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AG ECON
The Theory of Production
❖ Production is the process of transforming inputs of resources into outputs of goods and services
❖ The theory of the firm describes how a firm makes cost-minimizing production decisions and
how the firm’s resulting cost varies with its output.
The Short Run versus the Long Run
• short run : Period of time in which quantities of one or more production factors cannot
be changed.
• long run : Amount of time needed to make all production inputs variable.
• fixed input : Production factor that cannot be varied
❖ Production function shows 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.
▪ Q = F( K, L )
▪ Function showing the highest output that a firm can produce for every specified
combination of inputs.
▪ Q= Total Product
▪ K= Capital (Fixed factor of Production)
▪ L=Labor (Variable factor of Production)
Some Formula & Symbols
▪ Output, Total Product= TP=Q=f(L)

▪ Input, X, variable input
▪ Average Product, AP
➢ AP = TP ÷ X
▪ Marginal Product, MP
➢ ∆TP ÷ ∆X
Production in the Short Run: One variable input

Production in the Short Run: Law of Diminishing Returns
…as the use of an input increases, (together with other fixed inputs), a point will eventually be
reached at which the resulting additions to output decrease
…declining marginal product
Production Function: With One Variable Input

THE LAW OF DIMINISHING RETURN
As additional units of a variable input are combined with a fixed input, after a point the additional
output (marginal product) starts to diminish. This is the principle that after a point, the marginal
product of a variable input declines
The law of variable proportions states that as the quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that factor will eventually decline. This means that up to
the use of a certain amount of variable factor, marginal product of the factor may increase and
after a certain stage it starts diminishing. When the variable factor becomes relatively abundant, the
marginal product may become negative.
Assumptions of Law.
→Constant technology--- This law assumes that technology does not change throughout the
operation of the law.
→Fixed amount of some factors.—One factor of production has to be fixed for this law.
→ Possibility of varying factor proportions—This law assumes that variable factors can be --changed
in the short run.
The three stages of production
Stage I: The range of increasing average product of the variable input.
From zero units of the variable input to where AP is maximized
Stage II: The range from the point of maximum AP of the variable to the point at which the MP of is
zero.
From the maximum AP to where MP=0
Stage III: The range of negative marginal product of the variable input.
From where MP=0 and MP is negative.
In the short run, rational firms should only be operating in

Stage II.
Why not Stage III?
Firm uses more variable inputs to produce less output
Why not Stage I?
Underutilizing fixed capacity
Can increase output per unit by increasing the amount of the variable input
THREE STAGES OF PRODUCTION
What level of input usage within Stage II is best for the firm?
The answer depends upon how many units of output the firm can sell, the price of the product,
and the monetary costs of employing the variable input.
Production With Two Variable Inputs
Isoquants show combinations of two inputs that can produce the same level of output.
Firms will only use combinations of two inputs that are in the economic region of production,
which is defined by the portion of each isoquant that is negatively sloped.
THEORY OF COST
COST
➢ It is the firm of the individual operating in a marketing has a influence on the market supply of
the commodity.
➢ In order to make use of the various factor and non-factor inputs.
➢ In common, the amount spend on these inputs is called the cost of production.
CONCEPT OF COST
• MONEY COST :
➢ The amount spend in terms of money for the production of the commodity is known as
money cost .
• NOMINAL COST:
➢ It is the money cost of production.
• REAL COST :
➢ It is the mental and physical and sacrifices undergone with a view in producing a
commodity .
• OPPORTUNITY COST :
➢ The value of a forgone activity or alternative when another item or activity is chosen.
• IMPLICIT COST :
➢ It is the cost of self-owned resources such as salary of proprietor.
• EXPLICIT COST :
➢ It is the paid-out cost.
➢ It means payments made for the productive resources purchased (variable cost and
fixed cost).
• ACCOUNTING OR BUSINESS COST:
➢ Cash payments which firms make for factor and non-factor input depreciation that are
in the book keeping entries.
• SOCIAL COST:
➢ It is the amount of cost the society bears due to industrialization.
• ENTREPRENEUR’S COST:
➢ The cost of production in the sense of money cost or expenses of production.
SHORT-RUN COST
• In the short run at least one factor of production is fixed.

• Output can be varied only by adding more variable factors.
Example: labor/day is fixed at 380.00, but you are allowed to add materials to produced more
output which can be finished in a day work.
FIXED COST
• Remains constant.
• Also known as short-run cost.
• This cost includes (but not limited to) :
➢ Capital items
➢ Cost on managerial staff.
➢ Expenditure on depreciation.
➢ Maintenance cost of the factory.
VARIABLE COST
• Vary directly with the level of output

• Used in the actual production process.
• Functions of output changes.
• Eg: Cost of raw-materials, Cost in direct labor.
TOTAL COST
• Sum of total fixed cost and total variable cost.

• TC=TVC+TFC.
• TVC=0, when the output is zero and increases with increase in the output.
AVERAGE COST
1. AVERAGE FIXED COST:

• It is the per-unit cost of the fixed factors.
• AFC=TFC/Q.
2. AVERAGE VARIABLE COST:
• It is the per-unit cost of the variable factors.
• AVC=TVC/Q.
3. AVERAGE TOTAL COST
• It is the total cost divided by the number of units produced.
• Sum of average fixed cost and average variable cost
• ATC=TC/Q.
• AC=AFC+AVC.
MARGINAL COST
• Change in the total cost resulting from the unit change in the quantity produced.
o MC=Change in Q/Change in TC.

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AG ECON

The Theory of Production

The Short Run versus the Long Run

• fixed input : Production factor that cannot be varied

Some Formula & Symbols

▪ Output, Total Product= TP=Q=f(L)

Production in the Short Run: One variable input

…declining marginal product

Production Function: With One Variable Input

The three stages of production

Stage I: The range of increasing average product of the variable input.

From zero units of the variable input to where AP is maximized

From the maximum AP to where MP=0

From where MP=0 and MP is negative.

In the short run, rational firms should only be operating in

Why not Stage III?

Firm uses more variable inputs to produce less output

Why not Stage I?

Underutilizing fixed capacity

Production With Two Variable Inputs

• In the short run at least one factor of production is fixed.

• Vary directly with the level of output

• Sum of total fixed cost and total variable cost.

1. AVERAGE FIXED COST:

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