Theory of Production

and Cost
Chathuranga Adhikari
B.com (Sp)(Hons), M.com (Reading)
Theory of the Firm: Production & Cost

• A business firm is an organization, owned and operated by private

individuals, that specializes in production.
• Production is the process of combining inputs to make outputs.
• The firm buys inputs from households or other firms and sells its
output to consumers.

• Profit of the firm = Sales revenue – Input costs

The Nature of the Firm
Every firm must deal with the government

• Pays taxes to the government

• Must obey government laws and regulations
• Receive valuable services from the government
▪ Public capital
▪ Legal systems
▪ Financial systems
The Firm and Its Environment

Owners

Initial Financing Profit After Taxes

Input Costs Taxes

Input The Firm
Government
Suppliers (Management)
Inputs Government Services
Government Regulations
Output Revenue

Customers
Production
• Production involves using inputs to produce an output
• Inputs include resources
▪ Labor
▪ Capital
▪ Land
▪ Raw materials
▪ Other goods and services provided by other firms
• The way in which these inputs may be combined to produce output is
the firm’s technology
Production Technology
A firm’s technology is treated as a given

• Constraint on its production, which is spelled out by the firm’s

production function

• 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
The Firm’s Production Function

Alternative Production Different

Input Quantities of
Combinations Function Output
The Short Run and the Long Run
• Useful to categorize firms’ decisions into
▪ Long-run decisions
▪ Short-run decisions

• To guide the firm over the next several years

The manager must use the long-run lens

• To determine what the firm should do next week

The short-run lens is best
Production in the Short Run
•When firms make short-run decisions, there is nothing they can do
about their fixed inputs

•Fixed inputs
An input whose quantity must remain constant, regardless of how much output is
produced
•Variable input
An input whose usage can change as the level of output changes
•Total product
The maximum quantity of output that can be produced from a given combination of
inputs
Production in the Short Run
• The marginal product of labor (MPL) is the change in the total product
(ΔQ) divided by the change in the number of workers hired (ΔL)

ΔQ
MPL =
ΔL
• Tells us the rise in output produced when one more worker is hired,
leaving all other inputs unchanged
Total Product and Marginal Product
Units of Output

196 Total Product

184
161
Q from hiring fourth worker
130
Q from hiring third worker
90

Q from hiring second worker

30
Q from hiring first worker

1 2 3 4 5 6 Number of Workers
increasing diminishing
marginal marginal returns
returns
Marginal Returns To Labor
• As more and more workers are hired
▪ MPL first increases
▪ Then decreases

• The pattern is believed to be typical at many types

of firms
Increasing Marginal Returns to Labor
• When the marginal product of labor increases as
employment rises, we say there are increasing marginal
returns to labor

▪ Each time a worker is hired, total output rises by more than it did
when the previous worker was hired
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 the marginal product is positive
▪ But the rise in output is smaller and smaller with each successive worker

• The 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
Q = f ( K , L) 600

500
L Q MP AP
400
1 80

2 170 300

3 270 200

4 368
100
5 430
0
6 480
1 2 3 4 5 6 7 8 9 10
7 504

8 504

9 495

10 470
L Q MP AP 600

1 80 80 80 500

2 170 90 85 400

3 270 100 90
300
4 368 98 92
200
5 430 62 86
100
6 480 50 80
0
7 504 24 72 1 2 3 4 5 6 7 8 9 10

8 504 0 63

TP TP TP
MPL = MPK = APL =
9 495 -9 55

10 470 -25 47 L K L
 600

500
L Q MP AP
400
1 80 80 80
300
2 170 90 85
200

3 270 100 90 100

4 368 98 92 0
1 2 3 4 5 6 7 8 9 10
5 430 62 86
120
6 480 50 80 100

80
7 504 24 72
60

8 504 0 63 40

20
9 495 -9 55
0
1 2 3 4 5 6 7 8 9 10
10 470 -25 47 -20

-40
 600

500
L Q MP AP
400
1 80 80 80
300

2 170 90 85 200

3 270 100 90 100

0
4 368 98 92 1 2 3 4 5 6 7 8 9 10

5 430 62 86 120

100
6 480 50 80
80

60
7 504 24 72
40

8 504 0 63 20

0
9 495 -9 55 -20
1 2 3 4 5 6 7 8 9 10

-40
10 470 -25 47
 600

Short term production function 500

400

L Q MP AP 300

1 80 80 80 200

100
2 170 90 85
0
3 270 100 90 1 2 3 4 5 6 7 8 9 10

1 2 3
4 368 98 92 120

100
5 430 62 86 80

60
6 480 50 80
40

20
7 504 24 72
0
1 2 3 4 5 6 7 8 9 10
8 504 0 63 -20

-40
9 495 -9 55

10 470 -25 47
1 Increasing marginal productivity zone
2 Diminishing marginal productivity zone
3 Negative marginal productivity zone
Costs
• A firm’s total cost of producing a given level of
output is the opportunity cost of the owners
▪ Everything they must give up in order to produce that amount of
output
The Irrelevance of Sunk Costs

