Unit Introduction to

5 Production and Cost

Introduction
This chapter has two major sections. The first part will introduce you to the basic
concepts of production and production function, essential features of short run
production functions and the stages of short run production. The second part mainly
deals with the difference between economic cost and accounting cost, the characteristics
of short run cost functions, and the relationship between short run production functions
and short run cost functions.
Unit Objectives
At the end of this unit, students will be able to:
6 Describe productivity
6 Explain the types of inputs and outputs.
6 Analyze types of cost of production

✍ Start-up Activities
1. Have you ever been engaged yourself in any production activity?
2. What makes a period of production short run and long run?
3. Assume a wheat flour factory using different types of factors of production.
Discuss what variable and fixed costs are incurred.

👉 Key Concepts
Input, Outputs, Production, Short-run, Long-run, Production function, Cost,
Fixed cost, Variable cost, Total cost, and Marginal cost

5.1 Definition of Production, Inputs and Outputs

At the end of this section, students will be able to:

6 Describe production
6 Explain inputs and outputs

✍ Start-up Activity
Have you ever been engaged yourself in any production activity?
55 Unit 5: Introduction to Production and Cost
Production is a process of combining various inputs to produce an output for
consumption. It is the act of creating output in the form of a commodity or a service
which contributes to the utility of individuals. In other words, it is a process in which
the inputs are converted into outputs. For example, when we produce wheat on a plot
of land with the help of inputs like labour, capital and seeds, it is termed as production
of wheat.
Inputs are economic resources that can be used in the production of goods and services.
In economics, there four basic inputs commonly used in the production of goods and
services. These are labour, capital, land and entrepreneurial ability.
Outputs are inputs transformed into final usable form since inputs give less satisfaction
to the consumer by themselves. In other words, outputs are consequences of the
production process.
We can classify outputs into tangible and intangible ones. Tangible outputs are physical
products that can be touched. Intangible outputs are products, which may have value
but are not physical objects. The main difference between tangible and intangible
outputs is that tangible output is something that a person can see or touch, and thus it
has a physical existence while intangible output is something, which a person cannot
see or touch and thus it does not have any physical existence.
Examples of tangible outputs include: building, machinery, equipment, car, etc. that
have long term physical existence. Examples of intangible outputs include: insurance
coverage, consultancy service, computer software, educational training, health care
service, etc. that cannot often be tried out, inspected, or tested in advance.
Type of Inputs
Inputs can be divided into two main groups – fixed and variable inputs. A fixed input is
one whose quantity cannot be varied during the period under consideration. Building
and machinery are examples of fixed inputs. An input whose quantity can be changed
during the period under consideration is known as a variable input. Raw materials and
labour inputs are examples of variable inputs.
Ă Activity 5�1
1. Make a classroom observation and explain the inputs used in the teaching-
learning process.
2. Define production and explain the difference between inputs and outputs
3. Distinguish between fixed and variable inputs.

Unit 5: Introduction to Production and Cost

56
 5�2 Periods of Production
At the end of this section, students will be able to:
6 Describe the short run and long run production
6 Differentiate among Total Product, Average Product and Marginal Product

✍ Start-up Activity
What makes a period of production short run and long run?

This classification of periods of production is mainly based on the degree of flexibility

of economic resources to changes in business environment of products consuming
those resources. The two periods of production are commonly known as short run and
long run.

Short run refers to a period of production in which at least one of the inputs is fixed
while the remaining is variable. This implies that an increase in output in the short-run
can be brought about by increasing those inputs that can be varied,-which are known
as ‘variable inputs’. For example, if a producer wishes to increase output in the short-
run, she/he can do so by using more of variable factors like labour and raw materials.

Long run refers a period of production in which all inputs are variable or there is no
fixed input. A firm can install a new plant or construct a new factory building. Long-
run is the period during which the size of the plant can be changed. Thus, all the
factors of production are variable in the long-run.
It must be understood that when we say short run and long run it does not necessarily
mean a relatively short or long period of time like one year or less than one year or like
two or five years. It rather refers to the nature of economic arrangement of the inputs
in response to the changing economic environment.
Total Product, Average Product and Marginal Product in the Short Run
The productivity of variable inputs can be measured in different forms:

Total product (TP): -it is the overall amount of output produced by the factors of
production employed over a given period. It is the gross or entire output by workers
and expressed in terms of Quantity (Q). In the short run production function, a firm
obtains its total product by using a combination of variable inputs with specific amount
of fixed inputs.
Average product (AP): - a firm’s average product is obtained by dividing the total

57 Unit 5: Introduction to Production and Cost

output by the number of workers employed. This can be put in the form of AP=TP/L;
Where AP=Average Product, TP= Total Product and L=Labor.
Similarly, average product of labor may be defined as

Where, TP stands for total production.

