INTRODUCTION ECONOMICS

Arba Minch University

College of Business and Economics
Department of Economics
by
11/14/2022
Zigale Y.(M.Sc.) 1
 CHAPTER FOUR
The Theory of Production and Cost

What is production?
Raw materials yield less satisfaction to the consumer by themselves.

In order to get better utility from raw materials, they must be transformed into

outputs.

Production is the process of transforming inputs into outputs.

However, transforming raw materials into outputs requires inputs such as land,

labor, capital and entrepreneurial ability.

The end products of the production process are outputs which could be

tangible (goods) or intangible (services).

 4.1.2 Production function
 Production function is a technical relationship between inputs and outputs.
 It shows the maximum output that can be produced with fixed amount of
inputs and the existing technology.
 A production function may take the form of an algebraic equation, table or
graph.
 A general equation for production function can, be described as:
 Q= f(X1 ,X2,X3 ,...,Xn ),where,
 Q is output and X1, X2, X3,…, n are different types of inputs.
Inputs
 Inputs are commonly classified as fixed inputs or variable inputs.
 Fixed inputs are those inputs whose quantity cannot readily to changed
when market conditions indicate that an immediate adjustment in output is
required.
 Cont’d …
 Buildings, land and machineries are examples of fixed inputs
because their quantity cannot be manipulated easily in a short
period of time.
 Variable inputs are those inputs whose quantity can be altered
almost instantaneously in response to desired changes in output.
 That is, their quantities can easily be diminished when the market
demand for the product decreases and vice versa.
 The best example of variable input is raw materials and unskilled
labor.

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 Cont’d …
 In economics, mainly there are two types of time period

 Short run refers to a period of time in which the quantity of at least

one input is fixed.
 It refers to the period of time over which the amount of some
inputs, called the ‘fixed inputs’, cannot be changed.
 In other words, short run is a time period which is not sufficient to
change the quantities of all inputs so that at least one input remains
fixed.
 Here it should be noted that short run periods of different firms
have different durations. 5
 Cont’d …
 Long run refers the production period in which all inputs are variable.

 In general short run and long run doesn’t refers time period rather they
infer the possibility of the adjustments of the input during the production.
 Consider a firm that uses two inputs: capital (fixed input) and labor
(variable input). Given the assumptions of short run production, the firm
can increase output only by increasing the amount of labor it uses.
 Hence, its production function can be given by = f (L)where, Q is output
and L is the quantity of labor .

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4.1.3 Total, average, and marginal product
 In production, the contribution of a variable input can be described in
terms of total, average and marginal product.
 Total product (TP): it is the total amount of output that can be
produced by efficiently utilizing specific combinations of the variable
input and fixed input.
 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 if we
employ more and more unit of the variable input beyond the carrying
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capacity of the fixed input, output tends to decline.
 Cont’d …
 In general, the TP function in the short-run follows a certain trend:
it initially increases at an increasing rate, then increases at a
decreasing rate, reaches a maximum point and eventually falls as
the quantity of the variable input rises.
 Marginal Product (MP): it is the change in output attributed to the
addition of one unit of the variable input to the production process,
other inputs being constant .

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 Cont’d …
 In the short run, the marginal product of the variable input first
increases, reaches its maximum and then decreases to the extent of
being negative.
 Average Product (AP): Average product of an input is the level of
output that each unit of input produces, on the average. It tells us
the mean contribution of each variable input to the total product.
 Average product of labor first increases, reaches its maximum value
and eventually declines but It cannot be negative.

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 Cont’d …

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 Cont’d …

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 Cont’d …
 The relationship between MPL and APL can be stated as follows.

 When APL is increasing, MPL> APL.

 When APL is at its maximum, MPL= APL.

 When APL is decreasing, MPL< APL

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 Cont’d …

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 4.1.4 The law of variable proportions

 The law of variable proportions states that as successive units of a

variable input(say, labor) are added to a fixed input (say, capital or land),
beyond some point the extra or marginal product that can be attributed to each
additional unit of the variable resource will decline.
 example, if additional workers are hired to work with a constant amount of
capital equipment, output will eventually rise by smaller and smaller
amounts as more workers are hired.
 This law assumes that technology is fixed and thus the techniques of
production do not change.
 Moreover, all units of labor are assumed to be of equal quality.
 Cont’d …

 Each successive worker is presumed to have the same innate ability,

education, training, and work experience. Marginal product
ultimately diminishes not because successive workers are less skilled
or less energetic rather it is because more workers are being used
relative to the amount of plant and equipment available.
 The law starts to operate after the marginal product curve reaches its
maximum (this happens when the number of workers exceeds L1 in
figure 4.1). This law is also called the law of diminishing returns.

