fixed cost by total output.

TFC
AFC = ——–
Q

The average fixed cost curve is a rectangular hyperbola.

Average Fixed Cost Curve

Average Fixed Cost = Fixed Costs/Quantity.

In the above diagram, we see that when the quantity produced is low, the average
fixed cost is very high and this cost lowers as the quantity produced increases.

For example, if the Fixed Cost is $100 and initially you produce two units, then
the average fixed cost is $50. If you start creating 20 units, then the average fixed
cost falls to $5.

In the above diagram, as TFC is constant, AFC falls when the output level
increases.

The following diagram shows the relationships between the marginal cost curve,
the average cost curve, the average variable cost curve and the average fixed cost
curve.

In the above diagram, from the first unit of output to Q0, MC is falling due to
increasing marginal returns, and is rising thereafter due to diminishing marginal
returns. From the first unit of output to Q1, MC is lower than AC and AVC and hence
AC and AVC are falling. After Q1, MC is higher than AVC and hence AVC is rising.
After Q2, MC is higher than AC and hence AC is rising. As AC is the sum of AVC

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and AFC, the vertical distance between the AC curve and the AVC curve is equal to
AFC. As AFC falls when the output level increases, the vertical distance between the
AC curve and the AVC curve narrows as the output level increases.

5 THE LONG-RUN THEORY OF COSTS

5.1 LONG- RUN COSTS

The long-run is a period of time during which the firm can vary all its inputs. In
the short-run, some inputs are fixed and others are varied to increase the level of
output. In the long-run, none of the factors is fixed and all can be varied to expand
output. The firm has no fixed cost in the long-run. Accordingly, there is no TFC or
AFC curves in the long-run. As there is no distinction between total cost and total
variable cost, we simply use the term ‘total cost’. There is no distinction between
average cost and average variable costs, so it is called long-run average cost, denoted
by LAC, where‘L’ stands for long-run. The concept of marginal cost is the same
and is denoted by LMC. Thus we have three concepts of long-run cost:

i) Total cost
ii) Long-run average cost (LAC) and
iii) Long-run marginal cost (LMC)

5.1.1 Long-run Average Cost (LAC)

Like short-run average cost curve, long-run average cost curve is also ‘U’ shaped.
Factor that explains the ‘U’-shape of the average cost is the combination of the
economies of scale and the diseconomies of scale. The expansion in the scale of
production of a firm in the long-run leads to certain advantages in the form of cost
reduction, after a stage, further expansion of the firm gives rise to disadvantages and
cost begin to rise. ‘U’ shape of the LAC curve can be explained with the help of laws
of returns to scale that is increasing returns to scale (IRS), and constant returns to
scale (CRS) and then by the diminishing returns to scale (DRS). Its downward
sloping portion corresponds to IRS and upward rising portion corresponds to DRS.
At the minimum point CRS is observed. Hence, LAC has a flat portion inthe
middle.The long-run average cost, (LAC) curve of a firm shows the minimum or
lowest average total cost at which a firm can produceany given level of output in the
long-run. In the long-run, a firm will use the level of input at the lowest possible
average cost. Consequently, the LAC curve is the envelop of the short-run average
total cost curves. Therefore, the long-run average cost curve is known as the
enveloping curve. In the following diagram SC1, SC2, SC3, SC4 and SC5 are five
different scales of production. As the firm moves from SC1 to SC2 and from SC2 to
SC3 and so on, it indicates that size of the firm is expanding. The scale of
production represented by SC3 is the most desirable scale because at the lowest point
of SC3 the average cost is the minimum. The firm will prefer this scale in the
long-run. As the firm moves from one scale of production to another, thelong-run
average cost curve, LAC envelops the short-run cost curves. LAC curve is always
flatter than the short-run cost curves.

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 In the long-run, if the firm neither enjoys the advantages oflarge-scale production
nor suffer from any disadvantages. The LAC will not be ‘U’ shaped. It will be
parallel to the OX-asis. As the minimum cost of each scale of production will be
equal to one another, the LAC curve will be tangent to the lowest minimum points of
the short-run average cost curves. This is shown in the figure below

LAC is the long-run average cost curve which is a horizontal straight line. It is
tangent to the short-run average cost curves SC1, SC2 and SC3.

5.1.2 Long-Run Marginal Cost (LMC)

In the previous section we have discussed about marginal cost and how the short
run marginal cost is derived and what relationit has with the short-run average cost
curve. Like short-run, long-run marginal cost is also important, so it is useful to know
how thelong-run marginal cost curve can be driven. Long-run marginal cost(LAC)
curve can be derived from the long-run average cost curve, because the long-run
marginal curve is related to long-run average cost curve in the same way as the
short-run marginal cost curve is related to short-run average cost curve. Like long-run
average cost (LAC) curve, long-run marginal cost (LMC) curve is also ‘U’-shoped.

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For the first unit of output,both LMC and LAC are the same. As output increases,
LAC initially falls and then, after a certain point, it rises. As long as average costis
falling, marginal cost must be less than the average cost. When the average cost is
rising, marginal cost must be greater than the average cost. LMC curve is, therefore
U-shoped curve. It cuts the LAC curve from below at its minimum point.

