Production and Cost of

Production
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Aims & Objectives

After studying this lesson, you will be able to understand:
● Theory of Production
● The production function
● Short run vs Long run
● Total, Average and Marginal Product
● Law of Diminishing Returns to a factor
● Stages of Production
● Returns to Scale
● Theory of Cost
● Economic vs Accounting Cost
● Short run costs and cost curves
● Long run costs and cost curves
● Economies & diseconomies of scale
● Economies of Scope
● Learning Curves
Theory of Production
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Production Functions
 Is a technical relation that connects factor inputs and output.
 It specifies the maximum output that can be produced with a given
quantity of inputs. It is defined for a given state of engineering and
technical knowledge
 It may be represented as
Q = Q (K, L)
Where, the production process employs only two inputs Labour (L) and
Capital (K) and Q is the quantity of output

● A general form of production function can be expressed as

Q = Q (I1, I2, I3……….In)
Where Q is the quantity of output and inputs are represented as I1,I2……..In
● Cobb- Douglas is a type of production function and is given as
Q = AKLβ
Where A denotes state of technology, K & L are the inputs/factors and 
& β are called the transformation parameters
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Short run Vs Long run

● Short run in production refers to a time period when some
inputs used in production are fixed and some are variable
● Long run in production refers to a time period when all
inputs used in production are variable
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TP, AP, MP
● Three very important concepts related to production analysis
are:
● Total product (TP)
● Average product (AP)
● Marginal product (MP)
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Total Product
● Total product is total output.
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Average Product
● It is the total product divided by the number of variable input
employed. That is, it is the production per unit of input. It
may be represented as,
● APx = Q/x
Where Q denotes total product and x denotes quantity of
variable input x
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Marginal Product
● Marginal Product is the change in output caused by increasing input
use.
● It is represented as: MPX=∂Q/∂X where x is the quantity of variable
input
● If MPX=∂Q/∂X> 0, total product is rising.
● If MPX=∂Q/∂X< 0, total product is falling (rare).
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AP curve rises at first, reaches a

maximum and falls thereafter.
MP also rises at first, reaches a
maximum and falls thereafter.
When AP is rising MP > AP
When AP is maximum MP = AP
When AP is falling MP < AP
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Law of diminishing returns to variable

factor/law of variable proportion
● As more and more of a variable input is added in production
while holding all other inputs fixed, the additional output
obtained is gradually lesser and lesser
● Alternatively stated, the Marginal Product of each unit of
input will decline as the amount of that input increases,
holding all other inputs constant.
● Diminishing Returns to a Factor explains the shape of the TP
curve and also explains the most efficient stage of production
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Stages of production
Stage I – origin to X1
Stage II – X1 to X3
Stage III- beyond X3
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Stage I – origin to X1
Stage II – X1 to X3 – the most
efficient stage of
production
Stage III- beyond X3
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Returns to Scale
● Returns to scale show the output effect of increasing all inputs.
● Three types of returns to scale

 Increasing returns to scale ⇒ ∂Q/Q ÷ ∂Xi/Xi > 1

 Constant returns to scale ⇒ ∂Q/Q ÷ ∂Xi/Xi = 1
 Decreasing returns to scale ⇒ ∂Q/Q ÷ ∂Xi/Xi < 1

Where ∂Q/Q denotes proportional change in output

∂Xi/Xi denotes proportional change in input
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Returns to Scale and Returns to a

Factor
● Returns to scale measure output effect of increasing all
inputs.- Long run phenomenon
● Returns to a factor measure output effect of increasing one
input. – Short run phenomenon
Theory of Cost
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Economic Costs
● The payment that must be made to obtain and retain the services of
a resource
● Explicit Costs
√ Monetary payments
● Implicit Costs
● Value of next best use
● Self-owned resources
● Includes normal profit

LO1 7-18
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Accounting Profit and Normal Profit

• Accounting profit
= Revenue – Explicit Costs

• Economic profit
= Accounting Profit – Implicit Costs

• Economic profit (to summarize)

