2.

1 Production Unit: A Firm

THEORY OF PRODUCTION
2
Production is defined as the process of transforming inputs into output. Inputs are also called factors
of production. Output are products derived from a production process and they are usually goods
and services. Production process is carried out by firms. A firm is defined as unit of production that
takes decision with respect to production and sale of goods and services.

A firm’s profit is the difference between the revenues it receives from selling its output and its cost
of producing that output. Algebraically; profit is defined as

π = T R −TC

The above equation tells us that what happens to profit depends on what happens to revenue and
costs. The cost of production depends on quantity and quality of factors of production that the firm
employs in the production process.

2.2 Inputs or Factors of Production

Production processes usually require a wide variety of inputs, an input being anything that the firm
uses in its production process. For example some of the inputs in corn cultivation include fertilizers,
pesticides, labor, etc. In representing and analyzing the production process, we assume that all in-
puts can be divided into two categories: fixed inputs and variable inputs. A fixed input is an input
whose quantity cannot be changed during the period of time under consideration. The firm’s plant
and equipment are examples of inputs that are often included in this category.

On the other hand a variable input is an input whose quantity can be changed during the period
under consideration. For example, the number of workers hired to perform job like construction can
often be increased or decreased on short notice. Both fixed and variable inputs are generally classified
into four groups: land, labor, capital and entrepreneurship or management.

2.2.1 Land
Land as a factor of production includes minerals, forests, water, and all other natural resources as well
as soil used in agriculture and a site upon which economic activities take place. Land as a factor of
production has three main features; it is fixed in supply; it is a gift of nature; and it varies in quality.

2
CHAPTER 2. THEORY OF PRODUCTION 3

2.2.2 Labor
Labor in its simplest term describes the human effort or other work done by human beings. Labor is
so important in production activities that some radical economists like Karl Marx and other socialist
oriented economists believe that labor is the only embodiment in production. Labor as a factor of
production can be classified into skilled and unskilled labor, as well as technicians and professionals
like engineers, doctors, lawyer etc. Labor can be more productive through training and education.

2.2.3 Capital
Capital can be defined as man - made wealth that is used in the production of goods and services. It
is defined as a “produced means of production” and it includes raw materials, machinery, buildings,
factories, tools and other manufactured inputs.

2.2.4 Entrepreneurship
It is the entrepreneur who coordinates all the factors of production by bringing them together in the
production process. It involves the use of initiatives, skills as well as the willingness and ability of the
decision-maker to take risk.

2.2.5 Production
Production in economics refers to the process of transforming inputs (such as labor, capital, land, and
raw materials) into outputs (goods and services) that can be sold in the market. The aim of production
is to create value by producing goods and services that satisfy human wants and needs.

2.3 The Production Function

The production function is the technical relationship between output and quantities of various in-
puts used per period of time. More specifically, production function for any commodity is an equa-
tion, table or graph showing the (maximum) quantity of the commodity that can be produced per unit
of time for each of a set of alternative inputs, when the best production techniques available are used.
The simplest production function for corn can be specified algebraically as follows;

Q x = f (L, K )

Where;

• Q x = is the output of x in units per time period.

• K= capital which is assumed to be fixed.

• L= labor
CHAPTER 2. THEORY OF PRODUCTION 4

2.3.1 The Short Run: Production with One Variable Input

The short run is defined to be that period of time in which some of the firm’s inputs are fixed. More
specifically, since the firm’s plant and equipment are among the most difficult inputs to change quickly,
the short run is generally understood to mean the length of time during which the firms plant and
equipment are fixed.

Short run is that period of time over which the input of at least one factor of production cannot be
varied.

Assumption

Assumption 1: Only one input is variable: Labor

In the short run, firms face constraints on their ability to change inputs. While capital is considered a
fixed input during this period, labor is typically the variable input. This means that firms can adjust
the amount of labor they employ to respond to changes in output demand or other factors affecting
production.

