The Theory of Production and Costs: Jasmin D. de Silva Assistant Professor 1 BA Department

The Theory of Production and Costs
Jasmin D. De Silva
Assistant Professor 1
BA Department
Outline:
BASIC CONCEPTS UNDER THE

THEORY OF PRODUCTION
COSTS CONCEPTS AND MEASURES
OF PROFIT
FINDING THE OPTIMAL OUTPUT
WITH THE LEAST COST
COMBINATION OF INPUTS
OBJECTIVES
Know the basic concepts of production

and costs.
Analyze the behavior of total product,
marginal product and average product.
Understand the law of diminishing
marginal returns.
Know the different costs concepts and
analyze their behavior.
Find the profit maximization point using
the least cost rule.
Theory of Production
Production is the transformation of inputs into

outputs.
Inputs in production are also called factors of
production.
Classification of factors of production: fixed
factor and variable factor.
Fixed factor remains constant regardless of the

volume of production
Variable factor changes in accordance with the
volume of production
Production Function
A model which shows the relationship

between quantities of various inputs used
and the maximum output that can be
produced with those inputs, given a certain
state of technology during a given time
period.
It can be expressed in a table, graph, or an
equation.
It shows what is technically feasible when the
firm operates efficiently.
A Production Function...
Quantity of
Output
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
Production function
5 Number of Workers Hired
Short-Run versus Long-Run
Short-run some factors of

production cannot be changed
(fixed factors)
Long-run all factors can be
changed.
PRODUCTION CONCEPTS
TOTAL PRODUCT
Total amount of goods and services
produced
As the number of an input
increases, total product also
increases
AVERAGE PRODUCT
Output produced per unit of an

input employed
Total Product/ number of input
(labor)
Measures the productivity of labor
in terms of how much on average
each worker can perform.
MARGINAL PRODUCT
The extra product or output

produced by adding an extra unit of
an input while holding other inputs
fixed.
Change in total product/ change in
input
Hypothetical Short run Production data

of a firm
THREE STAGES OF PRODUCTION

Increasing Marginal Return
As more inputs are added in production,
total product increases at an increasing
rate so marginal product increases.
Diminishing Marginal Return
As more inputs are added in production
while holding other inputs fixed, total
product increases but at a decreasing rate
so marginal product declines.
Negative Marginal Return
As more inputs are added in production,
total product decreases so marginal
product becomes negative.
Diminishing Marginal Product

Diminishing
marginal product is the

property whereby the marginal product of
an input declines as the quantity of the
input increases.
Example: As more and more workers are
hired at a firm, each additional worker
contributes less and less to production
because the firm has a limited amount of
equipment.
Diminishing Marginal Product

Marginal =
product
Additional output
Additional input
Relationship Between Average

Product and Marginal Product
When the MP is greater than AP, the

average product increases as labor
increases.
When the MP is equal to AP, the
average product is constant.
When MP is less than the AP, the
average product will fall as labor
input increases.
The Firms Objective
The economic goal of the firm is to

maximize profits.
A Firms Profit
Profit is the firms total revenue minus its

total cost.
Profit = Total revenue - Total cost
Total Cost includes all of the opportunity costs
of production
Economic Profit versus Accounting

Profit
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Explicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
TWO TYPES OF COSTS

Explicit
-
Costs
Costs firms pay for the inputs

Actual cash payments for resource
purchases
Costs recorded by accountants
i.e. wages, rent, interest, insurance,
taxes, etc.
TWO TYPES OF COSTS

Implicit
-
Measured by what the owners could

have earned have they worked and
invested in their next best alternative.
Opportunity costs of the owners time
and capital
Require no cash payments and no
entry in the firms accounting
statement
Normal Profit
Is the profit when economic profit is

zero.
Gives the minimum amount that
one has to make to cover the
explicit as well as the implicit costs.
Problem 1:
Jerry was a computer programmer who

earned $50,000 a year. He decided to go
into business. He invested $100,000 of
his savings (which had been earning7% in
a money market fund) into the business.
In the first year, his business had
$200,000 in revenues and $120,000 in
explicit costs. How much was his
accounting profit? What about his
economic profit?
Fixed and Variable Costs
Fixed costs are those costs that do

not vary with the quantity of output
produced.
Variable costs are those costs that
do change as the firm alters the
quantity of output produced.
Short Run vs. Long Run Costs
Family of Total Costs
Total Fixed Costs (TFC)

Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
Family of Total Costs

Quantity
0
1
2
3
4
5
6
7
8
9
10
Total Cost
$ 3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
Fixed Cost Variable Cost
$3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
$ 0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00
Total-Cost Curve...
$16.00
Total-cost
curve
$14.00
Total Cost
$12.00
Variable
Cost
curve
$10.00
$8.00
$6.00
Fixed
cost
$4.00
$2.00
$0.00
0
Quantity of Output
(glasses of lemonade per hour)
10
12
Average Costs
Average costs can be

determined by dividing the
firms costs by the quantity of
output produced.
The average cost is the cost of
each unit of product produced.
Family of Average Costs
Average Fixed Costs

(AFC)= FC/output
Average Variable Costs
(AVC)= VC/output
Average Total Costs
(ATC) = TC/output
ATC = AFC + AVC
Marginal Cost
Marginal cost (MC) measures the

amount by which total cost rises
when the firm increases
production by one unit.
Marginal cost helps answer the
following question:
How much does it cost to produce an

additional unit of output?
Marginal Cost
(Changein totalcost)
MC=
(Changein quantity)
= TC
Relationship between marginal cost

and marginal product
Marginal cost is the key to decision

making in the short run
Changes in marginal cost reflect
changes in marginal product of the
variable input.
Marginal cost falls when the
marginal product of the variable
resources increases and rises when
the marginal product of the variable
resources declines, i.e. when
diminishing marginal returns set in.
Average-Cost and Marginal-Cost Curves...

$3.50
$3.00
Costs
$2.50
M
C
$2.00
AT
C
AVC
$1.50
$1.00
$0.50
AFC
$0.00
0
Quantity of Output
10
12
Relationship Between Marginal Cost and

Average Total Cost
$3.50
$3.00
Costs
$2.50
$2.00
M
C
$1.50
AT
C
$1.00
$0.50
$0.00
0
Quantity of Output
10
12
The Relationship between Marginal

Cost and Average Cost
If marginal cost lies below average

cost, it pulls average cost down so
average cost decreases; if marginal
cost lies above, it pulls average cost
up so average cost increases.
If the marginal cost curve intersects

both the average variable cost curve
and the average total cost curve from
below, the average variable cost and
average total cost are at their
minimum level.
Three Important Properties of Cost

Curves
Marginal cost eventually rises with the

quantity of output.
Law of Diminishing Marginal Returns
The average-total-cost curve is U-shaped.

The marginal-cost curve crosses the
average-total-cost curve at the minimum
of average total cost.
Costs in the Long Run

For many firms, the division of
total costs between fixed and

variable costs depends on the time
horizon being considered.
In the short run some costs are fixed.

In the long run fixed costs become
variable costs.
COST IN THE LONG RUN

Long run Production
The long run is best thought of as a
planning horizon.
Firms plan in the long-run, but they
produce in the short-run.
In the long run, all inputs that are under
the firms control can be varied and the
firm could expand in terms of its size or
scale of production.
The appropriate size, or scale, for the
plant (firm) depends on how much
output the firm will produce.
The long run average cost curve
The long run average cost curve is

the envelop curve, or planning
curve, made up of the segments of
short run average total cost curves
for various sizes of plant and
represent the lowest cost per unit for
each output level.
Each short run cost curve is tangent
to the planning curve.
Average Total Cost in the Short and Long

