Chapter Three

Theory of Production
• Production is a process that create/adds
value or utility
• It is the process in which the inputs are
converted in to outputs.
• Input is The factors of production such as
Land, Labor, Capital, Technology ,etc
• Output is The goods and service produced such as
Soap, Car ,etc

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 3.1 Production Function
• Production function means the functional
relationship between inputs and outputs
in the process of production.
• It is a technical relation which connects
factors inputs used in the production
function and the level of outputs
Example ;
• Q = f (Land, Labour, Capital,, Technology, etc)

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 Factor input
Input is The factors of production that is
carry out the production .
Land, Labor, Capital, Technology, are the
example of inputs

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Continued …..

Inputs Factors

Variable inputs Fixed Inputs

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 Continued ……
Fixed inputs( short run production )

 Remain the same in the short period .

 At any level of out put, the amount is
remain the same.
 The cost of these inputs are called Fixed
Cost

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 Continued …..
• Variable inputs (long run production)

In the long run all factors of production

are varies according to the volume of
outputs.
The cost of variable inputs is called
Variable Cost
Example:- Raw materials and labor

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 3.4 Various concept of production

 Total product (total physical product) =

the total amount of output produced, in
physical units .
 Average product (AP) – total output
divided by total units of input, means
production per unit of input.
• Marginal product – the extra product or
output added by 1 extra unit of that input
while other inputs are held constant
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Graphically ……

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 3.5 Law of Production Function
1) Laws of Variable proportion-
 It is Law of Diminishing Return ( Short
run production function with at least one
input is variable) .
It states , If one of the variable factor of
production used more and more unit,
keeping other inputs fixed, the total
product(TP) will increase at an increase
rate and eventually the TP starts to
decline. 9
 3.4 Stages in Law of variable proportion

First Stage: Increasing return

 TP increase at increasing rate till the end
of the stage.
 AP also increase and reaches at highest
point
 MP also increase at increasing rate.

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 Continued…….

Second Stage: Diminishing return

 TP increase but at diminishing rate and it
reach at highest at the end of the stage.
 AP and MP are decreasing but both are
positive

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 Continued ….

Third Stage: Negative return

 TP decrease and TP Curve slopes
downward
 MP is negative.

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Graphically ….

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 Law of return to scales: Long run
Production Function

• If inputs increase by 10% leads to

Outputs 15% increase it is Increasing
returns to scale

• If inputs 10% increase leads to

Outputs 10% increase it is Constant
returns to scale
• If Inputs 10% increase –leads to
Outputs 5% increase it is Decreasing
returns to scale 14
 4. Iosquants .
• An isoquants represent ; all those possible
combination of two inputs (labor and capital),
which is capable to produce an equal level of
output .

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4.1 Graphical indication of Iosquants

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 Slop of Isoquant
• The slop of isoquant is known as
Marginal Rate of Technical
Substitution (MRTS).
• It is the rate at which one factors of
production is substitute with other
factor so that the level of the out
put remain the same.

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 Properties of isoquant
• Isoquants slope down ward.
• The further an isoquant lays away
from the origin, the greater the level
of output it denotes.
• Isoquants do not cross each other

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 The efficient region of production:
long run

• In the long run efficient production is

takes place Over the range of output
where:-
• the marginal product of factors is positive
and declining. In the short run production
function efficient region of production
prevails in stage (stage II), where MPL >O,

• Similarly, efficient region of production in

the long run prevails when the marginal
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 2. Theory of costs of production

Cost is, 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.

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 Continued…
• Social cost: is the cost of producing an
item to the society.
• This cost has realized because some
production process, by their nature, emit
dangerous chemicals, bad smell, etc to
surrounding society

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 Continued …
• Private cost: This refers to the cost of
producing an item to the individual
producer.
• Private cost of production can be
measured in two ways:
• i) Economic cost
• The actual or out- of- pocket expenditures
that the firm incurs to purchase inputs
which is explicit costs.
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 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 are fixed.
• long- run costs are the cost over a period
long enough to permit the change of all
factor of production
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 Concept of total cost

• 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 total fixed cost
• TVC: is total variable cost
• Fixed costs, we mean a cost which
doesn’t vary with the level of out put. 24
 Continued
• But, the producer can also use his/ her
own inputs which are not purchased from
the market for the production purpose
which is implicit cos
)Accounting Cost
• iFor accountant, the cost of production
includes the cost of purchased inputs only
which is explicit cost

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Graphically indication of TFC

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 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 is employed, its productivity
increases & finally start to decline which cause
increase in STVC
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• Graphically STVC is indicated as:-
Continued…

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 Average cost/per unit cost

Average fixed cost

(AFC)
 is found by dividing
the TFC by the level
ofoutput.
• The AFC curve is
continuously
decreasing but never
be zero
• Graphically, the AFC
is a rectangular hyper 29
 Short run AVC

• The AVC is similarly

obtained by dividing
the TVC with the
corresponding level of
output.
• Graphically the SAVC
curve has a U-shape
and the reason
behind is the law of
variable proportions
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 Short run ATC
• ATC 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.
SATC= TVC +TFC/ Q
Graphically the AC curve is U-
shaped because of the law of
variable proportions.

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 Marginal cost (MC)
• The marginal cost is defined as the
additional cost that the firm incurs to
produce one extra unit of the output
• Which is given as =
• ӘTC/ӘQ
• ӘTVC + ӘTFC/ ӘQ
• ӘTFC/ӘQ = 0
• = ӘTC/ӘQ = Ә TVC/ӘQ
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 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.
• thus, 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 33
 Graphical indications of LAVC

• Graphically LAVC is -
U-shaped and derived
from short run AVC.
• Its U- shape is b/c of
economies of scale

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 Why is the LAC U-shaped?

• It is b/c of law of return to scale (increasing and

decreasing returns to scale )
Economies of scale may prevail for various
reasons such as:-
 specialization of skills,
 lower prices for bulk-buying of raw materials,
 decentralization of management system and
etc.
 This leads to reduce LAC

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 Reasons of decreasing return to scale

• If the plant size increases further than

the optimal size diseconomies of scale
start b/c:-
• Managerial inefficiencies,
• the price advantage from bulk-buying
may also stop beyond a certain limit etc.
• These diseconomies of scale will lead to
increasing LAC curve
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Graphically indication of returns to
scale

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