Chapter Four :Theory of Production and

Cost

1
 Chapter objectives
ü After successful completion of this chapter, you will be able to:
ü Define production and production function
ü Differentiate between fixed and variable inputs
ü Describe short run total product, average product and marginal product
ü Compare and contrast the three stages of production in the short run
ü Explain the difference between accounting cost and economic cost
ü Describe total cost, average cost and marginal cost functions
ü Explain the relationship between short run production and short run cost
functions
 Theory of Production and Cost

ü 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.
ü However, transforming raw materials into outputs requires inputs such as land,
labour, capital and entrepreneurial ability.
ü Production is the process of transforming inputs into outputs. It can also be
defined as an act of creating value or utility.
ü The end products of the production process are outputs which could be tangible
(goods) or intangible (services).
 4.1.2 Production function

ü Production function is a technical relationship between inputs and outputs. It

shows the maximum output that can be produced with fixed amount of inputs
and the existing technology.
ü A production function may take the form of an algebraic equation, table or
graph. A general equation for production function can, for instance, be
described as:
ü Q= f(X1 ,X2 ,X3 ,...,Xn ) where,
Q is output and X1, X2, X3,…, Xn are different types of inputs.
 4.1.2 Production function

üFixed inputs are those inputs whose quantity cannot readily be changed when
market conditions indicate that an immediate adjustment in output is required.

üFor example, if the demand for Beer rises suddenly in a week, the brewery
factories cannot plant additional machinery overnight and respond to the
increased demand.

ü Buildings, land and machineries are examples of fixed inputs because their
quantity cannot be manipulated easily in a short period of time
 4.1.2 Production function

üVariable inputs are those inputs whose quantity can be altered almost
instantaneously in response to desired changes in output.

ü That is, their quantities can easily be diminished when the market demand for
the product decreases and vice versa.

üThe best example of variable input is unskilled labour.

ü In economics, short run refers to a period of time in which the quantity of at

least one input is fixed.
 4.1.2 Production function…….

üConsider a firm that uses two inputs: capital (fixed input) and labour (variable
input).

üGiven the assumptions of short run production, the firm can increase output
only by increasing the amount of labour it uses.

üHence, its production function can be given by: Q = f (L)

where, Q is output and L is the quantity of labour

üThe production function shows different levels of output that the firm can
produce by efficiently utilizing different units of labour and the fixed capital.
 Production in the short run: Production with one variable input

üProduction 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.
Assumption of short run production analysis
üIn order to simplify the analysis of short run production, the classical
economist assumed the following:
1. Perfect divisibility of inputs and outputs
ü This assumption implies that factor inputs and outputs are so divisible that
one can hire, for example a fraction of labor, a fraction of manager and we can
produce a fraction of output, such as a fraction of automobile.
 Production in the short run: Production with one variable input

2. Limited substitution between inputs

üFactor inputs can substitute each other up to a certain point, beyond which
they can not substitute each other
3. Constant technology
üThey assumed that level of technology of production is constant in the short
run.
üSuppose a firm that uses two inputs: Capital (which is a fixed input) and labor
(which is variable input). Given the assumptions of short run production, the
firm can increase output only by increasing the amount of labor it uses.
 Production in the short run: Production with one variable input

Hence, its production function is

Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain
by efficiently utilizing different units of labor and the fixed capital. In the above
short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is
a function of L only in the short run.
 Production in the short run: Production with one variable input

Hence, its production function is

Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
The production function shows different levels of output that the firm can obtain
by efficiently utilizing different units of labor and the fixed capital. In the above
short run production function, the quantity of capital is fixed. Thus output can
change only when the amount of labor used for production changes. Hence, Q is
a function of L only in the short run.
 4.1.3 Total, average, and marginal product

üTotal product (TP): it is the total amount of output that can be produced by
efficiently utilizing specific combinations of the variable input and fixed input.

üIncreasing the variable input (while some other inputs are fixed) can increase
the total product only up to a certain point.

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

of one unit of the variable input to the production process, other inputs being
constant.
 4.1.3 Total, average, and marginal product…

üFor instance, the change in total output resulting from employing additional
worker (holding other inputs constant) is the marginal product of labour
(MPL).

