3.

THEORY OF PRODUCTION AND

COSTS
PRODUCTION-The process by which inputs are
combined, transformed and turned into
outputs

FIRM- an organisation that comes into being

when a person or a group of people decide to
produce a good or service to meet a perceived
demand
• Most firms exist to make a profit i.e. The main
objective of a firm is to maximize profits
• All firms must make some decisions in order
to achieve their objective of profit
maximization
• 3 decisions that all firms must make are
1. How much output to supply (quantity of the
product)
2. How to produce the output (which
production technique/technology to use)
3. How much of each input to demand
 ECONOMIC COSTS AND PROFITS
• ECONOMIC COSTS: payments a firm must
make or incomes it must provide to attract
resources it needs away from alternative
production opportunities
• i.e. Economic costs are the opportunity costs
of resources used, whether the resources are
owned by others or by the firm
• EXPLICIT COSTS: monetary payments (or cash
expenditure) a firm makes to those who
supply labour services, material, fuel etc
• Such monetary payments are for the use of
resources owned by others
• IMPLICIT COSTS: the opportunity costs of
using a firm’s self-owned, self-employed
resources
• To the firm, implicit costs are the money
payments that self employed resources could
have earned in their best alternative use
• The economic objective of a firm is to
maximize profit
• Profit = Total revenue – total cost
• i.e. Profit = TR –TC
• TR =P.Q
• TC is the market value of the inputs a firm
uses in production (i.e. The amount that a firm
pays to acquire inputs)
Economic Profits Vs Accounting Profits
• Economist measure a firm’s economic profits
as total revenue less total costs. Total costs
includes both implicit and explicit costs.
• Accountants measure accounting profits as
the firm’s total revenue minus only explicit
costs.
• Illustration
Use the following cost information for a production unit

• Entrepreneur's potential earnings as a salaried worker = P75, 000

• Annual lease on building = P60, 000
• Annual revenue from operations = P550, 000
• Payments to workers = P180, 000
• Utilities (electricity, water, disposal) costs = P20, 000
• Entrepreneur's potential economic profit from the next best
entrepreneurial activity = P100, 000
• Entrepreneur's forgone interest on personal funds used to finance
the business
• = P60, 000
By using the above information calculate the
following:

a) Explicit costs
b) Implicit costs
c) Total economic costs
d) Accounting profit
e) Economic profit
Short run and long run
• Short run (SR)
• A period of time in which at least one factor of production is fixed in
quantity (i.e. Cannot be varied).
• In the short run at least two conditions hold
i. The firm is operating under a fixed scale of production
ii. Firms can neither enter nor exit an industry
n.b. In the SR, the firm can vary its output by applying larger or smaller
amounts of labour, materials and other resources to the fixed
plant

• Long run (LR): the time period when all factors of production are
variable
• A period long enough for the firm to adjust the quantities of all the
resources it employs , including plant capacity.
• In the LR,
i. There are no fixed factors of production
ii. Firms can increase or decrease their scale of
operation
iii. New firms can enter and existing firms can
exit the industry
• EXAMPLE
• If Boeing hires 100 extra workers for one of its
commercial airline plants or adds an entire
shift of workers, we are speaking of the short
run
• If Boeing adds a new production facility,
installs more equipment, we are speaking of
the long run
 SHORT-RUN PRODUCTION
RELATIONSHIPS
PRODUCTION FUNCTION: A numerical or
mathematical expression of a relationship
between inputs and outputs
• it shows units of total product as a function of
units of inputs
• E.g. Q= f(K,L)
• In the short run, only L is varied therefore
 
Q  f ( K , L)
PRODUCTION-The process by which inputs are
combined, transformed and turned into
outputs

FIRM- an organisation that comes into being

when a person or a group of people decide to
produce a good or service to meet a perceived
demand
• TOTAL PRODUCT (TP) –Total quantity or
output produced
• MARGINAL PRODUCT (MP) – change in total
product which comes about as a result of
change in labour
• AVERAGE PRODUCT (AP) – Total product per
unit of the variable factor of production
 LAW OF DIMINISHING RETURNS/LAW OF DIMINISHING
MARGINAL PRODUCT/LAW OF VARIABLE PROPORTIONS

• As successive units of a variable resource (say

labour) are added to a fixed resource (say,
capital or land), beyond some point the extra,
or marginal product attributable to each
additional unit of the variable will decline.
Suppose you are given the table below
Units of the variable input (Labour) Total Product
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
• Total product rises, reaches a maximum and
declines
Total Product Curve
Units of the Variable Input Total Product (TP) Average Product (AP)
(L)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
Quantity of Labour Total Product (TP) Average Product Marginal Product
(AP) (MP)
0 0 -
1 10 10
2 25 12.5
3 45 15
4 60 15
5 70 14
6 75 12.5
7 75 10.71
8 70 8.75
• Initially the MP increases and its positive.
• Then it declines
• MP is equal to zero at the maximum of the
total product curve
• When the MP is rising the AP is rising and
when MP is falling AP is falling
• MP=AP at the maximum of AP
• At what point does diminishing returns set in?
Shape of MP and AP curves
 Relationship between MP and TP
• MP rises when TP increases at an increasing
rate, and declines when TP increases at a
decreasing rate.
• MP is negative if TP declines when labor use
rises
Relationship of AP and MP
 Relationship between AP and MP

• AP rises when MP > AP

• AP falls when MP < AP
• AP is at a maximum when MP = AP
 Computation of AP and MP
• Computation
Quantity
of labor TP AP MP
0 0 -
10
5 50 10
14
10 120 12
12
15 180 12
8
20 220 11
6
25 250 10
4
30 270 9
1
35 275 7.86
0
40 275 6.88
-1
45 270 6
Total, Marginal and Average Product
• Total product (TP): the total output relative to the
variable input
• Marginal Product (MP): the change in TP due to a
one unit change in the variable input.
total product Q
MPL  
labour input L
• Average Product (AP): the total product divided by
the quantity of the variable input.

