THE THEORY OF PRODUCTION

 Whatever the objective of the firm, achieving optimum efficiency in production or minimizing
cost of production is one of the prime concerns of management today. Indeed, the survival of
any given firm is dependent on its ability to produce its output at a competitive cost.
 The theory of production is concerned with the problem of combining various factor inputs, given
the state of technology in order to produce a stipulated output at a minimum cost. The theory
therefore consists mainly of an analysis of how firms given the level of technology, chooses and
combines various inputs to produce a given level of output with a view of maximizing profits
 This theory mainly focuses on the following key issues;
 How factors of production are combined in order to produce given levels of output
 Costs of production
 Theory of the firm

Relevance of the Theory of Production

There are four important areas in which the theory of production is relevant as follows:
1. Price theory
- Theory of production provide a basis of the analysis of the relation between costs and
quantities of inputs.
- Prices of inputs influences the cost of production and thus play a crucial role in determining
of prices of outputs.
2. Theory of firm
- The theory of firm is primarily concerned with determination of the level of output which
would result in profit maximization.
- The concept of marginal cost and average cost are critical in determination of profit
maximizing output.
- Changes in marginal cost and average cost triggered by increase in the level of output are
determined by physical relationship between inputs and outputs (theory of production),
besides the prices of factors of production.
3. Demand for factors of production
- Theory of production explains the forces that determine the marginal productivity of the
factors of production which in turn determines the demand for factors of production.

Page 1 of 28
 - Demand for factors of production is one of the fundamental forces that determines the prices
of inputs and therefore cost of production.
4. Theory of distribution
- The theory of production is used in determination of the aggregate distributive share of the
various factors of production.
- It is always important to know the proportion of wage, rent or profit in the national income.
- The proportion of wage, rent or profit in the national income can be worked out only when
the demand for the various factors of production and their respective prices are known.
What is production?
 Production refers to the process used by firms to create various goods and services that have
value either to the consumer or other producers. Essentially production facilitates transformation
of firm’s inputs into outputs.
 Managers/decision makers are primarily concerned with achieving optimum efficiency in
production or minimizing the overall costs of production.
 The composition of the total output can be classified into consumer goods and producer goods and
services.
i) Consumer goods - are commodities that satisfy human needs directly .They can be:
a) Durable consumers’ goods provide a steady stream of satisfaction and their value
diminishes slowly through age and usage.
b) Non- durable consumer goods are consumed and destroyed in the very act of being
used e.g. Food, juice, cigarettes.
ii) Producer goods- are commodities that do not directly satisfy human wants but they are used
for the contribution they make to the production of other goods. Example: factories,
buildings etc.
 Services- are intangible economic goods e.g. Banking, transport, tourism and
administration. Services are non-transferable i.e. they cannot be purchased and then
resold at a different price.
 Production can be categorized into three:
a) Extractive industries; examples are farming, fishing and forestry. Primary products result
from such industries
b) Manufacturing industries; these include engineering, vehicle manufacture, chemical

Page 2 of 28
 and food processing.
c) Distribution industries; these incorporate the activities of wholesaling and retailing.
 Firms production decisions are classified into wo categories;
(i) Decisions relating to inputs or factors of production
(ii) Decisions relating to output
 The main production decisions of a firm are;
(i) Plant location
(ii) Budget for acquiring factors of production
(iii) Allocation of finances among different factors of production
(iv) Allocation of input factors for desired level of output
(v) Nature and extent of output.
 In their effort to minimize the cost of production managers are faced with the following key
issues
 The functional relationships between firm’s inputs and outputs
 Determination of least cost factor combination
 The effects of substitution of one factor for the other on the cost of production
 Factors giving rise to the economies of scale or diseconomies of scale
 The rate of returns when the scale of production varies
 Optimal size operation and capacity utilization
 The theory of production attempts to deal with the above critical issues through the analysis
of;
 Production function
 Laws of production
 Least cost factor combination
Production Function
 The production function refers to the;
- Technical relationship between the quantity of good produced (output) and the factors of
production (input) required to produce such output.
- Functional relationship between the quantity of good produced (output) and the factors of
production (inputs) necessary to produce it.
 For simplicity, assume that all inputs or factors of production can be grouped into two broad

