CHAPTER FOUR

THE THEORY OF PRODUCTION AND COSTS

Objectives

After successful completion of this unit, you will be able to

 Define production and production function

 Differentiate short run and long run, and fixed and variable inputs
 Know the concepts of short run production and efficiency
 Know the concepts of long run production, laws of returns to scale and
how to determine least cost production process.

4.1. Theories of production

4.1.1. Introduction: Definition and basic concepts
Dear learner, how do you define production? What is needed to undertake
production? Attempt to answer these questions and then read the following
paragraphs to be sure on the answer.

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To an economist production means creation of utility for sales.

Alternatively, production may be defined as the act of creating those
goods/services which have exchange value for sale. Raw materials yield
less satisfaction to the consumer by themselves. In order to get utility from
raw materials, first they must be transformed into output. However,
transforming raw materials into final products require factor inputs such as
land, labor, and capital and entrepreneurial ability.

Thus, no production (transforming raw material into output) can take place
without the use of inputs.

Fixed Vs variable inputs

In economics, inputs can be classified as fixed & variable. Fixed inputs are
those inputs whose quantity can not readily be changed when market
conditions indicate that an immediate change 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 shoots up suddenly in a
week, the brewery factories cannot plant additional machinery over a night
to respond to the increased demand. It takes long time to buy new
machineries, to plant them and use for production. Thus, the quantity of
machinery is fixed for some times such as a weak. Buildings, machineries
and managerial personnel are examples of fixed inputs because their
quantity cannot be manipulated easily in short time periods.

Variable inputs, on the other hand, are those inputs whose quantity can be
changed almost instantaneously in response to desired changes in output.
That is, their quantity can easily be diminished when the market demand
for the product decreases and vice versa. The best example of variable
input is unskilled labor.

In our previous example, if the brewery factory had idle machinery before
the market demand shot up, the factory can easily and immediately
respond to the market condition by hiring laborers.

Short run vs. long run

Dear learner, what do you expect about the definitions of short run and
long run?

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In economics, short run refers to that period of time in which the quantity
of at least one input is fixed. For example, if it requires a firm one year to
change the quantities of all the inputs, those time periods below one year
are considered as short run. Thus, short run is that time period which is not
sufficient to change the quantities of all inputs, so that at least one input
remains fixed. One thing to be noted here is that short run periods of
different firms have different duration. Some firms can change the quantity
of all their inputs within a month while it takes more than a year to change
the quantity of all inputs for another type of firms. For example, the time
required to change the quantities of inputs in an automobile factory is not
equal with that of flour factory. The later takes relatively shorter time.
Long run is that time period (planning horizon) which is sufficient to
change the quantities of all inputs. Thus there is no fixed input in the long
-run.

4.1.2. Production in the short run: Production with one variable input
Production with one variable input (while the others are fixed) is obviously
a short run phenomenon because there is no fixed input in the long run.

Total product, marginal product and average product

Dear learner, do you remember what is meant by total utility and marginal
utility from the previous chapter discussion? Then what do you suggest
about total product, marginal and average product?

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Total product: is the total amount of output that can be produced by

efficiently utilizing a specific combination of labor and capital. The total
product curve, thus, represents various levels of output that can be
obtained from efficient utilization of various combinations of the variable
input, and the fixed input. It shows the output produced for different
amounts of the variable input, labor.

Dear learner, do you think that output can always be increased by

increasing the variable input while there is a fixed input?

Any ways, 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, increasing the unit of the
variable input may not help output increase. Even as we employ more and
more unit of the variable input beyond the carrying capacity of a fixed
input, output may tends to decline. Thus increasing the variable input can
increase the level of output only up to a certain point, beyond which the
total product tends to fall as more and more of the variable input is
utilized. This tells us what shape a total product curve assumes. The shape
of the total variable curve is nearly S-shape (see fig 2.1 Panel A)

Marginal Product (MP)

The marginal product of variable input is the addition to the total product
attributable to the addition of one unit of the variable input to the
production process, other inputs being constant (fixed). Before deciding
whether to hire one more worker, a manager wants to determine how much
this extra worker (L =1) will increase output, q. The change in total
output resulting from using this additional worker (holding other inputs
constant) is the marginal product of the worker. If output changes by q
when the number of workers (variable input) changes by ∆L, the change in
output per worker or marginal product of the variable input, denoted as
MPL is found as

Q dTP
orMPL 
L dL
MPL =

Thus, MPL measures the slope of the total product curve at a given point.
In the short run, the MP of the variable input first increases reaches its
maximum and then tends to decrease to the extent of being negative. That
is, as we continue to combine more and more of the variable inputs with
the fixed input, the marginal product of the variable input increases
initially and then declines.

Average Product (AP)

The AP of an input is the ratio of total output to the number of variable

inputs.

totalprodu ct TP
APlabour  
numberofL L

The average product of labor first increases with the number of labor (i.e.
TP increases faster than the increase in labor), and eventually it declines.

