1 John 4:16-21

• 16 And so we know and rely on the love God has for us.
• God is love. Whoever lives in love lives in God, and God in them. 17 This is
how love is made complete among us so that we will have confidence on the
day of judgment: In this world we are like Jesus. 18 There is no fear in love. But
perfect love drives out fear, because fear has to do with punishment. The one
who fears is not made perfect in love.
• 19 We love because he first loved us. 20 Whoever claims to love God yet hates
a brother or sister is a liar. For whoever does not love their brother and sister,
whom they have seen, cannot love God, whom they have not seen. 21 And he
has given us this command: Anyone who loves God must also love their
brother and sister.
8-2
 Chapter 8
Production and Cost in the Short Run

8-3
 Learning Outcomes
• Define production and production function
• Distinguish between the short-run and long-run
production functions
• Explain the “law of diminishing returns” and how it
relates to the Three Stages of Production
• Define the Three Stages of Production
• Differentiate the different types of costs
• Explain the relation between the cost and
production functions

8-4
 CONTENTS

1 2 3
Relation
Basic Concepts of Cost Between Short-
Production Theory Concepts Run Cost and
Production
 What do we mean by Production?

 The Production Process

 Combining inputs or factors of production to achieve
an output
 Categories of Inputs (factors of production)
 Land
 Labour
 Capital
 Thus, in simple words, production means transforming
inputs into outputs.

Slide 6 8-6
 The Production Process

INPUTS OUTPUTS

FACTORS OF GOODS &

PRODUCTION SERVICES

Production is an activity where resources are altered or changed and

there is an increase in the ability of these resources to satisfy wants.
Slide 7 8-7
 Production Function
• A production function expresses the relationship between a set of
inputs and the output of a good or service.
• Q=f(X1,X2,...,Xk)
• The relationship is determined by the nature of the good and
technology.
• A production function is “like” a recipe for cookies; it tells you the
quantities of each ingredient, how to combine and cook, and how
many cookies you will produce.
Q = F(K,L) where: Q = Output, K = Capital, L = Labour
8-8
The Production Function

8-10
 Basic Concepts of Production Theory
• Production function
• Maximum amount of output that can be produced
from any specified set of inputs, given existing
technology
• Technical efficiency
• Achieved when maximum amount of output is
produced with a given combination of inputs
• Economic efficiency
• Achieved when firm is producing a given output at the
lowest possible total cost
8-11
 Basic Concepts of Production Theory

• Inputs are considered variable or fixed depending on how

readily their usage can be changed
• Variable input
• An input for which the level of usage may be changed quite
readily

• Fixed input
• An input for which the level of usage cannot readily be
changed and which must be paid even if no output is
produced
8-12
 Basic Concepts of Production Theory
• Short run
• At least one input is fixed
• All changes in output achieved by changing usage of variable
inputs
• Long run
• All inputs are variable
• Output changed by varying usage of all inputs

8-13
 Sunk Costs
• Sunk cost
• Payment for an input that, once made, cannot be recovered
should the firm no longer wish to employ that input
• Not part of the economic cost of production
• Should be ignored for decision making purposes
Examples: Rent, marketing campaign expenses, money spent on
new equipment

8-14
 Avoidable Costs
• Avoidable costs
• Input costs the firm can recover or avoid paying should it no
longer wish to employ that input
• These matter in decision making and should not be ignored
• Reflect the opportunity costs of resource use

8-15
The Short-run Production Function

• 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.

8-16
The Long-run Production Function

• 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.

8-17
 Short Run Production
• In the short run, capital is fixed
• Only changes in the variable labor input can change the level of
output
• Short run production function

Q = f (L, K) = f (L)

8-18
 Production in the Short Run
• When discussing production in the short run, three definitions are
important.
• Total Product
• Marginal Product
• Average Product

Slide 19 8-19
 AVERAGE PRODUCT (AP)
 The average product (AP) of an input is the total product divided by the
level of the input.

 Average product tells us, on average, how many units of output are
produced per unit of input used.

Output Q
AP  
Labor Input L

Slide 20 8-20
 MARGINAL PRODUCT (MP)

The marginal product (MP) of a variable input is the change in output (or
TP) resulting from a one unit change in the input.

Marginal product tells us how output changes as we change the level of

the input by one unit.

 Output Q
MP L  
 Labor Input  L

Slide 21 8-21
 Total, Average, & Marginal Products
of Labor, K = 2 (Table 8.2)
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4
8-22
Total, Average, & Marginal Products
K = 2 (Figure 8.1)

8-23
Total, Average, & Marginal
Product Curves
Q2

Q1 Total product

Panel A
Q0

L0 L1 L2

Panel B

Average product

L0 L1 L2
Marginal product 8-24
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

8-25
The Three Stages of Production

8-26
 The Three Stages of Production

• In the short run, rational firms should only be operating in

Stage II.
• Why Stage II?

•Why not Stage III?

•Firm uses more variable inputs to produce less output!
•Why not Stage I?
•Underutilizing fixed capacity.
•Can increase output per unit by increasing the amount of the
variable input.

