CHAPterS 6-7

PRODUCTION BEHAVIOR
& ANALYSIS OF COSTS

Factory skyline, Image Source: https://ih1.redbubble.net/image.6777787.4994/flat,1000x1000,075,f.jpg, date accessed 01 February 2017

Products
market

HOUSEHOLD FIRM

factors
market

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Firms makes use of inputs and transform them to outputs
that they can sell in the market
The production function specifies the maximum output that can be
produced with a given quantity of inputs. It is defined for a given
state of engineering and technology. The marginal product of an
input is the extra output produced by an additional unit of that input
while other inputs are held constant.

Additional output declines as a firm utilizes more and

more inputs

Law of diminishing marginal returns

A firm will get less additional output when it adds additional units
of an input while holding other inputs fixed. Total output increases
with a change in single input at a decreasing rate, ceteris paribus.
Samuelson and Nordhaus, 2010, page 108-109

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Product output rises with an input at a decreasing rate
Land input (T) 10 10 10 10 10 10
Labor input (L) 0 1 2 3 4 5
Output/ Product (Q) 0 2 000 3 000 3 500 3 800 3 900
Marginal product 2 000 1 000 500 300 100
Average product 2 000 1 500 1 167 950 780

For example, as more of an input such as labor is added to a

fixed amount of land and other inputs, the labor has less and less
of the other factors to work with. The land gets more crowded, the
machinery is overworked, and marginal product of labor declines.

The effect on output of changing all inputs in a firm’s

production function refers to returns to scale

Decreasing Constant Increasing

returns to scale returns to scale returns to scale
A change in all inputs leads to A change in all inputs leads to A change in all inputs leads to
less than proportional change in same change in output. For more than proportional change
output. For example, if labor, example, if labor, land, capital, in output. For example, if labor,
land, capital, and other inputs and other inputs are doubled, land, capital, and other inputs
are doubled, then output would then output would also double. are doubled, then output would
increase but less than double. more than double.

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Production requires not only inputs, but also time. Two
time periods distinguish firm behavior analysis:

Short run Long run

Firms can adjust production by Firms can adjust both fixed and
changing variable factors such as variable production factors.
labor but cannot change fixed
factors such as capital.

Firms must pay for their input. Firm's costs are determined
by their factor prices and production function

TC = FC + VC
Total cost (TC) represents the lowest peso expense needed to
produce each level of output. The major elements of a firm’s costs
are its fixed costs (FC) and its variable costs (VC).

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The major components of a firm’s total costs are its fixed
costs and variable costs.

Fixed cost Variable cost

Fixed cost represents the total peso
expense paid out even when no
output is produced. Fixed cost is
unaffected by any variation in the
quantity of output.
Variable cost represents expenses
that vary with the level of output
such as raw materials, wages, and
fuel It includes all costs that are not
fixed.

The major components of a firm’s total costs are its fixed

costs and variable costs.

TC = FC + VC
Quantity (Q) 0 1 2 3 4 5

Fixed cost (FC) 50 50 50 50 50 50

Variable cost (VC) 0 30 55 75 105 155
Total cost (TC) 50 80 105 120 155 205

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 Costs

total cost

Variable cost

50 Fixed cost
Q

Marginal cost (MC) denotes the additional cost of producing one

extra unit of output.

MC = TC(Q) ─ TC(Q-1)
Quantity (Q) 0 1 2 3 4 5
Fixed cost (FC) 50 50 50 50 50 50
Variable cost (VC) 0 30 55 75 105 155
Total cost (TC) 50 80 105 120 155 205
Marginal cost (MC) 30 25 15 35 50

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Average total cost (ATC) is the total cost divided by the total
number of units produced.
ATC = TC/Q
Average fixed cost (AFC) is fixed cost divided by the total number
of units produced. Since fixed cost is constant, an increasing output
gives a steadily falling AFC.
AFC = FC/Q
Average variable cost (AVC) is variable cost divided by the total
number of units produced.
AVC = VC/Q

Quantity (Q) 0 1 2 3 4 5
Fixed cost (FC) 50 50 50 50 50 50
Variable cost (VC) 0 30 55 75 105 155
Total cost (TC) 50 80 105 125 155 205
Marginal cost (MC) 30 25 15 35 50
Average fixed
cost (AFC) 50 25 17 13 10
Average variable
cost (AVC) 30 28 25 27 31
Average total
cost (ATC) 80 53 42 39 41

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Costs
MC AFC falls as Q increases.
ATC MC, AVC, and ATC fall
then increase.
A AVC AVC is below ATC.
If MC is below ATC, ATC is
decreasing; if MC is above
ATC, ATC is increasing.
At point A where MC = ATC,
ATC is at its minimum value.

AFC
Q

PROVE: If MC is below ATC, ATC is decreasing

PROVE: If MC < ATC, derivative of ATC is negative

Given: ATC = C(Q) / Q

d/dQ (ATC) = [Q*C’(Q) ─ C(Q)*1]/Q2
d/dQ (ATC) = C’(Q)/Q ─ (C(Q)/Q) * (1/Q)
d/dQ (ATC) = 1/Q [MC ─ATC]
But if MC < ATC
d/dQ (ATC) < 0

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Costs
MC
ATC

If MC is below ATC, this means that the last unit

produced costs less than the average cost of all the
previous units produced. This implies that the new ATC
must be less than the old ATC, so ATC must be falling.

Costs
MC
ATC

AVC

Cost curves are U-shaped because of diminishing

returns. In the short run, variable factors show an
initial phase of increasing followed by diminishing
marginal product. This corresponds to an initial
phase of declining MC, then increasing MC after
Q
diminishing returns have set in.

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Consider the short-run case where the land and labor
are inputs to production
Output (Q) 0 1 2 3 4 5
Labor input (L) 0 6 11 15 21 31
Wage per worker (w) 5 5 5 5 5 5
Land input (T) 10 10 10 10 10 10
Rent per acre(r) 5.5 5.5 5.5 5.5 5.5 5.5
Marginal product of
labor (MPL) 0.17 0.2 0.25* 0.17* 0.10
Total cost (TC) 55 85 110 130 160 210
Marginal cost (MC) 30 25 20 30* 50*
Average total cost
(ATC) 85 55 43.3 40* 42

Consider the short-run case where the land and labor

are inputs to production
Output (Q) 0 1 2 3 4 5
Labor input (L) 0 6 11 15 21 31
Wage per worker (w) 5 5 5 5 5 5
Land input in acres (T) 10 10 10 10 10 10
Rent per acre(r) 5.5 5.5 5.5 5.5 5.5 5.5
Marginal product of
labor (MPL) 0.17 0.2 0.25 0.17 0.10
Total cost (TC) 55 85 110 130 160 210
Marginal cost (MC) 30 25 20 30 50
Average total cost
(ATC) 85 55 43.3 40 42

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 MPL

mpl
L
Costs
MC
Initially, the added cost (MC) of hiring
atc another worker is less than the ATC and
thus additional productivity of labor (MPL)
is increasing. Such is the case until MC is
A higher than the average cost of all the
previous units produced, and thus MPL
Q decreases.

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