By:

Lecturer, Department of Economics

Wolkite University

Wolkite , Ethiopia 1
 Definition of Production
 Raw materials yield less satisfaction to the consumer by
themselves.

 In order to get better utility from raw materials, they must be

transformed into outputs.

 Transforming raw materials into outputs requires inputs such

as land, labor, capital and entrepreneurial ability.

 Production is the process of transforming inputs into outputs

(an act of creating value or utility).

 The end products of the production process are outputs which

could be tangible (goods) or intangible (services).
 Production Function
• Shows the relationship between inputs and the resulting output.
• Production function displays different levels of output that the
firm can produce by efficiently utilizing different units of labor
and the fixed capital.
• Assume that there are only two inputs, labor (L) and capital (K).
– We can then write the production function as; Q = F (K, L)
 There Are Two Types of Inputs
• Fixed inputs: inputs that cannot vary overtime or inputs whose
quantity remain fixed for a given period of time.
– Example: machineries, capital.
• Variable inputs –those inputs whose quantity vary overtime
– Example: unskilled labor.
 Short Run Production Function
• Short run refers to a period of time in which the quantity of at
least one input is fixed.

 Short run periods of different firms have different durations.

 The production with one variable input and one fixed input.

 A firm that uses two inputs: capital (fixed input) and labor
(variable input).

 The firm can increase output only by increasing the amount

of labor it uses.

 Long run: refers to a period of time in which all factors of

production are variable
 Total, Average, and Marginal Product
• Total product (TP): It is the total amount of output that can be
produced by a combinations of the variable input and fixed input.

• Marginal Product (MP): It is the change in output attributed to the

addition of one unit of the variable input.

• Average Product (AP): Average product of an input is the level of

output that each unit of input produces, on the average.
Cont’d
 Cont’d
 Example: Suppose that the short-run production function of certain cut-
flower firm is given by: fixed capital input (K=5).
a) Determine the average product of labor (APL) function.
b) At what level of labor does the TP of cut-flower reach the maximum?
c) What will be the maximum achievable amount of cut-flower production?
 Law of Variable Proportions
 The law states that as successive units of a variable
input(labor) are added to a fixed input (capital or land),
beyond some point the extra, or marginal, product that can be
attributed to each additional unit of the variable resource will
decline.
 Stage of Production in the Short Run
• Accordingly, we divide this production function into three
stages as:
– Stage I (starting from zero TPL up to the maximum of
APL),
– Stage II (starting from the maximum of APL to zero MPL),
and
– Stage III (starting from zero MPL onwards).
• In summary, the production theories concentrate only on the
efficient part of the production function, that is, on the ranges
of output over which the marginal productivities are positive
but declining.
Cont’d
 Cont’d
• The second stage of production in the above analysis
corresponds to this efficient stage in the short run.

• Short summery;

– If MPL > APL, the latter will be rising as labor input (L)
increases. This is in stage I of production.

– If MPL = APL, the latter will be at its maximum. This is in

stage II of production.

– If MPL < APL the latter will be declining as labor input (L)
increases. This is the case in stages II and III of production.
 THEORY OF COST
• Cost is the monetary value of inputs used in the production of
an item.

• Economists use the term profit differently from the way

accountants use it.

– To the accountant, profit is the firm‘s total revenue less its

explicit costs (accounting costs).

– To the economist, economic profit is total revenue less

economic costs (explicit and implicit costs).

 Accounting cost is the monetary value of all purchased inputs

used in production; it ignores the cost of non-purchased (self-
owned) inputs.
 Cont’d
 Explicit costs: are out of pocket expenses for the purchased
inputs.

 Implicit Cost: the estimated monetary cost for non-purchased

or the cost of non-purchased (self-owned) inputs.

 Examples of implicit costs include the loss of interest income

on funds and the depreciation of machinery for a capital
project. They may also be intangible costs that are not easily
accounted for, including when an owner allocates time
toward the maintenance of a company, rather than using
those hours elsewhere.
 Cont’d
 Accounting profit = Total revenue – Accounting cost = Total
revenue – Explicit cost
where as
 Economic profit =Total revenue – Economic cost (Explicit cost
+ Implicit cost)
 Accounting profit of a firm will be greater than economic profit
by the amount of implicit cost.
 If all inputs are purchased from the market, accounting and
economic profit will be the same.
 If implicit costs exist, then accounting profit will be larger than
economic profit.
 Analysis of Costs In The Short-run
 In the short run, some of the firm’s inputs to production are
fixed, while others can be varied as the firm changes its output.

 Various measures of the cost of production can be

distinguished on this basis.

 Total Cost (TC): The total cost of production has two

components:

 Fixed cost (FC): costs do not vary with the level of output.

 Variable cost (VC): which varies with the level of output

TC = TFC + TVC
 Cont’d

16
 Cont’d

17
• Average fixed cost (AFC) is the fixed cost divided by the level of
output.
AFC = FC/Q
• Average Variable Cost (AVC): is variable cost divided by the
level of output.
AVC = VC/Q
• Average total cost (ATC): is the firm’s total cost divided by its
level of output. ATC = TC/Q
 Cont’d

19
 Cont’d

 In summary, AVC, AC and MC curves are all U-shaped due

to the law of variable proportions.
Example: Suppose the short run cost function of a firm is given by:
a) Find the expression of TFC & TVC
b) Derive the expressions of AFC, AVC, AC and MC
c) Find the levels of output that minimize MC and AVC and then find the minimum
values of MC and AVC
 The relationship between short run production and cost curves
• Let the price of labor be given by w, which is constant.

• Given these conditions, we can derive the relation between MC and

MPL as well as the relation between AVC and APL.

• • This expression shows that MC and

MPL are inversely related.
• When initially MPL increases, MC
decreases;
• When MPL is at its maximum, MC
must be at a minimum
• When finally MPL declines, MC
increases.
• This expression also shows inverse
relation between AVC and APL.
• When APL increases, AVC decreases;
• When APL is at a maximum, AVC is at
a minimum and
• When APL declines, AVC increases.
The r/n ship b/n these production and cost curves using graphs.

 MC curve is the mirror image of MPL curve and

 AVC curve is the mirror image of APL curve.
 THANKS!!!

THE END OF LECTURE FORE!!!

THANKS!!!