THEORY OF PRODUCTION AND COST

Production is the use of factors of production to

produce and market goods and services.

Inputs include the broad categories of land, labor,

capital, other intermediate inputs and
entrepreneurship.

In a mixed economy, both firms and governments

organize the production of various goods and
services.
 Production in the Short-run

An input that cannot vary in quantity during the relevant

time period is called a fixed input or fixed factor.
An input having a quantity that can change during the
relevant time period is called a variable input or
variable factor.
The short-run is a period of time such that there is at least
one fixed factor.
The long-run is a period of time such that all inputs are
variable in quantity.
A production function summarizes the relationship
between all combinations of inputs and the corresponding
maximum attainable levels of output, for a given
technology.
The total product, TP, of a variable input is the amount
of output produced over the period when that input is used
with fixed quantities of all other inputs.
The marginal product of an input F, MPF, is the
additional output per unit increase in the input, holding all
other inputs (and technology) constant;  TP
MPF 
F
 Total Product

MP, 250 TP
Marginal

bushels of potatoes
output 200

TP, per unit 150

fertilizer Output of input
100
0 0 ---
50
1 15 15
0
2 38 23 0 2 4 6 8 10
3 68 30 pounds of fertilizer

4 103 35 Marginal Product

5 137 34

bush els of po tatoes

per un it of fertiliz er
6 168 31 30

7 192 24 20
. MP
10
8 211 19
0
9 226 15
0 2 4 6 8 10
10 235 9 pounds of fertilizer
Diminishing marginal product: As more of
a variable input is employed, with the
quantities of all other inputs held constant,
the marginal product of the variable input
will decline after some point.

Diminishing marginal product results from the

process of adding additional units of a variable
input to given quantities of other inputs.
 Measuring costs and profits
Total (Economic) Cost is the monetary value of all
inputs used in a particular activity over a given period.

Explicit Costs correspond to the monetary payments for

inputs.

Implicit Costs are the opportunity costs of inputs that

have no explicit monetary payments as a result of the
inputs not being purchased in markets.

All opportunity costs, both explicit and implicit, are

part of economic costs.
 Measuring costs
Economic depreciation is the reduction in the value of
a capital good over the relevant period that results from
wear and tear as well as obsolescence.

Accounting depreciation measures the annual

accounting cost of capital, expressed as some portion of
the capital’s monetary cost.

Accounting costs measure the explicit costs of

production during a given period plus accounting
depreciation.
 Measuring costs and profits

Total revenue is the explicit monetary return

associated with an economic activity over a given
period.

Economic activities can also yield implicit

returns.

The total return includes both total revenues and

implicit returns.
Economic and accounting profits are defined below:
Total return Total revenue
less: less:
explicit costs explicit costs
economic depreciation accounting depreciation
other implicit costs
Economic Profits Accounting Profits
Economic profits measure the net (private) economic
gain resulting from an economic activity.

When economic profits are zero the returns to owner

supplied inputs exactly equal the opportunity costs of
those inputs. These returns are called normal profits.
 Related Cost Measures

Variable cost, VC, is the cost of the variable input(s)

used to produce any given level of output.

Fixed costs, FC, is the cost of all fixed inputs.

Total cost, TC, is the sum of the costs of all inputs used
to produce output during the period;
TC = VC + FC.
 Example of Potato Production
(The price of fertilizer is $50 per unit and the costs associated with fixed input $40.)
F Q FC VC TC
bushels of
fert. potatoes $ $ $
0 0 40 0 40
1 15 40 50 90
2 38 40 100 140
3 68 40 150 190
4 103 40 200 240
5 137 40 250 290
6 168 40 300 340
7 192 40 350 390
8 211 40 400 440
9 226 40 450 490
10 235 40 500 540
 Related Cost Measures

Marginal cost, MC, is the increase in total or

variable cost per unit increase in output, Q;
VC TC
MC  
Q Q
Average variable cost, AVC, is the variable cost
VC
of production per unit of output; AVC  .
Q

Average fixed cost, AFC, is the fixed cost per

FC
unit of output; AFC  .
Q

Average cost, AC, is the total cost of all inputs

TC
per unit of output; AC  .
Q
 TC VC  FC VC FC
AC    
Q Q Q Q
AC  AVC  AFC
 Marginal, Average, Average Variable and
Average Fixed Costs

Various Costs for Potatoes Example 6.0

Q MC AVC AFC AC 5.5 AC
0 --- --- --- --- 5.0
15 3.33 3.33 2.67 6.00 4.5 MC

d o lla rs p er u n it o f Q
38 2.17 2.63 1.05 3.68 4.0
68 1.67 2.21 0.59 2.79
3.5
103 1.43 1.94 0.39 2.33
137 1.47 1.82 0.29 2.12 3.0
168 1.61 1.79 0.24 2.02 2.5
192 2.08 1.82 0.21 2.03 2.0
211 2.63 1.90 0.19 2.09 1.5 AVC
226 3.33 1.99 0.18 2.17 1.0 1.43
235 5.56 2.13 0.17 2.30 0.5 AFC
0.0
0 50 100 150 200 250
Q, quantity of output
103
 Marginal, Average, Average Variable and
Average Fixed Costs

Various Costs for Potatoes Example 6.0

Q MC AVC AFC AC 5.5 AC
0 --- --- --- --- 5.0
15 3.33 3.33 2.67 6.00
4.5 MC

d o lla rs p er u n it o f Q
38 2.17 2.63 1.05 3.68
68 1.67 2.21 0.59 2.79
4.0
103 1.43 1.94 0.39 2.33 3.5
137 1.47 1.82 0.29 2.12 3.0
168 1.61 1.79 0.24 2.02 2.5
192 2.08 1.82 0.21 2.03 2.0
211 2.63 1.90 0.19 2.09 1.5 AVC
226 3.33 1.99 0.18 2.17 2.33
1.0 1.94
235 5.56 2.13 0.17 2.30
0.5 AFC
0.39
0.0
0 50 100 150 200 250
Q, quantity of output
103
 Family of Average Costs
Fixed cost FC
AFC = =
Quantity Q
Variable cost VC
AVC = =
Quantity Q
Total cost TC
ATC = =
Quantity Q
 Marginal Cost

