Managerial Economics

4. Theory of Production and Cost in the Short

Run

Antigen B.(PhD)

December, 2021
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Table of Contents

1 Basic Production Concepts

2 Short Run Production

3 Short Run Production Costs

4 Relations Between Short-Run Costs & Production

 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Basic Production Concepts

Production:- is the process of using economic recourses to

produce outputs, or it is the process of transforming inputs into
outputs.
• Production function: shows the relationship between
various combinations of inputs and the maximum outputs
obtainable from those combinations. Q=f (x1, x2, x3,…….,xn)
• Technical efficiency: Achieved when maximum amount
of output is produced with a given combination of inputs.
• Economic efficiency: Achieved when firm is
producing a given output at the lowest possible total
cost.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Basic Production Concepts

Inputs: are factors of production that can be use in the production of
goods and services. It includes labor, land, capital an entrepreneurship.
Inputs are considered variable or fixed depending on how readily their
usage can be changed.
 Variable input: An input for which the level of usage may be
changed quite readily. changes with the level of output.
 Fixed input: An input for which the level of usage cannot
readily be changed, and which must be paid even if no output
is produced. i.e. its quantity does not change with the change
in output.
Short run: At least one input is fixed. All changes in output achieved
by changing usage of variable inputs.
Long run: All inputs are variable. Output changed by varying usage of
all inputs.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short Run Production

• In the short run, capital is fixed.

Only changes in the variable labor input can change the
level of output.
• Short run production function:

Q = f (L, K ) = f (L) (1)

 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Total, Average & Marginal Products

Total product (Q):- is the overall amount of output produced by the

factors of production employed over a given period.
Average product (AP):- a firm’s average product is obtained by
dividing the total output by the number of workers employed.
 Average product of labor AP = Q/L (2)
Marginal Product (MP):- the increase in output which results from using
one additional or extra unit of a single factor input, holding the quantities
of other factors constant.
 Marginal product of labor MP = △Q/△L (3)
Law of diminishing marginal product
As usage of a variable input increases, a point is reached
beyond which its marginal product decreases.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Total, Average & Marginal Products

 When AP is rising, MP is greater than AP
 When AP is falling, MP is less than AP
 When AP reaches it maximum, AP = MP
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Figure 4.1: Total Products ( TP L )

As the number of the labor hired increases (capital being fixed), the
TP curve first rises, reaches its maximum when L2 amount of labor
is employed, beyond which it tends to decline.

Assuming car manufacturing industry, it implies that L2 numbers of

workers are required to efficiently run the machineries. If the
numbers of workers fall below L2, the machine is not fully operating,
resulting in a fall in TP below L2.

On the other hand, increasing the number of workers above L2 will do

nothing for the production process because only L2 number of
workers can efficiently run the machine. Increasing the number of
workers above L2, rather results in lower total product because it
results in overcrowded and unfavorable working environment.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Figure 4.1: Marginal Products (MP L )

• Marginal product curve increases until L1 number of labor is hire

and reaches its maximum at L1, and then it tends to fall.
• The MP is zero at L2 (when the TP is maximal); beyond which its
value assumes zero indicating that each additional worker above
L2 tends to create overcrowded working condition and reduces
the total product.
• Thus, in the short run, the marginal product of successive units
of labor hired increases initially, resulting in the limit to the total
production.
• Geometrically, the MP curve measures the slope of the TP. The
slope of the TP curve increases (MP increases) up to L0, it
decreases from L0 to L2 and it becomes negative beyond L2.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Figure 4.1A: Average Products (AP L )

• The average product curve increases up to L1, beyond which

it continuously declines.
• The AP curve can be measured by the slope of rays
originating from the origin to a point on the TP curve.
• For example, the APL at L1 is the ratio of TP1 to L1.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

The relationship between AP and MP of the variable input

The relationship between MPL and APL can be stated

as follows:
 For all number of workers (Labor) below L1, MPL
lies above APL.
 At L1, MPL and APL are equal.
 Beyond L1, MPL lies below the APL
 Thus, the MPL curve passes through the maximum
of the APL curve from above.
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Law of Diminishing Marginal Product (Returns)

• LDMR only holds in the short-run as it is a short-run law
of production.
• As the quantity of the variable input (labor) increases,
the capital to labor ratio declines.
• Eventually an incremental increase in the variable input
adds less to output than the previous incremental increase
in the variable input.
• When the labor input is small (and capital is fixed), extra
labor adds considerably to output, often because workers get
the chance to specialize in one or few tasks.
• Eventually, however, the LDMR operates when the number
of workers increases further, some workers will inevitably
become in-effective and the MPL falls (this happens when
the number of workers exceeds L0 in g 4.1).
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short Run Production Costs

