CHAPTER III: THEORY OF PRODUCTION AND COST

ANALYSIS
 Introduction
 Production refers to the transformation
of inputs or resources into outputs or
goods and services.
 Production is a process in which
economic resources or inputs (composed
of natural resources like labour, land and
capital equipment) are combined by
entrepreneurs to create economic goods
and services (outputs or products)..
 Introduction
 Production theory is just an application
of constrained optimization
technique.
 The firm tries either to minimize cost of
production at a given level of output or
maximize the output achievable with a
given level of cost.
 Inputs are the resources used in the
production of goods and services and are
generally classified into three broad
categories – labour, capital and land or
natural resources.
 They may be fixed or variable.
 Introduction
 Fixed Inputs are those that cannot be quickly
changed during the time period under
consideration except, perhaps at a very great
expense, (e.g., a firms’ plant).

 Variable Inputs are those that can be

changed easily and on very short notice
(e.g., most raw materials and unskilled
labour).
 Production Function with One Variable Input

 A production function defines the

relationship between inputs and the
maximum amount that can be produced
within a given time period with a given
technology.
 Mathematically, the production function
can be expressed as
Q=f(K, L)
 Q is the level of output
 K = units of capital
 L = units of labour
 f( ) represents the production technology
 Production Function with One Variable Input

 When discussing production, it is important

to distinguish between two time frames.
 The short-run production function
describes the maximum quantity of good or
service that can be produced by a set of
inputs, assuming that at least one of the
inputs is fixed at some level.
 The long-run production function
describes the maximum quantity of good or
service that can be produced by a set of
inputs, assuming that the firm is free to
adjust the level of all inputs
 Production in the short run
Production in the Short Run
 When discussing production in the short run,
three definitions are important.
•Total Product
•Marginal Product
•Average Product
 Total product(TP) is another name for output
in the short run.
 The marginal product(MP) of a variable input
is the change in output (or TP) resulting from
a one unit change in the input.
 MP tells us how output changes as we change
the level of the input by one unit.
 Production in the short run
 The average product (AP) of an input is the
total product divided by the level of the input.

 AP tells us, on average, how many units of

output are produced per unit of input used.
 Consider the two input production function
Q=f(X,Y) in which input X is variable and input
Y is fixed at some level.
 The marginal product of input X is defined as
 holding input Y constant.
 Cont’ed

 The table below represents a firm’s production

function, Q=f(X,Y):
 Cont’ed

 In the short run, let Y=2. The row highlighted below

represents the firm’s short run production function.
Cont’ed

 Re-writing this raw

can create the
following table and
calculate marginal
and average
product.
Cont’ed

 Calculating marginal product.

Cont’ed

 Calculating average product.

 Cont’ed

 The figure illustrate TP, AP MP

•If MP is positive then TP
is increasing.
•If MP is negative then
TP is decreasing.
•TP reaches a maximum
when MP=0
•If MP > AP then AP is rising.
•If MP < AP then AP is
falling.
•MP=AP when AP is
maximized.
The Law of Diminishing Returns
 Definition
 As additional units of a variable input
are combined with a fixed input, at
some point the additional output
(i.e., marginal product) starts to
diminish.
The Three Stages of Production
Stage I
 From zero units of the variable input to
where AP is maximized
Stage II
 From the maximum AP to where MP=0
Stage III
 From where MP=0 on
The 3 stages of Production
 Optimal Level of Variable Input Usage
 Consider the following short run
production process. Where is Stage II?
Optimal Level of Variable Input
Usage
Optimal Level of Variable Input Usage
 What level of input usage within Stage II is best
for the firm?
 The answer depends upon how many units of
output the firm can sell, the price of the product,
and the monetary costs of employing the
variable input.
 In order to determine the optimal input usage
we assume that the firm operates in a perfectly
competitive market for its input and its output.
 Product price, P=$2
 Variable input price, w=$10
 Define the following
 Total Revenue Product (TRP) = Q•P
Marginal Revenue Product (MRP) =

