Chapter Four

The Theory of Production and Cost

 Production
• Production is the process of transforming inputs into
outputs / an act of creating value or utility.
• The end products of the production process are
outputs which could be tangible (goods) or
intangible (services).
 Production function
Production function is a technical relationship between inputs
and outputs.
• It shows the maximum output that can be produced with
fixed amount of inputs and the existing technology.
A general equation for production function can be given as:
𝑄 = 𝑓 𝑋1 , 𝑋2 , 𝑋3 , … 𝑋𝑛
where 𝑄 is output and 𝑋1 , 𝑋2 , 𝑋3 , … 𝑋𝑛 are different types of inputs.
 Inputs
Inputs are commonly classified as fixed/variable.

• Fixed inputs: are those inputs whose quantity cannot readily be changed
when market conditions indicate that an immediate adjustment in output
is required. E.g. buildings, land and machineries etc.
– no input is ever absolutely fixed but may be fixed during an immediate
requirement.
Eg. if the demand for Beer rises suddenly in a week, the brewery factories cannot
plant additional machinery overnight and respond to the increased demand.

• Variable inputs: are those inputs whose quantity can be altered almost
instantaneously in response to desired changes in output.
Eg. Unskilled labor.
Theory of production in the short run
Short run: refers to a period of time in which the
quantity of at least one input is fixed.
• It is a time period which is not sufficient to change
the quantities of all inputs so that at least one input
remains fixed.
• short run periods of different firms have different
durations. /The short run period vary across firms,
industries or economic variables being studied.
Theory of production in the short run
Production with one variable input and one fixed input
• Consider a firm that uses two inputs:
– Capital (fixed input)
– Labor (variable input)

Given the assumptions of short run production, the firm can

increase output only by increasing the amount of labor it uses.
Hence, its production function can be given by: 𝑄 = 𝑓 𝐿
where, 𝑄 is output and 𝐿 is quantity of labor

• The production function shows different levels of output

that the firm can produce by efficiently utilizing different
units of labor and the fixed capital.
 Total, average, and marginal product
The contribution of a variable input can be described in terms of total, average and
marginal product.

• Total product (TP) is total amount of output that can be produced by efficiently
utilizing specific combinations of the variable input and fixed input.

• Marginal Product (MP) is the change in output attributed to the addition of one
unit of the variable input to the production process, other inputs being constant.
In our case, the change in total output resulting from employing additional worker
𝒅𝑻𝑷 ∆𝑻𝑷
(holding other inputs constant) is the marginal product of labor (𝑴𝑷𝑳 = = )
𝒅𝑳 ∆𝑳

• Average Product (AP) is the level of output that each unit of input produces, on
average. The ratio of total output to the number of the variable input (labor in our
𝑻𝑷
case) is the average product of labor (𝑨𝑷𝑳 = 𝑳 )
Total, average, and marginal product in the
short run
TP function in the short-run follows
a certain trend:
 Initially increases at an
TPmax increasing rate, then increases
at a decreasing rate, reaches a
maximum point. Eventually falls
as the quantity of the variable
input rises.

I II III

In the short run, the MP of the

variable input first increases,
reaches its maximum, then
decreases and becomes
MPL > APL MPL < APL
negative.
MPL = APL
AP first increases, reaches its
maximum value and eventually
declines
• shape of TP tells:
– Increasing the variable input (while some other inputs are fixed) can increase the total
product only up to a certain point. Initially, as we combine more and more units of the
variable input with the fixed input, output continues to increase, but eventually if we
employ more and more unit of the variable input beyond the carrying capacity of the
fixed input, output tends to decline.
• MPL measures the slope of the total product curve at a given point.
– As we continue to combine more and more of the variable input with the fixed input,
the marginal product of the variable input increases initially and then declines.
• The AP curve can be measured by the slope of rays originating from the
origin to a point on the TP curve.
– AP of labour first increases, reaches its maximum value and eventually declines.

The relationship between MPL and APL can be stated as follows.

