Theory and

Cost of
Production
 DEFINITION OF
PRODUCTION
Definition
Production means the process of
using the factor of production to
produce goods and services.
Production is the process of
transforming
INPUTS inputs into outputs.
OUTPUTS

Inputs refers to Refers to what we

the Processing get at the end of
factors of the production
production process that is
that a firm use in finished products.
the
production
 ENTREPRENEUR
A person who combines the diferent CAPITAL
factors of production, and initiates Part of man-made wealth
the process of production and also used for further production
bears the risk
PRODUCTION
OF FACTORS OF
CLASSIFICATION
LAND
LABOUR All natural resources
Physical or mental or gift of nature
activities of human beings
 PRODUCTION FUNCTION

A production function is a statement of the

functional relationship between inputs and
outputs, where it shows the maximum
output that can be produced with given
inputs.
Q = (K, L, M, etc.)

Where: Q = Output
K = Capital
L = Labour
M = Raw Material

 SHORT RUN AND LONG RUN
PRODUCTION FUNCTION
Two Types of Factor Inputs
1. Fixed Input
An input which the quantity does not change according to the
amount of output.
Example: Machinery, land, buildings, tools, equipments, etc.
2. Variable Input
An input which the quantity changes according to the amount of
output.
Example: Raw materials, electricity, fuel, transportation,
communication, etc.

Short Run and Long Run Period

. Short run period is the time frame, which at least one of the inputs
(factor of production) is fixed and other inputs can be varied.
. Long run period is the time frame which all inputs are variable.
 SHORT RUN PRODUCTION
FUNCTION
In the short run, we assume that at least
one of the inputs is fixed that is capital.
Therefore, in the short run the
production function can be written as:
Q = ( K , L)
Where: Q = Output
L = Labour
K = Capital (fixed)

 SHORT RUN PRODUCTION FUNCTION

(cont.)

LAW OF DIMINISHING MARGINAL

RETURNS

Law of diminishing marginal

returns states that as more of a
variable input is used while other
input and technology are fixed,
the marginal product of the
variable input will eventually
 AVERAGE PRODUCT (AP)
Divide the total product by the amount of that input
used in the production
Average Product (APL) = Total Product
Total Labour
APL = TP/ L
TOTAL PRODUCT (TP)
The amount of output produced when a given amount of that
input is used along with fixed inputs.
SHORT RUN PRODUCTION FUNCTION (cont.)
 MARGINAL PRODUCT (MP)
Change in the total product of that input corresponding to an addition
unit change in its labour assuming other factors that is capital fixed.
Marginal Product (MPL) = Change in Total Product
Change in Total Labour
MPL = TP/ L
FUNCTION (cont.)
SHORT RUN PRODUCTION
 SHORT RUN PRODUCTION
FUNCTION (cont.)
Capital Labour Total Marginal Average Stages of
(Fixed (Variable Product Product Product Production
input) input)

10 0 0 0 0
10 1 8 8 8
10 2 20 12 10 STAGE I
10 3 33 13 11
10 4 44 11 11
10 5 50 6 10
10 6 54 4 9
STAGE II
10 7 56 2 8
10 8 56 0 7
10 9 54 -2 6
STAGE III
10 10 50 -4 5
MP = 54 - 56 AP =56
9-8 8
= -2 = 7
 SHORT RUN PRODUCTION
FUNCTION (cont.)
RELATIONSHIP BETWEEN TP AND MP
RELATIONSHIP BETWEEN AP AND
When MP is increasing, TP increase at an increasing
MP
rate.
When MP is above AP , AP is
When MP is decreasing, TP increase at a decreasing
increasing
rate.
When MP is below AP, AP is
When MP is zero, TP at its maximum.
decreasing.
When MP is negative, TP declines.
60 When
TP MAX MP equals to AP, AP is at
STAGE I STAGE II maximum.STAGE III
50

40

30 TP

MP
20
AP MAX;
AP =MP AP
10
MP=0
0
1 2 3 4 5 6 7 8 9 10
-10
 TPL, MPL and APL curves
TP(Q)

Stag Stage Stage

e1
2 3

MP/APP

AP

0 L1 L2 MP L
 Stage III
Proportion of fixed factors is lower than variable factors
Increase in variable factors decline the TP because of overcrowding
A producer would not like to operate at this stage
STAGES OF PRODUCTION
Stage II
Called law of diminishing returns
Stage I
The most efcient stage of production Proportion of fixed factors are
because the combinations of inputs are fully greater than variable factors
utilized Under utilization of fixed factor
Operation involves a waste of resources
SHORT RUN PRODUCTION FUNCTION (cont.)
PRODUCTION COST
Money spent in the process of production. Eg:
pay wages, rent, etc
2 types:
Explicit cost money spent on factor of production.
Eg: land rental, wages, interest on capital
Implicit cost opportunity cost (no actual
payment). Eg: gave up opportunity to work as
ofcer, not earn rental payment when use own
building as firm
What is the short run?
A period of time so short that there is
at least one fixed input

The short run is a period of time

during which a firm can increase
output by hiring more workers
(variable input), while the size of the
firms plant (fixed input) remain
unchanged.
SHORT RUN PRODUCTION COST

Fixed Cost
Variable Cost
Total Cost
Average Fixed Cost
Average Variable Cost
Average Cost
Marginal Cost
Total Fixed Cost
Costs that do not vary as output
varies and that must be paid even if
output is zero
E.g: rental, interest payment, insurance
premium
Total variable cost

Costs that are zero when

output is zero and vary as
output varies

E.g: cost of labor wages

cost of raw material
Total cost
The sum of total fixed
cost and total variable
cost at each level of
output

TC= TFC +
TC = AC x Q
TVC
TC = TFC + TVC
Output TFC TVC TC

0 100 0

1 100 50

2 100 80

3 100 105

4 100 120
# As output increases, * When output = 0, VC = 0. when
FC remains constant. output increases, VC also rises

Total Cost
Cost (RM)
Curves
150 TC=TFC+TVC TC

TVC
As output
100 increases, TC also
increases. TC not
start from zero
since FC has to be
paid
50

TFC

051015 Quantity(units)
Average fixed cost

Total fixed cost divided

by the quantity of output
produced
AFC = TFC / Q
@ AFC = AC - AVC
Average Variable Cost
Total variable cost divided
by the quantity of output
produced
AVC = TVC / Q
@ AVC = AC - AFC
Average Cost
Total cost divided by the
quantity of output
produced

AC = AFC + AVC =
TC/Q
Marginal Cost
The change in total cost when one unit
of output is produced

MC = TC/Q = TVC/Q

In deciding how many units to produce, the

most important variable is marginal cost.
Short run cost table

Q TC AC AVC AFC MC
0 50 - - - -
1 100 100 50 50 50
2 130 65 40 25 30
3 155 51.67 35 16.67 25
4 170 42.5 30 12.5 15
5 190 38 28 10 20
6 220 36.67 28.34 8.33 30
Cost (RM)

MC AC
AVC

AFC

0 Quantity
(units)
The Short Run Cost of Production
Q TFC TVC TC AFC AVC AC MC
0 100 - - - -
1 130
2 154
3 163
4 176
5 190
6 214
7 240
8 276
9 316
10 370