Page 3 of 28
 inputs ie labour (L) and capital (K)
 The relationship between an input and output may be mathematically represented as follows;
Q = f (K, L)
Where; Q= Output
L=Labour
K=Capital

Factors Affecting the Production Function

 Quantities of resources used in production
 State of technology
 Relative prices of factors of production
 Possible technological processes
 Size of the firm
 Combination of factors of production

The Managerial Functions of the production Function

a) Provides the knowledge of the inputs used in producing given levels of output
b) Explains how maximum quantities of output can be produced from minimum quantities of
input
c) Clearly states how much of the inputs are required to produce a given level of output
d) Determines whether additional inputs are necessary as long as Marginal revenue productivity
is equal to price
e) Used in long-run decisions on input engagement and their substitutability

BASIC CONCEPTS
a) Fixed Costs (FC)
 These are costs that do not change as output varies.
 They are associated with fixed factors of production and include; rent rates, insurance,
interest on loans and depreciation.
 Fixed costs are also referred to as overhead costs or unavoidable costs.

Page 4 of 28
b) Variable Costs (VC)
 These are costs that vary with changes in output; eg wage, costs of raw materials, fuel
and power.
 Variable costs are also known as direct costs or prime costs.
c) Total Cost (TC)
 Total cost is the minimum economic cost of producing some quantity of output which is
comprises of:
 Fixed and variable cost in the short-run
Total Cost = Fixed Cost +Variable Cost
 Variable cost only in the long-run
Total Cost = Variable Cost
d) Average product (AP)
 Refers to the output per unit of the variable factors
AP = Total product (TP)
Number unit of variable factors
 E.g. the average product of workers and capital are given by:
APL = TP and APK = TP
L K
e) Marginal products (MP)
 This is the change in total product brought about by employment of an extra unit of the
variable factor
 It measures the change of production/level of output arising from a unit change in the variable
factor of production.
 Illustration;
 Marginal product of labor
MPL = Change in total product
Change in labor
MPL = ∆TP …….. In discrete terms
∆L
𝑑𝑄
MPL = ………in continuous terms
𝑑𝐿

Page 5 of 28
  Marginal product of capital
MPK = Change in total product
Change in Capital
MPK = ∆TP …….. In discrete terms
∆K
𝑑𝑄
MPK = ………in continuous terms
𝑑𝐾

Note:
 Graphically, marginal product is the slope of the production function.

SHORT-RUN
 The short run is the period of time within which one or more factors of production cannot be varied
whereas other factors varies with level of output. e.g. Capital is fixed but labor is variable.
 In the short run, production can be varied only by changing the variable input
 Any input whose quantity can be freely adjusted is a variable input, however, an input whose quantity
cannot be freely adjusted is a fixed input.
 In the short-run the firm can employ an unlimited quantity of the variable factor against a given
quantity of the fixed factor.
 Therefore, in the short-run, the production function is characterized by both fixed and variable factors
of production. This kind of input combination leads to variations in factor proportions.
 In the short run it is not possible to change the scale of production.
 Supposing;
 A firm produces output according to the production function Q = f (K, L)
 In the short run, the amount of capital cannot be varied (fixed input) – assume it is fixed at
K0.
- This implies that Q = f (K0, L) and thus, the total cost for this firm is equivalent;
TC = FC +VC

Page 6 of 28
 f (K0, L)
Q

Law of Variable Proportions

 When one input is variable and all the other inputs are fixed, the production function of the firm
exhibits the law of variable proportions.
 The law of variable proportion is also referred to as law of diminishing returns or law of non-
proportional output
 The law of variable proportions states that “ceteris paribus, as additional unit of a variable
factor are added to a given quantity of a fixed factor, total output will initially increase at
an increasing rate, but beyond a certain level of output, it will increase at a decreasing rate
and eventually decline.

