PRODUCTION AND

COST THEORY
By
Eric Ekobor-Ackah Mochiah

1
 Learning Objective
• Understand production, production function and its
curves.

• Understand the stages of production and diminishing

marginal returns

• Understand the cost theory and its curves

• Evaluate the relationship the production curves and

cost curves.

• Understand the short-run and long-run cost curves.

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 Making Production Decisions
• Economy is made up of thousands of firms that produce
the goods and services you enjoy every day

• To make their decisions:

– Firms look at costs of various inputs and the technologies
available for combining these inputs.
– Then decide which combination offers the lowest cost.

• The firm makes decisions on the basis of the expected costs

and expected usefulness of inputs.

• Production theory gives a better understanding of the

decisions behind the supply curve.
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 The Production Function
• The production function shows the technical relationship
between quantities of inputs used per unit of time and a
maximum amount of the commodity or output that can be
produced per period of time.

• For each different combination of inputs, the production

function tells us the maximum quantity of output a firm can
produce over some period of time.

• For simplicity we will often consider a production function

of two inputs:
Q=f(X, Y)
Q = output; X = labor; Y = capital

• It describes the rate at which resources are transformed4

into products
 Basic Concepts
• Production function
– Maximum amount of output that can be produced from
any specified set of inputs, given existing technology

• 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

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 The Short Run and the Long Run
• Useful to categorize firms’ decisions into
– Long-run decisions—involves a time horizon long
enough for a firm to vary all of its inputs
– Short-run decisions—involves any time horizon over
which at least one of the firm’s inputs cannot be
varied

• To guide the firm over the next several years

– Manager must use the long-run lens

• To determine what the firm should do next week

– Short run lens is best

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 Average & Marginal Products
• Average product of labor
– AP = Q/L

• Marginal product of labor

– MP = Q/L

• 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
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 Total, Average, & Marginal
Products of Labor, K = 2
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 1
9 318 35.3 04

10 314 31.4 -4
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Total, Average & Marginal
Products, K = 2

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 Total, Average & Marginal
Product Curves
Q2

Q1 Total
product
Panel A
Q0

L0 L1 L2

Panel B

Average
product

L0 L1 L2
Marginal
product 10
 Short-run Analysis Of Total,
Average, And Marginal Product
• The Three Stages of Production in the short run:

– Stage I (Increasing average returns ): from zero units of the

variable input to where AP is maximized (where MP=AP)

– Stage II (Decreasing average and marginal returns ): from

the maximum AP to where MP=0

– Stage III (Negative marginal returns): from where MP=0 on

• At the boundary between stage 2 and stage 3, the

highest possible output is being obtained from the
fixed input
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 Short-run analysis of Total,
Average, and Marginal product
• In the short run, rational firms should be operating only
in Stage II

Q: Why not Stage III?  firm uses more variable inputs

to produce less output
• Variable inputs are over-utilized in the sense that
their presence on the margin obstructs the
production process rather than enhancing it.

Q: Why not Stage I?  underutilizing fixed capacity, so

can increase output per unit by increasing the amount
of the variable input
• Output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always
operate beyond this stage.
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 Short-run analysis of Total,
Average, and Marginal product
• What level of input usage within Stage II is best for the
firm?

 answer depends upon:

• how many units of output the firm can sell
• price of the product
• the monetary costs of employing the variable input

• In this stage, the employment of additional variable

inputs increases the output per unit of fixed input but
decreases the output per unit of the variable input.

13
 Short-run Analysis Of Total,
Average, And Marginal Product

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 Diminishing Returns To Labor
• When the marginal product of labor is decreasing
– There are diminishing marginal returns to labor
– Output rises when another worker is added so marginal product
is positive
– But the rise in output is smaller and smaller with each
successive worker

• As usage of a variable input increases, a point is reached

beyond which its marginal product decreases.

• Law of diminishing (marginal) returns states that as we

continue to add more of any one input (holding the other
inputs constant)
– Its marginal product will eventually decline
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 COST THEORY
• People in business worry about three things:
– Measuring costs (accounting)
– Controlling costs (efficiency)
– Reducing costs (minimization)

• A firm’s total cost of production is the

opportunity cost of the owners
– Everything they must give up in order to produce
output.

