3. Theory of Production and Cost
Short and Long run production functions
Behavior of Costs
Law of Diminishing Returns
Law of Returns to scale in the theory of production
Fixed Costs and Variable Costs
Explicit Costs and Implicit Costs
4. What are Costs?
“The Market Value of the inputs a firm uses in production”
Total Revenue – the amount a firm receives for the sale of its
outputs.
Eg: Each Ice-Cream takes Rs. 10 to make and it is sold at Rs.
25 – Nelum sells 2000 ice-creams
You know you're getting old when the candles
cost more than the cake.
Bob Hope
5. Economic Cost
This is different to accounting cost
What is accounting cost?
Remember Nelum? – She made Rs. 30000 profit
making ice-cream. Assume Nelum was an amazing
programmer and she could earn Rs. 80000 a month
programming.
Her Opportunity cost = 80000 – 30000 = Rs. 50000
Which means she is losing Rs 50000 by making ice-
cream.
6. Implicit and Explicit Costs
Explicit Costs – input costs that require an outlay of money by the firm.
Implicit costs – input costs that do not require an outlay of money by the
firm.
Accounting Profit = TR – Explicit Costs
Economic Profit = TR – (Implicit Costs+ Explicit Costs)
No other investment yields as great a return as the
investment in education. An educated workforce is the
foundation of every community and the future of every
economy.
Brad Henry
8. The production functions
Two Assumptions
Short Run
Size of Nelum’s factory is fixed
She can only vary the amount of ice-cream by increasing
workers
Long run – She can build a new factory.
The production function
The relationship between the quantity of inputs used to make a
good and he quantity of outputs for that good.
9. Output
per Hour
Marginal
product of
labour
Cost of
factory
(FC)
Cost of
workers
(VC)
Number of
Workers
Total Cost
0 0 0 30 0 30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
6 155 5 30 60 90
10. Production Function
0, 0
1, 50
2, 90
3, 120
4, 140
5, 150
6, 155
0 1 2 3 4 5 6 7
Output per Hour
Output per Hour
11. Total Cost Curve
Marginal Product
The increase in output that arises from an additional unit of
output
Diminishing Marginal Product
The property whereby the marginal product of an input
declines as the quantity of the input increases.
13. Fixed and Variable Costs
Fixed Costs
Costs that do not vary with the quantity of output produced
Variable Costs
Costs that vary with the quantity of output produced.
Average Total Cost – Total cost divided by the quantity of
output
Average Fixed Cost – Fixed cost divided by the quantity of
output
Average Variable Cost – Variable cost divided by the quantity of
output
Marginal Cost – The increase in total cost that arises from an
extra unit of production.
16. Observations
Rising Marginal Cost
MC rises with the quantity of out produced. This reflects the
property of diminishing marginal product.
U-Shaped Average Total Cost
Average fixed costs always reduces
Average variable costs typically rises as output increases
because of diminishing marginal product
The bottom of the U shaped curve occurs at the
quantity that minimizes average total cost
17. Long run costs curves
In the short term you cannot increase the number of
factories, only the number of workers
In the long run this is not an issue.
Economies of Scale – (Specialization) – When long run
average total costs falls as the quantity of output increases
Diseconomies of Scale – (Coordination Issue) – When LRATC
increase as the output increases
Constant returns of scale – When LRATC stays the same as
the quantity of output changes.
