“ Your Kids Our Kids!

” “ልጆችዎ ልጆቻችን
ናቸው!”
 +251(0)116-607203 +251(0)911-469878 3628 admin@ safariacademy.et Addis Ababa,
Ethiopia

2022/23 Academic Year

Economics
Lesson Note for Grade 10

1.
ECONOMICS

UNIT-3

2
Unit 3
Theories of Production and Cost
 3.1 Theory of Production
 3.2 Theory of Cost

3
Introduction
 Production is a scientific process that
involves the transformation of raw materials
(inputs) into desired products or services
(outputs) by adding economic value.
 Production of goods and services involves

transforming resources such as labor power,

raw materials, services, and machines into
finished products.

4
3.1. Theory of Production

5
3.1.1 Production Function
The production function is a function that
shows the highest output that a firm can
produce for every specified combination of
inputs.
 In particular, the production function tells

us the quantity of output the firm can

produce given quantities of the inputs that
it might employ.

6
Mathematically
 Production function (Assume there are only two
inputs)
Q = f (L,K)
 The production function allows inputs to be
combined in varying proportions so that
output can be produced in many ways (using
either more capital or less labor or vice versa).
 Based on time production can be of two types
Short Run Production Function
Long-Run Production Function

7
3.1.2 Short Run Production
Function
 Short-run refers to the period of time over which
at least one factor of production is fixed.
 In the real world, land and capital (such as
plants and equipment) are usually treated as
fixed factors.
 The long run is the period of time (planning
horizon) which is sufficient when all quantities of
inputs are variable.
 Here we are considering a simple production
process with only two factors. We treat capital as
the fixed factor, and labor as the variable factor.

8
In the short run
Production with one variable input
Production with one variable input (while
the others are fixed) is obviously a short run
phenomenon.
 So, let’s now consider a farmer producing

wheat. To the farmer, the only variable input

is assumed to be labor, and all other inputs,
like land, capital, and technology, are fixed
inputs.

9
 Short run production function tells us only
the effect of a change in the farmer’s labor
on the production of wheat, while keeping
the size of land, capital, and technology
constant.

10
Basic Concepts Of Production
Function:
1. Total physical product (total product) (TP)
2. Average physical product (Average
product) (AP)
3. Marginal physical product (marginal
product) (MP)

11
Total product (TP)
refers to the total output produced by a
given amount of a variable input, keeping
the quantity of other (fixed) inputs constant.
 It is the overall amount of output produced

by the factors of production employed over

a given period.

12
Average Product (AP)
 Average product (AP) is equal to the total
product divided by the number of units of
that input (Labor).
 Suppose in the production of wheat, the AP

of a farmer is obtained by dividing the total

output (TP) by the number of workers
employed(Labor).
 (AP ) = AP
L Labor=Total product/number
of workers=TP/L

13
Marginal Product (MP)
 The marginal product (MP) is the extra or
additional output obtained with one extra
unit of the variable input while all other
variables remain constant.
 In other words, the MP is the percentage

change in total output resulting from a

percentage change in variable input, all other
things being equal.
 MP is equal to the slope of the total product

(TP).
 TP,MP, and AP are interrelated

14
Mathematically

15
3.1.2.1. The Law of Diminishing
Marginal Productivity
 According to the law of diminishing returns
or Productivity, increasing the amount of
the variable factor (labor) with the fixed
factor (capital) will lead to an eventual
decline in the marginal contribution of the
additional labor to the total output. This is
also accompanied by an eventual decline in
total output.

16
3.1.2.2 Stages of
production
 Stage 1 (increasing returns stage)
this stage includes the range of variable inputs at
which the MPL continues to rise, i.e., up to the point
of MPL.
 Stage 2 (the diminishing returns stage)
this stage includes the value over which MPL is
positive but decreasing.
 Stage 3 (negative returns stage)
defined as a range of negative MPL or decreasing
TP. In this stage of production, since MP L is
negative, additional units of variable inputs (L)
actually cause a decrease in TP.

17
18
Graph of Stages of
production

19
The Relationship between TPL &
MPL
 MPL increases when TP increases at an
increasing rate.
 MP starts to fall but then remain positive
L
when TP increases at a decreasing rate.
 MP reaches zero when TP is maximum and
L
 When TP is falling, MPL becomes negative.
 APL also increases first, reaches its
maximum, and starts to fall, but it remains
positive whenever TP is positive.

