Theory of Production

Why do we need to understand the

behavior of the firm?
Why do we need to understand the
behavior of the firm?
• To better understanding of the decisions behind the supply curve
• How firms’ decisions about prices and quantities depend on the
market conditions they face (industrial organization)
• Learn about the cost of production
How can we link this with the case?
• How to better understanding of the decisions behind the supply curve?
• The challenges and the opportunities
• How firms’ decisions about prices and quantities depend on the market
conditions they face?
• The business environment, factors of production, available resources
• How to learn about the cost of production?
• Understanding the cost structure, input choices and the production
function
What to study in the production decisions
of a firm?

• Production technology: A firm produces output by using

different combination of inputs.
• Cost Constraints: A firms always want to minimize the cost
of production.
• Input choices: Firms chose how much each input to be
used to produce an output depends on the production
technology and cost of inputs.
The technology of production
Labour
• Skilled
• Unskilled

Capital
• Land
• Building
• Machinery

Inputs
• Raw materials
• Infrastructure
Let us consider Caroline’s Cookie Factory

• Caroline buys flour, sugar,

chocolate chips, and other
cookie ingredients.
• She also buys the mixers and
ovens and hires workers to
run this equipment.
• She then sells the cookies to
consumers.
What is the Goal of Caroline?
• To maximize profit
• Profit = Total revenue − Total cost
• Total revenue is the amount a firm receives for the sale of its output
Total Revenue= Price * Quantity
Eg If Caroline produces 10,000 cookies and sells them at $2 a cookie,
her total revenue is $20,000.
• Total cost is the market value of the inputs a firm uses in production
Costs as Opportunity Costs

• Explicit costs (opportunity costs require the firm to pay out some money)
1. When Caroline pays $1,000 for flour, that $1,000 is an opportunity cost because
Caroline can no longer use that $1,000 to buy something else.
2. Similarly, when Caroline hires workers to make the cookies, the wages she pays are
part of the firm’s costs.
• Implicit costs (opportunity costs that do not require a cash outlay)
1. Imagine that Caroline is skilled with computers and could earn $100 per hour
working as a programmer. For every hour that Caroline works at her cookie factory,
she gives up $100 in income, and this forgone income is also part of her costs.
• The total cost of Caroline’s business is the sum of her explicit and implicit costs
The Cost of Capital as an Opportunity
Cost
• Caroline used $300,000 of her savings to buy her cookie factory from its
previous owner.
• If Caroline had instead left this money deposited in a savings account
that pays an interest rate of 5 percent, she would have earned $15,000
per year.
• Implicit opportunity costs: forgone $15,000
• An economist consider the $15,000 in interest income as an implicit
cost of her business.
• An accountant donot consider $15,000 as a cost because no money
flows out of the business to pay for it.
Calculate the cost by the economist and the
accountant
• Suppose now that Caroline did not have the entire $300,000 to buy
the factory. Instead, used $100,000 of her own savings and borrowed
$200,000 from a bank at an interest rate of 5 percent.
Solution
• Accountant: Will consider $10,000 interest paid on the bank loan
every year as a cost because this amount of money now flows out of
the firm.
• Economist: The opportunity cost equals the interest on the bank loan
(an explicit cost of $10,000) plus the forgone interest on savings (an
implicit cost of $5,000).
What is the difference between economic profit and accounting profit?

Economists include all

opportunity costs when
analyzing a firm, whereas
accountants measure only
explicit costs.
Economic profit is smaller
than accounting profit
A Production Function and Total Cost: Caroline’s
Cookie Factory
Production Function, Total-Cost Curve
and diminishing marginal product
Production function: the
relationship between
quantity of inputs used to
make a good and the
quantity of output of that
good
Diminishing marginal
product: the property
whereby the marginal
product of an input declines
as the quantity of the input
increases
 The production function

• Production function: Function showing the highest output that a firm can produce
for every specified combination of inputs.

q = F(K,L)

• Usage of the combination of inputs depend

on technology. With technological • Rightward Shift in supply curve
innovations, the firm can obtain higher
output with the same input.
The Various Measures of Cost: Conrad’s
Coffee
Shop
Some basic definitions
• Fixed costs: costs that do not vary with the quantity of output
produced. Eg rent, book keepers salary
• Variable costs: costs that vary with the quantity of output produced.
Eg cost of coffee beans, milk, sugar, and paper cups, the salaries of
these workers.
• 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
Average-Cost and Marginal-Cost Curves

