AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of

and Production and Cost

CHAPTER THREE: THEORY OF PRODUCTION

3.1. Introduction
In simple words, production refers to the process of transferring inputs into outputs. An input (factor
of production) is a good or service that goes into the production of another good or service. In other
words, an input is simply anything which the firm buys for use in its production process. Inputs
include labor, land, capital and entrepreneurial talent. The end products of the production process are
outputs which could be tangible (goods) or intangible (services).

Simple examples of production:

- A furniture-producing firm combines workers labor time, machineries, his organizational skills and
various raw materials like wood, metal, etc to produce sofas for sale to its customers.
- A high school uses teachers, books, educational materials (aids), class rooms, the available
technology (like plasma tv), etc to provide educational services to students.

The theory of production explains and formalizes the nature of relationships between factors (inputs)
used and output. As you might have noticed, the production process does not necessarily involve
physical conversion of raw materials into tangible goods. Besides teachers, lawyers, doctors, social
workers, consultants, hair-dressers, etc are all engaged in producing intangible goods.

To an economist production means creation of utility for sales. Alternatively, production may be
defined as the act of creating those goods/services which have exchange value for sale (not for
personal consumption).Raw materials yield less satisfaction to the consumer by themselves. In order to
get utility from raw materials, first they must be transformed into output. However, transforming raw
materials into final products require factor inputs such as land, labor, and capital and entrepreneurial
ability.

Thus, no production (transforming raw material into output) can take place without the use of other
inputs.

Production function is a technical relationship between inputs and outputs. It shows the maximum
output that can be produced with a fixed amount of inputs and the existing technology. A production
function may take the form of an algebraic equation, table or graph.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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A general equation for production function could for instance be described as:

Q = f(X 1 , X 2 , X 3 ,..., X n )

where Q is the maximum output produced; and

X1, X2, X3,…, Xn are different types of inputs.

To illustrate, suppose a wheat-producing firm uses labor (L), capital (K), land (S) and entrepreneurship
(E). Other inputs such as seeds, fertilizers, insecticides, and the like may be included in one of these
large groups of factors of production. The production function for wheat may then be expressed as:

Quantity of Wheat = f(L, K, S, E)

Note that we must assume that the production of Q tons of wheat is realized in the most efficient way
possible. If it, for instance, is possible to produce 20 tons of wheat using a certain combination of L,
K, S and E, it is also possible to produce only 19 tons with the same combination. So, the second
technology has to be abandoned as it is not efficient (it is wasting resources that could be used for the
production of one more ton).

In sum, production functions describe what is technically feasible when the firm operates efficiently:
that is, when the firm uses each combination of inputs as effectively as possible.

Classification of inputs

Normally, firms employ inputs whose amount does not change for some time and others whose
quantity varies according to the amount of production (output). One can hence categorize inputs as
fixed and variable.

Fixed inputs are those inputs whose quantity can not readily be changed when market conditions
indicate that an immediate change in output is required. In fact no input is ever absolutely fixed, but
may be fixed during an immediate requirement. For example, if the demand for Beer shoots up
suddenly in a week, the brewery factories cannot plant additional machinery over a night to respond to
the increased demand. It takes long time to buy new machineries, to plant them and use for production.
Thus, the quantity of machinery is fixed for some times such as a weak. Buildings, plot of land and
machineries are examples of fixed inputs because their quantity cannot be manipulated easily in short
time periods.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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Variable inputs, on the other hand, are those inputs whose quantity can be changed almost
instantaneously in response to desired changes in output. That is, their quantity can easily be
diminished when the market demand for the product decreases and vise versa. The best example of
variable input includes unskilled labor and raw materials.

Production period

Depending on the nature of economic adjustment in a firm to changing economic environment, the
production period is divided into short-run and long-run.

The short run refers to a period of time in which the quantity of at least one input remains fixed while
others are variable .Put it differently, one or more factors of production cannot be changed. In this
case, the firm can alter its level of output by increasing or decreasing the use of variable inputs. A
firm‟s capital, for example, usually requires time to change – a new factory must be planned and built,
machinery and other equipment must be ordered and delivered, all of which can take a given time
period.

The long run, on the other hand, is the amount of time needed to make all inputs variable. Here the
period is long enough to allow changes in the level of all inputs. i.e all inputs are variable and there is
no fixed input .

Here , it should be noted that short run doesn‟t refer to relatively short period of time like a year or
less than a year , and long run doesn‟t mean to period of time greater than a year than or 10 years .
They rather refer to the nature of economic adjustment in the firm to changing economic environment.

Note that the supply of fixed inputs in the short-run is inelastic while the supply of variable inputs in
the short-run is elastic.

How long should the long-run be? A month? A year? 2-3 years?10 years? …What do you think? If
you attempt to put figures, that is wrong. Sorry, there is no precise answer for the question. In short, it
differs from industry to industry and more specifically from firm to firm. In some industries, such as
groceries, short-run may be a few weeks or while in some other industries like electricity and
telecommunications, short-run may mean 4 or more years. Similarly, long-run may be 2 or 3 years
while in other industries it might be 10 or more years. Therefore, long-run and short-run do not refer to
any fixed period of time. There is no hard and fast rule that specifies how short is short-run or how
long is long-run.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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Based on these classifications and concepts, we can see the short-run and the long-run production
functions in the sub-sections that follow.

3.2. The Short-run Production Function: Production with one variable input

The majority of production decisions of firms are made in the short-run in which the quantity of at
least one factor of production changes with output. Hence, the short-run production function shows the
relationship between the maximum product and the level of the variable input. In more general
expression, a short-run production could take the following form, for Q output and X1 variable input
quantities:

Q = f(X 1 )

Imagine, for example, that you are managing a clothing plant. You have a fixed amount of equipment,
but you can hire more labor or less to sew and to run the machines. You have to decide how much
labor to hire and how much clothing to produce. To make the decision, you will need to know how the
amount of output Q increases (if at all), as the input of labor L increases. Therefore, the short-run
production function of cloth could be expressed as:

Quantity of Cloth = f (Labor)

Here, the short-run level of cloth produced is supposed to depend on labor, the only variable input.
Since other factors are assumed to be fixed in the short-term, we do not include them in the production
function. This, however, does not mean that they are not used in the production process.

Total, Average and Marginal Products

The contribution that variable input makes to the production process can be described in terms of the
total, average and marginal product.

Total Product (TP)

It refers to the total output (say cloth) produced by a given amount of a variable input (say labor)
keeping the quantity of other inputs fixed (say machines). In almost all real world production
processes, TP in the short-run follows a certain trend: it initially increases at an increasing rate, then
increases at a decreasing rate, reaches a maximum point but eventually falls with a rise in the quantity
of the variable input. That is, initially, as we combine more and more units of the variable input with
the fixed input output continues to increase. But eventually, increasing the unit of the variable input

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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may not help output increase. Even as we employ more and more unit of the variable input beyond the
carrying capacity of a fixed input, output may tends to decline. Thus increasing the variable input can
increase the level of output only up to a certain point, beyond which the total product tends to fall as
more and more of the variable input is utilized. This tells us what shape a total product curve assumes.
The shape of the total product curve is nearly S-shape.

Average 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 in the total product. Mathematically, AP is total
product divided by the amount of variable input used to produce that product. The average product of
labor (APL), for instance, is given by:

Total Product TP
APL = =
Total Labor L

Like that of TP, APL first increases, gets its maximum value and eventually falls continuously
afterwards.

Marginal Product (MP)

We may, at times, be interested in knowing the extra output brought about by the extra employment of
a variable input. In terms of labor, we may ask “how much has the last laborer added to total product?”
These issues are explained by the marginal concept.

Marginal product is the extra or additional output obtained when one extra unit of a variable input is
entered in production while other factors remain fixed. Simply, marginal product is a change in the
amount of total product divided by a change in the amount of variable input used. For instance,
marginal product of labor (MPL) is given by:

Change in Total Product TP Q

MPL = = =
Change in Labor L L

The last term in this equation (read as the partial derivative of Q with respect to L) is applied when a
continuous production function (i.e. an algebraic equation) is given for output Q.