The long-run average cost (LRAC) curve shows the lowest average cost of
production at each output level when all the factor inputs used in the production
process are variable in the long run. Each point on the LRAC curve is a point of
tangency to the AC curve with the lowest average cost of producing the
corresponding output level.

The above figure shown the shapes of the long-run marginal cost and long-run
average cost curves for a typical firm. LAC reaches its minimum at Q level of output.
To the left of Q, LAC is falling and LMC is less than theLAC and therefore LMC
curve lies below LAC curve. To the right of Q, LAC is rising and LMC is higher than
LAC and therefore, LMC curve lies above the LAC curve.

Relationship between LAC and LMC:

i) Since LAC is U-shaped, LMC is also a U–shaped curve.

ii) When LAC falls, LMC lies below LAC and when LAC rises, LMC lies above
LAC.
iii) At the lowest point of LAC curve, both LAC and LMC are equal.
iv) LMC always cuts LAC from below at its minimum point.

5.2 MANAGERIAL USES OF COST FUNCTION

Production cost as discussed earlier refers to the amount of expenditure incurred

in acquiring inputs. In business firm it refers to the expenditure incurred to produce
an output or provide services.Thus,the cost incurred in connection with raw-material,
labor and other heads constitute the overall cost of production.

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 A managerial economist must have a clear understanding of the different cost
concepts for clear business decision making. The main motive of every firm is to earn
maximum amount of profit and it depends on the proper management of business. A
firm can earn maximum profit by minimizing its production cost. An efficient
manager can produce maximum output at lower per-unit cost of production. Output is
an important factor which influences the cost. The cost output relationship
(discussed earlier as cost function) plays an important role in determining the
optimum plant size. The optimumplant size is defined in terms of minimum cost
per-unit of output. In other words, an optimum plant size is given by that value for
which average cos tis minimum.
The estimated cost function can help the manager to take meaningful decision
with regard to–

i) determination of optimal plant size

ii) determination of optimum output for a given plant and
iii) determination of firms supply curve.

In the process of decision-making, a manager should understand clearly the

relationship between the inputs and output on one hand and output and cost on the
other. The short-run production estimates are helpful to production manager in
arriving at a optimal mix of inputs to achieve a particular output target of a firm. This
is referred to as ‘least-cost combination of inputs’ in production analysis. For a given
cost, optimum level of output can be find if the production function of a firm is
known. Estimation of long-run production function may help a manager in
understanding and taking decision of long-term nature such as capital expenditure.
Estimation of cost curves will help production manager in understanding the
nature and shape of cost curves and taking useful decisions. Both short-run cost
function and long-run cost function must be estimated, since sets of information
will be required for some important decision. The decision makers can judge the
optimality of present output levels and solve the decision problems from the
knowledge of short-run cost function. When considering the expansion or
contraction of plant size, knowledge of long-run cost function is important. This is
also important for confirming that the present plant size is optimal for the output
level that is being produced. In the earlier section we discussed about different
short-run and long-run cost curves. The optimum plant size in the long-run is
determined at that level where long-run average cost is minimum. For a given plant,
the optimum output level will be achieved at a point where the average cost is the
least. This condition can be easily varified for the short-run cost curves.

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 Exercise No. 1 Theory of Production and Costs

Name: ____________________________Course & Section: __________________

Directions: Each of the questions or incomplete statements below is followed by five

suggested answers or completions. Select the one that is best in each case and write the
correct letter of your anwer in the space provided for.

___1. Total revenue equals the quantity of output the firm produces times the price at
which it sells its output
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___2. Average total costs are total costs divided by marginal costs
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___3. If there are implicit costs of production, accounting profits will exceed
economic profits
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___4. The efficient scale of production is the quantity of output that minimizes
A. Average total cost
B. Marginal cost
C. Average fixed cost
D. Average variable cost
E. Total Cost
___5. If total revenue is $100, explicit costs are $50, and implicit costs are $30, then
accounting profit equals $50
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___6. Economic profit is equal to total revenue minus
A. Implicit costs
B. Explicit costs
C. The sum of the implicit and explicit costs
D. Marginal costs
E. Variable costs
___7. Fixed cost plus variable costs equal total costs
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___8. Wages and salaries paid to workers are an example of implicit costs of
production
A. True B. False C. Either A or B D. Neither A nor B E. Incomplete
information
___9. Accounting profit is equal to total revenue minus
A. Implicit costs
B. Explicit costs
C. The sum of implicit and explicit costs
D. Marginal costs
E. Variable costs

