Economics of Production and Cost

Theory of Firm Behavior

1. Theory of Firm Behavior in the Short run

2. Theory of Firm Behavior in the Long run
Factors of Production:

a. Land:
All the free gifts of nature is called as land. We pay rent as reward to land services.
b. Labor:
A person who uses his physical efforts and mental abilities to convert raw material to
finished good. We pay wages as reward to labor services.
c. Capital:
Things which have been made by human hands and these things are further used in the
production process to earn income or profit. We pay interest as reward to capital services.
d. Organization:
Organization is an input which manages or combines all the above three inputs to produce
finished goods. We pay profit as reward to organization services.

Short run Time:

It is a time in which
1. Some factors of production remains fixed and some are variable.
2. In this time labor is the only variable factor of production however, all the remaining
three factors of production are fixed in the short run.
3. Production capacity and scale of the plant of any firm depends on capital. As capital
is fixed in the short run therefore, both production capacity and scale of the plant do
not change in the short run.
For example: As Capital = K = Fixed in Short run
Productive Capacity of a firm = f (Capital)
Scale of the Plant of a firm = f (Capital)

4. In the short run a firm faces laws of return. Laws of return are the combination of law
of increasing return and law of decreasing return.

Law of Return or Laws of Cost

Both laws move in opposite direction.

Law of Increasing Return or Law of Decreasing Cost

This refers to the advantages of short run time. In this time, both average production and
marginal production are increasing and average cost and marginal cost are decreasing.

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 Economics of Production and Cost

Advantage of the Short Run

1. Increase in Production Curves
2. Decrease in Cost Curves

Law of Decreasing Return or Law of Increasing Cost

This refers to the disadvantages of short run time. In this time, both average production and
marginal production are decreasing and average cost and marginal cost are increasing.

Disadvantages of Short Run

1. Decrease in Production Curves
2. Increase in Cost Curves

Terms will be used in the Content:

a. Total Product of Labor = TPL

b. Total Product of Capital = TPK
c. Average Product of Labor = APL = TPL / L
d. Average Product of Capital = APK = TPK / K
e. Marginal Product of Labor = MPL = Change in TPL / Change in L
f. Marginal Product of Capital = MPK = Change in TPK / Change in K
g. Total Fixed Cost = TFC
h. Total Variable Cost = TVC
i. Total Cost = TC = TFC + TVC
j. Average Fixed Cost = TFC / Q (TPL or TPK)
k. Average Variable Cost = TVC / Q (TPL or TPK)
l. Average Total Cost = ATC = TC / Q (TPL or TPK)
m. Average Total Cost = ATC = AFC + AVC
n. Marginal Cost = MC = Change in TC / Change in Q (TPL or TPK)

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 Economics of Production and Cost

Relationship between Production Curves (APL and MPL) and Cost Curves (ATC and MC)

Production Curves and Cost Curves move in opposite direction.

1. The moment when MPL increases, MC falls. When MPL becomes maximum, at the same
time MC becomes minimum. When MPL falls, MC starts increasing.

Relationship between MPL and MC

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 Economics of Production and Cost

2. When APL increases, ATC falls. When APL becomes maximum, it becomes equal to
MPL (APLMax = MPL), at the same time ATC becomes minimum and it also becomes
equal to MC (ATCMin = MC). When APL falls, ATC starts increasing.

Relationship between APL and ATC

3.
Behavior of APL or
Laws of Returns Concepts of Production Concepts of Cost
ATC
Both MC and ATC are
When Average Both MPL and APL are
When Law of Decreasing but the MC
Product of Labor is Increasing but the MPL
Increasing Return decreases more than
Increasing and ATC is increases more than increase
is Experienced decrease in ATC. Hence MC
Decreasing. in APL. Hence MPL > APL
< ATC
When Average
Product of Labor
becomes Maximum or MPL = APL (Maximum) MC = ATC (Minimum)
When Law of
Average Total Cost
Decreasing
becomes minimum.
Return is
When Average Both MPL and APL are Both MC and ATC are
Experienced
Product of Labor is Decreasing but the MPL Increasing but the MC
Decreasing and ATC decreases more than decrease increases more than increase
is Increasing. in APL. Hence MPL < APL in ATC. Hence MC > ATC

Muhammad Shahid Hassan EC – 210

 Economics of Production and Cost

Relationship between Production Curves (MPL and APL)

and Cost Curves (MC and ATC)

Muhammad Shahid Hassan EC – 210

 Economics of Production and Cost

K Units of Capital
L Units of Labor
Quantity of Product X produced
QX=TPL
(Total Product of Labor: TPL)
PX Price of Good X
TR=P x Q Total Revenue TR = P x Q
AR Average Revenue AR=(TR/Q)=(PxQ)/Q= P x (Q/Q)=Px1=P
MR Marginal Revenue MR = Change in TR / Change in Q
APL Average Product of Labor APL = Q (TPL)/L
MPL Marginal Product of Labor MPL = Change in Q (TPL)/Change in L
MRPL=
Marginal Revenue Product of Labor MRPL = MR x MPL
MRxMPL
VMPL=PxMPL Value of Marginal Product of Labor VMPL = P x MPL
Wages (Price of Labor), Variable
W=PL Given
Input in Short Run
Interest Rate (Price of Capital)
i=PK Given
Fixed Input in Short Run
All the expenditures made by the firm
TFC Total Fixed Cost upon its fixed inputs are called fixed cost.
TFC = i(PK) x K
All the expenditures made by the firm
upon its variable inputs are called variable
TVC Total Variable Cost
cost.
TVC = W(PL) x L
TC = TFC + TVC or
TC Total Cost
TC = PK x K + PL x L)
AFC Average Fixe Cost AFC = TFC / Q (TPL)
AVC Average Variable Cost AVC = TVC / Q (TPL)
ATC = TC /Q (TPL) or
ATC Average Total Cost
(ATC = AFC + AVC)
MC Marginal Cost MC = Change in TC/Change in Q (TPL)
T. Profit Total Profit T.Profit = TR – TC
M.Profit = Change in T.Profit
M. Profit Marginal Profit / Change in Q (TPL)
Or (M.Profit = MR – MC)

Muhammad Shahid Hassan EC – 210