THEORY OF PRODUCTION

AND COST

Class 3
Theory of Production and Cost
 Short and Long run production functions
 Behavior of Costs
 Law of Diminishing Returns
 Law of Returns to scale in the theory of production
 Fixed Costs and Variable Costs
 Explicit Costs and Implicit Costs
 What are Costs?
 “The Market Value of the inputs a firm uses in
production”
 Total Revenue – the amount a firm receives for the
sale of its outputs.
 Eg: Each Ice-Cream takes Rs. 10 to make and it is
sold at Rs. 25 – Nelum sells 2000 ice-creams

PROFIT = TOTAL REVENUE – TOTAL

COST
Economic Cost
 This is different to accounting cost
 What is account cost?
 Remember Nelum? – She made Rs. 30000 profit
making ice-cream. Assume Nelum was an amazing
programmer and she could earn Rs. 80000 a month
programming.
 Her Opportunity cost = 80000 – 30000 = Rs. 50000
 Which means she is losing Rs 50000 by making ice-
cream.
Implicit and Explicit Costs
 Explicit Costs – input costs that require an outlay
of money by the firm.
 Implicit costs – input costs that do not require an
outlay of money by the firm.
 Accounting Profit = TR – Explicit Costs
 Economic Profit = TR – (Implicit Costs+ Explicit
Costs)
35

30

25 10

20 20
Profit Implicit Cost Explicit Cost

15 10 30

10

5 10 10

0
Economic Profit Total Revenue Accounting Profit
The production functions
Output per Marginal Cost of Cost of Total Cost
Hour product of factory workers
labour (FC) (VC)
 Two Assumptions Number of
Workers
0
 Short Run
0 0 30 0 30

1
 Size of50Nelum’s factory
50
is fixed
30 10 40
 She can only vary the amount of ice-cream by increasing
2 90 40 30 20 50
workers
3  120 – She can
Long run 30 build a new
30 factory.
30 60

4 140 20 30 40 70

5 The production
150 function
10 30 50 80

6 The relationship
155 between
5 the quantity
30 of inputs
60 used90to
make a good and he quantity of outputs for that good.
Production Function
180

160

140

120

100
Output per Hour
80

60

40

20

0
0 1 2 3 4 5 6 7
 Total Cost Curve
Chart Title
100
90
 Marginal Product
80  The increase in output that arises from an additional
70 unit of output
60  Diminishing Marginal Product
50 Total Cost
 The property whereby the marginal product of an input
40 declines as the quantity of the input increases.
30
20
10
0
0 20 40 60 80 100 120 140 160 180
Fixed and Variable Costs
 Fixed Costs
 Costs that do not vary with the quantity of output produced
 Variable Costs
 Costs that vary with the quantity of output produced.
 Average Total Cost – Total cost divided by the quantity of output
 Average Fixed Cost – Fixed cost divided by the quantity of
output
 Average Variable Cost – Variable cost divided by the quantity of
output
 Marginal Cost – The increase in total cost that arises from an
extra unit of production.
Cups
Per Total Fixed Variable Average Fixed Average Variable Average Total Marginal
Hour Cost Cost Cost Cost Cost Cost Cost

0 300 300 0 0 0 0

1 330 300 30 300 30 330

2 380 300 80 150 40 190

3 450 300 150 100 50 150

4 540 300 240 75 60 135

5 650 300 350 60 70 130

6 780 300 480 50 80 130

7 930 300 630 43 90 133

8 1100 300 800 38 100 138

9 1290 300 990 33 110 143

10 1500 300 1200 30 120 150

350

300

250

200

150

100

50

0
0 1 2 3 4 5 6 7 8 9 10
Average Fixed Cost
Average Variable Cost Average Total Cost
Observations
 Rising Marginal Cost
 Chatura’s MC rises with the quantity of out produced.
This reflects the property of diminishing marginal
product.
 U-Shaped Average Total Cost
 Average fixed costs always reduces
 Average variable costs typically rises as output
increases because of diminishing marginal product
The bottom of the U shaped curve occurs at the
quantity that minimizes average total cost
Long run costs curves
 In the short term you cannot increase the number of
factories, only the number of workers
 In the long run this is not an issue.

 Economies of Scale – (Specialization) – When long run

average total costs falls as the quantity of output increases
 Diseconomies of Scale – (Coordination Issue) – When
LRATC increase as the output increases
 Constant returns of scale – When LRATC stays the same
as the quantity of output changes.
Break Time!