Theory of Production and Cost

Unit 3: Theories of Production and Cost

 Title: Unit 3 Introduction

 Content:
o The unit explores the link between a firm’s production process and its total
cost.
o Focus on how inputs (labour and capital) are transformed into outputs.

Theory of Production

 : What is Production?
o Production transforms raw materials (inputs) into desired products or services
(outputs), adding economic value.
o It involves labour and capital as key inputs in the production process.

The Production Function

o Formula: Q=f(L,K)
 Q = Quantity of output
 L = Labour input
 K = Capital input
o Describes the relationship between input quantities and the quantity of output.

Short-Run vs Long-Run Production

o Short-Run: At least one input is fixed (usually capital).

o Long-Run: All inputs are variable.
o Example: In short-run wheat production, labour is variable and capital (land)
is fixed.

Basic Concepts of Production

o Total Physical Product (TP): Total output produced.

o Average Product (AP): output per unit of labour.
o Marginal Product (MP): Additional output from one more unit of labour.
MPL=ΔTP/ΔL

The Law of Diminishing Marginal Productivity

 Law of Diminishing Marginal Productivity

o As more labour is added to fixed capital, initially the output increases.
o Eventually, the marginal contribution of each additional labourer decreases,
leading to diminishing returns.
o At some point, more labour reduces total output.
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Unit 3: Theories of Production and Cost

Stages of Production

 Stages of Production
o Stage I: Increasing returns (MPL increases).
o Stage II: Diminishing returns (MPL decreases but remains positive).
o Stage III: Negative returns (MPL becomes negative, TP decreases).

Example: Short-Run Production

 Hypothetical Example (Table 3.1) (see from your textbook!)

o Labour (L): Number of workers.

o Total Product (TP): Total Output produced.
o Average Product (AP):

Marginal Product (MP): Additional output from one more worker.

Labor Total Marginal Average

(L) Product Product Product Stage of Production
(TP) (MP) (AP)
0 0 - -
Stage I
1 5 5 5
-Increasing returns
2 11 6 5.5 - MP continue to rise up to inflection point(11)
3 19 8 6.33 -MP>AP
11(inflection -MP Increase at an increasing rate
4 30 7.5 -irrational stage of production
point)
Explained in terms of fuller utilization of fixed factors and
5 40 10 8 division of labour
6 48 8 8
7 54 6 7.71 - Stage II
8 57 3 7.12 -diminishing returns scale
-Range of negative MPL Or decreasing TP
9 59 2 6.56 - TP Reaches maximum MPL =0
10 60 1 6 -Rational stage of production
11 60 0 5.4 -arise b/c of imperfect substitutability of factors
12 58 -2 4.8 Stage III
13 55 -3 4.23 -Negative returns stage
-Negative MPL or decreasing TP
14 51 -4 3.64 - irrational stage of production
-explained in terms of managerial problems
 Theory of Production and Cost

Unit 3: Theories of Production and Cost

 Theory of Production and Cost

Unit 3: Theories of Production and Cost

 Theory of Production and Cost

Unit 3: Theories of Production and Cost

Relationships Between TP, AP, and MP

 Theory of Production and Cost

Unit 3: Theories of Production and Cost

o MPL and TP: MPL increases when TP increases at an increasing rate. MPL
decreases but remains positive when TP increases at a decreasing rate.
o MPL and APL:
 For APL to rise, MPL > APL.
 For APL to fall, MPL < APL.
o When APL is at its maximum, MPL = APL.

Conclusion

 Content:
o The production function helps firms understand the relationship between
labour and capital and how they affect output.
o The law of diminishing returns shows that beyond a certain point, adding more
labour results in reduced productivity.
o Understanding the stages of production is essential for firms to optimize their
use of labour and capital.

The Long-Run Production Function & Cost Theory

What is the Long-Run Production Function?

 The long run is a planning horizon where all inputs (labour and capital) are variable.
 Firms have complete flexibility to adjust both labour and capital to optimize
production.
 Focus on understanding how a firm combines labour and capital to produce output
efficiently.