Graphing the short run production curves

The following figures shows how the TP, MP and AP of the variable
(labor) input vary with the number of the variable input.
 Output

TP3

TP2 TPL

TP1
L1 L2 L3 Units of labor (variable input)

APL, MPL

APL

Units of labor (variable input)

L1 L2 L3
MPL
Fig 3.1 Total product, average product and marginal product curves:

As the number of the labor hired increases (capital being fixed), the TP
curve first rises, reaches its maximum when L 3 amount of labor is
employed, beyond which it tends to decline. Assuming that this short run
production curve represents a certain car manufacturing industry, it
implies that L3 numbers of workers are required to efficiently run the
machineries. If the numbers of workers fall below L3, the machine is not
fully operating, resulting in a fall in TP below TP3. On the other hand,
increasing the number of workers above L3 will do nothing for the
production process because only L3 number of workers can efficiently run
the machine. Increasing the number of workers above L3, rather results in
lower total product because it results in overcrowded and unfavorable
working environment.

Marginal product curve increases until L1 number of labor reaches its

maximum at L1, and then it tends to fall. The MPL is zero at L3 (when the
TP is maximal); beyond which its value assumes zero indicating that each
additional worker above L3 tends to create over crowded working
condition and reduces the total product. Thus, in the short run (where some
inputs are fixed), the marginal product of successive units of labor hired
increases initially, but not continuously, resulting in the limit to the total
production. Geometrically, the MP curve measures the slope of the TP.
The slope of the TP curve increases (MP increases) up to L1, it decreases
from L1 to L3 and it becomes negative beyond L3.

The average product curve increases up to L2, beyond which it

continuously declines. The AP curve can be measured by the slope of rays
originating from the origin to a point on the TP curve. For example, the
APL at L2 is the ratio of TP2 to L2. This is identical to the slope of ray a.

The relationship between AP and MP of the variable input

The relationship between MPL and APL can be stated as follows:

For all number of workers (Labor) below L2, MPL lies above APL.

At L2, MPL and APL are equal.

Beyond L2, MPL lies below the APL

The law of diminishing marginal returns (LDMR): short –run law of

production

The LDMR states that as the use of an input increases in equal increments
(with other inputs being fixed), a point will eventually be reached at which
the resulting additions to output decreases. When the labor input is small
(and capital is fixed), extra labor adds considerably to output, often
because workers get the chance to specialize in one or few tasks.
Eventually, however, the LDMR operates: when the number of workers
increases further, some workers will inevitably become ineffective and the
MPL falls (this happens when the number of workers exceeds L1 in fig
2.1)

Note that the LDMR operates (MP of successive units of labor decreases)
not because highly qualified laborers are hired first and the least qualified
last. Diminishing marginal returns results from limitations on the use of
other fixed inputs (e.g. machinery), not from decline in worker quality.

The LDMR applies to a given production technology (when the level of

technology is fixed). Over time, however, technological improvements in
the production process may allow the entire total product curve shift
upward, so that more output can be produced with the same input.

3.5 Efficient Region of Production in the short-run

Dear learner, we are now not in a position to determine the specific

number of the variable input (labor) that the firm should employ because
this depends on several other factors than the productivity of labor such as
the price of labor, the structure of input and output markets, the demand
for output, etc. However, it is possible to determine ranges over which the
variable input (labor) be employed.

To do best with this, let’s refer back to fig 2.1 and divide it into three
ranges called stages of production.

Stage I: – ranges from the origin to the point of equality of the APL and
MPL.

Stage II: – starts from the point of equality of MPL and APL and ends at a
point where MP is equal to zero.

Stage III:
III: – covers the range of labor over which the MPL is negative.

Now, which stage of production is efficient and preferable?

To answer the question, let us follow elimination method.

Obviously, a firm should not operate in stage III because in this stage
additional units of variable input are contributing negatively to the total
product (MP of the variable input is negative) because of overcrowded
working environment i.e., the fixed input is over utilized.

Stage I is also 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 underutilized (not efficiently utilized)

Thus, the efficient region of production is stage II. At this stage 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 over that
range of employment of variable input where the marginal product of the
variable input is declining but positive.

Check your progress activity

1. Define production, what are the major inputs required for production?

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2. Which of the following activities is / are considered as production in
economies?

a) A mother washing her child’s cloth-----------------------------------------

b) A farmer producing wheat for self

consumption--------------------------

c) A farmer fattening beef for sale---------------------------------------------

3. Differentiate between:

- Fixed and variable input

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- Short run and long run

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4. List and explain the assumptions of short run production

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5. Explain the following terms and concepts

-
TP--------------------------------------------------------------------------------------
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-
MP--------------------------------------------------------------------------------------
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-
AP--------------------------------------------------------------------------------------
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-
LDMR---------------------------------------------------------------------------------
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6. Which stage of production is efficient region of production? Why?

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4.2. PRODUCTION COSTS
Objectives:-

 Explain different ways of measuring private costs, i.e. economic costs

vs. accounting costs.
 Define the meaning and nature of cost functions both in the short run
and long run.
 Explain the relationship between short run production function and
short run cost function.

4.2.1. Basic concepts

Dear learner! Do you know about costs?

(Use the space left below to write your response)

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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
production of an item.

We can identify two types of cost of production: social cost and private
cost.

Social cost: is the cost of producing an item to the society. This cost is
realized due to the fact that most resources used for production purpose are
scarce and some production process, by their nature, emit dangerous
chemicals, bad smell, etc to surrounding society.