üIn other words, MPL measures the slope of the total product curve at a given
point.

üIn the short run, the marginal product of the variable input first increases,
reaches its maximum and then decreases to the extent of being negative.
 4.1.3 Total, average, and marginal product…

üAverage Product (AP): Average product of an input is the level of output that
each unit of input produces, on the average. It tells us the mean contribution of
each variable input to the total product.

üMathematically, it is the ratio of total output to the number of the variable

input.

üThe average product of labour (APL), for instance, is given by:

 4.2. Production Function…cont’d
ØThe table below illustrates the short run production function
Unit of K Unit of L TP AP MP
4 0 0 ̶ ̶
4 1 10 10 10
4 2 30 15 20
4 3 60 20 30
4 4 80 20 20
4 5 95 19 15
4 6 108 18 13
4 7 112 16 4
4 8 112 14 0
4 9 108 12 -4
4 10 100 10 -8
18 June 2023 Microeconomics Lecture Note 15
4.1.3 Total, average, and marginal product…
 4.1.3 Total, average, and marginal product…

üThe relationship between MPL and APL can be stated as follows.

ü When APL is increasing, MPL > APL.

ü When APL is at its maximum, MPL = APL.

ü When APL is decreasing, MPL < APL.

 Example

• Example: Suppose that the short-run production function of certain cut-flower

firm is given

by: Q=4KL-0.6K2 -0.1L2 where Q is quantity of cut-flower produced, L is labour

input and K is fixed capital input (K=5).

a) Determine the average product of labour (APL) function.

b) At what level of labour does the total output of cut-flower reach the maximum?

c) What will be the maximum achievable amount of cut-flower production?

Example
 4.1.4 The law of variable proportions

üThe law of variable proportions states that as successive units of a variable

input(say, labour) are added to a fixed input (say, 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.

üFor example, if additional workers are hired to work with a constant amount of
capital equipment, output will eventually rise by smaller and smaller amounts as
more workers are hired.
 4.1.5 Stages of production

üStage I: This stage of production covers the range of variable input levels over
which the average product (APL) continues to increase.

ü It goes from the origin to the point where the APL is maximum, which is the
equality of MPL and APL (up to L2 level of labour employment in figure 4.1).

üThis stage is not an efficient region of production though the MP of variable input
is positive.

üThe 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 under-utilized (not
efficiently utilized).
 4.1.5 Stages of production….
üStage II: It ranges from the point where APL is at its maximum (MPL=APL) to
the point where MPL is zero (from L2 to L3 in figure 4.1).

üHere, as the labour input increases by one unit, output still increases but at a
decreasing rate. Due to this, the second stage of production is termed as the
stage of diminishing marginal returns.

ü The reason for decreasing average and marginal products is due to the scarcity
of the fixed factor.

ü Hence, the efficient region of production is where the marginal product of the
variable input is declining but positive.
 4.1.5 Stages of production….
üStage III: In this stage, an increase in the variable input is accompanied by
decline in the total product.

üThis stage is also known as the stage of negative marginal returns to the

üvariable input.

üThe cause of negative marginal returns is the fact that the volume of the variable

üinputs is quite excessive relative to the fixed input; the fixed input is over-
utilized.

üObviously, a rational firm should not operate in stage III because additional
units of variable input are contributing negatively to the total product (MP of the
variable input is negative). In figure 4.1,
 4.2 Theory of costs in the short run
4.2.1 Definition and types of costs
üTo produce goods and services, firms need factors of production or simply
inputs.
To acquire these inputs, they have to buy them from resource suppliers.

üCost is, therefore, the monetary value of inputs used in the

production of an item.
ü Economists use the term ―profit differently from the way accountants use it.
üTo the accountant, profit is the firm‘s total revenue less its explicit costs
(accounting costs).
üTo the economist, economic profit is total revenue less economic costs (explicit
and implicit costs).
 4.2 Theory of costs in the short run
üIt considers only direct expenses such as wages/salaries, cost of raw
materials, depreciation allowances, interest on borrowed funds and utility
expenses (electricity, water, telephone, etc.). These costs are said to be
explicit costs.
Accounting profit = Total revenue – Accounting cost = Total revenue – Explicit cost
üThe estimated monetary cost for non purchased inputs is known as implicit cost.

