3.

10301

FOUNDATION
ECONOMICS

PART I :

PRINCIPLES OF
MICROECONOMICS
PRODUCTION COST

TOPIC 5 :

Introduction
This topic focuses on the fundamental task of a firm: the
physical combining of input to create output.
The technical possibilities are summarised by production
function that relates alternative input combinations used
during a period to maximum possible output qualities
associated with each state of technical knowledge.
These input -output relationship is explored in detail,
both for short run ( When some inputs are fixed) and the
long run ( when all inputs are varied).
Isoquant analysis is also introduced, a more
sophisticated approach to production functions.

Introduction
Economic activity is a process of converting inputs (factors
of production) into outputs or products (goods and services).
Inputs can be in the form of fixed or variable inputs
The output produced in the process of converting inputs is
called total product.
As additional inputs are employed in production process
additional increases in total product also occurs. This
additional increase is called marginal product.
Marginal product can be both positive and negative. When it
is positive, it can show whether total product is increasing at
a constant rate, increasing rate or, decreasing rate.
When marginal product decreases it shows that diminishing
returns is experienced in production and that total product is
increasing at decreasing rate, reaches its maximum and
eventually declines.

Introduction
Firms purchase factor inputs in the factor market and the
cost incurred in purchasing fixed inputs is called fix cost
while the cost incurred in purchasing variable inputs is
called variable cost. Whether a firm produces or not, it
is always liable to pay for the fix cost.
In this Unit, we will study the theory of production and
cost separately and see how the total cost, average cost,
marginal cost, average variable cost and fixed costs are
related to fixed and variable inputs and total product,
average product and marginal product. The study of
production and cost is the first step to understanding firm
behaviour.

Production Theory
Production refers to the transformation of
resources into outputs of goods and services.
The output of a firm can either be a final
commodity such as cars or an intermediate
product such as steel (which is used in the
production of cars and other goods). Output can
also be a service rather that a good, e.g.,
banking, accounting work etc.
A firm is an organization that combines and
organizes resources for the purpose of
producing goods and services for sale at a profit.

Production Theory
Firms generally seek to maximize profits.
= TR TC

PxQ
Costs: wages, Input purchases, Opportunity cost
opportunity cost refers to the income the owner of a firm would
have earned by working for someone else and the return that
he would have received from investing his or her capital in the
best alternative use.
The profit maximization assumption provides the framework for
analyzing the behavior of the firm in microeconomic theory.

Classification of inputs
Inputs, resources, or factors of production are
the means of producing the goods and services
demanded by society. Inputs can be classified
broadly into labour or human resources
(including entrepreneurial talent), capital, land or
natural resources.
Entrepreneurship: refers to the ability on the
part of some individuals to see opportunities to
combine resources in new and more efficient
ways to produce a particular commodity or to
produce entirely new commodities.

Further classification
Fixed inputs are those inputs that cannot be varied or
can be varied only with excessive cost during the time
period under consideration, e.g., firms plant and
specialized equipment. Generally, it takes many years to
build a new factory or equipment.
Variable inputs: those inputs that can be varied easily
and on a short notice during the time period under
consideration, e.g., raw materials, many types of workers
(low level of skills) etc.
Short run (SR): is the time period during which at least
one input is fixed.
Long run (LR): is the time period during which all inputs
are variable.

Production with one variable input

Land

Labour
(workers per
year)
(1)

Output
TPP

APL

MP
PL

12

14

3.5

14

2.8

12

-2

A production function is a unique

relationship between inputs and
outputs. It can be represented
by a table, a graph, or an
equation showing the maximum
output of a commodity that can
be produced per period of time
with each set of inputs.
In this example a farmer is using
various quantities of labour to
cultivate wheat on one acre of
land (no other input).
1 L TP = 3 bushels of wheat
per year
2 L TP = 8
3 L TP = 12 etc.
TP = Total Product

Production with one variable input

From the example
we can derive APP
(average physical
product) and MPP
(marginal physical
product).