TP
Stage I Stage II Stage III
APL

MPL
TP

APL

L
MPL

Page 7 of 28
Stage 1
 There is increasing returns to the variable factors since the total product is increasing at
an increasing rate. Furthermore, marginal product increases with increase in the variable
factor. This phase is thus referred to as stage of increasing returns.
 The marginal product and average product are increasing in such a way that the marginal
product is higher than average product at any given point.
 This stage is characterized by increasing efficiency with increase in the use of the variable
factor of production because the fixed factor is still under-utilized and there is greater scope
of specialization. In essence, the fixed factor of production has not been fully utilized by the
variable factor and as such has some idle capacity.
 Given that the marginal product increases with increase in the variable factor, the firm should
employ more units of the variable factor to efficiently utilize the fixed factors.

Stage 2
 The total product increases but at a diminishing/decreasing rate. Furthermore, marginal
product decreases with increase in the variable factor while remaining positive.
 This stage represents a decreasing return to the variable factor in that the total
product is increasing at a decreasing rate and is therefore referred to as the stage of
diminishing returns.
 The marginal product and the average product are declining in such a way that the average
product is higher than the marginal product.
 In this stage the fixed factor of production has been fully utilized by the variable factor. As
such there is no idle capacity in the fixed factor.
 This stage is the most appropriate stage of operation for rational production

Stage 3
 The total product starts decreasing with increase in the variable factor. Furthermore, marginal
product continues decreasing with increase in the variable factor but attains a negative value.
This phase is therefore referred to as the stage of negative returns as it represents the stage of
negative return of the variable factors.
 It represents a stage of extreme inefficiency where the excess capacity in the variable factor
causes the factors of production to get into each other’s way.

Page 8 of 28
A hypothetical case of the law of variable proportions

Capital Labour Total Average Marginal Production Stage

Product Product Product
20 0 0 0 -
20 1 10 10 10 Increasing Returns
20 2 24 12 14
20 3 39 13 15
20 4 52 13 13
20 5 60 12 8
20 6 66 11 6 Decreasing Returns
20 7 70 10 4
20 8 72 9 2
20 9 72 8 0
20 10 70 7 -2
20 11 66 6 -4 Negative Returns
20 12 60 5 -6

Numerical Illustration
The data set below reveals the characteristic behavior of the quantity of output for different levels of
labor for a small manufacturing enterprise.
Capital 5 5 5 5 5 5 5 5 5 5 5 5
Labor 1 2 3 4 5 6 7 8 9 10 11 12
Total Output 24 72 138 216 300 384 462 528 576 600 594 552
By using the concepts of total product, average product and marginal product, discuss the implications
of the law a variable proportions using a matching graphical illustration.

Assumptions of the Law of variable proportions

a) The state of technology remains unchanged.
b) Successive units of the variable factors are equally efficient
c) Production take place in the short run where at least one factor of production is fixed.
d) There is one variable factor of production under consideration.
e) Prices of inputs are constant
f) Product is measured in physical units

Page 9 of 28
Importance of the Law of variable proportions
a) Helps in determination of the rational and irrational stages of production for a given firm
b) Enables firms to efficiently engage resources in the production process
c) Helps in evaluating demand for various resources of production

Long Run Changes in Production

 In the long run, as production expands the firm is able to adjust or vary all its factors of
production ie all factors of production are variable
 Therefore, the firm will choose the input combination which optimize output and at the same
time minimize its cost.
 This can be sufficiently illustrated through the use of;
 Isoquant
 Isocost

Isoquant
 Isoquant is a function or a curve that shows all possible combinations of factors of production that
yield the same level of output.
 The curve joins all points representing different combinations of labor and capital which a firm
can use or engage to produce the same level of output. In this case, the use of one factor of
production can be optimally substituted by the other factor without affecting the level of output.

Numerical illustration
The data set below shows the different combinations of capital and labor that can be utilized to
yield and output of 200 units.
Capital 12 8 5 3 2
Labor 1 2 3 4 5
Total Output 200 200 200 200 200
Illustrates the isoquant for this production process graphically?

