UNIT 3: PRODUCTION FUNCTION, COST AND REVENUE

OVERVIEW
The module analysed the production function of firms. An analysis of the costs of production in
the short run and long run is explained which is followed by an analysis of the revenue curves
under perfect and imperfect market conditions.

LEARNING OUTCOMES
By the end of this unit, you should be able to do the following:
1. Analyse production periods and production function.
2. Analyse the cost of production and revenue in the short run and long run.
3. Differentiate between revenue curves under perfect and imperfect market conditions.

PRODUCTION PERIODS AND PRODUCTION FUNCTIONS

The production function relates to how much the firm can produce given an input of resources.
In particular, it represents the firm’s technology. Mathematically, the production function can
written as
Q = F (K, L)

Where Q = Output, K = Capital, L = Labor

If a firm can change all inputs variable, then the firm is operating in the long run. However, in
the short run, some inputs are fixed, others are variable. For instance, the amount of capital can
be fixed in the short term. But in the long run, the amount of capital can be increased.

If one doubles the amount of capital and labour, the output level may or may not double. If as
input doubles, output also doubles, then there is constant return to scale. If input is doubled and
output increases by more than two folds, then there will be increasing return to scale. If input
doubles and output increase by less than two folds, then there is decreasing to scale.

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In the short run, at least one factor is fixed. In this case, one needs to ask the question how much
output will change with respect to change in the variable factor. As such, there is the law of
variable proportion, also known as the law of diminishing returns, which ascertains that as the
number of units of a variable input increases, there will be a point where resulting additions to
output decreases. In other words, the Marginal Product of the variable factor will increase but
will eventually fall. It is assumed that labour is the variable factor, such that we speak of
marginal product and average product of labour.

The marginal product is measured as follows;

Output Q
MPL  
Labor Input L

While the average measured is defined as follows:

Output Q
AP  
Labor Input L

From above, it can be observed that the marginal product of labour is the additional output which
is generated following an additional worker being employed. On the other hand, the average
product is the output per worker produced.

In particular, when the labour input is small, MP (marginal product) increases due to
specialisation while when the labour input is large, MP decreases due to inefficiencies.

To see the effect of the law of diminishing returns, one can consider the table below

Capital Labour Output Marginal Average

(Machine- (Man- (Units) Product Product
hours) hours) (3) (4) (5)
(1) (2)

10 1 7 7 7

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 10 2 17 9 8
10 3 23 7 7
10 4 29 5 6.5
10 5 33 3 5.8
10 6 36 2 5.2
10 7 38 1 4.5
10 8 39 1 4

The above table shows that the average product and marginal product of labour increases until
the second unit. After that, both average product and marginal product fall. It also noted that
when average product is falling, marginal product is falling faster. Similarly, when average
product is rising, marginal product is above it.

The behaviour of marginal product and average product can be illustrated below:

Output (Q)

Output

MPL

APL

L1 L2 Variable factor (labour)

The above diagram is an illustration for the law of diminishing returns whereby marginal product
increases initially and then fall subsequently after a given level of the variable factor.

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THE THEORY OF COST
Cost of production is defined as costs incurred while undertaking productive activities. Cost of
production can be viewed in the following ways:

 The Short Run Cost

The short run cost is defined as a period which is too short to allow the manufacturer to vary the
use of its factor inputs. In the short run, there is at least one fixed factor while others are variable.
Therefore, in the short run, there are both fixed and variable costs.

(A) Fixed Costs and Average Fixed Cost

Fixed costs are costs which do not vary with the level of output.

Average fixed cost refers to fixed cost per unit of output and is calculated as follows:

Where Q refers to Quantity

(B) Variable cost and Average variable cost

Variable costs, sometimes referred to as direct or prime costs, are costs which are directly related
to output. Thus, as output increases, the level of variable costs also increases and vice versa.
Examples of variable costs are wages, costs of raw materials, fuel and power.

Production is subject to the law of variable proportion in the short run; hence the short run
production function will primarily be subject to increasing returns followed by diminishing
returns. Regarding costs, production will therefore be subject to diminishing costs followed by
increasing costs. Variable costs will therefore initially increase at a diminishing rate and then,
increase at an increasing rate.

Average variable cost refers to the variable cost per unit of output. It is calculated as follows:

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Where TVC is total variable cost and Q is quantity

Total cost and Average total cost/Average cost

Total cost represents the sum of fixed and variable costs. Therefore,
Total cost = Fixed cost + Variable cost

The total cost can also be represented by the following cost function:
The average cost refers to the cost per unit of output produced; hence,

Or AC = AFC +AVC
The diagram below shows the link between the total cost (TC) curve, variable cost (VC) curve
and fixed cost (FC) curves AND the link between average cost (AC), average variable cost
(AVC) and average fixe cost (AFC) curves.

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Marginal Cost
The marginal cost is defined as the addition to total cost when an extra unit of output is
produced. It is calculated as follows:
MCn= TCn– TCn-1 OR

As per the diagram below, both AC and MC fall and then rise. When AC is falling, MC is
smaller than AC. However, when AC starts rising, MC is above AC. MC is equal to AC when
AC is at its minimum as shown below.

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  The Long-run Cost Concept
The long-run average cost curve is the envelope of the short-run average total cost curves, with
each short-run average total cost curve tangent to the long-run average cost curve at a particular
point. The long-run average cost curve is that each short-run average total cost curve is
constructed based on a given amount of the fixed input, usually capital. Hence, when the quantity
of the fixed input changes, the short-run average total cost curve shifts to a new location.