Three features
(1)Marginal cost rises with the
quantity of output.
(2)The average-total-cost curve
is U-shaped.
(3) the marginal-cost curve
crosses the average-total-cost
curve at the minimum of
average total cost.
Explanations
(1)Marginal cost rises with the quantity of output: property of diminishing
marginal product
(2)The average-total-cost curve is U-shaped: because of the behavior of the
fixed cost and variable cost
(3) The marginal-cost curve crosses the average-total-cost curve at the
minimum of average total cost: Consider this analogy; Average total cost is
like your cumulative grade point average. Marginal cost is like the grade you
get in the next course you take. If your grade in your next course is less than
your grade point average, your grade point average will fall. If your grade in
your next course is higher than your grade point average, your grade point
average will rise.
Marginal and average cost curve
• Marginal cost curve: Marginal cost curve
decreases with increase in output.
• It is the slope of VC. 100 Cost (rupees
per unit) MC
• Average cost curve:
75
• AVC decreases till, MC < AVC. ATC

• AVC start increasing after MC > AVC. 50

A AVC

25
• Average variable cost curve is minimum
when MC = AVC AFC
0
2 4 6 8 10 12
Output (units per year)
The marginal-cost curve crosses the average-
total-cost curve at its minimum. Why?
• At low levels of output, marginal cost is below average total cost, so
average total cost is falling.
• But after the two curves cross, marginal cost rises above average total
cost.
• For the reason we have just discussed, average total cost must start to
rise at this level of output.
Cost Curves for a Typical Firm
• Many firms experience
increasing marginal product
before diminishing marginal
product.
• Notice that marginal cost and
average variable cost fall for a
while before starting to rise.
 Cost (rupees
per year)
TC

Cost curves
400
VC

300

• Fixed Cost curve: Fixed cost does not vary with

output. 175
A
• Variable Cost curve: It increases with increase in 100
output. FC
• Total Cost curve: Vertical addition of FC and VC. 0
2 4 6 8 10 12
Output (units per year)
100 Cost (rupees
per unit) MC
• Average Fixed Cost curve: Average fixed cost
declines as the rate of output increases. 75
ATC

• Average Variable Cost curve: Average variable cost 50

AVC
A
decreases and then increases.
• Marginal curve crosses AVC and ATC at its 25

minimum. AFC
0
2 4 6 8 10 12
Output (units per year)
The Many Types of Cost: A Summary
Mention the time period required by Tata
Motors to
• Build a factory? Or close an existing one?
• Hire labourers?
• Install a machine?
Costs in the Short run and in the Long run
• The figure presents three short-run average-total-cost curves—for a small,
medium, and large factory.
• It also presents the long-run average-total-cost curve.
• As the firm moves along the long-run curve, it is adjusting the size of the
factory to the quantity of production.
• Long-run average-total-cost curve is a much flatter U-shape than the short-
run average total-cost curve.
• All the short-run curves lie on or above the long-run curve, because firms
have greater flexibility in the long run.
• In the long run, the firm gets to choose which short-run curve it wants to
use. But in the short run, it has to use whatever short-run curve it has,
based on decisions it has made in the past.
How a change in production alters costs
over different time horizons
• When Ford wants to increase production from 1,000 to 1,200 cars per
day, it has no choice in the short run but to hire more workers at its
existing medium-sized factory.
• total cost Because of diminishing marginal product, average rises from
$10,000 to $12,000 per car.
• In the long run, however, Ford can expand both the size of the factory
and its workforce, and average total cost returns to $10,000.
Average Total Cost in the Short and long
Runs
Because fixed costs are
variable in the long run,
the average-total-cost
curve in the short run
differs from the average-
total-cost curve in the long
run.
How long does it take a firm to get to the
long run?
• The answer depends on the firm.
• It can take a year or more for a major manufacturing firm, such as a
car company, to build a larger factory.
• By contrast, a person running a coffee shop can buy another coffee
maker within a few days.
• No single answer to the question of how long it takes a firm to
adjust its production facilities.
Cost in the short run
• Marginal cost :
• Change in Variable cost = wage per unit of labour X change in labour to produce extra
output.
• MC = ∆VC/ ∆q = w ∆L/ ∆q
• MC = w/ MPL
• If marginal product of labour is low, then marginal cost would be
higher.
• Diminishing Marginal returns and costs: When diminishing marginal
productivity of labour sets in then the marginal cost would increase
with increase in output.
Economies and Diseconomies of Scale
• The shape of the long-run average-total-cost curve tells us how costs vary with
the scale—that is, the size—of a firm’s operations.
• When long-run average total cost declines as output increases, economies of
scale occurs.
• When long-run average total cost rises as output increases, there are said to be
diseconomies of scale.
• When long-run average total cost does not vary with the level of output,
constant returns to scale occurs.
• It is measured in terms of a cost-output elasticity.
• Ec = (∆C/C)/(∆q/q)
• Ec = (∆C/∆q)/(C/q) = MC/AC
What might cause economies or
diseconomies of scale?
• Economies of scale arise because higher production levels allow
specialization among workers.
• Diseconomies of scale can arise because of coordination problems
that are inherent in any large organization.
• Explains the U-shape of long-run average-total-cost curves.
• At low levels of production, the firm benefits from increased size
because it can take advantage of greater specialization.
• At high levels of production, coordination problems become more
severe.
Long-run average cost
• In the long-run, the ability of a firm to change the inputs allows
the firm to reduce costs.
• Depends on returns to scale
• Constant returns to scale:
• the long run average cost is constant at all level of outputs.
• Decreasing returns to scale:
• the long run average cost increases with increase in output.
• Increasing returns to scale:
• the long run average cost decreases with increase in output.
Returns to scale
• The rate at which output increases as inputs are increased
proportionately.
Capital
• Increasing returns to scale: Output more (machine hours)