Page 10 of 28
Assumption of isoquant
a) There are only two factors of production i.e. labor and capital
b) It is possible to substitute labor for capital and vice versa continuously in the production process.
c) The state of technology is constant.

K2
Q3

K1 Q2
Q1

L1 L2 L
Note: Q1 < Q2 < Q3

 The slope of the isoquant indicates how the quantity of on factor of production can be traded off
for another factor of production without affecting the level of output of the firm ie marginal rate of
technical substitution (MRTS)
 In the case illustrated above, the slope of the isoquants represent marginal rate of technical
substitution of labor for capital (MRTSLK ).
 The marginal rate of technical substitution of labor for capital is the amount of capital that a firm
can give up by increasing the amount of labor used in the production process by 1 unit so as to
maintain the same level of output. This slope is also equivalent to MPL/MPk.
 As the firm progress down a given isoquant the marginal rate of technical substitution of labor for
capital diminishes or decreases. (Make use of the above numerical illustration to demonstrate
this observation).

Page 11 of 28
Properties of Isoquants
a) Isoquants are convex to the origin
b) Isoquants cannot intersect
c) Isoquants have a negative slope
d) Isoquants do not touch or intersect the axes
e) Higher isoquants represent higher levels of production

Isocost
 Isocost is a function or a curve that shows all possible combinations of factors of production that
can be purchased for a given level of expenditure outlay and factor prices.
 The curve joins all points representing different combinations of labor and capital that a firm can
purchase given the total outlay of the firm and factor prices.
 Isocost is used alongside isoquant to determine the cost minimizing combination of factors of
production that a firm can employ in order to produce a desired level of output at an optimum
level of profit.
Assumptions
a) The firm takes the input prices as given by the market
b) There are only two inputs ie labor and capital.

K
C
PK*

*
C
PL
L
 The slope of an isocost line is given by ∆PL
∆PK
 The total cost for utilizing labor and capital will be given by

Page 12 of 28
 C = wL+rK Where w=price of labor; r=Price of capital
rK = C - wL

K = C/ r - wL/r
Slope of Isocost = w/r
Optimal Input Utilization /Least Cost Factor Combination
 For a firm to minimize the cost of production and thus achieves the optimal input utilization
point, it must do so at the point where the isocost is tangent to the isoquant

C
*
Optimal input utilization
B*
A*

L
 At point B, the firm is able to minimize cost of producing a given level of output
 At point A, the firm’s resources are underutilized. However, the firm does not have adequate
resources to produce at point C.
At point B; Slope of Isoquant = Slope of Isocost
MPL/MPK = PL/PK
MPL/PL = MPK/PK

Page 13 of 28
Expansion Path
 As the firm expands in the long run, it will continue to attempt to minimize its costs. Thus it
will focus on achieving successive optimal input utilization points for subsequent isocosts and
isoquants as shown below

K
Firm’s expansion path

C
*
B*
A*

L factor combination is called the firm’s

 The line joining the successive points of least cost
expansion path

Return to Scale
 In the long-run all factors of production are variable
 The concept of return to scale refers to the changes in input as all the factors are changed by a
given proportion ie effects of scale relationships. It’s a long-run concept of production
 In the long-run output may be increased by changing all factors by the same proportion or by
different proportions
 The term return to scale refers to the changes in output as all factors change by the sam proportion.
 There are three technical possibilities of return to scale;
a) Constant return to scale
 When all inputs are increased by a given proportion, output increases by the same
proportion.
b) Increasing return to scale
 When all inputs are increased by a given proportion, output increases more than
proportionately.
c) Deceasing return to scale
 When all inputs are increased by a given proportion, output increases less than

Page 14 of 28
 proportionately.