üFor example, if Mr. X quits a job which pays him Birr 10, 000.00 per month in
order to run a firm he has established, then the opportunity cost of his labour is
taken to be Birr 10,000.00 per month (the salary he has forgone in order to run
his own business).

Economic profit =Total revenue – Economic cost (Explicit cost + Implicit cost)
 4.2.2 Total, average and marginal costs in the short run
üIn the short run, total cost (TC) can be broken down in to two – total fixed
cost (TFC) and total variable cost (TVC).
ü By fixed costs we mean costs which do not vary with the level of output.
üThey are regarded as fixed because these costs are unavoidable regardless
of the level of output.
üThe firm can avoid fixed costs only if he/she stops operation (shuts down
the business).
üThe fixed costs may include salaries of administrative staff, expenses for
building depreciation and repairs, expenses for land maintenance and the
rent of building used for production.
 4.2.2 Total, average and marginal costs in the short run……
üVariable costs, on the other hand, include all costs which directly vary with the
level of output.
üFor example, if the firm produces zero output, the variable cost is zero.
üThese costs may include the cost of raw materials, the cost of direct labour and
the running expenses of fuel, water, electricity, etc.
ü TC = TFC + TVC
ü Total fixed cost (TFC): Total fixed cost is denoted by a straight line parallel to
the output axis. This is because such costs do not vary with the level of output.
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. At the initial
stage of production with a given plant, as more of the variable factor is employed,
its productivity increases.
 4.2.2 Total, average and marginal costs in the short run……
üTotal Cost (TC): The total cost curve is obtained by vertically adding TFC and
TVC at each level of output.
üThe shape of the TC curve follows the shape of the TVC curve, i.e. the TC has
also an inverse S-shape.
 Per unit costs
üFrom total costs functions we can derive per-unit costs. These are even more
important in the short run analysis of the firm.
üa) Average fixed cost (AFC) - Average fixed cost is total fixed cost per unit of
output. It is calculated by dividing TFC by the corresponding level of output.
üThe curve declines continuously and approaches both axes asymptotically.
���
AFC=
�

üb) Average variable cost (AVC) - Average variable cost is total variable cost
per unit of output. It is obtained by dividing total variable cost by the level of
���
output. AVC=
�
��
üc) Average total cost (ATC) or simply Average cost (AC) AC=
�
 Per unit costs
üMarginal Cost (MC) Marginal cost is defined as the additional cost that a firm
incurs to produce one extra unit of output. Graphically, MC is the slope of TC
function.
���
üMC= In fact, MC is also a change in TVC with respect to a unit change in
��
the level of output
����+ ���� ���� ����
üMC= = since =0
�� �� ��

üGiven inverse S-shaped TC and TVC curves, MC initially decreases, reaches its
minimum and then starts to rise.
üFrom this, we can infer that the reason for the MC to exhibit U shape is also
üthe law of variable proportions. In summary, AVC, AC and MC curves are all U-
shaped due to the law of variable proportions
Per unit costs
 Per unit cost
üIn the above figure, the AVC curve reaches its minimum point at Q1 level of
output and AC reaches its minimum point at Q2 level of output.
üThe vertical distance between AC and AVC, that is, AFC decreases continuously
as output increases. It can also be noted that the MC curve passes through the
minimum points of both AVC and AC curves.
 Per unit cost
üExample: Suppose the short run cost function of a firm is given by:
TC=2Q3 –2Q2 + Q + 10.
üa) Find the expression of TFC & TVC
üb) Derive the expressions of AFC, AVC, AC and MC
üc) Find the levels of output that minimize MC and AVC and then find the
minimum values of MC and AVC
 4.2.3 The relationship between short run production and cost curves
üSuppose a firm in the short run uses labour as a variable input and capital as a
fixed input.
üLet the price of labour 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
 Average Variable Cost and Average Product of Labour

üThis 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 finally APL declines, AVC increases.
Average Variable Cost and Average Product of Labour
Chapter Five Market structure