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___10. Costs that do not change when the quanity of output produced changes?
A.Fixed Costs B.Variable Costs C.Explicit Costs D. Implicit Costs E. None of the
above
___11. Additional cost associated by producing one additional unit of product.
A.Fixed Costs B.Average Costs C.Marginal Costs D.Implicit Costs E. None of the
above
___12. The amount a firm receives for the sale of its output. P x Q = _____
A.Profit B. Total Revenue C. Marginal Revenue D. Average Profit E. None of the
above
___13.Input costs that may not have a direct outlay of money.Value of the
opportunity cost.
A. Fixed Cost B. Variable Cost C. Implicit Cost D. Explicit Cost E. None of the
above
___14. Revenue generated by producing one additional unit of product.
A. Marginal Revenue B. Marginal Profit C. Total Revenue
D. Average Revenue E. None of the above
___15. Fixed Cost divided by the quantity of output.
A. Average Fixed Cost B. Average Variable Cost C. Marginal Cost
E. Marginal Fixed Cost E. None of the above
___16. The relationship between the quantity of inputs used to make a good and the
quantity of output produced.
A. Diminishing Marginal Utility B. Production Function C. Conjunction
Junction
D. Economies of Scale E. None of the above
___17. What is a production process?
A. Technical relationship between physical inputs and physical output.
B. Relationship between fixed factors of production and variable factors of
production.
C. Relationship between a factor of production and the utility created by it.
D. Relationship between quantity of output produced and time taken to produce the
output.
E. None of the above
___18. The alaw of diminishing returns applies to :
A. The short run, but not the long run.
B. The long run, but not the short rim.
C. Both the short run and the long run.
D. Neither the short run nor the long run
E. None of the above
___19. In describing a given production technology, the short run is best described as
lasting:
A. Up to six months from now.
B. Up to five years from now.
C. As long as all inputs are fixed.
D. As long as at least one input is fixed
E. None of the above

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___20. To economists, the main difference between the short run and the long run is
that :
A. In the short run all inputs are fixed, while in the long run all inputs are variable.
B. In the short run the firm varies all of its inputs to find the least-cost combination of
inputs.
C. In the short run, at least one of the firm's input levels is fixed.
D. In the long run, the firm is making a constrained decision about how to use
existing plant and equipment efficiently.
E. None of the above

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 Exercise No. 2 Theory of Production and Costs

Name: ____________________________Course & Section: __________________

The graphical illustration below shows the theory of production. Label the unknown
variables represented by numbers.

1) Quantity of Labor__________________________________
2) Labor___________________________________________
3) TP_____________________________________________
4) AP_____________________________________________
5) MP_____________________________________________
6) 1st Stage________________________________________
7) 2nd Stage_________________________________________
8) 3rd Stage__________________________________________

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 Exercise No. 3 Theory of Production and Costs

Name: ____________________________Course & Section: __________________

A. Use the following data to compute for average product and marginal product.

Number of Marginal Product Average Product

Total Product
Workers Minus yung mga total Total/Workers

0 0

1 5

2 15

3 30

4 45

5 55

6 60

7 60

8 55

B. Plot the total, average and marginal product and identify the stages of
production.

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 Exercise No. 4 Theory of Production and Costs

Name: ____________________________ Course & Section:

__________________

1. Suppose the Perez Enterprises has the following cost schedule. Its TFC is
P1,000 per month and its variable cost are in column 3. Complete the table
below and graph TFC, TVC and TC and the AFC, AVC, ATC and MC curves in
another graph.

Output TFC TVC TC AFC AVC ATC MC

0 1,000 0 1,000 0 0 0 1,000

1 500

2 1,000

3 2,000

4 3,500

5 5,500

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 Exercise No. 5 Theory of Production and Costs

Name: ____________________________Course & Section: __________________

IDENTIFICATION

____________________1. The additional cost from an additional unit of output

produced.
____________________2. It shows the relationship between the level of inputs and
output.
____________________3. The difference between ATC and AVC in the short-run
period.
____________________4. Cost that exists only in the very short run or immediate
period.
____________________5. Cost that decreases with the increases in the output
produced.
____________________6. A monetary expenditure made to outsiders who supply
the inputs.
____________________7. Inputs that do not vary with the level of output.
____________________8. Variable cost per unit of output.
____________________9. It states that as you combine the fixed inputs to the
variable inputs, total product increases at an increasing rate continuously increase at a
decreasing rate and at a certain point it declines.
____________________10. Cost of self-owned or self-employed resources.
____________________11. The total output produced per unit of a resourced
employed.
____________________12. Production period where all factors of production used
are variable inputs.
____________________13. The rational stage of production.
____________________14. A production stage where the firm is over utilizing its
fixed input.
____________________15. It is J shaped curve.
TRUE OR FALSE
______1. Land and managerial talent are fixed inputs in the short-run.
______2. Rent, depreciation and salary of the managers are variable costs in the
short-run.
______3. Implicit cost of a resource is counted as economic cost due to the
opportunity cost of the said resource.
______4. When TP is maximum, MP is negative.
______5. In the short-run period, TC=TFC at zero output.
______6. In the long-run, ATC = AVC.
______7. From the economist’s point of view, the real importance of cost lies in the
fact they represent constraints to production.
______8. For the firm to reduce its fixed cost, it has to produce more output.
______9. Normal profit is part of the firm’s implicit cost.
______10. In the short-run, the firm’s plant capacity or size of the plant is fixed.

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