THE THEORY OF PRODUCTION AND COSTS.

• This is basically about the theory of a firm.

A firm is a technical unit which uses factors of production to produce
goods of services for sale.
• A firm is a governance structure that can range from simple to highly
complex (sole owner to large multi-national corporation).
• Firms allocate resources and coordinate economic activities internally
using commands and incentive systems.
• The major or traditional objective of the firm is Profit Maximization.
Privately owned firms are motivated to earn profits.
INPUT-OUT PUT RELATIONSHIP

•Production involves transformation of inputs such as capital, equipment, labor and land into
output- goods and services.
•An input is anything which a firm uses in the production process while an output is the goods
or services that a firm produces for sale.
•Production theory seeks to analyze input and output relationship and tries to answer the
following questions.
1. Suppose inputs are increased by a given factor, will output increase by the same factor?
2. Suppose there is more than one production process of the produced commodity, how will
output change in response to change in factor proportion? I.e. labour exceeding capital or
capital exceeding labour or labour = capital hence the least cost combination.
3. How can a firm attain the least cost combination of O utputs? Since all firms are profit
maximizing.
FACTORS OF PRODUCTION AND THEIR PAYMENT.

i. Land - Rent payment.

ii. Labour - Wage/Salaries.
iii.Capital - Interest.
iv. Entrepreneur - Profit.
•Technical efficiency Vs Technical inefficiency
•A technically efficient firm is attaining the maximum possible output from its inputs
(using whatever technology is appropriate)
•A technically inefficient firm is attaining less than the maximum possible output
from its inputs (using whatever technology is appropriate)
•Production set: all points on or below the production function
Causes of technical inefficiency

Shirking
-Workers don’t work as hard as they can
-Can be due to laziness or a union strategy

Strategic reasons for technical inefficiency

-Poor production may get government grants
-Low profits may prevent competition

Imperfect information on “best practices”

-inferior technology
Production function
• A firm’s output can be represented as a production function. It gives
the quantities of output that can be produced using a certain
combination of inputs.
• A simplified version can be expressed as: 𝑄 = 𝑓(𝑋1,𝑋2, 𝑋3, … …
… 𝑋𝑛) Q is the output whereas 𝑋1,𝑋2, 𝑋3, … … … 𝑋𝑛 are the
quantities of factor inputs.
• Factor or resource inputs can be fixed or variable. For example,
buildings and machineries are examples of capital and are considered
fixed resources. Labor is considered a flexible resource and a variable
input.
• A production function refers to the technical relationship between factor input and output.

Inputs Output Profits

• It shows the relationship between minimum quantities of various inputs used in a given
period of time and the maximum quantity of output produced in a period of time.
• Its signifies a firm’s ability to convert inputs into out puts.
The production function can be expressed in various forms.
(i) Table form
(ii) Equation
Q = ƒ(L,)
(iii) Graphical form
 Example

A medical company faces the production function:

Q=K1/2L1/2

Given labour of 10 and capital of 20, is this company producing

efficiently by producing 12 units?
What level of production is technically efficient?
 Solution’
Q =K1/2L1/2
=201/2101/2
=14.14
This company is not operating efficiently by producing 12 units. Given
labour of 10 and capital of 20, the company should be producing 14.14
units in order to be technically efficient.
 Marginal Product and the law of diminishing returns

• Whereas Total product is the output produced by using all inputs,

Marginal product is the additional output that is generated when
additional unit of a particular input is added assuming that other inputs
are kept constant.
• 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 = 𝛥 𝑄/𝛥
𝑋
• 𝑄 is the change in quantity of output and 𝑋is the change in quantity of
input.

MPL = Q/L (holding constant all other inputs)

MPK = Q/K (holding constant all other inputs)

 Law of Diminishing Returns

•The law states: “In a production process if one input is increased while
all others are kept constant there is a point at which marginal per unit
output will start to decrease”. It is also known as the “law of diminishing
marginal returns”.
•e.g. if a company increases its labor but manufacturing capacity is kept
constant, initially production will increase but there will be a point when
adding labor will not yield additional output and it will eventually start
to decline.