For example, a factory may be able to hire more workers or reduce the number of working hours for
existing employees in response to fluctuations in demand for its products. However, it cannot easily
expand or reduce its physical capital, such as machinery and equipment, in the short run.

Assumption 2: Perfect divisibility of inputs and outputs

This assumption implies that inputs and outputs can be divided into very small increments without
incurring significant costs or inefficiencies. In reality, however, inputs like labor and capital may not
be perfectly divisible. For instance, hiring an additional worker may require providing equipment and
workspace, which might not be possible in small increments. Similarly, increasing capital may involve
purchasing costly machinery or expanding facilities, which may not be feasible in small, perfectly di-
visible units.

Nonetheless, this assumption is often made in economic models for analytical simplicity and to focus
on the core relationships between inputs and outputs.

Assumption 3: Limited substitution between inputs

In the short run, firms often face limitations on their ability to substitute one input for another. For
example, if a firm experiences an increase in demand for its products and wants to increase output,
it may primarily rely on hiring additional labor rather than investing in more capital. This is because
adjusting capital inputs, such as purchasing new machinery or expanding facilities, takes time and
resources that may not be available in the short run.

However, the degree of substitutability between inputs may vary across industries and firms. Some
CHAPTER 2. THEORY OF PRODUCTION 5
industries may have more flexibility to substitute between labor and capital inputs than others, de-
pending on factors such as the nature of production technology, labor market conditions, and capital
intensity.

Assumption 4: Constant technology

This assumption implies that the firm’s production technology remains unchanged during the short
run. In other words, the firm cannot adopt new production techniques or technologies in response to
changes in input prices or output demand.

While technological change is a pervasive feature of modern economies, the short-run assumption
of constant technology allows economists to isolate the effects of changes in input quantities on out-
put levels without complicating the analysis with changes in production methods. However, in reality,
firms often innovate and adopt new technologies over time, which can influence their production pro-
cesses and efficiency.

Production function is an important starting point in the analysis of theory of the firm. But we need
to know more about the average and marginal product of labour. The average product of labor (APL)
is defined as total product (TP) divided by the number of units of labor used. Algebraically, it can be
expressed as:
TP
AP L = (2.1)
L
Where; APL is the average product of labor; TP is the total product and L is the labor. The marginal
product of labor (MPL) is given by the change in TP per unit change in the quantity of labor used.
Algebraically, it can be expressed as:
∆T P
M PL = (2.2)
∆L
Where; ∆T P is the change in the total product and ∆L is the change in labor input. The shapes of
the APL and MPL curves are determined by the shape of the corresponding TP curve. The APL at any
point on the TPL curve is given by the slope of the line from the origin to that point on the TPL curve.

the MPL curve also rises at first, reaches a maximum (before the APL reaches its maximum) and then
declines. The MPL becomes zero when the TP reaches maximum and it becomes negatives as TP falls.
The falling portion of the MPL curve illustrates the law of diminishing returns.

The law of diminishing marginal returns states that, as additional units of a variable
factor are added to a given quantity of fixed factors, with a given state of technology, the
marginal product of the variable factor will eventually decline.

Several things should be noted about this law. First, it assumes that technology remains fixed. The
law of diminishing marginal returns cannot predict the effect of an additional unit of input when
technology is allowed to change. Second, it is assumed that there is at least one input whose quantity
is being held constant. The law of diminishing marginal returns does not apply to cases where there
is a proportional increase in all inputs.
CHAPTER 2. THEORY OF PRODUCTION 6

2.3.2 Three Stages of Production

Stage I goes from the origin to the point where the APL is maximum. Stage II goes from the point
where the APL is maximum to the point where the MPL is zero. Stage III covers the range over which
the MPL is negative. The producer will not operate in Stage III, even with free labor, because he could
increase total output by using less labor in one acre of land. Similarly, the producer will not operate in
stage I because average product of labor is still increasing as a result of utilization of variable input. In
stage I, an increase in variable input result in larger and larger increases in total output. Thus the firm
will try to operate in stage II, which is defined to include the range of utilization of the variable input
from the point at which the average product of the variable input is a maximum to the point at which
the marginal product is zero. In stage II, the marginal product of both inputs is positive.