For example, when a certain beer factory wants to produce beer in

Ethiopia, the society as a whole also incurs a cost. Because, the next-best
alternative of the raw material (such as barely) used for the production of
beer is sacrificed. When the beer factories buy barley from the market, the
amount of barely available for consumption by society may be reduced
and the price may become dearer. Hence, the production of beer imposes
an indirect cost on the society, moreover, by its nature; the production of
beer emits bad chemicals to the environment, which pollutes waters, air,
etc. To control the understandable consequences of the production process
on the environment and their property, the society incurs cost.

Private cost: This refers to the cost of producing an item to the individual
producer. It is the cost that the beer factory incurs to produce the beer, in
our example:

Private cost of production can be measured in two ways:

i) Economic cost

In economics the cost of production to the individual producer includes the

cost of all inputs used for the production of the item.

The producer may buy part of the inputs from the market. For example,
he/ she hire workers, buy raw materials, the necessary machines, etc. the
actual or out- of- pocket expenditures that the firm incurs to purchase these
inputs from the market are called explicit costs.

But, the producer can also use his/ her own inputs which are not purchased
from the market for the production purpose. For example, the producer
may use his/ her own building as a production place, he/she may also
manage his firm by himself instead of hiring another manager, etc. since
these inputs are used for the purpose production, their value has to be
estimated and included in the total cost of production. As to how to
estimate the cost of these non- purchased inputs is concerned, we usually
estimate their cost from what these inputs could earn in their best
alternative use. For instance, if the firm uses his own building for
production purpose, the cost of using this building for production is
estimated by the rent income foregone. If the producer is a teacher with
salary of 1000 birr per month and fruits his job to manage his factory, then
the next best alternative of his labor is the salary that he sacrificed to be
the manager of his factory. The estimated cost of there non- purchased
inputs are called implicit costs.

Thus, in economics the cost of production includes the costs of all inputs
used in the production process whether the inputs are purchased from the
market or owned by the firm himself that is:
Economic cost: Explicit cost plus Implicit cost

ii) Accounting Cost

For accountant, the cost of production includes the cost of purchased

inputs only. Accounting cost is the explicit cost of production only. More
over, accountant’s doesn’t consider the cost of production from the
opportunity cost of the resources point of view. To clarify the difference
between accounting cost and economic cost on this regard, consider the
following example.

Suppose Bedele Brewery factory purchases 1000 quintals of barely for 200
birr per quintal in 1998 to use this barley for production purpose in the
year 1999. However, suppose that the price of the barely has been
increased to 300 birr per quintal in the year 1999.

-Now shall we use the actual price with which the barely was bought in
1998 or the current price (1999 price) to estimate the cost of barely in
1999?

In economics, the 1999 price should be taken because, though the barley
was bought for 200 birr per quintal in 1998, the cost of using this barely
for the production purpose in 1999 is the 300 birr per quintal, the amount
of income that could be obtained if the barely were sold in the market.

But accountants use the 1998 price to estimate the cost of production in the
year 1999.

Check your progress activities

Consider a barber in your locality. What are the explicit and implicit costs
that the barber incurs to provide the service?

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What are the main differences between accounting and economic ways of
measuring costs? Which one do you believe is more appreciate? Why?
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Explain the distinction between social and private costs of production

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4.2.2. Cost functions

Cost function shows the algebraically relation between the cost of
production and various factors which determine it. Among others, the cost
of production depends on the level of output produced, technology of
production, prices of factors, etc. hence; cost function is a multivariable
function. Symbolically,

C = f (x, t, pi)

Where c- is total cost of production

x - is the amount of output

T – is the available technology of production.

Pi – is the price of input

Graphically, cost functions can be illustrated by using a two- dimension

diagrams. To do so, first we observe the relationship between the total cost
of production and the level of output (the most factor determining the cost
of production), by assuming that all other factors are constant. Then, the
impact of change in “other factors” such as technology on the cost of
production will be handled by shifting the total cost curves up ward or
down- ward.

4.2.3. Short run vs. long run costs

Dear learner! What do we mean by short run and long run in economics?

(Use the space left below to write your response)

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Economics theory distinguishes between short run costs and long run
costs. Short run costs are the costs over a period during which some
factors of production (usually capital equipments and management) are
fixed. The long- run costs are the cost over a period long enough to permit
the change of all factor of production.

Short run costs of the traditional theory

In the traditional theory of the firm, total costs are split into two groups:
total fixed costs and total variable costs:

TC = TFC + TVC

Where – TC is short run total cost

TFC is short run total fixed cost

TVC is short run total variable cost

By fixed costs, we mean a cost which doesn’t vary with the level of out
put. The fixed costs include:

 Salaries of administrative staff

 Expenses for building depreciation and repairs
 Expenses for land maintenance
 The rent of building used for production , etc

All the above costs are regarded as fixed costs because whether the firm
produces much output or zero output, these costs are unavoidable, and the
firm can avoid fixed costs only if he / she shut down the business stops
operation.

Variable costs, on the other hand, include all costs which directly vary
with the level of output. The variable costs include:

 The cost of raw materials

 The cost of direct labor
 The running expenses of fixed capital such as fuel, electricity power, etc.
All these costs are regarded as variable costs because their amount
depends on the level of output. For example, if the firm produces zero
output, the variable cost is zero.

Graphical presentation of short run costs

Total fixed cost (TFC)

Graphically, TFC is denoted by a straight line parallel to the output axis.

