5LECTURE

Production and Cost

Theory
 Objectives
5. THEORY AND COST PRODUCTION
• 5.1 Short-run and long-run
• 5.1.1 Definition
• 5.1.2 Differences
5.2 Law of diminishing marginal returns
5.3 Stages of production
• 5.3.1 Diagram
• 5.3.2 Explanation of each stage
5.4 Types of Costs (short-run)
• 5.4.1 TC,TVC, TFC, AC@ATC, AVC, AFC and MC
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• 5.4.2 Diagram of each cost

5.5 Long run average cost
• 5.5.1 Economies of scale
• 5.5.2 Diseconomies of scale
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 Production
Definition of Production
•Production is the process of transforming resources
into finished products. It involves the combining of
the factors of production, namely land, labor, capital
and enterprise and tuning them into outputs
(finished products).
The Production Function
The production function shows the relationship
between quantity of inputs used ( factor of
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production) to make a good and the quantity of

output of that good.

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Short and Long Run Production
Functions

• The short run period is the time frame in

which at least one of the inputs ( factors
of production) is fixed but the other
inputs are varied.
• The long run period is the time frame
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which all the inputs are variable.

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 Production Function
• Total Production (TP) = It is the amount of output
produced when a given amount of that input is used
together with fixed inputs.
• Average Product (AP)= It can be obtained by dividing
the total product by the amount of that input used.
In this case, labor is used.
• Marginal Product ( MP) = It is the change in the total
product of that input corresponding to an addition or

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unit change in its labour. Marginal product is the
additional to total product when one more unit of
labour is employed.
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SHORT-RUN PRODUCTION RELATIONSHIPS

Marginal Product (MP)

Change in Total Product
Marginal Product =
Change in Labor Input

Average Product (AP)

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Total Product
Average Product =
Units of Labor

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 Production Function
• Law of Diminishing Marginal Returns
- states that if the quantities of certain factors are increased while
the quantities of one or more factors are held constant, beyond a
certain level of production, the rate of increase in output will
decrease (total product will increase in a decreasing rate) and
eventually the marginal product declines.

• Example: As more and more workers are hired at a

firm, each additional worker contributes less and less
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to production because the firm has a limited amount

of equipment.

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 Law of Diminishing Returns

Units of Variable Factor

TP
Law of increasing Law of
Law of negative
return diminishing
return
return

AP
Stage III

MP
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Stage II

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 Stages of Production
STAGES TOTAL PRODUCT AVERAGE MARGINAL
PRODUCT PRODUCT
STAGE I Increase at an increasing rate Increases Increases

Increases at a decreasing rate Continues to Reaches maximum

increase and begins to
diminish
STAGE II Increase at a decreasing rate Reaches maximum Continues to
and begins to diminish
diminish
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Reaches maximum Continues to Becomes zero

diminish
STAGE III Diminishes Continues to Becomes negative
diminish

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 The Three Stages of Production
Stage I The Stage of Increasing Marginal Return
Output (total product) increases at an
increasing rate as the number of workers
(variable input) is increased. Marginal
product is positive and increasing. Likewise,
the average product is positive and
increasing.
Stage II The Stage of Decreasing Marginal Return
Output (total product) increases at a
decreasing rate as the number of workers is
increased. The average product is positive
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but decreasing.
Stage III The Stage of Negative Marginal Returns
Output (total product) declines as the
number of workers is increased.
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Exercise 1

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Exercise 2

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Exercise 3

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 WHAT ARE COSTS?
• The Firm’s Objective
• The economic goal of the firm is
to maximize profits.
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 Costs as Opportunity Costs
• A firm’s cost of production includes all the
opportunity costs of making its output of
goods and services.
• A firm’s cost of production include explicit
costs and implicit costs.
• Explicit costs are input costs that require a
direct outlay of money by the firm.
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• Implicit costs are input costs that do not

require an outlay of money by the firm.
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 Short Run Production Costs
1. Fixed costs refer to the firm’s total expenditure for fixed inputs
per period of time. Those costs whose total does not vary with changes
in short‑run output. It remain constant when output increases.
2. Variable costs refer to the firm’s total expenditure on
variable inputs per period of time. Variable cost change with
the level of output. They include payment for materials, fuel,
power, transportation services, most labor, and similar costs.
3. Total cost is the sum of total fixed and total variable costs
at each level of output.
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Total Cost = Total Fixed Costs + Total Variable Costs

