Chapter 4

Production Theory and Cost

Production - Definition
Factors of Production :
Process Output / final
products
Productionis the process of using the factors of production to produce goods and services as the final output
Factors of Production are:
Factors of Production Explanation
Land Includes all natural resources e.g. Land area, water, air, mineral
Labour Refers to physical or mental activities carried out by workforce for
monetary value
Capital That part of man-made wealth which is used to further produce wealth
e.g. buildings, machinery, techonology, money,
Entrepreneur A person who combines the three factors of production to initiate the
process of production
Production Function
Production function is represented mathematically as below:
= , ,
Where : K = Capital, L = Land, M = Raw Material
Therefore, Production function is a statement of functional relationship between inputs and outputs. It tells
how much input is required to produce certain quantity of output
Production function or the functional r/ship between inputs and outputs is divided into short-run and long-run:
Short-run : Time frame in which at least ONE of the factor of productions is fixed and others vary. E.g.
= (, )
Long-run : Time frame in which all inputs are variable
K = fixed or constant
Law of Diminishing Marginal Returns also known as Law of Variable
Proportions explains the production function in the short-run :
It says that if the quantities of certain factors are increased while the quantities of
one or more factors are held constant, beyond a certain level of production, the
rate of increase in output will decrease i.e. marginal product of the variable input
will eventually decline
Short-run Production Law of Diminishing Marginal Returns
Total Product
Total Product, TP is the total product produced with a given variable input together with fixed
input
Average Product
Average Product, AP is the Total Product, TP divided by the total amount of input used. E.g.
Average Product for Labour

=


Marginal Product
Marginal Product, MP is the additional units of products produced with an extra unit of
specific variable input employed

