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DEC5015 (Microeconomics) / Production, Inputs and Costs
PART 5 : PRODUCTION , INPUTS AND COSTS
Objectives:
Upon completion of this chapter , you should be able to :
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Distinguish between explicit and implicit costs, accounting and economic profit.
Explain the relationship between a firm's output and its costs
Explain the meaning of average total cost and marginal cost and how they are related
Explain the shape of typical firm's cost curves
Examine the relationship between short run and long run costs
Describe and explain the least cost technique of production (using isoquants and
isocost)
Explicit & implicit costs, accounting and economic profit
Explicit cost- A cost that is incurred when an actual (monetary) payment is made.
Implicit Cost- A cost that represents the value of resources used in production for which
no actual (monetary) payment is made.
Accounting profit- Total Revenue-Explicit costs
Economic profit-The difference between total revenue and total opportunity cost,
including both its explicit and implicit components.
Economic profit = Total Revenue-Total opportunity cost
Economic profit = Total revenue-(Explicit + Implicit costs)
 Economic profit is usually lower (never higher) than accounting profit because
economic profit is the difference between total revenue and total opportunity
costs, including both explicit and implicit costs.
Please refer to page 260, Table 11.1
The firm's objective and constraint
The traditional theory of the firm assumes that firms aim to maximise profits .
In its pursuit of profit , the firms faces market constraints and technology constraints .
 Market constraints are the price and the quantity conditions that determine how the
firms buy its inputs and sells its output .
 Technology constraints are the limits to the quantity of output that can be produced
by using given quantities of inputs .
Under technology constraint , to maximise profits , firms must use production methods
that are both technologically and economically efficient .
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Technologically efficient occurs when it is not possible to increase output without
increasing inputs . Equivalently , it refers to the minimum number of inputs used to
produce a given level of output .
Methods
Inputs
Capital
A
2
B
4
C
2
D
1
E
1
Table 5.1 Technologically efficient



Labour
2
2
3
2
1
Inputs
Capital
A
2
B
3
C
2
D
2
E
1
Table 5.2 Economically efficient


100
100
100
100
100
Method E is technologically the most efficient method of production as it uses the
least number of inputs (2) to produce the given level of output.
Method B is considered to be the most technologically inefficient, using 6 inputs to
produce the same 100 units of output.
Economically efficient occurs when the cost of producing a given output (TC) is as
low as possible.
Method

Output
Labour
1
2
3
2
2
Output
Total cost
100
100
100
100
100
25
40
35
30
20
Method E is the most economically efficient because the producer incurs the least
cost (TC) with given level of output
Although method A is technically efficient as efficient as method E i.e. both use 3
inputs , method E is still relatively cheaper
In contrast , method B is the most economically inefficient
The Production Function
 Production is a transformation of resources into goods and services
 shows the relationship between the amount of factors used and the amount of output
generated per period of time
 the simplest model assumes just 2 factors of production ( fop ) ; labour and capital or
labour and land
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The Short Run and the Long Run
 The possibilities for changing productions methods depends on two planning
horizons:the short run and the long run.
 The short run is a period of time in which the quantity of at least one input cannot be
changed and the quantity of other inputs can be varied.
 The long run is a period of time in which the quantity of all inputs can be varied.
 Inputs whose quantity can be varied as output changes in the short run are called
variable inputs.
 Inputs whose quantity cannot be varied as output changes in the short run are called
fixed inputs.
 There is no specific time that can be marked on the calendar to separate the short run
from the long run.
Production in the short run
Production in the S/R is subject to diminishing returns
The law of diminishing returns says that :
when increasing amounts of a variable factor are used with a given amount of fixed
factor , there will come to a point when each extra unit of the variable factor will
produce less extra output than the previous unit
To increase output in the short run , a firm must increase the amount used of a variable
input .
The effect of a change in the quantity of a variable input can be described using 3 related
concepts

