Chapter 3: Theory of Production and Costs

The Theory and Estimation of Production

The Production Function
The Cost Function
The Production Function
A production function defines the relationship
between inputs and the maximum amount that
can be produced within a given time period
with a given technology.
 Mathematically, the production function can
be expressed as
Q=f(K, L)
Q is the level of output
K = units of capital
L = units of labour
When discussing production, it is important
to distinguish between two time frames.
The short-run production function describes
the maximum quantity of good or service
that can be produced by a set of inputs,
assuming that at least one of the inputs is
fixed at some level.
The long-run production function describes
the maximum quantity of good or service
that can be produced by a set of inputs,
assuming that the firm is free to adjust the
level of all inputs
 Cont…d
The average product (AP) of an input is the
total product divided by the level of the input.

AP tells us, on average, how many units of

output are produced per unit of input used.
Consider the two input production function
Q=f(X,Y) in which input X is variable and
input Y is fixed at some level.
The marginal product of input X is defined
as
holding input Y constant.
The table below represents a firm’s
production function, Q=f(X,Y):
In the short run, let Y=2. The row
highlighted below represents the firm’s short
run production function.
Cont..
 Production in the Short Run
The figures illustrate TP, MP, and AP
graphically.
•If MP is positive
then TP is
increasing.
•If MP is negative
then TP is
decreasing.
•TP reaches a
•maximum
If MP > APwhenthen
AP
MP=0is rising.
•If MP < AP then
AP is falling.
•MP=AP when AP
is maximized.
The Law of Diminishing Returns
Definition
As additional units of a variable input are
combined with a fixed input, at some point
the additional output (i.e., marginal
product) starts to diminish.
The Three Stages of Production
Stage I
From zero units of the variable input to
where AP is maximized
Stage II
From the maximum AP to where MP=0
Stage III
From where MP=0 on wards
The 3 stages of Production
Optimal Level of Variable Input Usage
Consider the following short run production
process. Where is Stage II?
 Optimal Level of Variable Input
Usage

II
ge
a
St
 In the long run, all inputs are variable.
Isoquant defines combinations of inputs that yield the
same level of product. Isoquant
K
The long run production process is described
by the concept of returns to scale.
Returns to scale describes what happens to
total output as all of the inputs are changed
by the same proportion.
If all inputs into the production process are
doubled, three things can happen:
output can more than double
◦ increasing returns to scale (IRTS)
output can exactly double
◦ constant returns to scale (CRTS)
output can less than double
◦ decreasing returns to scale (DRTS)
Returns to Scale
Returns to scale can be generalized to a
production function with n inputs

q= f(X1,X2,…,Xn)
If all inputs are multiplied by a positive
constant m, we have

If k=1, we have constant returns to scale

If k<1, we have decreasing returns to scale
If k>1, we have increasing returns to scale
THE THEORY AND ESTIMATION OF COST
The Short Run Relationship Between
Production and Cost
The Short Run Cost Function
The Long Run Relationship Between
Production and Cost
The Long Run Cost Function
Economies of Scope
Other Methods to Reduce Costs
SR Relationship Between Production and Cost
A firm’s cost structure is intimately related
to its production process.
Costs are determined by the production
technology and input prices.
Assume the firm is a “price taker” in the
input market.
 SR Relationship Between Production and
Cost

In order to
illustrate the
relationship,
consider the
production
process described
inTotal
the table. variable
cost(TVC) is the cost
associated with the
variable input, in this
case labor. Assume
that labor can be
hired at a price of
w=$500 per unit. TVC
has been added to
the table.
 Cont…
Total fixed cost(TFC) is the cost
associated with the fixed inputs.
Total cost(TC) is the cost associated
with all of the inputs. It is the sum of
TVC and TFC.
TC=TFC+TVC
Marginal cost (MC) is the change in
total cost associated a change in
output.

