T h i s i s m a t e r i a l
2 . 3 T H E O R Y O F P R O D U C T I O N
2.3. THEORY OF PRODUCTION
2.3.1. The Short and Long run Production Theories
The production function describes the relationship between
inputs and output. In other words it is the process of using the
services of different inputs to obtain output. From this
definition it follows that the production function is the
relationship between any combinations of input services and
the maximum output attainable, given the technology.
The Period of Production
The production period, during which the output level can
depend on the condition of the input combinations, is divided
into two: short run and long run.
(a) Short run
In the short run a firm’s plant capacity is assumed to be fixed.
The term short run refers to a period of time in which
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A N D C O S T
producers are able to change the quantity of some, but not all
of the resources they employ. It is a period in which some
resources (usually plant) are fixed and some are variable.
Variable inputs are inputs whose use must change for output to
change. Fixed inputs are those inputs whose use is constant
regardless of the level of output. For example, in the corn
production fertilizer, seeds, insecticides and gasoline are
variable inputs while farm buildings, machinery and truck are
fixed inputs.
(b) Long run
In the long run a firm can vary its plant size and firms can enter
or leave the industry. A period of time long enough to enable
producers of a product to change the quantities of all the
resources they employ. It is a period, in which all the resources
and costs are variable and no resources or costs are fixed.
 T h i s i s
2 . 3 T H E O R Y O F P R O D U C T I O N
The actual period of time that is required to vary the plant size
or to change the quantities of fixed inputs is likely to vary from
industry to industry. In sum industries it might take less than a
year while in others it might take a decade or more. Long run
time period is considered as a planning period during which the
firm can make a plan whether to change the use of fixed inputs.
The Law of Diminishing Returns
As successive increments of a variable resource are added to
fixed resources, the marginal product of the variable resource
will eventually decrease. The law of diminishing returns
indicates that, beyond some point, output will increase by
diminishing amounts as more units of a variable resource
(labor) are added to a fixed resource (capital).
The Stages of Production
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m a t e r i a l
A N D C O S T
As more and more of an input are supplied, the effect of this
addition on production changes and the change is explained by
three stages.
Stage I – the quantity of output increases more rapidly than the
quantity of the input (increasing marginal returns),
Stage II – the quantity of output increases less rapidly than the
quantity of the input (diminishing marginal returns), and
Stage III – the quantity of output declines as the quantity of the
input increases (negative marginal returns)
Among these stages of production Stage II, being the stage
where profit maximization takes place, is the most relevant
one. Observe that not all production processes have all the
three stages of production.
2.3.2. Short run Production Functions
 Total, Average and Marginal Products
 Total Product
 T h i s i s m a t e r i a l

2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
The total product shows the relationship between the amounts
The total product curve for corn production
of an input used and how much is produced.
300
Table 1: Total, Average and Marginal Schedules
250
Number of Total Marginal Average Total Product
Workers Product Product Product Stages 200 Curve
Number Tones Tones Tones
1 29 29 29 150
2 72 43 36
100
3 123 51 41
4 176 53 44 I
50 Stage I Stage II Stage III
5 225 49 45
6 264 39 44 0
7 287 23 41 1 2 3 4 5 6 7 8 9 10
8 288 1 36 II
Number of employed workers
9 261 -27 29
10 200 -61 20
III
A unit increase in labor initially has an increasing corn yields
The above table and the figure below show how much corn can up to the fourth unit of labor, in the first stage of production –
be produced as the variable inputs used, the number of workers increasing marginal returns. At the fifth point the average
employed, varies when it is used together with the fixed inputs, product is at its maximum value. Starting from the fifth unit of
land. labor, as the input increases by one unit, corn production still
increases but at a decreasing rate, i.e., each additional
increment on labor generates a smaller increase in output than

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 T h i s i s m a t e r i a l