Thus, MPL measures the slope of the total product curve at a given point. In the short run, the MP of
the variable input first increases reaches its maximum and then tends to decrease to the extent of being

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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negative. That is, as we continue to combine more and more of the variable inputs with the fixed input,
the marginal product of the variable input increases initially and then declines.

The above can be summarized as follow:

TP = is the overall/entire amount of output produced by the factors of production employed over a
given period

= total physical units of output

= total quantity of output, Q  f ( K , L)

AP =output per unit of input

= output of „average‟ input

= slope of a line from origin to TP curve

TP Q
= is a good indicator of the productivity of labor, APL  
L L

MP = additional output per unit of additional input

= is the extra product or output added by 1 extra unit of that input while other inputs are held constant.

=The additional output that can be produced by adding one more unit of a specific input, ceteris paribus

=slope of TP curve

=output of last input unit

TP dTP dQ
MPL   
L dL dL

Both MP and AP of the variable factor/ i.e. labor/ are derived from the TP of the factor. The three
returns are interrelated

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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Table & figure 3.1

K L TP MPL APL
1 0 0 - -
1 1 3 3 3
1 2 8 5 4
1 3 12 4 4
1 4 14 2 3.5
1 5 14 0 2.8
1 6 12 -2 2

As we can see from the above table & figure, the TP goes through 3 phases

 Initially TP rises at an increasing rate(until H);

 In the 2nd phase it still rises but at a decreasing rate (H to J);

 Finally it reaches its maximum& then starts to decline (point J and afterwards).

 The MP also initially rises showing increasing returns, and reaches maximum & starts to diminish,
then becomes negative

 The AP also rises& reaches maximum at 3rd unit of labor & then declines. The AP can‟t cross the
horizontal axis, i.e. AP can‟t be negative, since there is no negative output in economics.

Relationship between MPL & TP:

 When MPL is ing, TP is also ing at an ing rate

 When MPL is ing until it reaches zero, TP is ing but at a ing rate

 When MPL =0, TP is maximum(constant level)

 When MPL is negative, TP is declining

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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Relationship between MPL & APL:

 If MP > AP, AP is ing

 If MP = AP, AP is either at a maximum or is constant(H‟)

 If MP < AP, AP is ing

Numerical Illustration:

Suppose that the short-run production function for cut-flower by a certain Ethiopian firm is given by:

Q = 4KL - 0.6K 2 - 0.1L2

where Q - represents the annual quantity of cut-flower produced.

K - annual capital input; suppose K=5.

L - annual labor input.

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

b) At what level of labor does the total output of cut-flower reach the maximum?
c) What will be the maximum achievable amount of cut-flower production?

Solution:

Q 4KL - 0.6K 2 - 0.1L2 0.6K 2 15 20L - 15 - 0.1L2

a) APL = = = 4K - - 0.1L = 20 - - 0.1L =
L L L L L

Q
b) We know that when total product (Q) is maximum, MP will be zero. And MPL = .
L
That is, partially differentiating1 Q with respect only to L and equating it to zero:
Q (4KL - 0.6K 2 - 0.1L2 )
MPL = = = 4K - 0.2L = 0
L L
20
 20 - 0.2L = 0  L = = 100
0.2
(Q – cut-flower level of output will be the maximum if the firm employs 100 units of labor.)
1
As you may recall from your calculus, the partial derivatives of the multivariate function
Z = aX b +cY d +eXY with respect to X and Y (a-e are constants), respectively, are:
Z Z
= baX b-1 +eY and = dcY d -1 +eX
X Y

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

c) Substituting the optimal values of labor (L=100) and capital (K=5) into the original production
function (Q) gives the maximum level of cut-flower production:

Qmax = 4KL - 0.6K 2 - 0.1L2 = 4* 5* 100 - 0.6* 52 - 0.1* 100 2 = 985

The Three Stages of Production

There are 3 stages of production on the basis of the marginal & average returns to the variable inputs,
i.e. lab our.

Stage I: Increasing Returns

- Marginal product of the variable input is higher than its AP (MP>AP), AP is increasing

- Goes from the origin (where TP=0) to the point where the APL is max ( APL = MPL ).

This stage begins at the start of the production where L= 0, and runs to the point corresponding to L=3
where average product of labor is at maximum. In this stage the proportion of labor to capital (variable
input to fixed input is too low relative to the purpose for which the production plant was designed, too
much capital relative to labor.

Stage II: Diminishing Returns

Marginal product of the variable input is falls below its AP (MP<AP), AP is ing MP > 0, and

MP > 0 ranges from maximum APL to zero MPL or it begins when APL starts to declining & ends
when MP becomes zeros or reaches its maximum level.

Stage III: Negative Returns

- Marginal product of the variable input/labor/turns negative (MP < 0)

 A rational producer will not continue in stage Ι. Because the producer is not making the best use
of the fixed factor(capital) and further he will not be utilizing fully the opportunities of
increasing production by increasing quantity of the variable factor (labor) whose average
product continuous to rise throughout the stage.

 Thus, a rational consumer will not stop in stage I but will expand to stage II. Similarly a rational
producer never prefers stage III since the return is negative. As a result, stages I & III

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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customarily known as non-economic regions in production process. Only stage II is
economically feasible because in this stage both APL & MPL are diminishing but positive which
entails a room or promise for greater production with a limited capital.

*Firms will be maximizing profits only if they are operating in Stage II.

The law of diminishing marginal returns (LDMR)

As additional units of a variable input are combined with fixed inputs, there will come a point where
the marginal product of the variable input will start to decline. When additional units of a variable
input are added to fixed inputs, after a certain point, the marginal product of the variable input
declines.

The Law states that if more and more units of a variable input are applied to a fixed input, the total
output may initially increase at an increasing rate, but beyond a certain level of output, it increases at a
diminishing rate. More precisely, if some factors are held constant and more and more units of
variable factors are employed, the marginal product of the variable factor eventually decreases.

Diminishing returns always apply in the short-run, and in the short run every firm will face
diminishing returns. And the law is valid when the following conditions are satisfied:

 Technological progress is constant;

 All other inputs are fixed;

 Variable factors must increase continuously up to a certain limit; and

 Input prices are given.

3.3. The Long-run Production Function: Production with two variable inputs
We have completed our analysis of the short-run production function in which the firm uses one
variable input (labor) and one fixed input (capital). Now we turn to the long run analysis of
production. Remember that long run is a period of time (planning horizon) which is sufficient for the
firm to change the quantity of all inputs. For the sake of simplicity, assume that the firm uses two
inputs (labor and capital) and both are variable. This can be expressed in equation form as:

Q = f(L, K)

The firm can now produce its output in a variety of ways by combining different amounts of labor and
capital. With both factors variable, a firm can usually produce a given level of output by using a great

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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deal of labor and very little capital or a great deal of capital and very little labor or moderate amount of
both. In this section, we will see how a firm can choose among combinations of labor and capital that
generate the same output. To do so, we make the use of isoquant and isocosts. So it is necessary to first
see what is meant by isoquants and isocosts and their properties.

3.3.1 The Isoquant Curves

The term „isoquant‟ has been derived from a Greek word „iso‟ meaning equal & a Latin word
„quantus‟ meaning quantity. Isoquant curve also known as equal product curve. An isoquant curve
represents the various combinations of two inputs that produce the same level of output.

Assumptions to draw an Isoquant:

Isoquant curves are drawn on the basis of the following assumptions.

i. There are only two inputs L & K, to produce a commodity.

ii. The two inputs L & K can be substituted one another at a diminishing rate up to a certain limit;

iii. Production function is continuous, implying that L & K are perfectly divisible & can be
substituted in any small quantity.

 In the example, the following combinations of inputs L and K produce 52 units of output:
(2,6),(3,4),(4,3),(6,2)

7
6
Units of Y

5
4
3 Isoquant; TP = 52 units
2
1
0
0 2 4 6 8 10
Units of X

 The slope and the shape of the isoquant curves depend on the degree of substitutability between
the two inputs (X and Y in the above case).

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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 The degree of substitutability is a measure of the case with which one input can be used in place of
the other in producing a given amount of output; i.e. it tries to answer the question like how much
easy or difficult to substitute inputs.

 The set of isoquant curves make isoquant map.