Total product

Marginal product

Average product
Total Product
 Total product shows the maximum output attainable from a given amount of fixed
input (e.g: capital) as the amount of variable input (e.g: labour) is changed .
 Please refer page 263, figure 11.2
 The total product schedule shows how the quantity of smooties that Sam’s produce
changes as the quantity of labor employed changes.
 The total product curve, TP graphs the data in the table. Points A through H on the
correspond to the columns of the table.
 It separates between attainable and unattainable output levels . Points below the curve
are attainable but inefficient , only points on TP curve are technologically efficient .
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Marginal product
 Marginal product (MP) of an input shows the change in total output from one unit
change in the amount of an input .
 For e.g. MP for labour is the change in output resulting from one unit change in the
amount of labour employed .
 Please refer to page 265, Figure 11.3
 Please pay attention to the explaination in the lecture.
 MP can be measured by the slope of TP curve .
 The steeper the slope of TP curve , the larger is the marginal product .
 Marginal product increases to a maximum (when 1 worker is employed) and then
declines -diminishing marginal product .
Average product
 Average product of an input is the total output divided by the total amount of the
input.
 For e.g. average product of labour equals total output divided by the number of
workers employed.
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The average product increases when the marginal product exceeds the average
product .
The average product falls when the marginal product is smaller than the average
product
The average product is at its maximum and does not change when the marginal
product equals the average product .
The relationship between marginal product and average product is called the marginalaverage rule ( Refer to page 266, Figure 11.4)
 When marginal product of labour curve rises , the firms experiencing increasing
marginal returns, that is , marginal product of an additional worker exceeds the
marginal product of the previous worker .
 But , increasing marginal returns do not always occur , eventually , all production
processes will reach a point of diminishing marginal returns .
 Law of diminishing returns states that , "as firms uses more of a variable input
without changing the quantity of fixed inputs , the marginal product of the
variable input eventually diminishes" .
 Diminishing marginal returns occur when marginal product of additional worker is
less than the marginal product of the previous worker .
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Short Run Cost
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A firm's cost of production will depend on the factors of production .
The more factors it uses, the greater will its costs be.
A firm's total cost is the sum of the costs of all inputs uses in production
It includes
 Total fixed cost, TFC . It is the cost of the firm's fixed inputs. This cost is
independent of the level of output.
 Total variable cost, TVC . It is the cost of the firm's variable inputs. This cost
changes with the firm's level of output.
 Thus , total cost equals total fixed cost plus total variable cost , or " TC = TFC +
TVC"
 Please refer page 269, Table 11.2
Marginal cost
 Marginal cost , MC is the change in total cost resulting from 1-unit change in output .
 Equivalently , it is the change in its total cost divided by the change in its output i.e.
MC = change in TC / change in Q
 Please refer page 271, Table 11.3
 Notice that , when the firm hires a second worker marginal cost decreases .
 But , when a sixth workers are employed marginal cost increases .
 This is due to law of diminishing returns , which means that , each additional worker
produces a smaller addition to output .
 So , to get an additional output, more workers are required. Thus, cost of additional
output (marginal cost) will increase .
Average cost
 Average cost is the cost per unit of output .
 There are 3 average costs :
 Average fixed cost (AFC)
 Average variable cost (AVC)
 Average total cost (ATC)
 Average fixed cost is the total fixed cost per unit
 Average variable cost is the total variable cost per unit output.
 Average total cost is the total cost per unit output.
 In equation form , these definitions are as follows:
AFC = FC / Q
AVC = VC / Q
ATC = TC / Q
= AVC + AFC
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Please refer page 270, Figure 11.6
 In general , the ATC is always above the AVC .
 The gap between ATC and AVC is AFC (indicated by arrows) .
 AFC declines as output rises, since the same constant fixed cost is spread over a large
output.
 Thus, as output increases, the difference between the ATC and AVC becomes small.
 Please refer page 272, Figure 11.7
 The MC curve intersects the AVC curve and ATC curve at their minimum.
 When MC is less than AC ( ATC and AVC ), average cost is decreasing.
 When MC exceeds AC, AC is increasing.
Why ATC curve is U-shaped ??
 The U-shaped of ATC curve arises from the influence of 2 opposing forces.
 The ATC curve slopes downward because the AFC drops rapidly as fixed costs are
spread over more output.
 The ATC curve slopes upward because diminishing returns sets in which leads the
AVC curve begins to increase. Eventually, AVC increases more rapidly than AFC
decreases. So, ATC increases.
 The MC curve cuts the ATC and AVC curves at their minimum.
Cost curves and Product curves
Relationship between marginal product and marginal cost
 Over the range of rising MP , MC is falling.
 When MP is a maximum , MC is minimum.
Please refer page 275, Figure 11.8
Relationship between average product and average variable cost
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Over the range of rising AP, AVC is falling.
When AP is a maximum, AVC is a minimum.
Over the range of diminishing marginal product, MC is rising.
Over the range of diminishing average product, AVC is rising.
For the above, graphs will be shown in lecture
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A closer look at the relationship between product and costs
Shifts in the cost curve
Factors that will cause the cost curves to shift:
Taxes
 Taxes will affect variable costs. As a consequence of the tax, the firm has to pay
more for each unit of X it produces. Because variable costs rise, so does total cost.
This means AVC and ATC rise, and the representative cost curves shift upward.
Besides, because marginal cost is the change in total cost (or variable cost) divided by