• When APL is increasing, MPL > APL.
• When APL is at its maximum, MPL = APL.
• When APL is decreasing, MPL < APL.
 Examples
Example 1: Suppose that the short-run production function of certain
cut-flower firm is given by:
𝑄 = 4𝐾𝐿 − 0.6𝐾 2 − 0.1𝐿2
where Q is quantity of cut-flower produced, L is labor input and K is
fixed capital input (K=5).
a) Determine the average product of labor (APL) function.
b) At what level of labor does the total output of cut-flower reach the maximum?
c) What will be the maximum achievable amount of cut-flower production?

Example 2: The production function for a firm is given by

𝑄 = 6𝐿2 − 0.4𝐿3 .
a) At what units of labor is output maximum?
b) At what units of labor is the APL maximum?
C) At what unit of labor is MPL maximum?
 The law of variable proportions
(law of diminishing returns)
Assuming :
– Fixed technology, thus the techniques of production do not change.
– All units of the variable inputs (labor in our case) has the equal quality
(same innate ability, education, training, and work experience)

• The law states that as successive units of a variable input (labor)

are added to a fixed input (capital or land), beyond some point
(optimal combination of the inputs), the extra or marginal product
that can be attributed to each additional unit of the variable
resource will decline. i.e for L > L1.
MP ultimately diminishes not because successive workers are less skilled/less
energetic rather it is because more workers are being used relative to the
amount of plant and equipment available.
 Three stages of short run production

• Stage I (up to L2): where APL continues to increase. It goes from the origin to the point
where the APL is maximum (i.e where MPL = APL)
– This stage is not an efficient region of production (though the MP of variable input is positive) as the
fixed input is under-utilized. i.e. the variable input (the number of workers) is too small to
efficiently run the fixed input.
• Stage II (the stage of diminishing marginal returns) (from L2 to L3): It ranges from the point
where APL is at its maximum (MPL=APL) to the point where MPL is zero.
– Decreasing AP and MP due to the scarcity of the fixed factor. That is, once the optimum capital-
labour combination is achieved, employment of additional unit of the labor will cause the output to
increase at a slower rate. As a result, the marginal product diminishes.
– The efficient region of production (where the MPL is declining but positive). Additional inputs are
contributing positively to the TP and MP of successive units of variable input is declining (indicating
that the fixed input is being optimally used).
• Stage III (the stage of negative marginal returns to the variable input) (beyond L3):
• an increase in labor is accompanied by decline in the TP. Thus, TP lopes downwards, and the MPL
becomes negative (additional units of variable input are contributing negatively to the total product).
Obviously, a rational firm should not operate in stage III
• Negative marginal returns because the fixed input is over-utilized (the volume of labor is quite
excessive relative to the fixed input). because (MP of the variable input is negative).
 Theory of costs in the short run
 Cost - is the monetary value of inputs used in the
production of an item.
Types of Cost Considers…. Example

Accounting Cost The monetary value of all wages/salaries, cost of raw

purchased inputs used in materials, depreciation
production allowances, interest on
borrowed funds and utility
expenses (electricity,
water, telephone, etc.)
Economic Cost The monetary value of all Opportunity cost of
inputs, both purchased resources owned by
and non-purchased entrepreneurs
 Total costs in the short run
• A cost function shows the total cost of producing a
given level of output.
C = f (Q)
where C is the total cost of production and Q is the level of output.
• In the short run, total cost (TC) can be broken down
into two:
– Total fixed cost (TFC) and
– Total variable cost (TVC).
 Total costs in the short run
• TFC: Costs associated with fixed factors such as cost
of acquiring a plant (building), cost of machineries
and provision for depreciation of machineries.

• TVC: costs associated with the variable factors such

as cost of raw materials and cost of labor.

TC = TFC + TVC
Total costs in the short run

TFC is denoted by a straight line

parallel to the output
axis. This is because such costs do
not vary with the level of output.

TVC: The total variable cost of a

firm has an inverse S-shape due to
the law of variable proportions in
production.

