THEORY OF

PRODUCTION
Input and output

Fixed Input (building and machinery)and Variable Input (labor and raw materials)

Short run : period of time in which the supply of certain inputs(eg : Building and
machinery) is fixed or inelastic. (production can be increased through variable inputs)
 Costs
Total cost
Average Cost
Marginal cost
 Costs in the Short Run

fixed cost Any cost that does not depend on the firms level of output. These costs are incurred even
if the firm is producing nothing.

variable cost A cost that depends on the level of production chosen.

total cost (TC) Total fixed costs plus total variable costs.

TC = TFC + TVC
Average Cost : average costand/or unitcostis equal to totalcostdivided by
the number of goods produced (the output quantity, Q).

Marginal Cost : The marginal cost of production is the change in total cost that
comes from making or producing one additional item. Or Marginal cost is the
cost of marginal unit produced.
Short run cost output
relationship
C= f(Q, T , K)

In short run all determinants of cost other than q are constant

C= f(Q)
 Relationship between cost and
output in short run
total fixed costs (TFC) or overhead The total of all costs that do not change with output even if output is
zero.

In short run TFC (cost of building, plant machinery, equipment) remains fixed whereas the TVC varies with
the variation in the output
For a given output q,
AC= TC Q
AFC= TFC Q
AVC= TVC Q

Since TC=TFC+TVC

AC= TC Q = TFC Q+TVC Q

Marginal Cost = change in total cost change in output

Since TC = TFC + TVC and in short run fixed cost = 0
Hence, Marginal Cost = TVC Q
TABLE 8.4 Short-Run Costs of a Hypothetical Firm
(3) (4) (6) (7) (8)
(1) (2) MC AVC (5) TC AFC ATC
q TVC ( TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)
0 $ 0.00 $ - $ - $ 100.00 $ 100.00 $ - $ -

1 20.00 20.00 20.00 100.00 120.00 100.00 120.00

2 38.00 18.00 19.00 100.00 138.00 50.00 69.00

3 53.00 15.00 17.66 100.00 153.00 33.33 51.00

4 65.00 12.00 16.25 100.00 165.00 25.00 41.25

5 75.00 10.00 15.00 100.00 175.00 20.00 35.00

6 83.00 8.00 13.83 100.00 183.50 16.67 30.50

7 94.50 11.50 13.50 100.00 194.50 14.28 27.78

8 108.00 13.50 13.50 100.00 208.00 12.50 26.00

9 128.50 20.50 14.28 100.00 228.50 11.11 25.39

10 168.50 40.00 16.85 100.00 268.50 10.00 26.85

1. As output Increases the TFC remains Constant
2. As output increases, TVC increases at varying rate. It increases first at
decreasing rate and then at decreasing rate
3. As output increases, the TC increase at the rate of increase in TVC
4. AFC = TFC/Q, decreases continuously As TFC is constant
5. AVC decreases till the rate of increase in TVC decreases. Beyond it
increases
6. The MC decreases till certain level and then increases. The marginal cost
follows the TVC in short run
Graphical
Representation
Graphing Total Variable Costs and
Marginal Costs
Total variable costs
always increase with
output. The marginal
cost curve shows how
total variable cost
changes with single
unit increases in total
output.
Below 100 units of output, TVC
increases at a decreasing rate.
Beyond 100 units of output, TVC
increases at an increasing rate.
Relationship Between Average
Variable Cost and Marginal Cost
When marginal cost
is below average
cost, average cost is
declining.
When marginal cost is above
average cost, average cost is
increasing.

Rising marginal cost intersects

average variable cost at the
minimum point of AVC.
At 200 units of output, AVC is
minimum, and MC = AVC.
The Shape of the Marginal Cost
Curve in the Short Run
Marginal costs ultimately increase with output in the
short run.
Relationship Between Average Total
Cost and Marginal Cost
If marginal cost is below
average total cost,
average total cost will
decline toward marginal
cost.
If marginal cost is above
average total cost,
average total cost will
increase.
Marginal cost intersects
average total cost and
average variable cost
curves at their respective
Long-Run Cost Curves
Planning Horizon
The long run, during which all inputs
are variable

long-run average cost curve (LRAC) The envelope of a series of short-run cost curves.

16
Preferable Plant Size and the Long-
Run Average Cost Curve

17
Long-Run Cost Curves
Long-Run Average Cost Curve
LAC increases deceases until the optimum utilization of second
plant
The locus of points representing the minimum unit cost of
producing any given rate of output, given current technology
and resource prices
Only at minimum of long-run average cost curve, the short-run
average cost curve is tangent to long-run average cost curve at
their respective minimum

18
 Why the Long-Run Average Cost
Curve is U-Shaped
Economies of scale
Constant returns to scale
Diseconomies of scale

19
Application of Traditional Cost
Curves

Predatory Pricing: MC=MR is the basic principle of profit

maximization.

However, firms in the short run operate at prices below their

Marginal Cost and also Average Total Cost (ATC) i.e. incurring
losses. But at least they should earn AVC.

If price is below the AVC even in the short run firm ceases to
exist.
Other Cost Concepts
Sunk costs: It is a past cost which cannot be altered by future
action. So it is irrelevant but it is very difficult to ignore.

For e.g. you bought 1000 shares at Rs. 25 per share and now
it is priced at Rs. 15. There are other shares available which
may have a better future than share presently possessed. But
many people hold on to their present share until they recover
their losses from same share.
Other Cost Concepts
Opportunity cost: It is the cost of opportunity lost or
foregone in terms of next best alternative.

For e.g.: A given amount of money can be invested in any one

of the alternatives:

1. Shares/bonds

2. Gold

3. Real Estate

. You can choose an alternative which has least opportunity

cost.
Other Cost Concepts
Recurring costs refer to any expense that is known,
anticipated, and occurs at regular intervals.

Nonrecurring costs are one-of-a-kind expenses that occur at

irregular intervals and thus are sometimes difficult to plan for
or anticipate from a budgeting perspective
Other Cost Concepts
Incremental Costs: One of the fundamental principles in
engineering economic analysis is that in making a choice
among a set of competing alternatives, focus should be placed
on the differences between those alternatives

For e.g.: There may be incremental costs associated with one

option not required or stipulated by the other. In comparing the
two leases, the focus should be on the differences between the
alternatives, not on the costs that are the same.
Other Cost Concepts
Life Cycle Cost: The products, goods, and services designed
by engineers all progress through a life cycle.

Life-cycle costing refers to the concept of designing products,

goods, and services with a full and explicit recognition of the
associated costs over the various phases of their life cycles.
Figure illustrates how costs are committed early in the product
life cycle-nearly 70-90% of all costs are set during the design
phases. At the same time, as the figure shows, only 10-30% of
cumulative life-cycle costs have been spent.

Two key concepts in life-cycle costing are that the later design
changes are made, the higher the costs, and that decisions
made early in the life cycle tend to "lock in" costs that are
incurred later.
Life-cycle design change costs and
ease of change.