THEORY OF PRODUCTION
AND COST
Class 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
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
Economic Cost





This is different to accounting cost
What is account 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 icecream.
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)
35
30
25
10
20
20
Profit
15
10
30
10
5
10
10
0
Economic Profit
Total Revenue
Accounting Profit
Implicit Cost
Explicit Cost
The production
functions
Output per
Marginal
Cost of
Hour

0
1
2
3
4
5
6
Two Assumptions
product of
labour
factory (FC)
 Short
Cost of
workers
(VC)
Number of
Workers
Run
0
0
30
0
 Size of Nelum’s factory is fixed
50 only vary
50 the amount
30 of ice-cream
10
 She can
by
increasing
workers
90
40
30
20
 Long run – She can build a new factory.
120
30
30
30
Total Cost
30
40
50
60
140
20
30
40
70
The production
function
150
10
80 to
The relationship
between
the 30
quantity of50inputs used
make a 155
good and 5he quantity30of outputs
for that good.
60
90
Production Function
180
160
140
120
100
Output per Hour
80
60
40
20
0
0
2
4
6
8
Total Cost
Total Cost Curve
100
90
 Marginal Product
80
 The increase in output that arises from an additional
70
unit of output
60
50  Diminishing Marginal Product
Total
Cost

The
property
whereby
the
marginal
product
of
an
input
40
declines as the quantity of the input increases.
30
20
10
0
0
50
100
150
200
Fixed and Variable Costs

Fixed Costs


Variable Costs





Costs that do not vary with the quantity of output produced
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.
Cups
Per
Hour
Total
Cost
Fixed
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
Variable Average Fixed Average Variable Average Total Marginal
Cost
Cost
Cost
Cost
Cost
350
300
250
200
150
100
50
0
0
1
2
3
4
Average Fixed Cost
Average Total Cost
5
6
7
8
9
10
Average Variable Cost
Observations

Rising Marginal Cost
 Chatura’s
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
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.
Break Time!