Chapter III: 1

Theory of Production
Chapter 3

Theory of production
 2

3.1 Introduction: Definition and basic concepts of Production

• To an economist production means creation of utility for sales.

Alternatively, production may be defined as the act of creating those
goods/services which have exchange value for sale (not for personal
consumption).
• Raw materials yield less satisfaction to the consumer by themselves.
In order to get utility from raw materials, first they must be
transformed into output. However, transforming raw materials into
final products require factor inputs such as land, labor, and capital
• Thus, no production (transforming raw material into output) can
take place without the use of inputs.
 3

Fixed Vs variable inputs

In economics, inputs can be classified as fixed & variable.

• Fixed inputs are those inputs whose quantity can not readily be
changed when market conditions indicate that an immediate change
in output is required. For example, if the demand for Beer shoots up
suddenly in a week, the brewery factories can not plant additional
machinery over a night to respond to the increased demand. It takes
long time to buy new machineries, to plant them and use for
production.
• Thus, the quantity of machinery is fixed for some times such as a
weak. Buildings, machineries and managerial personnel are
examples of fixed inputs because their quantity can not be
manipulated easily in short time periods.
 4

Cont…
• Variable inputs, on the other hand, are those
inputs whose quantity can be changed almost
instantaneously in response to desired changes
in output. That is, their quantity can easily be
diminished when the market demand for the
product decreases and vise versa. The best
example of variable input is unskilled labor.
• In our previous example, if the brewery factory
had idle machinery before the market demand
shot up, the factory can easily and immediately
respond to the market condition by hiring
laborers.
 5

Short run Vs. long run

short run refers to that period of time in which the

quantity of at least one input is fixed. For example, if it
requires a firm one year to change the quantities of all
the inputs, those time periods below one year are
considered as short run.
Thus, short run is that time period which is not sufficient
to change the quantities of all inputs, so that at least one
input remains fixed. Some firms can change the quantity
of all their inputs with in a month while it takes more
than a year to change the quantity of all inputs for
another type of firms.
Long run is that time period (planning horizon) which is
sufficient to change the quantities of all inputs. Thus
there is no fixed input in the long -run
 6

3.2 Production in the short run: Production with

one variable input

• Production with one variable input (while the

others are fixed) is obviously a short run
production
Assumption of short run production
analysis
• In order to simplify the analysis of short run
production, the classical economist assumed the
following:
 7

Cont...

1. Perfect divisibility of inputs and

outputs
This assumption implies that factor inputs and
outputs are so divisible
2. Limited substitution between inputs
Factor inputs can substitute each other up to a
certain point, beyond which they can not
substitute each other
3. Constant technology
they assumed that level of technology of
production is constant in the short run.
 8

3.3 Total product, marginal product and average product

• Total product (TP): is the total amount of output that

can be produced by efficiently utilizing a specific
combination of labor and capital.
• The total product curve, thus, represents various levels
of output that can be obtained from efficient utilization
of various combinations of the variable input, and the
fixed input.
• It shows the output produced for different amounts of
the variable input (example, labor).
 9

Cont...
• Increasing the variable input (while some other inputs
are fixed) can increase the total product only up to a
certain point.
• Initially, as we combine more and more units of the
variable input with the fixed input output continues to
increase. But eventually, increasing the unit of the
variable input may not help output increase.
• Thus increasing the variable input can increase the level
of output only up to a certain point, beyond which the
total product tends to fall as more and more of the
variable input is utilized.
• This tells us what shape a total product curve assumes.
The shape of the total variable curve is nearly S-shape.
 10

Marginal Product (MP)

• he marginal product of variable input is the addition to the total product
attributable to the addition of one unit of the variable input to the
production process, other inputs being constant (fixed).
• when variable input (labor) changes by ∆L, the change in out put per
worker or marginal product of labor, denoted as MPL is found as
∆TP dTP
MPL = or MPL =
∆L dL

• Thus, MPL measures the slope of the total product curve at a given point. In
the short run, the MP of the variable input first increases reaches its
maximum and then tends to decrease to the extent of being negative. That
is, as we continue to combine more and more of the variable inputs with the
fixed input, the marginal product of the variable input increases initially
and then declines.
 11

Average Product (AP)

• The AP of an input is the ratio of total output to

the number of variable inputs used .

totalproduct TP
APlabour = =
numberof L L

• The average product of labor first increases with

the number of labor (i.e. TP increases faster than
the increase in labor), and eventually it declines.
 12

Production in the short run

Total
product

TP

Stage I Stage II
Stage III

APL
MPL

Unit of labor (variable input) used

Figure 3.1
 13

3.4. The law of diminishing marginal returns (LDMR): short –run

law of production

• The LDMR states that as the use of an

input increases (with other inputs being
fixed), a point will eventually be reached at
which the resulting additions to output
decreases.
• The LDMR is in the short run (at least one
input is fixed) and it starts where the
Marginal product starts to decline.
 14

