Chapter Four

The Theory of Production and Cost

Definition of production
• Production is the process of converting inputs such as
labour, land, capital and entrepreneurial ability into
outputs .

• Production is the process of transforming inputs into

outputs. It can also be defined as an act of creating value
or utility.

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 Production function
• Production function is a technical relationship b/n
inputs and outputs.
• It shows the maximum output that can be produced
with fixed amount of inputs and existing technology.
• A production function may take the form of algebraic
equation, table or graph.
• e.g. A general equation for production function can
be described as:
Q = f(X1 ,X2 ,X3 ,...,Xn)
where, Q is output and X1, X2, X3,…, Xn are different
types of inputs.
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• Inputs are commonly classified as fixed or variable.
• Fixed inputs are those inputs whose quantity cannot
readily be changed when market conditions indicate
that an immediate adjustment in output is required.
• In fact, no input is ever absolutely fixed but may be
fixed during an immediate requirement.
• E.g. Buildings, land and machineries are examples
of fixed inputs since their quantity cannot be
manipulated easily in a short period of time.
• Variable inputs are those inputs whose quantity can
be altered almost instantaneously in response to
desired changes in output.

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• i.e., their quantities can easily be diminished when
the market demand for the product decreases and
vice versa. The best example of variable input is
unskilled labor.
• Production period : based on time horizon
• 1. short run refers to a period of time in which the quantity of
at least one input is fixed.
• In other words, short run is a time period which is not
sufficient to change the quantities of all inputs so that at least
one input remains fixed.
• 2. long run :planning horizon and sufficient time to adjust the
quantities of all inputs used in production
• all inputs used in production are variable
• No fixed input in the longrun
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Production in the short run:

Consider a firm that uses two inputs: capital

(fixed) and labour (variable).
• Given the assumptions of short run production, the firm can
increase output only by increasing the amount of labour it
uses.
• Hence, its production function can be given by:
• Q = f (L,k) or Q = f (L) only…in the short run , outputs can
changes only by changing /adjusting variable input only …
since fixed inputs cannot be adjusted easily.where, Q is
output and L is the quantity of labour.
• Total, average, and marginal product in the short run
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1. Total product (TP): is the total amount
of output that can be produced by efficiently
utilizing specific combinations of the variable input
and fixed input.
• 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.
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• In general, the TP function in the short-run
follows a certain trend:
• it initially increases at an increasing rate, then
increases at a decreasing rate, reaches a
maximum point and eventually falls as the
quantity of the variable input rises.
• This tells us the shape a total product curve
assumes.

2. Marginal Product (MP): is the change

in output attributed to the addition of one unit of
the variable input to the production process,
ceteris paribus. 7
• e.g., the change in total output resulting from
employing additional worker (holding other inputs
constant) is the marginal product of labour (MPL

• In other words, MPL measures the slope of the total

product curve at a given point.

MPL = dTP/dL = ∆Q/∆L

• In the short run, the MP of the variable input first

increases, reaches its maximum and then decreases
to the extent of being negative.
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 3. Average Product (AP): AP of an input is the
level of output that each unit of input produces, on
the average.
• It tells us the mean contribution of each variable
input to the total product.
• Mathematically, it is the ratio of total output to the
number of the variable input.
• The average product of labour (APL), for instance, is
given by:
APL = TP/L
• Average product of labour first increases, reaches its
maximum value and eventually declines.
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• The AP curve can be measured by the slope of rays
originating from the origin to a point on the TP curve
(see figure 4.1).
• e.g., the APL at L2 is the ratio of TP2 to L2.
• This is identical to the slope of ray a.

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 Stages of production
Stage I: Covers the range of variable input levels over which
the APL continues to increase.
• It goes from the origin to the point where the APL is
maximum, i.e., MPL = APL. This stage is not an efficient region
of production though the MPL is positive. fixed input is
under-utilized. Its is Increasing marginal returns
Stage II: It ranges from the point where APL is at its maximum
(MPL = APL) to the point where MPL is zero.
• Here, as the labour input increases by one unit, output still
increases but at a decreasing rate.
• Thus, the second stage of production is termed as the stage
of diminishing marginal returns. APL declines throughout
it .MPL is decline but positive . It is an efficient region of
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production
Stage III: In this stage, an increase in the variable input is accompanied by
a decline in the TP.
• Thus, the TP curve slopes downwards, and the marginal product of labor
becomes negative.
• This stage is also known as the stage of negative marginal returns to the
variable input.
• Obviously, a rational firm should not operate in stage III because
additional units of variable input are contributing negatively to the TP
(MPL is negative).
• Under this region fixed input; capital is over utilized and variable input ;
labor is overemployed
The relationship b/n 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.
In figure 4.2, this stage is indicated by the employment of labor beyond L 3.
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Example: Suppose that the short-run production
function of a certain cut-flower firm is given by:
Q = 4KL− 0.6K2 − 0.1L2, where Q is quantity of cut-flower
produced, L is labour input and K is fixed capital input (K
= 5).
a) Determine the average product of labour (APL)
function.
b) At what level of labour does the total output of cut-
flower reach the maximum?
c) What will be the maximum achievable amount of
cut-flower production?