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 Nature of Cost
• Economic cost
– Economists define cost in terms of opportunities that
are sacrificed when a choice is made.
– Economic cost refers to the sum of explicit and
implicit costs.

• Accounting cost
– Defined in terms of resources consumed.
– Reflect changes in stocks (reductions in good things,
increases in bad things) over a fixed period of time.
– Only to the firm’s actual expenditures, or explicit cost,
incurred for purchased or hired inputs.
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 Explicit Vs. Implicit Cost
• Explicit cost
– Explicit costs are actual expenditures of the firm
to hire, rent, or purchase the inputs it requires in
production.
• Wages to hire labour,
• Rental price of capital, equipment, and buildings, and
the
• Purchase price of raw materials and semi finished
products

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 Explicit Vs. Implicit Cost
• Implicit cost
– refers to the value of the inputs that are owned
and used by the firm in its own production
activity.
• the highest salary that the entrepreneur could earn in
his or her best alternative employment and
• the highest return that the firm could receive from
investing its capital in the most rewarding alternative
use or renting its land and buildings to the highest
bidder.

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 Total Cost
Average Total Cost:
TC TFC  TVC
ATC   AFC  AVC
Q Q
average fixed cost: TFC
AFC 
Q
average variable cost: divide through by Labour units (L)

w L
TVC w L w w
AVC    L  
Q Q
Q Q AP
L L
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 Shape Of Cost Curves

AFC
AFCcurve
curvedrops
drops
continuously.
continuously.((∵∵AFC
AFC
==TFC/Q)
TFC/Q)

AVC
AVCcurve
curveisisU-U-
shaped.
shaped.((∵∵AVC
AVC==
w/AP
w/APand
andAPAPisis
inverted-U
inverted-Ushaped.)
shaped.)

ATC
ATCcurve
curveand
andAVC
AVCcurve
curvewill
willcome
comecloser
closerand
andcloser
closeras
as
the
theamount
amountofofoutput
outputincreases
increases((∵∵ATC
ATC==AFC
AFC++AVC
AVCand
and
AFC
AFCdrops
dropscontinuously).
continuously).
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 Shape Of Cost Curves
The
Theturning
turningpoint
pointof
ofATC
ATCcurve
curve(b)
(b)occurs
occursatataalarger
larger
output
outputthan
thanthe
theturning
turningpoint
pointof
ofAVC
AVCcurve
curve(a).
(a). Why?
Why?
∵∵At
At(a),
(a),the
thefall
fallin
inAFC
AFCisis>>the
therise
risein
inAVC
AVCinitially
initially
but
butat
at(b),
(b),the
thefall
fallin
inAFC
AFCisis<<the
therise
risein
inAVC
AVCeventually
eventually

(a) (b)
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 Marginal Cost

Is the change in total cost for producing an additional

unit of output, composed of :
• Marginal fixed cost (MFC): is the change in fixed cost
for producing an additional unit of output

• Marginal variable cost (MVC): is the change in variable cost

for producing an additional unit of output.

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 Formula
Marginal cost:
TC TFC  TVC
MC   MFC  MVC
Q Q

marginal fixed cost: TFC

MFC  0
Q
marginal variable cost: divide through by change in Labour
w L
TVC w L w w
MVC    L  
Q Q
Q Q MP
L L
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 The Relationship Between Average And
Marginal Costs
• At low levels of output, the MC curve lies below the AVC
and ATC curves
– These curves will slope downward

• At higher levels of output, the MC curve will rise above

the AVC and ATC curves
– These curves will slope upward

• As output increases; the average curves will first slope

downward and then slope upward
– Will have a U-shape

• MC curve will intersect the minimum points of the AVC

and ATC curves
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 As
AsTFC
TFCisisaaconstant,
constant,MFC
MFC==0.
0. So
SoMC
MC==MVC.
MVC.

MC
MC==MVC
MVC==w/MP.
w/MP. As
AsMP
MPcurve
curveisisinverted-U
inverted-Ushaped,
shaped, MC
MC
or
orMVC
MVCcurve
curveisisU-shaped.
U-shaped.

MC
MCcurve
curvepasses
passesthrough
throughthe
theminimum
minimumpoints
pointsof
ofAVC
AVCcurve
curve
and
andATC
ATCcurve.
curve.

