ECO162 - Chapter 5 Production and Cost Theory

CHAPTER 5
PRODUCTION AND COST THEORY
Principles of Economics second edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T) 2010 Ch. 5: 1
Production and Cost Theory
6.1 Short-run production

6.2 Law of diminishing marginal returns
6.3 Stages of production
6.4 Short-run costs
6.5 Long run average cost
6.5.1 Economies of scale
6.5.2 Diseconomies of scale

DEFINITION OF PRODUCTION
Definition
 Production means the process of using the factor of production to
produce goods and services.
 Production is the process of transforming inputs into outputs.
OUTPUTS
INPUTS
Refers to what we
Inputs refers to the Processing get at the end of the
factors of production production process
that a firm use in the that is finished
production process. products.

A loaf of bread requires certain amount of
1. water
2. flour
3. yeast
4. some kneading and patting
5. an oven and gas or electricity

LAND
All natural resources LABOUR
or gift of nature Physical or mental
activities of human beings
CLASSIFICATION
OF FACTORS OF
PRODUCTION
CAPITAL ENTREPRENEUR
Part of man-made wealth A person who combines the different
used for further production factors of production, and initiates
the process of production and also
bears the risk

PRODUCTION FUNCTION
A production function is a statement of the

functional relationship between inputs and
outputs, where it shows the maximum output that
can be produced with given inputs.
Q = (K, L, M, etc.)
Where: Q = Output
K = Capital Complementary inputs
L = Labour
M = Raw Material

SHORT RUN AND LONG RUN
PRODUCTION FUNCTION
Two Types of Factor Inputs

1. Fixed Input
• An input which the quantity does not change according to the amount of
output.
• Example: Machinery, land, buildings, tools, equipments, etc.
2. Variable Input
• An input which the quantity changes according to the amount of output.
• Example: Raw materials, electricity, fuel, transportation, communication, etc.
Short Run and Long Run Period

• 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.

6.1 SHORT RUN PRODUCTION
• 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
K = Capital (fixed)


6.2 LAW OF DIMINISHING MARGINAL
RETURNS
• It states that if the quantities of certain factors are increased while
the quantities of one or more factors are held constant, beyond a
certain level of production, the rate of increase in output will
decrease.
OR
• “Law of diminishing marginal returns states that as more of a
variable input is used while other input and technology are fixed,
the marginal product of the variable input will eventually decline”.

SHORT RUN PRODUCTION
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 (AP L) = Total Product

Total Labour
AP L = TP/ L

SHORT RUN PRODUCTION (cont.)
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 (MP L) = Change in Total Product

Change in Total Labour
MP L = TP/ L


6.3 STAGES OF PRODUCTION
Capital Labour Total Marginal Average Stages of
(Fixed (Variable Product Product Product Production
input) input)
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10 STAGE I
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
STAGE II
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
STAGE III
10 10 50 -4 5
MP = 54 - 56 AP = 56
9-8 8
= -2 = 7
STAGES OF PRODUCTION (cont.)
RELATIONSHIP BETWEEN TP AND MP
RELATIONSHIP BETWEEN AP AND MP
When MP is increasing, TP increase at an increasing rate.
When MP is above AP , AP is increasing
When MP is decreasing, TP increase at a decreasing rate.
When MP is below AP, AP is decreasing.
When MP is zero, TP at its maximum.
When MP equals to AP, AP is at maximum.
When MP is negative, TP declines.
60 TP MAX
STAGE I STAGE II STAGE III
50
40
30 TP
MP
20
AP MAX;
AP =MP AP
10
MP=0
0
1 2 3 4 5 6 7 8 9 10
-10

STAGES OF PRODUCTION (cont.)-pg 115
Stage I Stage II
Proportion of fixed factors are Called law of diminishing returns


greater than variable factors The most efficient stage of production

Under utilization of fixed factor because the combinations of inputs are fully

Operation involves a waste of resources utilized


STAGES OF PRODUCTION
Stage III
Proportion of fixed factors is lower than variable factors

Increase in variable factors decline the TP because of overcrowding


A producer would not like to operate at this stage



• 3 2017

15
6.4 SHORT-RUN COSTS
SHORT RUN
A production period in which at least on
of the input is fixed*.