Output

Total Product

Stage II
Stage I Stage III
Maximum MP

Maximum AP (MP=AP)

MP=0
Average product
Labour

Marginal Product

Exercise
Exercise 1. The short run production function of ABC company is represented by the following equa-
tion:
Q = 6L 2 − 0.2L 3
. Where L denotes the number of workers.

1. Determine the size of the workforce which maximizes output (Hint: where MPL=0)

2. Determine the size of the workforce, which maximizes the average product of labour.
CHAPTER 2. THEORY OF PRODUCTION 7
3. Compute MPL and APL at this value of workforce at AP L is maximum ?

2.4 The Long Run: Production with Two Variable Inputs

Long run is defined as that period of time in which all factors of productions are variable. Firms
wishing to maximize their profits, therefore, will attempt to produce their chosen output by employing
combinations of capital and labor which minimizes their production costs. We can illustrate this cost-
minimization graphically with the use of isoquant and isocost lines. These also enable us to trace the
path along which a firm can expand in the long-run.

2.4.1 Isoquant
An isoquant shows the different combinations of labor (L) and capital (K) with which a firm can pro-
duce a specific quantity of output. A higher isoquant such as Q2 in following figure indicates greater
quantity of output and a lower one such as Q1, indicates smaller quantity of output. In the Figure
, point B on the isoquant labeled Q1, represents just one possible combination of capital and labor
(0K1 units of capital and 0L1units of labor) with which a firm can produce Q1units of output. There
are in fact an infinite number of other points on the isoquant Q1 all of which represent different com-
binations of capital and labor which can be used to produce output Q1. An output of Q2 units bigger
than Q1 can be produced using any of the combinations of capital and labor represented by points
along the isoquant labeled Q2, such as point D and E.
CHAPTER 2. THEORY OF PRODUCTION 8

2.4.2 Properties of Isoquants

Isoquants have three important properties. First, isoquant can never intersect. the Figure , shows two
intersecting isoquants, Q1 and Q2. As drawn, point A represents a combination of capital and labor
which, when used efficiently, can apparently produce two different quantities of Q1and Q2. This ab-
surd result confirms the statement that two isoquants can never intersect. Secondly, isoquants are

Figure 2.1: Intersecting Isoquant Curve

negatively sloped. If both capital and labor have positive marginal products (so that the employment
of extra units increases total output), then it follows that to maintain a given level of output when
the quantity of one of factors is reduced, the quantity of other must be increased. Thirdly, isoquants
are convex to the origin. As units of capital are given up, successively bigger quantities of labor must
be employed to keep the output level unchanged. This makes the isoquants convex to the origin
as shown in Figure above. Note that the slope of isoquant is called the Marginal Rate of Technical
Substitution. The Figure shows that the movement from point A to point B requires more K to be
sacrificed. However, the movement from point B to point C requires less of K to be sacrificed, i.e.
∆K > ∆K ∗.

The marginal rate of technical substitution of labor (L) for capital (K), (i.e., MRTSLK) refers to the
amount of capital that firm can give up by increasing the amount of labor by one unit and still remain
on the same isoquant. The MRTSLK is also equal to the ratio of marginal product of labor (MPL) to the
marginal product of capital (MPK) or MPL /MPK. As the firm moves down an isoquant the MRTSLK
CHAPTER 2. THEORY OF PRODUCTION 9

Figure 2.2: Convex Isoquant Curve

diminishes.
MPL
M RT S LK = (2.3)
MPK

2.4.3 Isocost lines

An isocost line is defined as the locus of points that join all the combination of factors of production
such as capital and labor that can be bought for a given monetary outlay. Algebraically, the isocost is
as follows:

C = P L (L) + P K (K ) (2.4)

Where;

• C is Total outlay

• PL is price of labour (wage rate)

• PK is price of capital (rental rate of capital),

• L is labour and K is capital

C PL L
K= − (2.5)
Pk PK
CHAPTER 2. THEORY OF PRODUCTION 10
dK PL
Slope = =−
dL PK

Figure 2.3: Isocost line

2.4.4 Producer Equilibrium

A producer’s equilibrium occurs where an isoquant is tangent to the isocost. At the point of tangency,
the absolute slope of the isoquant is equal to the absolute slope of the isocost. That is, at equilibrium,
MRTSLK = PL/PK (This is completely analogous to the concept of consumer equilibrium in lecture
seven) Since MRTSLK = MPL/MPK at equilibrium

MPL PL
= (2.6)
M P K PK

Where; MPL denotes the marginal product of labor, MPK denotes the marginal product of capital, PL
denotes the price of labor and PK denotes the price of capital. Equation 9.9 tells us that at equilibrium,
the marginal product of the last money spent on labor is the same as last money spent on capital. The
same would be true for other factors, if the firm had more than two factors of production.

Figure 2.4: producer’s equilibrium

CHAPTER 2. THEORY OF PRODUCTION 11

Exercise
Exercise 2. Assume that the production function for ABC product is given by Q = 100K L. What is the
minimum cost of producing 1000 pairs of shoes if the price of capital and labor per day are Birr 120 and
30 respectively?

Exercise 3. Given the production function and price of labour and price of capital

q = 10K 0.7 L 0.3 , P K = 28, P L = 10, and Bud g et = 4000

Compute optimal values of L and K?

2.5 Expansion Path

The firm’s expansion path is defined as the locus of points of tangency between isoquant and isocost
line. If the firm changes its total outlay while the prices of labor and capital remain constant, firm’s
isocost shifts parallel to itself up and to the right if total outlay is increased or down and to the left if
total outlay is decreased. These different isocosts will be tangent to different isoquants, thus defining
different equilibrium points for the producer.

Figure 2.5: firm’s expansion path

2.6 Effect of Change in Input Prices on Output

The analysis of the effects of changes in input prices on output proceeds along exactly the same lines
as the analysis of the effects of changes in the prices of goods in consumer theory. If one of the price of
input, say PL (i.e., price of labor) falls while the price of other input (i.e., capital) and the isocost remain
constant, then we can separate the effect of a price change into two components. The first component
is the substitution effect. This is movement along the original isoquant. The second component is the
scale effect. This is a movement to the higher isoquant. The Figure show that a fall in the price of
labor pivots the isocost line from TO/PK1, TO/PL1 to TO/PK1, TO/PL1*. Substitution effect shows
that following a fall in the price of labor, a firm moves along an isoquant from E1 to E2. It is evident
CHAPTER 2. THEORY OF PRODUCTION 12

Figure 2.6: Substitution and Scale Effect

that a firm now hires more unit of labor than before (i.e., 0L2>0L1). This result is obtained by drawing
a parallel isocost (i.e., TO/PK2, TO/PL2), which is just below the new isocost TO/PK1, TO/PL1*. The
scale effect on the other hand shows that a firm would employ both labor and capital where the new
isocost TO/PK1, TO/PL1* is tangent to the new isoquant (i.e. Q2). Thus, the movement from E2 to E3
is called the scale effect. The total effect is denoted by movement from E1 to E3.

2.7 Returns to Scale and Homogeneity

The concept of returns to scale is used to describe the size of the increase in output when all inputs are
increased by the same proportional rate. Return to scale may be constant, decreasing or increasing.
Let us have a look on each of these.