=Total Revenue – Economic Costs
=Total Revenue – Explicit Costs – Implicit Costs

LO1 7-19
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Cost Function
● In economic theory, costs are taken as a function of output.
C = C (q)
● Output is produced by combining the use of fixed factors &
variable factors.
● In short run, some factors are fixed and others are variable.
Accordingly, there is a fixed cost and a variable cost in the
short run while in the long run all costs are variable cost
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Short run total costs

● Short run total cost (STC) is the sum total of Total fixed cost (TFC)
and Total variable cost (TVC)

STC = TFC + TVC

● Shapes of Short run cost curves

TC
C
TVC

TFC

q
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Explanations for shapes of total cost

curves
● TFC curve is horizontal – this is because total fixed cost remains fixed at
all levels of output including zero level of output

● TVC curve is upward rising- this is because total variable cost varies
directly with the level of output and is zero when output is zero. In
particular, it rises at a diminishing rate initially and then at an increasing
rate. This is explained by the shape of the Total Product Curve, which in
turn in explained by the Law of Diminishing Marginal Returns to a
Factor. The Law states that as the input of the variable factor increases
with fixed factor remaining constant total product rises initially at a
increasing rate but then at a diminishing rate, eventually reaching a
maximum and falling thereafter

● TC curve is upward rising – Total cost which is sum of TFC and TVC
looks like the TVC curve and hence its shape too is explained by the law
of Diminishing Returns to a Factor. But unlike the TVC curve, TC curve
starts from the level of TFC curve. This is because at zero output there is
no TVC and TC equals TFC. The difference between TC curve and TVC
curve is given by the TFC
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Average cost curves

• It is the cost per unit of output. It is given as

ATC or AC = TC/q where TC denotes total cost & q

denotes total output
= (TFC + TVC)/q
= TFC/q + TVC/q
= AFC + AVC
• Shapes of Short run cost curves:
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Explanation for shapes of Average cost

curves
● Shape of AFC curve:
AFC = TFC /q
TFC remains constant throughout, so as output increases TFC/q
falls throughout.

● Shape of AVC curve:

Let labour be the only variable factor hired in quantity ‘L’ and
paid a given wage of Rs w per unit. Thus, TVC = wL
AVC =TVC/q = wL/q
Or, AVC = w/{1/(q/L)}
Or AVC  1/(q/L) i.e. AVC is inversely related to q/L which is the
Average Product of labour. Thus, as AP of labour curve is dome-shaped,
AVC curve is U-shaped ie. When AP rises at first, AVC falls, when AP
falls thereafter, AVC starts rising
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Explanation for shapes of Average cost

curves
● Shape of AC curve:
The AC curve is a vertical summation of AFC and AVC curves.
Initially when both AFC and AVC are falling AC also falls,
then when AVC starts rising, AC under the influence of the
falling AFC falls briefly. But thereafter the rising AVC pushes
the AC curve up. Thus, the minimum point of AC curve comes
after the minimum point of AVC curve
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Marginal Cost
● It is defined as the addition to total cost due to one unit
addition in the total output
Marginal Cost, MC = d(TC)/dq = TCq+1 - TCq
where d denotes change, q denotes output and C
denotes cost
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Marginal Cost is independent of fixed

cost
● MC = TCq+1 – TCq
= (TFCq+1 + TVC q ) – (TFCq + TVCq)
= TFCq+1 + TVC q – TFCq – TVCq
= TVC q – TVCq (since TFCq+1 = TFCq & cancels)

● Thus, MC = d(TC)/q
or MC = d(TVC)/q

● This implies whenever an additional unit of output is produced

the entire addition to cost is addition to variable costs.
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Shape of Marginal cost curve

● Let labour be the only variable factor hired in quantity ‘L’ and
paid a given wage of Rs w per unit. Thus, TVC = wL