Properties of isoquant curves

1. Have negative slope: -Like ICs, they slope downward from left to right due to substitutability.
Because if one combination of L & K contains more of L, it will contain less of K than another
combination in order for the two combinations to give the same level of output & thus is on the
same isoquant.

2. Like ICs, isoquants are convex to the origin: - convexity of isoquants implies not only the
substitution between the inputs but also the diminishing rate of technical substitution between
inputs (due to imperfect substitutability of the factors) in the economic region of production.

3. Cannot intersect each other: -the intersection of two isoquants implies that a given quantity of a
product can be produced with a smaller as well as a larger input combination. But this is impossible as long
as marginal productivity of inputs is greater than zero. For e.g. as seen from the figure (a) the two isoquants
intersect at “A”. from this one can easily infer that output that can be produced with combination of L & K
at point „A‟ can be also produced with factor combination at „A‟ & „C‟, since point „A‟=‟B‟, & „A‟ = „C‟
then B = C since OL2 is common to both the sides, it means wrongly that L2B = L2C, but it can be seen from
the figure that L2C > L2B. The intersection of the isoquants means the output from L2C & L2B units of
capital are equal. But this can not happen so long as MPK is greater than zero. So, if isoquants intersect; it
violates the law of production.

4. Upper isoquants represent a higher level of output: - the reason is that an upper isoquant curve
contains the higher output because all along it, a large quantity of one or both of the inputs which
is supposed to produce greater output than the smaller quantity of inputs; provided that MP of
inputs are greater than zero. E.g. from the panel (b) of the following figure any point at isoquant Q2
consists more of either capital or both. E.g. consider point „A‟ on Q1 & compare it with any point
at Q2. Point „B‟ on Q2 indicates more of K, point „D‟ more of L & point ‟C‟ more of both.
Therefore, Q2 represents a higher level of output than Q1.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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K K
B
A C
C
D
Q2 A
B Q1 Q2
L Q1
O L1 L2 L
(a) Isoquants crossing each other (b) Isoquants with higher level of output

Marginal Rate of Technical Substitution (MRTS)

It is the rate at which one input can be substituted for another given constant output. It is the absolute
value of the slope of the isoquant at the given point, i.e., marginal rate of technical substitution is the
slope of an isoquant.

amount of K given up K dK K
Slope of an isoquant = MRTS L for K = = = =
amount of L employed L dL L

The d before a variable indicates a change or total differential in the variable.

MRTS and marginal products are highly related. Recall the two-factor long-run production function in
equation (4.8).

Q = f(L, K)

The total differential of Q is given by:

Q Q
dQ = dL+ dK
L K
= MPL (dL)+ MPk (dK)

However, along an isoquant the change in output is zero so that

dQ = MPL (dL)+ MPk (dK)= 0

dK MPL
 =-
dL MPK

This means that the ratio of marginal products is also similar to MRTS, i.e,

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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MPL
MRTS L for K = -
MPK

Note that the following two things:

(i) It is also possible to arrive at the same finding using the following concept. When a producer
employs additional labor, he will get additional output given by MPL(ΔL). When the producer
reduces the use of capital input, he will face a decrease in output given by MPK(ΔK). Since along
an isoquant the change in output is zero, the increase and the decrease in output should be equal in
magnitude, i.e,

MPL (L)= -MPK ( K)

K MPL MPL
 =-  MRTS L for K = -
L MPK MPK

(ii) Marginal rate of technical substitution of labor for capital ( MRTSL for K or MRTS L, K ) & marginal

rate of technical substitution of capital for labor ( MRTSK for L or MRTSK, L ) are not identical.

Hence,

L dL MP
MRTS K, L = = =- K
K dK MPL

The Law of Diminishing Marginal Rate of Technical Substitution (LDMRTS)

Most of the time inputs are imperfect substitutes. The LDMRTS states that as the amount of a given
input increases, given other inputs, its marginal product decreases. On the other hand when the amount
of a given input decreases, its marginal product increases. The more labor the firm has, the harder it is
to replace the remaining capital with labor. So, MRTS L, K falls as the isoquant becomes flatter.

Table 4.3 Marginal Rate of Technical Substitution

Input Combination Labor (L) Capital(K) MRTS L, K MRTS K, L

A 1 12 - 0.25
B 2 8 4 0.33
C 3 5 3 0.5
D 4 3 2 1
E 5 2 1 -

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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MRTSL, K decreases as more and more labor is employed – it falls to 1 from 4. It is that we called the

law of diminishing marginal rate of technical substitution. On the other hand, MRTSK, L increases as
the employment of capital increases. This is easily observable from the above table.

Isoquant Map, Ridge Lines & Economic Regions of Production

An isoquant map is a set of isoquants presented on a two dimensional graph as shown by the following
isoquants.

* It is noteworthy that the whole isoquant map or production plan is not technically efficient, nor is
ever point on an isoquant technically efficient. The reason is that, on a convex isoquant the MRTS
decrease along the isoquant & zero is the limit to which the MRTS can decrease. The point at which
MRTS = zero makes the limit to which one input can substitute another. Beyond this point, an
additional employment of one input will need employing additional units of the other input. E.g. the
firm would note produce 36Q at point „U in the figure below, b/c it would produce 36Q by using the
smaller quantity of L & K indicated by point V.

Economic Region of Production

Ridge lines: - lines that separate the irrelevant portion of the isoquant (i.e. positively sloped) from the
relevant (or the negatively sloped) one. In the figure, the lower ridge line OVI joins points on the
various isoquants where the isoquants have zero slopes (or zero MRTSL, K). The isoquants are
negatively sloped to the left of this ridge line & positively sloped to the right. This means that stating
as an example at point V on the isoquant for 36Q, if the firm used more labor it would also have to use
more capital to remain on the same isoquant. Starting from point V, if the firm used more labor with
the same amount of capital, the level of output would fall (i.e. the firm would fall back to lower
isoquant: see the dashed horizontal line at capital =2.8). The same is true at all other points on the
ridge line OVI. Therefore, the MPL must be negative to the right of this ridge line. Note that points on

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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ridge line OVI specify the minimum quantities of K required produce the level of output indicated by

the various isoquants. Note that at all points on this ridge line, MRTSL, K= MPL = O = 0 similar to
MPK MPK

this on the ridge line OZI, MRTSL, K= MPL = MPL = infinity.

MPK O

Thus, we conclude that the negatively sloped portion of the isoquants within the ridge lines represent
the economic region of production, where the MPL & MPK are positive but declining. Producers will
never want to operate outside this region.

Other forms of isoquants

The shape of an isoquant depends on the assumption regarding the degree of substitutability between
the factors in the production function. The convex isoquant is based on the assumption that the two
inputs can be substituted for one another at a diminishing rate, up to a certain limit. But there is other
degree of substitutability between L & K and have demonstrated the existence of three other kinds of
isoquants.

1) Linear isoquants: - a linear isoquant assumes perfect substitutability between the two factors of
production K & L. The isoquant AB (in figure A) indicates that a given quantity of a product can
be produced by using only capital or only labor or by using both. A linear isoquant implies that
the MRTS between labor and capital remains constant all along its length.

A) Perfect Substitutes B) Perfect Complements

The mathematical form of the production function exhibiting perfect substitutability of factors is
Q  f ( L, K )  aL  bK where Q is the weighted sum of L and K. The slope of the resulting isoquant
a Q
from this production function is given by (  ).This can be proved as, MPL  =a
b L

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
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Q MPL a
,and MPK  b since MRTSL, K=    . But, such type of an isoquants exhibiting
K MPK b
perfect substitutability of factors is rare in the real world production process.

2) Input-Output Isoquant or Fixed Factor Proportion & L-shaped isoquant:

 The production function in this case assumes a fixed proportion between K and L as a result the
isoquants takes an L- shape/right angle as shown (in figure B)

 This assumes prefect complementarities‟(i.e. zero substitutability)

 Implies also that if quantity of one input increased, holding the other constant, there will be no
change in output. Thus, output can be increased only by increasing both the inputs proportionally.