3.5 Efficient Region of Production in the short-run

we are now not in a position to determine the specific number of the

variable input (labor) that the firm should employ because this
depends on several other factors such as the price of labor.
However, it is possible to determine ranges over which the variable
input (labor) be employed.
To do best with this, let’s refer back to fig 2.1 and divide it into three
ranges called stages of production.
• Stage I – ranges from the origin to the point of equality of the APL
and MPL.
• Stage II – starts from the point of equality of MPL and APL and
ends at a point where MP is equal to zero.
• Stage III – covers the range of labor over which the MPL is
negative or TP is decreasing.
Now, which stage of production is efficient and preferable?
To answer the question, let us follow elimination method.
 15

Cont...
• Obviously, a firm should not operate in stage III because in this stage
additional units of variable input are contributing negatively to the total
product (MP of the variable input is negative) because of over crowded
working environment i.e., the fixed input is over utilized.
• Stage I is also not an efficient region of production though the MP of
variable input is positive. The reason is that the variable input (the
number of workers) is too small to efficiently run the fixed input; so that
the fixed input is under utilized (not efficiently utilized)
• Thus, the efficient region of production is stage II. At this stage
additional inputs are contributing positively to the total product and MP
of successive units of variable input is declining (indicating that the fixed
input is being optimally used). Hence, the efficient region of production
is over that range of employment of variable input where the marginal
product of the variable input is declining but positive.
 16

3.6 Long run Production: Production with two variable inputs

• we have completed our analysis of the short-run production
function. Now we turn to the long run analysis of production.
• Remember that long run is a period of time (planning horizon)
which is sufficient for the firm to change the quantity of all
inputs. For the sake of simplicity, assume that the firm uses
two inputs (labor and capital) and both are variable.
• The firm can now produce its output in a variety of ways by
combining different amounts of labor and capital. With both
factors variable, a firm can usually produce a given level of
output by using different combinations of labor and capital.
• In this section, we will see how a firm can choose among
combinations of labor and capital that generate the same
output. To do so, we make the use of isoquant. So it is
necessary to first see what is meant by isoquants and their
properties.
 17
Isoquants
• An isoquant is a curve that shows all possible efficient
combinations of inputs that can yield equal level of output. If
both labor and capital are variable inputs, the production
function will have the following form.
Q = f (L, K)
• Thus, isoquants show the flexibility that firms have when
making production decision: they can usually obtain a
particular output (q) by substituting one input for the other.
• Isoquant maps: when a number of isoquants are combined
in a single graph, we call the graph an isoquant map. An
isoquant map is another way of describing a production
function. Each isoquant represents a different level of output
and the level of out puts increases as we move up and to the
right. The following figure shows isoquants and isoquant map.
 18

Isoquant
Capital

q3
2
q2
1
q1

1 3 6
Labor

Figure3.2 shows the fact that long run production

process is very flexible. A firm can produce q1 level of
output by using either 3 units of capital and l unit of
labor or 2 capital and 3 labor or 1 capital and 6 labor
or any other combination of capital and labor on the
curve. The set of isoquant curves q1, q2, q3 are
called isoquant map
 19

Prosperities of isquants
Isoquants have most of the same properties as
indifference curves.
1. Isoquants slope down ward. Because isoquants
denote efficient combination of inputs that yield the
same output, isoquants always have negative slope.
2. The further an isoquant lays away from the
origin, the greater the level of output it
denotes. Higher isoquants (isoquants further from
the origin) denote higher combination of inputs and
outputs.
3. Isoquants do not cross each other. This is
because such intersections are inconsistent with the
definition of isoquants.
4. Isoquants must be thin. If isoquants are thick,
some points on the isoquant will become inefficient.
 20

Shape of isoquants
• Isoquants can have different shapes (curvature)
depending on the degree to which inputs can subistitute
each other.
1-Linear isoquants
Isoquants would be linear when labor and
K
capital are perfect substitutes for each
other. In this case the slope of an isoquant 10
is constant. As a result, the same output
can be produced with only capital or only
labor or an infinite combination of both. 8
q=100

12 15 L
 21

2. Input output isoquant

• It is also called Leontief isoquant. This assumes

strict complementarities or zero substitutability
of factors of production. In this case, it is
impossible to make any substitution among
inputs. Each level of output requires a specific
combination of labor and capital. As a result, the
isoquants are L-shaped. See following figure
 22

