Production and Cost

Dr. Divya Gupta

Economics I

Dr. Divya Gupta Production and Cost Economics I 1 / 26

References

Neva Goodwin: Chapter 16

Mankiw: Chapter 13

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Producer’s Theory: Basic Assumptions
Recall that our discussion on the free market mechanism has taken a
producer’s ‘supply curve’ as given.
Previously, we de-constructed the demand curve - and understood the
‘rational consumer behaviour’ that leads to it.
Now likewise, in the producer’s theory, we focus on the supply curve.
We will investigate what all decisions a producer takes - what to produce,
how to produce, how much to produce, how much to sell it for; and on what
motivations - profit, that help us derive the supply curve.
For this purpose, we start with a few simplifying assumptions:
We only consider supply decisions of ‘for-profit’ firms/businesses -
leaving aside public sector firms - which produce for social welfare, and
some private sector firms which are non-profit organisations such as
private schools, universities and hospitals.
Recall that neo-classical theories focus on ‘self-interest maximisation’
by individuals. In case of consumers, this self-interest was their own
utilities; now, in case of producers, this self-interest is their profits.
Thus, we assume that private firms will always take decisions with an
objective of ‘profit-maximisation’.
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What is Production?
Production, loosely speaking, is the process of making something; or the
process of conversion of inputs into output.
In economics, a ‘production function’ can be defined as a technical
relationship between types and quantities of inputs and the quantity of
output.
Mathematically, it can be defined as: Y = f (inputs), where Y is the
quantity of output. Thus, production function defines output as a technical
function of inputs.
Example: If the output is that of production of corn, then the inputs could
be seeds, fertilisers, pesticides, land, labour etc.
These inputs can be broadly categorised into - variable inputs and fixed
inputs.
Variable Inputs - a production input whose quantity can be changed
relatively quickly, resulting in changes in the level of production.
Example: Labour.
Fixed Inputs - production input that is fixed in quantity, regardless of
the level of production. Example: Land, Capital, Technology etc.
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Production Function
As discussed previously, a production function is the systematic relation
between inputs and output.
Considering the two categories of inputs, we can see that the fixed
inputs/factors cannot be changed very quickly, and hence require a longer
time period to be adjusted to ensure increase in production capacities.
Example: expanding the size of a garment factory by buying more of plant
and machinery, or expanding the size of a Subway outlet by putting more
counters and buying additional land etc.
Thus, the only way to increase output in the short-run is to increase the
quantity of variable inputs. Example: increasing the number of workers in a
factory, increasing the quantity of bread and veggies as raw materials to
make more sandwiches at a Subway outlet.
This relationship, however, between increased quantity of variable inputs and
output is not straightforward.
That is, there is not always a one-to-one increase in output, every time a
variable input increases by one additional unit.
This can be summarised and explained by a S-shaped production function.
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Production Function (contd.)

Before we explain the S-shaped production function, let’s lay down a few
assumptions and definitions:
Let’s assume only two inputs in the short-run - Labour (L) and
Capital (K).
Labour is the variable input and Capital is the fixed input.
Thus, output is given by: Y = f (L, K ).
As stated previously, the only way to increase output is by increasing
labour - L.
Thus, the increases in output would be contributed by what is called
as the ‘marginal returns to labour’ (because capital is fixed), or
‘marginal product of labour’.
Marginal Product of labour (MPL) is the additional quantity of output
produced when labour is increased by a small amount at the margin.

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Production Function (contd.)
Now, let’s take an example of a Subway outlet (the fast food restaurant) to
investigate the relation between output and labour.
The output is the sandwiches, fixed inputs (K) are the sandwich counter,
cash counter, other machine and equipment; and variable input is the
labour/workers employed in the store - who are responsible for making the
sandwiches and also maintain the cash counter.
The relation between number of sandwiches (output) and increasing number
of workers (variable input) can be shown as:

Number of Workers Total Product (TP) Marginal Product of Labour (MP

0 0 -
1 50 50
2 90 40
3 120 30
4 140 20
5 150 10
6 155 5
7 155 0
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Law of Diminishing Marginal Product

Based on the table on previous slide, we can observe the following patterns:
There is a positive relation between output and input.
This relation, however, is not constant.
Initially, when the number of workers increased from 1 to 2, the total
product increased by 40. This is because increasing the number of workers
allows specialisation. That is, in the same kitchen, with a fixed space - one
oven and one counter only, the productivity of each worker initially increases
- as one worker can now make sandwiches and the other can handle the cash
counter.
However, with the same fixed space, if the number of workers continue to
increase, gradually the productivity of each worker starts to decline, due to
to factors like over crowding in the kitchen space, coordination failures
within the larger team etc.
This property is called as the ‘law of diminishing marginal
productivity/product (DMP)’.

