CHAPTER 6

THEORY OF PRODUCTION AND COST

This chapter looks at the behaviour of firms in their endeavour to use wisely their
resources or inputs to produce output. This includes topics on the concept of production function,
the different production periods, the law of diminishing marginal returns, the stages of production,
economic cost and other cost concepts.

Production Function

The production function shows a technical relationship between the firms inputs and
its output.

This can be expressed in mathematical form:

Output = f (inputs)

The above function shows that output is dependent on or is a function of the factors of
production or inputs used by the firm. This further means that the value of the firm’s output depends
on the amount of inputs that they use such as land, labor, capital and entrepreneur. The more inputs
used in the production by the firm, the higher the output, and the less inputs used, the lower the
output.

Fixed Input and Variable Input

Inputs are classified into inputs and variable inputs.

Fixed Inputs are inputs whose quantity is not changed by the firm, regardless of its
reasons. In most cases, it may not have the money to pay for added quantity of said inputs and
therefore maintains the use of a fixed input. Factory capacity and entrepreneur are examples of
inputs that are fixed or do not change.

Variable inputs are inputs whose quantities can readily changed like labor and raw
materials.

Production Periods

There are three different production periods in Economics; these are the very short-
run and the long-run period.

The very short-run period or the immediate period is a production period in which
all factors of production used by the firm are fixed inputs.
 The short-run period is a production period in which some inputs used by firm are
fixed while others are variable.

The long-run period is a production period in which all the inputs used in production
of the firm are variable inputs.

Take note that in Economics, the production period refers to how firms adjust their use
of inputs which may also depend on the available money to pay for inputs such as land, labor, capital
and entrepreneur. In other words, this refers to the nature of economic adjustments rather than to
time periods themselves.

For some firms, the very short-run period might last a few days. For other firms, the
short-run can extend for several years. It depends on the production technology used by the firm
and how difficult it is to change the quantity of capital and other fixed inputs. Many real world firms
operate in the short-run for its practical reason that expansion by increasing inputs is easy, but what
if there is no longer enough demand? Is the firm to decrease production making productive inputs
idle or unutilized? Remember our discussion of the PPC in chapter 2.

The Law of Diminishing Marginal Returns

The law states that as successive units of variable inputs are added to fixed inputs,
total product increases at an increasing rate, continuously increases at a decreasing rate and at a
certain point total product declines.

Table 6.1
Total Product, Marginal Product and Average Product

Total Product Marginal Product Average Product

Land (Hectare) Labor Input
(TP) (MP) (AP)
1 0 0 --- --
1 10 10 10
1 22 12 11
1 32 10 10.67
1 40 8 10
1 46 6 9.2
1 50 4 8.33
1 52 2 7.43
1 52 0 6.28
1 50 -2 5.56
Stage I

Stage II

Stage III

Table 6.1 exhibits the Law of Diminishing Marginal Returns. Notice that the firm
operates in the short-run period with a fixed input of land and a variable input of labor. This shows
that as number of worker increases total product continuously increases from 10 units, 22, 32, etc.,
until it reaches 52 units as more workers are employed.

Notice that when the 9th worker is employed, total product declines from 52 to 50 units.
A decline in the total product despite of an increasing use of variable input is due to the fact that
land is fixed. A fixed input has a maximum potential as exhibited in Table 6.1. In the example the
maximum production capacity of a hectare of land is 52 sacks of palay for the upland farm. This
brings us to the next discussion on the stages of production.

Average Product (AP) is the total product per unit of the variable input.
Formula: AP = TP / Labor
Marginal Product (MP) is the additional or extra product contributed by the last
worker,

Formula: MP = ∆TP / ∆L

Figure 6.1
The Law of Diminishing Marginal Returns and the Stages of Production
Figure 6.1 is the graphical presentation of Table 6.1 which exhibits the law of diminishing marginal
returns. The three stages of production for the firm are shown in the above figure.

The Three Stages of Production

The stages of production can be best understood given Figure 6.1 and Table 6.1. The
behaviour of the total product, average product and the marginal product is depicted in the 3 stages
of production, given example of a palay farm.

I. Stage of Increasing Returns. This stage is where any addition in variable input used, TP
increases at an increasing rate.

Stage I is where the production level is not yet efficient because this is a stage
of underutilization of the fixed input. Why be contented to produce only 22 cavans when the
land can produce unitl 52 cavans of palay? Both AP and MP are increasing in this stage but
MP>AP.
II. Stage of Decreasing Returns. This is the stage where the producer continuously employs
more labor input to a fixed land, total product continuously increases but at a decreasing rate
(increasing slowly) until it reaches the maximum production level at 52 units. Both AP and
MP are decreasing at this stage but AP>MP. This is the stage of diminishing returns. Stage
II of production is where the producer has fully utilized the fixed resource. This stage is the
rational stage of production.

