CHAPTER FOUR

THEORIES OF PRODUCTION AND COST

4.1. THEORY OF PRODUCTION
4.1.0. Introduction: As we have discussed in chapter one “how to produce” is one of the
basic economic problem common to every economic system. The theory of production is
concerned to deal with this question.
4.1.1 Definition of concepts
i. Inputs to production: - are factors of production that go into the production of goods and
services. Thus, no production (transforming raw material into output) can take place without
the use of inputs.
 Fixed inputs: - are inputs whose supply cannot be varied over the time under
consideration. Fixed inputs are those inputs whose quantity cannot readily be changed
when market conditions indicate that an immediate change in output is required. In
fact, no input is ever absolutely fixed, but may be fixed during an immediate
requirement. For example, if the demand for Beer shoots up suddenly in a week, the
brewery factories cannot 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.
 Variable inputs: - are those the supply of which can be varied in the short run. In
other word, variable inputs 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.
ii. Production: - is a process by which resources are transformed in to final goods and
services. Alternatively, production may be defined as the act of creating those goods/services,
which have exchange value for sale (not for personal consumption)
iii. Short –run period: - is a time period over which at least one input is fixed. In economics,
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 periods that is
not sufficient to change the quantities of all inputs, so that at least one input remains fixed.
iv. Long – run period: - is a period of time in which all inputs are variable. 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.
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Note that:
 Short – run does not refer to relatively short period like a year or less, and long- run
does not refer to a period of time greater than a year. They rather refer to the nature of
economic adjustment in the firm to changing economic environment.
 Short run periods of different firms have different duration. 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. For example, the time
required to change the quantities of inputs in an automobile factory is not equal with
that of flour factory. The later takes relatively shorter time.
V. Production function:- describes the technological relationship between inputs & outputs.
Example: Q = f( L, K, Ld, R…..)
Where; Q= Output
L= Labor
K= Capital
Ld= land
R= Raw materials
4.1.2. 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
phenomenon because there is no fixed input in the long run. Consider that a farmer wants to
produce wheat on one hectare of land. To produce wheat, he needs land, labor, fertilizer,
water and some equipment. Assume that all of the inputs except labor are fixed at a certain
quantity. Suppose a firm uses two of these inputs; land (which is a fixed input) and labor
(which is variable input). Given the assumptions of short run production, the firm can
increase output only by increasing the amount of labor it uses.
The short run production function can be written as Q = f (L, ) where
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
is the quantity of land (which is fixed)
Look at the following hypothetical data with labor the variable input, and land a fixed input.

Table 4.1.1: Short run production

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Land Number of Output Average Marginal Stage of
workers (Q) product product production
(APL) (MPL)
1 hectare 0 0 - 0
“ 1 2 2 2
“ 2 5 2.5 3 Stage – I
“ 3 9 3 4
“ 4 12 3 3
“ 5 14 2.8 2
“ 6 15 2.5 1 Stage – II
“ 7 15 2.14 0
“ 8 14 1.75 -1 Stage – III

Graphically:

TP

Stage – I Stage – II Stage – II

TP, ( Q= f(L, ))

7 Labour

MPL
APL

APL

MPL

Fig 4.1.1 Total, average and marginal products

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4.1.2.1. Basic concepts related to Short run production function: Total product,
marginal product and average product
I. Total output (Total product or TP):- describes the total amount of output produced
during some period by efficiently utilizing a specific combination of labor and fixed land. It
shows the output produced for different amounts of the variable input, labor. Any ways,
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. However, eventually, as we employ more
and more unit of the variable input beyond the carrying capacity of a fixed input, out put may
tends to decline.
II. Average product (APL) :- is the total product per unit of the variable input.

APL =
III. Marginal product (MP):- is a change in total product resulting from one unit change in
the variable input. If output changes by Q when the number of workers (variable input)
changes by ∆L where (L =1), the change in out put per worker or marginal product of the
variable input, denoted as MPL is found as

MPL=

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.
IV. Stage of production: The short run production function can generally be classified into
three stages of production.
Stage I: It goes from the origin up to the point where average product is maximum (i.e. AP
= MP).
- In this stage total product increases at an increasing rate.
- In stage I each additional unit of labor contributes more than the average (i.e. MP
> AP).
- In this stage the fixed input is underutilized.
Stage – II: - It goes from the point where the AP is maximum to the point where MP is zero (
i.e. TP is maximum).
- In this stage TP increases at a decreasing rate.
- In stage – II, AP > MP.

