Chapter Four

The Theory of Production and Cost

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Production is the process of transforming inputs in to output.

• The end products of the production process are outputs which could be
tangible (goods) or intangible (services).

It can also be defined as an act of creating value or utility.

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

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 Q= f(X1,X2,X3,...,Xn)
where, Q is output and X1, X2, X3,…, Xn are different types of inputs.

Inputs are commonly classified as fixed inputs or variable inputs.

Fixed inputs are those inputs whose quantity cannot readily be changed
when market conditions indicate that an immediate adjustment in output is
required.

For example, if the demand for Beer rises suddenly in a week, the brewery
factories cannot plant additional machinery overnight and respond to the
increased demand.

Buildings, land and machineries are examples of fixed inputs because their
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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 unskilled labour.

# Based on the possibility of changing the amount of input,

we can have short run and long run production period.
short run is a period of time in which the quantity of at least one input is
fixed.

In other words, short run is a time period which is not sufficient to change
the quantities of all inputs 4
Long run is a period of time in which the quantity of all input is changeable.

• There is sufficient time to change the quantity of all inputs.

• In this section we discuss the short run production period.

Short run production period

• Consider a firm that uses two inputs:

capital (fixed input) and

labour (variable input)

• Since capital is fixed, the firm can increase output only by increasing the
amount of labour it uses. Hence, its production function can be given by:
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• 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.

• The TP function in short run follows a certain trend: it initially increases at

increasing rate, increases at decreasing rate, reaches a maximum point and
eventually falls as the quantity of 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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• In the short run, the MP of the variable input first increases, reaches its
maximum and then decreases to the extent of being negative.

• That is, as we continue to combine more and more of the variable input with
the fixed input, the MP of the variable input increases initially and then
declines.

• Average Product (AP): is the level of output that each unit of input
produces, on the average. Mathematically, it is the ratio of total output to
the number of the variable input.

• AP of labour first increases, reaches its maximum value and eventually

declines.
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• 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.
• Example: Suppose the short-run production function of cut-flower firm is:

Q= 4KL -0.6K2 -0.1L2 where Q is quantity of cut-flower produced, L

is labour input and K is fixed capital input (K=5).
a) Determine the average product of labour (APL) function.
b) At what level of labour does the total output of cut-flower reach the 10
b) When t otal product (Q ) is maximum, MP will be zero.

Hence, t ot al out put will be the maximum when 100 workers are employed.

c) Subst it ut ing the opt imal values of labor (L=100) and capital (K=5) into

t he original product ion f unct ion (Q ):

.
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The law of variable proportions

It states that as successive units of a variable input (labour) are added to a
fixed input (capital or land), beyond some point, the marginal product that
can be attributed to each additional unit of the variable resource will decline.

This law assumes that technology is fixed and thus the techniques of
production do not change.

Moreover, all units of labour are assumed to be of equal quality.

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. 12

Three stages of production

• Stage I: it 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, which is the equality of
MPL and APL (up to L2 level of labour employment in figure 4.1).

• 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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• Stage II: It ranges from the point where APL is at its maximum (MPL=APL) to the point where MPL is zero
(from L2 to L3 in figure 4.1).
• Here, as the labour 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.
• 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 where the marginal product of the variable input is declining
but positive.

Stage III: This stage is also known as the stage of negative marginal returns to the
variable input.
• The cause of negative marginal returns is the fact that the volume of the variable inputs is quite excessive
relative to the fixed input; the fixed input is over-utilized.
• Obviously, a rational firm should not operate in stage III because additional units of variable input are
contributing negatively to the total product (MP of the variable input is negative).
• In figure 4.1, this stage is indicated by the employment of labour beyond L3.

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4.2 Theory of costs in the short run

4.2.1 Definition of costs

To produce goods and services, fi rms need f actors of production or

simply input s. To acquire these input s, t hey have to buy t hem f rom

resource suppliers.

Cost is, therefore, the monetary value of inputs used in the

production of an item

We know that profi t is the diff erence bet ween total revenue and

t ot al cost .

For accountant s, P =TR – Explicit cost (account ing cost )

For economist s, P =TR – Economic cost (I mplicit cost +Explicit cost )

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Account ing cost :

I s t he monetary value of all purchased input s used in production.

Are out of pocket expenses f or t he purchased input s.

I t considers only direct expenses such as wages/ salaries, cost of raw

mat erials, depreciat ion allowances, int erest on borrowed f unds and

ut ilit y expenses (elect ricit y, water, t elephone, et c.).

Economic cost :

Economic cost of producing a commodit y considers t he monet ary value

of all input s (purchased and non-purchased).

T he monet ary value of non-purchased inputs is obt ained by estimating

their opportunity costs in monetary terms.

T he estimat ed monet ary cost f or non-purchased input s is known as

implicit cost. 16
 For example, if Mr. X quits a j ob which pays him Birr 10, 000.00 per

month in order to run a fi rm he has established, then the opportunity

cost of his labor is taken to be Birr 10,000.00 per month (the salary

he has f orgone in order to run his own business).

NOTE:

 Economic profi t will give the real profi t of the fi rm since all costs

are taken into account.

 Accounting profi t of a fi rm will be greater than economic profi t by

the amount of implicit cost.

 I f all inputs are purchased f rom the market, accounting and

economic profi t will be the same.

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4.2.2 Total, average and marginal costs in the short run

I n t he short run, tot al cost (T C) can be broken down in t o t wo – total

fixed cost (TFC) and total variable cost (TVC).

By fixed costs we mean cost s which do not vary with t he level of

output .

 T hey are regarded as fi xed because t hese cost s are unavoidable

regardless of the level of output .