•L-shaped isoquant. When

Cont…
K
isoquants are L-shaped, there is
only one efficient way of producing
a given level of output: Only one
combination of labor and capital
q3 can be used to produce a given
level of output.
q2
K2 • To produce q1 level of output
q1 there is only one efficient
K1
combination of labor and capital (L1
L
and K1).
L1 L2 •Output cannot be increased by
keeping one factor (say labor)
constant and increasing the other
(capital). To increase output (say
from q1 to q2) both factor inputs
should be increased by equal
proportion.
 23

3. Kinked isoquants

• This assumes limited substitution between inputs. Inputs can substitute each other
only at some points. Thus, the isoquant is kinked and there are only a few alternative
combinations of inputs to produce a given level of output. These isoquants are also
called linear programming isoquants or activity analysis isoquants. See the figure
below.LKABC D

12 A

7
B

5
C

L
1 3 5 9
 24

4. Smooth, convex isoquants

• This shape of isoquant assumes continuous

substitution of capital and labor over a certain
range, beyond which factors cannot substitute
each other.
• Traditional economic theory mostly adopted the
continuous isoquants because they are
mathematically simple to handle by the simple
rule of calculus, and they are approximation of
the more realistic isoquants.
• From now on we use the smooth and convex
isoquants to analyze the long run production.
 25

Cont… the smooth and convex isoquant. This

K
type of isoquant is the limiting case of
smoothIsoquant the kinked isoquant when the number
kink is infinite.
∆K=4
The slope of the iso quant decrease as
we move from the top (left) to the right
∆L=1 (bottom) along the isoquant.
∆K=2 ∆K=1/2

This indicates that the amount by

Q
which the quantity of one input
∆L=1

∆L=1

(capital)can be reduced when one extra

L
unit of another inputs(labor)is used ( so
that out put remains constant)
decreases as more of the latter input
(labor)is used.
 26

3.7. The slope of an isoquant: marginal rate of technical

substitution (MRTS)
• The slope of an isoquant (-∆K/∆L) indicates how the
quantity of one input can be traded off against the
quantity of the other, while out put is held constant.
The absolute value of the slope of an isoquant is
called marginal rate of technical substitution
(MRTS).
• The MRTS shows the amount by which the quantity
of one input can be reduced when one extra unit of
another input is used, so that output remains
constant.
• MRTS of labor for capital, denoted as MRTS L, K
shows the amount by which the input of capital can
be reduced when one extra unit of labor is used, so
that output remains constant.
 27

Cont..
• MRTS L, K (the slope of isoquant) can also be given by the ratio of marginal products
of factors. That is,
∆K MPL
MRTS L , K = − =
∆L MPK
• This can be shown algebraically as follows:
Let the production function is given as:
q= f (L, K)
Where q- is output
L- is unit of labor employed
K-is the amount of capital employed.

• Given this production function, the equation of a specific isoquant can be obtained by
equating the production function with a given level of output, say

− −

qq = f ( L, K ) = q

• Total differential measures

q the total change in that happens qas a result of a
simultaneous change in L and K. i.e,
 28

Cont...
∂q ∂f
dq = .dL + .dk = d q
∂L ∂k
q q q
∂q ∂q
.dL + dk = 0
∂L ∂k
• But since is constant,∂qd is zero (d =0)
∂q
= MPl = MPk
So, ∂L ∂k
• (But, and )
• Thus, the above equation can be written as:
MPL. dL + MPK.dk = 0

MPL − dK
=
MPk dL

• There fore, the slope of an isoquant can be given as the ratio of

marginal products of inputs.
• There fore, the slope of an isoquant can be given as the ratio of
marginal products of inputs.
 29

3.8 The efficient region of production: long run

• In principle the marginal product of a factor may assume any value,

positive, zero or negative. However, the basic production theory
concentrates only on the efficient part of the production function, i.e. over
the range of out put over which the marginal product of factors are positive
and declining.
• In the short run production function efficient region of production prevails
∂MPL
∂L
in stage two (stage II), where MPL >O, but < 0.
• Similarly, efficient region of production in the long run prevails when the
marginal product of all variable inputs is positive but decreasing.
Graphically this can be represented by the negatively slopped part of an
isoquant.
• The locus of points of isoquants where the marginal products of factors are
zero form the ridge lines.
 30

Graphically, efficient region of production is shown as follow:

Capital
Upper ridge line

The upper ridge line implies that the MP

of capital is zero. MPk is negative for all
points above the upper ridge line and Lower ridge line

positive for points below the ridge line. q3

The lower ridge line implies that the MPL q2

is zero. For all points below the lower q1

ridge line the MPL is negative and

positive for points above the line. labor
Production techniques are technically
efficient inside the ridge lines
symbolically; in the long run efficient
production region can be illustrated as
∂MPL
MPL >0, but <0 ∂L