• Sunk cost is one that already has been paid, or must be

paid, regardless of any future action being considered
• Should not be considered when making decisions
• Even a future payment can be sunk
If an unavoidable commitment to pay it has already been made
Explicit vs. Implicit Costs
• Types of costs
▪ Explicit (involving actual payments)
Money actually paid out for the use of inputs

▪ Implicit (no money changes hands)

The cost of inputs for which there is no direct money payment
Economic versus Accounting Costs

• Economic costs are theoretical constructs that are intended

to aid in rational decision-making.

• Accounting costs are legal constructs intended to provide

uniformity in measurement.
Profit
• Profit = Total Revenue – Total Costs
• Total Net Benefits = Total Benefits minus Total Costs
• Costs as Opportunity Costs
▪ Explicit Costs
▪ Implicit Costs
• The opportunity cost of entrepreneur’s invested capital
• The opportunity cost of the entrepreneur’s time
Economic versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright © 2004 South-Western

Costs in the Short Run
• Fixed costs
Costs of a firm’s fixed inputs

• Variable costs
Costs of obtaining the firm’s variable inputs
Measuring Short-Run Costs: Total Costs

• Types of total costs

▪ Fixed costs
Cost of all inputs that are fixed in the short run
▪ Total variable costs
Cost of all variable inputs used in producing a
particular level of output
▪ Total cost
• Cost of all inputs - fixed and variable
• TC = TFC + TVC
The Firm’s Total Cost Curves
RS ‘000
TC
435
375 TFC TVC
315
255
195
135
TFC

0 30 90 130 161 184 196

Units of Output
Average Costs
• Average fixed cost (AFC)
Total fixed cost divided by the quantity of output produced
TFC
AFC =
Q
• Average variable cost (TVC)
Total variable cost divided by the quantity of output
produced TVC
AVC =
Q

• Average total cost (TC)

Total cost divided by the quantity of output produced
TC
ATC =
Q
Marginal Cost
•Marginal Cost
Increase in total cost from producing one more unit or
output
•Marginal cost is the change in total cost
(ΔTC) divided by the change in output (ΔQ)
ΔTC
MC =
ΔQ

• Tells us how much cost rises per unit increase in output

• The marginal cost for any change in output is equal to the shape of
the total cost curve along that interval of the output
Average And Marginal Costs
Rs MC
4

AFC ATC
2 AVC

0 30 90 130 161 196

Units of Output
Explaining the Shape of the Marginal Cost
Curve
•When the marginal product of labor (MPL) rises, marginal
cost (MC) falls

•Since MPL ordinarily rises and then falls, MC will do the

opposite. it will fall first and then rise

Thus, the MC curve is U-shaped

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
Average and Marginal Costs
Cost Formulas
• TC = TFC +TVC
• Dividing both sides of the total cost formula by Q, we
get the average cost formula:
▪ TC/Q = TFC/Q + TVC/Q
▪ ATC = AFC +AVC
▪ Average Total Cost = Average Fixed Cost + Average Variable Cost
 Fixed Variable Total Marginal
Quantity Cost Costs Costs Costs

0 $ 3.00
1 $ 3.00 $ 0.30 $ 3.30 $ 0.30
2 $ 3.00 $ 0.80 $ 3.80 $ 0.50
3 $ 3.00 $ 1.50 $ 4.50 $ 0.70
4 $ 3.00 $ 2.40 $ 5.40 $ 0.90
5 $ 3.00 $ 3.50 $ 6.50 $ 1.10
6 $ 3.00 $ 4.80 $ 7.80 $ 1.30
7 $ 3.00 $ 6.30 $ 9.30 $ 1.50
8 $ 3.00 $ 8.00 $ 11.00 $ 1.70
9 $ 3.00 $ 9.90 $ 12.90 $ 1.90
10 $ 3.00 $ 12.0 $ 15.00 $ 2.10
Quantity AFC AVC ATC MC