(Change in total cost)

MC =
(Change in quantity)

= TC
Q
Note the relationship between MP and MC.
fertilizer TP MP Q TC MC
0 0 --- 0 40 ---
1 15 15 15 90 3.33
2 38 23 38 140 2.17
3 68 30 68 190 1.67
4 103 35 103 240 1.43
5 137 34 137 290 1.47
6 168 31 168 340 1.61
7 192 24 192 390 2.08
8 211 19 211 440 2.63
9 226 15 226 490 3.33
10 235 9 235 540 5.56
The marginal cost of output directly depends upon
the marginal product and price of each variable
input; input price
MC  .
MPL

For example, if MPL= 0.5 widgets per hour and the wage
rate is a constant $10.00 per hour,
MC = ($10 per hour) / (0.5 widgets per hour)
= $20 per widget .
Intuition: If MPL= 0.5, it takes two hours of work to
create one widget. With a wage of $10 per hour, this
translates into a marginal cost of $20.00 for an additional
widget.
 input price
MC  .
MP L
Implications:
• An increase in the price of a variable input, ceteris paribus,
will result in an increase in the marginal cost of output.
• Holding the input price constant, an increase in the marginal
product of a variable input will cause MC to decrease.
• Often we talk about MC increasing as output increases (after
some point). The underlying reason is diminishing marginal
product of the variable input(s).
 Total-Cost Curve...(Another Example)
$16.00
Total-cost
$14.00 curve
MC = 1.90
$12.00

$10.00
Total Cost

MC = 1.30
$8.00

$6.00 MC = 0.70

$4.00
ΔTC = 0.70
$2.00
ΔQ = 1
$0.00
0 2 4 6 8 10 12
Quantity of Output
 Average-Cost and Marginal-Cost
Curves...
$3.50

$3.00

$2.50

MC
$2.00
Costs

$1.50
AVC
$1.00

$0.50

$0.00
0 2 4 6 8 10 12

Quantity of Output
Relationship Between Marginal Cost and
Average Variable Cost
Whenever MC is greater than AVC,
AVC will be rising.
Whenever MC is less than AVC,
AVC will be falling.
Relationship Between Marginal Cost and
Average Total Cost
$3.50

$3.00

$2.50

MC
$2.00
Costs

$1.50 ATC

$1.00

$0.50

$0.00
0 2 4 6 8 10 12

Quantity of Output
Relationship Between Marginal Cost and
Average Total Cost
Whenever MC is less than ATC,
ATC will be falling.
Whenever MC is greater than ATC,
ATC will be rising.
 Average-Cost and Marginal-Cost
Curves...
$3.50

$3.00

$2.50

MC
$2.00
Costs

$1.50 ATC
AVC
$1.00

$0.50
AFC
$0.00
0 2 4 6 8 10 12

Quantity of Output
 Cost Curves and Their Shapes

The average total-cost curve is U-shaped.

At very low levels of output ATC is high because
fixed cost is spread over only a few units.
ATC initially declines as output increases because of
the decline in AFC.
ATC eventually starts to rise because AVC rises
substantially.
 Total-Cost Curve...
$16.00
Total-cost
$14.00 curve

$12.00

$10.00
Total Cost

$8.00

$6.00

$4.00

$2.00

$0.00
0 2 4 6 8 10 12
Quantity of Output
 Big Bob’s Cost Curves...
$20.00

$18.00

$16.00
Total Cost Curve
$14.00
Total Cost

$12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$0.00
0 2 4 6 8 10 12 14 16
Quantity of Output
(bagels per hour)
 Big Bob’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5

AVC
1

0.5

0
0 2 4 6 8 10 12 14 16
Quantity of Output
 Big Bob’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5

AVC
1

0.5

AFC
0
0 2 4 6 8 10 12 14 16
Quantity of Output
 Big Bob’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5
ATC
AVC
1

0.5

AFC
0
0 2 4 6 8 10 12 14 16
Quantity of Output
Three Important Properties of Cost Curves:
Marginal cost eventually rises with the
quantity of output.
The average-total-cost curve is U-
shaped.
The marginal-cost curve crosses the
average-total-cost and average-
variable-cost curves at their minimums.
 Cost Curves and Their Shapes

•The bottom of the U-shape AC curve

corresponds to the quantity that minimizes
the average cost of production.
•This quantity is sometimes called the
efficient scale of the firm.
•The marginal-cost curve crosses the
average-total-cost curve at the efficient
scale.
 Costs in the Long Run

For many firms, the division of total costs

between fixed and variable costs depends
on the time horizon being considered.
 In the short run some costs are fixed.

 In the long run fixed costs become

variable costs.
 Average Total Cost in the Short and
Long Runs...
Average ATC in short ATC in short ATC in short
Total run with run with run with
Cost small factory medium factory large factory

ATC in long run

0 Quantity of
Cars per Day
 Economies and Diseconomies of
Scale
Economies of scale occur when long-run
average total cost declines as output
increases.
Diseconomies of scale occur when long-
run average total cost rises as output
increases.
Constant returns to scale occur when long-
run average total cost does not vary as
output increases.
 Economies and Diseconomies of
Scale
Average
Total
Cost
ATC in long run

Economies Constant Returns Diseconomies

of scale to scale of scale

0 Quantity of
Cars per Day