MPk >0, but <0 ∂MPk

∂K
 31

3.9 Laws of returns to scale: long run analysis of

production
• In the long run all inputs are variable. Expansion of output may be
achieved by varying all factors of production by the same proportion
or by different proportions.
• The traditional theory of production concentrates on the first case,
i.e. the study of output as all inputs change by the same proportion.
The term returns to scale refers to the change in output as all factors
change by the same proportion. Suppose initially the production
function is
X0 = f (L, K)
• If we increase all factors by the same proportion t, we clearly obtain a
new level of output X* where,
X* = f (tL, tK)
• If X* increases by the same proportion t or if X* = tX0, we say that
there is constant returns to scale.
• If X* increases less than proportionally with the increase in the
factors (or if X* increases by a proportion less than t), we have
decreasing returns to scale.
• If X* increases more than proportionally with the increase in the
factors (by a more than t proportion), we have increasing returns to
scale
 32

3.10 Equilibrium of the firm: Choice of optimal combination of factors of

production

• In our previous discussion we have said that an isoquant

denotes efficient combination of labor and capital
required to produce a given level of out put.
• But, this does not mean that the monetary cost of
producing a given level of out put is constant along an
isoquant.
• That is, though different combinations of labor and
capital on a given isoquant yield the same level of out
put, the cost of these different combinations of labor and
capital could differ because the prices of the inputs can
differ.
• Thus, isoquant shows only technically efficient
combinations of inputs, not economically efficient
combinations.
 33

Cont…
To determine the economically efficient input
combination, the following simplifying assumptions
hold true:
Assumptions
1. The goal of the firm is maximization of profit ( ) ∏
where Where -Profit,
∏ R-revenue and C-is
cost outlay.
2. The price of the product is given and it is equal to .
3. TheP prices of inputs are given (constant). Price of a
X

unit of labor is and that of capital is .

Now before we go to the discussion
w
of optimal input
r

combination (or economically efficientcombination),

we need to know the isocost line, because optimal
input is defined by the tangency of the isoquant and
isocost line.
 34

Isocost line
• Dear learner, do you remember what the budget line
denotes?
• Isocost lines have most of the same properties as that
of budget lines, an isocost line is the locus points
denoting all combination of factors that a firm can
purchase with a given monetary outlay, given prices of
factors.
• Suppose the firm hasC amount of w
costr out lay (budget)
and prices of labor and capital are and respectively.
The equation of the firm’s isocost line is given as:
C = rK + wL , where K and L

are quantities of capital and labor

respectively. C C C
• Given the cost outlay , the maximum amounts r of w

capital and labor that the firm can purchase are equal
to and respectively. The straight line that connects
these points is the iso-cost line. See the following
figure:
 35
Cont…
•the iso cost line: shows different
combinations of labor and capital that the
firm can buy given the cost out lay and prices
of the inputs.
Capital
• Now we are in a position to determine the
firm’s optimal in put combination. However, C/r
the problem of determining optimal input
combination (economic efficiency) takes two Iso cost
line
forms.
•Some times, situations may happen when a
firm has a constant cost outlay and seek to
maximize its out put, given this constant and C/w Labor
cost out lay and prices of in puts.
•Still, there are also situations when the goal
of the firm is to produce a predetermined
(given) level of output with the least possible
cost.
 36

Case1: Maximization of output subject to cost constraint

• Suppose a firm having a fixed cost out lay (money
budget) which is shown by its iso-cost line.
• Here, the firm is in equilibrium when it produces the
maximum possible out put, given the cost outlay and
prices of input.
• The equilibrium point (economically efficient
combination) is graphically defined by the tangency of
the firm’s iso-cost line (showing the budget constraint)
with the highest possible isoquant.
• At this point, the slope of the iso cost line ( ) is equal to
the slope of the isoquant ( ).
• The condition of equilibrium under this case is, thus:

w MPL MPL MPK w MPL

= or = MPK
r MPK w r r
 37

Cont…
w MPL MPL MPK
= or =
r MPK w r

Capital

• this is the first order(necessary) Q3

E
condition. The second K1

order(sufficient) conditon is that Q2

isoquant must be convex to the Q1

origin.
L1
• E is the equilibrium point. Labor

• K1 and L1 are the optimum

combination of capital and labor
that maximize output or minimize
cost.
 38

Numerical example

Suppose the production function of a firm is given as

prices of labor and capital are given as Birr 5 and
Birr 10 respectively, and the firm has a constant cost
out lay of Birr 600.Find the combination of labor
and capital that maximizes the firm’s out put and the
maximum out put.
Solution:
The condition of equilibrium is MPL MPK
= or
MPL w
=
w r MPK r