0
1 $ 3.00 $ 0.30 $ 3.30 $ 0.30
2 $ 1.50 $ 0.40 $ 1.90 $ 0.50
3 $ 1.00 $ 0.50 $ 1.50 $ 0.70
4 $ 0.75 $ 0.60 $ 1.35 $ 0.90
5 $ 0.60 $ 0.70 $ 1.30 $ 1.10
6 $ 0.50 $ 0.80 $ 1.30 $ 1.30
7 $ 0.43 $ 0.90 $ 1.33 $ 1.50
8 $ 0.38 $ 1.00 $ 1.38 $ 1.70
9 $ 0.33 $ 1.10 $ 1.43 $ 1.90
10 $ 0.30 $ 1.20 $ 1.50 $ 2.10
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Short-Run Cost
 Question

Total
Total Fixed Total Cost Marginal Average Fixed Average Variable Average Total
Quantity Variable Cost
Cost (TFC) (TC) Cost (MC) Cost (AFC) Cost (AVC) Cost (ATC)
(TVC)
0 3000
1 150
2 150
3 540
4 200
5 792
Economic vs. Accounting profit
• Economic profit = Total revenue - All economic costs
• Accounting profit = Total revenue - All accounting costs
• Accounting costs include only current or historical explicit
costs, not implicit costs
Economic vs. Accounting profit
• The difference between economic cost and accounting
cost is the opportunity cost of resources supplied by the
firm's owner.
• The opportunity cost of these owner-supplied resources
is called normal profit.
• Normal profit is the cost of production.
Economic vs. Accounting profit
• If a firm is receiving economic losses (negative
economic profits), the owners are receiving less income
than could be received if their resources were employed
in an alternative use.
• In the long run, we'd expect to see firms leave the
industry when this occurs.
Economic profits = 0
•If economic profits equal zero, then:
▪ Owners receive a payment equal to their opportunity
costs (what could be received in their next-best
alternative),
▪ No incentive for firms to either enter or leave this
industry,
Economic profit
• Economic profit = Total Revenue - Economic Costs
• When output rises, both total revenue and total costs
increase
• Profits increase when output increases if total revenue rises
by more than total costs.
• Profits decrease when output rises if total costs rise by
more than total revenue
Production And Cost in the Long Run
• In the long run, there are no fixed inputs or fixed
costs - All inputs and all costs are variable

• The firm’s goal is to earn the highest possible profit

To do this, it must follow the least-cost rule
Production And Cost in the Long Run
•Long-Run Total Cost
▪ The cost of producing each quantity of output when the least-cost input mix is
chosen in the long run
•Long-Run Average Total Cost
▪ The cost per unit of output in the long run, when all inputs are variable
•The long-run average total cost (LRATC)
▪ Cost per unit of output in the long-run

LRTC
LRATC =
Q
The Relationship Between Long-Run And
Short-Run Costs
• For some output levels, LRTC is smaller than TC
• The long-run total cost can never be higher than, the
short-run total cost
• The long-run average cost can never be higher than the
short–run average total cost
Average Cost And Plant Size
• Plant - Collection of fixed inputs at a firm’s disposal
• In the long run, the firm can change the size of its plant
▪ In the short run, it is stuck with its current plant size
• The ATC curve tells us how average cost behaves in the short run when
the firm uses a plant of a given size
• To produce any level of output, it will always choose that ATC curve
among all of the ATC curves available that enables it to produce at the
lowest possible average total cost
Graphing the LRATC Curve
• A firm’s LRATC curve combines portions of each
ATC curve available to the firm in the long run
• In the short run, a firm can only move along its
current ATC curve
• In the long run, it can move from one ATC curve
to another by varying the size of its plant
Long-Run Average Total Cost
Rs
ATC1 LRATC
4.00 ATC3
ATC0 ATC2
3.00 C
D
2.00 B
A E
1.00

0 30 90 130 161 184 250 300

175 196
Use 0 Use 1 Use 2 Use 3
automated automated automated automated
lines lines lines lines
Units of Output
Economies of Scale
• Economics of scale
▪ Long-run average age total cost falls as output increases
▪ When an increase in output causes LRATC to fall, we say that the
firm is enjoying increasing economies of scale
▪ When long-run total cost rises proportionately less than output,
production is characterized by decreasing economies of scale

• LRATC curve slopes downward

The Shape of LRATC
Rs
4.00

3.00
LRATC
2.00

1.00

0 130 184

Economies of Scale Constant Diseconomies of Scale

Returns to
Scale Units of Output
Thank you