than doubles when all inputs are doubled.

• Most of infrastructure companies like
electricity, water supply. 3

• Fixed cost is generally very high. 2

1 30
10 20
0
1 2 3
Labour (hours)
Returns to scale
• Constant returns to scale: Situation in which • Decreasing returns to scale: Output less
output doubles when all inputs are doubled. than doubles when all inputs are
doubled.
• Size of the firm does not affect the productivity of
its factors. • This phenomena is observed in due to
coordination problems.
Capital Capital
(machine hours) (machine hours)

3 3

2 2 30
1 30 1
20 10 20
10 0
0
1 2 3 1 2 3
Labour (hours)
Labour (hours)
Economies of scope
• Firms produce more than one output.
• Products may be related or unrelated.

• Product transformation curve Number of

• Variety is more important than specialization. tractors

• Negative slope represents that the firm must give

up one output to have more of the other output.
O2
O1
• Straight line represent that there is no difference if a
single firm produce the products or two firms.
Number of
cars
Economies and diseconomies of scope
• Economies of scope: Situation in which joint output of a single firm is greater than
output that could be achieved by two different firms.

• Diseconomies of scope: Situation in which joint output of a single firm is less than
could be achieved by separate firms when each produces a single product.

• Degree of economies of scope: Percentage of cost savings when two or more

products are produced jointly rather than individually.
• SC = (C (q1)+C(q2)-C(q1,q2))/C(q1, q2)
Long-run Average and Marginal cost
Cost (rupees
per unit of
output)

• Long-run curves are determined by LMC

scale of production whereas short run is LAC

determined by marginal productivity.

A

Output
 Output per

Slopes of product curves

month D
112

C Total product
curve

• Total product: Output of the firm increases 60 B

with increase in labour and reaches the A
maximum output; thereafter it starts falling.
O 1 2 3 4 5 6 7 8 9 10
• Marginal product is tangent to the total Labour per month
Output per
product curve at that point. worker per
30 month
• Tangent to curve is the point of
maximization, so MPL is the maximum 20
E

change in output by addition of one more Average

unit of labour. product curve

10

• Average product is the slope of the line from Marginal

product curve
origin to the point in total product curve. 0
1 2 3 4 5 6 7 8 9 10
Labour per month
Average and Marginal products
• Output starts decreasing when Marginal product becomes negative.

• If APL increases in L, then MPL > APL.

• If APL decreases in L, then MPL < APL.

• Average product is equal to marginal product at its maximum i.e.

when average product neither increases nor decreases in labor.
Three stages of production
• Stage 1: Marginal product reaches its maximum, then falls as diminishing returns set in
but average product rises and reaches its maximum.

• Stage 2: The stage from average product at its maximum till marginal product
reaches zero. Average product decreases but is still positive.