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Production Function

The law of diminishing marginal product, thus, gives a production

function that looks like:

As we can see, although the total product increases, the amounts of

increases in the output continues to decline.

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S-Shaped Production Function
A more complete production function is the one that is S-shaped (figure below),
which incorporates three stages of production, as shown in the figure below:

1 Stage I: Increasing Marginal Returns: Initially, at very low levels of input

and output, due to high productivity, the marginal product (MP) of labour
increases, as quantity of labor increases. This is due to factors like
specialisation and division of labour etc. (recall the Subway example). At
this stage, the total product/output (TP) increases very rapidly, i.e. at an
increasing rate. Hence, the production function is convex.
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S-Shaped Production Function (contd.)
2 Stage II: Constant Marginal Returns: Then, as the quantity of labor
increases, its marginal product (MP) becomes constant, albeit for very short
range of input/output. This implies a one-to-one relation between variable
input and total output. Each additional unit of the variable input (workers)
results in the same increase in total output, i.e. constant MP. Hence, the
total product/output (TP) increases at the constant rate, thereby,
production function becomes a straight line.
3 Stage III: Decreasing Marginal Returns: As we continue to increase the

quantity of the variable input, it starts losing its marginal productivity, i.e.
marginal product of labor starts declining (recall DMP). As explained
previously, this happens because the fixed factor remains unchanged, leading
to issues like overcrowding, congestion, coordination failure etc. Due to this,
the total product/output (TP) increases, but at a much slower rate. Note
that in this stage, only MP is declining, while TP is still increasing, just at a
diminishing rate. This makes the production function concave.
Note that even after this, if the quantity of variable input continues to increase,
the MP becomes negative and TP starts falling. This can also be termed as
another stage of production function.
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Total Product and Marginal Product

Based on the previous discussions, the

relation between MP and TP can be
stated as follows:
As MP increases, TP increases at
an increasing rate.

As MP becomes constant, TP
increases at a constant rate.

As MP decreases, TP increases at
a diminishing rate.

As MP becomes negative, TP
starts falling. As shown in the
figure, this happens at points N
and B, respectively.

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Producer’s Profits
As per the neo-classical models, private firms are profit maximisers. What is
profit? Or more specifically, what is Economic Profit?
Simply put, Profit = Total Revenue (TR) - Total Cost (TC)
Total revenue is the total earnings of the firm from its sale of output.
Thus, it depends on the ‘price’ at which the output is sold, and the
‘quantity’ of output sold, i.e. TR = PxQ.
This price usually depends on the nature of market/market structure in
which the firm is operating.
Given this price, firms choose ‘Q’ to maximise their profits.
Total cost is the total market value of the inputs that a firm uses and makes
payments for, like wages paid to labour, rent paid on land etc.
There are two types of cost that a firm incurs - explicit costs and implicit
costs.
Explicit cost: input cost that requires an outlay of money or that needs to be
paid out by the firm. Examples: wage cost, cost of raw material, etc.
Implicit cost: these includes those input costs that does not require any
tangible monetary payments. Example: payments to be made to ones own
self as an entrepreneur. Opportunity cost: cost of something that you give
up in order to produce the output.
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Producer’s Profits: Economic profit v/s Accounting profit
The previously discussed distinction between explicit and implicit costs highlights
an important difference between how economists and accountants analyse a
business.
Economists are interested in studying how firms make production and pricing
decisions. Since these decisions are based on both explicit and implicit costs,
economists include both when measuring a firm’s costs.
By contrast, accountants have the job of keeping track of the money that flows
into and out of firms. As a result, they measure the explicit costs only.
Thus, Economic profit: total revenue minus total cost, including both implicit and
explicit cost.
Accounting profit: total revenue minus total cost (only explicit costs)
Thus, by construct, Economic Profit is always an underestimation, compared to
Accounting Profit (as depicted in the picture below).