III. Stage of Negative Returns. Stage III is referred to as the stage of over-utilization of the fixed
input. Note that as labor input increases from 8 to 9, Total Product is now decreasing so the
contribution of the 9th labor input is already negative. Do you think the producer would choose
this level? will he prefer to increase the use of labor which will only mean a decrease in total
output or a negative marginal product? AP still decreases at this stage but remains positive
while MP is negative.

The three stages of production exhibit the law of Diminishing Marginal Returns. This
law states that as one employs more of a variable input (labor input in the illustration) to a
fixed input (land), Total Product increases at an increasing rate (Stage 1), and continuously
increases at a decreasing rate (stage II) and at a certain point total product starts to decline
(Stage III).

Human beings as labor factor input may also experience diminishing return. This is
the state where no matter how hard we work, we are no longer productive because of
tiredness. We also have maximum potentials and abusing ourselves by overworking may
hinder productivity.

To understand the law of diminishing returns is to understand the limitations of man.

A foreman must not ask his painter to work over time if he knows that he is already at the
point of diminishing returns. If he really needs the work to be done, he can look for another
person who is not yet tired to continue the task otherwise it will be a mess a man trying to
work hard for additional pay but his body dictates he cannot because of tiredness.

Economic Costs

The firm in order to produce the goods and services needs inputs like land, labor,
capital, and entrepreneur which may be owned by firm itself for by consumers or household. The
payment for the inputs that firm uses in the production processes is what is known as economic
cost.
 Economic cost does not only include those payments to outsiders who supply the
inputs called explicit cost, but also the implicit cost.

Explicit costs are monetary expenditures paid to outsiders who supply the inputs.

Implicit costs are the cost of self-owned or self-employed resources. The valuation
of the supposedly payment or income of the firm is important to be included because of the
opportunity cost concept.

Opportunity cost measures things that must be given up or sacrificed when one
chooses one alternative over the other. Example if you decide to quit from your job and run a
business the salary you give up is the opportunity cost.

Cost can also be viewed in the aspect of the three different production periods, the
very-short run, short-run and the long-run period. Table 6.2 shows the mathematical definitions of
total, average and marginal cost in the three production periods.

Table 6.2
Mathematical Definition of Cost Functions
PRODUCTION
TOTAL COST AVERAGE COST MARGINAL COST
PERIOD
Immediate period TC=TFC AFC=TFC/Q
ATC=TC/Q
AFC=TFC/Q MC=∆TC
Short-run period TC=TFC+TVC
AVC=TVC/Q ∆Q
ATC=AFC+AVC
ATC=TC/Q
MC=∆TC
Long-run period TC=TVC AVC=TVC/Q
∆Q
AVC=ATC

The table above shows that if the firm operates in the immediate period, all cost are
fixed cost.

In the short-run, Total Cost (TC) for the firm includes Total Fixed Cost (TFC) and Total
Variable Cost (TVC). If the firm operates in the long-run period, TC=TVC, meaning all cost are
variable.

Total Fixed Cost (TFC), Total Variable Cost (TVC) and Total Cost (TC) for the Firm

Total Fixed Costs are those costs that do not vary with output like rentals and their
amount would be the same even if output is one unit or one million units. The costs of fixed inputs
are fixed costs. TFC is the sum of all fixed cost, it is constant and thus, its curve is a horizontal line.
 Total Variable Costs are costs that vary directly with output (like costs of labor and
raw materials). TVC is rising as more is produced and falling as less is produced. If labor is a variable
input, then wage is a variable cost. TVC is the sum of all variable cost. It increases as output
increases, hence TVC curve is upward sloping.

Total Cost is the sum of total fixed costs and total variable cost.

Figure 6.2
Graphical Presentations of Cost Curves
PRODUCTION
TOTAL COST AVERAGE COST MARGINAL COST
PERIOD

Immediate period

Short-run period

Long-run period

Figure 6.2 shows comparison of different cost curves in the 3 production periods.

AFC, AVC, ATC and MC

Average Fixed Cost (AFC) is fixed cost per unit of the product AFC declines as output
increases with an asymptotic curve along the horizontal axis.

Average Variable Cost (AVC) is the total variable cost per unit of output. It initially
decreases, reaches a minimum and rises as output expands.

Average Total Cost (ATC) is cost per unit of output, this decreases as output
increases, reaches minimum then increases. ATC and AVC are U shaped curves. ATC is also the
sum of AFC and AVC
 Marginal Cost (MC) is the additional or the extra cost associated with the additional
unit of the good produced. MC first declines and then continuously rises as output is increased and
is a J-shaped curve.