Total Labor Cost (TLC) = w•X

Marginal Labor Cost (MLC) =

Optimal Level of Variable Input Usage
 A profit-maximizing firm operating in
perfectly competitive output and input
markets will be using the optimal amount of
an input at the point at which the monetary
value of the input’s marginal product is
equal to the additional cost of using that
input.
 Where MRP=MLC.
 When the firm employs multiple variable
inputs, the firm should choose the level of the
inputs which equates the marginal product
per dollar across each of the inputs.
Mathematically,
 Production in the Long Run
 In the long run, all inputs are variable. Isoquant defines
combinations of inputs that yield the same level of
product. Isoquant
 The long run production process is described
by the concept of returns to scale.
 Returns to scale describes what happens to
total output as all of the inputs are changed
by the same proportion.
 If all inputs into the production process are
doubled, three things can happen:
 output can be more than double
◦ increasing returns to scale (IRTS)
 output can be exactly double
◦ constant returns to scale (CRTS)
 output can be less than double
◦ decreasing returns to scale (DRTS)
Returns to Scale
 Returns to scale can be generalized to a
production function with n inputs

q= f(X1,X2,…,Xn)
 If all inputs are multiplied by a positive
constant m, we have

 If k=1, we have constant returns to scale

 If k<1, we have decreasing returns to scale
 If k>1, we have increasing returns to scale
The Linear Production Function
 Suppose that the production function is
 q= f(K,L) = aK+ bL
 This production function exhibits constant
returns to scale
 f(mK,mL) = amK+ bmL= m(aK+ bL) = mf(K,L)
 All isoquants are straight lines
 MRTS is constant
Cobb-Douglas Production Function
 Suppose that the production function is

 This production function can exhibit any returns

to scale

 if a+ b= 1 constant returns to scale

 if a+ b> 1 increasing returns to scale
 if a+ b< 1 decreasing returns to scale
Production in the Long Run
 Economists hypothesize that a firm’s
long run production function may exhibit
at first increasing returns, then constant
returns, and finally decreasing returns to
scale.
THE THEORY AND ESTIMATION OF COST
 The Theory and Estimation of Cost

 The Short Run Relationship Between

Production and Cost
 The Short Run Cost Function
 The Long Run Relationship Between
Production and Cost
 The Long Run Cost Function
 Economies of Scope
 Other Methods to Reduce Costs
SR Relationship Between Production and
Cost
 A firm’s cost structure is intimately
related to its production process.
 Costs are determined by the production
technology and input prices.
 Assume the firm is a “price taker” in the
input market.
 SR Relationship Between Production
and Cost
In order to illustrate
the relationship,
consider the
production process
described in the table.

Total variable cost(TVC)

is the cost associated
with the variable input, in
this case labor. Assume
that labor can be hired at
a price of w=$500 per
unit. TVC has been added
to the table.
SR Relationship Between Production and
Cost
 Plotting TP and TVC illustrates that they
are mirror images of each other.
 When TP increases at an increasing rate,
TVC increases at a decreasing rate.
 Cont…
 Total fixed cost(TFC) is the cost associated
with the fixed inputs.
 Total cost(TC) is the cost associated with all of
the inputs. It is the sum of TVC and TFC.
 TC=TFC+TVC
 Marginal cost (MC) is the change in total
cost associated a change in output.