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Stage – III:- It covers the range over which the marginal product is zero.
- In this stage TP diminishes.
- In stage – II, the additional unit of labor contributes negatively to total product.
- Since there is over employment of the variable input, the fixed input is over
utilized.
- In this stage, AP > MP.
Now, which stage of production is efficient and preferable? Note: A rational producer should
produce in stage – II (why?). To answer the question, let us follow elimination method.
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.
The law of diminishing Marginal Returns
The law states that as an increasing amount of a variable input is combined with fixed inputs,
eventually the contribution of each additional amount of the variable input to the total product
declines. This is due to the fact that the amount of the fixed input per unit of the variable
input declines. The law starts to operate after the marginal product curve reaches its
maximum.

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4.2. THEORY OF COSTS OF PRODUCTION
In this unit, we 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 in long
run.) because most decisions regarding price and production are taken on the bases of money
value of input and our put rather than their physical quantities.
Hence, the money value of inputs and output are, respectively called cost of production &
revenue. Therefore, here the general objective of this chapter is just to discuss the relationship
between the output and cost of production.
4.2.1 Basic concepts of cost
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 output.
We can identify two types of cost of production: private cost and social cost.
1. 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:
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. The payments on account for wages , utility expenses, interest rate ,rent ,purchase of
materials ,license fee, insurance premium & depreciation charges are examples of explicit
costs. These costs involve direct cash payments from firm’s pocket and are clearly reflected
by the usuall accounting practices.
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 purpose production, their value has to be
estimated and included in the total cost of production. As to how to estimate the cost of these
non- purchased inputs is concerned, we usually estimate their cost from what these inputs
could earn in their best alternative use. For instance, if the firm uses his own building for
production purpose, the cost of using this building for production is estimated by the rent

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income foregone. If the producer is a teacher with salary of 1000 birr per month and fruits his
job to manage his factory, then the next best alternative of his labor is the salary that he
sacrificed to be the manager of his factory. The estimated cost of their non- purchased inputs
are called implicit(Opportunity) costs.
Suppose that Mr. .smith quits his job that earns $ 50,000 per year and instead opens his own
small business and expects to earn an annual net income of $70,000 from the new small
business. Mr. smith‘s opportunity cost is $ 50,000 per year the earnings he foregoes by
working for his own firm.
When we come to our real life, it is also full of such examples.E.g. If a student opts for
Economics, then he cannot be simultaneously a science graduate.
Associated with the concept of opportunity cost there is a concept of economic rent or
economic profit based on the above e.g. the economic rent = 70,000 -50,000=20,000 and the
business implication of this concept is that opening a new business is preferable so long as
its economic rent is greater than zero .
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:
Generally; Economic cost: Explicit cost plus Implicit cost
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. Moreover, accountant’s doesn’t
consider the cost of production from the opportunity cost of the resources point of view. To
clarify the difference between accounting cost and economic cost on this regard, consider the
following example.
Suppose Bedele Brewery factory purchases 1000 quintals of barely for 200 birr per quintal in
1998 to use this barley for production purpose in the year 1999. However, suppose that the
price of the barely has been increased to 300 birr per quintal in the year 1999. Now shall we
use the actual price with which the barely was bought in 1998 or the current price (1999
price) to estimate the cost of barely in 1999?
In economics, the 1999 price should be taken because, though the barley was bought for 200
birr per quintal in 1998, the cost of using this barely for the production purpose in 1999 is the
300 birr per quintal, the amount of income that could be obtained if the barely were sold in
the market.But accountants use the 1998 price to estimate the cost of production in the year
1999.
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2.Social cost: is the cost of producing an item to the society. It implies the cost which a
society bears on account production of a commodity. 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.
For example, when a certain beer factory wants to produce beer in Ethiopia, the society as a
whole also incurs a cost. 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
increased. 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.
Social cost includes both private and external costs.
External cost includes
 The cost of resources for which the firm is not compelled to pay a price. E.g.
atmosphere, river, lakes and also for the use of public utility service like roadways,
drainage system e.t.c. and
 The cost in the form of ‘disutility’ created through air, water & noise pollutions, e.t.c
e.g. buses, trucks, e.t.c, cause both air and noise pollution. Such pollutions cause
tremendous health hazards which impinges a cost on the society as a whole.
Such costs do not figure in the cost structure of the firms & hence are termed as external costs
from the firm’s point of view, & social cost from society’s point of view.
Short run & 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.
Fixed and Variable Costs
A. Fixed Costs: - are costs that do not vary over a certain level of output.
They are associated with the very existence of a firm’s plant & therefore must be paid even if
the firm’s rate of output is zero.
 The concept of fixed cost is associated with short run.
E.g. Rental Payments, depreciation of machinery, building and other fixed assets, and the
salaries of top management & key personnel are generally fixed costs.