Isoquant Definition

What is an Isoquant?

 An isoquant is a curve that shows all combinations of labour (L) and capital (K) that
produce the same level of output.
 Isoquants represent the flexibility of firms to substitute one input for another.
 Isoquant Function:
Q=f(L,K)
where Q is output, L is labour, and K is capital.
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Unit 3: Theories of Production and Cost

 A simple isoquant curve with labour on the x-axis and capital on the y-axis.

Properties of Isoquants

1. Downward Sloping: More of one input means less of the other is needed.
2. Further from the Origin = Greater Output: Isoquants further from the origin
represent higher levels of output.
3. Non-Intersecting: Isoquants do not cross each other.
4. Convex to the Origin: Reflects diminishing returns to substitution between inputs.

Isoquant Schedule

A schedule shows combinations of labour and capital that produce the same output level.

 Example: To produce 100 units of output, different combinations of labour and capital
can be used.

Table Example: Isoquant Schedule - Example

Factor Combination Labor (L) Capital (K) Output (Q)

A 1 11 100
B 2 7 100
C 3 4 100
D 4 2 100
E 5 1 100

 Table and a plot of these points on a graph.

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Unit 3: Theories of Production and Cost

Isoquant Curve & Map

Isoquant Curve and Isoquant Map

 The isoquant curve plots all combinations that produce the same level of output.
 An isoquant map is a graph showing multiple isoquants, each representing a different
level of output.
 Moving right and upward on the map increases output.

The Marginal Rate of Technical Substitution (MRTS)

MRTS: Slope of the Isoquant

 The MRTS is the rate at which one input can be substituted for another while keeping
output constant.
 MRTS = ∆K/∆L
It decreases (in absolute terms) as we move down the isoquant.
 The MRTS of labour for capital (MRTSL,K ) tells us how much capital can be
reduced when one additional unit of labour is used..

Returns to Scale

 Returns to scale refer to how output changes when all inputs are increased by the
same proportion.
 Three Types of Returns to Scale:
o Increasing Returns to Scale: Output increases by more than the proportional
increase in inputs.
o Constant Returns to Scale: Output increases exactly in proportion to input
increase.
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Unit 3: Theories of Production and Cost

o Decreasing Returns to Scale: Output increases by less than the proportional
increase in inputs.

Technological Change & Production Curves

 Technological progress makes factors more productive, shifting the production curve
upward.
 Technology helps firms achieve higher output with the same amount of labour and
capital.

Graph showing the shift in the total product curve due to technological advancement.
 Theory of Production and Cost

Unit 3: Theories of Production and Cost

Short-Run Costs

Components of Short-Run Costs

 Total Fixed Cost (TFC): Costs that do not change with output.
 Total Variable Cost (TVC): Costs that change with output.
 Total Cost (TC): The sum of TFC and TVC.

Table and chart showing TFC, TVC, and TC at different output levels.
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Unit 3: Theories of Production and Cost

Average and Marginal Costs

Average and Marginal Costs in the Short-Run

 Average Fixed Cost (AFC): TFC / Output.

 Average Variable Cost (AVC): TVC / Output.
TFC +TVC TFC TVC
 Average Total Cost (ATC): TC / Output= = + =AFC+AV C
Q Q Q
 Marginal Cost (MC): Change in TC resulting from producing one additional unit

MC= change in TC over change in quantity.

MC= change in TVC/change in quantity

Where output =Q

Graph showing ATC, AVC, AFC, and MC curves, with MC intersecting the minimum points
of AVC and ATC.
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Unit 3: Theories of Production and Cost

Long-Run Costs

Long-Run Costs and Economies of Scale

 Long-Run Cost Curve (LTC): In the long run, there are no fixed costs; all inputs are
variable.
 Long-Run Average Cost Curve (LAC): Typically U-shaped, reflecting economies
and diseconomies of scale.
 Long-Run Marginal Cost Curve (LMC): Also U-shaped and typically lies below
the LAC curve.