One mathematical form of a fixed proportion production function, frequently called as Leontief
production function is Q = f (L, K) = Min(aL, bK) where „min‟ means that production of Q equals
the lower of two terms, aL and bK. That is, if aL > bK, Q = bK; and if bK > aL, then Q = aL.
If aL= bK, it would mean that both L & K are fully employed. Then, the fixed labor-capital ratio will
L b
be  . To double the production it requires doubling both inputs. To run a car or taxi or to operate
K a
one truck we need to employ a minimum of one worker (driver) i.e. machine (K) labor (L) ratio in this
case is fixed. So, any extra marginal labor becomes redundant.

3) Kinked or Linear programming Isoquants:

The fixed proportion production function assumes that there is only one process of production and the
capital and labor can be combined only in a fixed proportion. To double production would require
doubling of both the inputs K & L.

Unlike the fixed proportion production function the production of an output may have different
techniques of production which combines K & L. This assumes there are only a few processes for
producing any one commodity. Substitutability of the factor is possible only at the kinks.

A
K

B C
D
L

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Each point on the kinked isoquant represents a combination of capital and labor capable of producing
any one units of a commodity. If there are other processes of production, many other kinks would be at
different points between, A&B, B&C, and C&D, by increasing the number of kinks of the isoquant
ABCD.

Then the resulting isoquant would then become smooth convex isoquant. There is an important
difference between the smooth convex isoquant and kinked isoquant. Each points on the smooth
convex isoquant is technically feasible, but in the case of kinked isoquant only the kink points are
technically feasible .Therefore, kinked isoquants represent limited substitutability of K & L. i.e. only
at the kink points. Such type of an isoquant is mostly used in linear programming & thus called linear
programming isoquants or activity analysis isoquants.

Elasticity of substitutions (σ):

MRTS refers only the slope of an isoquant. It doesn‟t reveal how difficult or easy the substitution of
factors of production is. The substitution of one factor of production by the other is not a direct or
forward task. This is mainly because factors of production are scarce and cannot easily be substituted.
Thus how difficult or easy the substitution of factors is measured by elasticity of substitution.

Elasticity of substitution (σ) is thus formally defined as the percentage change in the capital labor
ratio to the percentage changes in the marginal rate of technical substitution.

%  K L    K L MRTS L, K
i.e. Es( )   
%MRTS L, K   MRTS L, K   K L 

Since K/L and MRTS move in the same direction, the value of (  ) is always positive.  is a pure
number independent of the units of measurement of K & L, since both numerator & denominator are
measured in the same unit. The value of  depends on the curvature of the isoquants. Thus, it varies
from 0 to ∞ depending on the nature of the production function. Production function determines the
curvature of the various kinds of isoquants; i.e. For L-shaped isoquants/fixed proportion production
function/   0 . For a linear isoquants    ; incase of homogenous production function of degree one
of the Cobb-Douglas type   1 .

The law of Returns to scale

So far we were through the examination of effects of increasing one input while holding the other
input constant (shift from one isoquant to another) or decreasing the other input by an offsetting

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
amount (the movement along an isoquant). Specifically in the short run law i.e. law of variable
proportion we have seen the output behavior in response to change in one input (L) holding the other
input (K) constant. But in this section we discussed the input output relations under the condition that
all the inputs (L & K) are changed proportionally and simultaneously. The law that pertain this type of
relation is called the laws of return to scale. The word ‘scale’ refers to the long-run situation where all
inputs are changed in the same proportion. But now the question is how much the output changes if a
firm increases all its input proportionately? When all inputs are increased proportionately (i.e. by the
same multiple of the existing scale), there are technically three possible ways in which TP or output
may increase.

 it may increase more than proportionately

 it may increase proportionately

 it may increase less than proportionately

This kind of input-output relationship gives three laws of returns to scale; Constant returns to scale,
Increasing returns to scale and decreasing returns to scale:

1) Constant returns to scale: - In this case, if we increase all factor in a given proportion and the
output increases in the same proportion, return to scale are said to be constant. In other words, if
quantity of both the inputs, K & L, are doubled and output is also doubled in the same proportion.
When economies of scale disappear & diseconomies of scale are yet to begin, the return to scale
becomes constant.

a) Constant Returns to b) Increasing Returns to C) Decreasing Returns

Scale Scale to Scale

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
2) Increasing returns to scale: -If the increase in all factors of production leads to a more than
proportionate increase in output, return to scale are said to be increasing. For example, suppose
inputs increase by 50% and output increased by more than 50%., say by 75%. If all inputs are
doubled, output more than doubled.

Factors that cause increasing return to scale include:

a) Division of labor & specialization: -when the scale of operation of a given manufacturing
industry increase, each worker assigned to perform only one repetitive task rather than different
activities. The workers become more efficient in the performance of a single task & avoid the
time lost in moving from one machine to another. Then the result is higher productivity &
increasing return to scale.

b) Technical and managerial indivisibility (Non-division of factors): - certain inputs,

particularly machinery & managerial skills, used in the process of production are available in a
given size .such inputs can‟t be divided into parts to suit the small scale of production. Therefore,
when scale of production increased by increasing all inputs, the productivity of indivisible
factors increase. This results in increasing returns to scale.

c) Dimensional relations (Scale effect): - increasing return to scale is also a matter of dimensional
relations. E.g. when the size of a room (15 X 10) =150sq is doubled to 30X20 the area of the
room is more than doubled (i.e. 600). Following this dimensional relationship, when the labor &
capital are doubled, the output is more than doubled over same level of output.

3) Decreasing return to scale: -If the increase in all factors of production leads to a less than
proportionate increase in output, return to scale are said to be decreasing. I.e. when inputs are
double, output is less than doubled.

Factors that cause decreasing returns to scale include:-

 Diseconomies of scale: - as the scale of operations es, the firm may be unmanageable
(managerial Diseconomies) i.e. it is difficult to manage the firm effectively & coordinate the
various operations and divisions of the firm. Because the channel of communication becomes
more complex, the number of meetings , paper work, the telephone bills es more than
proportionate to the in the scale of operations.

 Exhaustibility of natural resources

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Production functions & returns to scale

The laws of return to scale can be explained more precisely through the production function.

Linear production functions & returns to scale

Suppose that the production function in the long-run is given as Q=f (L, K); for this production
function:

 If K & L are increased by a factor „r‟ output also increases by a factor „r‟ by implying that
constant return to scale. rQ= f (rK, rL), rQ = r(K,L).

 But it is quite likely that if all the inputs are increased by a certain proportion say by „r‟ output
may not increase in the same proportion. In this case the production function may then be
written as hQ=f (rK,rL),where „h‟ denotes the „h‟ times increase in Q as a result of „r‟ times
increase in the input, K & L.

Accordingly it shows the three laws of returns to scale.

i. If h = r, the production function reveals constant returns to scale

ii. If h > r ,the production function reveals increasing returns to scale

iii. If h < r, the production function reveals decreasing returns to scale

Cobb-Douglas production functions & returns to scale

o The Cobb-Douglas production function is give as Q  f ( K , L), Q=AK L (Where A, α & β are
positive constants)

A = represent technology, the advanced the technology the more the value of A, α = gives the output
elasticity of capital (i.e. %Δ in output as a result of one % Δ in K), L remaining constant. And “β”=
represent output elasticity of labor (i.e. e %Δ in output as a result of one % Δ in L), K being constant

Let as see the application of Cobb-Douglas production function for deriving the law of returns to scale.
If input L & K is multiplied by a factor „r‟ & output by „h‟, then the equation becomes.

hQ  A(rK ) (rL)  Ar r  ( K  L )  r    ( AK  L )

Since Q  AK  L , h  r   , from this relation we can derive the rules for the laws of returns to scale:

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
 If α +β >1 ，h > r the production function gives, increasing returns to scale

 If α +β =1 ，h = r, the production function gives, Constant returns to scale

 If α +β <1 ，h < r, the production function gives, Decreasing returns to scale

3.2.2. The Isocost Line

As we will discuss in the upcoming chapter, production requires money at least for the acquisition of
factors of production. This money is a cost to the producer. A very interesting and simple fact is that a
firm can spend an identical total cost for various combinations of inputs. Here comes the concept of an
isocost.

An isocost is simply a line that shows the various combinations of two inputs (in our case, labor and
capital) that can be purchased for the same amount of outlay (total cost).

