Module 5
Theory of Cost and
Production
Unit 1: Concept of Cost
Unit 2: Production
Unit 3: The Law of Diminishing Returns
Unit 4: Production Possibility Curve.
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Unit 1
Cost Concepts
Content
1.0 Introduction
2.0 Learning Outcomes
3.0 Learning Content
3.1 Meaning of Cost
3.2 Types of Cost
3.3 Cost Concept
3.4 Cost Schedule
3.5 Short-term and Long-term cost
4.0 Conclusion
5.0 Summary
6.0 Tutor-marked assignment
7.0 References/Further Reading
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1.0 Introduction
The monetary valuation of resources used in the production of goods and services is known as cost.
Knowing what consists cos is very important because it helps in fixing the prices of goods and services
and also the amount of goods and services to be produced. This unit will look at cost and the concepts of
cost.
2.0 Learning Outcomes
At the end of this unit, you should be able to:
i. Explain the significant of cost in production
ii. Identify the various types of cost
iii. Explain the concepts of cost
3.0 Learning Content
3.1 Meaning of Cost
Cost is the monetary valuation of effort, material, resources, time and utilities consumed, risks incurred
and opportunity forgone in the production and delivery of a good or service. The firm’s cost determines
its supply; Supply along with demand, determines price. To understand the process of price determination
and the forces behind supply, we need to understand the nature of cost.
3.2 Types of Cost
i. Money (Accounting or Explicit) Cost: These are total money expenses incurred by a firm in producing
a commodity.
ii. Economic (Implicit) Cost: These are the imputed value of the entrepreneur’s own resources.
iii. Production Cost: these are the expenses incurred by a firm on both fixed and variable factors used in
production.
iv. Real Cost/Opportunity Cost: This refers to the next best alternative that could be produced using the
same inputs.
v. Private Cost: It includes explicit and implicit costs.
vi. Social Cost: The production activities of a firm may lead to economic benefit or harm for others.
Production of petroleum products pollutes the environment which is harmful to the residents. Cost
incurred in taking care of the harm is called social cost.
3.3 Cost Concept
a. Total Cost (TC): Addition of fixed and variable costs i.e TC = FC + VC. Total cost is divided into
two:
i. Total Fixed Cost (TFC): this can simply be referred to as fixed cost (FC). It represents the part of
total cost that does not vary directly with output e.g. rent, machinery, wages of the permanent staff,
etc. TFC = TC – TVC. Fixed cost is known as overhead cost.
ii. Total Variable Cost (TVC): this represents the part of total cost that varies directly with the level of
output e.g. raw materials, wages of factory workers, etc.
TVC = TC – TVC
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b. Average Cost (AC): This can also be referred to as Average Total Cost (ATC). It is the cost of
producing one unit of output i.e AC = TC ÷ Q; where Q stands for output. Average usually has a U-
shaped curve. Average cost is divided into two:
i. Average Fixed Cost (AFC): it is defined as the total fixed cost of production divided by the quantity
of output produced. AFC = TFC ÷ Q
ii. Average Variable Cost (AVC): it is defined as the variable cost of production divided by the quantity
of output produced AVC = TVC ÷ Q
c. Marginal cost (MC): This is the cost of producing one extra unit of output or change in total cost as
a result of producing one more unit of output, i.e MC = ΔTC/ΔQ.
Table 6: Cost Schedule
Output(Q) TFC TVC TC AFC AVC ATC MC
0 300 0 300 0 0 0 -
1 300 300 600 300 300 600 300
2 300 400 700 150 200 350 100
3 300 450 750 100 150 250 50
4 300 500 800 75 125 200 50
5 300 600 900 60 120 180 100
Table 6 can be represented using a graph as shown in Figure 14:
Figure 14: Various Cost Curves
1000
AS 0 900
0800
Output
0
700
TC
0
600
0
500 TVC
0400
0
300 TFC
0200
AC
100
0
0
1 2 3 4 5 MC
1 Output 3
3.5 Short-run and Long-run Cost
i. Short-run: A period of time in which at least one input (factor of production) is fixed. A producer
can only increase (reduce) output by varying the variable input. The cost incurred during the short-
run period is termed short run cost.
ii. Long-run: The long run period is a period of time in which all factors of production are variable. A
producer can increase (or reduce) output by varying all factors (inputs). The costs incurred during
the long-run period are termed long-run costs.
