LECTURE 5: THEORY OF PRODUCTION AND COST

Definition of production and related concepts

(i) Production- this is the creation of goods and services through the transformation of
inputs into outputs.
(ii) Inputs- these are the ingredients used by a firm to produce a good or service. Sometimes
they are called factors of production or resources. These include land, capital, labour,
entrepreneurs etc.
(iii) Output- this is the end product of transforming input into goods or services. Output is
thus a function of the various input expressed in the production function.
(iv) Production function- a production function is a schedule (or table, or mathematical
equation) showing the maximum amount of output that can be produced from any
specified combination of inputs, given the existing technology.
In short the production function is like a “recipe book” showing what output is associated
with which combination of inputs.

It may be represented as follows

Q  f K , L, r 

Where : Q is output

L is labour

K is capital

r are other input resources

(v) Short run period- refers to the period of time during which it is impractical to
change the employment levels of some inputs so as to immediately increase output.
Factors input that cannot be varied during this period are referred to as fixed input
incase an immediate change in output is desired, it would be extremely costly to

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 immediately vary such inputs. Such inputs include buildings, machinery, managerial
personnel. Therefore changes in output must be accomplished exclusively by changes
in the usage of variable inputs. A variable input- is one whose quantity may be
changed almost instantaneously in response to desired changes in output. Many types
of labour services and the inputs of raw and processed materials fall in this category.
Thus in short run period one factor is held fixed (e.g. capital) while other one variable
(labour)

(vi) Long run period- is defined as that period of time in which inputs are variable in the
long run it may be economical to install additional productive facilities. In order to
produce a certain level of output, we could use different combinations of labour and
capital.
(vii) Isoquant- is a curve that shows all the combinations of inputs that will produce a
certain level of output, given same level of technology.
In the analysis of theory of production two approaches will be used.

1) Analysis of production: in the short run when one factor is variable and
the other is fixed. (short run period function approach)
2) Isoquant analysis, which is long-run approach and which assumes that all
factors are variable.

Differences between consumer behavior & production theory

Objectives- the consumer aims at maximizing utility while producer aims at maximizing cost.

Constraint- the consumer is constrained by the income level and prices of commodities while
the producer is constrained by technology level and the cost of inputs.

Tools of analysis- the analysis of consumer behavior employ indifference curves, while that of
the production theory employs isoquant.

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TYPES OF PRODUCTION CURVES

Here distinction is made between three types of production curves.

1) Total product curve

2) Marginal product curve
3) Average product curve
1) Total Product (TP)
In the short run, production function gives the total (maximum) output obtainable from
different amounts of the variable inputs, given a specified amount of the fixed input.

In the short-run, production function is written as Q  f K , L  , where capital is fixed and

labour is variable.

2) Average Product (AP) or Average Physical Product (APP)

The average product of an input is that product divided by the amount of the input used to
produce this output.

Q f K , L 
APL  
L L

This can be read as average product of the variable input labour.

3) Marginal Physical Product (MPP or MP)

Is the change in total product that results from one unit change in the amount of variable
inputs (e.g. labour), the fixed input remaining unchanged. (may also say, other inputs other
than labour remaining unchanged)

Therefore marginal product of labour is the derivative of output with respect to labour.

Q f K , L 
MPL  
L L

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No of capital No. of labour TPL  TP   TP  Stages
APL   MPL  
 L   L 

1 unit 0. 0 0 0

1 unit 1. 5 5 5

1 unit 2. 16 8 11 I

1 unit 3. 36 12 20

1 unit 4. 68 17 32

1 unit 5. 95 19 27

1 unit 6. 114 19 19

1 unit 7. 119 17 5 II

1 unit 8. 120 15 1

1 unit 9. 117 13 -3

1 unit 10. 100 10 -17 II

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 TP, MP, AP

Stage II Stage III

Stage I C MP  0
120

B
114

Q
MP 
68 A L

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19
AP

4 6 8
0 MP No. of Labour

This is a short run case whereby not all inputs are variable. Labour (L) is variable, while capital
is fixed at 1 unit.

TP Curve

From the table and figure, total output increases with more employment of labour, reaches a
maximum at Q x  120 , and number of labour employed equal 8. as more and more laborers are
employed beyond 8, output starts to decline.

MP Curve

As more laborers are employed, marginal product of labour increases, reaching maximum at
L  4 , then declines reaching zero, when L  8 beyond L  8 , MPL becomes negative.

AP Curve

Average product curve also increases initially as L increases, reaching maximum at L  6 then
start declining. APL remain positive as long as total product is positive.

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The law of diminishing returns

 If more and more units of a variable input (in our case labour) are applied to a given quantity
of fixed input, the total output may initially increase at an increasing rate, but beyond a
certain level of output, the rate of increase in the total output diminishes.
 The reason behind the operation of this law is that with increasing units of labour to a fixed
factor (say capital) each additional worker has less and less tools and equipment to work
with. Consequently, the productivity of the marginal worker eventually decreases. As a
result, the total product increases at a diminishing rate beyond a point.

STAGES OF PRODUCTION

Using figure 1 above, we can identify three stages of production.

Stage I

 Marginal product continues to increase making total product increase at an increasing rate.
Marginal product reaches maximum at L  4
 It is a stage of increasing returns because output increases as you increase the use of the
variable factor (Labour). Here fixed factors (capital) are under-utilized. That is why as more
and more workers are added, utilization of machine increases and productivity of additional
workers increases. At this stage it would be inefficient for firms to operate since there is still
room for increased output and hence high profit.