Also, since the scale of operation changes in the long-run, the firm will benefit from economies
of scale and also experience diseconomies of scale. Therefore, the LAC will have normally a U
shaped form as illustrated below:

Economies of Scale
Internal – advantages that arise as a result of the growth of the firm:
– Technical
– Commercial
– Financial
– Managerial
– Risk Bearing

External economies of scale – the advantages firms can gain as a result

of the growth of the industry.

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  Supply of skilled labour
 Reputation
 Local knowledge and skills
 Infrastructure
 Training facilities

Diseconomies of Scale
 Managerial problems
 Communication problems
 Co-ordination/control problems
 Staffing problems

ACTIVITY 1

1) Bloomy Experts is a florist specializing in floral arrangements for weddings, anniversary

and other events. The following are the costs associated with the operation of the firm.
Fixed cost - £ 100 per day
Each worker is paid £50 per day

The daily production function for the firm is shown in the following table.
Quantity of Labour Quantity of Floral arrangements
0 0
1 5
2 9
3 12
4 14
5 15

(i) Calculate the marginal product of each worker.

(ii) As the number of workers increases, what happens to marginal product of labour?
Describe the principle which explains this behaviour?
(iii) Calculate the marginal cost of each level of output.

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THE REVENUE CONCEPT
The total revenue is the proceeds or total receipts firms obtain from selling goods or services.
The total revenue is calculated as follows:

Total Revenue = Price x Quantity

The average revenue (AR) also referred to price and is defined as the revenue received per unit
of output sold. Also, the demand curve is often referred as the AR curve.

Marginal revenue (MR) is defined as the additional revenue obtained from the sale of an extra
unit of output. It is also referred as the rate at which total revenue increases when an additional
unit of output is sold.

Revenues under Conditions of Perfect Competition

Firms which are classified under the perfectly competitive market normally sell identical goods.
Also, the firms are very small and thus they cannot influence the market price by altering output.
Prices are determined by the industry, through the market forces of demand and supply and thus,
there will be a single price in the market as illustrated below:

Output Price Total revenue Average revenue Marginal revenue

(TR) (AR) (MR)
1 200 200 200 200
2 200 400 200 200
3 200 600 200 200
4 200 800 200 200
5 200 1000 200 200
6 200 1200 200 200
7 200 1400 200 200
8 200 1600 200 200

Hence, it can be seen that under perfect competition, Price=AR=MR

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Revenues under Conditions of Imperfect Competition
Under conditions of imperfect competition, the key feature is product differentiation. Firms will
normally charge different prices to maximise sales proceeds. They are normally price bidders
and will charge different prices for different levels of output as shown below:

Price Quantity Total Average Marginal Price Elasticity

demanded Revenue (TR) Revenue Revenue of demand
10 1 10 10 10 E>1
9 2 18 9 8 E>1
8 3 24 8 6 E>1
7 4 28 7 4 E>1
6 5 30 6 2 E>1
5 6 30 5 0 E=1
4 7 28 4 -2 E<1
3 8 24 3 -4 E<1
2 9 18 2 -6 E<1

Source: Introductory Economics by Stanlake 7th Edition

Several relationships can be observed from the above schedule. For instance, due to price
differentiation, the total revenue will increase at different rates. Also, the MR will always
measure the slope of the total revenue curve. When MR is positive, TR will increase, whereas as
MR becomes zero, TR will reach its maximum point and when MR becomes negative, TR will
fall. The illustration is as follows:

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As it can be observed, both AR and the MR curve fall continuously. However, AR will always
lie above the MR curve.

Normally firms will not produce when MR is negative (TR falls). Production will stop at the
point where total revenue is maximised or before; hence, under imperfect competition, firms will
cease production in the elastic portion of its demand.

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PROFIT MAXIMISATION FOR FIRMS
Firms may have a wide range of objectives. The traditional objective is profit maximisation.
Ideally, a firm attains equilibrium at the point where profit is maximised.

There are two main approaches used to explain profit maximisation or the equilibrium of the
firm. These are:
 TC and TR approach
 MC and MR approach

According to the TC and TR approach profit is maximized where the gap between TC and TR is
largest. This is illustrated in the diagram below;

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The Marginal Cost and Marginal Revenue approach (MC & MR Approach)
Profit maximisation under this approach is reached where marginal cost (to the addition to total
cost when an extra unit of output is produced) is equal to marginal revenue (the addition to total
revenue when an extra unit of output is sold) and also the MC curve must be rising. This is
explained by the fact that if MC is falling, then, it is profitable to expand output and it will not be
an equilibrium point.

Consider diagrams below:

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ACTIVITY 2
1. Differentiate between perfect and imperfect competition.
2. Explain the two approaches used to attain firm’s equilibrium.

SUMMARY
Students can now explain the production functions of firms. Moreover, they can differentiate
between the short and long run cost of production. Also, the revenue concepts are discussed
given different types of markets.

SUGGESTED READINGS
 STANLAKE, F.G. & GRANT, S.J., 2000. Stanlake’s Introductory Economics (7th
Revised Edition), Pearson Education Limited.

 Mc CONNELL, C., BRUE, S. & FLYNN, S., 2008. Economics (McGraw-Hill Series
Economics; McMillan/McGraw-Hill Publishing.

 BEGG, D., FISCHER, S. & DORNBUSCH, R., 2008. Economics. Paperback - Apr. 1,
2008.

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