• Stage 3: The stage after which marginal product is negative.

Law of diminishing marginal returns
• Principle that the use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

• Law of diminishing returns is applicable to short or long run?

Output per
month C

• In short run, one of the inputs is fixed, so additions112

of the other input cannot be utilized fully. B

A
• In long run or with technological inventions, Total product
total output can shift up along with marginal 60
curves

product curve.
• Output is increasing from ‘A’ to ‘B’ to ‘C’ with
increase in labour. 1 2 3 4 5 6 7 8 9 10
Labour per
month
Production with two variables-long run
• Isoquants: Curve showing all possible combinations of inputs that yield the same
output.

• Isoquants shows the flexibility that firms Capital per year

have when making production decisions. 5

• Substitution among Inputs: The slope of each 4

isoquant indicates how the quantity of one
3
input can be traded off against the quantity of
other, while output is held constant. 2 Q3= 90
1 Q2= 75
Q1= 55
• Marginal rate of technical 0
substitution = -∆K/∆L (for a 1 2 3 4 5 6

fixed level of ‘q’) Labor per year

Marginal rate of technical substitution
• As more and more labour is added to replace capital, the
labour becomes less productive and capital becomes more
16 A
and more productive.
14

• Diminishing MRTS: Isoquants are convex, i.e. 12 -6

productivity decreases as more and more of one 10 B

Capital per year

1
type of input is added. 8
-4
D
• Movement along isoquant: Output remains constant 6 1
-2
4
E
1 Q=75
-1
2 1
• (MPL)(∆L ) + (MPK)(∆K)=0 0
1 2 3 4 5 6
• (MPL)/ (MPK) = -(∆K )/ (∆L)= MRTS Labour per year
Marginal rate of technical substitution
• -(MPL)/ (MPK) = -(∆K )/ (∆L)= MRTS

• Marginal rate of technical substitution between two inputs is equal to the ratio
of the marginal products of the inputs.

• Production functions:
12
• Perfect substitutes: MRTS is constant. 10

Capital per year

• Same output can be produced with all 8

capital or all labour. 6

4
2
q1 q2 q3
0
1 2 3 4 5

Labour per year

Fixed- proportion production function
• Leonitief production function: Inputs act as 8

perfect complements. 7

• Each level of output requires a fixed amount 6

of both the factors of production. 5

Capital per year

• Factors cannot be substituted. 4

3
• L-shaped Isoquants
2
1

0
1 2 3 4 5 6

• Brown line shows technically efficient combination of inputs. Labour per year
• Vertical and horizontal segments have either marginal product of capital
or marginal product of labour as zero.
Isocost
• All possible combinations of labour and capital that can be purchased for a given
total cost.
• C = wL + rK Capital per year

K2 B

• Slope of isocost line = -(w/r) = -∆K/ ∆L

A
K1
• The point of tangency of a isocost line with
the isoquant line shows the minimum cost Q1
combination. C0 C1 C2
0
L1 L2
Labor per year
Choosing inputs
• What happens when there is a change in expenditure of all inputs?
• The slope of isocost does not change (change is proportionate)
• There is change in intercept
Capital per
year

• What happens when there is a change in

Slope - ∆K/∆L= -w/r
cost of an input? = - MPL/ MPK= MRTS
K2 B
• The slope of isocost line changes
A
• There is change in –w/r K1
q1
• With increase in wage of labour, lesser C1
C2
labour is used and more capital is used. 0
L1 L2
Labour per year
Expansion path and long run costs

Capital per
• Expansion path shows the lowest cost 150 hour
combination of labour and capital to produce Expansion Long-run Total
path cost
output in the long run.
100
• By varying both inputs to production.
50
C 300 unit
B
• The output cost combination of the expansion A
200 unit
100 unit
path gives the long-run total cost curve. 0
100 200 300
Labour per
hour
Long-run versus Short-run cost curves
• Inflexibility of short-run production: In short run,
factors of production are not flexible.
Capital per
hour
Long-run
Expansion
• Q1 is produced by using L1 units of labour and K1 path
units of capital.

C Short-run
• Q2 would be produced by using fixed capital K1 K2 Expansion path
and L3 units of labour. B D q2
K1
• This is at a higher Isocost curve IC3. A IC2 IC3 q1
IC1
0
L1 L2 L3
Labour per
• With higher capital K2, Q2 can be produced at a hour
lower Isocost curve IC2.