Factors Responsible for Increasing Returns to Scale

1. Fixed factors are indivisible and are therefore used in fixed minimum units. When more units of
the variable factor are applied on such fixed factors, production increase more than
proportionately
2. In the first stage, the fixed factors are larger in quantity than the variable factor. Moreover,
applying more units of the variable factor results in more intensive use of the fixed factor and thus
production increases rapidly
3. As production begins, the fixed factors cannot be put to maximum use due to non-availability of
sufficient units of the variable factor. Addition of more units of the variable factor provides for
division of labour and specialization leading to increased returns

The Theory of Cost

 The cost theory deals with the behavior of costs in relation to a change in output. It considers
cost-output relations such that the total cost varies with variation in output.
 It is critical to understand the concept of costs in economics since costs are critical in guiding
firms in their operations. An input multiplied together with their respective prices and added
together gives the money value of inputs i.e. the costs of production.
 The understanding of the costs of production is critical particularly when making decisions
pertaining to;
i. Locating the levels of efficiency by firms.
ii. Minimizing the costs of production.
iii. Finding optimal levels of output to be produced
iv. Pricing of output
v. Estimating the rates of returns

NOTE;
The costs of production of any product will always depend on the following factors:
i. The prices of acquiring inputs used in production.
ii. Total output produced by the firm with respect to its capacity

Page 15 of 28
 iii. Management and labor efficiency
iv. The period of production i.e. whether short-run or long run
v. Level and nature of competition
vi. Macro-economic environment
vii. Stability of production level.
viii. Plant size.

IMPORTANCE OF COST ANALYSIS BY FIRMS

i. Cost analysis forms the basis of determining the level of efficiency by firms in both
resource allocation and utilization.
ii. Costs form the basis of pricing by firms.
iii. Costs help firms in determining the level of engagement or resources.
iv. By estimating the fixed costs managers are able to set up their sales targets.
v. It’s only after establishing the firm’s profits that it is possible to calculate the profit
margin (Profits=TR-TC)
vi. Costs can enable firms to estimate the anticipated rates of returns.

COST CONTROL AND MANAGEMENT

 Cost control is the regulation of behavior of the costs of operations in the production process.
Cost control is exercised through numerous techniques, like standard costing, budgetary
control, and inventory, quality control and performance evaluation.
 Cost control involves the following steps and covers various aspects.
i. Initially a plan is set to establish budgets, standards, or estimates. These are expressed
either in physical terms or monetary terms or both. These serves as a point of comparison.
ii. The next step is to communicate the plan to the implementers.
iii. Evaluation of the performance based on the standards.

NOTE
To control costs two types of standards are established.
i. Internal standards which are used for the evaluation of intra-firm cost elements like
material, labour etc. Internal standards used includes, Budgets, and standard hosting.

Page 16 of 28
 ii. External standards are applied for comparing performance with other organizations,
using cot riots.

SOME ANALYTICAL COST CONCEPTS

a) Opportunity Cost
 Assuming that all resources are allocated and employed in production of goods and services,
increasing the production of any one product involves the sacrifice of an alternative product.
 The cost involved in producing the choice product at the expense of the competing product is the
forgone value of the alternative product.
b) Private cost
 Refers to these costs which relates to an individual producer. Private costs include both
explicit cost and implicit cost.
a) Explicit costs refer to the money that is paid out by the firm for resources bought or hired
e.g. wages, cost of raw materials, rent etc.
b) Implicit cost includes the resources owned and used by the firm’s the owner.
NOTE
 If profit is calculated on the bases of explicit and implicit cost, economic profit is obtained
 However, if profit is calculated only on basis of explicit cost, financial profit is obtained.
c) Social costs
 Refer to these costs which occur to the third party in the production process eg Health
problems associated with emissions from a factory

Assumptions
i) The firms take prices or input as determined by the market forces.
ii) Firms aim at minimizing the production cost.

Short Run Cost Function

 In the short run input levels will depend on output level that the firm wants to achieve.
 In short run not all factors will be varied. At least one must be fixed and therefore the cost
incurred on it will be fixed cost.