2.7.1 Constant Returns to Scale

Constant returns to scale arise when a proportionate increase in output is matched exactly by an equal
proportionate increase in inputs. For example, if a company doubles all its inputs—labor, capital, and
raw materials—its output will also double. This implies that the firm’s production function exhibits a
linear relationship between inputs and output.

In practical terms, constant returns to scale suggest that the firm is operating at an optimal size, where
scaling up or down does not affect its efficiency. This situation can occur in industries where tech-
nology and production processes are well understood and standardized, allowing firms to expand
without significant changes in per-unit costs. It reflects a scenario where there are no significant
economies or diseconomies of scale.
CHAPTER 2. THEORY OF PRODUCTION 13

2.7.2 Decreasing Returns to Scale

Decreasing returns to scale arise when a proportionate increase in output is less than the proportion-
ate increase in inputs. For instance, if a firm doubles its inputs but finds that its output less than
doubles, it is experiencing decreasing returns to scale.

This phenomenon often occurs due to inefficiencies that arise as the scale of production increases.
These inefficiencies can stem from factors such as increased complexity in management, difficulties
in coordination, and potential resource constraints. As a firm grows, it might face challenges like
overcrowded production facilities or a diluted managerial effectiveness, leading to lower marginal
productivity of inputs. This scenario is indicative of diseconomies of scale, where the cost per unit of
output increases as the scale of production expands.

2.7.3 Increasing Returns to Scale

Increasing returns to scale arise when the proportionate increase in output exceeds the proportionate
increase in inputs. For example, if a firm doubles its inputs but finds that its output more than dou-
bles, it is experiencing increasing returns to scale.

This situation often occurs due to efficiencies gained through larger scale production, such as spe-
cialization of labor, better utilization of capital, and technological advancements. Increasing returns
to scale are typically associated with economies of scale, where the cost per unit of output decreases
as the scale of production increases. This can be seen in industries with high fixed costs but low
marginal costs, such as manufacturing and technology sectors, where spreading the fixed costs over a
larger output reduces the average cost per unit.

2.7.4 Homogeneous production function

In addition to returns to scale, the concept of homogeneity in production functions is essential. A
production function is said to be homogeneous of degree n if, when all inputs are scaled by a factor
t , the output is scaled by t n . For example, if a production function f (K , L) is homogeneous of degree
1, it means that doubling both capital (K ) and labor (L) will double the output, indicating constant
returns to scale.

Homogeneity helps in understanding how changes in scale affect output and allows for the simpli-
fication of production analysis. It provides a framework for analyzing production processes and for
understanding how firms can adjust their input combinations to achieve desired output levels effi-
ciently. Homogeneous production functions are often used in economic modeling to derive implica-
tions about firm behavior, cost structures, and the impact of scaling on productivity.

The concept of returns to scale is closely related to the concept of homogeneity in the neo-classical
production function. One of the most commonly used production functions in applied economics
work is the Cobb-Douglass production function, put forth by Cobb and Douglass in 1928. In its sim-
plest form, Cobb-Douglass production function can be written as:

Q = AK α L β (2.7)
CHAPTER 2. THEORY OF PRODUCTION 14
Where: Q=output; A=Constant; L=Labour; and K =Capital. The coefficients α and β can be interpreted
as the elasticities of output with respect to the labour and capital inputs respectively. The important
feature of Cobb-Douglass production function is that (α + β) measures returns to scale. For example,
suppose we double L and K by λ. Then the new output Q is given by

Q = A(λK )α (λL)β (2.8)

³ ´
Q = λα+β AK α L β (2.9)

The production function Q = AK α L β is said to be homogeneous of degree (α+β), if given any positive
A, doubling inputs by λ, raises output by λα+β . When

1. α + β > 1,the function exhibits increasing returns,

2. α + β < 1, decreasing returns

3. α + β =1, it is homogeneous of degree 1, and it exhibits constant returns.

