MMB 4163

BUSINESS ECONOMICS

Learning Unit 4:

Theory and Costs of Production

Tan Chiang Ching

School of Business and Management
University of Technology Sarawak (UTS)
96000 Sibu, Sarawak
LEARNING OUTCOME

▪ Describe the classification of factors of production

▪ Describe several concepts of firms and economic costs
▪ Draw the curves of short-run costs
▪ Explain the curves of short-run costs
▪ Relate the various measures of short-run costs with the long-run costs
and their differences
▪ Evaluate why the long-run average costs curve has a U-shape.

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Definition of Production
■ Production means the process of using the factor of production to
produce goods and services.

■ Production is the process of transforming inputs into outputs.

INPUTS OUTPUTS

Inputs refers to the Refers to what we get

factors of production Processing at the end of the
that a firm use in the production process
production process. that is finished
products.

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Definition of Production
▪ Factors of production refers to the goods and services which assist
the production process. Factor of production is a group or class of
productive resources. Some economists use the term ‘input’ in place
of ‘factors’, where various inputs are used to produce outputs.

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 Classification of Factors of Production

LAND LABOUR
All natural resources Physical or mental
or gift of nature activities of human beings

CLASSIFICATION
OF FACTORS
OF PRODUCTION

CAPITAL
Part of man-made wealth
used for further production
ENTREPRENEUR
A person who combines the different
factors of production, and initiates
the process of production and also
bears the risk
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Production Function
▪ A production function is a statement of the functional relationship
between inputs (factors of production) and outputs (goods and
services), where it shows the maximum output that can be produced
with given inputs.

Q = (K, L, M, etc.)

Where: Q = Quantity of Output

K = Capital
L = Labour
M = Raw Material
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Short Run and Long Run Production Function
▪ What is short run? What is long run?

▪ Short-run and Long-run Periods

▪ Short run period is the time frame, which at least one of the inputs
(factor of production) is fixed and other inputs can be varied.

▪ Long run period is the time frame which all inputs are variable. In
the long run, firms can alter the inputs to increase the output.

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Short Run and Long Run Production Function
▪ Two Types of Factor Inputs

▪ Fixed Input
▪ An input which the quantity does not change according to the
amount of output.
▪ Example: Machinery, land, buildings, tools, equipment, etc.

▪ Variable Input
▪ An input which the quantity changes according to the amount of
output.
▪ Example: Raw materials, electricity, fuel, transportation,
communication, etc.

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Short Run and Long Run Production Function
▪ In the short run, we assume that at least one of the inputs is fixed
that is capital.

▪ Therefore, in the short run the production function can be written as

Q = ( K , L)
Where: Q = Output
L = Labour (variable input)
K = Capital (fixed input)

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Short Run Production Function

TOTAL PRODUCT (TP)

The amount of output produced when a given amount of
That input is used along with fixed inputs.

AVERAGE PRODUCT (AP)

Divide the total product by the amount of that input
used in the production

Average Product (APL) = Total Product

Total Labour
APL = TP/ L 10
Short Run Production Function

MARGINAL PRODUCT (MP)

Change in the total product of that input corresponding to an addition
unit change in its labour assuming other factors that is capital fixed.

Marginal Product (MPL) = Change in Total Product

Change in Total Labour

MPL =  TP/  L

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Table 1: Total Product, Marginal Product and
Average Product

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Figure 1: Total Product, Marginal
Product and Average Product
Stage I: Increasing Returns

Stage I begins with the usage of the

first labour until the maximum point
of APL. At this level, both, the
average product and marginal
product are positive. Since the
marginal product exceeds average
product, average product increases.

Stage I is an irrational production

level because AP can always be
increased by adding in labour. An
increased return to fixed input also
L occurs at this level. Therefore,
rational producers will not operate
at this level.

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Figure 1: Total Product, Marginal
Product and Average Product
Stage II: Diminishing Returns

Stage II is the area between the

maximum point of APL and the
point where MPL is zero. Both
MP and AP are still positive but
MP is less than AP. Thus, AP
decreases.

Rational producers will operate

at this level because the
marginal product of fixed input
and variable input is positive.
L

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Figure 1: Total Product, Marginal
Product and Average Product
Stage III: Negative Returns

Stage III covers the area of

negative MPL and total
product decrease. This
means that additional
variable input will further
decrease the total output.

Rational producers will not

operate at this level.

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What Are Costs?

▪ The Firm’s Objective

▪ The economic goal of the firm is to maximize profits.

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Economic Profits VS Accounting Profits

▪ Profit is the difference between total revenue (TR) with total cost
(TC).

▪ The calculation of profit from the perspective of an economist

differs from the calculation of profit by an accountant.

▪ Accountant only consider the explicit costs and hence the profit
calculated is referred as the accounting profit.

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Economic Profits VS Accounting Profits

▪ For an economist, the explicit costs and implicit costs are both
taken into account and profit calculated is known as the economic
profit.