Page 17 of 28
 The total fixed cost will be constant regardless of the output level e.g. rent for factory building,
salaries of office staff etc.
 Variable costs are incurred by the firm for its variable input. A firm wishing to increase its output
will require large variable input thus higher variable cost.
 The variable costs of a firm will increase as the output levels increase e.g. cost of raw materials,
cost of direct labor and other direct running expenses.
VC = f (Q)
Where; VC = Variable costs
f (Q) =Function of output

 Total cost represents the sum of the fixed cost and the variable cost.

TC = VC + FC
Where; TC =Total costs
VC=Variable costs
FC = Fixed costs

Output (Q) Total Fixed Cost Total Variable Cost Total Cost
(Ksh) (Ksh) (Ksh)
0 50 0 50
1 50 20 70
2 50 30 80
3 50 35 85
4 50 45 95
5 50 65 115
6 50 110 160

TC

Costs TVC
TFC

0
Output
Page 18 of 28
 Average cost refers to cost per unit output
A C = TC
Q
Where; AC = average cost
TC = total cost
Q = total units produced

 Average fixed cost is fixed cost per unit output.

AFC = TFC
Q
Where; AFC = average fixed cost
TFC = total fixed cost
Q = total units produced
 Average variable cost is variable cost per unit output.
AVC = TVC
Q
Where; AVC = average variable cost
TVC = total variable cost
Q = total units produced
 Marginal cost is the change in the total cost as a result of a unit change in output.
MC = ∆TC
∆Q.
Where; MC = marginal cost
∆TC = change in total cost
∆Q = change in output

Output (Q) Average Fixed Cost (Ksh) Average Variable Cost (Ksh) Marginal Cost(Ksh)
1 50 20 -
2 25 15 10
3 16.7 11.7 5
4 12.5 11.3 10
5 10 13 20
6 8.3 18.3 45

Page 19 of 28
 MC
Costs
AC

AVC

AFC

Output

RELATIONSHIP BETWEEN AVERAGE COST AND MARGINAL COST

 Mathematically it can be shown that;
i) If the slope of average cost is less than zero, then the marginal cost will be less than
average cost
Slope of AC<0; MC<AC

Thus, if the cost of producing an additional unit of output (MC) is lower than the average
cost (AC), the average cost decreases as production increases.
ii) If the slope of average cost is equal to zero, then marginal cost equal average cost.
Slope of AC= 0; MC=AC
Thus, if the cost of producing an additional unit of output (MC) is equivalent to the average
cost (AC), the average cost is at its lowest point (minima)
iii) If the slope of average cost is greater than zero, then marginal cost is greater than
average cost.
Slope of AC>0; MC>AC
Thus, if the cost of producing an additional unit of output (MC) is higher than the average
cost (AC), the average cost increases as production increases.
 Since the average cost curve is U- shaped the slope of average cost becomes zero at its
minimum and hence marginal cost is equal to average cost at this point.

Page 20 of 28
Exercise
i. Given that total cost is TC = Q2+ 3Q + 2
Find;
a) Marginal cost function
d) Average total cost function
e) Average variable cost function
f) At what level of output would the firm minimize its average total cost and its average
variable cost in the short run
2. Suppose that the total cost function of a firm operating in the short run is given by
TC = Q2 + 5Q+6
Find;
i) ATC function
ii) Marginal cost function
iii) Average variable cost function
iv) Calculate the average fixed cost where Q= 3
v) What will be the value of the following at the output of 100 unit
a. Average variable cost
b. AFC
c. Marginal cost
vi) At what level of output will the firm minimize its average total cost by average variable
cost?

The Revenue Function

 Revenue is the receipt from the sales of a good or service
 Total revenue is given by the product of price and quantity sold
TR = PQ
Where; TR= Total revenue
P= Price
Q= Quantity
 Average Revenue is given by;
AR = TR
Q
Where; AR= Average revenue
TR= Total revenue
Q= quantity

Page 21 of 28
 Marginal revenue it is the increase in revenue brought about on extra unit sold.
MR = ∆TR
∆Q
Where; AR= Average revenue
TR= Total revenue
Q= quantity
Exercise
Given a demand function P = 5 - Q/4. Calculate total revenue, marginal revenue and average revenue.