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 The law of variable proportions(Law of diminishing
marginal returns )
• This law states that as successive units of a variable
input(labour) are added to a fixed input (capital or
land), b
• beyond some point the extra, or marginal, product
that can be attributed to each additional unit of the
variable resource will decline.
• e.g., if additional workers are hired to work with a
constant amount of capital equipment, output will
eventually rise by smaller and smaller amounts as
more workers are hired. This law assumes that
technology is fixed and thus the techniques of
production do not change. 18
• All units of labour are assumed to be of equal quality.
• Each successive worker is presumed to have the same
innate ability, education, training, and work
experience.
• Marginal product ultimately diminishes not because
successive workers are less skilled or less energetic
rather it is because more workers are being used
relative to the amount of plant and equipment
available.
• The law starts to operate after the marginal product
curve reaches its maximum (this happens when the
number of workers exceeds L1 in figure 4.1).
• This law is also called the law of diminishing returns.
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 Theory of costs in the short run
Definition and types of costs
• To produce goods and services, firms need factors of
production or inputs. To acquire these inputs, they
have to buy them from resource suppliers.
• Cost is the monetary value of inputs used in the
production of an item.

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• To the economist, economic profit is total revenue
less economic costs (explicit and implicit costs).
• Accounting cost is the monetary value of all
purchased inputs used in production; it ignores the
cost of non-purchased (self-owned) inputs.
• It considers only direct expenses such as
wages/salaries, cost of raw materials, depreciation
allowances, interest on borrowed funds and utility
expenses (electricity, water, telephone, etc.).
• These costs are said to be explicit costs.
• Explicit costs are out of pocket expenses for the
purchased inputs.

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• If a producer calculates her cost by considering only
the costs incurred for purchased inputs, then her
profit will be an accounting profit.

Economic cost of producing a commodity considers

the monetary value of all inputs (purchased and non-
purchased).

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• Calculating economic costs will be difficult since it is
based on estimation.
• The monetary value of these inputs is obtained by
estimating their opportunity costs in monetary terms.
• The estimated monetary cost for non-purchased inputs
is known as implicit cost.
• e.g., if Mr. X resigns a job which pays him Birr 10, 000
per month to run a firm he has established, then the
opportunity cost of his labor is taken to be Birr 10,000
per month (the salary forgone to run his own business).
• Economic cost is given by the sum of implicit cost and
explicit cost.

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 Calculation of the firm’s profit
Profit: is the difference between total revenue and total cost
Total Revenue: the product of output and price
Economists use the term ―profit differently from the way
accountants use it.
To the economists, profit is the firm‘s total revenue less both
explicit costs or accounting costs and implicit cost
To the accountant, profit is the firm‘s total revenue less its
explicit costs (accounting costs).

Accounting profit = Total revenue – Accounting cost

= Total revenue – Explicit cost

Economic profit =Total revenue – Economic cost 24

• Economic profit will give the real profit of the firm
since all costs are taken into account.
• Accounting profit of a firm will be greater than
economic profit by the amount of implicit cost.
• If all inputs are purchased from the market,
accounting and economic profit will be the same.
• If implicit costs exist, then accounting profit will be
larger than economic profit.

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 Firm’s total costs in the short run
• A cost function shows the total cost of producing a given
level of output, which can be described using equations,
tables or curves.
• A cost function can be represented using an equation as
follows.
TC = 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 in to
two – total fixed cost (TFC) and total variable cost (TVC).
• Total fixed costs : costs which do not vary with the
level of output.
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• Fixed costs are costs which do not vary with the level
of output produced.
• They are regarded as fixed because these costs are
unavoidable regardless of the level of output.
• A firm can avoid fixed costs only if it stops operation.
• Fixed costs: salaries of administrative staff, expenses
for building depreciation and repairs, expenses for
land maintenance and rent of building used for
production.
• Total Variable costs include all costs which
directly vary with the level of output produced.

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• e.g., if the firm produces zero output, the variable
cost is zero.
• These costs may include the cost of raw materials,
the cost of direct labour and the running expenses of
fuel, water, electricity, etc.
• In general, the short run total cost is given by the
sum of total fixed cost and total variable cost. i.e.,
TC = TFC + TVC
• Based on the definition of the short run cost
functions, let‘s see what their shapes look like.
Total fixed cost (TFC): Total fixed cost is denoted by a
straight line parallel to the output axis since such
costs do not vary with the level of output.
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 Total variable cost (TVC): The total variable cost of a
firm has an inverse S-shape, which indicates the law
of variable proportions in production.
• At the initial stage of production with a given plant,
as more of the variable factor is employed, its
productivity increases.
• TVC increases at a decreasing rate, which continues
until the optimal combination of the fixed and
variable factor is reached.

