22/10/2018

CHAPTER 6 THEORY OF PRODUCTION

Production and Cost Theory DEFINITION OF PRODUCTION
Production
1.Short-run production PRODUCTION
2.Law of diminishing marginal returns – means the process of using the factors
3.Stages of production of production to produce goods and
Cost
1.Short-run costs services.
2.Long run average cost OR
•Economies of scale
•Diseconomies of scale
- transformation of inputs to outputs.

INPUTS (FACTORS OF PRODUCTION) 1 2 3

Refers to those things that a firm buys for use in production
such as land labour capital &entrepreneur.
• PRODUCTION • Production • Where Q = amount
FUNCTION function can be of output depends
Refers to the on the quantity of
written as
relationship inputs.
• Q = f (K, L, M , E) • K = Capital
between
inputs and • L = labour
outputs • M = land or raw
material
• E = entrepreneur
OUTPUTS
Refers to what we get at the end of the production or refers
to finished products.
(goods and services produced)

Q = f (K, L, M , E)
SHORT RUN AND LONG RUN
The formula explains that the qtty of output (Q) depends on the factor of PRODUCTION FUNCTION
production.

The difference THERE ARE 2 TYPES OF Variable input – is an

Assume that the QUALITY of inputs is homogeneous. (to between a FACTOR INPUTS:
input in which the qtty
ensure that only QUANTITY differs and not QUALITY) short run and Fixed input – is an input in
long run which the qtty does not changes according to
depend on the change according to output. output. Example, raw
inputs, which Example, machinery, land,
buildings, tools, equipment,
material, fuel,
can be varied
etc. electricity, etc.
in production .
The larger the number of input, larger the number of
output.

1
 22/10/2018

SHORT RUN LONG RUN SHORT RUN PRODUCTION FUNCTION

• Period is the time frame • Period is the time frame

in which at least one of in which all inputs are
Assuming that only
the inputs is fixed but variable. Assume two factors of
the other inputs are that at least production are used
varied. ONE in the production
• In long run firms can one of the process:
• Fixed resources or input alter the inputs to VARIABLE
for most firms are AND ONE inputs is LABOUR (L) and
increase the output CAPITAL (K)
capital such as FIXED fixed that is
Q = f (K, L)
buildings, equipment, INPUT Capital. K = the quantity of
tools, etc. output can be capital is fixed.
increased by varying
labour.

LAW OF DIMINISHING MARGINAL RETURNS (LDMR).

This law explains the behavior of production in the short run. TOTAL
PRODUCT MARGINAL PRODUCT
LDMR can (TP) AVERAGE PRODUCT (MP)
be The (AP) Change in the total
explained product of that input
The LDMR states that after a certain point, when the additional amount of corresponding to an
with the output Divide the total addition
units of variable input are added to fixed inputs, the marginal help of a produced product by the unit change in its labour
product of the variable input declines. table amount of that input assuming other factors
when a that is capital fixed.
showing given used in the
the amount of production
Marginal Product (MPL)
production that input =
functions of is Average Product Change in Total Product
a firm. used along (APL) = Total Product Change in Total Labour
with fixed Total Labour
inputs. MPL = TP1 – TP0
This law also called the LAW OF VARIABLE PROPORTIONS APL = TP/ L
Q = f (K, L) TP = Qty L1 – L0
=
Output

STAGE 1 STAGE 11 STAGE 111

Capita
l
Labour
(Variabl
Total
Product
Margina
l
Averag
e
Stages
of DIAGRAM TP, -It
begins from the origin This stage begins from the This stage
(Fixed e input) Product Produc Producti 60
input) t on
STAGE I STAGE II STAGE III AP & MP until the AP and MP
curves intersect.
intersection point of MP and APbegins
curves (end of stage 1) until MP
MP = 0 and
when
curve equals zero.
-In this stage MP curve is
continues to
50 TP
TP MAX above AP curve. -In this stage, the value of AP decline with
and MP are Decreasing. Note negative value.
•This shows that for each that the AP curve is always
40 additional increase in Higher than the MP curve and - A rational
10 0 0 - - labour will results in when the MP curve touches the producer
greater increase in TP. horizontal axis, the TP reaches should not
10 1 8 8 8 its maximum points.
30
-A rational producer will
produce any
STAGE
10 2 20 12 10 continue to produce -This is the most efficient stage output in this
I
goods since he can still of production because the stage since TP
10 3 33 13 11
20 increase the quantity of combinations of variable and will decrease if
10 4 44 11 11 labour used fixed inputs are used efficiently. he adds one
more units of
10 5 50 6 10 -A rational producer will
10 labour to the
produce in this stage since the
10 6 54 4 9 TP has already achieve its
fixed input.
STAGE
II AP maximum point
10 7 56 2 8 AP MAX
0 AP =MP
10 8 56 0 7 MP -if he continues to produce
after this stage the TP will start
10 9 54 -2 6 1 2 3 4 5 6 7 8 9 10
STAGE to decline
10 10 50 -4 5 III -10 MP=0