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 Short Run Production Costs
• Average Costs (AC)
• Average costs can be determined by
dividing the firm’s costs by the quantity of
output it produces.
• The average cost is the cost of each
typical unit of product.
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Average cost = Total cost

output
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 Short Run Production Costs
• Average Costs
• Average costs can be determined by dividing
the firm’s costs by the quantity of output it
produces.
• The average cost is the cost of each typical
unit of product. It consists of:
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)

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 The Various Measures of Cost: Thirsty
Thelma’s Lemonade Stand
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 Short Run Production Costs
Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q
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Total cost TC
ATC  
Quantity Q

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 Short Run Production Costs
• Marginal Cost
• Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
• Marginal cost helps answer the following
question:
• How much does it cost to produce an
additional unit of output?
(change in total cost) TC
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MC  
(change in quantity) Q
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 Thirsty Thelma’s Lemonade
Stand
Quantity Total Marginal Quantity Total Marginal
Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
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5 6.50 1.10 10 15.00 2.10

Note how Marginal Cost changes with each change in Quantity.

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 Thirsty Thelma’s Average-Cost and Marginal-
Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
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1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
23 (glasses of lemonade per hour)
 Cost Curves and Their Shapes
• Marginal cost rises with the amount
of output produced.
• This reflects the property of
diminishing marginal product.
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 Cost Curves and Their Shapes
• The average total-cost curve is U-shaped.
• At very low levels of output average total cost is
high because fixed cost is spread over only a few
units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.
• The bottom of the U-shaped ATC curve occurs at
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the quantity that minimizes average total cost.

This quantity is sometimes called the efficient
scale of the firm.
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 Cost Curves and Their Shapes
• Relationship between Marginal Cost and
Average Total Cost
• Whenever marginal cost is less than
average total cost, average total cost is
falling.
• Whenever marginal cost is greater than
average total cost, average total cost is
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rising.

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 Cost Curves and Their Shapes
• Relationship between Marginal Cost and
Average Total Cost
• The marginal-cost curve crosses the
average-total-cost curve at the efficient
scale.
• Efficient scale is the quantity that
minimizes average total cost.
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 Cost Curves in Long Run
• Long-run total cost (LTRC) is the cost
incurred as a result of producing goods
and services in the long run.
• Long - run Average Cost Curves- shows
the minimum cost of producing any given
output when all the inputs are variable.
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 Average Total Cost in the Short and Long Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
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of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

29 Cars per Day
 • The average-total-cost curve is U-shaped.
• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.
• A firm’s costs often depend on the time
horizon being considered.
• In particular, many costs are fixed in the short
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run but variable in the long run.

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 Economies and Diseconomies of Scale
In the long run, as a firm increases production, it will at first experience
decreasing average costs(i.e. economies of scale) after which it will
experience increasing average costs(i.e. diseconomies of scale)

• Economies of scale refer to the property whereby long-

run average total cost falls as the quantity of output
increases.
• Diseconomies of scale refer to the property whereby
long-run average total cost rises as the quantity of output
increases.
• Constant returns to scale refers to the property whereby
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long-run average total cost stays the same as the

quantity of output increases.

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 Economies of Scale
INTERNAL EXTERNAL
1. Labour Economies 1. Economies of Government
Action
2. Managerial Economies 2. Economies of
Concentration
3.Marketing Economies 3. Economies of Information
4. Technical Economies 4. Economies of Marketing
5. Financial Economies
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6. Risk- bearing Economies

7. Transport and Storage
Economies
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 Diseconomies of Scale
INTERNAL EXTERNAL

1. Labour Diseconomies 1. Scarcity of Raw Material

2. Management Problems 2. Wage Differentials

3. Technical Difficulties 3. Concentration Problems

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 Long Run Average Cost
Costs

LRAC
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Economies of Scale Diseconomies of Scale

Output

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Exercise 4

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Exercise 5

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Exercise 6

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