8-27
 Average & Marginal Products
• Average product of labor
• AP = Q/L
• Marginal product of labor
• MP = Q/L
• When AP is rising, MP is greater than AP
• When AP is falling, MP is less than AP
• When AP reaches it maximum, AP = MP
• Law of diminishing marginal product
• As usage of a variable input increases, a point is reached beyond which
its marginal product decreases
8-28
Total Product

8-29
29
 Total Product

• Total Product Function: A single-input production function. It

shows how total output depends on the level of the input
• Increasing Marginal Returns to Labor: An increase in the
quantity of labor increases total output at an increasing rate.
• Diminishing Marginal Returns to Labor: An increase in the
quantity of labor increases total output but at a decreasing rate.
• Diminishing Total Returns to Labor: An increase in the quantity
of labor decreases total output.
8-30
Chapter Six 30
 The Law of Diminishing Marginal Returns

• As the use of an input increases in equal

increments, a point will be reached at which the
resulting additions to output decreases (i.e. MP
declines).

• When the labour input is small, MP increases

due to specialization.

• When the labour input is large, MP decreases

due to inefficiencies.

Slide 31 8-31
 The Law of Diminishing Returns

• Reasons
Increasing Returns
Teamwork and Specialization
MP Diminishing Returns Begins
Fewer opportunities for teamwork
and specialization

X
MP
Slide 32 8-32
 To summarize
MP = 0 TP is at its maximum

MP > AP AP is increasing

MP < AP AP is decreasing

MP = AP AP is at its maximum

Slide 33 8-33
The Production Function & Technical Efficiency

8-34
34
 Optimal Level of Variable Input Usage

• Consider the following short run production process.

Labor Total Average Marginal
Unit Product Product Product
(X) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
Where is 2 25,000 12,500 15,000
Stage II? 3 45,000 15,000 20,000
4 60,000 15,000 15,000
5 70,000 14,000 10,000
6 75,000 12,500 5,000
7 78,000 11,143 3,000
8 80,000 10,000 2,000
8-35
 Optimal Level of Variable Input Usage
Labor Total Average Marginal
Unit Product Product Product
(X) (Q or TP) (AP) (MP)
0 0
1 10,000 10,000 10,000
2 25,000 12,500 15,000
3 45,000 15,000 20,000
4 60,000 15,000 15,000
5 70,000 14,000 10,000
Stage II 6 75,000 12,500 5,000
7 78,000 11,143 3,000
8 80,000 10,000 2,000
8-36
 Exercises
1. Let: Q = 12 (KL)2 – K4
Determine the AP and MP equations
2. Given: Q = 100L + 0.05L2 – 0.002L3

Determine the:
a) AP and MP equations
b) optimum level of input use.
b) maximum level of output

3. Given: Q = 6L2 – L3
Determine the level of L where AP and MP are maximum

8-37
 Short Run Production Costs
• Total variable cost (TVC)
• Total amount paid for variable inputs
• Increases as output increases
• Total fixed cost (TFC)
• Total amount paid for fixed inputs
• Does not vary with output
• Total cost (TC)
TC = TVC + TFC
8-38
 Short-Run Total Cost Schedules
(Table 8.4)

Output (Q) Total fixed cost Total variable cost Total Cost
(TFC) (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

8-39
Total Cost Curves (Figure 8.3)

8-40
 Average Costs
• Average variable cost (AVC)
TVC
AVC 
Q
• Average fixed cost (AFC)
TFC
AFC 
Q
• Average total cost (ATC)
TC
ATC   AVC  AFC
Q 8-41
 Short Run Marginal Cost
• Short run marginal cost (SMC) measures
rate of change in total cost (TC) as output
varies

TC TVC
SMC  
Q Q

8-42
Average & Marginal Cost Schedules
(Table 8.5)

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=TC/Q)
AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

8-43
Average & Marginal Cost Curves
(Figure 8.4)

8-44
Short Run Average & Marginal
Cost Curves (Figure 8.5)

8-45
Short Run Cost Curve Relations
• AFC decreases continuously as output
increases
• Equal to vertical distance between ATC &
AVC
• AVC is U-shaped
• Equals SMC at AVC’s minimum
• ATC is U-shaped
• Equals SMC at ATC’s minimum
8-46
Short Run Cost Curve Relations
• SMC is U-shaped
• Intersects AVC & ATC at their minimum
points
• Lies below AVC & ATC when AVC & ATC
are falling
• Lies above AVC & ATC when AVC & ATC
are rising

8-47
 Relations Between Short-Run
Costs & Production
• In the case of a single variable input,
short-run costs are related to the
production function by two relations

w w
AVC  and SMC 
AP MP
Where w is the price of the variable input

8-48
Short-Run Production & Cost
Relations (Figure 8.6)

8-49
 Relations Between Short-Run
Costs & Production

• When marginal product (average product) is increasing,

marginal cost (average cost) is decreasing
• When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
• When marginal product = average product at maximum
AP, marginal cost = average variable cost at minimum
AVC

8-50