Let us assume that the total cost incurred by a firm is only TC. And if the price of labor (L) and price
of capital (K) are symbolized by w and r respectively, then

TC = wL+rK (4.11)

If we express K in terms of others, we get

TC w
K= - L (4.12)
r r

This equation is known as isocost equation. It has the following implications:

 If the firm devotes its entire fund to purchase K, then it can employ TC/r amount of K, leaving no
money to hire labor (L=0).

 If the firm devotes all the funds to buy labor, then it can hire TC/w amount of L, leaving no
money to purchase K (K=0).

 All the intermediate positions on these two extreme points show any other combinations of L and
K the firm can hire at a cost of exactly TC.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

Graphically, this could easily be put as follows.

Capital

TC/r

TC/w Labor

Slope of an isocost line is given by the ratio of price of labor (w) and the price of capital (r), i.e., it is
just the derivative of the isocost equation given by equation (3.13) with respect to labor (L).

dK w
Slope of an isocost = =-
dL r

Note that the slope an isoquant and the slope of an isocost are both negative, implying the use or
purchase of one input disregards the other

3.4. Optimum combinations of inputs

In the pervious section, we have seen the laws of returns to scale assuming that firms can expand the
scales of production to any level-with out considering resource/cost constraint. But in reality, firms
have limited resources & supposed to maximize their profit from their given resources.

A profit maximizing firm has to minimize its cost for a given output or to maximize the output for a
given total cost. Given the technology a given output can be produced with, different input
combinations. But all input combinations do not conform to the least cost criteria. In this section, we
define isocost lines & examine how a firm chooses the combination of inputs to minimize the costs of
producing a given level of output when all factors are variable or maximize the output for a given cost.

3.4.1. Producer’s equilibrium: Maximization of output with a given cost

The firm is said to be equilibrium when it maximizes its output given his TC or outlay & the prices of
the factors, w & r. Two conditions must be fulfilled for the producer to be in equilibrium.

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 AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
1. The first order condition (F.O.C):- is that the slope of the isoquant (MRTSL, K) must be equal to
the ratio of the input prices (i.e. slope of isocost line)

K MPL PL w
MRTSL , K     ; This is necessary but not sufficient condition for maximization.
L MPK PK r

2. Second order condition (2nd O.C): - the second order condition must be fulfilled at the highest
attainable isoquant curve.

Graphical presentation of the equilibrium of the producer: - given the isoquant map of the
producer & his isocost line, the equilibrium is defined by the point of tangency of the isoquant line
with the highest attainable isoquant curve.
* point P and Q, are on the lower isoquant
(Q1) denotes lower output level than Q2 and Q3
Capital (K)
is totally unattainable. a small output

* At point „E‟ both the F.O.C & S.O.C are fulfilled

P
Q3 * Thus, Q2 is the maximum attainable output under the
E given cost condition
K* Q2

Q1
R
Labor (L)
L*

Mathematical derivation of the equilibrium: - The equilibrium condition may be obtained by

applying calculus and solving a constraint maximizing problem. The rational firm /entrepreneur seeks
the maximization of his output, given his total cost or outlay and the price of factors, formally:

Maximize Q = F (L, K)

Subject to TC = wL + rK, we can solve this constrain maximizing

problem by using Lagrange multiplier method.

The steps involved in this method are:

 Step1: Define the Lagrangian function:

F  Q   [ wL  rK  TC] Or F  Q   [ TC  wL  rK ]

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
 Step 2: Employ the necessary conditions (F.O.C) with respect to L, K and  to find the
stationary value of F: i.e. for a maximization of a function its partial derivative be equal to
zero

F L  0  MPL   w  0
  MPL / w          (1)
F K  0  MPK   r  0 
F   0  PLL  PKK  Tc  0  MPK / r          (2)


MPL MPK MPL PL w

By equating the 1st the 2nd equation we get (λ = λ)  or  
PL PK MPK PK r

The firm is in equilibrium when it equates the ratio of the marginal productivities of factor to the ratio
of their prices. At equilibrium MP of each input divided by its prices is the same. If this is not the case,
the producer/firm could increase his/her output by using the output with higher ratio of MP to price,
& less on the other inputs.

The S.O.C for equilibrium of the firm requires that the marginal product curves of the two factors
have a negative slope. The slope of the MP curve of the factors is the second order derivative of the
production function with respect to the factor.

Slope of MPL curve = MPL L   2Q L2  0 ,

Similarly for capital: slope of MPK curve  MPK K   2Q K 2  0

3.4.2. Minimization of cost (the least-cost input combination)

Minimization of cost for a given level of output is equivalent to maximizing of output for a given
cost. That is, there must be tangency of the given isoquant and the lowest possible isocost line and the
isoquant must be convex. In this case we have a single isoquant which denotes the desired level of
output, but we have a set of isocost lines.

Curves closer to the origin show a lower total-cost outlay. Each isocost lines are parallel because they
are drawn on the assumption of constant prices of factors. That is, since w & r do not change, all the
isocost lines have the same slope.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

The input combination at J, E & K all

used to produce Q

K per period
The input combination at E - where the isoquant is
tangent to the isocost line, is the least expensive
C1
J C3

C2
E
K
*
K
* Q

L per period
L
*
The firm minimizes its cost by employing the combination of K & L determined by the point of
tangency of Q-isoquant with the isocost line (C2).

 Points below „E‟ are desirable because they show lower cost but not attainable for output Q.

 Points above „E‟ show higher costs. Hence point E is the least- cost combination point.

 The condition for equilibrium of cost minimizing are the same as output maximizing case

Choice of optimal expansion path

In the long-run, all inputs are variable. So, if there is no resources constraint on the expansion of
output, the firm can employ more of both K & L to expand its scale of production. But a profit
maximizing firm would employ K & L in a proportion that is economically most efficient. This is
called an optimum factor proportion which is essentially the same as the least cost input combination.

 Given the production function & input prices, the optimum factor proportion is determined by the
point of tangency between the isocost & isoquant (i.e. MRTSL, K = PL/PK)

 The expansion of inputs & outputs through the points of optimal factor proportions gives the
optimal expansion path.

 Expansion path: - is the line joining the origin with the points of tangency of isoquants & isocost
lines with input prices constant.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
 If the production function is homogenous of degree one ( constant return to scale ,i.e. when all
inputs increased in the same proportion, outputs also increased by the same proportion), the expa
nsion path will be a straight

 line through the origin, whose slope depends on the ratio of factor- prices. * the optimal expansion
path OA, defined by the locus of points of tangency of the isoquant with successive parallel isocost
w
lines with slope of
r

K per period

A W/r
Note that all along expansion
W*/r path line MRTS is constant
B
q1

q0

q00 L per period

O

 For instance when wage decreases the isocost line becomes flatter implying that labor-intensive
w*
method of production (with slope ) the expansion path will be the straight line OB.
r

 Initially the firm moves or expands production along OA, but after the change in factor prices it
moves along OB.

 If the production function is non-homogenous or of a general form, the expansion path will not be
a straight line (instead it is represented by a curve), even if the ratio of factor prices remains
constant.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Numerical Illustration

Suppose a certain small enterprise allocates only 20,000 birr for the production of furniture (school
armchairs). The enterprise wants to employ workers (L) whose wage is w=1000 birr and purchase
implements (K) at a price of r=4000 birr. Suppose further that the production function for furniture is
given by Q = 10L0.5 K 0.5 .

(a) Determine the marginal product functions of workers and implements.

(b) Find MRTS L, K and MRTSK, L .
(c) How many workers (L) and implements (K) must be acquired for the small enterprise to
produce the maximum possible number of armchairs.
(d) How many armchairs will be produced at the equilibrium of the enterprise?

Solution:

We are given the production function as Q = 10L0.5 K 0.5 and the total cost (TC) function as
TC = wL+rK  1000L+4000K = 20,000 .