Runs...
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in long run

0
Q1
Q2
Quantity of
Cars per Day
Q3
The long run average cost curve
The points of tangency of the

SRAC curves to the LRAC curves,
represent the least cost way of
producing each particular rate
of output, given the technology
and resource prices.
Returns to scale
Shows the effect on quantity

produced when all inputs are
changed.
Returns to Scale
1.
2.
3.
Three Important Cases

Constant returns to Scale
Increasing returns to scale or
Economies of Scale
Decreasing returns to Scale or
Diseconomies of scale
Economies and Diseconomies of Scale

Average
Total
Cost
ATC in long run
Economie
s
of scale
0
Constant Returns
to scale
Diseconomi
es
of scale
Quantity of
Cars per Day
Economies of Scale
Economies of scale exist when long

run average cost declines as plant
size increases.
Economies of scale can result from
increased opportunity for
specialization.
The minimum efficient scale is the
lowest rate of output at which the
firm can take full advantage of
economies of scale.
Diseconomies of scale
Diseconomies of scale exist

when long run average cost
rises as plant size increases.
Diseconomies of scale arise as
a result of (1) the information
problems associated with a
large bureaucracy (2) the
firms lack of control over some
resources
Problem 2:
Mary Jones can work in a factory and earn

$16,000 a year or, alternatively be a farmer.
Assume that except for monetary reward,
she doesnt care which she does. In farming,
Mary has to invest her savings of $20,000,
which was earning 10% annually. The
annual cost of seed, fertilizer, etc., is $5,000.
A. How much is the total cost of farming
(including implicit costs)?
B. What is the minimum amount Mary must
make in farming to just make it worthwhile?
C. If her farm revenues are $30,000, how
much is her accounting profit? Her
economic profit?
D. Should she stay in farming? Why?
COSTS CONCEPTS
Total Fixed Variable
Cost Cost
Cost AFC AVC ATC
Quantity
0
1
2
3
4
5
6
7
8
9
10
$
$3.00 $ 0.00
0.30
3.00
3.3 3.00
0.80
0
3.8
3.00
1.50
0
4.5
3.00
2.40
0
5.4
3.00
3.50
0
6.5
3.00
4.80
0
7.8
3.00
6.30
0
9.3
3.00
8.00
0
11.0
3.00
9.90
0
12.9
3.00
0
15.0
3.00 12.00
MC

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The Theory of Production and Costs

BASIC CONCEPTS UNDER THE

Know the basic concepts of production

Production is the transformation of inputs into

Fixed factor remains constant regardless of the

A model which shows the relationship

5 Number of Workers Hired

Short-Run versus Long-Run

Short-run some factors of

Output produced per unit of an

The extra product or output

Hypothetical Short run Production data

THREE STAGES OF PRODUCTION

Diminishing Marginal Product

marginal product is the

Diminishing Marginal Product

Relationship Between Average

When the MP is greater than AP, the

The Firms Objective

The economic goal of the firm is to

Profit is the firms total revenue minus its

Economic Profit versus Accounting

TWO TYPES OF COSTS

Costs firms pay for the inputs

TWO TYPES OF COSTS

Measured by what the owners could

Is the profit when economic profit is

Jerry was a computer programmer who

Fixed and Variable Costs

Fixed costs are those costs that do

Family of Total Costs

Total Fixed Costs (TFC)

Family of Total Costs

Fixed Cost Variable Cost

Average costs can be

Family of Average Costs

Average Fixed Costs

ATC = AFC + AVC

Marginal cost (MC) measures the

How much does it cost to produce an

Relationship between marginal cost

Marginal cost is the key to decision

Average-Cost and Marginal-Cost Curves...

Relationship Between Marginal Cost and

The Relationship between Marginal

If marginal cost lies below average

If the marginal cost curve intersects

Three Important Properties of Cost

Marginal cost eventually rises with the

Law of Diminishing Marginal Returns

The average-total-cost curve is U-shaped.

Costs in the Long Run

total costs between fixed and

In the short run some costs are fixed.

COST IN THE LONG RUN

The long run average cost curve

The long run average cost curve is

Average Total Cost in the Short and Long