∂X
MPL = = 0.25L−1 / 2 K 1 / 2 ∂X
∂L MPK = = 0.25L1 / 2 K −1 / 2
∂K
 39

Case -2: Minimization of cost for a given level of output

• In this case, consider an entrepreneur (a firm) who wants to

produce a given output (for example a bridge or a building or x
tones of a commodity) with minimum cost outlay.
• That is, we have a single isoquant which denotes the desired level of
output, but there are a set of isocost lines which denotes the
different cost outlays.
• Higher isocost lines denote higher production costs. The production
costs of a desired level of output will therefore be minimized when
the isoquant line is tangent to the lowest possible isocost line (see
the following fig).
• At the point of tangency, the slope of the isoquant and isocost lines
are identical.
 40

cont w MPL
=
r MPK

• That is,
Capital

c
a
E

L1 b d f
labor
 41

Numerical example

• Suppose a certain contractor wants to maximize

Profit from building a bridge. The contractor
uses both labor and capital, and efficient
combinations of Labor and capital that are
sufficient to make a bridge is given by the
function 0.25 LK. If the prices of labor (w) and
capital (r) are Birr 5 and Birr 10 respectively,
find the least cost combination of L and K, and
the minimum cost.
 42

0 . 25 L − 1 / 2 K −1 / 2
$5
=
Cont… 0 . 25 L − 1 / 2 K −1 / 2
$ 10

• Thus, the equilibrium exists when,

K 1
⇒ = ⇒ L = 2K...................................(1)
L 2
• The constraint equation is:
wL + rK = C
5 L + 10 K = 600......................................( 2)
• Solving equation(1) and (2) would give us the
optimal combination of L and K.

L = 2K
L=60 units and K=30 units. 5 L + 10 K = 600
 43

Cont..

• Thus, the firm should use 60 units of labor and

30 units of capital to maximize its production
(out put). (Check the second order condition).
• The maximum out put can be found by
substituting 60 and 30 for L and K in the
production process.
 44

Case -2: Minimization of cost for a given level of output

• In this case, consider an entrepreneur (a firm) who wants to

produce a given output (for example a bridge or a building or x
tones of a commodity) with minimum cost outlay.
• That is, we have a single isoquant which denotes the desired level of
output, but there are a set of isocost lines which denotes the
different cost outlays.
• Higher isocost lines denote higher production costs. The production
costs of a desired level of output will therefore be minimized when
the isoquant line is tangent to the lowest possible isocost line (see
the following fig)
• At the point of tangency, the slope of the isoquant and isocost lines
are identical. That is
w MPL
=
r MPK
 45

Cont…
Capital

c
•the equilibrium combination of a
factors is K1 and L1 amounts of E
K1
capital and labor respectively. Q

•Lower isocost lines such as ‘ab’ are

economically desirable but un
attainable given the desired level of b f
L1 d
output. Labor

• So point E shows the least cost

combination of labor and capital to
produce X amount of output.
 46

example
• Suppose a certain contractor wants to maximize Profit
from building a bridge. The contractor uses both labor
and capital, and efficient combinations of Labor and
capital that are sufficient to make a bridge is given by the
function 0.25 LK. If the prices of labor (w) and capital (r)
are $ 5 and $ 10 respectively, find the least cost
combination of L and K, and the minimum cost.
Solution
• The contractor wants to build one bridge. Thus, the
constraint equation can be written as
1 1
0 . 25 L 2
K 2
= 1
− 1 1
MPL = 0 . 125 L 2
K 2

1 − 1
MPK = 0 . 125 L 2
K 2
 47
−1 1
0 . 125 L 2 K 2
5
1 −1 =
0 . 125 L K 2 2 10
K 1
= ⇒ L = 2K
Cont..
MPL W
=
L 2 MPK r

• The equilibrium condition is

− 1 1
0 . 125 ( 2 K ) 2
K 2
= 1
0 . 125 2 K = 1
1 8
K = = K =
0 . 125 2 2
16
L = 2 K ⇒
• Substituting L=2K in the constraint
2 equation we obtain

16 8
2 2
• Therefore, efficient combination (least cost combination) of L and K
are and respectively.
16 8
C = 5( ) + 10( ) =
160
• The least cost
2 is 2 2
 48

CAPTER FOUR
THEORY OF COSTS OF PRODUCTION

Introduction
• In this unit, you will study the meaning and behaviors of
costs of production, the relationship between production
(output) and costs (i.e. cost function both in the short
run and long run.)
Objectives
• After successful completion of this unit, you will be able
to:
• Explain different ways of measuring private costs, i.e.
economic costs vs. accounting costs.
• Define the meaning and nature of cost functions both in
the short run and long run.
• Explain the relationship between short run production
function and short run cost function.
• State how learning and experience affects the costs of
production.
 49

4.1 Basic concepts

• To produce goods and services, firms need factors
of production or simply inputs. To acquire these
inputs, they have to buy them from resource
suppliers.
• Cost is, therefore, the monetary value of inputs
used in production of an item.
• We can identify two types of cost of production:
social cost and private cost.
• Social cost: is the cost of producing an item to the
society. This cost is realized due to the fact that
most resources used for production purpose are
scarce and some production process, by their
nature, emit dangerous chemicals, bad smell, etc to
surrounding society.
 50

Cont…
• For example, when a certain beer factory wants to produce beer in
Ethiopia, the society as a whole also incurs a cost. Because, the next-
best alternative of the raw material (such as barely) used for the
production of beer is sacrificed.

