The Theory of Supply

The Factors of Production (inputs)

This is defined as the economic resources that are used to produce goods and services. This is
divided into four categories:

Land – this is all the natural resources, usable in the productive process. Such resources as arable
land, forests, mineral and oil deposits and water resources come under this classification. Land
has the following features:
 Fixed in supply
 Geographically immobile
 No cost of production attached

Capital – or investment goods, is all manufactured aids to production, that is, all tools,
machinery, equipment and factory, storage, transportation and distribution facilities used in
producing goods and services and getting them to the ultimate consumer. The process of
purchasing capital goods is known as investment. It carries the following features:
 Physical or financial
 Man-made so units of the same type of capital are homogenous
 Generally mobile
 Can be imported

Labour - This is a broad term that economists use for all the physical and mental talents of
humans available and usable in producing goods and services. It is the human contribution to the
production process which consists of time and energy spent producing the output. Labour carries
the following features:
 Skilled, semi-skilled and unskilled
 More geographically and occupationally mobile
 Not homogeneous
 No separation between labour and service
 Cannot be stored

Entrepreneurial Ability - This is the initiating and organizing of the production of new goods or
the risk taking associated with it.

The Theory of Production

Production - this is the process of converting inputs into outputs. Production process involves:
Input Throughput Output

Short run: - this is a time frame (less than a year) in which the quantities of some resources are
fixed. Examples are technology, land, and capital.

Long run: - this is a time (more than a year) frame in which all the factors of production are
variable.

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Fixed factor: - This is an input that cannot be varied in the short run, e.g. buildings or land.

Variable factors: - factors that can be varied in the short run to increase or decrease the level of
production e.g. labour or raw materials.

What is the relationship between the quantity of inputs used and the quantity of production?
To answer this question, we look at the concepts of total, average and marginal products.

Total physical product: - is the total quantity of a good produced in a given period. TPP or TP
is an output rate – the number of units produced per unit of time. Example, the TP schedule lists
the maximum quantities of bottled water per hour that a firm can produce with its existing plant
at each quantity of labour or other inputs.

Marginal Physical Product: - This is the additional output produced when one additional unit
of input is employed. It is the change in total product that results from a one-unit change in the
quantity of labour employed holding all other inputs constant. This is calculated as:

Average Physical Product (APP or AP): - is the total product per worker employed or the total
output produced per unit of resource employed. It is calculated as TP divided by the quantity
resource employed.

APP is largest when it is equal to MP, that is, the MP curve cuts AP curve at its maximum point,
see graph below. When MP > AP, AP will increase. When MP < AP, AP will decrease.
For example, if the TPP of 4 input (L) is 20 units and the MPP from the 5th input (L) is 10 units.
What is the effect on the APP.
APP = TPP/L i.e. 20/4 = 5 units per worker
APP 2 = 30/5 = 6 units per worker

If MPP for the 5th input of labour was 2 units

TPP for 5 units of input = 22
APP = 22/5 = 4.4 units per worker

Increasing Marginal Returns (IMR):- this occurs when the marginal product of an additional
worker exceeds the MP of the previous worker. IMR usually occurs when a small number of
workers are employed and arise from increased specialization and division of labour in the
production process.

Decreasing Marginal Returns: - this occurs when the MP of an additional worker is less than
the MP of the previous worker. DMR arise from the fact that more and more of the variable
factor (labour) is added to the fixed factors (e.g. land).

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The law of Diminishing Marginal Returns: - this law states that as additional quantities of the
variable resources are combined with a given amount of fixed resources, a point is eventually
reached where each additional unit of the variable resource yields a smaller MP. In other words,
when one or more factors are held fixed, there will come a point beyond which the extra output
from additional units of the variable factor will diminish. Put another way, as long as more and
more variable factor is added to a fixed factor there will come a point when the output produced
by the variable factor will start to decrease.