2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
the last, this is exhibited in the second stages of production – maximum value at the end of Stage I of the production
diminishing marginal returns. This continues until output function. Additional amounts of labor in Stage II still increase
reaches its maximum, i.e., the second stage provides the corn production, but output is increasing at a decreasing rate.
optimum amount of labor at the eighth unit of labor. Any This implies that at the second stage the AP falls although
further additional labor unit after this point will result in a output increases until total product reaches at its maximum at
decline in output, such a movement happens at the third stage the end of Stage II. Even in Stage III, where increasing more
of production - negative marginal returns. labor results in a decrease in corn production, the AP continues
to fall and becomes smaller and smaller but never has a value
 Average Product of zero.
Average product (AP) is the total output produced per unit of a
resource employed (total product divided by the quantity of
that employed resource) and indicates the productivity of the
input used. The formula is given by
Quantity of Output Q
AP   o
Quantity of Variable Input Qi

At low levels of labor unit, as the amount of labor is increased,

the corn output per unit of labor also increases and reaches its

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2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
Qo
Corn product

The AP and MP curves  Quantity of Output

MP  
 Quantity of Variable Input Qi
60
50
The MP is the change in the TP (corn) for a one-unit change in
40 the input (labor).
30
20
Important Relationships
AP
10 (a) Between TP and MP
0 Stage I Stage II Stage III
-10 1 2 3 4 5 6 7 8 9 1  As MP is increasing TP is also increasing at the increasing
-20 rate.
-30
Labor input
 As Mp reaches a maximum point TP changes its rate of
MP change.
 Marginal Product  As MP starts to decline TP still increases but at a decreasing
The additional output produced when one additional unit of a rate.
resource is employed (the quantity of all other resources  As MP becomes zero TP reaches a maximum point
employed remaining constant); equal to the change in total  As MP becomes negative TP starts to decline
product divided by the change in the quantity of a resource (b) Between MP and AP
employed.  When MP > AP, AP is increasing ,i.e. the MP curve (broken
line) lies above the AP curve

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 T h i s i s
2 . 3 T H E O R Y O F P R O D U C T I O N
 when MP = AP, AP is at its maximum ,i.e., AP crosses MP
 when MP < AP, AP is falling, i.e. MP lies below AP
2.4. THEORY OF COSTS
Cost can be defined as the measures of the monetary value of
inputs used to produce an item over a given period of time.
2.4.1. Analysis of Costs in the Short-run
In the short run the total cost of any output is the sum of fixed
and variable costs (TC = TFC + TVC).
1. Total Cost
Total Variable Cost (TVC)
 is the sum of all variable costs needed to produce a
given level of output. It varies with output.
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m a t e r i a l
A N D C O S T
 The monetary values of services of workers, fuel,
materials and rent for machineries and equipments on
hourly basis are examples of variable cost.
 To determine total variable cost for a given amount of
output, simply multiply the quantity of each variable
input by the price of that input and sum the result
 The curve that plots the total variable cost of producing
each level of output is given by the TVC curve
Total Fixed Costs (TFC)
 Are costs that remain the same regardless of the level of
output
 Property taxes, mortgage payments, insurance, interest
on borrowed money, managers salary, depreciation and
general overhead costs are examples of TFC
 Regardless of the amount of output you choose to
produce (even if you don’t produce anything) you have
to pay for these items.
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2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
Total Cost (TC)
 Is the total cost of all the inputs used to produce a given  The total cost curve plots the total cost of producing at
level of output different levels of output
o The TFC is a straight line
Total Cost = Total Fixed Cost + Total Variable Cost o The vertical distance between the TVC and the
(TC) = (TFC) + (TVC) TC is a constant
o The TVC and TC curves are ‘curvy’,i.e, not
straight lines
o the shape of TVC curve mirrors that of the Total
Table 2.4. Cost of Productions for different level of
Product Curve
Output
Output TFC TVC TC AFC AVC AC MC TC,
TVC & TFC
0 140 0 140
10 140 70 210 14 7 21 7 1800-- Total Cost Curve
20 140 110 250 7 5.5 12.5 4 1600--
30 140 180 320 4.7 6 10.7 7
1400--
40 140 280 420 3.5 7 10.5 10
50 140 450 590 2.8 9 11.8 17 1200--
60 140 720 860 2.3 12 14.3 27
1000--
70 140 1120 1260 2 16 18 40
80 140 1680 1820 1.8 21 22.8 56 800--

600-- Total Variable Cost Curve

400--

31 200-- Total Fixed Cost

| | | | | | | |
10 20 30 40 50 60 70 80
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2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
TC
ATC 
Quantity produced