APL stands for average product for labor.

The average product is a good indicator of the productivity of labor. Productivity is

a measure of output per unit input (i.e. output ratio for each level of input and the
corresponding level of output).
Marginal Product (MP): - holding the quantities of other factors constant, the in-
crease in output which results from using one additional or extra unit of a single factor
input, is called the marginal physical product or simply marginal product. In other
words, all other things being equal the MP is the percentage change in total output
resulting from a percentage change in variable input.
MPL = ΔTP/Δ L
Where, ΔTP stands for change in total production
ΔL stands for change in labor input

Mathematically, MP=ΔTP/ΔL. Both the MP and AP of the variable factor (labor) are
derived from the TP of labor. Thus, the three returns, viz. total product (TP), marginal
product (MP) and average product (AP) are interrelated.

Unit 5: Introduction to Production and Cost

58
 Table 5.1 Production function with one variable input
Variable Fixed input Total Product Average Marginal Stages of
input (capital) (TP) (In product Product Production
(labour) quintals) (AP) (MP)
0 10 0 - -
1 10 10 10 10
2 10 28 14 18 Stage I
3 10 51 17 23
4 10 76 19 25
5 10 95 19 19
6 10 108 18 13 Stage II
7 10 108 15.4 0
8 10 96 12 -12
Stage III
9 10 80 8.89 -16

The above schedule can also be expressed graphically by drawing TP, MP and AP
curves.

Figure 5.1 Stages of production

Ă Activity 5�2
1. Differentiate among Total Product, Average Product and Marginal Product
2. Elaborate the concepts of fixed and variable inputs in relation to short-run and
long-run production functions by giving a practical example in your locality.

59 Unit 5: Introduction to Production and Cost

5�3 Cost of Production
At the end of this section, students will be able to:
6 Define the cost of production.
6 Differentiate among the different types of costs.

✍ Start-up Activity
Assume a wheat flour factory using different types of factors of production.
Discuss what variable and fixed input costs are incurred.
The concepts of production and cost are inseparable. The cost of production generally
refers to the monetary outlays associated with production activity, or it is the total
expenditures and sacrifices made in the entire process of production and distribution
of goods and services.
Types of Cost of Production
1� Explicit and implicit costs
Explicit costs: These are the actual monetary payments or cash outlays that business
firms make to outsiders who are suppliers of inputs or resources to them. For example,
the rewards of labour, land, capital, and entrepreneurs are all costs for a business
firm that employs them in certain production processes. In addition, there are other
payments made for other raw materials, fuel, transport, sieve, power, and the like are
all costs to a firm. Such costs are usually termed “accounting costs” because they are
out-of-pocket costs. Thus, accounting cost refers to the cost of purchased inputs only,
and this only refers to the explicit cost.
Implicit costs: are costs standing for the values of non-purchased resources owned
and used by firms in their own production activities. These are costs of firms’ own
and self-employed resources in carrying out activities such as the salary of an owner-
manager or the estimated rent of a building that belongs to the owner of a firm, etc.
The values of these self-owned resources should be estimated from what they could
earn in their best alternative uses.
2� Economic Cost and Accounting Costs
It is obvious that costs and profits are inseparable concepts of business. Here, the
main idea is to understand the cost treatment differences and their consequence in cost
analysis of business activities.
Economists and Accountants define and treat costs differently. Economists define

Unit 5: Introduction to Production and Cost

60
costs in terms of opportunity costs and they include these implicit costs in profit
calculations. Thus,

Economic cost = Implicit costs + Explicit 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.
3� Fixed and Variable Costs
Fixed costs are those costs that do not vary as the firm changes the level of output.
These are costs that are always incurred even if the firm does not produce anything.
These are also costs of fixed inputs. For example. rents on leased properties, interest
on borrowed funds, the wear and tear of machineries, cost of administrative staff, etc.
Variable costs are those costs of production that directly vary with the level of output
of the firm. When output is zero variable costs are also zero. But as the firm expands
its output these costs tend to rise. In short, variable costs of a firm are dependent on
the level of output. Examples of variable costs are wage of workers excluding the
administrative staff, cost of raw materials, etc.
Total cost is the sum of total fixed cost and total variable cost. Or

TC = TFC + TVC
Where, TC = Total Cost; TFC = Total Fixed Cost; TVC = Total Variable Cost.
Table 5.2 Short run costs of a firm
Q (output) TFC (birr) TVC (birr)) TC (birr))
0 60 0 60
1 60 20 80
2 60 40 100
3 60 60 120
4 60 65 125
5 60 75 135
6 60 120 180

We can also show the above data graphically, as follows:

61 Unit 5: Introduction to Production and Cost