ODA Special Boarding School

Economics

Grade 9

Unit five: - Introduction to Production and cost

Prepared by:- Fasil H.

 Introduction to production
5.1. Definition to production, input & Output
 Production:-
 is a proc ess of c ombining various inputs to prod uc e an
output for consumption.
 I t i s t he ac t o f c re at i ng o ut put i n t he fo rm o f a
c ommod ity or a serv ic e whic h c ontributes to the utility
of individuals.
 I t i s a pro c e ss i n w h i c h t h e i n pu t s a r e c o n v e r t e d i n t o
outputs.
 For example, when we prod uc e wheat on a plot of land
with the help of inputs like labor, capital and seed s, it is
termed as production of wheat.
 Cont.….
 Inputs
 are economic resources that can be used in the production of
goods and services.
 In economics, there four basic inputs commonly used in the
production of goods and services.
 These are
Labor
 capital
land and
entrepreneurial ability.
 Cont.….
 Outputs;
 are inputs transformed into final and semi-final usable form of
inputs since inputs give less satisfaction to the consumer by
themselves.
 are consequences of the production process.
 We can classify outputs into tangible and intangible ones.
 Tangible outputs are physical products that can be touched.
 Intangible outputs are products, which may have value but are
not physical objects.
 Type of Inputs

 Based on flexibility or adjustment ability in the process of

production inputs are classified in to two;
 Namely fixed and variable inputs.
 fixed input is one whose quantity cannot be varied or not
easily adjusted during the period under consideration.
 Fixed inputs are considered fixed b/c their quantity or
availability remains constant within specific time frame
 Typically Building and machinery are examples of fixed inputs.
 Cont.….
 v a r i a bl e i n pu t s : A n i n pu t w h o s e q u a n t i t y c a n be c h a n ge d o r
adjusted during the period under consideration is known as a
variable input.
 Va r i a b l e i n p u t s p l a y s a k e y r o l e i n d e t e r m i n i n g t h e l e v e l o f
output and can be adjusted to optimize production ef ficiency
and cost effectiveness.
 R a w m a t e r i a l s a n d l a bo r i n pu t s a re e x a m pl e s o f v a r i a bl e
inputs.
 5.2 Periods of Production
 This c lassif ic atio n o f pe rio d s o f pro d uc tio n is mainly base d
on the degree of f lexibility of economic resources to changes
i n busi ne ss e nv i ro nm e nt o f pro d uc t s c o nsum i ng t ho se
re so u rc e s. O r i n sh o r t ba se d o n t h e t ype o f i n pu t u se d i n
production process
• The two periods of production are commonly known as short
run and long run.
 Short run
• Refers to a period of prod uc tion in whic h at least one of the
inputs is fixed while the remaining is variable.
• I nc re ase i n o ut put i n t he sho r t - run c an be bro ught abo ut by
increasing those inputs that can be varied
• For example, if a producer wishes to increase output in the
short run, she/he can do so by using more of variable factors
like labor and raw materials.
 Cont.….
 Long run
 Refers a period of production in which all inputs are variable or there
is no fixed input.
 A firm can install a new plant or construct a new factory building.
 L o n g ru n is t h e pe rio d du rin g w h ic h t h e siz e o f t h e pla n t c a n be
changed.
 Thus, all the factors of production are variable in the long-run.
 NB:- The term plant in economics refers the f irms stock or capital , which are essential for
carrying out production activities.
 w h e n w e s ay s h o r t r u n a n d l o n g r u n i t d o e s n o t n e c e s s a r i l y m e a n a re l a t i v e l y s h o r t o r l o n g
period of time like one year or less than one year or like two or f ive years. It rather refers to
t h e n a t u r e o f e c o n o m i c a r ra n g e m e n t o f t h e i n p u t s i n r e s p o n s e t o t h e c h a n g i n g e c o n o m i c
environment.
 Measurements of production
 The productivity of inputs can be measured in different forms:
 Total product (TP): -it is the overall amount of output
produced by the factors of production employed over a given
period.
 It is the gross or entire output by workers and expressed in
terms of Quantity (Q).
 In the short run production function, a firm obtains its total
product by using a combination of variable inputs with
specific amount of fixed inputs.
 Average product (AP): - a firm’s average product is obtained
by dividing the total output by the number of workers
employed. This can be put in the form of AP=TP/L;
 Where AP=Average Product, TP= Total Product and L=Labor.
 The average product is a good indicator of the productivity of
labor. Productivity is a measure of output per unit input
 Cont.….
 Marginal Product (MP): - holding the quantities of other factors
const a nt , t he increa se in out put which result s from using one
a d d i t i o n a l o r e xt r a u n i t o f a s i n g l e f a c t o r i n p u t , i s c a l l e d t h e
marginal physical product or simply marginal product.

 In ot h er wor d s , a l l ot h er t h i n g s b ei n g equ a l t h e MP i s t h e
percentage change in total output resulting from a percentage
change in variable input.

 MPL = ΔTP/Δ L

 Wh e r e , Δ T P s t a n d s f o r c h a n g e i n t o t a l p r o d u c t i o n Δ L s t a n d s
for change in labor input
 Cont.….
 Both the MP and AP of the variable factor (labor) are derived
from the TP of labor. Thus, the three returns, viz. total product
( T P ) , m a r g i n a l p r o d u c t ( M P ) a n d a v e ra g e p r o d u c t ( A P ) a r e
interrelated.