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B.Variable Costs: - are those, which vary with the variation in the total output. Such costs
are functions of the output.
E.g. Cost of raw materials, running cost of fixed capital, such as fuel, ordinary repairs, direct
lab our charges associated with the level of output, and the costs of all other inputs that vary
with output.
These cost concepts are economic in nature and are associated with economic analysis of cost
behavior in relation to output.
4.2.2. 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 and Pi – is the price of input
4.2.2.1. Short-run cost functions and curves
A. Short-run cost functions
1. Total, Average & Marginal costs
A. Total Cost (TC) - refers to the total outlays of money expenditure, both explicit &
implicit, on the resources used to produce a given output.
The total cost for a given output is obtained from the cost function. Cost function: - is a
function derived from the production function and the market supply of inputs.

TC=TFC+TVC

B. Average cost (AC) rather than being an actual cost, it is obtained simply by dividing the
TC by the total output (Q),
i.e, AC = TC/Q

C. Marginal Cost (MC) is the addition to the total cost on account of producing one
additional unit of the product.
 It is the cost of marginal unit produced.
i.e.
MC = TC/Q

2. Average Fixed and Variable cost

and AVC=TVC/Q
AFC=TFC/Q
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Short- runs cost- out put relationships
The basic cost concepts used in the analysis of cost-out put relations are total, average &
marginal costs. The short-run TC is composed of two major elements: i.e total fixed cost
(TFC) and Total variable cost (TVC). Thus
TC = TFC +TVC
For a given quantity of output, Q, the ATC or AC, AFC &AVC can be obtained as
AC= TC/Q
AFC = TFC / Q, AVC =TVC/Q
TC =TFC + TVC
AC= TFC + TVC = AFC + AVC
Q Q
And MC can be obtained as MC= TC/Q since TC =TFC+ TVC and in the short sue
TFC = O,
:: TC = TVC
In other words, in the short run MC = TVC/Q
Relationship b/n TC & outputs
Here TC = TFC + TVC but here TFC remains constant for the entire range of output.
TVC on the other hand, changes with the changes on output.
TVC first increases with an increase in output, with a decreasing rate, then after some point it
will increase with an increase rate. This kind of change in TVC takes place due to first
increasing and then diminishing returns to the variable input.
Since TFC remains constant in the short-run, TC changes at the rates of change in TVC. So
here TC increase (decrease) with increase (decrease) in the output.
Output and average and marginal costs relation
The relation of average and marginal costs to the change in output is a more important aspect
of input – output relations. AFC = TFC /Q decreases throughout as output increases, because
TFC remains constant while Q increases.
The AVC =TVC/Q first decreases and then increases. This is so because, while output
increases at a constant rate of one , TVC increases first at a diminishing rate and then at an
increasing rate.
AC = TC/Q first decrease and then begins to increase.

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AC falls over some level of output b/se of increasing returns to the variable input, and it
increases beyond a level of output b/se of diminishing returns to the variable input. And this
property of cost output relations makes the AC curve U- shaped.
The Mc =  TC/Q, decreases till certain level of output & then begins to rise at an
increasing rate. Given the TFC, the fall & rise in MC is determined by the changes in TVC
(i.e. TVC) .for TC is determined by TVC.
B. . Short-run cost curves
The short – run output – cost relations have been presented through the cost curves in fig
2&3. Fig 2 below shows the relationship b/n output and TFC, TVC & TC. The TFC remains
fixed for the whole range of output, and hence, take the form of a horizontal line. The TVC
curve shows that the total variable cost first increases at a decreasing rate and then, at an
increasing rate with the increase in the total output. The rate of increase can be obtained from
the slope of TVC curve. The TC curve must necessarily have the same pattern of behavior
b/se, TFC remaining constant.
Given the TFC, TC increases by the amount of increase in the TVC.The distance between
TC& TVC denotes the fixed cost at all the levels of output.

TC
Cost

TVC

TFC

O
Output (Q)

Fig (2) Graph for Total fixed cost, Total Variable cost & Total cost

As fig (3) below shows, in the initial stage of production, both AFC & AVC are declining
b/se of internal economies

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 Since AC = AFC + AVC, the AC is also declining & this shows the operation of the law of
increasing returns. But beyond output of Q1 units, while AFC continues to fall, AVC starts
increasing b/se of a faster marginal increase in the TVC. Consequently, the rate of fall in AC
decreases. The AC reaches its minimum when output increases to Q2 units.
Beyond this level of output, AC starts increasing which shows that the law of diminishing
returns comes in operation
The MC curve represents the patterns of change in both the TVC & TC curves as output
changes. Decrease in MC shows increasing marginal productivity of the variable input which
is mainly b/se of internal economies resulting from increase in production. Increase in MC
marks the disappearance of internal economies of the firm.