● Therefore, MC = d(TVC)/q = d(wL)d/q = w dL/dq

Or, MC = w/{1/(dq/dL)}
Or, MC  1/(dq/dL)
i.e. MC is inversely related to dq/dL which is the Marginal
Product of labour. Thus, as MP of labour curve is dome-
shaped, MC curve is U-shaped ie. When MP rises at first, MC
falls, when MP falls thereafter, MC starts rising
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Per-Unit, or Average, Costs

$200

150
Costs

ATC
100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3
7-29
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Marginal Cost
$200

MC
150
Costs

ATC
100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3
7-30
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MC and Marginal Product

Production Curves

Average Product and

Marginal Product

AP
MP
Quantity of Labor

MC
AVC
Cost (Dollars)

Cost Curves
Quantity of Output
LO3 7-31
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Long-Run Production Costs

● The firm can change all input amounts, including plant size.
● All costs are variable in the long run.
● Long run ATC
● Different short run ATCs

LO4 7-32
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Firm Size and Costs

Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4

Output

LO4 7-33
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The Long-Run Cost Curve

Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4 Long-run
ATC

Output

LO4 7-34
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Economies & Diseconomies of Scale

Internal Economies & Diseconomies
● When a firm expands in size by increasing the scale of its
output, certain cost advantages (due to factors like division of
labor, indivisibility of factors etc) accrue to the firm. This is
referred to as internal economies
● When a firm grows larger and larger, there could be several
cost disadvantages facing the firm. This is referred as internal
diseconomies. Eg: diseconomies due to managerial issues like
trade union related to large scale production
External Economies & Diseconomies
● External economies occur when there are physical and cost
advantages that result from the general development of the
industry
● External diseconomies arise when the industry expands in
size indefinitely and the control of the industry becomes a
problem
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Economies and Diseconomies of Scale

● Economies of scale
• Labor specialization
• Managerial specialization
• Efficient capital
• Other factors
● Constant returns to scale

● Diseconomies of scale
• Control and coordination problems
• Communication problems
• Worker Alienation
• Shirking

LO4 7-36
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MES and Industry Structure

● Minimum Efficient Scale (MES):
• Lowest level of output where long- run average costs are
minimized
• Can determine the structure of the industry

LO4 7-37
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MES and Industry Structure

Economies Constant Returns Diseconomies

Average Total Costs

Of Scale To Scale Of Scale

Long-run
ATC

q1 q2
Output

LO4 7-38
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MES and Industry Structure

Economies Diseconomies
Average Total Costs

Of Scale
Of Scale

Long-run
ATC

Output

LO4 7-39
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MES and Industry Structure

Economies Diseconomies
Average Total Costs Of Scale Of Scale
Long-run
ATC

Output

LO4 7-40
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Don’t Cry Over Sunk Costs

• Sunk costs
• Costs have already been incurred and thus are irrecoverable
• Rule: Do not engage in any activity where MB<MC
• Rule: Ignore sunk costs
• They are irrecoverable

7-41
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Economies of Scope
● Economies of Scope Concept
● Scope economies are cost advantages that stem from producing multiple
outputs.
● Big scope economies explain the popularity of multi-product firms.
● Without scope economies, firms specialize.
● Exploiting Scope Economies
● Scope economics often shape competitive strategy for new products.
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Learning curve
● As firms gain experience in production of a commodity or
service, their average cost of production usually declines. i.e.
for a given level of output per time period, the increasing
cumulative total output over many time periods often
provides the manufacturing experience that enables firms to
lower their average cost of production
● The learning curve shows the decline in the average input
cost of production with rising cumulative total outputs over
time
● Example: It may take 1000 hours to assemble the 100th
aircraft, but only 700 hours to assemble the 200th aircraft as
mangers and workers become more efficient as they gain
production experience
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Learning curve contd..

● The adjacent figure shows

that average cost declines as
the unit of production
increases. In particular it is
convex from the origin as
average cost declines at a
decreasing rate. This
implies that a firm usually
achieves the largest decline
in average costs when
production process is
relatively new & less decline
as the firm matures
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