Production Theory and

Cost Analysis
Objectives:
 Describethe concept of a short run and
long run production.

Explain the productivity and the Law of

Diminishing Return.

Describe the following costs of production.

 Production
Production refers to the output of goods and
services produced by businesses within a
market. This production creates the supply
that allows our needs and wants to be
satisfied. To simplify the idea of a production
function, economists create a number time
periods for analysis.
Business may also Business may
produce capital produce
goods, which are consumer goods
products used to or goods sold
make other goods. directly to
Example: Machines individuals to be
used to assemble used as they are.
automobiles.
 PRODUCTION
INPUTS OUTPUTS
PROCESS

GOODS AND
RESOURCES
SERVICES
Production Process:
Planning – includes
choosing a location for the
business and scheduling
production.
Quality Control – Involves over seeing the
grade or freshness of goods, their strength or
workability, their construction or design, safety
or industry, standards and many other factors.

Inventory Control - Almost all

manufacturer and many service businesses such
as dry cleaners need inventories of the materials
they use in making their products or offering
their services.
Purchasing – In order to do
business in a company obviously
needs the raw material to produce its
goods and services.
The people who purchased good
for a business have to decide;

What to buy?

For Whom? What Price?

What is Production function?

This refers to the greatest

output that can be created
given an exact number of
inputs.
 Short Run Production
 The Short Run is a period of time when there is
at least one fixed factor input. This is usually
the capital input such as plant and machinery
and the stock of buildings and technology.
 The short run is where the firm adjusts only its
variable.
 Long Run Production
 In the Long Run, all the factors of the
production can change giving a business the
opportunity to increase the scale of its
operations. For example, a business may grow
by adding extra labor or capital to the
production process and introducing new
technology into their operation.
 Also in the long run is where all the inputs are
variable.
 2 Kinds of Inputs
● Fixed Inputs – inputs that do not change
as output increases
Ex: Land resources

● Variable Inputs – inputs that changes

when output increases
 The Meaning of Productivity
When economists and government
ministers talk about productivity they are
referring to HOW PRODUCTIVE LABOR IS.
But productivity is also about other inputs.
 Example:

Acompany could increase productivity by

investing in new machinery which
embodies the latest technological
progress, and which reduces the number
of workers required to produce the same
amount of output.
Productivity of the variable factor labor
and the Law of Diminishing Return

𝑡𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 ( 𝑨𝑷 )=
𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟
Units of Labor Total Product Marginal Average
Employed (tonnes of corn) Product (tonnes Product (tonnes
of Corn) of CORN)
0 0
1 3 3 3
2 10 7 5
3 24 14 8
4 36 12 9
5 40 4 8
6 42 2 7
7 42 0 6
Production Stages:

The three stages of production are

characterized by the slopes, shape, and
interrelationships of the total, marginal, and
average product curves.
Stage 1
 The product has a positive slope.
 Marginal product is greater than average
product. Marginal product initially increases,
then decreases until it is equal to average
product at the end of Stage I.
 Average product is positive and the average
product has a positive slope.
 Stage II
 Thetotal product curve has a decreasing positive
slope.

 Marginalproduct is positive and the marginal

product curve has a negative slope.

 Averageproduct is positive and the average

product curve has a negative slope.
Stage III
 Production is most obvious for the marginal
product curve, but indicated by the total
product curve.

 The total product curve ha a negative

slope. It has passed its peak and is heading
down.
 Table Production of Tricycles

Labor (L) Total Product Marginal Average

Units (TP) Units Product (MP) Product (AP)
Units Units
1 10 10.0
2 19 9 9.5
3 26 7 8.7
4 30 4 7.5
5 30 0 6
6 26 -4 4.3
7 19 -7 2.7
 35

30
Output, Total Product

25

20

15 Total Product (TP)

10

0
1 2 3 4 5 6

Input, Labor (L)

 12

10
Average Product

Output, Marginal Product (MP)

8 (AP)
Marginal Product

Average Product (AP)

6 (MP)

0
1 2 3 4 5 6
Input Labor (L)
-2

-4

-6

-8
35

30

25

20

Total Product (TP) Units

15
Marginal Product (MP)
Units
10 Average Product (AP)
Units
5

0
1 2 3 4 5 6
-5

-10
Table 5.2 Summary of Returns to Scale

TP MP AP

Stage 1 Increasing Diminishing Decreasing

Stage 2 Maximum/constant Zero Decreasing

Stage 3 Diminishing Negative decreasing

 Marginalproduct is negative and the marginal
product curve has a negative slope. The
marginal product curve has intersected the
horizontal axis and its moving down.

 Averageproduct remains positive but the

average product curve has a negative slope.
 The last stage of production is where the
economic phenomenon referred to as “The Law of
Diminishing Returns” appears. In this stage, as the
non-fixed factor is added or increased (in our
example, as more employees are hired), output
ceases to increase and may even begin to
decrease. At the point where decreases in output
(i.e. marginal product) begin, the law of
diminishing returns.
Law of Diminishing Return
DiminishingReturns is said to occur when the
marginal product of labor starts to fall.
This is the stage that all companies strive
for. Somewhere at the peak of this stage is
the exact ideal spot where companies should
operate, where marginal product and averag
product intersect, meaning that a business
will be able to optimize its output.
Economists say this is the stage in which
“rational” firms should operate.
COST OF PRODUCTION

 Are defined as those expenses faced by a

business when producing goods or services for a
market.
 Cost production can be categorized as fixed costs
and variable costs.
Fixed costs