•Generally the first few inputs are highly productive, but additional units are less
productive
Q Example: Production as workers increase
Each Each
Each Additional Additional
Additional worker worker
worker Is less Decreases
Is equally productive Production
productive

Each
Additional
worker
Is more
Total Product
productive

L 12
 Average Product
Average product: total output that is to be produced divided by
the quantity of the input that is used in its production:

APL = Q/L
APK = Q/K
Example:
Q=K1/2L1/2
APL = [K1/2L1/2]/L = (K/L)1/2
APK = [K1/2L1/2]/K = (L/K)1/2
 Marginal, and Average Product

When Marginal Product is greater than average product, average

product is increasing
-ie: When you get an assignment mark higher than your average, your average
increases
When Marginal Product is less than average product, average product
is decreasing
-ie: When you get an assignment mark lower than your average, your average
decreases

Therefore Average Product is maximized when it equals marginal product

Relationship Between TP, AP and MP
•From the above, note the following.
i. TP increases, up to maximum and then falls.
ii. MP increases, reaches maximum and then falls up to 0 and into negatives.
iii.MP is positive when TP is increasing, it is 0 when TP is at maximum and it is
negative when TP is falling. The point which MP is maximum, defines the point
of DMP (diminishing marginal productivity.)
iv. AP rises up to maximum and then it falls bit will never be equal to 0. Since
output will fall and will not reach 0. The point at which AP is at maximum
defines the point of diminishing average productivity. (DAP)
• MP curve shows the law of DMP i.e. output increases initially at an increasing
rate then at a decreasing rate up to a given point beyond which it falls.
• Marginal rate of technical substitution (MRTS)

Marginal rate of technical substitution (labor for capital):

measures the amount of K the firm the firm could give up in
exchange for an additional L, in order to just be able to produce
the same output as before.

Marginal products and the MRTS are related:

MPL/MPK = -K/L = MRTSL,K

The marginal rate of technical substitution, MRTSL,K tells us:

The amount capital can be decreased for every increase in labour,

holding output constant
OR
The amount capital must be increased for every decrease in labour,
holding output constant

-as we move down the isoquant, the slope decreases, decreasing the
MRTSL,K
-this is diminishing marginal rate of technical substitution
-as you focus more on one input, the other input becomes more
productive
 MRTS EXAMPLE

Let Q=4LK
MPL=4K
MPK=4L

Find MRTSL,K

MRTSL,K = MPL/MPK
MRTSL,K =4K/4L
MRTSL,K =K/L
 Isoquant

• An isoquant is a locus of all technically efficient methods or all

possible combinations of inputs for producing a given level of output.
• All inputs are now considered to be variable (both L and K in our
case)
• How to determine the optimal combination of inputs?
Properties of Isoquants
• Isoquants have a negative slope.

• Isoquants are convex to the origin.

• Isoquants cannot intersect or be tangent to each other.

• Upper Isoquants represents higher level of output

Isoquant Map
• Isoquant map is a set of isoquants presented on a two dimensional
plain. Each isoquant shows various combinations of two inputs that
can be used to produce a given level of output.
Figure : Isoquant Map

Y
Capital Y

IQ4
IQ3
IQ2
IQ1

O Labour X X
Special Production Functions
1. Linear Production Function:
Q = aL + bK

· MRTS constant
· Constant returns to scale
· Inputs are PERFECT SUBSTITUTES:
-Ie: 10 CD’s are a perfect substitute for 1 DVD for storing data.

2. Cobb-Douglas Production Function:

Q = aLK
Q= Out put
L = qty of Labour
K = qty of Capital

a - Coefficient
THE THEORY OF COSTS
• Costs of production refer to what is incurred in the process of production.

Costs are further classified into;

1. Fixed costs. (FC)
These are called overhead costs or supplementary costs or indirect costs. E.g. salaries for administrators, depreciation
of machinery, expenses for the land security etc.
These are un avoided costs incurred by a firm even when it is not producing hence not depend on the level of output.
2. Variable costs (VC)
The are also called prime costs or direct costs or operating or running costs. These are costs incurred depending on the
level of output. E.g. cost of raw material, payments for direct labour. The running expenses of fixed capital such as fuel
maintenance etc.
•Total Fixed costs + Total Variable costs = Total cost.
Explicit and implicit costs

(i) Explicit costs.

•These are costs which are included in the calculation of the profits of the firm. They are also those costs, which
fall under actual or business costs that are entered into the books of accounts. They include wages and salaries,
materials, license fees, insurance premiums; rent etc. these costs involve cash payments and are used to calculate
the loss or gains of the firm.
(ii) Implicit costs.
•These are costs not included in the calculations in the profits of the firm because they are incurred indirectly e.g.
pollution, opportunity cost etc.

• These are also costs that do not take form of cash outlays and do not therefore appear in the accounts of a firm.

The implicit and explicit costs both make the economic costs of
production.
Example:
• Suppose you start a business:
- the expected revenue is $50,000 per year.
- the total costs of supplies and labor are $35,000.
- Instead of opening the business you can also work in the bank and
earn $25,000 per year.

What would be calculate the opportunity cost and the accounting profit?
- The opportunity costs are $25,000 –
- The accounting profit is $15,000
Objective of the firm

• A firm chooses Q to maximize profit.