MC or MVC
curve is
U-shaped

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 Cost curves

MC
MCcurve
curve(=
(=MVC
MVC
curve)
curve)==Slope
SlopeofofTC
TC
curve
curve&&TVC
TVCcurve.
curve.

Notice
Noticethe
thepoints
points
where
whereMCMC==mini.;
mini.;
MC
MC==AVC
AVCand
and MC
MC
==ATC.
ATC.

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 Relations Between Short-Run Costs &
Production
• When marginal product (average product) is
increasing, marginal cost (average cost) is
decreasing.

• When marginal product (average product) is

decreasing, marginal cost (average variable
cost) is increasing.

• When marginal product = average product at

maximum AP, marginal cost = average
variable cost at minimum AVC.
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An Example…..Short-run Cost

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 Economies of Scale
• In the long run all inputs are variable, • Reasons for this
so only economies of scale can include:
influence the shape of the long-run
cost curve. – Specialisation &
division of labour
• In real-world production processes, – Managerial
economies of scale are extremely Specialization
important at low levels of production.
– Efficient Capital
• Long run average total costs decrease
as output increases. – Bulk Buying

– Greater efficiency
• As firm increases its scale of output of large machines
Long Run Average Cost (LRAC)
decreases.
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 Diseconomies of Scale
• Diseconomies of scale refer • Reasons for this include:
to decreases in productivity – Over specialization of
which occur when there are labour
equal increases of all inputs
(no input is fixed). – Managerial Problems-
Bureaucracy ,
• Occur on the right side of monitoring cost
the long-run average cost
curve where it is upward – Access to Materials
sloping.
– Access to skilled labours
• It is the cost incurred by the
firm as it expands beyond a
certain threshold. – Low team spirit or
morale
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A Typical Long-Run Average Total Cost
Costs per
Curve
unit
$60
Long-run
Minimum
average total
efficient level cost (LRATC)
$55 of production

$50

Q
11 14 17 20
ATC falls because of ATC is constant ATC rises because of
economies of because of constant diseconomies of
scale returns to scale scale
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 The Envelope Relationship
• Long-run costs are always less than or equal to short-run costs
because:
• In the long run, all inputs are flexible
• In the short run, some inputs are fixed

• There is an envelope relationship between long-run and

short-run average total costs. Each short-run cost curve
touches the long-run cost curve at only one point.

• In the short run all expansion must proceed by increasing only

the variable input
– This constraint increases cost

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 The Envelope of
Short-Run Average Total Cost
Costs per
unit
Curves
LRATC
SRATC4
SRATC1
SRMC1 SRMC4 The long-run average total
SRATC2
SRMC2 SRATC3 cost curve (LRATC) is an
SRMC3
envelope of the short-run
average total cost curves
(SRATC1-4)

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 Empirical Estimation
Functional Form for Short-Run Cost Functions
Theoretical Form Linear Approximation

TVC aQ  bQ 2  cQ 3 TVC a  bQ

TVC a
AVC  a  bQ  cQ 2
AVC   b
Q Q

MC a  2bQ  3cQ 2 MC b

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Mathematical Example (costs as a
function of Q only)
Q  3KL Where, if K = 10:
Q  30L  L = Q2/30

TVC=PL*L TVC = PL *Q2/30 Then

TFC=PK*K TFC = PK*10 ATC = (PLQ2)/(30Q) + (PK10)/Q

AVC = (PLQ2)/(30Q)
TC=TVC+TFC TC = PLQ2/30 + PK10 AFC = (PK10)/Q
MC = dTC/dQ = PLQ/15

And if PL = 100 and PK = 200; ATC = (100Q2)/(30Q) + (2000)/Q

TVC=(100Q2)/30 AVC = (100Q2)/(30Q)
TFC=2000 AFC = (2000)/Q
TC= (100Q2)/30 + 2000 MC = dTC/dQ = 100Q/15

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 E.g.…..The following table is composed of product items and cost
items of a firm. Suppose the unit cost of capital and labour are $10 and
$20 respectively. Fill in the missing columns (try on your own)..

Units Units TP AP MP TFC TVC TC ATC

of of
capital labour
4 1 2
4 2 5
4 3 10
4 4 14
4 5 14
4 6 12

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