=


Short-run Production Law of Diminishing Marginal Returns
When Law of Diminishing Marginal Returns takes place, the following relationships TP vs. MP and MP vs. AP
hold:
Relationship between TP and MP
Relationship between MP and AP
Short-run Production Law of Diminishing Marginal Returns
Marginal Product, MP Total Product, TP
MP increases TP increases at an increasing rate
MP decreases TP increases at a decreasing rate
MP = 0 TP reaches the maximum
MP < 0 TP decreases
Marginal Product, MP Average Product, AP
MP > AP AP increases
MP < AP AP decreases
MP = AP AP is at the maximum
Short-run Production Law of Diminishing Marginal Returns
Capital
(Fixed Input)
Labour
(Variable Input)
Total
Product,
TP
Marginal
Product,
MP
Average
Product,
AP
Stages of
Product
10 0 0 0 0
10 1 8 8 8
10 2 20 12 10
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
10 10 50 -4 5
Stage 1
Stage 2
Stage 3
Stage 1
Stage 2
Stage 3
TP
AP
MP
TP / AP / MP
Units of
Variable Input
Short-run Production Law of Diminishing Marginal Returns
Stages of Production Beginning Point Ending Point Explanation
Stage 1 TP = 0 MP = AP Stage 1 is known as Law of Increasing Returns, when:
1. TP increases at an increasing rate initially and then
subsequently increases at a decreasing rate
2. AP keeps rising and reaches maximum
3. MP increases, reaches the maximum and declines
Stage 2 MP = AP MP = 0 Stage 2 is known as Law of Diminishing Returns, when:
1. TP increases at a decreasing rate and reaches
maximum
2. AP diminishes
3. MP diminishes and becomes zero
Stage 3 MP = 0 Stage 3 is known as Law of Negative Returns, when :
1. TP diminishes
2. AP diminishes
3. MP becomes negative
Short-run Production Tutorial
Capital (Fixed
Input)
Labour (Variable
Input)
Total
Product, TP
Marginal
Product, MP
Average
Product, AP
10 0 0
10 1 10
10 2 30
10 3 60
10 4 80
10 5 95
10 6 108
10 7 112
10 8 112
10 9 108
10 10 100
Compute MP and AP for each labour input and identify the beginning and ending point of the 3 production
stages.
0
20
40
60
80
100
120
140
160
1 2 3 4 5 6 7
Labour Input
Product Curve
Capital Input 1 Capital Input 2 Capital Input 3 Capital Input 4 Capital Input 5
Production Short-run vs Long-run
Short-run Production
Long-run Production
Recalls that Long-run Production function allows all factors of productions (input) to vary. The
variation of inputs is represented by Isoquant Curve.
Isoquant curve is a series of possible combinations of two factor inputs, which give the same
level of output. A number of Isoquant curves on the same Y and X axis is called an Isoquant
Map.
Long-run Production ISOQUANT Curves
Machinery
Labour
A
B
C
D
9
5
3
2
1 2 4 6
1. Isoquant slopes downward from left to right:
Substitution effect increasing one factor requires a
decrease of another factor to hold the output constant
2. Isoquant curve is convex
Decreasing opportunity costs due to the diminishing
Marginal Rate of Technical Substitution
Productivity of the increased factor reduces, while
productivity of the reduced factor increases
3. Isoquant curve higher and further to the right represents
larger output
4. Two or more Isoquant curves never intersect
It is impossible to have a combination of two factors that
produce two different level of output
Output = 100 units
Output = 200 units
Long-run Production Type of ISOQUANT Curves
Machinery
Labour
Machinery
Labour
Isoquants When Inputs Are Perfect Substitutes
MRTS is constant
The substitution rate of capital and labour is the same across
level of output
Isoquants When Inputs Are Fixed Proportions
Isoquants are L-shaped
Only one combination of inputs for a specific level of output
Thus, Marginal Product for one input while the other input is
fixed is zero
Isoquant curves show the various combinations of input to yield a given output. However,
over the long run, firms need to increase their output.
How do they do that?
The decision to increase output is driven by the Return to Scale.
Return to scale is defined as the rate of increase of output when inputs are increased
proportionately
Long-run Production Return to Scale
Long-run Production Return to Scale
Machinery
Capital
2
4
6
5 10
15
Q
1
=10
Q
2
=20
Q
3
=30
Machinery
Capital
2
4
5 10
15
Q
1
=10
Q
2
=20
Q
3
=30
Constant Return to Scale:
1. Output doubles when all inputs are doubled
2. The rate of increase for output equals to the
rate of proportionate increase for inputs
Increasing Return to Scale:
1. Output more than doubles when all inputs
are doubled
2. The rate of increase for output is more than
the rate of proportionate increase for inputs
Long-run Production Return to Scale
Machinery
Capital
2
4
6
5 10
15
Q
1
=10
Q
2
=20
Decreasing Return to Scale:
1. Output less than doubles when all inputs are doubled
2. The rate of increase for output is less than the rate of
proportionate increase for inputs
Long-run Production ISOCOST
Isocost Line is a series of possible combination of two factor inputs, which can be purchased
with a given amount of money at a given price per unit.
Example :
Total Budget
Cost of
Factor Y
Cost of
Factor X
Period 1 2,000.00 $ 200.00 $ 100.00 $
Period 2 2,000.00 $ 400.00 $ 100.00 $
Period 3 2,000.00 $ 200.00 $ 200.00 $
Period 4 2,000.00 $ 400.00 $ 200.00 $
Period 5 4,000.00 $ 200.00 $ 100.00 $
Machinery
Labour
10
20
5
10
20
40
Period 1
Period 2
Period 3
Period 4
Period 5
Production Producers Equilibrium
Machinery
Labour
A
Producers Equilibrium happens when Isoquant Curve is tangent or
integrates with Isocost Line i.e. Point A.
So what does it mean?
1. Isoquant Curve is a series of combinations of input that yield a given
level of output
2. Isocost Line represents the production budget to be spent on two
types of inputs
3. For a given level of output, the most cost efficient combination of
inputs happen at point A, given the lowest Isocost Line
4. Consider Point B and C the same level of output is achieved with a
higher cost. Thus, it is not cost efficient at all.
B
C
Tutorial 2 Production
1. In any production process the marginal product of labour equals:
a. total output divided by total labour inputs.
b. total output minus the total capital stock.
c. the change in total output resulting from a 'small' change on the labour input.
d. total output produced by labour inputs.
2. Which of the following statements describes the presence of diminishing returns. Holding at least one factor constant ....
a. the marginal product of a factor is positive and rising.