Let’s examine these product curves:

labour (TPP) (MPP) (APP)

Gallons/hr Change TPP/L
TPP/Change L
0 0 - 0
1 1 1 1
2 3 2 1.5
3 6 3 2
4 8 2 2
5 9 1 1.8
6 9 0 1.5
7 8 -1 1.1

Production Function as a Graph

10
8
6
output

4
2
0
-2 0 1 2 3 4 5 6 7
(AP)
Labour (TP)
(MP)

Production Function

This shows the volume of output that can be produced from given inputs (such as labour and
capital), given the available technology. In other words, it’s a functional relation showing the
maximum output that can be produced by each and every combination of inputs. Since the
quantity of output depends upon the quantities of inputs used, the relationship can be depicted in

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the form of functional notation: Q = f (I1, I2,,,In), where Q = output of a product and I1, I2, etc, are
quantities of the various factor inputs 1, 2, etc, used in producing that output.

Production and its stages

To simplify the interpretation of a production function, it is common to divide its range into 3
stages. Examine the graph below:

In Stage 1 (from the origin to point B) the variable input is being used with increasing efficiency,
reaching a maximum at point B (since the average physical product is at its maximum at that
point). The average physical product of fixed inputs will also be rising in this stage (not shown in
the diagram). Because the efficiency of both fixed and variable inputs is improving throughout
stage 1, a firm will always try to operate beyond this stage. In stage 1, fixed inputs are
underutilized.

In Stage 2, output increases at a decreasing rate, and the average and marginal physical product
is declining. However, the average product of fixed inputs is still rising. In this stage, the
employment of additional variable inputs increases the efficiency of fixed inputs but decrease the
efficiency of variable inputs. The optimum input/output combination will be in stage 2.
Maximum production efficiency must fall somewhere in this stage. Note that this does not define
the profit maximizing point. It takes no account of prices or demand. If demand for a product is
low, the profit maximizing output could be in stage 1 even though the point of optimum
efficiency is in stage 2.

In Stage 3, too much variable input is being used relative to the available fixed inputs: variable
inputs are over-utilized. Both the efficiency of variable inputs and the efficiency of fixed inputs
decline throughout this stage. At the boundary between stage 2 and stage 3, fixed input is being
utilized most efficiently and short-run output is at its maximum.

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Complete the table below:
Inputs of variable Total Product Marginal product Average Product
resource (labour) (output)
0 0 --- 0
1 10 10 10
2 24 14 12
3 37 12 12.3
4 47 10 11.8
5 55 8 11
6 60 5 10
7 63 3 9
8 63 0 7.9
9 62 -1 7
1. Identify the points of increasing marginal returns and diminishing marginal return
2. Plot all three curves on a graph. (Labour is on the x-axis, TPP, MPP, APP is on the y-axis)

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 Stage 1
Stage 2 Stage 3

The Theory of Costs

Most companies analyze costs in order to try and improve their performance. But what are these
costs and why are they important. In this section we will examine, calculate and draw the
different costs curves.

Total cost (TC)

This is the cost of all the resources necessary to produce any particular level of output. TC
always rises with output. This is because obtaining lore output always require more input. It is
the summation of Fixed costs and variable costs, i.e. TC = TFC + TVC

Total Fixed costs (FC or TFC)

These are costs which do not alter with output in the short-run. Fixed costs usually comprise
such things as building and machinery as these costs will be incurred whether or not the business
is producing. (diagram) examples are rent and insurance,

Total Variable Costs (VC or TVC)

These are costs which change as output changes. Variable costs are zero when output is zero and
rise directly with output. It is the change in total cost associated with each change in the quantity
of output. It is assumed that the unit variable cost will remain constant, but the total variable cost
will increase with increasing output. E. g. sales commission where it is treated as a fixed
percentage of sales turnover and telephone call charges. (diagram)

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Putting it all together:
The graph below shows Total cost where the costs involved have a fixed and a variable element.