However, no fixed length of time in terms of week, months or years for either periods. It depends on
the type of industry or production unit.
4.0 Conclusion
Cost helps the seller or producer of commodities fix price. With price, the quantity to be produced is
known. There are costs that are incurred irrespective of the production activity level, such costs are known
as fixed cost. They do not change within the period (weekly, monthly or yearly). Whereas, there are some
other costs that change based on the activities level, these are referred to as variable cost. Both the fixed
and variable costs form the total cost of production.
5.0 Summary
This unit takes a look at cost and the various types of cost. It further looked at how cost behaves in short-
run and long-run period.
6.0 Tutor-Marked Assignment
i. Define cost
ii. List and explain the types of cost you know
iii. Distinguish between fixed cost and variable cost
7.0 References/Further Reading
Ohale, I., & Onyema, J.I. (2002). Foundations of Microeconomics. Amethyst& Colleagues Publishers,
Port Harcourt
Ray, P. (2000). A level Economics. Letts Educational Ltd., London.
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Unit 2
Production
Contents
1.0 Introduction
2.0 Learning Outcomes
3.0 Learning Content
3.1 Meaning of Production
3.2 Factors of Production
3.3 Meaning of Product
3.4 Concepts of Total, Average and Marginal Products
4.0 Conclusion
5.0 Summary
6.0 Tutor-marked assignment
7.0 References/Further Reading
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1.0 Introduction
The conversion of raw materials into finished goods and the provision of services is known as production.
In production, costs are incurred from the combination of factors of production. Knowing the cost of these
factors of production help in the fixation of price. Price determines supply and demand of goods and
services.
2.0 Learning Outcomes
At the end of this unit, you should be able to:
i. Define production
ii. Enumerate factors of production
iii. Highlight the significance of marginal products
3.0 Learning Content
3.1 Meaning of production
Production is the creation of goods and provision of services to satisfy human wants. There are different
forms or types of production. They include;
i. Primary Production: Primary production involves the extraction of raw materials and food from
nature. E.g farming, fishing, mining, lumbering, etc
ii. Secondary Production: Secondary production involves processing and conversion of raw materials
into finished goods e.g manufacturing, construction, etc
iii. Tertiary Production: Tertiary production involves the distribution of goods (trade and aids to trade)
and rendering of services (direct and indirect). E.g transportation, insurance, teaching, banking,
service of the lawyer, etc.
3.2 Factors of Production
a. Land: A free gift of nature used in production, e.g soil, forest, rivers, fishing ground, minerals,
vegetations, rocks, etc. the reward for land is rent.
b. Labour: Human efforts (mental or physical) used in production process. Labour can be skilled e.g.
an engineer; semi-skilled, e.g. a carpenter; and unskilled, e.g. a cleaner. The reward for labour is in
the form of salaries/wages.
c. Capital: This refers to man-made assets used in the production process or wealth, set aside for
production of further wealth. Capital can be fixed, e.g. factory building; circulating or working, e.g.
cash; raw materials; and social, e.g. infrastructural facilities. The reward for capital is interest.
d. Entrepreneur: An entrepreneur is a person who organizes, controls, and coordinates other factors to
obtain maximum output at minimum cost, with a view to making profit. The reward for entrepreneur
is profit/loss.
3.3 Meaning of a Product
A product is an output or finished goods; that is, the end results of a production process. They are goods
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or services which result from the combination of appropriate quantities of factors of production. Examples
of products are yam, beer, cement, legal services, etc
3.4 Concepts of Total, Average and Marginal Products
i. Total Product (TP): total product refers to the total amount of output produced during a period of time
by all factors of production employed. It is calculated as:
TP = Average Product × Labour
ii. Average Product (AP): this is defined as out per unit of labour employed, i.e output per head. It is
calculated as :
AP = Total Product ÷ Labour (No of people employed)
iii. Marginal Product (MC): This is defined as addition to total product due to one more unit increase of
variable factor (labour). It is calculated as:
MP = ∆TP
∆
3.5 The Law of Diminishing Returns
The Law of Diminishing Returns states that as more and more unit of a variable input (e.g. labour) is
applied to a fixed input (land), production will increase up to a point where marginal and average products
will begin to decrease. It is also called the Law of Variable Proportion. It is a short- run phenomenon.