Table 6.3
Cost Schedules for the Hypothetical Firm in the Short-run
Total Total Average Average
Average Marginal
Output Fixed Variable Total Cost Fixed Variable
Total Cost Cost
Cost Cost Cost Cost
0 10 0 10 - - - -
10 5 15 10 5 15 5
10 9 19 5 4.5 9.5 4
10 12 22 3.33 4 7.33 3
10 15 25 2.5 3.75 6.25 3
10 19 29 2 3.8 5.8 4
10 25 35 1.67 4.16 5.83 6
10 33 43 1.43 4.71 6.14 8
10 43 53 1.25 5.38 6.63 10

The table above shows the cost schedule of the hypothetical firm in the short-run.
Total Fixed Cost is 10 regardless of output while Total Variable Cost increases 0 to 43 as
corresponding output increases from 0 to 8. Total cost is just the sum of TFC and TVC.

AFC continuously declines from P10 to P1.25 as output increases, Average Variable
Cost declines initially from P5 to P3.75 then rise continuously. This behaviour of VC is like the
behaviour of the TC which declines from P15, reaches minimum at P5.83 before it continuously
increases.

Figure 6.3
The Different Cost Curves for Hypothetical Firm in the Short-run
 Figure 6.3 shows the graphical presentation of total and per unit costs in the short-run.

TFC curve is a horizontal line, while TVC curve is upward sloping to show that TVC
increases as output increases. TC curve is the vertical sum of TFC and TVC curve. It is also an
upward sloping curve to show its increase as output increases.

The AVC and ATC are U shaped while MC is a J shaped curve as shown in the graph
above.

Production Costs in the Long-run

Figure 6.4
The Long-run ATC Curve

The Long-run ATC curve in Fig. 6.4 is composed of short-run ATC curves, which
represent the various plant sizes a firm is able to operate in the long-run. Notice that the minimum
short-run average cost average cost decreases as output rises then reaches minimum before it
continue to increase.

In the long-run, the firm can alter its plant capacity, it can build a larger plant or revert
to a smaller plant.

Economies of scale exists when long-run average costs decline as output rises, and
larger firms will be more efficient than smaller firms.

Diseconomies of scale are said to exist in the range where average costs rise with
increases in output. Diseconomies of scale emerge because managerial skills have reached the
point of diminishing returns.
 EXERCISE 1
Name_______________________________________________Score__________________
Course&Section_______________________________________Date___________________

The graphical illustration below shows the theory of production. Label the unknown variables
represented by numbers.

1. ____________________________________________________________________
2. ____________________________________________________________________
3. ____________________________________________________________________
4. ____________________________________________________________________
5. ____________________________________________________________________
6. ____________________________________________________________________
7. ____________________________________________________________________
8. ____________________________________________________________________

EXERCISE 2
A. Use the following data to compute for average product and marginal product.
Number of Workers Total Product Marginal Product Average Product

0 0

15

30

45

55

60

60
 55
B.

B. Plot the total, average and marginal product and identify the stages of production.

EXERCISE 1
Name_______________________________________________Score__________________
Course&Section_______________________________________Date___________________

Suppose the Payumo Enterprises has the following cost schedule. Its TFC is P1,000 per month and
its variable cost are in column 3. Complete the table below and graph TFC, TVC and TC and the
AFC, AVC, ATC and MC curves in another graph. See pp 106 for your guide in graphing.

Output TFC TVC TC AFC AVC ATC MC

0 0

500

1,000

2,000

3,500

5,500

C
 Q

EXERCISE 1
Name_______________________________________________Score__________________
Course&Section_______________________________________Date___________________

IDENTIFICATION

__________________1. The additional cost from an additional unit of output produced.

__________________2. It shows the relationship between the level of inputs and output.
__________________3. The difference between ATC and AVC in the short-run period.
__________________4. Cost that exists only in the very short run or immediate period.
__________________5. Cost that decreases with the increases in the output produced.
__________________6. A monetary expenditure made to outsiders who supply the inputs.
__________________7. Inputs that do not vary with the level of output.
__________________8. Variable cost per unit of output.
__________________9. It states that as you combine the fixed inputs to the variable inputs, total
product increases at an increasing rate continuously increase at a
decreasing rate and at a certain point it declines.
__________________10. Cost of self-owned or self-employed resources.
__________________11. The total output produced per unit of a resourced employed.
__________________12. Production period where all factors of production used are variable
inputs.
__________________13. The rational stage of production.
__________________14. A production stage where the firm is over utilizing its fixed input.
__________________15. It is J shaped curve.
TRUE OR FALSE
____________1. Land and managerial talent are fixed inputs in the short-run.
____________2. Rent, depreciation and salary of the managers are variable costs in the short-
run.
____________3. Implicit cost of a resource is counted as economic cost due to the opportunity
cost of the said resource.
____________4. When TP is maximum, MP is negative.
____________5. In the short-run period, TC=TFC at zero output.
____________6. In the long-run, ATC = AVC.
____________7. From the economist’s point of view, the real importance of cost lies in the fact
they represent constraints to production.
____________ 8. For the firm to reduce its fixed cost, it has to produce more output.
____________9. Normal profit is part of the firm’s implicit cost.
____________10. In the short-run, the firm’s plant capacity or size of the plant is fixed.