20
The Relationship between MPL &
APL
 For the APL to rise the addition to TP (or MPL)
must be greater than the previous APL, i.e.
APL rises when MPL>APL
 For the APL to fall, the addition to TP (or MPL)
must be less than the previous average, i.e.
APL falls when MPL<APL
 For the APL to remain unchanged, the addition
to total product (or MPL) must be equal to the
previous Average. i.e.
APL is at its maximum if APL=MPL

21
3.1.3 The Long-Run Production
Function
 Remember that, long run is a period of time
(planning horizon) which is sufficient for the
firm to change the quantity of all inputs.
 Assume, however, that a firm produces

output using only two factors of production:

Labor
Capital
 The output from the various combinations
of inputs can be shown by using isoquant.

22
3.1.3.1 Isoquant
 An isoquant is a curve that shows all possible
efficient combinations of inputs that can
yield equal level of output.
 Isoquant schedule: is a tabular
representation of the various combinations of
two variable inputs that give the same level
of output.
 Isoquant map : is a graph combining
several or a set of isoquants. An isoquant
map is another way of describing a
production function.

23
Isoquant Schedule
 Factor Combinations to Produce a 100 units
of Output

24
Isoquant Curve

25
Isoquant map

26
Properties of isoquants
1) Isoquants are down ward sloping: implying
that if more of one factor is used, less of
the other factor is needed for producing
the same level of output.
2) The further an isoquant lays away from the
origin, the greater the level of output it
denotes.
3) Isoquants do not cross each other
4) Isoquants are convex to the origin

27
The slope of an isoquant/ marginal
rate of technical substitution (MRTS)
The slope of the isoquant is called the rate
of technical substitution, or the marginal
rate of technical substitution (MRTS) of
factors.
 MRTS of labor for capital, denoted as
MRTS L, K

 shows the amount by which the input of

capital can be reduced when one extra unit
of labor is used so that output remains
constant.

28
3.1.3.2. Scale Returns
 The rate at which output increases as
inputs are increased by the same
proportion is called “returns to scale.”
 We have three cases of returns to scale:
Increasing returns to scale
Constant returns to scale
decreasing returns to scale

29
The three cases of returns to
scale
 Increase returns to scale: increasing input by
proportion ‘m’ leads to an increase in output by
more than ‘m’ scale.
 Constant returns to scale: increasing input by
proportion ‘m’ leads to an increase in output by
Equal scale ‘m’.
 Decreasing returns to scale: increasing input
by proportion ‘m’ leads to an increase in output
by less than ‘m’ scale.
 This is because difficulties in organizing and
running a large scale operation may lead to
decreased production of both labor and capital.

30
3.1.4 Technology Change and the
Position of Production Curves
Technological change (progress) makes
factors of production more productive or
the production system more efficient so
that the firm will get higher output from the
same combinations of labor and capital
than before.
 Figure below shows upward movement of

the total product curve indicating higher

output level can be achieved from the same
input after technological advancement.

31
Technology change and the
position of production curves

32
3.2. Theory of Cost
 Cost functions are derived functions
(derived from production functions) that
describe the cheapest way to produce
each level of output, given the prices of
production factors and technology.
 Both in the short-run and the long-run, total

cost is a multi-variable function, i.e. total

cost is determined by many factors such as
output, technology, prices of variable and
fixed factors.

33
3.2.1 Short-Run Costs
Short-run costs are costs over a period
during which some factors of production
(usually capital equipment and
management) are fixed.
 In short run based fixed and variable

inputs, total cost (TC) is divided into two

parts:
TFC
TVC

34
Total Fixed Cost (TFC):
 Total Fixed Cost (TFC): TFC is a cost that
does not vary with the level of output
 It does not change with change in quantity

of output).
 It is independent of output.
 Fixed costs consists costs such as: salaries

of administrative staff, expenses for

building depreciation and repairs, etc.

35
Total variable cost (TVC)
 Total variable cost (TVC): TVC is a cost
that varies as output varies.
 These costs vary directly with changes in

the volume of output, rising as more is

produced and falling as less is produced.
 The variable costs include: the cost of raw

materials, the cost of labor, etc.

36
Total Cost (TC)
 Total Cost (TC): Total cost is the cost
incurred on all types of inputs fixed, as well
as variable inputs incurred in producing a
given amount of output.
 Total cost of production is the sum of all

fixed and variable costs (TC = TFC+TVC).