The point of intersection of the TFC line with the cost axis (vertical axis)
shows the amount of the fixed. For example if the level of fixed cost is $
100, it can be shown as.

$100
TFC

X
Fig 4.1

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. According to this
law, at the initial stage of production with a given plant, as more of the
variable factor (s) is employed, its productivity increases. Hence, the TVC
increases at a decreasing rate. This continues until the optimal combination
of the fixed and variable factors is reached. Beyond this point, as increased
quantities of the variable factors(s) are combined with the fixed factor (s)
the productivity of the variable factor(s) declined, and the TVC increases
by an increasing rate. Thus, the TVC has an inverse s-shape due to the law
of diminishing marginal returns.

Graphically, the TVC looks the following.

TVC

X
Fig 4.2

Total Cost (TC):-

The total cost curve is obtained by vertically adding the TFC and the TVC
i.e., by adding the TFC and the 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. But the TC curve doesn’t start from the origin as that of
the TVC curve. The TC curve starts from the point where the TFC curve
intersects the cost axis.

TC

TVC

TFC
 Q

Fig 4.3 the TC and TVC curves has an inverse S- shape. The vertical
distance between them (TFC) is constant.

Check your progress activities

1. What does the cost function show?

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2. Why does the TC curve possess the inverse S-shape? is it due to the law
of variable proportions as that of the TVC curve?

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3. Differentiate between TVC and TFC, and give at least three examples of
each.

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Per unit costs (average costs)

From total costs we can derive per-unit costs. These are even more
important in the short run analysis of the firm. Average fixed cost (AFC) -
is found by dividing the TFC by the level of output.
Graphically, the AFC is a rectangular hyper parabola. The AFC curve is
continuously decreasing curve, but decreases at a decreasing rate and can
never be zero. Thus, AFC gets closer and closer to zero as the level of
output increases, because a fixed amount of cost is being divided by
increasing level of output.

AFC
Q

Fig 4.4 the average fixed cost curve is derived from the total fixed cost,
and it represents the slope of straight lines drawn from the origin to a
given point on the TFC curve.

Average variable cost (AVC):-

The AVC is similarly obtained by dividing the TVC with the

corresponding level of output.

TVC
AVC 
X

Graphically, the AVC at each level of output is derived from the slope of a
line drawn from the origin to the point on the TVC curve corresponding to
the particular level of output.
The following graph clearly shows the process of deriving the AVC curve
from the TVC curve.

C C
TVC

AVC
d

d
a

b c b c

0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

Panel A Panel B

Fig 4.5 in the figure above, the AVC at Q1 from panel A is given by the
slope of the ray 0a, the AVC at Q2 is given by slope of the ray 0b, and so
on. The slope of the rays decreases until Q3 and starts to rise beyond Q3.

It is clear from this figure that the slope of a ray through the origin
declines continuously until the ray becomes tangent to the TVC curve at C.
To the right of this point (Point c) the slope of the rays through the origin
starts increasing. Thus, the short run AVC (SAVC now on) falls initially,
reaches its minimum and then start to increase. Hence, the SAVC curve
has a U-shape and the reason behind is the law of variable proportions.
Had the TVC not been inverse S-shaped, the SAVC would never assume a
U-shape.
Generally, at initial stage of production, the productivity of each additional
unit a variable input increases, thus, the variable input requires to produce
each successive units of output decreases at this stage, implying that the
AVC (Variable Cost Incurred to produce a unit of output) decreases. This
process continues until the point of optimal combination between the fixed
input and the variable input is reached. Beyond this point, the productivity
of each additional unit of the variable combined with the existing fixed
input decreases because the fixed input is over utilized. As the productivity
of such variables decreases, more and more of the variables are required to
produce successive units of the output, implying that the VC incurred to
produce each successive unit (AVC) increases.

Average total cost (ATC) or simply, Average cost (AC)

ATC (or AC, now on) is obtained by dividing the TC by the corresponding
level of output. It shows the amount of cost incurred to produce each unit
of successive outputs.

TC
AC 
Q

TVC  TFC
AC 
Or equivalently, Q

TVC TFC
 
Q Q

= AVC + AFC

Thus, AC can also be given as the vertical sum of AVC and AFC.

Graphically, AC curve can be obtained by vertically adding the AVC and

AFC for each level of successive outputs. Alternatively, the AC curve can
also be derived in the same way as the SAVC curve. The AC curve is U-
shaped because of the law of variable proportions. Observe the figure that
follows.
 Q

TC

SAC

b c a

b d
c

Q
0 Q Q2 Q3 Q4
1 Q1 Q2 Q3 Q4

Fig 4.6 Panel-A Panel-B

From this figure (Panel A), the AC at any level of output is the slope of the
straight line from the origin to the point on the TC curve corresponding to
that particular level of output. That is, for example, the AC of producing
Q1 level of output is given by the slope of the line 0a, the AC of producing
Q2 level of outputs is given by the slope of the line Ob and so on.

Marginal Cost (MC) ;-

The marginal cost is defined as the additional cost that the firm incurs to
produce one extra unit of the output. One thing to be noted here is that, the
additional cost that the firm incurs to produce the 10th unit of output is
no0t equal to the additional cost of producing the 1000th unit. They would
be equal if the TC curve is straight line.