• When the beer factories buy barley from the market, the amount of
barely available for consumption by society may be reduced and the
price may become dearer. Hence, the production of beer imposes an
indirect cost on the society, moreover, by its nature; the production of
beer emits bad chemicals to the environment, which pollutes waters, air,
etc.

• To control the understandable consequences of the production process

on the environment and their property, the society incurs cost.
 51

Cont…

• Private cost: This refers to the cost of

producing an item to the individual producer. It
is the cost that the beer factory incurs to produce
the beer, in our example:
• Private cost of production can be measured in
two ways:
• Economic cost
• Accounting cost
 52

Economic cost
i) Economic cost
• In economics the cost of production to the individual
producer includes the cost of all inputs used for the
production of the item.
• The producer may buy part of the inputs from the
market. For example, he/ she hire workers, buy raw
materials, the necessary machines, etc. the actual or out-
of- pocket expenditures that the firm incurs to purchase
these inputs from the market are called explicit costs.
• But, the producer can also use his/ her own inputs which
are not purchased from the market for the production
purpose. For example, the producer may use his/ her
own building as a production place, he/she may also
manage his firm by himself instead of hiring another
manager, etc. since these inputs are used for the
production purpose, their value has to be estimated and
included in the total cost of production
 53

Cont…
• The estimated cost of there non- purchased
inputs are called implicit costs.
• Thus, in economics the cost of production
includes the costs of all inputs used in the
production process whether the inputs are
purchased from the market or owned by the firm
himself that is:
• Economic cost: Explicit cost plus Implicit
cost
 54

Cont…
ii)Accounting Cost
• For accountant, the cost of production includes
the cost of purchased inputs only. Accounting
cost is the explicit cost of production only. More
over, accountant’s doesn’t consider the cost of
production from the opportunity cost of the
resources point of view.
 55

4.2 cost functions

• Cost function shows the algebraically relation between the cost of
production and various factors which determine it. Among others, the
cost of production depends on the level of output produced, technology of
production, prices of factors, etc. hence; cost function is a multivariable
function. Symbolically,
C = f (x, t, pi)
Where c- is total cost of production
x - is the amount of output
T – is the available technology of production.
Pi – is the price of input
• Graphically, cost functions can be illustrated by using a two- dimension
diagrams. To do so, first we observe the relationship between the total
cost of production and the level of output (the most factor determining
the cost of production), by assuming that all other factors are constant.
 56

4.3 – Short run vs. long run costs

• Economics theory distinguishes between short run costs

and long run costs. Short run costs are the costs over a
period during which some factors of production (usually
capital equipments and management) are fixed. The
long- run costs are the cost over a period long enough
to permit the change of all factor of production.
 57

Short run costs

• In the traditional theory of the firm, total costs are split

into two groups: total fixed costs and total variable costs:
TC = TFC + TVC
Where – TC is short run total cost
TFC is short run total fixed cost
TVC is short run total variable cost
• By fixed costs, we mean a cost which doesn’t vary with
the level of out put. The fixed costs include:
▫ Salaries of administrative staff
▫ Expenses for building depreciation and repairs
▫ Expenses for land maintenance
▫ The rent of building used for production , etc
 58

Cont…
• All the above costs are regarded as fixed costs because whether the
firm produces much output or zero out put, these costs are
unavoidable, and the firm can avoid fixed costs only if he / she shuts
down the business stops operation.
• Variable costs, on the other hand, include all costs which directly
vary with the level of output. The variable costs include:
▫ The cost of raw materials
▫ The cost of direct labor
▫ The running expenses of fixed capital such as fuel, electricity power, etc.
• All these costs are regarded as variable costs because their amount
depends on the level of out put. For example, if the firm produces
zero output, the variable cost is zero.
 59

Total fixed cost (TFC)

• Graphically, TFC is denoted by a straight line parallel to

the out put axis. The point of intersection of the TFC line
with the cost axis (vertical axis) shows the amount of the
fixed. For example if the level of fixed cost is $ 100, it can
be shown as,

$100 TFC

X
 60

Total variable cost (TVC)

• The total variable cost of a firm has an inverse s- shape. The shape
indicates the law of variable proportions in production. According to
this law, at the initial stage of production with a given plant, as more
of the variable factor (s) is employed, its productivity increases.
Hence, the TVC increases at a decreasing rate. This continues until
the optimal combination of the fixed and variable factors is reached.
Beyond this point, as increased quantities of the variable factors(s)
are combined with the fixed factor (s) the productivity of the
variable factor(s) declined, and the TVC increases by an increasing
rate.
• Thus, the TVC has an inverse s-shape due to the law of diminishing
marginal returns.
 61

• Graphically, the TVC looks the following.