MC can also be expressed as the change

in TVC associated with a change in
output.
The Short Run Cost Function
A firm’s short run cost function tells us the
minimum cost necessary to produce a particular
output level.
For simplicity the following assumptions are made:
the firm employs two inputs, labor and capital
labor is variable, capital is fixed
the firm produces a single product
technology is fixed
the firm operates efficiently
the firm operates in competitive input markets
the law of diminishing returns holds
The following average cost functions will be useful
in our analysis.
Average total cost(AC) is the average per-unit cost
of using all of the firm’s inputs.
Average variable cost(AVC) is the average per-unit
cost of using the firm’s variable inputs.
Average fixed cost(AFC) is the average per-unit
cost of using the firm’s fixed inputs.
The Short Run Cost Function
Mathematically,
AVC = TVC/Q
AFC = TFC/Q
ATC=TC/Q=(TFC+TVC)/Q=AFC+AVC
The Short Run Cost Function
The Short Run Cost Function
Graphically, these results are be depicted in the
figure below.
 Important Observations
AFC declines steadily over the range
of production.
In general, AVC, AC, and MC are u-
shaped.
MC measures the rate of change of
TC
When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its
minimum
The distance between AC and AVC
represents AFC
The LR Relationship Between Production
and Cost
In the long run, all inputs are variable.
In the long run, there are no fixed
costs
The long run cost structure of a firm is
related to the firm’s long run
production process.
The firm’s long run production process
is described by the concept of returns
to scale.
Economists hypothesize that a firm’s long-run
production function may exhibit at first
increasing returns, then constant returns,
and finally decreasing returns to scale.
When a firm experiences increasing
returns to scale
A proportional increase in all inputs increases
output by a greater percentage than costs.
Costs increase at a decreasing rate
When a firm experiences constant
returns to scale
◦ A proportional increase in all inputs
increases output by the same percentage
as costs.
◦ Costs increase at a constant rate
When a firm experiences
decreasing returns to scale
◦ A proportional increase in all inputs
increases output by a smaller percentage
than costs.
◦ Costs increase at an increasing rate
 The LR Relationship Between Production and Cost
This graph
illustrates the
relationship
between the
long-run
production
function and
the long-run
cost function.
The Long-Run Cost Function
 Long run marginal cost(LRMC) measures the change in
long run costs associated with a change in output.

 Long run average cost(LRAC) measures the average per-

unit cost of production when all inputs are variable.
 In general, the LRAC is u-shaped.
When LRAC is declining we say that
the firm is experiencing economies
of scale.
Economies of scale implies that per-
unit costs are falling.
When LRAC is increasing we say that
the firm is experiencing
diseconomies of scale.
Diseconomies of scale implies that
per-unit costs are rising.
 The Long-Run Cost Function

The figure
illustrates the
general shape
of the LRAC. LRAC L
decrease inc
with with
output.. disec
Economies of s
of size at every
ever level of ou
output
LRAC remains as output
increases: all sizes of
firm produce output at
the same average cost
 The Long-Run Cost
 In theFunction
short run,
the firm has a
fixed level of
capital
equipment or
plant size.
The figure
illustrates the
SRAC curves for
various plant
sizes.
 Once a plant
size is chosen,
per-unit
production costs
are found by
moving along
that particular
SRAC curve.
The Long-Run Cost Function
In the long run the firm is able to adjust its
plant size.
LRAC tells us the lowest possible per-unit
cost when all inputs are variable.
What is the LRAC in the graph?
The LRAC is the lower envelope of all of the
SRAC curves.
PROFIT MAXIMIZATION AND
COMPETITIVE SUPPLY
 Do Firms Maximize Profits
Profit is likely to dominate decisions in
owner managed firms.
Managers in larger companies may be
more concerned with goals such as
revenue maximization
dividend pay-out
on the long run they must have profit as one
of their highest priorities
Competitive Firm
Competitive Firm Incurring Losses
Adequate Condition for Profit Maximization:
P >=AVCmin
Variation of Short-Run Cost with
Output
Iso-cost curves
Various combinations of inputs that a firm can
buy with the same level of expenditure
PLL + PKK = M
where M is a given money outlay.
Maximization of output for given cost
MPL/PL= MPK/PK
Application of various cost concepts in Decision
Making
TC: useful in breakeven analysis and in
determining whether a firm is making
profit or loss
ATC: used for calculating profit to be
obtained from per unit of output
produced
MC: useful in deciding whether a firm
can expand its output further or not of a
particular enterprise
Long-run cost: useful in making
decision about investment for