To sum up, the MC is the change in total cost which results from a unit
change in output i.e. MC is the rate of change of TC with respect to output,
Q or simply MC is the slope of TC function and given by:
 dTC
MC 
dQ

In fact MC is also the rate of change of TVC with respect to the level of
output.

dTFC  dTVC dTVC dTFC

MC   0
dQ dQ , since dQ

Graphically, the MC the TC curve (or equivalently the slope of the TVC
curve) obviously, the slope of curved lines at a given point is measured by
constructing a tangent line to the curve at each point. So, the slope of the
curve at a given point is equal to the slope of the tangent line at that
specific point. Given the inverse S-shaped TC (or TVC) curve, the MC
curve will be U-shaped. Thus given inverse S-shaped TC or TVC curve,
the slope of the TC or TVC curve (i.e. MC) initially decreases, reaches its
minimum and then starts to rise.

From this, we can logically infer that the reason for the U-shaped ness of
MC is also the law of variable proportion. That is, had the TC or TVC
curve not been inverse S-shaped, the MC curve have would never assumed
the U-shape, and obviously, the TC or TVC is inverse S-shaped due to the
law of variable proportions. Observe the figure that follows for more
discussion. Fig 3.7

C C

TC
MC

S
 Qs Q Qs Q

Panel-1 Panel-2

In Panel 2 the slope of the tangent lines to the TC curve ( MC) decreases
up to point S and then starts to rise.

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

4.2.4. The relationship between AVC, ATC and MC

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC
are u – shaped, reflecting the law of variable proportions however, the
minimum of ATC occurs to the right of the minimum point of the AVC
( see the following figure) this is due to the fact that ATC includes AFC
which continuously decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over
a certain range is more than offset by the fall in the AFC, so that the ATC
continues to fall (over that range) despite the increase in AVC. However,
the rise in AVC eventually becomes greater than the fall in AFC so that
the ATC starts increasing. The AVC approaches the ATC asymptotically
as output increases.
 C

AC
MC

AVC

AFC

Q
Q1
Q2

Fig 4.8

The AVC curve reaches its minimum point at Q1 output and ATC reaches
its minimum point at Q2. The vertical distance between ATC and AVC
(AFC) decrease continuously as out put increases. The MC curve passes
through the minimum point of both ATC and AVC

Check your progress activities

Why are AVC, ATC and MC curves U-

shaped………………………………………………………………………
…………………………………………………………..

Graphically derive the ATC curve from TC

curve………………………………………………………………………
……………………………………………………

Define the ‘Marginal cost’……………………………………………..

Show (mathematically) that AVC and MC are inversely related with AP

and MP of the variable input respectively.
Summary
Costs are the monetary value of inputs used for production purpose. Costs
of production may involve explicit costs (costs of purchased in puts) and
implicit cost (estimated costs of inputs owned by the producers it self).

Managers, investors and economists must take into account the

opportunity cost associated with the use of a firm’s resources the cost
associated with the opportunities forgone when the firm uses its resources
in its next best alternative.

Costs of production depend on several factors such as the quantity of

production, the level of technology and input prices. Thus cot functions are
a multivariate function.

In the shotrun, one or more of a firm’s inputs are fixed. Thus, total cost of
production can be divided to fixes cost and variable costs. Fixed costs are
constant irrespective of the level output. A firm cannot avoid fixed cost
even by producing zero level of output. Variable costs, on the other hand,
vary with the level of output directly.

By dividing the total cost and total variable costs for the quantity of
production, we obtain average cost (AC) respectively. In the short run,
when not all inputs are variable, the AC and AVC curves assume a U-
shape due to the law of variable proportions.

Marginal costs of production are additional costs incurred to produce one

more unit of a commodity. The MC curve has a U- shape due to the law of
variable proportions.

Short run marginal and average variable cost curves are a mirror reflection
of the marginal product and average product of the variable input
respectively.

In the long run, all inputs to the production process are variable. As a
result, the choice of inputs depends both on ht e relative costs of a factor of
production and on the extent to which the firm can substitute among inputs
in its production process.
 Module 2
Dear winter in-service students, how did you get the first module of this
course? I hope you find it very attractive and educative. at the same time
I hope you exerted most of your effort and devoted most of your time to
understand the concept written in that module. Now I welcome you to the
second module of this course. this module introduces the concept of
Macroeconomics module introduces you the concept of national income
accounting, international trade, natural resource and natural resource
economics.

Module objectives:-
 Examine the basic concept and measurement in national income
accounting

 Analyze why international trade

 Recognize the major macroeconomics problem of inflation,

unemployment, and social equality
 CHAPTER ONE

National income accounting

Objectives:

At the end of your study on this unit, you should be able to:

 Discuss the concept of national income

 Discuss the method of nation income measuring

 Explain the importance of national income accounting

 Differentiate the difficulties in measuring national income particularly in

developing nations

 Definition of national income

The concept of national income has three interpretations: it represent a

receipt/income/ total, an expenditure total and total value of production
over the course of one year. This threefold interpretation arises out of the
principle that every expenditure is at the same time receipt, and if goods
or services bought are valued at their sales prices, we have three fold
identity that the value received equals the v value paid equals the value of
goods and services given in exchange.