b. the marginal product of a factor is positive but falling.
c. the marginal product of a factor is falling and negative.
d. the marginal product of a factor is constant.
3. Which of the following statements describes increasing returns to scale:
a. Doubling the inputs used leads to double the output.
b. Increasing the inputs by 50% leads to a 25% increase in output.
c. Increasing inputs by 1/4 leads to an increase in output of 1/3.
d. None of the above.
4. If a firm moves from one point on a production isoquant to another, which of the following will not happen.
a. A change in the ratio in which the inputs are combined.
b. A change in the marginal products of the inputs.
c. A change in the rate of technical substitution.
d. A change in the level of output.
5. If 1 orchard, 7 workers, and 3 tons of fertilizer yield 1,000 bushels of peaches, while 1 orchard, 7 workers, and 4 tons of
fertilizer yield 1,300 bushels,
a. the average product of labor equals 1,150 bushels.
b. the marginal product of labor cannot be calculated.
c. the average product of fertilizer equals 1,150 bushels.
d. the marginal product of fertilizer cannot be calculated.
When answering the next five questions (6-), refer to the following graph
6. The marginal product of labor is rising with increased use of labor until
a. 10 workers are employed.
b. 20 workers are employed.
c. 30 workers are employed.
d. 40 workers are employed.
7. The average product of labor is falling with increased use of labor once
a. 10 workers are employed..
b. 20 workers are employed.
c. 30 workers are employed
d. 40 workers are employed.
8. As long as fewer than 30 workers are employed,
a. the average product of labor exceeds the marginal product of labor.
b. the marginal product of labor exceeds the average product of labor.
c. the marginal product of labor is rising.
d. both (a) and (c) are true.
9. Between points d and e, increased use of labor means
a. negative marginal product of labor.
b. falling average product and falling marginal product of labor.
c. marginal product of labor below average product of labor.
d. all of the above.
10. Maximum average product of labor corresponds to
a. point a.
b. point b.
c. point c.
d. point d.
11. An isoquant curve shows
a. all the alternative combinations of two inputs that yield the same maximum total product.
b. all the alternative combinations of two products that can be produced by using a given set of inputs fully
and in the best possible way.
c. all the alternative combinations of two products among which a producer is indifferent because they yield
the same profit.
d. both (b) and (c).
12. A negatively sloped isoquant implies
a. products with negative marginal utilities.
b. products with positive marginal utilities.
c. inputs with negative marginal products.
d. inputs with positive marginal products.
13. The marginal rate of technical substitution is
a. the rate at which a producer is able to exchange, without affecting the quantity of output produced, a
little bit of one input for a little bit of another input.
b. the rate at which a producer is able to exchange, without affecting the total cost of inputs, a little bit of
one input for a little bit of another input.
c. the rate at which a producer is able to exchange, without affecting the total inputs used, a little bit of one
output for a little bit of another output.
d. a measure of ease or difficulty with which a producer can substitute one technique of production for
another.
14. An isocost line identifies
a. the least costly combination of inputs needed to produce a given level of output.
b. the relative prices of inputs.
c. the technological relationships among inputs.
d. the rate at which one input can be substituted for another in the production process.
15. If a firm triples all inputs, and output triples as well, the firm is subject to
a. constant returns to scale.
b. increasing returns to scale.
c. economies of scale.
d. both (b) and (c).
Definition :
Expenses incurred by the producer in producing a particular quantity of output.
Implicit vs Explicit Cost
Implicit costs Intangible value of input that are employed in production which are not subjected to market
evaluation i.e. no market value
Explicit costs Tangible value of input that are employed in production which are subject to market
evaluation i.e. purchases from the market
Accounting only takes into consideration of Explicit Cost, while Economics take into consideration of BOTH !
Opportunity Cost
It is the value of the next best use of a resource
Social Cost
It is the total cost of production of a product and includes direct and indirect costs incurred by society
Cost of Production Cost Concepts
Total Fixed Cost, TFC
- refers to the cost of input that are independent of output.
- it is the entry cost required to start production and remains constant throughout
Total Variable Cost, TVC
- refers to the cost of input that changes with output.
- it is incurred due to the purchase of variable inputs
- it follows the Law of Diminishing Marginal Returns. It starts from the origin with steep sloop, reflecting
- the increased output, then flattens out correspond to the diminished output and finally slopes up
steeply due to negative output
Total Cost, TC
- Sum of costs of all inputs i.e. fixed and variable inputs used to produce goods and services
- Total Fixed Cost + Total Variable Cost
Cost of Production Cost In The Short Run
Graphical representation of TC, TFC and TVC:
Cost of Production Cost In The Short Run
1. TC does not start from the origin because even
though, no output is produced, fixed cost is still
incurred
2. Shape of TC follows exactly TVC. Therefore, for TC,
the intercept is TFC and the slopes / shape mirrors
TVC
3. TVCs shape is due to Law of Diminishing Returns
refers to the shadow Short-run Production Curve
Cost of Production Cost In The Short Run
Marginal Cost, MC
- refers to the extra costs incurred to produce one unit of extra output
- it is calculated as change in total cost divided by the change in total output
- MC does not take FC into picture as FC is a sunk cost (already incurred)
- MC curve will fall to the lowest and then rises again corresponding to the increasing marginal returns
followed by diminishing marginal returns.
Cost
Output
Cost of Production Cost In The Short Run
Average Fixed Cost, AFC
- refers to fixed cost per unit of output.
- computed by dividing total fixed cost with total output i.e. =