Costs MC
ATC

AVC

AFC
O output (Q)

Fig (3) Average & marginal cost curves

Relationship between AC & AVC
 Since AC = AFC + AVC, AC falls so long as AVC fall.
 When AFC continues to fall but AVC start increasing, the change in AC depends on the rate
of change in AFC & AVC, on the following pattern:
i. If decrease in AFC > increase in AVC, AC falls;
ii. If decrease in AFC < increase in AVC, AC begins to increase. and
iii. If decrease in AFC = increase in AVC, AC remains constant
Note that, in fig (3) as output increases AC & AVC are getting closer and closer. The reason
is, the distance b/n AC & AVC equals AFC. Hence; AFC = TFC/Q, decreases when Q
increase.

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Relationship between MC, AVC & AC
MC cuts both AVC & AC at their minimum. When both the marginal and AVC’S are falling,
Average variable cost will fall at a slower rate. As a result MC will attain its minimum before
the AVC. However when MC & AVC are increasing, MC will rise at a faster rate. The other
relation is, as long as MC lies below AVC, the later will fall and where MC is above AVC, AVC
will rise. Therefore, at the point of intersection where MC = AVC, AVC has just ceased to fall
& attained its minimum, but has not yet begun to rise.
Mathematically the relationship between MC and AVC
From AVC = TVC , => TVC = (AVC).Q
Q
MC = d(TC) = d(TFC+TVC) = d(TFC) + d(TVC)
dQ dQ dQ dQ
=> MC = d(TVC) , since change in the TFC= 0
dQ
=> MC = d(AVC.Q) = AVC.dQ + Q.d(AVC)
dQ dQ dQ
=> MC = AVC + (Q) (slope of AVC)

Given that AVC and Q are Positive,

 MC < AVC if slope of AVC<0
 MC =AVC if slope of AVC=0 (at the minimum point of the AVC).
 MC >AVC if slope of AVC>0.
Similarly, the MC curves cuts the AC curve at the latter’s minimum point. This is b/se MC
can be defined as the addition either to TC or total variable cost (TVC) resulting from one
more unit of output.
To look mathematically from AC = TC => TC= (AC).Q By definition;.MC = d(TC)
dQ dQ

=> MC = d(AC.Q)
dQ
=> MC = AC.dQ + Q.d(AC)
dQ dQ
=> MC = AC + (Q)(slope of the AC)
Given that, Q and AC are Positive,
 MC < AC if slope of AC is negative.
 MC = AC if slope of AC=0, (at the minimum of the AC).
 MC > AC if slope of ATC>0.
However, such relationship does not exist b/n MC & the AFC, b/se the MC by definition
includes only those costs, which change with output, and fixed costs by definition are
independent of output.

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Functional and graphical relationship between AP & MP and AVC & MC-
There is straight forward relationship b/n factor productivity & output costs. To see this, let
us consider a single variable factor, labor. All other inputs are fixed.
AP & MP will denote the Average & marginal products of labor respectively.
If W is the wage rate & L is the quantity of labor, then
TVC = WL
Hence, AVC = TVC/Q = WL/Q = W (L/Q)
But Q/L = AP.Hence, AVC = W/AP. Also,
TVC = W. L. (W does not change .It is assumed as given.) dividing by Q we get
MC = TVC = W. L
Q Q
But Q/L = MP
Hence, we have MC = W/ Mp.the relationships AVC = W/AP and MC = W/MP show that
MC is at a minimum when MP is at a maximum, and AVC is at a minimum when AP is at a
maximum.
Also, when AP is at a maximum, AP =MP .Hence, when AVC is at a minimum, AVC=MC.
These relationships are illustrated in the following figure
Graphically:
AP/MP

APL
Fig.1.Graps for AP and
AC/MC MPL AVC; MP and MC
MC
AC
AVC

Q
Note that: unit costs and unit products are mirror images of one another.

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4.2.4. Optimum output & cost curves
Where cost minimization is the objective of the firm, optimum level of output is one, which can
be produced at a minimum average cost, given the technology. The minimum level of AC is
determined by the point of intersection b/n AC & MC curves. That means at MC= AC level of
output.Any other level of production, below or beyond this level, will not be optimal.
Note that the optimum level of output is not necessarily the maximum – profit output.

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