Introduction to

Economics
Chapter Four
Production and Costs
Why production?
 The motivation for business decisions is profit
maximization

To understand Profit, what is necessary?

 To distinguish between the way economists
measure costs and the way accountants measure
costs

What are Explicit Costs?

Payments to non-owners of a firm for their resources
Accounting verses Economics in costs
How is Accounting Profit defined?
Total revenue minus total explicit costs

What is Economic Profit?

Total revenue minus total opportunity costs

What are Total Opportunity Costs?

Explicit costs + Implicit costs

What are Implicit Costs?

The opportunity costs of using resources owned by the firm

What is an example of Implicit Costs?

When you invest your nest egg in your own enterprise, you give up earning
interest on that money
 Accounting profit verses Economic profit
ITEM Acco. Profit Eco. Profit
Total Revenue $500,000 $500,000
Less Explicit costs:
Wages & salaries $400,000 $400,000
Materials $ 50,000 $ 50,000
Interest paid $ 10,000 $ 10,000
Other payments $ 10,000 $ 10,000
Less implicit costs:
Foregone salary 0 $ 50,000
Foregone rent 0 $ 10,000
Foregone interest 0 $ 5,000

Equals profit $ 30,000 $-35,000

Fixed Costs, Variable Costs and Total
Cost
What is Total Fixed Cost?
Costs that do not vary as output varies and that must
be paid even if output is zero

What is Total Variable Cost?

Costs that are zero when output is zero and vary as
output varies

What is Total Cost?

The sum of total fixed cost and total variable cost at
each level of output
TC = TFC + TVC
Fixed Costs, Variable Costs and Total
Cost
What is Average Fixed Cost?
Total fixed cost divided by the quantity of
output produced. AFC = TFC / Q
What is Average Variable Cost?
Total variable cost divided by the quantity of
output produced AVC = TVC / Q
What is Average Total Cost?
Total cost divided by the quantity of output
produced ATC = AFC + AVC = TC/Q
 Marginal costs
What is Marginal Cost?
The change in total cost when one unit of
output is produced
MC = TC/Q = TVC/Q
Example for Derivation of Costs
Production function
 Production function: defines the relationship
between inputs and the maximum amount of
output that can be produced within a given
period of time with a given level of
technology

Q=f(X1, X2, ..., Xk)

Q =level of output
X1, X2, ..., Xk =inputs used in production
Production function
 For simplicity we will often consider a
production function of two inputs:

Q=F(L, K)
Q = Output
L = Labor
K = Capital
F = Functional form relating the inputs to
output
 Production function
 Fixed factors
These are the factors of production that cannot
be changed in the short run, But they can be
changed in the long run.
In practice these factors tend to involve that
aspect of land that relates to area of land, and
capital equipment. The nature of these factors
will vary from firm to firm and industry to
industry.
Production function
 Variable factors

These are the converse of the fixed factors,

meaning that they are inputs that can be
varied in both short and long run. In practice
this applies mainly to that part of land that
relates to raw materials and to labour.
Production function
 Short-run production function shows the
maximum quantity of output that can be
produced by a set of inputs, assuming the
amount of at least one of the inputs used
remains unchanged

 Long-run production function shows the

maximum quantity of output that can be
produced by a set of inputs, assuming the
firm is free to vary the amount of all the
inputs being used
Production function
 Alternative terms in reference to inputs
◦ ‘inputs’
◦ ‘factors’
◦ ‘factors of production’
◦ ‘resources’
 Alternative terms in reference to outputs
◦ ‘output’
◦ ‘quantity’ (Q)
◦ ‘total product’ (TP)
◦ ‘product’
Examples of production functions
One fixed factor, one variable factor
Q = f(L)K

 Quadratic:
Q = a + bL - cL2

 Cubic:
Q = a + bL + cL2 – dL3

 Power function: exponential for one input

Q = aLb
Short-run analysis of Total,
Average, and Marginal product
 Marginal product (MP) = change in output
(Total Product) resulting from a unit change
in a variable input
Q
MPX 
X