 Diagram showing LAC and LMC curves, highlighting economies of scale and
diseconomies of scale.
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Unit 3: Theories of Production and Cost

 The range from the minimum point of LAC to the left is called the economies of scale
range which means output can be doubled for a less than a doubled cost.
 The range from the minimum point of LAC to the right is called the diseconomies of
scale because doubling the output requires more than doubling of cost.

Relationship Between Product and Cost Curves

The Link between Product and Cost Curves

 When average product (AP) or marginal product (MP) rises, average cost (AC) or
marginal cost (MC) falls.
 When AP or MP falls, AC or MC rises.
 The minimum point of the AP/MP curve corresponds to the minimum point of the
AC/MC curve.

Visuals:

 Diagram showing the relationship between product curves (AP, MP) and cost curves (AC,
MC).

Conclusion

 Isoquants describe combinations of labour and capital for the same output.
 Returns to scale show how output changes as inputs are increased proportionally.
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Unit 3: Theories of Production and Cost

 Technological changes increase the productivity of inputs, shifting production curves
upward.
 Cost curves are derived from production functions and help firms make decisions
about optimal input combinations.

Work sheet
Part I. Write ‘True’ if the statement is correct or ‘False’ if the statement is incorrect.
1. When marginal products are rising, the total product curve reaches its maximum.
2. Isoquants show the flexibility that firms have when making production decisions.
3. When the marginal product of labor is rising, the average product of labor is also
increasing.
4. Advancement in technology may possibly shift both the production function and
the isoquant outward.
5. The gap between successive multiple isoquants is decreasing for a production
function with increasing returns to scale.
6. The law of variable proportions states the marginal product factor will eventually
decline.
7. The magnitude of fixed costs does not depend on the level of output.
8. All the short run average cost curves are u-shaped because of the law of
diminishing returns.
9. The gap between AVC and AC is continuously narrowing as output increasing.
10. The optimal expansion path for a homogenous production function is a straight
line from the origin.
11. Which of the following is a factor of production?
A . Land.
B . Labor. C
. Capital.
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Unit 3: Theories of Production and Cost

D . All of the above
12. In the third stage of production, A . Marginal product is negative. B . Marginal product
is positive.
C . A rational firm prefers to operate.
DAll of the above
13. Technological progress,
A . shift the isoquants inward.
B . shift the production function outward
C . reduce cost of production
D . All of the above
14. Which of the following is true?
A . Total cost is the sum of total fixed cost and total variable cost.
B . Total cost is the product of total fixed cost and total variable cost. C
. Fixed cost increase as output increase.
D . All of the above
15. All of the following curves are “U” shaped except:
A.The AVC curve B. The AFC curve
C . The ATC curve D. mc curve
Here are 20 multiple-choice questions focused on short-run and long-run costs,
including calculations. Each question includes detailed answers.

Multiple Choice Questions

1. What is the Total Fixed Cost (TFC) when the fixed costs are $500 and the
output is 10 units?
A) $50
B) $500
C) $5,000
D) $0
Explanation: TFC remains constant regardless of output. Here, TFC =
2. If Total Variable Cost (TVC) is $300 at an output level of 15 units, what is the
Average Variable Cost (AVC)?
A) $15
B) $20
C) $25
D) $30
Explanation: AVC = TVC / Output =
3. Calculate the Total Cost (TC) if TFC is $200 and TVC is $400.
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A) $200
B) $400
C) $600
D) $800
Answer: C) $600
Explanation: TC = TFC + TVC = $200 + $400 = $600.
4. What is the Average Total Cost (ATC) when TC is $800 and output is 20 units?
A) $30 B) $40 C) $50 D) $60
Explanation: ATC = TC / Output =