(a) Marginal product of a worker (MPL):

Q
MPL = = 0.5(10)L(0.5-1) K 0.5 = 5L-0.5 K 0.5
L
Marginal product of an implement (MPK):
Q
MPK = = 0.5(10)L0.5 K (0.5-1) = 5L0.5 K -0.5
K

MPL 5L-0.5 K 0.5 K

(b) MRTS L, K = - = - 0.5 -0.5 =  and
MPK 5L K L

MPK 5L0.5 K -0.5 L

MRTS K, L = - = - -0.5 0.5 = 
MPL 5L K K

(c) The optimum of the small enterprise is found at the following point:
w r
MRTS L, K = - or MRTS K, L = - .
r w
If we use the first equality, we have:
w K 1000 1
MRTS L, K = -  - =- = -  L = 4K
r L 4000 4

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Substituting this last equation into the TC equation, gives:

1000L + 4000K =20000

1000(4K) + 4000K =20000

8000K =20000

K = 2.5

Hence, L* = 4K = 4(2.5) = 10

If the enterprise purchases 2.5 implements and employs 10 workers, it will have the least cost optimal
level of armchair production.

(d) At those levels of employments, the least cost amount of armchairs produced will be:

Qmax = 10(L*)0.5(K*)0.5

= 10(10)0.5(2.5)0.5

= 10√25

= 50

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

CHAPTER FOUR: THEORY OF COST

4.1. Basic concepts
To produce goods and services, firms need factors of production or simply inputs. To acquire these
inputs, they have to buy them from resource suppliers. Cost is, therefore, the monetary value of inputs
used in production of an item.

We can identify two types of cost of production: social cost and private cost.

Social cost: is the cost of producing an item to the society. This cost is realized due to the fact that
most resources used for production purpose are scarce and some production process, by their nature,
emit dangerous chemicals, bad smell, etc to surrounding society.

For example, when a certain beer factory wants to produce beer in Ethiopia, the society as a whole
also incurs a cost. Because, the next- best alternative of the raw material (such as barely) used for the
production of beer is sacrificed. When the beer factories buy barley from the market, the amount of
barely available for consumption by society may be reduced and the price may become dearer. Hence,
the production of beer imposes an indirect cost on the society, moreover, by its nature; the production
of beer emits bad chemicals to the environment, which pollutes waters, air, etc. To control the
understandable consequences of the production process on the environment and their property, the
society incurs cost.

Private cost: This refers to the cost of producing an item to the individual producer. It is the cost that
the beer factory incurs to produce the beer, in our example:

Private cost of production can be measured in two ways:

i) Economic cost

In economics the cost of production to the individual producer includes the cost of all inputs used for
the production of the item.

The producer may buy part of the inputs from the market. For example, he/ she hire workers, buy raw
materials, the necessary machines, etc. the actual or out- of- pocket expenditures that the firm incurs to
purchase these inputs from the market are called explicit costs.

But, the producer can also use his/ her own inputs which are not purchased from the market for the
production purpose. For example, the producer may use his/ her own building as a production place,
he/she may also manage his firm by himself instead of hiring another manager, etc. since these inputs
are used for the purpose production, their value has to be estimated and included in the total cost of
production. As to how to estimate the cost of these non- purchased inputs is concerned, we usually
estimate their cost from what these inputs could earn in their best alternative use. For instance, if the
firm uses his own building for production purpose, the cost of using this building for production is
estimated by the rent income foregone. If the producer is a teacher with salary of 1000 birr per month

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
and fruits his job to manage his factory, then the next best alternative of his labor is the salary that he
sacrificed to be the manager of his factory. The estimated cost of there non- purchased inputs are
called implicit costs.

Thus, in economics the cost of production includes the costs of all inputs used in the production
process whether the inputs are purchased from the market or owned by the firm himself that is:

Economic cost: Explicit cost plus Implicit cost

ii) Accounting Cost

For accountant, the cost of production includes the cost of purchased inputs only. Accounting cost is
the explicit cost of production only. Moreover, accountant‟s doesn‟t consider the cost of production
from the opportunity cost of the resources point of view.

4.2. Short run cost functions

Cost function shows the algebraically relation between the cost of production and various factors
which determine it. Among others, the cost of production depends on the level of output produced,
technology of production, prices of factors, etc. hence; cost function is a multivariable function.
Symbolically,

C = f (x, t, pi)

Where c- is total cost of production

x - is the amount of output

T – is the available technology of production.

Pi – is the price of input

Graphically, cost functions can be illustrated by using a two- dimension diagrams. To do so, first we
observe the relationship between the total cost of production and the level of output (the most factor
determining the cost of production), by assuming that all other factors are constant. Then, the impact
of change in “other factors” such as technology on the cost of production will be handled by shifting
the total cost curves upward or down- ward.

Economics theory distinguishes between short run costs and long run costs. Short run costs are the
costs over a period during which some factors of production (usually capital equipments and
management) are fixed. The long- run costs are the cost over a period long enough to permit the
change of all factor of production.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
4.2.1. Short run costs of the traditional theory

In the traditional theory of the firm, total costs are split into two groups: total fixed costs and total
variable costs:

TC = TFC + TVC

Where – TC is short run total cost

TFC is short run total fixed cost

TVC is short run total variable cost

By fixed costs, we mean a cost which doesn‟t vary with the level of out put. The fixed costs include:

a. Salaries of administrative staff

b. Expenses for building depreciation and repairs

c. Expenses for land maintenance

d. The rent of building used for production , etc

All the above costs are regarded as fixed costs because whether the firm produces much output or zero
output, these costs are unavoidable, and the firm can avoid fixed costs only if he / she shuts down the
business stops operation.

Variable costs, on the other hand, include all costs which directly vary with the level of output. The
variable costs include:

e. The cost of raw materials

f. The cost of direct labor

g. The running expenses of fixed capital such as fuel, electricity power, etc.

All these costs are regarded as variable costs because their amount depends on the level of out put. For
example, if the firm produces zero output, the variable cost is zero.

Graphical presentation of short run costs.

Total fixed cost (TFC)

Graphically, TFC is denoted by a straight line parallel to the out put axis. The point of intersection of
the TFC line with the cost axis (vertical axis) shows the amount of the fixed. For example if the level
of fixed cost is $ 100, it can be shown as.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

TC

TFC
$100

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. According to this law, at the initial stage of production with a given plant,
as more of the variable factor (s) is employed, its productivity increases. Hence, the TVC increases at
a decreasing rate. This continues until the optimal combination of the fixed and variable factors is
reached. Beyond this point, as increased quantities of the variable factors(s) are combined with the
fixed factor (s) the productivity of the variable factor(s) declined, and the TVC increases by an
increasing rate. Thus, the TVC has an inverse s-shape due to the law of diminishing marginal returns.

Graphically, the TVC looks the following.

TC
TVC

Total Cost (TC)

The total cost curve is obtained by vertically adding the TFC and the TVC i.e., by adding the TFC and
the TVC at each level of output. The shape of the TC curve follows the shape of the TVC curve. i.e.
the TC has also an inverse S-shape. But the TC curve doesn‟t start from the origin as that of the TVC
curve. The TC curve starts from the point where the TFC curve intersects the cost axis.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

TC

Cost Output FC VC TC
TVC 0 200 0 200
1 200 50 250
2 200 90 290
3 200 120 320
4 200 140 340
5 200 150 350
6 200 156 356
7 200 175 375
8 200 208 408
TFC

Output

The TC and TVC curves have an inverse S- shape. The vertical distance between them (TFC) is
constant.

Average costs

Average costs are important as we may make comparisons with product price, which is always stated
on per unit basis.

Average fixed costs (AFC): is found by dividing total fixed cost by output.

TFC
AFC 
Q

Since total fixed costs are constant or independent of output, average fixed cost will continuously
decline as long as output increases.

TVC
Average variable cost (AVC): Is obtained by dividing total variable cost by output. AVC 
Q

Since total variable cost reflects the law of diminishing returns, so must the average variable cost
because average variable cost is derived from total variable cost.

Due to increasing returns, initially takes fewer and fewer additional variable resources to produce each
of the first few units of output.

After AVC hits minimum it will start to rise as diminishing returns require more and more variable
resources to produce each additional unit of output.

AVC is U-shaped.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Average total cost (ATC): is total cost divided by total output.
ATC
Average AVC
cost
TC
ATC 
Q

TC TVC TFC
ATC=AVC+AFC   
Q Q Q

AFC
Unit of
output
4.2.2 The relationship between AVC, ATC and MC

MC is the extra cost of producing one more unit of output.