The firm’s problem is Max (Q) = TR (Q) –TC (Q)
Total cost of producing Q units depends on the production function and
input costs.
Total revenue is the money that the firm receives from Q units (i.e.,
price times the quantity sold). It depends on competition and demand
• A firm is a price taker if it can sell any quantity at a given price of p
per unit.
• How much should a price taking firm produce?
For a given price, the firm’s problem is to choose quantity to
maximize profit.
Max PQ-TC(Q)
S.t Q ⦥
Optimality condition: P = MC(Q)
Profit Maximization
• Optimality condition:
P = MC(Q)

Suppose a firm has the cost function TC(Q) = 100 + 20Q + Q2;
What would be TFC, ATC, TVC, AVC and MC?

Answers
TFC = 100
ATC(Q)=100/Q+20+Q
TVC(q) = 20Q + Q2
AVC(q) = 20 + Q
MC(q) = 20 + 2Q
The Individual firm’s Decision
• Profit Maximization
● Let’s assume following two conditions for a firm that wants to
maximize profit:
○ It knows its own cost curves
○ Exogenous market price, po of its product that it cannot change
● Economic profit: 𝛱 = 𝑇𝑅 − 𝑇𝐶
TC is total cost including opportunity cost
TR is total revenue. For quantity, q it is equal to: 𝑇𝑅 = 𝑝𝑜. 𝑞
• The firm’s problem
Max = TR(Q) –TC(Q)
NB:

Marginal Revenue, MR is additional revenue generated by selling

additional unit of product i.e. it is slope of TR:
𝑀𝑅 = 𝑑(𝑇𝑅)/ 𝑑𝑞
For fixed price, MR is always going to be constant and equal to p 0
• Marginal Cost, MC is slope of TC
𝑀𝐶 = 𝑑(𝑇𝐶)/ 𝑑q
Maximum gap between TC & TR represents maximum profit as well as
maximum loss.
𝑑(𝑇𝑅)/ 𝑑𝑞 = 𝑑(𝑇𝐶)/ 𝑑𝑞
𝑴𝑪 = 𝑴𝑹

Therefore, Maximum economic profit, 𝜫𝒎𝒂𝒙 = 𝑴𝒂𝒙 (𝑻𝑹 − 𝑻𝑪) exists

when 𝑴𝑪 = 𝑴𝑹. Maximum loss can be found in a similar way as it is
also 𝑀𝑎𝑥 (𝑇𝑅 − 𝑇𝐶).
In the following example, output quantity, total cost and product price
are assumed, whereas the other quantities have been calculated:
ECONOMIES OF SCALE.
•These are advantages enjoyed by a firm when there is mass production of products resulting into lower average
costs. It may be in form internal economies and external economies.
INTERNAL ECONOMIES OF SCALE.
•These are economies or advantages made in a firm as a result of mass production within a firm resulting from
its internal organization. i.e as a firm produces more and more goods, its average cost of production will begin to
fall due to large scale operation. They may include;
i. Technical Economies, These arise out of actual production of the product e.g a large firm can use expensive
machinery extensively.
ii. Managerial Economies, These arise from the administration of a large firm by splitting up managerial
positions and employing specialists for a particular job.
iii. Financial Economies, These arise from the fact that a large firm can borrow money at lower rates of interests
than a small firm. Besides it can access loans because it has collateral securities.
iv. Marketing Economies, These arise from spreading the high cost of advertising on TVs, radios, newspapers
across the high level of output.
(v) Commercial Economies, These are made when buying of raw materials in bulky and selling of
products is also in bulk.
(vi) Transport Economies.
(vii) Research Economies.
(viii) Insurance Economies.

EXTERNAL ECONOMIES OF SCALE.