Optimum Seize of a Firm

 Refers to the scale at which a firm operates most efficiently, and is thus able to achieve the
lowest unit cost of production. Therefore, the firm is operating at its lowest average cost point,
and any increase or decrease in scale would results in efficiency
 This is the level of output at which total profit is at maximum.
 It is the most efficient size of a firm when the long run average cost of a firm is at minimum.
 At this point there will be no motive for further expansion since at any other size large or smaller
the firm will be less efficient.
 This is also attained when the firm cost of production is at its minimum level as illustrated below

Cost/Revenue B TC
A
C

B TR

0 L N
M
Output

 Between OL total cost exceeds total revenue and hence the firm is making loss.

Page 22 of 28
  At the points A and C, neither profit nor loss are being made and hence its breakeven
point (BEP) since total revenue is equal to the total cost.
 Maximum profit lies where the difference between total revenue and total cost is greatest
ie BB is the largest vertical distance.

Conditions for Profit Maximization

 For profit maximization the following two conditions must be met;
i) The necessary condition
 Profit can only be maximized at the level of output where marginal revenue is equivalent
marginal cost
 Thus; Marginal Revenue = Marginal Cost
However, at the point where marginal revenue and marginal cost are equal, the firm
has either maximized or minimized total profit
Recall that; π= TR - TC
d π = d (TR – TC) = 0
dQ dQ
d TR = d TC
dQ dQ
ii)The sufficient condition
 It is profitable to increase production, whenever MR > MC.
 On the contrary, it is profitable to decrease production whenever MR < MC.
 This implies that profit is maximized at the level of output where the marginal cost curve
intersects the marginal revenue curve from below.

MC

AC

AR, MR

Page 23 of 28
 d2 π = d2 (TR – TC) < 0
d2Q2 d2Q2

Exercise

1. Trusts enterprises is a medium sized firm which specializes in production of water taps
The finance department has determined the following cost structure per unit of a tap produced.

a) Variables cost per unit 15/=

b) The fixed cost period is 20/=
c) Selling price for tap is 2 5/=

Required:

i) Deriver the total cost function and re venue function

ii) Determine the break win point.
iii) The number of taps that would give a profit of 4/=
iv) If for some reason the price of taps increases to 3 5/= per tap. What will be the
breakeven output?
2. The total cost equation in the production of beckon at a certain factory is given as follows
C= 1000 + 1000-25Q2+ Q3, Where C = cost in Shs. and Q = quality in Kg.
Required:
i) Compute the total and average cost at the output of 1 0kg and 11kg.
ii) What is the marginal cost of the 12th kg?
iii) Explain the slope and relationship between the average cost, average variable cost,
marginal cost and fixed cost curve using relevant diagrams

Page 24 of 28
 Economies of Scale
 In the long run, all the input into production processes are variable so the problems
associated with diminishing returns to the variable factors do not arise.
 The law of diminishing returns therefore only applies to short run costs and not on long run
costs.
 This implies that whereas short term decisions are concerned with diminishing returns
given fixed factors of production, long run output decisions are concerned with
economies of scale which are based on assumptions that all factor inputs are variable.
 Economies of scale are aspects of increasing size which lead to falling long run average
costs.
 Economies of scale assist in explanation of trend towards large production units in some
industries.
 Economies of scale are the advantages that arise due to expansion in scale. There are two
categories;
a) Internal economies of scale
b) External economies of scale

Internal Economies of Scale

 These are factors which reduce average cost as the scale of production of individual firm
increases.
 Internal economies of scale is attributed to the activities within the firm hence the economics are
brought about by various source which include:
i) Marketing economies of scale consists of all the advantages a firm acquires as they approach the
market such as
a) Buying advantage
 Large firms enjoy buying advantage since they purchase goods in bulk hence receive
heavy bulk discounts that reduce cost of production.
b) Packaging advantage
 It is easier to package goods in bulk than in small unit with reference to packaging costs.
c) Transportation advantage
 Due to transporting many units at the same time which reduces transportation cost for a