Exercise 4. Show the degree of homogeneity of the following function

Q = 0.9K 0.2 L 0.6

 The Theory of Cost
3
The theory of cost is a fundamental concept in economics that examines how firms make production
decisions and incur costs in order to produce goods and services. It’s closely related to the theory of
production and the theory of the firm. Here’s an overview of the key components of the theory of cost.

3.1 Accounting Cost versus Economic Cost

Accountants define cost in terms of resources consumed. Accounting costs reflect changes in stocks
over a fixed period of time. Accounting cost measures are used in the evaluation of managerial per-
formance and as a basis for economic cost estimation. Hence, from an accountant’s standpoint, costs
are objective and retrospective in the sense that accountants have to keep the track of assets and lia-
bilities in order to evaluate past performance.

Economists define cost in terms of opportunities that are sacrificed when a choice is made. Hence,
economic costs are defined in terms of opportunity costs—the cost associated with opportunities
that are foregone by not putting the firm’s resources to their best use. Economic costs are subjective
as seen from the perspective of a decision maker not a detached observer. Moreover, economic costs
are prospective in the sense that economists are concerned with what costs are expected to be in the
future, and with how the firm might be able to lower its costs and improve its profitability. Economic
cost estimates are used for making decisions about pricing, output levels, buying or making, alterna-
tive marketing tactics/strategies, product introductions, etc.

However, both accountants and economists include explicit costs, in their calculations. Explicit costs
refers to contractual payments made by the firms to factor owners in the process of acquiring inputs
required in production or provision of services. These includes among others, wages and salaries,
payments for raw materials, payment for utilities, rent, taxes, and interest rate. Economists are thus
concerned with both explicit and implicit costs (i.e., opportunity cost).

3.2 Private and Social Cost

Private cost of producing a particular commodity is the cost paid by the firm in the processing of pro-
ducing and selling that commodity/service. These costs can also be described as the costs internal
to the firm’s production function. However, quite often, a firm may in the course of production pro-
cess imposes costs on society in the form of externalities. An externality is a cost or benefit from an

15
CHAPTER 3. THE THEORY OF COST 16
economic transaction that parties "external" to the transaction bear. Externalities can be either posi-
tive, when an external benefit is generated, or negative, when an external cost is imposed upon others.

Social cost of producing a commodity is equal to the private cost of producing it plus the cost to other
people. It is the cost of production borne by all members of the society at large when a commodity is
produced. A good example of social cost is that of a cement factory polluting air in the neighboring
townships, which harms human health. Thus, social costs are the private costs of resources that the
firm uses plus any additional costs imposed on society by the firm’ s operation.

3.3 Costs in the Short Run

3.3.1 Total Cost (TC)

Total cost refers to the sum of all expenses incurred by a firm in the production process. It includes
both explicit costs, which are monetary payments for inputs such as labor, capital, and raw materials,
and implicit costs, which are the opportunity costs of using resources owned by the firm.

3.3.2 Fixed Costs (FC)

Fixed costs are expenses that do not vary with the level of output in the short run. These costs are
incurred regardless of whether the firm produces anything. Examples of fixed costs include rent for a
factory, insurance premiums, and salaries of permanent staff. Since fixed costs remain constant, the
average fixed cost (AFC) decreases as output increases.

3.3.3 Variable Costs (VC)

Variable costs are expenses that change with the level of output. They include costs such as labor
wages, raw materials, and electricity used in production. Variable costs typically increase as output
increases. The average variable cost (AVC) and marginal cost (MC) are important concepts related to
variable costs.

3.3.4 Average Total Cost (ATC)

Average total cost represents the total cost per unit of output and is calculated by dividing total cost
by the quantity of output produced. It is the sum of average fixed cost and average variable cost. ATC
reflects the efficiency of production and includes both fixed and variable costs.