Total product Q
APL  
Total labour input L
 TP
MPL   slope of TP curve
L
Thus, the MPL at any point is the slope of the TP curve
at that point.
TP

TP

∆TP
A •

∆L

L
The Relationship Between TP, MP and AP

Labor input TP AP=TP/L MP=

0 0 - -
1 60 60
2 135 67.5
3 210 70
4 280 70
5 340 68
6 380 63.3
7 380 54.3
8 370 46.3
Figure 13: Total, Average and Marginal Product Curves
Features of the Diagram
i. As long as MP is positive, TP is rising. TP reaches a maximum when
MP=0 and begins to fall thereafter.
ii. When MPL is greater than APL, the AP is rising and the MP lies above
it.
iii. When MPL is less than APL, the AP is falling and the MP curve lies
below it.
iv. The MPL intersects the APL at the maximum point of the AP curve.
Thus, the two are equal at the maximum of the AP curve.
v. MPL is equal to zero when the TP is at a maximum.
vi. Point A lies on the line which is from the origin and tangent to the
TP curve. This point is the maximum of the MP curve.
vii. Where the MP curve is at a maximum, the corresponding point on
the TP curve, A is called the inflexion point. Point A is where
diminishing marginal returns set in, i.e. it is the point where the TP
curve switches from increasing at an increasing rate to increasing at a
decreasing rate.
Stages of Production
• Stage I: APL is rising; MPL rises, reaches a maximum and then begins
to fall. Since TP is increasing, MPL is positive.
• STAGE II: Both APL and MPL are declining, but since TP is rising, MPL is
still positive
• STAGE III: APL continues to decline; TP starts to decline and therefore
MPL becomes negative.
At which stage should firms produce?
•No firm would want to produce at Stage III. This is because at stage III,
further increments of the variable input leads to a decline in TP.
•At Stage I, there is still opportunity to increase TP by increasing the
variable input. Therefore, even though TP is still positive, producing at
this stage is not optimal because it is still possible to increase labor input
and in turn increase TP. TP is increasing at an increasing rate.
•Stage II is the most ideal stage of production. Even though TP is
increasing at a decreasing rate, it is still increasing, hence it is till
worthwhile to produce. This is known as the economic region of
production.
 Short Run vs Long run
• Short run
• Long run – a period of time long enough to
enable producers to change the quantities of
all the resources they employ
• Short run costs:
– fixed costs – costs that do not vary with the level
of output. Fixed costs are the same at all levels of
output (even when output equals zero).
– variable costs – costs that vary with the level of
output (= 0 when output is zero)
 Cost curves
• Total Costs
– Total Fixed Costs (TFC)
– Total Variable Costs (TVC)
– Total Costs (TC)
– TC = TFC + TVC
Short run Vs Long run
Total Fixed Cost
Total Variable cost
TC, TVC, TFC
 Average costs
• Average Costs
– Average Fixed Costs (AFC)
– Average Variable Costs (AVC)
– Average Total Costs (ATC)
– ATC = AFC + AVC
 Average Fixed Cost
• Average fixed cost (AFC) = TFC / Q
 Average variable cost
• Average variable cost (AVC) = TVC / Q
 Average total cost
• Average total cost (ATC) = TC / Q
• ATC = AFC + AVC (since TFC + TVC = TC)
 Marginal cost
• Marginal Cost
– Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an additional unit of
output?
 Marginal cost

(change in total cost) TC

MC  
(change in quantity) Q
Marginal cost
AFC
AVC, ATC, MC
 MC,AVC, ATC
• MC rises with the quantity of output
• The AC curve is U-shaped
• The MC curve intersects the AVC and ATC at their
respective minimum points
• MC curve reflects the law of DMP
– At low levels of output, few workers are hired, much of the
equipment are unused
– MP of an extra worker is large
– MC of an extra unit produced is small
– At larger outputs, MP is of an extra worker is low, MC of an
extra unit produced is large
 ATC
• ATC=AFC + AVC
• AFC always declines as output rises because
fixed cost is spread over larger number of
units
• AVC rises as output rises because of DMP
• ATC reflects the shape of the AFC and AVC
curves
 LONG RUN cost curves
• For many firms, the division of total costs between
fixed and variable costs depends on the time horizon
being considered.
– In the short run, some costs are fixed.
– In the long run, fixed costs become variable costs.
• Because many costs are fixed in the short run but
variable in the long run, a firm’s long-run cost curves
differ from its short-run cost curves.
L-R cost curves
 LR cost curves
• In the long run, a firm may choose its level of
capital, and will select a size of firm that
provides the lowest level of ATC.
Economies and Diseconomies of Scale
• Economies of scale refer to the property
whereby long-run average total cost falls as
the quantity of output increases.
– Economies of scale – factors that lower average
cost as the size of the firm rises in the long run
– Sources: specialization and division of labor,
indivisibilities of capital, etc.
Economies and Diseconomies of Scale
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as
the quantity of output increases.
– Diseconomies of scale – factors that raise average
cost as the size of the firm rises in the long run
– Sources: increased cost of managing and
coordination as firm size rises
Economies and Diseconomies of Scale
• Constant returns to scale refers to the
property whereby long-run average total cost
stays the same as the quantity of output
increases
Economies of Scale