Micro Economics for LSCM Dilla University

CHAPTER THREE
THE THEORY OF PRODUCTION AND COST
3.1 Theory of Production
To an economist production means creation of utility for sales. Alternatively, production
may be defined as the act of creating those goods/services which have exchange value for
sale (not for personal consumption). Raw materials yield less satisfaction to the consumer
by themselves. In order to get utility from raw materials, first they must be transformed
into output. However, transforming raw materials into final products require factor inputs
such as land, labor, and capital and entrepreneurial ability. Thus, no production
(transforming raw material into output) can take place without the use of inputs.
Fixed Vs variable inputs
In economics, inputs can be classified as fixed & variable.
Fixed inputs are those inputs whose quantity can not readily be changed when market
conditions indicate that an immediate change in output is required. Buildings,
machineries and managerial personnel are examples of fixed inputs because their quantity
can not be manipulated easily in short time periods.
Variable inputs, on the other hand, are those inputs whose quantity can be changed
almost instantaneously in response to desired changes in output. The best example of
variable input is unskilled labor.
Short run Vs long run
In economics, short run refers to that period of time in which the quantity of at least one
input is fixed. Thus, short run is that time period which is not sufficient to change the
quantities of all inputs, so that at least one input remains fixed. Long run is that time
period (planning horizon) which is sufficient to change the quantities of all inputs. Thus
there is no fixed input in the long -run.
3.1.1 Production in the short run: Production with one variable input
Production with one variable input (while the others are fixed) is obviously a short run
phenomenon because there is no fixed input in the long run.

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Suppose a firm that uses two inputs: Capital (which is a fixed input) and labor (which is
variable input). Given the assumptions of short run production, the firm can increase
output only by increasing the amount of labor it uses. Hence, its production function is
Q = f (L) K - being constant
Where Q is the quantity of production (Output)
L is the quantity of labor used, which is variable, and
K is the quantity of capital (which is fixed)
3.1.1.2 Short Run Total product, marginal product and average product
Total product: is the total amount of output that can be produced by efficiently utilizing
a specific combination of labor and capital during a given period of time.
Marginal Product (MP): is the change in total product (TP) due to a unit change in
labor. Thus, MPL measures the slope of the total product curve at a given point.
Q dTP
orMPL 
MPL = L dL

Average Product (AP)

The AP of an input is the ratio of total output to the number of variable inputs.
totalprodu ct TP
APL  
numberofL L

3.1.1.2 Graphing the short run production curves

Description:
 As the number of the labor hired increases (capital being fixed), the TP curve first
rises, reaches its maximum when L3 amount of labor is employed, beyond which it
tends to decline.
 The average product curve increases up to L2, beyond which it continuously declines.
 Marginal product curve increases until L1 number of labor reaches its maximum at L1,
and then it tends to fall. The MPL is zero at L3 (when the TP is maximal); beyond
which its value assumes negative indicating that each additional worker above L3
tends to create over crowded working condition and reduces the total product.

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The relationship between AP and MP of the variable input

 When MPL > APL, Slope of APL is positive (APL rises)
 When MPL = APL, Slope of APL is zero (APL is at its maximum).
 When MPL < APL, Slope of APL is negative (APL falls)
3.1.1.3 The law of diminishing marginal returns (LDMR): short –run
law of production
The LDMR states that as the use of a variable input increases, a point will eventually be
reached at which the resulting additions to output decreases. Thus, the LDMR operates:
when the number of workers increases further, some workers will inevitably become
ineffective and the MPL falls.
3.1.1.4 Efficient Region of Production in the short-run
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Three stages of production:

 Stage I – ranges from the origin to the point of equality of the APL and MPL.
 Stage II – starts from the point of equality of MPL and APL and ends at a point
where MP is equal to zero.
 Stage III – covers the range of labor over which the MPL is negative.

Now, which stage of production is efficient and preferable?

Obviously, a firm should not operate in stage III because in this stage additional units of
variable input are contributing negatively to the total product (MP of the variable input is
negative) because of over crowded working environment i.e., the fixed input is over
utilized. Stage I is also not an efficient region of production though the MP of variable
input is positive. The reason is that the variable input (the number of workers) is too
small to efficiently run the fixed input; so that the fixed input is under utilized (not
efficiently utilized)

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Thus, the efficient region of production is stage II. At this stage additional inputs are
contributing positively to the total product and MP of successive units of variable input is
declining (indicating that the fixed input is being optimally used).
Hence, the efficient region of production is over that range of employment of variable
input where the marginal product of the variable input is declining but positive (Law of
diminishing marginal returns/ Law of variable proportions).
3.1.2 Long run Production: Production with two variable inputs
Long-run is a time period where all inputs (labor and capital) are varying. Thus, the long-
run production function is given by: Q = f(L,K)
The expansion of output in the long-run can be explained by using Isoquant.
3.1.2.1 Isoquants
An isoquant is a curve that shows all possible efficient combinations of inputs (L & K)
that can yield the same level of output. When a number of isoquants are combined in a
single graph, we call the graph an isoquant map. Each isoquant represents a different
level of output and the level of out puts increases as we move up and to the right. The
following figure shows isoquants and isoquant map.