3.3.5 Average Fixed Cost (AFC)

Average fixed cost is calculated by dividing total fixed cost by the quantity of output produced. Since
fixed costs remain constant, AFC decreases as output increases. AFC approaches zero as output in-
creases indefinitely.
CHAPTER 3. THE THEORY OF COST 17
Per Marginal Cost
unit
Average Total Cost (AC)
Cost
Average Variable Cost (AVC)

Average Fixed Cost

Output

3.3.6 Average Variable Cost (AVC)

Average variable cost is calculated by dividing total variable cost by the quantity of output produced.
AVC typically decreases initially due to economies of scale but eventually increases as output expands
due to diminishing returns to the variable input.

3.3.7 Marginal Cost (MC)

Marginal cost represents the additional cost incurred by producing one more unit of output. It is
calculated as the change in total cost divided by the change in quantity of output. MC reflects the
cost of increasing production and is crucial for profit-maximizing decisions by firms. In competitive
markets, firms aim to produce where marginal cost equals marginal revenue to maximize profit.

3.3.8 The Relationship between Marginal Cost and Marginal Product

The shape of the marginal cost (MC) curve is related to the behavior of the marginal product curve,
which we discussed in lecture nine. If at low levels of output a firm benefits from increasing marginal
returns to the variable factor (that is increasing MP), MC will be declining. MC reaches a minimum at
the level of output at which the MP is at maximum. When the firm encounters diminishing marginal
returns, so that MP is falling, MC begins to rise. Whenever there is a fixed factor, so that the law of
diminishing returns comes into operation, the MC will eventually start to rise. The MC curve cuts the
AVC and ATC curves at their minimum for arithmetical reasons, similar to those, which meant that
the MP curve cut the AP curve at its maximum. We can also present the same results algebraically. We
know that when labor is the only variable input, TVC equals price of labor times the number of units
of labor used. That is; Let TVC =wL, where w= given wage rate & L =labour input
CHAPTER 3. THE THEORY OF COST 18

Figure 3.1: Relationship between Cost and Product Curves

WL W W
AV C = = =
Q Q/L AP L

∆W L ∆L W W
MC = =W = =
∆Q ∆Q ∆Q/∆L M P L

3.4 The Long-Run Average Total Cost Curve

The long-run cost function represents the minimum cost at which a given level of output can be pro-
duced when all factors of production are variable. Unlike the short run, where at least one input is
fixed, the long run allows firms to adjust all inputs to find the most cost-efficient combination.

Characteristics:
• All Inputs Variable: In the long run, firms can adjust the quantities of all inputs, such as labor,
capital, and raw materials. This flexibility allows firms to choose the optimal production scale.

• Economies of Scale: The long-run cost function often exhibits economies of scale, where in-
creasing the scale of production leads to a lower average cost per unit. This happens due to
factors like specialization, bulk purchasing, and more efficient use of capital.
CHAPTER 3. THE THEORY OF COST 19
• Diseconomies of Scale: Beyond a certain point, firms may experience diseconomies of scale,
where increasing the scale of production raises the average cost per unit. This can occur due to
factors like management inefficiencies, increased complexity, and resource constraints.

Shape of the Long-Run Average Cost (LRAC) Curve: The LRAC curve is typically U-shaped due to
economies and diseconomies of scale. Initially, costs decrease with increased production, reach a
minimum point, and then start to increase as diseconomies of scale set in.

The Long run Average Total Cost (LRATC) is illustrated in Figure 3.2. It indicates the minimum possi-
ble average cost of production for each level of output, given that the plant of the appropriate capacity
has been constructed. Figure 3.2 shows that as the firm changes its level of output with the plant ap-
propriate for minimum long run average cost of production at output OQ1, it moves along SRAC1, at
output OQ2 it moves along SRAC2 and so on. In fact, at every point of tangent on the LRAC, there is
an SRAC curve. Since each SRAC curve lies above the LRAC curve except at the point at which it is at a
tangent, the LRAC curve is sometimes called and envelope curve.

Figure 3.2: Long Run Average Total Cost