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• Beyond this point, as increased quantities of the
variable factor are combined with the fixed factor,
the productivity of the variable factor declines, and
the TVC increases at an increasing rate.

Total Cost (TC): The total cost curve is obtained by

vertically adding TFC and TVC at each level of output.

• The shape of the TC curve follows the shape of the

TVC curve, i.e. the TC has also an inverse S-shape.
• Note that when the level of output is zero, TVC is also
zero which implies TC = TFC.

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 Per unit costs(average costs).

• From total costs functions we can derive per-unit costs

which are even more important in the short run analysis of
the firm.
a) Average fixed cost (AFC) - Average fixed cost is total fixed
cost per unit of output.

• It is calculated by dividing TFC by the corresponding level of

output.
• The curve declines continuously and approaches both axes
asymptotically.
AFC = TFC/Q
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b) Average variable cost (AVC) - Average variable cost is
total variable cost per unit of output. It is obtained by
dividing total variable cost by the level of output.
AVC = TVC/Q
• The short run AVC falls initially, reaches its minimum,
and then starts to increase.
• The AVC curve has U-shape because the law of
variable proportions.
c) Average total cost (ATC) or simply Average cost (AC)
- Average total cost is the total cost per unit of
output. It is calculated by dividing the total cost by
the level of output.

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 AC = TC/Q
Equivalently, AC = (TVC + TFC)/Q = TVC/Q + TFC/Q
= AVC + AFC
• Thus, AC can also be given by the vertical sum of AVC
and AFC.
Marginal Cost (MC)
• Marginal cost is defined as the additional cost that a
firm incurs to produce one extra unit of output.
• In other words, it is the change in total cost which
results from a unit change in output.
• Graphically, MC is the slope of TC function.
MC = dTC/dQ
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• In fact, MC is also a change in TVC with respect to a
unit change in the level of output.
MC = (dTFC + dTVC)/dQ = dTVC/dQ (since dTFC/dQ = 0)

• Given inverse S-shaped TC and TVC curves, MC

initially decreases, reaches its minimum and then
starts to rise.
• From this, we can infer that the MC exhibits U shape
because of the law of variable proportions.
• In summary, AVC, AC and MC curves are all U-shaped
due to the law of variable proportions.

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• In the above figure, the AVC curve reaches its
minimum point at Q1 level of output and AC reaches
its minimum point at Q2 level of output.
• The vertical distance between AC and AVC, i.e., AFC
decreases continuously as output increases.
• Note that the MC curve passes through the minimum
points of both AVC and AC curves.
Example: Suppose the short run cost function of a
firm is given by: TC = 2Q3 – 2Q2 + 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
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Solution:
Given TC=2Q3 – 2Q2 + Q + 10
a) TFC = 10 , TVC = 2Q3 – 2Q2 + Q
b) AFC = TFC/Q = 10/Q
AVC = TVC/Q = (2Q3 – 2Q2 + Q)/Q = 2Q2 – 2Q + 1
AC = TC/Q = (2Q3 – 2Q2 + Q + 10)/Q= 2Q2 – 2Q + 1 +
10/Q
MC = dC/dQ= 6Q2 – 4Q + 1
c) To find the minimum value of MC,
dMC/dQ = 12Q - 4 = 0
Q = 1/3
MC is minimized when Q = 0.33
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The minimum value of MC will be:
MC = 6Q2 – 4Q + 1
= 6(1/3)2 -4(1/3) + 1 = 0.33
To find the minimum value of AVC
dAVC/dQ = 4Q – 2 = 0
Q = 0.5
AVC is minimized at Q =0.5
The minimum value of AVC will be:
AVC = 2Q2 – 2Q + 1
AVC = 2 (0.5) 2 - 2(0.5) +1
= 0.5 – 1 + 1
= 0.5
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 The relationship between short run production and
cost curves
• Suppose a firm in the short run uses labour as a
variable input and capital as a fixed input.
• Let the price of labour be given by w, which is
constant.
• Given these conditions, we derive the relation b/n:
MC and MPL as well as AVC and APL.

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• The above expression shows that 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 finally MPL declines, MC increases.
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43
• This expression also shows inverse relation b/n AVC and
APL.
• When APL increases, AVC decreases;
• when APL is at a maximum, AVC is at a minimum
• Finally, when APL declines, AVC increases.
•We can also sketch the relationship b/n these production
and cost curves using graphs.
• From the following figure, we can conclude that the MC
curve is the mirror image of MPL curve and AVC curve is
the mirror image of APL curve.

• Take look at
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The end of the Chapter 4

Thank you for attention

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