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Costs of Production: Total Cost
The total cost (TC) function is an exact mirror image of the total product (TP)
function.
That is, if the TP curve is a S-shaped curve (left panel of figure below), then the
TC curve is an inverted S-shaped (right panel of the figure below).

The economic reasons for the shape of the TC curve are the same as they were for
an S-shaped TP curve.
That is, as the quantity of input increases, its productivity starts declining, due to
which for every additional unit of output produced, the costs incurred by the firm
(in terms of payments to those inputs) starts increasing rapidly.
Thus, first the TC curve is concave, implying TC increasing at a diminishing rate,
then it becomes a straight line, implying, TC increasing at a constant rate, and
finally, it gets convex (steeper), implying TC increasing at an increasing rate.
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Types of Costs
Recall two types of inputs in short-run - Fixed inputs and Variable inputs.
Therefore, in the short-run, a firm faces two types of costs:
1 Fixed Costs (TFC) - paid for fixed inputs like rent for land, interest on loan
taken to set up the factory etc. These costs have to be paid, regardless of
whether the producer produces anything at all or not. Hence, these are also
called as ‘sunk costs’.
2 Variable Costs (TVC) - paid for variable inputs, like wages for labour etc.
These costs are to be paid only when the producer starts producing. Hence,
if production is zero, variable costs are also zero.
Therefore, total cost, TC = TFC + TVC
In terms of their cost structures, firms are interested in the following:
Average cost (AC or ATC) - it is the per unit cost of production (Q),
given by TC
Q . Since, TC = TFC + TVC ; therefore, ATC = AFC + AVC .
AFC = TFC TVC
Q , AVC = Q .
Marginal cost (MC) - it is the change in total cost if the output
increases by one unit, given by ∆TC
∆Q .
Since TC = TFC + TVC , therefore, ∆TC = ∆TFC + ∆TVC . Since
∆TFC = 0 (why?), MC = ∆TVC ∆Q .
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Types of Costs
Based on the previous discussion, consider the example below and calculate all
types of costs:
Q TC TFC TVC AFC ( TFC
Q
) AVC ( TVC
Q
) MC ( ∆TVC
∆Q
) ATC ( TC
Q
)
0 2 2 0 - - - -
1 3 2 1 2 1 0.8 3.00
2 3.8 2 1.8 1 0.90 0.6 1.90
3 4.4 2 2.4 0.67 0.80 0.4 1.47
4 4.8 2 2.8 0.50 0.70 0.4 1.20
5 5.2 2 3.2 0.40 0.64 0.6 1.04
6 5.8 2 3.8 0.33 0.63 0.8 0.97
7 6.6 2 4.6 0.29 0.66 1 0.94
8 7.6 2 5.6 0.25 0.70 1.2 0.95
9 8.8 2 6.8 0.22 0.76 1.4 0.98
10 10.2 2 8.2 0.20 0.82 1.6 1.02
11 11.8 2 9.8 0.18 0.89 1.8 1.07
12 13.6 2 11.6 0.17 0.97 2 1.13
13 15.6 2 13.6 0.15 1.05 2.2 1.20
14 17.8 2 15.8 0.14 1.13 - 1.27
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Shapes of Cost Curves
Considering all types of costs specified in the table provided in the previous slide,
we observe the following distinct patterns about the shapes of these curves:
Total fixed cost (TFC) remains same for all levels of output.
TVC continues to increase, as output (Q) increases.
AFC is declining throughout, because AFC = TFCQ , where the numerator
stays constant and the denominator continues to increase.
AVC is continuously increasing, as well.
ATC first declines then increases, thus making a U-shaped curve.
MC, which is capturing the successive increase in the TC or TVC, first
decreases, then becomes constant for a very short while and then is
increasing. (this is the reason which explains the inverted S-shape of the
total cost curve).
Note: Typically, AC, AVC and MC are all U-shaped curves

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Shapes of Cost Curves: Graphs

The shapes described previously, can be depcited as shown below:

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Shapes of Cost Curves: Explained
The shapes of these cost curves are so because of the following reasons:
Since AFC is declining throughout (because TFC is constant), the AFC
curve is a downward sloping curve.
The U-shaped MC curve - which first declines and then rises after staying
constant for a while, reflects the property of diminishing marginal product.
For small quantity of output, there are less workers (variable input) and
more equipment (fixed input), that is more equipment per unit of
worker. Hence, MC declines as output rises, because the productivity
of initial units of variable input is very high.
With increase in output, the number of workers increases and the
availability of equipment per unit of worker falls, leading to lower and
lower productivity of variable inputs. Hence every additional unit of
output, starts imposing higher and higher additional cost.
Since ATC = AFC + AVC, therefore, ATC first declines along with the
decline in AFC for the initial levels of output. After that, with increasing
AVC becoming more than the falling AFC, the ATC starts increasing too,
giving it a U-shape.
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Relation between Marginal and Average Cost
Based on the previously discussed tables and figures, we can infer the
following about relation between MC and ATC (also depicted in the figure
below):
1 As long as MC < ATC, ATC is falling. In the figure, at Q1 , MC1 < AC1 ,
therefore, in this range, the ATC curve is downward sloping.
2 When MC becomes > ATC, ATC is rising. In the figure, at Q3 , MC3 > AC3 ,
therefore, in this range, the ATC curve is upward sloping.
3 MC intersects ATC at a point where ATC is minimum. In the figure, at Q2 ,
MC curve intersects the AC curve, i.e. MC2 = AC2 . Note that
AC2 = min.ATC .

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Cost in Short-run and Long-run
So far, we assumed the inputs to be of two types in the short-run, and
accordingly, the two types of costs.
Short-run can be said to be the time span during which it is possible to
change one set of factors - like labor - variable inputs, whereas it is not
possible to change the other set of factors - like machinery, land etc. - fixed
inputs.
Long-run can be said to the time span during which all inputs can be
changed. That is, all inputs are variable inputs - even inputs like land,
machinery etc.
Note that these time-spans need not necessarily be fixed in terms of number
of years - like 2 years for short-run and more than 5 years for long-run etc. It
depends on industry to industry.
Since in the long-run, all inputs are variable, there is no difference between
fixed cost and variable costs.
Thus, in the long-run, we only consider the long-run average total cost
(LRATC).

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Long-run Cost Curve
All short-run average cost curves (SRATCs) lie inside long-run average cost
(LRATC) curve.
LRATC is flatter than SRATC because all the inputs are variable in long-run.
In in the short run, the firm stays on a specific short-run curve. But in the
long-run, the firm keeps shifting from one SRATC (S1 ) to another (S2 ) and
so on, as it keeps on changing all inputs.
Since firms get to choose in the long-run which SRC curve it wants to
operate at, they choose the one that minimises its cost of production.
Therefore, as shown in the figure below:
For Q < QA , the firm will choose to operate on S1 .
For QB > Q > QA , it will operate on S2 .
For Q > QB , it will operate on S3 .

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LRATC: Economies and Diseconomies of Scale

As shown in the figure above, the range of output over which the long-run
average total cost (LRATC) falls, is said to be the range of ‘increasing
returns to scale’ or ‘economies of scale’. Note that since firms are now
operating in the long-run, they can change all the inputs - labour as well as
fixed machinery. Thus, the returns are measured with respect to ‘change of
scale of operations’ and not just one specific input. Economies of scale often
arise because higher production levels allow specialization among workers,
which permits each worker to become better at a specific task.
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LRATC: Economies and Diseconomies of Scale (contd.)
Further, as output increases, the firms can continue to add more labour
along with adding more and more fixed machineries. Thus, they enjoy
‘constant returns to scale’, which is when the LRATC becomes constant and
flat.
Lastly, if the firms continue to increase their scale of operations, then the
larger corporations/businesses are bound to face problems such as those of
coordination and management failures, which starts leading to rising LRATC
- called as ‘decreasing returns to scale’ or ‘diseconomies of scale’.
As shown in the figure, many firms have a ‘minimum efficient scale’ - which
is the point at which the LRATC curve begins to bottom out.
Levels of output less than the minimum efficient scale may leave some
resources underemployed, thus creating the downward-sloping portion of the
long-run average cost curve.
Given the problems of managing very large organizations, one can also posit
the existence of a ‘maximum efficient scale’ - which is the largest an
enterprise can be and still benefit from low long-run average costs.
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 ALL THE BEST!

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