Short-run costs are costs over a period during which some
factors of production are fixed.
• Short-run total costs are split into two groups:
1. Total Variable Costs (TVC) and
2. Total Fixed Costs (TFC):
1. Total variable cost (TVC)
Total amount paid for variable inputs increases as output increases.
The TVC has usually an inverse-S shape which reflects the law of
variable proportions.
2. Total fixed cost (TFC)
Total amount paid for fixed inputs. Does not vary with output or As
the TFC does not depend on the level of output, it is represented by a
horizontal line.
Total cost (TC)
By adding the TFC and TVC we obtain the TC of the firm.
TC = TVC + TFC (4)
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

TFC, TVC and TC Curves

 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Average Costs
• Average Variable Cost (AVC)
AVC is the total variable cost divided by the amount of output
TVC
AVC = (5)
Q
The AVC curve falls initially as the productivity of the variable factor
increases, reaches a maximum when the plant is operated optimally
and rises beyond that point.
• Average Fixed Cost (AFC)
AFC is the total xed cost divided by the amount of output:
TFC
AFC = (6)
Q
A F C decreases continuously as output increases as TFC is
constant and, an increase in Q reduces the ratio.
Average Cost (AC): is the sum of AFC and AVC.
TC (TFC + TVC ) TFC TVC
AC = = = + = AVC + AFC (7)
Q Q Q Q
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short Run Marginal Cost

Short run marginal cost (SMC): measures rate of change in

total cost (TC) as output varies.
It is the slope of the TC curve (which of course is the same at
any point as the slope of the TVC).
SMC = △TC = △(TFC + TVC ) = △TFC + △ TVC = △ TVC
△Q △Q △Q △Q △Q
(8)
Since TFC is constant regardless of the level of output, change
in TFC is always zero in the short run (△TFC ) so that:
△ TFC = 0 =0
△Q △Q
This show that
1 MC is the slope of either TC or TVC.
2 MC does not depend of TFC.
3 The shape of TC and MC does not depend on TFC
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short Run Average & Marginal Cost Curves

peMdan.agerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short Run Cost Curve Relations

The relationship between ATC and AVC
The AVCis a part of the ATC, given ATC = AFC + AVC.
Both AVC and ATC are U-shaped, reflecting the law of
variable proportions.
However, the minimum point of the ATC occurs to the right of
the minimum point of the AVC.
This is due to the fact that ATC includes AFC which falls
continuously with increase in output.
Initially the fall in the AFC o sets the rise in the AVC and thus
the ATC declines.
But later on the rise in the AVC more than o sets the fall in
the AFC and thus the ATC will start rising continuously.
The AVC approaches the ATC asymptotically as output
increases since the AFC declines continuously.
Note: AFC is equal to vertical distance between ATC & AVC.
Managerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

The relationship between SMC, ATC and AVC

SMC:
Equals and Intersects AVC & ATC at their minimum points
Lies below AVC & ATC when AVC & ATC are falling
Lies above AVC & ATC when AVC& ATC are rising
Speci cally, (Show analytically)
MC<ATC if slope of ATC is negative.
MC=ATC if slope of ATC=0, (at the minimum of the ATC).
MC>ATC if slope of ATC>0.
MC<AVC if slope of AVC<0
MC =AVC if slope of AVC=0 (at the minimum point of the
AVC).
MC >AVC if slope of AVC>0.

Managerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Relations Between Short-Run Costs & Production

In the case of a single variable input, short-run costs are

related to the production function by two relations
AVC = WAPand SMC = W MP
Where w is the price of the variable input
That means, Unit products and unit cost curves are mirror
images of each other:
when AP(MP) is ring AC(MC) is falling;
when AP(MP) is falling AC(MC) is rising; and
when AP(MP) is maximum AC(MC) is minimum

Managerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Proof

AVC = TVC
Q
= wL = w =
Q Q
w
AP
L

SMC = OTC = OTVC = O(wL) = w OL = w =O Q w

OQ OQ OQ OQ MP
OL
Marginal cost is inversely related to marginal product
Average variable cost is inversely related to average product
See the following Figure for further relationships.

Managerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

Short-Run Production & Cost Relations

Managerial Economics
 Basic Production Concepts
Short Run Production
Short Run Production Costs
Relations Between Short-Run Costs & Production

References

Thomas et al. (2016). Managerial Economics: Foundations of

Business Analysis and Strategy, Chapter 8 and 10.
Baye (2010).Managerial Economics and Business Strategy,
Chapter 5.
Webster ,Thomas J. (2003). Managerial Economics: Theory
and Practice, Chapter 5 and 6.
Wilkinson, Nick (2005): Managerial Economics. A Problem
Based Approach,1st ed New York,: Cambridge, Chapter 5, 6
and 7.
Other microeconomics text books.

Managerial Economics