TPP
APPL
L

TPP
MPPL
L

The Law of Diminishing Returns

The decline of MPPL curve is a reflection of the law of
diminishing returns. The law postulates that as more
units of a variable input are used with a fixed amount of
other inputs, after a point, a smaller and smaller return
will accrue to each additional unit of the variable input.
That is MPPL (i.e., variable input) eventually declines.
This occurs because each additional unit of the variable
input has less and less of the fixed inputs with which to
work with. Eventually too much of the variable input is
used with the fixed inputs, and so MPPL declines.
A rational producer will not operate where MPPL<0. The
producer can still operate even if MPPL is falling and this
depends on the prices of inputs and outputs.

Production with 2 variable inputs:

Isoquants
Isoquant I
L

MR
TSLK

II
L

III
MR
TSLK

MRTS
LK

11

13

15

10

12

3.0

3.0

3.0

2.0

2.0

2.0

2.
3

0.7

4.2

0.8

6.
2

0.8

1.
8

0.5

3.5

0.7

5.
5

0.7

1.
6

0.2

3.2

0.3

1
0

5.
3

0.2

1.
8

3.5

1
1

5.
5

Supposing a firm has 2 factors

of production, both variable L
(labour) and K (capital). In this
situation we are dealing with
the LR.
An isoquant shows the
different combinations of
labour (L) and capital (K) with
which a firm can produce a
specific quantity of output. A
higher isoquant refers to a
greater quantity of output and
a lower one, a smaller quantity
of output.

Marginal Rate of Technical

Substitution (MRTS)
MRTS of L for K (MRTSLK): refers to the amount of K
that a firm can given up by increasing the amount of L
used, by one unit and still remain on the same isoquant.
MRTS LK

- K

TPP
MPPL
L

TPP
MPPK
K
equate both

( L) MPPL TPP

(K) MPPK TPP

( L) MPPL (-K) MPPK

so that

MPPL - K

MRTS LK
MPPK
L

MRTSLK = 3 firm gives up 3 units of K for one additional unit of L.

Characteristics of isoquants
1) Isoquants are negatively sloped (so that always
more L will substitute for less K),
(2) Isoquants are convex to the origin (reflection of
diminishing MRTSLK).
(3) Isoquants never cross. If they cross, the point of
intersection would imply that the firm could produce two
different levels of output with the same combination of L
and K. This is impossible if we assume that the firm uses
the most efficient production techniques at all times.
Lets recap what we have learnt so far. Remember,
production involves the transformation of inputs into
outputs. And inputs are not free.

Isocosts
TC w
-
L
K=
r
r

Isocosts: Shows the various

combinations of labour and
capital that the firm can hire
Slope of isocost line
or rent for the given total
cost (i.e., given the output of
the firm and factor prices).
TC = wL + rK, where w is
the wage rate (the price of
labour) and r is the price of
capital.
In order to draw a two
dimensional diagram, we
need to rearrange the
above equation.

Producer equilibrium
1) Producer is in
equilibrium when he
maximizes output
given total cost or
when the highest
isoquant is reached,
given the particular
isocost line.

Producer equilibrium

he
our
st

Producer is in
equilibrium when he
minimizes cost given
output level or when the
lowest isocost line is
reached, given the
particular isocost line.
That is at equilibrium
MRTSLK = PL/PK, and
also note that MRTSLK
= MPL/MPK.

MPL PL
MPL MPK

or

MPK PK
PL
PK

Expansion Path
If firm changes input
requirements while
factor prices remain
constant, the firms
isocost shifts parallel
to itself. The
expansion path can
be traced through the
origin by joining all
the tangency points.

Factor substitution
MPL w

MPK
r
MPL w

MPK
r

If, starting from a position

of producer equilibrium,
0.5
the price of a factor falls,
1
the equilibrium position
will be disturbed. In the
process of re-establishing
equilibrium, the producer
will substitute in
production this cheaper
factor for the other factor,
until equilibrium is reestablished.

Costs of production
Explicit costs refer to the actual expenditures of the firm
to purchase or hire the inputs it needs, i.e., out-of-pocket
expenses.
e.g., wages
interest
rent
expenditures on raw materials etc.
Implicit costs refer to the value of the inputs owned by
the firm and used by the firm in its own production
processes. The value of these owned inputs should be
imputed or estimated from what they could earn in their
next best alternative use or opportunity cost.