LONG RUN
A production period in which all the
inputs are variable**.
* A fixed input is an input which the quantity does not change
according to the amount of output. E.g. machinery
** A variable input is an input which the quantity varies according to
the amount of output. E.g. labour

SHORT-RUN PRODUCTION COST
TOTAL COST (TC)

The sum of cost of all inputs used to produce goods and services.


Total cost (TC ) also defined as total fixed cost (TFC) plus


total variable cost (TVC).
TC = TFC + TVC
TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

 The cost of inputs that are  The cost of inputs that changes
independent of output. with output.
 Examples: Factory, machinery and  Example: Raw materials, labours,
etc. etc.

SHORT-RUN PRODUCTION COST
(cont.)
AVERAGE TOTAL COST (ATC)

The total cost per unit of output.
The formula for average total cost (ATC) is the total
cost (TC) divided by the output (Q).

ATC = TC
Q
TC = TVC + TFC

SHORT-RUN PRODUCTION
COST (cont.)
AVERAGE FIXED COST (AFC)
Total fixed cost (TFC) divided by total output:
AFC = TFC
Q
AVERAGE VARIABLE COST (AVC)

Total variable cost (TVC) divided by total output:
AVC = TVC
Q
MARGINAL COST (MC)
The change in total cost that results from a change in output;
the extra cost incurred to produce another unit of output:
MC = TC
Q
SHORT-RUN COST CURVES
COST TOTAL COST (TC)

TC
The sum of cost of all inputs used to produce goods
and services.
Also defined as TFC plus TVC
TVC
TC = TVC + TFC
TOTAL VARIABLE COST (TVC)

The cost of inputs that changes with output.
TFC
TOTAL FIXED COST (TFC)

The cost of inputs that is independent of output.
QUANTITY

SHORT-RUN COST CURVES (cont.)
MARGINAL COST (MC)

Change in total cost that results from a change in output
MC = TC
 
COST Q
MC ATC
AVERAGE TOTAL COST (ATC)
Total cost per output
ATC = TC ATC = AFC + AVC
Q
AVC
AVERAGE VARIABLE COST (AVC)
Total variable cost (TVC) divided by total output
AVC = TVC
Q
AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total output
AFC = TFC
Q
AFC
QUANTITY

Total costs Average costs
(1) (2) (3) (4) (5) (6) (7) (8)

Quantity Total Total Total Average Average Average Marginal
(Q) fixed variable cost fixed cost variable total cost cost (MC)
cost cost (TC) (AFC) cost (AVC) (ATC)
(TFC) (TVC) TC=TFC AFC = AVC = ATC = MC =
+TVC TFC/Q TVC/Q TC/Q TC/Q

(2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1)
(5)+(6)
0 20 0 20 - - - -
1 20 15 35 20 15 35 15
2 20 25 45 10 12.50 22.50 10
3 20 30 50 6.67 10 16.67 5
4 20 35 55 5 8.75 13.75 5
5 20 45 65 4 9 13 10

SHORT-RUN COST CURVES
COST
STAGE STAGE II STAGE III

I STAGE I
AFC begins to fall with an increase in output and AVC decreases.
SATC As long as the falling effect of AFC is higher than the rising
effect of AVC, the ATC tends to decrease.
SAVC STAGE II
AFC continuous to decline and SATC will become minimum.
ATC remains constant at this stage since the falling effect of
AFC and rising effect of AVC is balanced.
.
STAGE III
The falling effect of AFC is lower than rising effect of AVC,
therefore ATC begins to increase.
SAFC
QUANITTY
ATC curve is “U-Shaped” because of the combined influences of AFC and AVC

RELATIONSHIP BETWEEN MC AND
ATC
Cost
MC
ATC
Quantity
ATC falling, MC curve lies below ATC curve.

ATC is at minimum point, ATC curve and MC curve are equal.
ATC starts to increase, MC curve lies above ATC curve.

6.5 LONG RUN AVERAGE COST
• Long run is a period where there are only variable factors

and no fixed cost involved.
• Long run total cost (LRTC) starts from origin because of
the absence of total fixed cost.
LONG RUN AVERAGE COST CURVE (LRAC)
• Shows the minimum cost of producing any given output
when all of the inputs are variable.
• Long run is a period where firms plan how to minimize
average cost.

