theory of production and costs

1. Theory of Production
and cost
Week 4

2. 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

3. 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

4. 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.

5. 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

6. 10 10
10
10
30
20
0
5
10
15
20
25
30
35
Economic Profit Total Revenue Accounting Profit
Profit
Implicit Cost
Explicit Cost

7. 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.

8. 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

9. 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

10. 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.

11. 0
10
20
30
40
50
60
70
80
90
100
0 20 40 60 80 100 120 140 160 180
Total Cost
Total Cost

12. 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.

13. Cups
Per
Hour
Total
Cost
Fixed
Cost
Variable
Cost
Average Fixed
Cost
Average
Variable Cost
Average Total
Cost
Marginal
Cost
0 300 300 0 0 0 0
1 330 300 30 300 30 330
2 380 300 80 150 40 190
3 450 300 150 100 50 150
4 540 300 240 75 60 135
5 650 300 350 60 70 130
6 780 300 480 50 80 130
7 930 300 630 43 90 133
8 1100 300 800 38 100 138
9 1290 300 990 33 110 143
10 1500 300 1200 30 120 150

14. 0
50
100
150
200
250
300
350
0 1 2 3 4 5 6 7 8 9 10
Average Fixed Cost Average Variable Cost
Average Total Cost

15. 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

16. 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.

18. Break Time!