TVC
C

X
 62

Total Cost (TC)

• The total cost curve is obtained by vertically adding the

TFC and the TVC i.e., by adding the TFC and the TVC at
each level of output. The shape of the TC curve follows
the shape of the TVC curve. i.e. the TC has also an
inverse S-shape. But the TC curve doesn’t start from the
origin as that of the TVC curve. The TC curve starts from
the point where the TFC curve intersects the cost axis.
 63

• the TC and TVC curves has an inverse S- shape. The vertical distance between them
(TFC) is constant.
C

TC

TVC

TFC

TFC

Q
 64

Per unit costs

• Average fixed cost (AFC): is found by dividing the
TFC by the level of output.
TFC
AFC =
Q

• Graphically, the AFC is a rectangular hyper parabola.

The AFC curve is continuously decreasing curve, but
decreases at a decreasing rate and can never be zero.
Thus, AFC gets closer and closer to zero as the level of
output increases, because a fixed amount of cost is being
divided by increasing level of output.
 65

Cont…
• Average variable cost (AVC)
• The AVC is similarly obtained by dividing the TVC with
the corresponding level of output.
TVC
AVC =
X

• Graphically, the AVC at each level of output is derived

from the slope of a line drawn from the origin to the
point on the TVC curve corresponding to the particular
level of output.
 66

Average total cost (ATC) or simply, Average cost (AC)

• ATC (or AC, now on) is obtained by dividing the TC by

the corresponding level of output. It shows the amount
of cost incurred to produce each unit of successive
outputs.
Or equivalently,
TC
AC =
Q
TVC + TFC
AC =
Q
TVC TFC
= +
Q Q

TC = AVC + AFC
• Thus, AC can also be given as the vertical sum of AVC
and AFC.
 67

Marginal Cost (MC)

• The marginal cost is defined as the additional cost that the firm incurs to
produce one extra unit of the output. One thing to be noted here is that, the
additional cost that the firm incurs to produce the 10th unit of output is not
equal to the additional cost of producing the 1000th unit. They would be
equal if the TC curve is straight line.
• To sum up, the MC is the change in total cost which results from a unit
change in output i.e. MC is the rate of change of TC with respect to output,
Q or simply MC is the slope of TC function and given by:

dTC
MC =
dQ
• In fact MC is also the rate of change of TVC with respect to the level of
output.
dTFC + dTVC dTVC
MC= =
dQ dQ
since dTFC
= 0
dQ
 68

Hypothetical total, average and marginal costs

Q TF TVC TC=TFC+T AFC=TF AVC=T ATC=TC/Q MC=∆TC/∆
C VC C/Q VC/Q =AFC+AV Q
0 60 0 60 - - -C -

1 60 30 90 60 30 90 30

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45
 69

Cost functions
• Cost of production is a function of output
produced (Q). Given the cost function,

TC = 3Q3 − 2Q 2 + 10Q + 100

Find FC,VC,AFC,AVC,ATC and MC functions?

VC 3Q 3 − 2Q 2 + 10Q
FC = 100 AVC = = = 3Q 2 − 2Q + 10
Q Q
VC = 3Q 3 − 2Q 2 + 10Q TC 3Q 3 − 2Q 2 + 10Q + 100 100
ATC = = = 3Q 2 − 2Q + 10 +
FC 100 Q Q Q
AFC = =
Q Q MC =
dTC
= 9Q 2 − 4Q + 10
dQ
 70

Graph of average cost curves

cost AC
MC

AVC

•The AVC curve reaches its minimum

point at Q1 output and AC reaches its
minimum point at Q2. AFC

Q1 Q2
• The vertical distance between AC and output

AVC (AFC) decrease continuously as out

put increases.