 Average product (AP) = Total Product per unit

of input used
Q
AP X 
X
Short run production functions, Q, MP, AP

Variable Input Total Product Marginal Average

(X) (Q or TP) Product (MP) Product (AP)

0 0 - -
1 8 8 8
2 18 10 9
3 29 11 9.67
4 39 10 9.75
5 47 8 9.4
6 52 5 8.67
7 56 4 8
8 52 -4 6.5
 Short-run analysis of Total,
Average, and Marginal product
 if MP > AP then
 AP is rising

 if MP <AP then
AP is falling

 When MP=AP
AP is maximized
Short-run analysis of Total,
Average, and Marginal product
 Law of diminishing returns:

As additional units of a variable input are

combined with a fixed input, after some point
the additional output (i.e., marginal product)
starts to diminish
Determining the optimal use of the
variable input

Marginal revenue product (MRP) =

change in the firm’s TRP resulting from a unit
change in the number of inputs used

MRP = MP · P =
TRP
X
Determining the optimal use of the
variable input
 Total labor cost (TLC) = total cost of using the
variable input labor, computed by multiplying the
wage rate by the number of variable inputs
employed
TLC = w · X

X= input labor.

 Marginal labor cost (MLC) = change in total labor

cost resulting from a unit change in the number of
variable inputs used
MLC = w
Determining the optimal use of the
variable input
 Summary of relationship between demand for
output and demand for a single input:

A profit-maximizing firm operating in perfectly

competitive output and input markets will be using
the optimal amount of an input at the point at
which the monetary value of the input’s marginal
product is equal to the additional cost of using that
input
 MRP = MLC
 Determining the optimal use of the variable
input
Number
Of
Output MPL APL Total
Revenue
Marginal Total Labor Marginal
Revenue Cost (TLC) Labor Cost MRP-
Workers Product Product (MLC) MLC
(TRP) (MRP)
0 0 -- -- 0   0   0
1 50 50 50 250 250 500 500 -250
2 110 60 55 550 300 1000 500 -200
3 300 190 100 1500 950 1500 500 450
4 450 150 112.5 2250 750 2000 500 250
5 590 140 118 2950 700 2500 500 200
6 665 75 110.83 3325 375 3000 500 -125
7 700 35 100 3500 175 3500 500 -325
8 725 25 90.63 3625 125 4000 500 -375
9 710 15 78.89 3550 -75 4500 500 -575
10 705 -5 70.5 3525 -25 5000 500 -525

Note
P=Product price $5
W = Cost per unit of Labor $500
MRP MP x P
TLC WxX
MLC ΔTLC/ΔX
Determining the optimal use of the variable
input
Isoquant
 Isoquant:

A graph that shows all the combinations of

capital and labor that can be used to
produce a given amount of output.
 Isoquant curve:
Isoquant curve:
TABLE: Alternative Combinations of Capital
(K) and Labor (L) Required to
Produce 50, 100, and 150 Units of
Output

QX = 50 QX = 100 QX = 150

K L K L K L

A 1 8 2 10 3 10
B 2 5 3 6 4 7
C 3 3 4 4 5 5
D 5 2 6 3 7 4
E 8 1 10 2 10 3

A figure of Isoquants Showing All

Combinations of Capital and Labor
That Can Be Used to Produce 50,
100, and 150 Units of Output
 The marginal rate of technical
substitution
 The marginal rate of technical substitution
(MRTS) is a measure of the degree of
substitutability between two inputs. More
specifically, the MRTS of X for Y corresponds
to the rate at which one input (X) can be
substituted for another (Y), while maintaining
total output constant.
Slope of isoquant:
For output to remain constant,
the loss of output from using less
capital must be matched by the
added output produced by using
more labor.
K  MPK =  L  MPL

Slope of isoquant:

K MPL

L MPK
 isocost line
The prices of the inputs can be used to
compute an isocost line. This line shows the
different combinations of inputs that can be
employed given a certain level of cost outlay.

isocost line: A graph that shows all the

combinations of capital and labor available
for a given total cost.
isocost line
Isocost Lines Showing the
Combinations of Capital and Labor
Available for $5, $6, and $7.