Short run cost curve

In the short run at least one input is fixed.
TFC (total fixed costs), TVC (total variable costs).
TC = TFC + TVC, where TC is total costs.

Short Run per unit cost curves

AFC = ,

TFC
rK

Q
Q

where AFC is average fixed costs.

AVC =
0

TVC
wL
w
w

Q
Q
Q/L APL

where AVC is average variable costs.

MC =

TVC (wL) w(L)

w
w

Q
Q
Q
Q/L MPL

where MC is marginal cost.

Short Run per unit cost curves

Notice that MC goes through

the minimum of AVC and ATC.
Why are per unit cost curves
U-shaped? Because of the
Law of diminishing returns.
Initially due to increasing
returns, per unit costs are
declining. As more and more
labour are employed, the
marginal productivity of labour
(MPL) declines, therefore this,
in proportion to increases in
TC implies that per unit cost
are rising. The minimum points
are where the forces of
increasing and decreasing
returns cancel out.

Long Run Cost Curves

Economic of Scale a situation in which a simultaneous and
equal percentage change in the use of all physical inputs
leads to a larger percentage change in physical change.
Constant Returns of Scale If simultaneous and equal
percentage change in the use of all physical inputs leads to
an Identical percentage change in physical output, a
production function is said to exhibit constant returns to the
scale
Increasing Returns to Scale - If simultaneous and equal
percentage change in the use of all physical inputs leads to
an larger percentage change in physical out put a production
function is said to exhibit constant returns to the scale
Decreasing Returns to Scale - If simultaneous and equal
percentage change in the use of all physical inputs leads to
an smaller percentage change in physical out put a
production function is said to exhibit constant returns to the
scale

Long Run Cost Curves

The shape of the cost curves

are determined by constant,
increasing and decreasing
returns to scale.
Increasing returns: If all inputs
are increased in a given
proportion, the output of the
commodity increases in a
greater proportion etc.
LAC = ,LTC
Q

where LAC is long run average

cost and LTC is long run total

cost.

Long Run Cost Curves

The U shape of LAC is due to
increasing and decreasing
returns to scale.
LTC

LMC = ,
Q
where LMC is long run
marginal cost.
The value of the productivity of
the last unit of labour (or input)
is:
MRP = MPP X P, where MRP
is marginal revenue product.
E.g., LabourMPP of 5th labour
is 5Q

Price of labour is K5

MRP = 5x5

= K25

To find MPPL,
dQ
differentiate
5
dL

at
L = 200

Q = 1000 500

= 500

P = 600-500

= K100

MRP = (5) (100)

= K500

Costs of Production
Explicit costs are actual out-of-pocket expenditures of the firm
to purchase or hire the inputs it requires in production. These
include wages to hire labour, interest on borrowed capital, rent
on land and buildings, and expenditures on raw and semi
finished materials.
Implicit costs refer to the value of the inputs owned by the
owner and used by the firm in its own production processes.
The value of these owned inputs must be imputed or estimated
from what these inputs could earn in their best alternative use.
These include maximum wages that the entrepreneur could
earn in working for someone else in a similar capacity (e.g., as
the manager of another firm), and the highest return that the
firm could obtain from investing its capital elsewhere and
renting out its land and other inputs to others

Costs of Production
From firms production function and the
price of inputs, we can derive firms cost
functions. This will show minimum costs
that the firm would incur in producing
various levels of output. We assume that
the firm is too small to influence input
prices.
Costs include explicit and implicit costs.

Costs of Production
Accountants traditionally include only actual
expenditures in costs, while economists always
include both explicit and implicit costs.
Implicit costs are the opportunity costs.
Private costs: Explicit + Implicit costs
Social costs: Explicit + Implicit + External costs
In this course we concentrate on private costs.

Reference
Dr. M Fogiel, 1999, The Essentials of
Microeconomics, Chapters 3 & 6,
Research and Education Association, New
Jersey , US
Paul Wonnacott & Ronald Wonnacott,
1990, Economics, 4th Edition, chapter 24,
John Wiley and Sons, USA