 T he fi rm can avoid fi xed cost s only if he/ she st ops operation

(shuts down the business).

 T he fi xed costs may include salaries of administ rat ive st aff ,

expenses f or building depreciation and repairs, and the rent of

building used f or production.

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 Variable costs, on t he other hand, include all cost s which directly

vary with the level of out put .

 For example, if t he fi rm produces zero out put , t he variable cost is

zero.

 T hese cost s may include cost of raw mat erials, the cost of direct

labor and t he running expenses of f uel, wat er, elect ricit y, et c.

I n general, t he short run t ot al cost is given by t he sum of t ot al fi xed

cost and tot al variable cost .

T hat is, TC = TFC + TVC

Based on the defi nit ion of t he short run cost f unct ions, let ‘s see what

their shapes look like.

Total fixed cost (TFC): is denot ed by a st raight line parallel to the

output axis. 19
This is because such costs do not vary with the level of output.

Total variable cost (TVC): has an inverse S-shape.

 The shape indicates the law of variable proportions in production.

Total Cost (TC): is obtained by vertically adding TFC and TVC at each

level of output.

 The shape of the TC curve f ollows the shape of the TVC curve, i.e.

the TC has also an inverse S-shape.

 I t should be noted that when the level of output is zero, TVC is

also zero which implies TC =TFC.

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Per unit costs

Fr om t ot al cost s f unct ions we can der ive per -unit cost s.

a) Average fixed cost (AFC) - Aver age fi xed cost is t ot al fi xed cost

per unit of out put .

 I t is calculat ed by dividing T FC by t he cor r esponding level of

out put .

 T he curve declines cont inuously and appr oaches bot h axes

asympt ot ically.

b) Average variable cost (AVC) - Aver age variable cost is t ot al

var iable cost per unit of out put .

 I t is obt ained by dividing t ot al variable cost by t he level of

out put . 22
  T he shor t r un AVC f alls init ially, r eaches it s minimum, and t hen

st ar t s t o incr ease.

 Hence, t he AVC cur ve has U-shape and t he r eason behind is t he

law of var iable pr opor t ions.

a) Average total cost (ATC) or simply Average cost (AC) - Aver age

t ot al cost is t he t ot al cost per unit of out put .

 I t is calculat ed by dividing t he t ot al cost by t he level of out put .

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Marginal Cost (MC)

o Marginal cost is defi ned as t he addit ional cost t hat a fi rm incurs

t o produce one ext ra unit of out put .

o I n other words, it is the change in t ot al cost which result s f rom a

unit change in output .

Graphically, MC is t he slope of T C f unct ion.

I n f act , MC is also a change in TVC wit h respect to a unit change in t he

level of output .

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Given inverse S-shaped TC and TVC curves, MC initially decreases,

reaches its minimum and then starts to rise.

From this, we can inf er that the reason f or the MC to exhibit U shape

is also the law of variable proportions.

 I n summary, AVC, AC and MC curves are all U- shaped due to the

law of variable proportions.

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Average and marginal cost:

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Graphically,

 I n the above fi gure, the AVC curve reaches its minimum point at Q 1

level of output and AC reaches its minimum point at Q 2 level of

output.
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 The vertical distance between AC and AVC, that is, AFC decreases

continuously as output increases.

 I t can also be noted that the MC curve passes through the minimum

points of both AVC and AC curves.

Example: Suppose the short run cost f unction of a fi rm is given by:

TC=2Q 3 –2Q 2 +Q +10.

a) Find the expression of TFC & TVC

b) Derive the expressions of AFC, AVC, AC and MC

c) Find the levels of output that minimize MC and AVC and then fi nd the

minimum values of MC and AVC.

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Solution:

Given T C=2Q 3 – 2Q 2 +Q +10

a) T FC =10, T VC =2Q 3 – 2Q 2 +Q

b) AFC =T FC/ Q =10/ Q

AVC =T VC/ Q =(2Q 3 – 2Q 2 +Q )/ Q =2Q 2 – 2Q +1

AC =T C/ Q =(2Q 3 – 2Q 2 +Q +10)/ Q =2Q 2 – 2Q +1 +10/ Q

MC =dC/ dQ =6Q 2 – 4Q +1

c) T o fi nd t he minimum value of MC, dMC/ dQ =12Q - 4 =0

Q =1/ 3

MC is minimized when Q =0.33

T he minimum value of MC will be:

MC =6Q 2 – 4Q +1

=6(1/ 3)2 -4(1/ 3) +1=0.33 29

T o fi nd t he minimum value of AVC

dAVC/ dQ =4Q - 2=0

Q=0.5

AVC is minimized at Q =0.5

T he minimum value of AVC will be:

AVC =2Q 2 – 2Q +1

AVC =2 (0.5) 2 - 2(0.5) +1

=0.5 – 1 +1

=0.5

4.2.3 The relationship between short run production and cost

curves

 Suppose a fi r m in t he shor t r un uses labor as a var iable input and

capital as a fi xed input .

 Let t he price of labor be given by w, which is const ant .

 Given t hese condit ions, we can der ive t he r elat ion bet ween MC and

MPL as well as t he r elat ion bet ween AVC and APL. 30

i) Marginal Cost and Marginal Product of Labor

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 fi nally MPL declines, MC

increases.
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ii) Average Variable Cost and Average Product of Labor

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 fi nally APL declines, AVC increases.

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We can also sket ch t he relat ionship bet ween t hese product ion and cost

curves using graphs.

From the above fi gure, we can conclude t hat t he MC curve is t he mirror

image of MPL curve and AVC cur ve is t he mirror image of APL curve 33