3.6 The Law of Return to Scale
The law of return to scale describes the relationship between output and the scale of input in the long run
when all inputs are increased in the same proportion. As the scale of production expanded, the effect on
output shows three stages. These stages are:
i. Increasing Returns to Scale: At this stage, increase in total output is more than proportional to the
increase in inputs.
ii. Constant Returns to Scale: At this stage, increase in total output is in exact proportion to the increase
in inputs
iii. Diminishing Returns to Scale: At this stage, increase in total output is less than proportionate increase
in inputs
4.0 Conclusion
There has to be a combination of resources for production to occur. Production makes available
commodities for consumption. Therefore, production, is a significant economic activity.
5.0 Summary
This unit looked at production, factors of production, and forms of production. It went further to discuss
the law of diminishing returns and the law of returns to scale.
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6.0 Tutor-Marked Assignment
i. Briefly explain the factors of production
ii. Explain the concept of marginal products
iii. Differentiate the law of diminishing return and the law of return to scale.
References/Further Reading
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Unit 3
Production Possibility Curve
Contents
1.0 Introduction
2.0 Learning Outcomes
3.0 Learning Content
3.1 Definition of Production Possibility Curve
3.2 Production Possibility Curve diagram
4.0 Conclusion
5.0 Summary
6.0 Tutor-marked assignment
7.0 References/Further Reading
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1.0 Introduction
Every nation is endowed with its own resources. The level of production of any nation is limited
by the available resources, hence, no individual or a group of individuals can go beyond such
boundaries/curves. Since resources has limitations, it is assumed that, when more of a particular
commodity is desired, lesser of the alternative commodity will be produced at a particular time.
This is because, the available resources will be shared among the commodities to be produced.
However, there could be situation of production below and above the production possibility curve
in the long run. Making the curve to shift below or above the boundaries.
2.0 Learning Outcomes
At the end of this unit, you should be able to:
i. Define production possibility curve
ii. Explain the possibility of producing beyond the production possibility boundary
3.0 Learning Content
3.1 Definition of Production Possibility Curve
A production possibility frontier (PPF), sometimes called a production possibility curve (PPC),
production possibility boundary, or product transformation curve, is a curve or graph showing the
combination of two goods that can be produced given the available resources.
Table 7: Production Possibility Curves diagram
Production Possibility schedule
Possible Combinations Quantity of guns Quantity of butter
produced produced
S 200 0
B 180 20
D 120 80
C 20 180
T 0 200
Table 7 shows a hypothetical country producing different combination of two goods- guns and
butter with all its available resources. Combinations S and T are regarded as extreme points as
they indicate a situation where the country produces only one of the two goods with all of its
resources. In-between these points, it can be seen that to produce a greater number of a particular
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goods, a certain quantity of the other good must be sacrificed. For instance, to increase the quantity
of butter produced from 0 to 20 (i.e moving from combination S to combination B), the quantity
of guns produced must decrease from 200 to 180 units. These points can be represented using a
graph as shown below:
Figure 15: Production Possibility Curve
A curve that joins all the point of intersection of the various combinations that can be produced is
known as the production possibility curve. On the graph, all the points on the PPC (B, C, and D)
represent the output level when the resources are optimally used. They show the point of technical
and economic efficiencies. Point A is below the optimal level i.e. the resources are not being fully
utilized (i.e. point of inefficiency), while point X is unattainable available resources is not enough
to produce at this point. Points T on the x-axis and S on the y-axis are points of extremity.
The PPC slopes downwards from left to right, reflecting that opportunity cost is involved in
moving from one combination to another, i.e. if much resources are used to produce more of one
of the goods, less resources will be available for the production of the other.
The two main determinants of the position of the PPC at any given time are the state of technology,
management expertise and the available quantities and qualities of factors of production. Only the
points on or within a PPC are actually possible to achieve in the short run. In the long run, if
technology improves or if the productivity or supply of factors of production increases, the
economy’s capacity to produce both goods increases, i.e. economic growth occurs. This increase
is shown by a shift of the production possibility curve to the right as shown in the Figure 16
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Figure 16: Rightward Shift in Production Possibility Curve.
Conversely, a natural, military or ecological disaster might move the PPC to the left, in response
to a reduction in an economy’s productivity.
4.0 Conclusion
Limited resources otherwise known as scarcity makes the production of goods and services limited
to the available resources.
5.0 Summary
This unit explains the possibility of what can produced at a given time using the PPC.
6.0 Tutor-Marked Assignment
i. What is PPC?
ii. How can production above the PPC be achieved?
References/Further Reading