2
 22/10/2018

STAGE 1 STAGE 11 STAGE 111

-It begins from the origin This stage begins from the intersection This stage begins
until the AP and MP curves point of MP and AP curves when MP = 0 and
COST THEORY
• An expenses incurred
intersect. (end of stage 1) until MP curve equals
zero. continues to
decline with Short Run production
-In this stage MP curve is -In this stage, the value of AP and MP are
negative value. by firm due to the Costs.
above AP curve. Decreasing. Note that the AP curve is
always Higher than the MP curve and utilization of economic Definition-
•This shows that for each when the MP curve touches the - A rational
additional increase in labour horizontal axis, the TP reaches its producer should resources in Short run is defined as the
will results in greater maximum points. not produce any time frame whereby some
increase in TP. output in this
Production activities. factors of production are
-This is the most efficient stage of
production because the combinations of
-A rational producer will variable and fixed inputs are used decrease if he
stage since TP will
• - short run cost fixed and some are vary.
continue to produce goods efficiently.
since he can still increase
adds one more (fixed + variable It means that in the short
units of labour to
the quantity of labour used -A rational producer will produce in this
stage since the TP has already achieve its the fixed input. factors) run, cost can be classified
maximum point
• - long run cost (all as either fixed or variable
-if he continues to produce after this
cost.
stage the TP will start to decline inputs can be varied)

Short Run production :TYPES OF COST Types of cost

• TOTAL FIXED COSTS (TFC)
• Fixed costs are costs, which in total do not vary with changes in
output.
• Even when output equals to zero, fixed cost still incurred.
• Fixed costs are independent of output. They are incurred in the short
run and must be paid regardless of output level.
• The examples of fixed cost are rental payments, a portion of
depreciation on equipment and building, insurance premiums.
• TFC = TC – TVC
• TFC = AFC x Q

TOTAL VARIABLE COST (TVC) TOTAL COST

• Variable costs are costs that change with the level of output.
• Variable costs are those which businesses can control or alter in the
• Is the sum of fixed cost and variable cost at
short run by changing production level. each level of output.
• For example, payments for materials, fuel, power, transportation
services and wages of for labour. • When outputs equals to zero, TC = TFC because
•TVC changes directly with output. TVC = 0. For other than zero unit of outputs, TC
•Variable costs will be zero if the firm close down and stop production.
varies by the same amount as does variable cost.
• TVC = TC – TFC
•TVC = AVC X Q TC = TFC + TVC
TC = AC X Q

3
 22/10/2018

AVERAGE TOTAL COST (ATC) @ AVERAGE COST AVERAGE FIXED COST (AFC)
• Can be defined as TC per unit of output. • Can be defined as FC per unit of output.
• The ATC curve is u-shape. • AFC will fall as output increases.
• Formula: • AFC = TFC/Output
• ATC = TC/output
• ATC = AFC + AVC

MARGINAL COST (MC)

AVERAGE VARIABLE COST (AVC)
• The changes in TC that results from a changes
• Can be defined as VC per unit of output.
in output.
• the AVC curve is u-shape
• MC will initially fall, reach the minimum and
• AVC= TVC/Output finally rise.
• MC = Δ TC/Δ output
• MC = TC1– TC0
Q1 –Q0

SHORT-RUN COST CURVES LONG RUN COST CURVES

COST
MC ATC
• The long run is a period where there are only
COST TC variable factors.
• There is no fixed factor.
AVC

TVC
• Long run Average Cost(LRAC): The long run
average cost can be defined as the long run
TFC
total cost per unit of output.
AFC

QUANTITY

QUANTITY
QUANTITY

4

• LRAC is the curve that shows
the minimum cost of producing
any given output when all of the
outputs are variable.
• The LRAC is derived by a series
of short run average cost curve
(SRAC).
• Tangential points of the a SRAC
are joint and make up the LRAC.
• The LRAC is U-shaped.
• This is due to economies and
diseconomies of scale.
3. Managerial Economies
Big firm can benefit by specializing its managerial department.
Managerial economies refer to the departmentalization and the employment
of professionals. Each department is under the charge of expert. It will ensure
high productivity and more
efficient in production whereby output increase and cost per
unit decrease.
4. Financial Economies
Big and established firms normally get favorable terms and
conditions when they borrow money from banks and other
financial institutions. For example, they normally get a lower
interest rate and longer repayment period.
5. Technical Economics
Large firms have more resources to use , more machines which are modern
and sophisticated. These firms be able to produce at maximum capacity and
fully machinery and reduce average cost.
22/10/2018
Economies of scale: a decrease in per unit cost as a result of an
increase in output. Economies of scale are advantages and benefits
enjoy as it becomes larger and larger.
The are several reasons that cause economies of scale.
1. Economies of Specialization(labor economies)
assigned worker to do the specific tasks will increase the
efficiency of labor. This will result an increasing in output
and reduce the average cost without any increase in wages.
2. Marketing Economies
big firms buy their in bulk. They get special discounts on
their prices , which again will reduces their costs. A firm can
also reduce the average cost of selling goods in large firms
can have their own sales agencies and channels to sell their
goods.
• Diseconomies of scale: an increase in per unit cost as a
result of an increase in output. Diseconomies of scale are
problems the firm will face when it becomes too large.
• There are few sources of diseconomies of scale.
1. Labor Diseconomies
Specialization may result boredom, disinterest, physical and metal fatigue which
can reduce labor productivity. Productivity
falls, the average cost rises.
2. Management Problem
When a firm grows too large, miscommunication, lack of coordination,
cooperation and control and monitoring are some of the problems it may face.
As a result there may be mismanagement of costs and funds making the
production cost per unit to increase.
3. Technical Difficulties
Every machine has an optimum capacity for work and an optimum proportion
with other factors. If this proportion is exceeded than diseconomies of scale are
realized.