▪ Implicit cost refers to opportunity cost.

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Explicit Costs and Implicit Costs

▪ Explicit cost is the market value of all inputs purchased by a

producer (direct outlay of money by the firm).

▪ Implicit cost is the market value of inputs owned by the producer

himself (do not require an outlay of money by the firm).

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Figure 2: Economic versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

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Total Revenue, Total Cost and Profit

▪ Total Revenue
▪ The amount a firm receives for the sale of its output.

▪ Total Cost
▪ The market value of the inputs a firm uses in production.

▪ Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

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Production Costs in the Short Run

▪ Fixed costs are costs that do not change according to change in

output.

▪ Variable costs are costs that change along with the change in output.

▪ Total cost of a firm is the economic cost of the firm.

TC= FC + VC

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Table 1: TC, FC and VC

OUTPUT FC VC TC

0 50 — 50

5 50 10 60

15 50 20 70

30 50 30 80

50 50 40 90

75 50 50 100

95 50 60 110

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Figure 3: TC, FC and VC

Cost ($)
TC

VC

FC

Output
0

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Average Cost

Fixed Cost
▪ Average Fixed Cost =
Total output
𝐹𝐶
AFC =
𝑄

Variable Cost
▪ Average Variable Cost =
Total output
𝑉𝐶
AVC =
𝑄

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Average Cost

Total Cost
▪ Total Average Cost =
Total output
𝑇𝐶
AC =
𝑄

OR

AC = AFC + AVC

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Marginal Cost

▪ Marginal cost is the change in total cost caused by one unit of

output change

▪ 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?

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Marginal Cost

Change in Total Cost

▪ Marginal Cost =
Change in Total Output

∆ TC
MC =
∆Q

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Table 2: Total Costs, Average Costs and Marginal Costs

OUTPUT FC VC TC AFC AVC AC MC

0 50 — 50 — — — —

5 50 10 60 10 2 12 2

15 50 20 70 3.33 1.33 4.67 1.00

30 50 30 80 1.67 1.00 2.67 0.67

50 50 40 90 1.00 0.80 1.80 0.50

75 50 50 100 0.67 0.67 1.33 0.40

95 50 60 110 0.63 0.63 1.16 0.50

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Figure 4: Average Cost and Marginal Cost Curves

Cost

MC AC

AVC

AFC

Output
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Differences between Long-Run and Short-Run Costs

▪ There are no fixed cost in the long-run. Hence,

TC = VC

▪ The law of diminishing marginal returns does not occur in the long-
run because the firm is able to change all inputs and hence does
not influence the long-run costs curve.

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Differences between Long-Run and Short-Run Costs

▪ Producers cannot build a plant that is tandem with the long-run

average costs curve (LRAC). This is because each plant has its own
short-run costs;

▪ Long-run is also the planning period for a firm. The producer will
plan to increase production if demand of products is increasing
and vice versa.

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Figure 5: Average Total Cost in the Short and Long
Run
Average
Total
Cost
SRAC₁

SRAC₂
SRAC₃

LRAC

0 Output
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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.

▪ Diseconomies of scale refer to the property whereby long-run

average total cost rises as the quantity of output increases.

▪ Constant returns to scale refers to the property whereby long-run

average total cost stays the same as the quantity of output
increases

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Figure 6: Average Total Cost in the Short and Long Run
Average
Total
Cost
LRAC
SRAC₁

SRAC₂
SRAC₃

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 Output
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Economies of Scale: Factors Influencing Decline of LRAC

▪ Labour specialisation - can be increase the size of the plant

increases. When more workers are hired, it would be easier to
perform more specialised tasks.

▪ Efficiency of Management - can be achieved when the size of the

plant increases and managers can increase efficiency by managing
more workers and more materials.

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Economies of Scale: Factors Influencing Decline of LRAC

▪ Efficiency of Equipment Usage

▪ When the size of the plant increases, usage of capacity can be
increased.

▪ Technical Economics
▪ Economies of scale arise due to technological improvements in
production. Large firms have more resources and more modern,
sophisticated machines. So, these firms will produce at
maximum capacity, fully utilizing machinery and reducing
average cost.

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Diseconomies of Scale

Can be caused by decreasing returns to scale or other factors which

includes:

▪ Management problems – Diseconomies of scale arise due to the

difficulties of managing large firms. Miscommunication, a lack of
cooperation, coordination and supervision of the work of different
departments, and poor specialization can all occur in large firms.
These will incur additional management cost.

▪ Labour diseconomies – When division of labour is pushed beyond

a point, indivisibility factors occur. Specialization can lead to
disinterest and boredom, thus reducing productivity. Once
productivity drops, the average cost will rise.
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Constant Economies / Return of Scale

▪ Caused by constant return to scale when output increase is

equivalent to input increase.

▪ The LRAC is horizontal.

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Thank You

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