Capital

q3

2 q2
1 q1
1

1 3 6 Labor

Fig 3.2 Isoquant and isoquant map.

Properties of isoquants

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1. Isoquants slope down ward.

2. Isoquants are convex to the origin – due to declining slope
3. The further an isoquant lays away from the origin, the greater the level of output
it denotes. Higher isoquants (isoquants further from the origin) denote higher level of
outputs.
4. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
Marginal Rate of Technical Substitution (MRTS)
MRTS measures the rate at which one factor substitute the other factor with output being
held constant. Thus, it is a slope of Isoquant curve.
MRTS L, K can also be given by the ratio of marginal products of factors. That is,
K MPL
MRTS L , K  
L MPK

3.1.2.2 The long run law of production: The law of returns to scale
The laws of production describe the technically possible ways of increasing the level of
production. In the long run output can be increased by changing all factors of production.
This long run analysis of production is called Law of returns to scale.
Returns to scale refers to the changes in output as all factors change (long-run
phenomenon) by the same proportion. Returns to scale are of the following three types:
 Increasing Returns to Scale (IRS): If output increases more than proportionally
with the increase in the factors.
 Constant Returns to Scale (CRS): If output increases by the same proportion of
inputs.
 Diminishing Returns to Scale (DRS): If output increases less than
proportionally with the increase in the factors.
3.2 Theory of Costs
3.2.1 Basic Concepts
To produce goods and services, firms need factors of production or simply inputs. To
acquire these inputs, they have to buy them from resource suppliers. Cost is, therefore,
the monetary value of inputs used in production of an item.
Cost of production can be measured in two ways:

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i) Economic cost
In economics the cost of production to the individual producer includes the cost of all
inputs used for the production of the item. There are two types of economic costs of
production:
• Explicit costs (accounting costs)… include costs of raw materials purchased, wages,
salaries, taxes, rents etc
• Implicit Costs (value of non-purchased inputs owned and used by a firm in its own
production activities)
 Economic cost: Explicit cost plus Implicit cost
ii) Accounting Cost
For accountant, the cost of production includes the cost of purchased inputs only.
Accounting cost is the explicit cost of production only.
Short run vs. long run costs
Economics theory distinguishes between short run costs and long run costs. Short run
costs are the costs over a period during which some factors of production (usually capital
equipments and management) are fixed. The long- run costs are the cost over a period
long enough to permit the change of all factor of production.
3.2.2 Cost Function and Short run costs of production
Cost function shows a foundational relationship between cost of production and output
flows. That is: C = f (Q)
In the short-run some of the firm’s inputs are fixed (K), yet others can be varied (L) to
change the rate of output. Likewise, total cost of production in the short-run has two
components, the fixed cost (FC) and variable cot (VC). That is:
TC = TFC + TVC
By fixed costs, we mean a cost which doesn’t vary with the level of out put. The fixed
costs include: salaries of administrative staff, expenses for building depreciation and
repairs, the rent of building used for production, etc
All the above costs are regarded as fixed costs because whether the firm produces much
output or zero out put, these costs are unavoidable, and the firm can avoid fixed costs
only if he / she shuts down the business stops operation.

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Micro Economics for LSCM Dilla University

Variable costs, on the other hand, include all costs which directly vary with the level of
output. The variable costs include: The cost of raw materials, the cost of direct labor, the
running expenses of fixed capital such as fuel, electricity power, etc.
All these costs are regarded as variable costs because their amount depends on the level
of out put. For example, if the firm produces zero output, the variable cost is zero.
Graphical presentation of short run costs.
3.2.2.1 Total, Fixed and Variable Cost Curves
TFC is denoted by a straight line parallel to the output axis. The total cost (TC) and TVC
both have an inverse s- shape. The shape indicates the law of variable proportions in
production.