37
Total Fixed Cost, Total Variable
Cost, and Total Cost

38
Total Fixed Cost, Total Variable
Cost, and Total Cost curves

39
Average cost curves
 From the total-cost curves, we obtain
average cost curves.
1) AFC (Average Fixed Cost)
2) Average Variable Cost (AVC)
3) ATC (Average Total Cost)
4) Marginal Cost (MC)

40
AFC (Average Fixed Cost)
 AFC (Average Fixed Cost): AFC is the
total fixed cost divided by the amount of
output, i.e., AFC= TFC/Q
 Since TFC is constant, an increase in output

(Q) reduces the ratio and thus the AFC

approaches the quantity (output) axis as
output rises.

41
Average Variable Cost
(AVC)
 Average Variable Cost (AVC): The
average variable cost is the per-unit cost of
the variable factors of production.
 It is obtained by dividing the total variable

cost by the total units of output. AVC=

TVC/Q

42
ATC (Average Total Cost)
 ATC (Average Total Cost): per-unit cost of
both fixed and variable factors of
production.
 It is obtained by dividing the total cost by

the total units of output.

 ATC=
TC/Q
TFC+TVC
TFC/Q+TVC/Q
 ATC=AFC+AVC

43
Marginal Cost (MC)
 Marginal Cost (MC): is the extra or
additional total cost that results from
producing one more unit of output
 It is the change in total cost resulting from a

percentage change in output

 MC=
∆TC/ ∆Q
∆TVC/ ∆Q + ∆TFC/ ∆Q (0)…… in the short run
∆TVC/ ∆Q

44
Average and Marginal cost
Schedule

45
The relationship
between ATC, AFC, AVC, and MC curve

46
The R/ship
between ATC,AVC, and MC curve

47
The R/ship
between TFC and AFC curves

48
The R/ship
between TFC,TVC and TC curves

49
The Relationship
between AC and MC Curves
 AFC falls continuously as output increases
since TFC is constant
 The AVC declines first, reaching a minimum

level, then starts rising and shows a U-

shape structure.
 The MC also declines first, reaches its

minimum, and then rises. The MC curve

passes through the minimum point of both
the AVC and ATC curves.

50
Average Variable Cost
 The AVC curve slopes downward, up to
output OQ1 (the optimum capacity level of
output), showing decreases in average
variable cost, and it slopes upward beyond
output OQ1, indicating increases in average
variable cost.
 In other words, the AVC curve is U-shaped
 Point A is at where AVC=MC and minimum

point of AVC, corresponding to optimum

capacity level of output, OQ1.

51
Average Total Cost
 The ATC curve can be obtained by adding the AFC
and AVC curves.
 An ATC curve is the summation of the AFC and AVC
curves.
 Therefore, at each level of output, the ATC curve lies
above the AVC curve at a distance equal to the value
of the AFC curve.
 The ATC curve slopes downward up to output OQ2,
shows a decrease, and slopes upward beyond output
OQ2, indicating an increase in average total cost.
 Point B is the minimum point of ATC and the point
where ATC=MC.

52
3.2.2 Long-run Costs
 For the analysis of the long-run cost of
production, we use only three types of
curves:
 the Long- Run Total Cost Curve (LTC)
 the Long-Run Average Cost Curve (LAC)
 the Long- Run Marginal Cost Curve (LMC)
 Here also, LAC and LMC curves are U-

shaped, but they are flatter than the short-

run cost curves.

53
Economies of scale
In LTC,LMC and LAC
 To the left of LAC “economies of scale range
or IRS,” which means output can be doubled
for less than a doubled cost.

54
IRS and DRS
In LTC,LMC and LAC
 To the right of LAC “diseconomies of scale
range or DRS,” which means doubling of
output requires more than a doubling of
cost.

55
Long run total cost (LTC)
 the total cost first increases at a deceasing
rate due to increasing returns to scale

56
3.2.3 The Relationship Between
Product and Cost Curves
 Cost and production curves are mirror
images of each other, i.e. the relationship
between cost and production is
When AP(MP) rises, AC(MC) falls
When AP(MP) falls, AC(MC) rises
When AP (MP) is maximum, AC (MC) is minimum.

Economics For Grade 10 57

(SAFARI AC
The relationships
between Production and Cost curves

58
 n d
E
h e
T 59