 The marginal cost curve intersects both the AVC and ATC curves at their minimum points.

This relationship is a mathematical necessity. If the marginal cost is below average total cost, average
total cost will decline towards marginal cost.

If marginal cost is above average total cost, average total cost will increase, i.e. ATC, always moves
towards MC. As a result, marginal cost intersects average total cost at ATC‟s minimum point. By the
same reasons marginal cost intersects average variable cost at AVC‟S minimum point.

No such relationship exists for the MC curves and the AFC curve because the two are not related. MC
includes only those costs which change with output, and FC and output are independent.

 The average variable cost reaches its minimum before the average total cost because of the
inclusion of average fixed cost.

Given ATC = AVC + AFC, AVC is part of the ATC. Both AVC and ATC are u – shaped, reflecting
the law of variable proportions however, the minimum of ATC occurs to the right of the minimum
point of the AVC ( see the following figure) this is due to the fact that ATC includes AFC which
continuously decreases as the level of output increases.

After the AVC has reached its lowest point and starts rising, its rise is over a certain range is more than
offset by the fall in the AFC, so that the ATC continues to fall (over that range) despite the increase in
AVC. However, the rise in AVC eventually becomes greater than the fall in AFC so that the ATC
starts increasing. The AVC approaches the ATC asymptotically as output increases.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

AC
AVC
AFC
MC
AC
MC

AVC

AFC

Q
Q1 Q2

The AVC curve reaches its minimum point at Q1 output and ATC reaches its minimum point at Q2.
The vertical distance between ATC and AVC (AFC) decrease continuously as out put increases. The
MC curve passes through the minimum point of both ATC and AVC

Finally, the MC curve passes through the minimum point of both ATC and AVC curves.

This can be shown by using calculus.

Suppose the TC = f (Q)

d ( f (Q))
MC   f (Q)
dQ

TC f (Q)
AC  
Q Q
d (f (Q)) ( f (Q))Q  Q. f (Q)
AC  d 
Slope of dQ Q2

But f (Q) is MC and Q1 (or dQ/dQ) =1

MC f (Q)

MC.Q - f(Q) Q Q
Thus, slope of AC  
Q2 Q

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

Slope AC = MC  AC , where

1 f (Q)
 AC
Q Q

Now,

i) when MC<AC, the slope of AC is negative, i.e.

AC curve is decreasing (initial stage of production)

ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing (after
optimal combination of fixed and variable inputs.

iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its minimum point.

The relationship between AVC and MC can be shown in a similar fashion.

To examine the behavior of the short – run costs and understand their relationship, let us take the
following typical short – run cost function.

Output TFC TVC TC AFC AVC AC MC

0 60 0 60 - - - -
1 60 15 75 60 15 75 15
2 60 25 85 30 12.5 42.5 10
3 60 30 90 20 10 30 5
4 60 50 110 15 12.5 27.5 20
5 60 80 140 12 16 28 30
6 60 125 180 10 25.3 35.3 45

As you can see from the table, the TFC is 60, which is a constant and remains constant at all levels of
output. However, TVC and TC continuously rise as output increase. The difference between TC and
TVC at all levels of output is constant 60 which is the fixed cost. At output level zero, TVC is zero but
TC has the value of the TFC. AFC continuously declines as output increases. AVC, AC and MC have
the same change of variation all first decrease; reach their respective minimum and then increase.

Example

Suppose the short – run cost function of a firm is given by: C=2Q3 –2Q2 + Q + 10 , Find

A. The expressions for TFC & TVC

B. The expressions for AFC, AVC & AC and MC

C. The minimum values of MC and AVC.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Solution

Given C=2Q3 – 2Q2 + Q + 10

A. TFC = TC at Q=0 Therefore ,

TFC = 10

TVC = TC – TFC = 2Q3 – 2Q2 + Q + 10 – 10

TVC = 2Q3 – 2Q2 + Q

B. AFC = TFC/Q = 10/Q

AVC = TVC/Q = (2Q3 – 2Q2 + Q)/Q = 2Q2 – 2Q + 1

AC = TC/Q = (2Q3 – 2Q2 + Q + 10)/Q= 2Q2 – 2Q + 1 + 10/Q

MC = dC/dQ= 6Q2 – 4Q + 1

C. Minimum value of MC is obtained at output level, which will make the first derivative of MC
zero. Therefore, to find the minimum value of MC:

dMC/dQ = 12Q-4 = 0

Q = 1/3

To find the minimum value of MC = 6(1/3)2 -4(1/3) + 1=0.37

We follow the same step to get the minimum value of AVC

AVC = 2Q2 – 2Q + 1

d AVC/dQ = 4Q - 2= 0, Q=0.5. To find the minimum value of AVC

AVC = 2 (0.5) 2-2(0.5) +1

= 0.5 – 1 + 1

= 0.5

4.2.3. Relationship between cost and production

 Average total cost and marginal cost curves are U-shaped.

 Average product and marginal product curves are inverted U-shape.

 The additional cost of production of a good is lowest at the output level where the
additional product of the variable input is maximum, MPmax  MCmin

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
 Similarly, the average variable cost is minimum when the average product of the variable
input is maximum, APmax  AVC min

 Thus, MC and AVC curves are mirror images of the MP and AP curves respectively.

TP

AP
L
MP
C

MC AC

Consider a single variable factor; labor (L) and all other factors are fixed. The wage rate is given by
„w‟ and it is constant.

TVC = w.L

AVC = TVC/Q but TVC = w

= w.L/Q

AVC = w (L/Q)

This shows that AVC and APL are inversely related. As AP increases (decreases), AVC decreases
(increases).

Remember that APL=Q/L and L/Q=1/AP

AVC= w/ APL

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Again note that; ∆ TC=∆TVC, since ∆TFC=0

∆TC=∆(w.L)

∆TC=w. ∆L

TC TVC w.L

MC   
Q Q Q

Q L 1
But  MPL  
L Q MP

w
 MC 
MPL

This also implies that MC and MP are negatively related. As MP increases (decreases) MC decreases
(increases).

4.3. Costs in the long run

In this section we will discuss the long run costs of a firm. The basic difference between long-run and
short run costs is that in the short run, there are some fixed inputs which results in some amount of
fixed costs. However, in the long run all factors are assumed to become variable. In the long run the
firm can change the quantities of all inputs including the size of the plant. This implies that all costs
are variable in the long-run in the sense that it is always possible to produce zero units of output at
zero costs. That is, it is always possible to go out of business.

The long –run cost curve is a planning curve, in the sense that it is a guide to the entrepreneur in his
decision to plan the future expansion of his plant.

Derivation of the long- run average cost curve

The long run average cost curve is derived from the short run average cost curves. Each point on the
long run average cost (LAC, now on) corresponds to a point on the short run cost curve, which is
tangent to the LAC at that point. Now let us examine in detail how the LAC is derived from the short
run average cost ( SAC) curves.

Assume that the available technology to the firm at a particular point of time includes three methods of
production, each with a different plant size: a small plant, medium plant and large plant. The operation
cost of the small plant is denoted by SAC1, the operating cost of the medium size plant is denoted by
SAC2 and that of the large size plant is denoted by SAC3 in the following figure.

If the firm plans to produce x1 units of output, it is well advised to choose the small size plant to
minimize its cost. For example, if the firm choose to use the medium size plant to produce x1 units of
output, the per unit costs will be C4 ( a point corresponding to x1 units of out put on the SAC2) but,

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
the firm can produce x1 units of output at a lower unit cost (c1) if it uses the small size plant.
Similarly, if it plans to produce x2 units of output, it will choose the medium size plant. If the firm
wishes to produce x3 units, it will choose the large size plant.