 MC can also be expressed as the change in

TVC associated with a change in output.
The Short Run Cost Function
 A firm’s short run cost function tells us the
minimum cost necessary to produce a particular
output level.
 For simplicity the following assumptions are made:
 the firm employs two inputs, labor and capital
 labor is variable, capital is fixed
 the firm produces a single product
 technology is fixed
 the firm operates efficiently
 the firm operates in competitive input markets
 the law of diminishing returns holds
 The following average cost functions will be useful
in our analysis.
 Average total cost(AC) is the average per-unit cost
of using all of the firm’s inputs.
 Average variable cost(AVC) is the average per-unit
cost of using the firm’s variable inputs.
 Average fixed cost(AFC) is the average per-unit
cost of using the firm’s fixed inputs.
 The Short Run Cost Function
Mathematically,
 AVC = TVC/Q
 AFC = TFC/Q
 ATC=TC/Q=(TFC+TVC)/Q=AFC+AVC
The Short Run Cost Function
 The Short Run Cost Function
 Graphically, these results are be depicted in the
figure below.
 Important Observations
 AFC declines steadily over the range of
production.
 In general, AVC, AC, and MC are u-shaped.
 MC measures the rate of change of TC
 When MC<AVC, AVC is falling
 When MC>AVC, AVC is rising
 When MC=AVC, AVC is at its minimum
 The distance between AC and AVC represents
AFC
The LR Relationship Between Production and
Cost
 In the long run, all inputs are variable.
 In the long run, there are no fixed costs
 The long run cost structure of a firm is related
to the firm’s long run production process.
 The firm’s long run production process is
described by the concept of returns to scale.
Economists hypothesize that a firm’s long-run

production function may exhibit at first
increasing returns, then constant returns, and
finally decreasing returns to scale.
When a firm experiences increasing
returns to scale
◦ A proportional increase in all inputs increases
output by a greater percentage than costs.
◦ Costs increase at a decreasing rate
When a firm experiences constant returns
to scale
◦ A proportional increase in all inputs increases
output by the same percentage as costs.
◦ Costs increase at a constant rate
When a firm experiences decreasing returns
to scale
◦ A proportional increase in all inputs increases
output by a smaller percentage than costs.
◦ Costs increase at an increasing rate
 The LR Relationship Between Production and Cost
This graph
illustrates the
relationship
between the
long-run
production
function and
the long-run
cost function.
The Long-Run Cost Function
 Long run marginal cost(LRMC) measures the
change in long run costs associated with a
change in output.
 Long run average cost(LRAC) measures the
average per-unit cost of production when all
inputs are variable.
 In general, the LRAC is u-shaped.
 When LRAC is declining we say that the firm
is experiencing economies of scale.
 Economies of scale implies that per-unit costs
are falling.
 When LRAC is increasing we say that the firm
is experiencing diseconomies of scale.
 Diseconomies of scale implies that per-unit
costs are rising.
  The Long-Run Cost Function
The figure illustrates the general shape of the LRAC.

LRAC decrease with LRAC increases with

output.. Economies of output… diseconomies of
size at ever level of size at every level of output
output

LRAC remains as output increases: all sizes of firm

produce output at the same average cost
The Long-Run Cost Function
 In the long run the firm is able to adjust its
plant size.
 LRAC tells us the lowest possible per-unit cost
when all inputs are variable.
 What is the LRAC in the graph?
 The LRAC is the lower envelope of all of the
SRAC curves.
PROFIT MAXIMIZATION AND
COMPETITIVE SUPPLY
Do Firms Maximize Profits
 profit is likely to dominate decisions in owner
managed firms
 managers in larger companies may be more
concerned with goals such as
◦ revenue maximization
◦ dividend pay-out
◦ on the long run they must have profit as one of
their highest priorities
Competitive Firm
 Competitive Firm Incurring Losses
Adequate Condition for Profit
Maximization: P >=AVCmin
Variation of Short-Run Cost with
Output
 TC: useful in breakeven analysis and in
determining whether a firm is making profit
or loss
 ATC: used for calculating profit to be
obtained from per unit of output produced
 MC: useful in deciding whether a firm can
expand its output further or not of a
particular enterprise
 Long-run cost: useful in making decision
about investment for expanding firm size in
the future

Application of various cost

concepts in Decision making
End of the chapter