AVERAGE COSTS
This is categorized under three headings:

Average Total Cost (ATC or AC) is the total cost per unit of output. This the total cost divided
by the number of units of the commodity produced. This is expressed as:
AC (ATC) = Total costs = TC = AFC + AVC
Output
Q

This curve is U-shaped in the short run. ATC starts at infinity and then falls rapidly as the
fixed costs are spread over more and more units. It continues to fall until the point of optimum
efficiency is reached. ATC then begins to rise as diminishing returns set in.

ATC is the sum of the AFC and the AVC. This will affect the shape of the ATC curve. The
ATC is U-shaped. Initially the ATC curve falls because it is being pulled down by the AFC and
AVC that are also falling. It continues to fall until it reaches its minimum point. However, the
AVC curve will start rising at some point while the AFC curve will continue to fall but not by
the same amount as before. (AFC is decreasing at a decreasing rate). The rise in the AVC is at a
higher rate than the fall in the AFC. This will result in an increase in the ATC thus pulling up
the curve.

Average Fixed Costs (AFC) is TFC per unit of output for any output. This found by dividing
TFC by the output: TFC or ATC – AVC
Q
TFC will be spread so long as output increases, in other words, AFC will decline so long as
output increases. For a given TFC of $100 as output increase the TFC per unit will decrease

AFC for 5 units = 100/5 = $20

AFC for 10 units = $100/10 = 10
AFC for 50 units = $100/50 = 2

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Average Variable Costs (AVC) is TVC per unit of output. The AVC for any output is
calculated by dividing total variable costs (TVC) by that output (Q): AVC = TVC
Q
Or AVC = ATC - AFC
AVC declines initially, reaches a minimum and then increases again. Graphically, this is a U-
shaped or saucer-shaped curve

Marginal Costs
This is the extra, or additional, cost of producing one more unit of output. MC can be
determined for each additional unit of output by noting the change in total cost which that unit’s
production entails. MC = change in TC
Change in Q
When plotted, the MC curve first falls and then rises, presenting a similar U-shape to the AC
curve. This is because the same principles of diminishing returns apply to marginal costs in the
short run as they do to all other costs.

Examine the table below and complete it:

Output TFC AFC TVC AVC TC ATC MC
(Q) units
0 12 - 0 - 12 -
1 12 12 10 10 22 22 10
2 … 6 16 … 28 … …
3 … … 21 7 … … …
4 … 3 … … 40 … 7
5 … 2.4 … … 52 10.4 12
6 … … … 10 … 12 …
7 … 1.7 91 13 103 … 31

Sunk costs are costs that cannot be recouped. It is any expenditure on durable and specific factor
inputs such as plant and machinery that cannot be used for other purposes or easily be resold.
Sunk costs have no effect on MC and do not influence short term output decisions.

The relationship between AC and MC

As long as new units of output cost less than the average, their production must pull the average
cost down, that is, if MC is less than AC, AC must be falling. If the extra cost of making one
more unit of the product (MC) is less than the cost per unit (AC) the average cost will fall.
Example: if the average cost of a unit is $5 and the firm produces an extra unit of the product for
$1 then the average cost will fall. TC = 6. New Atc = 6/2 answer 3

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Likewise, if new units cost more than the average, their production must drive the average up,
that is, if MC is greater than AC, AC must be rising. Example. If the AC of producing 1 unit is
$5 and the firm produces an extra unit for $9, AC will rise. TC = 14, New Atc = 14/2 ans 7
Therefore, the MC crosses the AC at its minimum point. Examine the diagram below:

The shape of the long run ATC curve

Like the short run ATC curve, the long run ATC (LAC) curve is also U-shaped; however the
reasoning is slightly different. Since all the factors in the long run are variable, the law of
diminishing return would not apply here. The reasoning behind the shape of the LAC is the
change in the scale of operations. When the LAC curve slopes downwards, it means that the AC
decreases as output increases. Whenever this happens the firm is experiencing economies of
scale. If the LAC curve slops upwards, the firm is incurring increases in average costs as output
increases. The firm is said to be experiencing diseconomies of scale. Finally, if the LAC curve
is invariant to changes in output, the firm is experiencing constant return to scale. This is shown
in the diagram below:

Additional information will be given in class