If the firm starts with the small plant and its demand gradually increases, it will produce at lower costs
(up to x1 level of output). Beyond that level of output costs start increasing. If its demand reaches the
level x1” the firm can either continue to produce with the small plant or it can install the medium size
plant. The decision, at this point, whether to install the medium size plant or not depends not on the
costs but on the firm‟s expectation about its future demand. If the firm expects that the demand will
expand further than x1” it will install a medium size plant because with this plant out puts larger than
x1” are produced with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level x2”. If the firm
expects its demand to stay constant at x2” level, the firm will not install the large plant, given that it
involves a large investment which is profitable only if demand expands beyond x2”. If the firm
expects that its demand will expand further, it will install the large size plant to reduce its cost. For
example the level of output x3 is produced at a cost c3 with the large plant, while it costs c2‟ if
produced with the medium size plant (c2‟ > c3).

Now if we relax the assumption of the existence of only three plant sizes and assume that the available
technology includes large number (infinite number) of plant sizes, each suitable for a certain level of
output, the points of intersection of consecutive plants cost curves (which are the crucial points for the
decision of whether to switch to a larger plant) are numerous and we obtain a continuous curve, which
is the planning LAC curve of the firm.

The LAC curve is then the tangent to these SATC curves of various plant sizes and shows the
minimum cost of producing each level of output.

SAC1

C4 SAC2
LAC
C1
C1‟
C2‟
SAC3
C2

C3

X1
X1‟‟‟‟ X2 X2‟ X3
X1‟‟

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
The relationship between LAC and short run average costs. The long run AVC curve is the lower
envelope of the short run average costs of various plant sizes.

Assuming that there is infinite number of plant sizes, the LAC curve is a smooth curve tangent to each
and every SAC curves corresponding to different plant sizes. See the following figure.

LAC
1 6

5
2 3 4

The long run average cost curve, assuming that there are large number of plant sizes

In summary, the LAC curve shows the minimum per-unit cost of producing any level of output when
the firm can build any desired scale of plant in the sense that the firm chooses the short –run plant
which allows it to produce the anticipated (in the long run)out put at the least possible cost.

Why is the LAC U-shaped?

Similar to the SAC curve, the LAC curve of a firm is also U-shaped, but the reason for the U-shapes of
LAC curve is different from that of the SAC curve.

The LAC curve is U-shaped due to the laws of returns to scale(i.e increasing and decreasing returns to
scale).that is, as output expands from a very low levels increasing returns to scale prevails (i.e., output
rises proportionally more than inputs), and so the cost per-unit of output falls(assuming that input
prices remain constant).As output continues expand, the forces of decreasing returns to scale
eventually begin to overtake the forces of increasing returns to scale and the LAC begins to rise.

In other words, the per unit costs of production decreases initially as the plant size increases, due to the
economies of scale which larger plant size makes possible.

Economies of scale is the cost dimension of increasing returns to scale and thus, they are like the two
sides of a coin. If a firm has increasing returns to scale in production(i.e., if it requires the firm less
than double inputs to produce double output) the firm will have economies of scale in costs (it will
require the firm less than double cost to produce double output). Thus, the reason for the decreasing
part LAC curve is increasing returns to scale or economies of scale.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
Economies of scale may prevail for various reasons such as specialization of skills, lower prices for
bulk-buying of raw materials, decentralization of management system and etc.

The traditional theory of the firm assumes that economies of scale exists only up to a certain size of
plant, which is known as optimal plant size, because with this plant size all possible economies of
scale are fully exploited. If the plant size increases further than this optimal size diseconomies of scale
will start to prevent, arising from managerial in efficiencies, the price advantage from bulk-buying
may also stop beyond a certain limit etc. These diseconomies of scale will lead to increasing LAC
curve. Thus, the increasing portion of the LAC curve shows the existence of diseconomies of scale or
decreasing returns to scale.

In general, the reason for the U-shaped of the LAC curve are the existence of increasing returns to
scale at initial stage of expansion decreasing returns to scale at a later stage of expansion.

(Increasing returns to scale

Decreasing returns to scale

C0 constant returns to scale

Q
QO

The LAC curve is U-shaped due to the combined effects of increasing, constant and decreasing
returns.

The long-run marginal cost curve.

The long-run marginal cost curve (LMC) is derived from the short run MC curve but does not
envelope them. The LMC is formed from points of intersection of the SMC curves with the vertical
lines (to the x-axis) drawn from the points of tangency of corresponding SAC curves and the LAC
curve.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost

SAC1
SMC1 SAC3
LMC
LAC
SAC2

SMC2 SMC3

Q1 Q2 Q3 Q

Long run marginal cost curve; it is derived from the short run marginal cost curves by connecting the
points of intersection of the vertical lines drawn from the point of tangency of SAC curves with the
LAC curves with and the corresponding SMC curves.

Note that, the LMC curve passes through the minimum of the LAC curve.

4.4. Dynamic changes in costs: the learning curve

Dear learner, so far we have suggested one reason why a large firm may have a lower long-run
average cost than a small firm: increasing returns to scale in production it is tempting to conclude that
firms which enjoy lower average cost over time are growing firms with increasing returns to scale .but
this need not be true.

In some firms, long-run average cost may decline over time because workers and managers absorb
new technological information as they become more experienced at their job. That is, as workers get
experience their efficiency increases which then reduces the average and marginal costs of producing a
unit of product.

As management and labor gain experience with production, the firm‟s marginal and average costs of
producing a given level of output fall for four reasons:

1. Workers often take long-run to accomplish a given task the first few times they do it. As they
become more adept, their speed increases. For example, a worker packing 20 dozens of soups per hour
in the first few months can pack more than 20dozens of soups in latter months when he/she gains
experience.

2- Managers learn to schedule the production process more effectively.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
3- Engineers who are initially cautious in their product designs may gain enough experiences to be
able to allow for tolerances in design that save costs with though increasing defects. Better and more
specialized tools and plant organization may also lower cost.

4- Suppliers may learn how to process required materials more effectively and pass on some of this
advantage in the form of lower costs to the firm.

In general, a firm ‟learns‟ over time as cumulative output increases. Managers can use this learning
process to help plan production and forecasts future costs. The following figure illustrates this process
in the form of learning curve: a curve that describes the relationship between the firms cumulative
output and the amount of inputs needed to produce each unit of output.

Number of labor required to produce one unit

Learning
curve

A
Cumulative
out put

Learning Curve: shows that at the firm’s cumulative output increases (as the firm gets
experienced),the amount of inputs(such as labor)required to produce one unit of output decreases.

In the above graph, the per unit production costs decreases along with the amount of labor required to
produce a unit of the commodity. This happens because labor input Per unit of out put directly affects
the production costs. The fewer the hours of labor needed to produce a unit of the commodity, the
lower the marginal and average costs of production.

The learning curve can algebraically be represented by the following relationship.

L =A+ BN- a or L = A+B/ Na

- Where-N is the cumulative number of out put produces.

L is the labor input required to produce a unit of out put.

A, B and N are constants, with A and B positive, and a between 0 and 1.

When N is equal to 1, L is equal to A + B, so that A + B measures the labor input required to produce
the first unit of output.

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AAU School of Commerce Dep’t of Economics Microeconomics lecture note on Theory of
and Production and Cost
When a is equal to zero, labor input per unit of output (L) remains the same as the cumulative level of
output (N) increases; there is no learning.

When a is positive, as N gets larger and larger L approaches arbitrarily close to A. A, therefore,
represents the minimum labor input per unit of output after all learning has taken place .That is,
B
lim L  lim ( A  a )
N  N
N 

B
B lim A  lim
 A0  A
lim ( A  a ) = Na
N
N  N  N 

Thus, as the firms cumulative output (N) increases (i.e. as the firm gains higher and higher
experience), the amount of labor required to produce a unit of output decrease and approaches to A
(the minimum amount of labor required to produce a unit of output).The large a is, the more important
learning effect on the labor require Ad to produce a unit of output. For example, with a equal to 0.5,
the labor input per unit of output falls proportionately to the square root of the cumulative output.

Learning vs Economies of scale

A firm‟s average cost of production can decline overtime because of growth of sales (out put) when
increasing returns to scale prevails in the firm (a move from A to B on curve AC,), or it can decline
because there is a learning curve ( a move from A on AC, to C on AC2).Thus, increasing returns to
scale reduces average cost of production with increase in out put, where as learning shifts the average
cost curve down ward.

Cost per unit of out put

Economies of scale
A
B

AC1
Learning

AC2

Out put

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