TC: is obtained by vertically

adding TFC and TVC at each
level of output. When the level
of output is zero, TVC is also
zero which implies TC = TFC.
 Per unit costs (AFC, AVC, ATC & MC)

• Average fixed cost (AFC) - Average fixed cost is

total fixed cost per unit of output.
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄
• Average variable cost (AVC) - Average variable
cost is total variable cost per unit of output.
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
 Per unit costs…
• Average total cost (ATC) or simply Average cost (AC) - is
the total cost per unit of output.
𝑇𝐶 𝑇𝑉𝐶 + 𝑇𝐹𝐶
𝐴𝐶 = = = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
𝑄 𝑄

• Marginal Cost (MC): the additional cost that a firm incurs

to produce one extra unit of output. It is the change in
total cost which results from a unit change in output.
𝑑𝑇𝐶
𝑀𝐶 =
𝑑𝑄
 AFC, AVC, ATC & MC
When AVC is minimum, MC = AVC
When ATC is minimum, MC = ATC
AFC: declines continuously and
approaches both axes asymptotically

AVC: falls initially, reaches its

minimum, and then starts to increase.
The AVC curve has U-shape because
of the law of variable proportions

ATC: has similar shape with AVC

(U-shaped) due to the law of
variable proportions

MC: also exhibit U shape due to

the law of variable proportions.
Average and marginal cost curves
• The average fixed cost (AFC) will fall as output rises because the total fixed
cost is being spread over increased output.
• Average variable cost (AVC) will be rising because of diminishing returns to
the variable factor.
• ATC will rise because the rising AVC eventually will outweigh the effect of
falling AFC. The result is the classic ‘U’ shape to the ATC curve because of
the law of diminishing returns.
The MC crosses AVC and ATC at their lowest points. It means that the most
efficient output for the firm is where the average total or unit cost is lowest.
i.e optimum output is where the firm is productively efficient in the short run,
which is not necessarily the most profitable (may be possible in the long run).
 Who benefits from your daily
cappuccino?
Sales of coffee in specialist shops such as Costa,
Starbucks and others continue to grow in many
countries. Drinking coffee in such outlets has
become a social experience. Coffee shops also
offer a workspace with free wi-fi. Some
customers may spend two to three hours
drinking a coffee. This may be good value for the
customer, but is less so for the retailer.
The cost structure of a large cappuccino with a
retail price of £2.60 in the UK.
• It is not well known that the cost of the coffee is less
than 4% of the retail price and that when the cost of
milk is added, the cappuccino costs less than the cost
of the disposable cup, lid and stirrer.
1. In a group, suppose you decide to lease a premises to
open your own coffee shop. Use the information
above to consider whether you as the owners are
likely to benefit. Or will the owners of the premises
benefit? Consider also how the coffee growers might
benefit? Make a list of all the possible beneficiaries.
Then try to put the beneficiaries in rank order
 AFC, AVC, ATC & MC
Example 1: Suppose the short run cost function of a firm is
given by: 𝑇𝐶 = 2𝑄 3 − 2𝑄 2 + 𝑄 + 10.
a) Find the expression of TFC & TVC
b) Derive the expressions of AFC, AVC, AC and MC
c) Find the levels of output that minimize MC and AVC and
then find the minimum values of MC and AVC

Example 2: TC = 50 + 2Q – 3Q2 + Q3
i) Find the expression of TFC, TVC, AFC, AVC, ATC and MC.
ii) At what level of output does AVC and MC reaches
minimum.
 The relationship between short run
production and cost curves
• Suppose a firm in the short run uses labor as a
variable input and capital as a fixed input.

• Let the price of labor be given by w, which is

constant.

Given these conditions, we can derive the relation

between MC and MPL as well as the relation between
AVC and APL.
 Marginal Cost and
Marginal Product of Labor
• MC and MPL are inversely related.
– When initially MPL increases, MC decreases;
– When MPL is at its maximum, MC must be at a minimum and
– When MPL declines, MC increases.
 Average Variable Cost and
Average Product of Labor
• The relationship between AVC and APL is also inverse.
– When APL increases, AVC decreases
– When APL is at a maximum, AVC is at a minimum
– When finally APL declines, AVC increases
Average Variable Cost and Average Product
of Labor
MC curve is the mirror
image of MPL curve
and AVC curve is the
mirror image of APL
curve.
 The relationship between short run
production and cost curves
Example 1: Given that the MPL = 5, wage rate is
20 and APL is maximum at the point MPL = 5,
find the AVC and MC.

Example 2: Given that the MPL = 10 and APL = 5

and wage rate is 100
a) Find MC and AVC?
b) At what stage of production is the firm?