To explain the above idea let us take an economy where there are only two
sectors: household and firm. Firms are required to produce goods. To
produce them they services of factors of production. Thus, income of these
factors arises in the course of production must equals the sum totals of
payments made by the firms to the factor of production in the form of
wages, rents, interest and profit. These incomes in turn become the sources
of expenditure. Thus, income flows from firms to households in exchange
for the productive services, while product flows in turn when expenditure
by the households takes place.

1.1. Measure of national income and output

Why do we measure national income and output? Use the space left below
to give your response (use the space below left for your response).
____________________________________________________________
________________________________________

Measure of income and output are used in economics to estimate the value
of goods and services produced in the country they use a system of
national accounts. Or national accounting first developed during the 1940.
Some of the more common measures are: gross domestic product (GDP),
gross national product (GNP), net national income (NNI), Personal income
(PI) and disposable income (DI). The difference between these national
income measures are listed below.

Gross domestic product (GDP)

What does GDP measure?

(Use the space left below for your response)

____________________________________________________________
____________________________________

GDP is the basic social accounting measures of the total output or

aggregate in supply of goods and services. GDP is the market monetary
value 0f all goods and services produced in one year within the boundary
of given country whether by citizen or foreign –supplied resources. It is
the total value of all goods and services produced within that territory
during a specified period (or if not specified, annually. GDP differs from
GNP in excluding inter-country income transfer, in effect attributing to a
territory the product generated within it rather than the income received
in it.

Gross national product (GNP)

How can you differentiate GNP from GDP?

____________________________________________________________
________________________________________

GNP is the market monetary value of all goods and services produced by
resources owned and supplied by citizens of the nation, irrespective of
where the resources are located. An economy statistics that include GDP
plus any income earned by the residents from overseas investment, minus
income earned within the domestic economy by overseas residents Or
GNP can be represented as follows:

GNP=GDP+ net factor income (NFI)

Where

NFI=factor income received from abroad – factor income paid abroad.

Net National productivity (NNP)

The third important concept of national income is that of net national

product. In the production of gross national product, of the year we
consume or use or use up some capital. That is equipment, machinery, etc.
the capital goods like machinery, wear out fall in the value as the result of
its consumption or use is production process. This consumption of fixed
capital or fall in the value of capital due to wear and tear is called
depreciation.

When charges for depreciation are deduced from GDP, we get net national
product. That is

NNP=GNP-DEPRECIATION

Net National Income of Factor Cost (NNI)

National income at factor cost means that the sum of all income earned by
resource suppliers for their contribution of land, labor, capital and
entrepreneurial ability which go in to the year’s net production.
Personal Income:-

Personal income is the sum is the sum of all incomes actually received by
all individual or households during a given year. National income (total
income earned) and personal (income received) must be different for
simple reason that some income which is earned social security
contributions, corporate income taxes and undistributed corporate profits
is not actually received by households and conversely some income
which is received like transfer payments –is not currently earned .
(transfer payments are old age pensions, unemployment ,compensation,
relief payment, interest payment on the public debt, etc.).

Personal is equal to national income minus social security, contribution

minus corporate income tax minus undistributed corporate profit plus
transfer payments. The importance of the concept of PI lies in the fact that
it serves as a good indicator of what is happening to family wellbeing and
spending.

PI=NNI-(retained earnings +Corporate tax transfer payment

+interest on public debt

How to measure national income

There are three different ways of measuring the NI of the nation. The
output approach and the closely related income approach can be seen as
the summation of consumption, saving and taxation. On the other hand,
expenditure approach determines gross national expenditure (GNE) by
summing consumption, investment, gov’t expenditure and net exports. The
three methods must yield the same results because the total expenditure of
goods services produced (gross national product which must be equal to
the total income paid to the factors that produced those goods and services
(GROSS NATIOONALINCOME). (GNP=GNI=GNE by definition

1. National product or output

This is the most direct method of computing national income. Under this
method, the output of goods and services from all firms over the year is
summed up. To avoid the double counting, only goods and services are to
be reckoned.

Dear students, try to explain what do we mean by final goods? Use the
space provided below for your response.

____________________________________________________________
____________________________________________________________
________________________

Final goods are those goods which are being purchased for final use and
not for resale or further processing. Intermediate goods, on the other hand,
are those goods that are purchased for further processing or for resale. the
sales of final goods is included in the gross national product .this is
because the value of final goods includes the value of all intermediate
goods used in their production .the inclusion of intermediate goods would
involve double counting and will, therefore, give unexaggerated estimate
of gross national product.

This method can be used where there exists a sense of production for the
year. In an many countries, figures of production of only important
industries are known. Hence, this method is employed along with other
method to arrive at the national income. The one great advantage of this
method is that it reveals the relative importance of the different sectors of
the economy by showing the respective contribution to the national
income.