 NB. L ook at f igure 5.1. t o unde r st and t he st age s of product ion wit h
one variable input.
 5.3 Cost of Production
 T h e c o n c e p t s o f p r o d u c t i o n a n d c o s t a r e i n s e p a ra b l e . T h e c o s t o f
p rodu ction g en erally refers to th e mon etary ou tlays associated w ith
production activity.
 It is the total expenditures and sacrif ices made in the entire process of
production and distribution of goods and services.
Types of Cost of Production
1. Explicit and implicit costs
i. E x p l i c i t c o s t s : T h e s e a r e t h e a c t u a l m o n e t a r y p ay m e n t s o r c a s h
ou tlays th at bu sin ess f irms make to ou tsiders wh o are su ppliers of
inputs or resources to them.
 For example, th e rewards of labor, land, capital, and entrepreneu rs are
all costs for a bu sin ess f irm th at employs th em in cer tain produ ction
 Cont.….
 In a ddi t i on , t h ere a re ot h er pa y men t s ma de for ot h er ra w
materials, fuel, transpor t, sieve, power, and the like are all costs
to a firm.
 Such costs are usually termed “accounting costs” because they
are out-of-pocket costs. Thus, accounting cost refers to the cost
of purchased inputs only, and this only refers to the explicit cost.
i i . Impl i ci t cos t s : a re cos t s s t a n di n g for t h e va l u es of n on -
purchased resources owned
 and used by firms in their own production activities.
 T h ese a re cost s of f ir ms’ own a n d sel f-empl oyed resou rces i n
ca rrying out a ct ivit ies such a s t he sa la ry of a n owner ma na ger
or the estimated rent of a building that belongs to the owner of
a firm, etc.
 The values of these self-owned resources should be estimated
from what they could earn in their best alternative uses.
 Cont.….
2. Economic Cost and Accounting Costs
 It is obvious that costs and prof its are inseparable concepts
o f bu s i n e s s . H e r e , t h e m a i n i d e a i s t o u n d e r s t a n d t h e c o s t
treatment differences and their consequence in cost analysis
of business activities.
 E c o n o m i s t s a n d A c c o u n t a n t s d e f in e a n d t r e a t c o s t s
differently.
 Ec onomists d ef ine c osts in terms of oppor tunity c osts and
they include these implicit costs in profit calculations. Thus,
• Economic cost = Implicit costs + Explicit costs
 Cont.….
 Accounting cost is the monetary value of all purchased inputs
used in production; it ignores the cost of non-purchased (self-
owned) inputs.
 It considers only direct expenses such as wages/salaries, cost
o f ra w m a t e r i a l s, d e pre c i a t i o n a l l o w a n c e s, i n t e re st o n
b o r r o w e d f u n d s a n d u t i l i t y e x p e n s e s ( e l e c t r i c i t y, w a t e r,
telephone, etc.).These costs are said to be explicit costs.
 E x pl i c i t c o s t s a r e o u t o f po c k e t e x pe n s e s f o r t h e pu r c h a s e d
inputs.
 Cont.….
3. Fixed and Variable Costs
 F i x e d c o s t s a r e t h o s e c o s t s t h a t d o n o t v a r y a s t h e f ir m
changes the level of output.
 These are costs that are always incurred even if the firm does
not produce anything.
 The se are also c o sts o f f ixe d inputs. Fo r e xample . re nts o n
leased proper ties, interest on borrowed fund s, the wear and
tear of machineries, cost of administrative staff, etc.
 Cont.….
 Variable c o sts are tho se c o sts o f pro duc tio n that direc tly vary w ith
the level of output of the firm.
 W he n o utput is ze ro v ariable c o sts are also ze ro . B ut as the f irm
expands its output these costs tend to rise.
 In short, variable costs of a firm are dependent on the level of output.
 E x a m p l e s o f v a r i a b l e c o s t s a re w a g e o f w o r k e r s e x c l u d i n g t h e
administrative staff, cost of raw materials, etc.
• Total cost is the sum of total fixed cost and total variable cost.
• Or TC = TFC + TVC
• Where, TC = To tal C o st; TFC = To tal Fixed C o st; TVC = To tal
Variable Cost.
 Cont.….
 Look at figure 5.2. to understand cost curves.
 Average Total Cost (ATC): This is the total cost per unit output
a n d i s c a l c u l a t e d by d i v i d i n g t h e t o t a l c o s t by t h e q u a n t i t y
produced.
 This means that ATC = TC/Q.
 It can also be divided into two parts, like the average variable
cost (AVC) and the average fixed cost (AFC).
 Thus, ATC = TFC/Q + TVC/Q, AFC = TFC/Q, and AVC = TVC/Q.
 AFC + AVC = ATC
 Cont.….
 M a r g i n a l C o s t ( M C ) : - i t i s t h e e x t ra o r a d d i t i o n a l t o t a l c o s t
t h a t r e s u l t s f r o m pr o d u c i n g o n e m o r e u n i t o f o u t pu t ; o r i t i s
the change in total cost resulting from a percentage change in
output, i.e.
MC = ΔTC/ΔQ or ΔTFC/ΔQ +ΔTVC/ΔQ
or MC = ΔTVC/ΔQ, when ΔTFC=0 (in the short run)