An isocost line shows all the

combinations of capital and labor that
are available for a given total cost.

(PK  K) + (PL  L) = TC
Slope of Isocost
Isocost Line Showing All
Combinations of Capital and Labor
Available for $25.
One way to draw an isocost line is to
determine the endpoints of that line
and draw a line connecting them.

Slope of isocost line:

K TC / P P
  K L

L TC / P PL K
Finding the Least-Cost Technology with
Isoquants and Isocosts
Finding the Least-Cost
Combination of Capital and Labor
to Produce 50 Units of Output.

Profit-maximizing firms will

minimize costs by producing their
chosen level of output with the
technology represented by the
point at which the isoquant is
tangent to an isocost line.

Here the cost-minimizing

technology—3 units of capital and
3 units of labor—is represented
by point C.
Expansion path

As the firm attains higher and higher output levels the optimal
combinations of inputs involved will trace an expansion path. The
expansion path goes through all the points of tangency, A, B and C. This
path can be used to determine the long-run relationships between costs
and output.
The Cost-Minimizing Equilibrium
Condition
 At the point where a line is just tangent to a curve,
the two have the same slope. At each point of
tangency, the following must be true:
MPL P
slope of isoquant    slope of isocost   L
MPK PK

MPL PL

 Thus, MPK PK
 Dividing both sides by PL and multiplying both
sides by MPK, we get MPL MPK

PL PK
Production function algebraic forms
Production function algebraic forms
Production function algebraic forms
Long-run production function
 In the long run, a firm has enough time to
change the amount of all its inputs

 The long run production process is described

by the concept of returns to scale

Returns to scale = the resulting increase in

total output as all inputs increase
Long-run production function
 If all inputs into the production process are
doubled, three things can happen:
 output can more than double
 ‘increasing returns to scale’ (IRTS)

 output can exactly double

 ‘constant returns to scale’ (CRTS)

 output can less than double

 ‘decreasing returns to scale’ (DRTS)
Long-run production function
 Returns to scale can also be described using
the following equation

hQ = f(kX, kY)

if h > k then IRTS

if h = k then CRTS
if h < k then DRTS
Long-run production function
 Graphically, the returns to scale concept can
be illustrated using the following graphs
Long-run production function

Cobb-Douglas function: exponential for

two inputs
Q = aLbKc

if b + c > 1, IRTS
if b + c = 1, CRTS
if b + c < 1, DRTS
Some Case studies
 Hassan is professor working at a university
and he is now considering leaving the
university and opening a consulting
business. For his service as consultant, he
would be paid $75,000 a year. To open this
business, The professor must convert a
house from which collects rent of $10,000
and hire a secretary at a salary of $15,000
per year;
Some Case studies
 He must withdraw $10,000 from saving for
miscellaneous expenses and forgo earning
10% of interest per year. The university pays
professor Hassan $50,000 a year. Based
only on economic decision-making do you
predict the professor will leave the
university to start a new business?
Comment your answer and show your
evidence.
 Computational question
An economist estimated that the cost function of a single-product firm is
C (Q) =50 + 25Q + 30Q2 + 5Q3
Based on this information, determine: a) The
fixed cost of producing 10 units of output
b) variable cost of producing 10 units of output
c) Total cost of producing 10 units of output.
d) The average fixed cost of producing 10 units of output
e) Average variable cost of producing 10 units of output
f) Average total cost of producing 10 units of output.
g) The marginal cost when Q = 10.
END
LECTURER: DR. Abdulkadir