5. If Marginal Cost (MC) is calculated as the change in TC from producing one

additional unit and TC increases from $600 to $630 with an increase in output
from 20 to 21 units, what is the MC?
A) $20 B) $30 C) $10 D) $15
Explanation: MC = Change in TC / Change in Quantity =
6. Given that TFC is $100 and TVC is $500 at an output of 25 units, what is the
AFC?
A) $2 B) $4 C) $20 D) $10
Explanation: AFC = TFC / Output =

7. If the long-run average cost (LAC) curve is U-shaped, what does the left side of
the curve indicate?
A) Diseconomies of scale B) Constant returns to scale
C) Economies of scale D) Increasing marginal cost
Explanation: The left side indicates economies of scale, where increasing
output leads to lower average costs.

8. What is the relationship between Marginal Cost (MC) and Average Total Cost
(ATC) when MC is below ATC?
A) ATC is increasing B) ATC is decreasing
C) ATC is constant D) ATC is at its minimum
Explanation: When MC < ATC, it pulls the ATC down.

9. If the Long-Run Marginal Cost (LMC) is $50 and the LAC is currently at $60,
what happens if LMC is below LAC?
A) LAC increases B) LAC decreases
C) LAC remains constant D) LAC is at its minimum
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Explanation: When LMC < LAC, it indicates that producing more will lower the
average cost.
10. What is the Average Total Cost (ATC) if TFC is $150, TVC is $350, and output is
25 units?
A) $20 B) $25 C) $30 D) $40
Explanation: TC = TFC + TVC =.
11. If the Average Fixed Cost (AFC) is $10 at an output level of 50 units, what is
the Total Fixed Cost (TFC)?
A) $500 B) $1,000 C) $1,500 D) $2,000
Explanation: TFC = AFC × Output
12. If the Average Variable Cost (AVC) is $30 and Total Variable Cost (TVC) is
$600, how many units are produced?

Explanation: AVC = TVC / Output ⇒ Output = TVC / AVC =

A) 20 B) 30 C) 40 D) 50

13. Calculate Marginal Cost (MC) if Total Cost (TC) increases from $900 to $950
when output increases from 30 to 31 units.
A) $50 B) $100 C) $200 D) $300
Explanation: MC = Change in TC / Change in Quantity =
14. If the Long-Run Average Cost (LAC) is minimized at 100 units of output, what
can be inferred about economies of scale?
A) No economies of scale B) Diseconomies of scale
C) Constant returns to scale D) Economies of scale
Explanation: The minimum point indicates that increasing output beyond this
does not reduce average costs.

15. What is the Total Cost (TC) if TFC is $400, TVC is $600, and output is 50 units?
A) $800 B) $1,000 C) $1,200 D)$1,400
Explanation: TC = TFC + TVC =.
16.If the Average Total Cost (ATC) is $60 and the Average Variable Cost (AVC) is $40,
what is the Average Fixed Cost (AFC)?

Explanation: ATC = AFC + AVC ⇒ AFC = ATC - AVC =.

A) $20 B) $10 C) $30 D) $15

17. If output increases from 10 to 12 units and TC increases from $400 to $460,
what is the Marginal Cost (MC) of the additional units produced?
A) $30 B) $20 C) $15 D) $25
Explanation: MC = Change in TC / Change in Quantity =
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Unit 3: Theories of Production and Cost

18. What is the Average Total Cost (ATC) if Total Cost (TC) is $1,200 at an output
of 40 units?
A) $30 B) $25 C) $20 D) $15
Explanation: ATC = TC / Output =
19. If the LAC curve is U-shaped, what does the right side of the curve indicate?
A) Economies of scale B) Constant returns to scale
C) Diseconomies of scale D) Increasing returns to scale
Explanation: The right side indicates that increasing output results in higher
average costs.
20. If the Marginal Cost (MC) is $40 and the Average Total Cost (ATC) is $50, what
can be said about ATC behavior?
A) ATC is increasing B) ATC is decreasing
C) ATC is constant D) ATC is at its minimum
Explanation: Since MC < ATC, ATC is decreasing.