3.2.2.2 Short-run Average Costs (SAC) and Marginal Cost

Average cost is the cost per unit of output. There are three types of average costs in the
sort- run:
 Average fixed cost (AFC) =AFC = TFC /Q
 Average Variable cost (AVC) = TVC/Q
 Average Total Cost (ATC) = TC/Q = AFC + AVC
Marginal Cost is the change in short-run total cost due to a unit change in output.
Mathematically,
MC = ΔTC/ΔQ
3.2.2.3 The relationship between AVC, ATC and MC

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AC
MC

AVC

AFC

Q
Q1 Q2

i) When MC<AC, the slope of AC is negative, i.e.AC curve is decreasing (initial stage
of production)
ii) When MC >AC, the slope of AC is positive, i.e. the AC curve is increasing (after
optimal combination of fixed and variable inputs.
iii) When MC = AC, the slope of AC is zero, i.e. the AC curve is at its minimum point.
The relationship between AVC and MC can be shown in a similar fashion.
In summary, AVC, ATC and MC curves are all U-shaped due to the law of variable
proportions.
3.2.3 Long-run cost of Production and Isocost line
Long run costs are costs associated with long run production. Long run costs are analyzed
by Isocost lines.
3.2.3.1 Isocost line
An isocost line is the locus points denoting all combination of inputs that a firm can
purchase with a given monetary outlay.
Suppose the firm has C amount of cost out lay (budget) and prices of labor and capital
are w and r respectively. The equation of the firm’s isocost line is given as:
C rK  wL
Where, K and L are quantities of capital and labor respectively.
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Given the cost outlay C , the maximum amounts of capital and labor that the firm can
C C
purchase are equal to and respectively. The straight line that connects these
r w
points is the iso-cost line. See the following figure:
Capital

C/r

Iso cost
line

C/w Labor

Fig: 3.18 The Iso-cost lines

Note that: The slope of the isocost line is the negative of the ratio of prices of two
factors. That is – (w/r)!
3.3 Equilibrium of the firm: Choice of optimal combination of factors of
production
Suppose a firm having a fixed cost out lay (money budget) which is shown by its iso-cost
line. Here, the firm is in equilibrium when it produces the maximum possible output,
given the cost outlay and prices of input. The equilibrium point (economically efficient
combination) is graphically defined by the tangency of the firm’s iso-cost line (showing
the budget constraint) with the highest possible isoquant. At this point, the slope of the

w MPL
iso cost line ( ) is equal to the slope of the isoquant ( ).
r MPK

The condition of equilibrium under this case is, thus:

w MPL MPL MPK
 or 
r MPK w r

This is the first order (necessary) condition. The second order (sufficient) condition is
that isoquant must be convex to the origin.
Mathematical derivation of the equilibrium condition
The problem can be stated as:

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Maximize X  f ( L, K )..........................Objective function

Subject to C  wL  rK ..........................Constra int function

or C  wL  rK  C 0

We use the lagrangian method to solve the problem.

The lagrangian equation is written as:
  X   (C )

  
Then we find , , and and set all of them equal to zero to solve for
L K 
L and K.

That is,
  X   ( wL  rK  C )

 X MP
And,   wL 0  MPL w    L
L L w
 X MP
  r 0  MPK r    K
K K r

 wL  rK  w 0  wL  rK C

Solving these equations simultaneously, we obtain the equilibrium condition
MPL MPK w MPL
 or 
w r r MPK

The second order condition (the convexity of isoquant) would be insured when:
2
2 X 2 X  2 X   2 X   2 X 
 0 , 0 and       
L2 K 2  L
2
  K
2
  LK 

Numerical Example
Suppose the production function of a firm is given as X 0.5 L1 / 2 K 1 / 2 prices of labor
and capital are given as $ 5 and $ 10 respectively, and the firm has a constant cost out lay
of $ 600. Find the combination of labor and capital that maximizes the firm’s output and
the maximum output.
Solution
MPL MPK MPL w
The condition of equilibrium is  or 
w r MPK r

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X
MPL  0.25L 1 / 2 K 1 / 2
L
X
MPK  0.25 L1 / 2 K  1 / 2
K
Thus, the equilibrium exists when,
0.25 L 1 / 2 K  1 / 2 $5
 1/ 2  1/ 2

0.25 L K $10
K 1
  L 2 K ...................................(1)
L 2
The constraint equation is:
wL  rK C
5 L  10 K 600......................................(2)

Solving equation (1) and (2) would give us the optimal combination of L and K.
L 2 K
5 L  10 K 600
 L*=60 units and K*=30 units.
Thus, the firm should use 60 units of labor and 30 units of capital to maximize its
production (output). (Check the second order condition!).
The maximum output can be found by substituting 60 and 30 for L and K in the
production function. That is:
Q* = 0.5 (30)1/2 (60)1/2 ≈ 21 units

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