- AFC will continue to decline as output increases because of the spreading of fixed cost
Average Variable Cost, AVC
- refers to the variable cost per unit of output.
- computed by dividing total variable cost with total output i.e. =

Average Total Cost, ATC

- refers to the total cost per unit of output
- ATC is also a summation of AFC and AVC
Stage 1 :
Increasing
Returns
Stage 2 :
Diminishing
Returns
Stage 3 :
Negative
Returns
AFC
Cost of Production Cost Curves In The Short Run
MC vs AVC
When MC > AVC , AVC increases
When MC < AVC, AVC decreases
When MC = AVC, AVC is at the minimum
MC vs ATC
When MC > ATC , ATC increases
When MC < ATC, ATC decreases
When MC = ATC, ATC is at the minimum
Cost of Production Short-run Cost Relationship
Cost of Production Long Run Cost Curves
1. Over the long-run, all costs are variable.
2. Therefore, only variable costs are involved in the
long run production (without fixed cost)
3. Long run average cost, LRAC curve shows the
minimum cost of producing any given output
when all the inputs are variable.
4. LRAC is derived by connecting the tangential
point of a series of SRACs
5. The tangential point of SRACs show the lowest
average cost possible in the short run i.e. total
product is increasing at an increasing rate
6. E.g. co is producing at Q1, assuming it wants to
increase output to Q2, it can continue to produce
at SRAC
1
without varying the fixed assets, at
point B. Or it can expand the fixed assets and
operate on new SRAC
2
and enjoy at a lower
average cost production at quantity, Q2
A
B
C
Q1 Q2
Increasing Returns
to Scale
Constant Returns
to Scale
Diminishing
Returns to Scale
Cost of Production Economies of Scale
Economies of Scale Diseconomies of Scale
Definition 1. Benefits or advantages that a firm enjoys as it
grows larger
2. Economies of scale will reduce LRAC
1. Problems or disadvantages faced by a firm as it
grows larger
2. Diseconomies of scale will increase LRAC
Examples 1. Increase of efficiency through specialization
2. Bulk purchase for raw material
3. Cheaper cost of funds for bulk borrowing
4. Diversification of risk through product
diversification
5. Higher bargaining power
1. Inefficiency due to miscommunication
2. Inefficiency due to misorganization on human
power
3. Risk of fraud due to excessive size
4. Failure to optimize due to ill resource planning
1. To the economist, total cost includes:
A. explicit and implicit costs, including a normal profit.
B. neither implicit nor explicit costs.
C. implicit, but not explicit, costs.
D. explicit, but not implicit, costs.
2. Which of the following is a short-run adjustment?
A. A local bakery hires two additional bakers.
B. Six new firms enter the plastics industry.
C. The number of farms in the United States declines by 5 percent.
D. BMW constructs a new assembly plant in South Carolina.
3. The law of diminishing returns indicates that:
A. as extra units of a variable resource are added to a fixed resource, marginal product will decline beyond some
point.
B. because of economies and diseconomies of scale a competitive firms long-run average total cost curve will be
U-shaped.
C. the demand for goods produced by purely competitive industries is downsloping.
D. beyond some point the extra utility derived from additional units of a product will yield the consumer smaller and
smaller extra amounts of satisfaction.
Cost of Production Tutorial
4. Refer to the above diagram. At output level Q total variable cost is:
A. 0BEQ.
B. BCDE.
C. 0CDQ.
D. 0AFQ.
5. Refer to the above data. The total variable cost of producing 5 units is:
A. $61.
B. $48.
C. $37.
D. $24.
6. Refer to the above data. The average total cost of producing 3 units of output is:
A. $14.
B. $12.
C. $13.50.
D. $16.
7. Refer to the above data. The marginal cost of producing the sixth unit of output is:
A. $24.
B. $12.
C. $16.
D. $8.
8. In the above figure, curves 1, 2, 3, and 4 represent the:
A. ATC, MC, AFC, and AVC curves respectively.
B. MC, AFC, AVC, and ATC curves respectively.
C. MC, ATC, AVC, and AFC curves respectively.
D. ATC, AVC, AFC, and MC curves respectively.
9. In the long run:
A. all costs are variable costs.
B. all costs are fixed costs.
C. variable costs equal fixed costs.
D. fixed costs are greater than variable costs.
Total Revenue = Total Sales = P * Q
Average Revenue
Total Revenue per unit output sold
=

=
Marginal Revenue
refers to the change in total revenue resulting from a one-unit increase in quantity sold
it is the additional amount to the total revenue when there is an increase in the sale of
one additional unit
Total Revenue
=

1. Revenue in a Perfect Competition Market

In a perfect competition market, no one single firm can control the market price
Therefore barring any obstruction on the supply chain, market price will remain constant
regardless of quantity supplied
In a Perfect Competition Market, as Price = AR = MR, therefore figure as below:
Total Revenue
Price
Quantity
P AR = MR = DD
2. Revenue in Imperfect Competition Market
Imperfect Competition Market refers to a market which is controlled by monopoly or
oligopoly firms
In order for a firm to sell more in a imperfect competition market, each quantity that the
firm sold, a price reduction is required
Therefore the relationship between Price, AR and MR is as below:
Total Revenue
Quantity Price Total
Revenue
Average
Revenue
Marginal
Revenue
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
Price
Quantity
10
AR = DD
MR