As the number of outputs produced increases

 AFC continuously declines but never becomes zero- showing
the spread of overhead costs over the total number of
outputs produced
 AVC and AC decline first, reach a minimum point ( the AC
reaches a minimum before the AVC does) and increases
 The gap between AVC and AC becomes narrower and
narrower because AFC becomes smaller and smaller

2. Average Cost
If we divide total cost values by the quantity produced, we
get average cost values. The three kinds of average values
are calculated using the following formula
TVC TFC
AVC  AFC 
Quantity produced Quantity produced

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2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
AFC, AVC, and AC Marginal cost is the extra or additional cost of producing
one more unit of output. It is calculated on the basis of an
additional unit, using the following formula.
Average Fixed, Variable and Total Cost curves
the change in total Cost
MC 
The change in output
25
AC In the short run, since the MC depends on the TVC
20
AVC curve only it possible to calculate MC by,
15
the change in total var iable cos t
10 MC 
the chnage in output
5 AFC
Important points about MC
0
a. The marginal cost is the same as the slope of the
10 20 30 40 50 60 70 80
Output total cost curve. The most accurate estimate of the
marginal cost is the first derivative of the total cost
function.
TC
MC 
Q
3. Marginal Cost
Since the total cost curve is not a straight line, the
marginal cost changes along the curve.

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 T h i s i s m a t e r i a l

2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
when output increases from 66 to 74
(74.00  66.00)
b. The MC curve first decreases, then reaches a  0.62
(99.3  86.4)
minimum and increase afterwards.
when output increases from 74 to 82
c. As indicated, it is possible to estimate the MC by (82.00  74.00)
 0.84
calculating the average change in cost per unit of (108.8  99.3)

added output. This is equivalent to calculating the Using this approach, calculate the marginal cost as output
slope of straight line segments approximating the changes from 86.4 units (TC of $66) to 108.8 (TC of $82)
TC curve. Given two total cost values – Which of the two estimates of marginal cost above do you
( x1 , y1 ) and ( x 2 , y 2 ) – the slope of the line think would best approximate the true MC at 70 to 71 units? At

between the values is: 74 to 75 unit of output? Why?

y 2  y1
Slope 
x 2  x1
Corn Yield Total Cost Marginal Cost
(X) (Y) (Slope)
86.04 66.00
0.62*
99.3 74.00
0.84
108.8 82.00
The actual slope calculations are:

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2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
 The law of diminishing returns indicates that, beyond some
MC

AVC
Average Fixed, Variable and Total Cost curves point, output will increase by diminishing amounts as more
and Marginal Cost
AC

units of a variable resource (labor) are added to a fixed

25

AFC
resource (capital).
20
 In the short run the total cost of any level of output is the
15
sum of fixed and variable costs (TC = TFC + TVC)
10
 Average fixed, average variable, and average total costs are
5
fixed, variable, and total costs per unit of output; marginal
AFC, AVC, and AC

0
10 20 30 40 50 60 70 80 cost is the extra cost of producing 1 more unit of output
Output  Average fixed cost declines continuously as output
increases; average-variable-cost and average-total-cost
Note that the MC curve cuts both the AVC and the ATC curves curves are U-shaped, reflecting increasing and then
at their minimum points. diminishing returns; the marginal-cost curve falls but then
rises, intersecting both the average-variable- and the
SUMMARY average-total-cost curves at their minimum points.

Short-run Production Costs

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 T h i s i s m a t e r i a l

2 . 3 T H E O R Y O F P R O D U C T I O N A N D C O S T
 Diseconomies of scale are caused by problems of
Long-run Production Costs coordination and communication which arise in large firms
 Minimum efficient scale is the lowest level of output at
 Most firms have U-shaped long-run average-total-cost which a firm’s long-run average total cost is at a minimum
curves, reflecting economies and then diseconomies of
scale (= increase in the average total cost of producing a
product as the firm expands the size of its plant – its output-
in the long run).
 Economies of scale (= reductions in the average total cost
of producing a product as the firm expands the size of plant
– its output – in the long run; the economies of mass
production.) are the consequence of greater specialization
( = the use of the resources of an individual, a firm, a
region, or a nation to produce one or a few goods and
services.) of labor and management, more efficient capital
equipment, and the spreading of start-up costs among more
units of output

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