Page 25 of 28
 large scale producer compared to a small scale producer.
d) Selling advantage
 In terms of advertising whereby the large scale producer will benefit more as he will sell
more as compared to a small scale producer due to mass advertisement
ii) Technical economic
 This scale consists of;
a) Factor indivisibility e.g., certain capital equipment must be of a specific minimum scale or
capacity to justify manufactures ability. A small firm will not utilize its equipments in full due
to idle capacity arising from the small production capacity. Large scale producer will be
advantaged since the production process will optimally utilize the equipments.
b) Increased specialization - The larger the scale of production the greater the scope of
specialization of both labour and machinery leading to high productivity.
c) Principle of multiples - if the production process involves use of different stages and type of
machinery the large firms will benefit due to high productivity while smaller ones will be
disadvantaged since they produce fewer units.
d) Research and developments - A large firm may be able to support its research and
development programs which could result in cost reducing innovations
iii) Financial economies - Large firms can easily obtain financial resources at lower rates than small
firms. Large firms can also produce more security for loans and investments
iv) Risk becoming economies - A large firm that has diversified into several markets is usually better
placed to withstand adverse trading conditions.
v) Managerial and administrative economies - Managers and administrators are highly qualified
in managements of large firms. This creates division of labour which improves efficiency.

External Economies of Scale

 These are advantages that arise from the growth of industry resulting from simultaneous
interaction of a number of industries in the same or various industries as well as the
community at large.
 External economies of scale are those advantages in the form lower average costs that a firm
gains from the growth of the industry.
 External economies are available to all firms in the industry no matter their size.

Page 26 of 28
 These advantages include:
i) Employment - Due to growth of industries employment opportunities are created that help
members of the communities improve their standard of living.
ii) Specialization -Different firms within the industry can concentrate in one area of production
which will reduce cost of production, improves quality of the product and reduce prices. An
example is in the motor assemble plant where many of the different stages in the assembly
are completed using computer controlled machines.
iii) Growth of complimentary service - Whenever a business is expanding its output, there are
some complimentary services that are developed e.g. schools, medical facilities, financial
institutions, better roads, etc. that benefit the society.
iv) Increased co-operation - Many firms within the industry can collaborate with one another in
terms of research and development hence improve the quality of a product, new techniques
in production which lowers the cost of production and reduction in prices.

Internal Diseconomies of Scale

 Refers to the increase in average costs caused by increasing the size of a firm beyond a certain
scale. This is because of management difficulties and rising prices of inputs.
 Management problems arise because;
a) As the size of departments in an organization increase, the task of coordination becomes more
difficult.
b) Despite the existence hierarchy of authority in large firms, the task of control, that is, of
ensuring implementation is extremely difficult in practice.
c) Large firms of large, communication network are generally more complex in large
organization with associated greater likelihood of communication breakdown.
d) The maintenance of morale is more difficult in large organizations because
individual workers in large organizations may feel unimportant to the firm and often do not identify
with the firm’s objectives.
e) Increase in price of inputs since as the scale of production increases, the firm’s demand for
inputs also increases and may lead to bidding up prices of certain inputs.

Page 27 of 28
External Diseconomies of Scale
 May arise because of a shortage of various inputs used in the industry leading to an increase in the
cost of those inputs.
 For example, an increased demand for raw materials may bid up the prices of raw materials and
cause their prices to rise.
 Heavy localizations of industry may make land for expansion scarce and therefore more expensive
to rent and purchase.
 Increased congestion could also lead to higher transport costs. Others costs include:
 Over production - Increase in growth of a firm will lead to overproduction leading to wastage
due to lack of a market
 Negative externalities e.g. pollution, poor working condition this will be experienced as many firms
expand their output.
 Maintenance of morale - Individual workers feel unimportant to the firm and may not identify
with the firm objectives
 Government interference - Whenever there is increase in output due to increase in growth it’s
led to increase in profit. The government then imposes tax which is a disadvantage to the firm

Page 28 of 28