LONG RUN PRODUCTION COST
LRAC curve are derived by a series of short run average cost curves
COST
SRAC1
SRAC5
SRAC2
SRAC4 LRAC
SRAC3
A
Tangential point of the SAC are joined

And made up the LRAC.
QUANTITY

(cont.)
• Long run average cost curve (LRAC) is “U–Shaped” due to the Law
of Returns to Scale.
• Law of Returns to Scale states that as the firm expand its size or
scale of production, its long run average cost (LRAC) will decrease
and increase at later stage.
Cost
LRAC
Increasing Constant Decreasing

Return to Return to Return to
Scale Scale Scale
Quantity
(cont.)
ECONOMIES OF SCALE
Advantages and benefits of a firm as it becomes larger and
larger.
Reduce long run average cost (LRAC).
Marketing economies, financial economies, labour
economies, technical economies, managerial economics.

DISECONOMIES OF SCALE
Problems faced by a firm as it becomes larger and larger.
Increase long run average cost (LRAC).
Mismanagement, competition, labour diseconomies.

ECONOMIES OF SCALE
Economies of scale are benefits and advantages of a firm

as it expands its production.
• Reduce the average cost.
INTERNAL
Internal economies happen inside an EXTERNAL
organization Advantages of the industry as a whole

DISECONOMIES OF SCALE (cont.)
Diseconomies of scale are problems and disadvantages

faced by a firm when it expands production.
• Increase the average cost.
INTERNAL EXTERNAL
Raise the cost of production of a firm as The disadvantages faced by the industry
the firm expands as a whole

© Oxford Fajar Sdn. Bhd. (008974-T) 2010 30
Ch. 5: 30
ECONOMIES AND DISECONOMIES
OF SCOPE
• Economies of scope appear when an individual firm’s output

for two different products is higher than the output reached
by two different firms each produce a single product.
• The diseconomies of scope appear in the productions of an

individual firm’s because the production of one product
might inconsistent with the production of another product.


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CHAPTER 5

PRODUCTION AND COST THEORY

Principles of Economics second edition All Rights Reserved

6.1 Short-run production

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

A production function is a statement of the

Two Types of Factor Inputs

Short Run and Long Run Period

Principles of Economics second edition All Rights Reserved

• In the short run, we assume that at least one of the inputs is

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

TOTAL PRODUCT (TP)

AVERAGE PRODUCT (AP)

Average Product (AP L) = Total Product

Principles of Economics second edition All Rights Reserved

MARGINAL PRODUCT (MP)

Marginal Product (MP L) = Change in Total Product

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Operation involves a waste of resources utilized

Increase in variable factors decline the TP because of overcrowding

A producer would not like to operate at this stage

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

Principles of Economics second edition All Rights Reserved

TOTAL COST (TC)

total variable cost (TVC).

TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

Principles of Economics second edition All Rights Reserved

AVERAGE TOTAL COST (ATC)

Principles of Economics second edition All Rights Reserved

AVERAGE VARIABLE COST (AVC)

COST TOTAL COST (TC)

TOTAL VARIABLE COST (TVC)

TOTAL FIXED COST (TFC)

Principles of Economics second edition All Rights Reserved

MARGINAL COST (MC)

AVERAGE FIXED COST (AFC)

Principles of Economics second edition All Rights Reserved

(1) (2) (3) (4) (5) (6) (7) (8)

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STAGE STAGE II STAGE III

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ATC falling, MC curve lies below ATC curve.

Principles of Economics second edition All Rights Reserved

• Long run is a period where there are only variable factors

Principles of Economics second edition All Rights Reserved

Tangential point of the SAC are joined

Principles of Economics second edition All Rights Reserved

Increasing Constant Decreasing

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Economies of scale are benefits and advantages of a firm

Principles of Economics second edition All Rights Reserved

Diseconomies of scale are problems and disadvantages

Principles of Economics second edition All Rights Reserved

• Economies of scope appear when an individual firm’s output

• The diseconomies of scope appear in the productions of an

Principles of Economics second edition All Rights Reserved

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