•The MC curve passes through the

minimum point of both AC and AVC
 71

4.4 The relationship between AVC, ATC and MC

• Given ATC = AVC + AFC, AVC is part of the ATC. Both

AVC and ATC are u – shaped, reflecting the law of
variable proportions however, the minimum of ATC
occurs to the right of the minimum point of the AVC (
see the above figure) this is due to the fact that ATC
includes AFC which continuously decreases as the level
of output increases.
• After the AVC has reached its lowest point and starts
rising, its rise is over a certain range is more than off set
by the fall in the AFC, so that the ATC continues to fall
(over that range) despite the increase in AVC.
• However, the rise in AVC eventually becomes greater
than the fall in AFC so that the ATC starts increasing.
The AVC approaches the ATC asymptotically as output
increases.
 72

4.5 The relationship between short run per unit

production and cost curves
• cost function is derived from production function.
• Now, lets see the important relation that per unit
production curves (i.e. AP and MP of the variable input)
and per unit cost curves (i.e. AVC and MC) have.
• The relationship is that the short run per unit costs are
the mirror reflection (against the x-axis) of the short run
production curves.
• That is the short run AVC is the mirror reflection of the
short run AP of the variable input. When AP variable
input increases, AVC decreases; when AP variable input
reaches its maximum, the AVC reaches its maximum
point, and finally when AP variable input starts to fall,
the AVC curve starts to rise.
 73

Cont…
• The same relationship exists between the short run MP
of variable input curve the MC curve. This can be shown
algebraically by using a linear short run cost function.
• Suppose the firm uses two inputs, labor L (which is
variable) and capital (which is fixed input).
• And suppose that the prices of both factors are given
and equal to w, and r respectively.
 74

Cont…
• The total cost of production is
TC= rK+wL
• thenThe first term (i.e. rk) is the fixed cost
because both r and k are constant and the
second term (i.e.wL) represents the variable
cost.
• Thus, TVC = WL
• AVC = = = But, represents APL
• Therefore, AVC = 1
TVC Q
WL Q
W . L
Q Q L

1
W.
APL
 75

Cont…
• Hence, AVC and APL are inversely related.
• Similarly, MC and MPL are inverserly related.
dTC dTVC
MC = =
dQ dQ
d ( WL )
MC =
dQ
dL
MC = W . .......... ( because W is cons tan t )
dQ
1
MC = W .
dQ
dL
1 dQ
MC = W . .......... we know that = MP
MP dL
Hence, MC and MPL have also an inverse relation.
 76

Cont….
•short run AVC and MC
curves are the mirror AP, MP

reflection (along the

AP
horizontal axis) of short
MP
run APL and MPL curves
•Maximum of MP
corresponds to the labor MC

minimum of MC MC, AVC AVC

•The maximum of AP
corresponds to the
minimum of AVC
Q
 77

4.6 Costs in the long run

• The basic difference between long-run and short run costs is that in
the short run, there are some fixed inputs which results in some
amount of fixed costs.
• However, in the long run all factors are assumed to become variable.
In the long run the firm can change the quantities of all inputs
including the size of the plant.
• This implies that all costs are variable in the long-run in the sense
that it is always possible to produce zero units of output at zero
costs. That is, it is always possible to go out of business.
• The long –run cost curve is a planning curve, in the sense that it is a
guide to the entrepreneur in his decision to plan the future
expansion of his plant.
 78

Derivation of the long- run average cost curve

• The long run average cost curve is derived from the short run
average cost curves. Each point on the long run average cost (LAC,
now on) corresponds to a point on the short run cost curve, which is
tangent to the LAC at that point.
• Now let us examine in detail how the LAC is derived from the short
run average cost ( SAC) curves.
• Assume that the available technology to the firm at a particular
point of time includes three methods of production, each with a
different plant size: a small plant, medium plant and large plant.
• The operation cost of the small plant is denoted by SAC1, the
operating cost of the medium size plant is denoted by SAC2 and that
of the large size plant is denoted by SAC3 in the following figure.
 79

Cont…
• If the firm plans to produce x1 units of output, it
is well advised to choose the small size plant to
minimize its cost.
• For example, if the firm choose to use the
medium size plant to produce x1 units of output,
the per unit costs will be C4 (a point
corresponding to x1 units of out put on the
SAC2) but, the firm can produce x1 units of
output at a lower unit cost (c1) if it uses the small
size plant.
• Similarly, if it plans to produce x2 units of
output, it will choose the medium size plant. If
the firm wishes to produce x3 units, it will
choose the large size plant.
 80

Cont…
• If the firm starts with the small plant and its demand
gradually increases, it will produce at lower costs (up to
x1 level of output).
• Beyond that level of output, costs start increasing. If its
demand reaches the level x1” the firm can either
continue to produce with the small plant or it can install
the medium size plant.
• The decision, at this point, whether to install the
medium size plant or not depends not on the costs but
on the firm’s expectation about its future demand.
• If the firm expects that the demand will expand further
than x1” it will install a medium size plant because with
this plant out puts larger than x1” are produced with a
lower cost.
 81

Graph of long run average cost curve

SAC1

SAC2
C4 LAC

C1’
C1

C2’
SAC3

C2

C3

X1

X1’’’’ X2 X3
X2’