These are economies or advantages enjoyed by a firm as a result of its relationship with the outside.
 Local skill labour is available.
 Specialists in the local area can supply services.
 An area has developed transport network.
 The area has excellent reputation for producing a particular good.
 Housing and other facilities are available.
•DISECONOMIES OF SCALE.
These are disadvantages incurred by the firm because it is operating on a large scale. They are both
internal and external.
•INTERNAL DISECONOMIES OF SCALE.
These occur when a firm has become too large and inefficient. As it increases the size eventually the
average cost begins to rise because of the following.
 Disadvantages of division of labour takes effect.
 Management becomes out of touch and some machinery becomes over managed or over used
hence depreciation.
 Decisions are not done quickly because of beauracracy hence there is delay.
 Lack of communication in large firms means that managerial tasks at some are done twice.
 Poor relations may develop in large firms between management and workers themselves.
EXTERNAL DISECONOMIES OF SCALE.
These occur when too many firms are located in an area (localization) as a result it
results into increasing of unit cost because of the following.
 Local labour becomes scarce and firms now have to offer higher wedges to
attract more laborer's.
 Land becomes scarce and rent rises.
 Housing becomes expensive.
 Local roads become congested and transport costs begin to increase.
Market Structures
• Market Comparison & Perfect Competition
Competitiveness of industries in a market varies between two extremes i.e. from
monopoly (1 firm) to perfect competition (large number of firms).
Perfect Competition
• For a market to be in perfect competition few conditions need to be
fulfilled:
○ There is a large number of relatively small buyers and sellers
○ All firms produce identical or homogeneous products
○ There is a freedom of entry and exit
○ There is perfect information and knowledge
● These conditions imply that all firms are price takers which means
that they cannot influence market price of the product, therefore all
firm’s demand curves are perfectly elastic.
Firms in perfect competition maximize profit by producing output
when MC = MR.
Supply Curve in a Perfectly Competitive Market
Short-run Equilibrium
● Short-run equilibrium in a perfectly competitive market is achieved
when:
○ Market is in equilibrium i.e. supply is equal to demand.
○ Sum of level of production of all firms is equal to the market demand.
○ Each firm’s level of production maximizes its economic profit (MR =
MC for every firm)
● In short run, increase in demand of a product (right shift of demand
curve) results in increase in prices and output quantity. Similarly, decrease
in demand results in decrease in prices and output.
● In short run, economic profits can be positive (supernormal), zero
(normal) or negative.
Abnormal profits under perfect competition in
the short-run

The firm produces output 0Q at total cost 0CBQ0 and sells it at price 0P getting
total revenue 0PAQ0, hence making abnormal profits CPAB.
Profits = TR- TC. 0PAQ0 – 0CBQ0 = CPAB
Long-run Equilibrium
• When economic profits are made, new firms are attracted into the
industry.
● This results in:
○ Increase in production which moves market supply curve to the right.
○ Market demand curve remains same, so the price goes down
○ Decrease in price reduces economic profit of all firms
○ As long as economic profits are positive, new firms keep adding
production, shifting supply curve to the right. Economic profit of each
firm keeps on reducing until it goes to zero.
Monopoly
• A pure monopoly is defined as a single seller of a product or service
with no threat of entry.
● A firm may gain monopoly because of following reasons:
○ Being first in that field
○ Mergers
○ Higher efficiency
○ Control of resources
● Monopoly maximizes profit where MR = MC.
● Monopoly results in price setting by the firm rather than price set by
competition i.e. monopolist firm is price maker not taker.
Price Strategy
• Firms try to maximize profitability for every unit sold by employing different
strategies.
• Price discrimination is one such price strategy in which different prices to
different consumers are charged for the same good or service, for reasons not
associated with the cost of supply.
Conditions for Price Discrimination
● Firms must have sufficient monopoly i.e. they are not price takers.
● Different market segments must be identified i.e. consumers with different
price elasticity of demand.
● There is sufficient information and ability to separate different groups.
● There must be ability to prevent arbitrage i.e. consumers cannot purchase at
the lower price and then resell it. This is easier to achieve for services than
goods.
Types of price discrimination
There are three types of price discrimination:
• First Degree
• Second Degree
• Third Degree.
First Degree Price Discrimination
● It is also known as perfect price discrimination.
● Unlike monopoly, where the seller charges one fixed price to
everyone, in first degree price discrimination, the monopoly seller
charges a maximum price that every consumer is willing to pay,
therefore, there is no fixed price.
Second Degree Price Discrimination
● Second degree price discrimination involves charging different
pricing for different quantities.
• It is achieved by offering larger quantities at lower prices.
• Such nonlinear pricing helps producers in capturing large portion of
total market surplus.
Third Degree Price Discrimination
● Third degree price discrimination occurs when a seller identifies two
(or more) separate groups of buyers that have different demand
elasticities.
● In such case sellers raise profits by setting different prices for the
separate groups. Firms charge higher to the consumers with inelastic
demand whereas they charge lower to the consumers with elastic
demand.
● Example of this is cinema tickets, where the students or seniors ticket
pricing is lower due to their relatively elastic demand.
Other Price Strategies
• Premium pricing means buyers have tendency to assume that
expensive items are more desirable and offer better quality. Businesses
create a value perception by charging higher prices for their products
that are not necessarily of better quality. Such pricing strategy needs
better marketing, packaging etc.
• Price skimming strategy means that firms set higher rates during
introductory phase of a product or service. It allows them to maximize
profits and also cover cost of investment that has gone in the research
for the product. This strategy targets early adopters of a product who
have relatively inelastic demand.
• Psychology pricing is a way to enhance value of a product by pricing
it in such a way e.g. a price of $9.99 appears better than $10.00 and
creates an illusion of enhanced value.
● Bundle pricing means selling multiple products for a price lower
than the sum of individual price of the products. This creates a value
perception.
The end