Stage II:

 Is a stage of diminishing returns MP starts declining until it reaches zero. Total product
increases but at a diminishing rate and reaches maximum when MP  0 .
 Once optimum capital-labour ratio is reduced additional workers have less and less tools to
work with. Consequently, the productivity of the marginal worker eventually decreases.
 Firms should operate in this stage because optimal utilization of factors is realized.

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Stage III:

2) It is the Stage of declining/decreasing returns

3) TP is declining and MP is negative.
4) It will be very illogical for a firm to operate in this stage because employment of
additional labour adds nothing to total product.
5) Thus, stages I and III are irrational stages of operation. In stage I, capital is under
utilized by small units of labour.
6) In stage III, capital is over utilized/overburdened by large units of labour.
7) Both extremes are uneconomical to operate in firms will thus operate in stage II,
where MP is positive for both variables & fixed factors of production.

ISOQUANT ANALYSIS

Isoquant-is a curve joining various combination s of inputs that yield a given amount of
output.

 In the short-run, we assume that one factor of production remain fixed as the other one varies
that is Q  f K , L 
 However, in the long-run, all factors of production become variable so that ̅ ̅ . In
isoquant analysis, all factors are assumed to be variable.

Capital (K)

K1 a

b Q2
K2
Q1

7 Labour (L)
0 L1 L2
 Combination of inputs (a) and (b) yield same level of output.
 A higher isoquant to the right represents superior output Q2  Q1 

 K 
 The slope of the isoquant    defines the degree of substitutability of the factors of
 L 
production (in our case, substitution between capital and labour)

Marginal rate of technical substitution (MRTS) of labour and capital

Is the slope of isoquant it refers to the amount of capital (K) that firm must give up by increasing
the amount employed of labour by one unit and still remain on the same isoquant (output level).

SHAPES OF ISOQUANTS

Isoquants may assume various shapes depending on the degree of substitutability.

1) Linear isoquant

Capital (K)

Ks

Q  f K , L 

0 Labour (L)
L7

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 It reflects perfect substitution between factors of production i.e. Q could be produced wholly
by using only capital and zero units of labour.

It represents infinite methods of production, which in economic analysis is unrealistic

assumption.

2) Input- output isoquant (Leontief isoquant)

Capital (K)

B
P

Q  f K , L 
A C

O Labour (L)
 In this group of isoquants input cannot be substituted for one another.
 There exists only one single production process (P).
 All efficient production must take place at the corner of the isoquant (point A). the input
combination represented by points B and C yield the same output as point A.
3. Smooth convex isoquant

Capital
(K) A

Q  f K , L 

Labour
(L)
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  Assume continuous substitutability between K and L over a certain range AB,
beyond which factors cannot substitute each other.
 This type of isoquant is mostly adopted in economic theory because it is
mathematically simpler to handle by the rules of calculus.
K
 E.g. to get its slope we differentiate the equation
L .

CHARACTERISTICS OF ISOQUANTS

1) Are downwards sloping within the relevant range. Increasing one factor would require that
the other factor be decreased to yield same level of output.
2) Isoquants do not intersect.

Capital
(K)

B Q2
T

Q1

O Labour
(L)

3) Superior isoquants are represented by those far away from the origin.
4) Isoquants are convex to the origin within the relevant range.

THE LAW OF RETURN TO SCALE

This is a long-term analysis of production it shows by how much total output will change as a
result of a change in all factor inputs by same proportion.

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Suppose we start from an initial level of input and output.

X 0  f  L, K 

And we increase all the factors by the same proportion k . We will clearly obtain a new level of
output X * , higher than the original level X 0

X *  f kL, kK 

If X * increases by the same proportion k as the input we say that there are constant returns to
scale.

If X * increases less than proportionally with the increase in the factors, we have decreasing
returns to scale.

If X * increases more than proportionally with the increase in the factors, we have increasing
returns to scale.

Summary of returns to scale

Constant returns to scale

 Doubling the factor inputs achieves double the level of initial output.
 Tripling inputs achieves triple output and so on.
Decreasing returns to scale

 By doubling the inputs, output increases by less than twice its original level.
Increasing returns to scale

 When inputs are doubled output increases by more than double.

Isocost line

Isocost line is a locus of all combinations of factors the firm can be purchased with a given
monetary cost outlay.

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THEORY OF COST

 Traditional theory distinguishes between the short run and the long run.
 The short run is the period during which some factor(s) is fixed, for example capital
equipment and entrepreneurship. During such a period the usage of the fixed factors cannot
be varied regardless of the level of output. Similarly, there are other inputs, variable inputs,
whose usage can be changed, e.g. unskilled workers and raw materials.
 In the long run, on the other hand, all inputs are variable. The quantity of all inputs can be
varied so as to obtain the most efficient input combination.

SHORT RUN COST

 In the short run, the firm incurs cost on fixed factors and variable factors known as fixed
variable cost and variable cost respectively.

This implies that

TC  TFC  TVC

TFC - total fixed cost

TVC - total variable cost

TFC does not vary with variation in the output between zero and a certain level of output.

 TFC is graphically denoted by a straight line parallel to the output axis.

100 FC

0 Q

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 TVC vary with variations of output. When output is zero, TVC  0 . It starts from the origin
and has an inverse S- shape.

TVC

100 TFC

Q
0

Total cost curve shape

TC

TVC

100 TFC

0 Q

 Total cost has same shape as a total variable cost but doesn’t start from the origin. Where it
intersects the vertical axis depends on the value of the fixed cost.
 The TVC has an inverse S-shape and increases as total output increases.

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Concept of average and marginal costs

ATC = AFC + AVC

TFC
AFC  (fixed cost per unit of output)
Q

TVC
AVC  (average cost per unit of output
Q

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