Fixed costs are expenses that does not

change in proportion to the activity of a
business.
Fixed costs include overheads (rent,
insurance-premium, interests, depreciation,
new equipment, marketing and advertising),
and also direct costs such as payroll
(particularly salaries).
Fixed cost does not change with the volume
of production.

costs

100 TFC

O Q
 Variable costs

Variable costs change in direct proportion to

the activity of a business such as sales or
production volume. In retail, the cost of goods
is almost entirely variable. In manufacturing,
direct material costs, wages, fuel costs are
examples of variable costs.
 Total costs for firm X
Output TFC
100 (Q)

0 12
1 12
80
2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

TFC
0
fig 0 1 2 3 4 5 6 7 8
 Output TFC TVC
Total costs for firm X
100
(Q)

0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC TVC
100
(Q)

0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 Total costs for firm X
100

TVC
80

Diminishing marginal
60
returns set in here

40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
Total costs for firm X
100
(Q) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
Total costs for firm X
100
(Q) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 Output TFC TVC TC
Total costs for firm X
100
(Q) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20

TFC
0
fig
0 1 2 3 4 5 6 7 8
 For a firm to maximize profit in a
competitive market, marginal revenue and
marginal cost must be balanced with the
price. At the point when total revenue is
only equal to total cost, no profit will be
made. However, there is also no loss at
this instance. This means that the firm has
a break-even in its production. A break-
even point refers to a situation where a
firm’s gain from its economic activity
equals the cost it incurred.
 TC and TR
600

500
490

400 400
390
375
350
325
COSTS

320
300 300
275
265
250
Break-even 225 221
ea
t A r195
200 200
P ro fi
175 175
150 159
131.2 137.7 146.7
126.2
125
110 114 117.5 121.7
100 100
75
50
25
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

TC TR

QUANTITY
Q TFC TVC TC = MC = AFC= AVC= ATC = TR = MR = TP=
TFC+ C inTC/ TFC / Q TVC / Q AFC + AVC P xQ Cin TR/ TR-TC
TVC Cin Q Cin Q

1 100 10 110 100.0 10.0 110.0 25 ----- -85

2 100 14 114 4 50.0 7.0 57.0 50 25 -64

3 100 17.5 117.5 33.3 33.3 5.8 39.2 75 25 -42.5

4 100 21.7 121.7 4.2 25.0 5.4 30.4 100 25 -21.7

5 100 26.2 126.2 4.5 20.0 5.2 25.2 125 25 -1.2

6 100 31.2 131.2 5 16.7 5.2 21.9 150 25 18.8

7 100 37.7 137.7 6.5 14.3 5.4 19.7 175 25 37.3

8 100 46.7 146.7 9 12.5 5.8 18.3 200 25 53.3

9 100 59 159 12.3 11.1 6.6 17.7 225 25 66

10 100 75 175 16 10.0 7.5 17.5 250 25 75

11 100 95 195 20 9.1 8.6 17.7 275 25 80

12 100 121 221 26 8.3 10.1 18.4 300 25 79

13 100 165 265 44 7.7 12.7 20.4 325 25 60

14 100 220 320 55 7.1 15.7 22.9 350 25 30

15 100 290 390 70 6.7 19.3 26.0 375 25 -15

16 100 390 490 100 6.2 24.4 30.6 400 25 -90

Quiz – Production/Cost Theory
1. It is the process of transforming resources into goods and services.
2. It refers to the resources used in the production process.
3. What do we call the goods and services created?
4-5 Cite the 2 kinds of Inputs
6. It refers to the greatest output that can be created given an exact number
of inputs.
7. As more inputs are added to production while holding other inputs fixed, the
additional outputs start to diminish at a certain point.
8. Time frame in production process where a firm adjusts only its variable
input.
9. A time frame in production process where a firm adjusts all inputs.
10. What do we call the intersection point of TR and TC?
Part II
Draw and label the graph of the stages of production. (9+1=10 pts.)

TP MP AP

Stage 1

Stage 2

Stage 3
Part III Solving (2Pts. each)

1. Given: TFC = 100 Req’d: TC ?

TVC = 26.2

Sol’n. TC =
=
TC =

2. Given: AFC = 12.5 Req’d: ATC ?

AVC = 5.8

Sol’n. ATC =
=
ATC =
3. Given: TVC = 165 Req’d: AVC ?
Q = 13

Sol’n. AVC =
=
AVC =

4. Given: TR = 275 Req’d: TP ?

TC = 195

Sol’n. TP =
=
TP =
Calculate the MP2, MP4, MP6, AP7, AP3. Show your solution. 2pts. each

Labor (L) Total Product Marginal Average

Units (TP) Units Product (MP) Product (AP)
Units Units
1 123
2 154
3 175
4 182
5 182
6 176
7 164
 Market Structures
Perfect Competition Monopolisti Oligopoly Monopoly
c
Competitio
n
Number of 1. Many Few 5.
sellers
Freedom of 2. Easy Difficult 6.
entry
Nature of 3. Differentiat Differentiated 7.
product ed
Seller’s control 4. low substantial Very
over price strong/substantial
 AK Q4 Market Structures
Perfect Competition Monopolistic Oligopoly Monopoly
Competition

Number of 1. Many Many 8. Few 13. One

sellers
Freedom of 2. Easy 5. Easy 9. Difficult 14. Very
entry difficult
Nature of 3. Undifferentiated 6. Differentiated 11. 15. Unique
product Differentiated
Seller’s control 4. none 7. low 12. substantial 10. Substantial
over price
35

30

25

20

Total Product (TP) Units

15
Marginal Product (MP)
Units
10 Average Product (AP)
Units
5

0
1 2 3 4 5 6
-5

-10