Example of GNP by calculation of output from industry

Industry added value

(Billions)

Mining 86.80

Construction 97.06

Transportation 122.66
 B. Income method

Under this method the income that accrue to the factors of production
provided by the normal residents of the national income classified by
distributive shares

The logic of this method is very simple. Every time a good or services is
produced, someone gets an income for producing it and the income
produced will be equal to the value of the things produced. Hence if we
want to find out the total value of goods and services produced in the
course of a year, we simply add together all the personal incomes received
during the year. The major components of a nation’s income are
compensation of employees in the form of wages or salaries, income
earned from rent of land, interest income, and profit. Profit is proprietors’
profit and profit of corporate. Nevertheless, not all of GNP is available to
produce final goods and services-part of it represents output that is set
aside to maintain the nation’s productive capacity. Capital goods such as
machineries and buildings lose value over time due to wear and tear
obsolescence. Depreciation measures the amount of GNP that must be
spent on new capital goods to offset this effect

GDP= wages +salaries +rent +proprietor profit + corporate profit

+depreciation +indirect taxes

GNP=GDP +NFI
Example of calculating GNP by income

Type of income
Amount (Billions)

Compensation of employers
1466.00

Proprietor income 134.00

Rental income 34.00

Corporate income 189.00

Net interest 215.00

Depreciation 322.00

Indirect tax 255.64

GDP 2,615.64

Net factor income 306.00

In the income approach

NNP is GNP _ depreciation

NNI is NNP – Direct taxes

PI is NNI-retained earnings, corporate taxes, transfer payments and

interest on the public debt

Personal disposable income is PI minus personal taxes, plus transfer

payment.
 CHAPTER TWO

INTERNATIONAL TRADE AND ECONOMIC

DEVELOPMENT

2.1. The Concept of International Trade

International trade is the exchange of goods and services across

international boundaries or it can be defined as between two trades or
more partners from different countries (an exporter and an
importer).International trade are part of daily life. In most countries, it
represents a significant share of GDP. While international trade has been
present throughout much of history, it’s economic, social and political
important has been on the rise in recent centuries. Internalization,
advanced transportation, globalization and Multinational Corporations, are
all having a major impact. Increasing international trade is the usually
primary meaning of ̒ globalization. International trade is a branch of
macroeconomic, which, together with international finance from the large
branch of international economics. Traditionally, international trade is
justified in economic comparative advantage theory. New development in
parent of international trade include: the integration of countries into trade
blocs.

On the other hand, exchange of goods and services within countries is

called ̒ inter -regional trade̕. What difference, then, does it make to the
theory of trade whether these goods are made in the same countries, or in
different countries? Why is a separate theory of international trade
needed? Well, domestic and foreign trade is really one and the same. They
both imply exchange of goods between personal and they both aim at
achieving increased production through division of labor. There are,
however, a number of things that make a difference between foreign trade
and domestic trade.

How is a foreign trade different from domestic trade?

Foreign trade is different from domestic trade in the following factors.

These include

1. Immobility of factors of production. Labour and capital do not move

as freely from one country to another, as they do within same countries. ̒̒̒̒̒̒̒ ̒
Man ̓ ̓ declared Adam smith, ̒ ̒ is of all form of luggage the most difficult to
transport ̕ ̓ much more so when a foreign frontier has to be crossed. Hence
difference cost of production cannot be removed by moving men and
money. The result is the movement of goods. On the contrary, between
region within the same Political boundaries people distribute themselves,
more or less according to opportunities. Real wages and standing of living
tend to seek a common level though they are not wholly uniform.

CHAPTER 3
OVERVIEW OF NATURAL RESOURCES AND RUSTAINABLE

Chapter objective:-

After successful completion of this chapter you will be able to:

 Explain the role of natural resources in growth and development

 Describe the kuznet environmental curve
 Understand sustainable development
 3.1. Introduction
Over the past twenty years, a major change has occurred in economic
thinking. No longer do we consider the economic process of producing
goods and services and generating human welfare to be solely dependent
on the accumulation of physical and human capital. An increasing number
of economists now accept that there is a third form of ‘‘capital’’ or
‘‘economic asset’’ that is also crucial to the functioning of the economic
system of production, consumption and overall welfare. This distinct
category consists of the natural and environmental resource endowment
available to an economy, which is often referred to as natural capital.
Figure 1.1 depicts the basic relationship between physical, human and
natural capital and the economic system. Human-made, or physical, capital
(KP), human capital (KH) and natural capital (KN) all contribute to human
welfare through supporting the production of goods and services in the
economic process. For example, KP, consists of machinery, equipment,
factory buildings, tools and other investment goods that are used in
production; KH includes the human skills necessary for advanced
production processes and for research and development activities that lead
to technical innovation; and KN is used for material and energy inputs into
production, acts as a ‘‘sink’’ for waste emissions from the economic
process, and provides a variety of ‘‘ecological services’’ to sustain
production, such as nutrient recycling, watershed protection and catchment
functions, habitat support and climate regulation. However, all three forms
of capital also contribute directly to human welfare independently of their
contributions through the economic process. For instance, included in
physical capital, KP, is fine architecture and other physical components of
cultural heritage; increases in KH also contribute more generally to
increases in the overall stock of human knowledge; and KN includes
aesthetically pleasing natural landscapes, and provides a variety of
ecological services that are essential for supporting life. There are some
important general issues and debates concerning the role of natural
resources in economic development. This introductory chapter elaborates
further on these issues and debates. In particular, the chapter has three
objectives. First, the chapter highlights some of the current economic
 thinking concerning natural capital, growth and development. For
example, it is clear from Figure 1.1 that the services provided by natural
capital are unique, and in the case of the ecological services and life-
support functions of the environment, are not well understood. As a result,
there has also been considerable debate in economics over the role of
natural capital in ‘‘sustainable’’ economic development. That is, does the
environment have an ‘‘essential’’ role in sustaining human welfare, and if
so, are special ‘‘compensation rules’’ required to ensure that future
generations are not affected adversely by natural capital depletion today?