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 4.1.5 Stages of production

Short run production periods is divided in to three stages of

production.
Stage I: This stage of production covers the range of variable input
levels over which the average product (APL) continues to increase.
It goes from the origin to the point where the APL is maximum.
This stage is 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).
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 Cont’d …
Stage II: It ranges from the point where APL is at its maximum
(MPL=APL) to the point where MPL is zero.
 Here, as the labor input increases by one unit, output still increases
but at a decreasing rate.
 Due to this, the second stage of production is termed as the stage of
diminishing marginal returns .
Stage III: In this stage, an increase in the variable input is accompanied
by decline in the total product.
 Thus, the total product curve slopes downwards, and the marginal
product of labor becomes negative.
 This stage is also known as the stage of negative marginal returns to
the variable input.
 stage iii also not an efficient region because of the overutilization of
fixed factor.
 Rational firms only relevant stage of production is stage ii.
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 4.2 Theory of costs in the short run

 4.2.1 Definition and types of costs

 Costs are the monetary values of inputs expenditures that have been
used to produce something.

There are different types of cost:

 Private cost refers to cost of production incurred by an
individual firm in producing a commodity.
 External cost’ is the cost that is not borne by the firm, but is
incurred by other members of the society or the entire society.
 Social cost, on the other hand, refers to the cost that the society
has to bear on account of production of a commodity. Social
cost is a wider concept than private cost.
 Social Cost = Private Cost + External Cost
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 Cont’d …

 explicit costs :refers to Actual payments made by a firm for

purchasing or hiring resources (or factor services) from the factor-
owners or other firms. It also called accounting cost

 Implicit costs refer to the imputed costs of the factors of

production owned by the producer himself/herself.
 They are called implicit costs because producers do not
make payment to others for them. For instance, rent of
his/her own land.

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 Cont’d …
 Thus economic cost is the sum total of explicit cost and implicit
cost.
 Economic Cost = Explicit Cost + Implicit Cost
 Economists use the term profit differently from the way
accountants use it.
 Accounting profit = Total revenue – Accounting cost = Total
revenue – Explicit cost.
 Economic profit =Total revenue – Economic cost (Explicit cost +
Implicit cost).
 Economic profit will give the real profit of the firm since all costs
are taken into account.
 Accounting profit of a firm will be greater than economic profit by
the amount of implicit cost.

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 Short-Run Cost of Production

4.2.2 Total, average and marginal costs in the short run

 A cost function shows the total cost of producing a given level of
output.
 It can be described using equations, tables or curves.
 A cost function can be represented using an equation follows C = f
(Q), where C is the total cost of production and Q is the level of
output.
 In the short run, total cost (TC) can be broken down in to two –
total fixed cost (TFC) and total variable cost (TVC).
 By fixed costs we mean costs which do not vary with the level of
output.
 The firm can avoid fixed costs only if he/she stops operation (shuts
down the business).

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 Cont’d …
 Variable costs, on the other hand, include all costs which directly vary with
the level of output.
 In general, the short run total cost is given by the sum of total fixed cost
and total variable cost.
That is: TC = TFC + TVC
 Total fixed cost is denoted by a straight line parallel to the output axis. This
is because such costs do not vary with the level of output.
 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.
 Total Cost (TC): The total cost curve is obtained by vertically adding TFC
and TVC at each level of output.
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 Cont’d …
 The shape of the TC curve follows the shape of the TVC curve, i.e.
the TC has also an inverse S-shape.
 It should be noted that when the level of output is zero, TVC is
also zero which implies TC = TFC.

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 Cont’d …
Per unit costs
 From total costs functions we can derive per-unit costs.
a) Average fixed cost (AFC) - Average fixed cost is total fixed cost
per unit of output. It is calculated by dividing TFC by the
corresponding level of output. The curve declines continuously
and approaches both axes asymptotically.

 Average variable cost (AVC) - Average variable cost is total

variable cost per unit of output. It is obtained by dividing total
variable cost by the level of output.
 Cont’d …
C) Average total cost (ATC) or simply Average cost (AC) - Average
total cost is the total cost per unit of output. It is calculated by dividing
the total cost by the level of output.

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 Cont’d …
 Marginal Cost (MC)
 Marginal cost is defined as the additional cost that a firm incurs to
produce one extra unit of output.
 In other words, it is the change in total cost which results from a unit
change in output.

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 Cont’d …
 Graphically, MC is the slope of TC function.

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 Cont’d …
 Given inverse S-shaped TC and TVC curves, MC initially
decreases, reaches its minimum and then starts to rise.
 From this, we can infer that the reason for the MC to exhibit U
shape is also the law of variable proportions. In summary, AVC, AC
and MC curves are all U-shaped due to the law of variable
proportions.

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 Cont’d …

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 Cont’d …
 4.2.3 The relationship between short run production and cost
curves
 Suppose a firm in the short run uses labor as a variable input and
capital as a fixed input. Let the price of labor be given by w, which
is constant.
 Given these conditions, we can derive the relation between MC and
MPL as well as the relation between AVC and APL.
i) Marginal Cost and Marginal Product of Labor

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 Cont’d …
 The above expression shows that MC and MPL are inversely
related.
 When initially MPL increases, MC decreases; when MPL is at its
maximum, MC must be at a minimum and when finally MPL
declines, MC increases.
ii) Average Variable Cost and Average Product of Labor

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 Cont’d …

 This expression also shows inverse relation between AVC and APL.

 When APL increases, AVC decreases; when APL is at a maximum,

AVC is at a minimum and when finally APL declines, AVC
increases.

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 Cont’d …

Thanks

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 Thanks

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 Cont’d …

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