A second debate has emerged over whether environmental degradation in

an economy may initially increase, but eventually declines, as per capita
income increases.

Sustainable development

Development that meets the need of present without compromising the

ability of future generation to meet their needs

Welfare does not decline overtime

 Total capital stock

Human capital Physical capital

Natural capital KH KP
KN

Substitute for KN
Weak sustain ability

All KN is non essential

 Keep essential KN “intact”

Strong sustainability because of:
Some KN is essential  Imperfect substitution
 Irreversible losses
 Uncertainty over values
Figure 1.1. Human, physical and natural capital and the economic system

While it is generally accepted by most economists that economic

development around the world is leading to the irreversible depletion of
natural capital, there is widespread disagreement as to whether this
necessarily implies that such development is inherently unsustainable.
From an economic standpoint, the critical issue of debate is not whether
natural capital is being irreversibly depleted, but whether we can
compensate future generations for the current loss of natural capital, and if
that is possible, how much is required to compensate future generations for
this loss. Economists concerned with this problem appear to be divided
into two camps over these two perspectives is whether natural capital has a
unique or ‘‘essential’’ role in sustaining human welfare, and thus whether
special ‘‘compensation rules’’ a special role of natural capital in
sustainable development. The main disagreement between e required to
ensure that future generations are not made worse off by natural capital
depletion today (see Figure 1.2). These two contrasting views are now
generally referred to as weak sustainability versus strong sustainability.
According to the weak sustainability view, there is essentially no inherent
difference between natural and other forms of capital, and hence the same
‘‘optimal depletion’’ rules ought to apply to both. As long as the natural
capital that is being depleted is replaced with even more valuable physical
and human capital, then the value of the aggregate stock – comprising
human, physical and the remaining natural capital – is increasing over
time. Maintaining and enhancing the total stock of all capital alone is
sufficient to attain sustainable development. In contrast, proponents of the
strong sustainability view argue that physical or human capital cannot
substitute all the environmental resources comprising the natural capital
stock, or all of the ecological services performed by nature. Consequently,
the strong sustainability viewpoint questions whether, on the one hand,
human and physical capital, and on the other, natural capital, effectively
comprise a single ‘‘homogeneous’’ total capital stock. Instead, proponents
of strong sustainability maintain that some forms of natural capital are
‘‘essential’’ to human welfare, particularly key ecological services, unique
environments and natural habitats and even irreplaceable natural resource
attributes (such as biodiversity). Uncertainty over the true value to human
welfare of these important assets, in particular the value that future
generations may place on them if they become increasingly scarce, further
limits our ability to determine whether we can adequately compensate
future generations for irreversible losses in such essential natural capital
today. Thus the strong sustainability view suggests that environmental
resources and ecological services that are essential for human welfare and
cannot be easily substituted by human and physical capital should be
protected and not depleted. The only satisfactory ‘‘compensation rule’’ for
protecting the welfare of future generations, is to keep essential natural
capital intact. That is, maintaining or increasing the value of the total
capital stock over time in turn requires keeping the non-substitutable and
essential components of natural capital constant over time.

The two sides in the debate between weak and strong sustainability are not
easy to reconcile. Recent extensions to the economic theory of sustainable
development have not so much resolved this debate as sharpened its focus.
Nevertheless, the weak versus strong sustainability argument is an
important one, especially for developing countries that are dependent on
the exploitation of natural capital for their current development efforts.

As we discuss further below, this dependence of low and middle-income

economies on natural resources is a key ‘‘stylized fact’’ for these
economies, and should shape our perspective on the role of efficient and
sustainable management of natural capital to foster long-run development.

3.2. Growth, environment and the EKC

Dear students how can you explain the environmental Kuznets curve?

Use the space below left for your response

____________________________________________________________
____________________________________________________________
___________________
 So far, we have identified the importance of natural capital as a
component of the total capital stock supporting economies, and in turn, the
role of maintaining this stock in order to enhance sustainable economic
development. However, for many developing countries, maintaining
natural capital is not a viable option in the short and medium run. As these
economies grow and develop, natural resource degradation and increased
pollution are likely to be increased. A critical issue for developing
economies, therefore, is whether at some point in the future they are able
to attain levels of economic development that will coincide with
improving rather than deteriorating environmental quality. This issue has
become the focus of a new area of enquiry in economics. This recent
literature is concerned with the analysis of environmental Kuznets curves
(EKC), i.e.
i.e. the hypothesis that there exists an ‘‘inverted-U’’-shaped
relationship between a variety of indicators of environmental pollution or
resource depletion and the level of per capital income. The implication of
this hypothesis is that, as per capita income increases, environmental
degradation rises initially but then eventually declines. The emerging EKC
literature has important implications for sustainable development, and in
particular, for whether or not developing economies may be able
eventually to overcome certain environmental problems through continued
economic growth and development. Studies are likely to continue for some
time.
kg

SO2

per

capit
a

GNP per capita

The above curve is the environmental Kuznets curve for sulfur

dioxide (SO2) Estimated across rich and poor countries of the world . The
“peak” or “turning point” level of per capita income where SO2 levels
start to fall