the change in output, marginal cost rises and the marginal cost curve shifts upward.
Technology
 technological changes often bring (1)the capability of using fewer inputs to
produce a good (for example, the introduction of the personal computer reduced
the hours necessary to type and edit a manuscript) or (2) lower input prices
(technological improvements in transistors have led to price reductions in the
transistor components of calculators). In either case, technological changes of this
variety lower variable costs, and consequently, lower average variable cost,
average total cost and marginal cost.
Input prices
 A rise or fall in variable input prices causes a corresponding change in the firm's
average total, variable, and marginal cost curves. For example, if the price of steel
rises, the variable costs of building rise and so must average variable cost, average
total cost, and marginal cost. The cost curves shift upward. If the price of steel
falls, the opposite effects occur.
Production and Costs in the Long Run
 The long run is distinguished from the short run by the firm's ability to vary all
factors of production freely in the long run .
 Long run cost is the cost of production when a firm uses the economically efficient
plant size .
Example 5.1 shows Swanky's production function .
Labor
(workers per day)
Plant 1
1
4
2
10
3
13
4
15
5
16
Knitting machines
1
Table 5.3 The production function
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Output (sweaters per day)
Plant 2
10
15
18
20
21
2
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Plant 3
13
18
22
24
25
3
Plant 4
15
21
24
26
27
4
DEC5015 (Microeconomics) / Production, Inputs and Costs
 The table shows the total product data for four plant sizes .
 These numbers are graphed as the total product curves TP1 , TP2 , TP3 , and TP4 .
 The bigger the plant , the larger is the total product for any given amount of labour
employed .
 But each total product curve displays diminishing marginal product .
Diminishing returns
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Just as marginal product of labour , marginal product of capital is the increase in
output resulting from a unit increase in the amount of capital employed , holding
constant the amount of labour employed .
For e.g. from Table 5.3 , if Swanky has 3 workers and increases number of machine
from 1 to 2 , output increases from 13-18 sweaters .
Marginal product of capital is 5 sweaters . If with 3 workers , output increases from
18-22 ,marginal product of capital is 4 sweaters .
Thus , just as the law of diminishing returns indicates that the marginal product of
labour diminishes , so too does the marginal product of capital diminishes .
Short Run Cost and Long Run Cost
 Many costs are fixed in the short run but variable in the long run, a firm's long run
cost curves differ from its short-run cost curves.
 Please refer to pg 492, exhibit 8. The figure shows the relationship between three
factory sizes and the Long-Run Average Cost Curve.
 Each of these short-run -average-total-cost curve (SRATC) schedules represents the
average total cost of producing different levels of output using plant of different
capacity. It also shows the long-run-average-total-cost curve (LRATC). As the firm
moves along the long run curve, it is adjusting the size of the factory to the quantity
of production.
 The LRATC is a much flatter U-shape than the SRATC. The long run curve lies
below all of the short run curves. This is because, in the long run firms is more
flexible in expanding their production.
 Each of these SRATC schedules represents the average total cost of producing
different levels of output using plant of different capacity .
Long Run Average Cost ( LRAC ) Curve
 The LRAC curve shows the lowest ATC for different levels of output when both
capital and labour are varied.
 The LRAC curve is derived from the short run ATC curves.
 Please refer to page 279, Figure 11.9
Returns to Scale
 Returns to scale are the increases in output that result from increasing all inputs by
the same percentage .
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 3 possible cases :
i) constant returns to scale
 occur when the percentage increase in firm's output is equal to the
percentage increase in its inputs . For e.g. if firm doubles all its inputs ,
its output exactly doubles .
ii) increasing returns to scale
 occur when the percentage increase output exceeds percentage
increase in inputs . If firm doubles all its inputs , its outputs more than
doubles .
iii) decreasing returns to scale
 occur when the percentage increase in output is less than the
percentage increase in inputs . If a firm doubles all its inputs , its
output less than doubles .
Economies and Diseconomies of Scale
 The shape of the LRAC curve reflects economies and diseconomies of scale , where
scale refers to the size of the firm as measured by its output .
 There are economies of scale when LRAC falls as output increases . When economies
of scale are present , the LRAC curve slopes downward .
 There are diseconomies of scale when LRAC rises as output increases . When
diseconomies of scale are present , the LRAC slopes upward .
Factors contributing to EOS and DOS
Economies of Scale
 There are a number of reasons why firms are likely to experience economies of scale .
 Specialization and division of labour .
 As a firm gets larger , each worker can concentrate more on one task and
handle it more efficiently.
 There is less time lost in workers switching from one operation to another ;
and supervision is easier.
 Indivisibilities
 A firm must have minimum amounts of some inputs to be in business.
 For instance, any firm has to be managed, has to keep its accounting record in
order, and probably needs a telephone and a desk .
 These requirements are indivisible, in the sense that a firm cannot keep only
half its book or use half of its telephone.
 As the firm grows, these inputs do not have to be increased much, and so their
costs per unit of output fall.
 Average cost falls, and thus, there are economies of scale because the same
indivisible factors are being spread over more units of output.
 Multi-stage production
 A large factory may be able to take a product through several stages in its
manufacture.
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 This saves time and cost in moving the semi-finished product from one firm
or factory to another.
Diseconomies of scale
 The main reasons for such diseconomies of scale :
 Management problems of coordination may increase as the firm becomes
larger and more complex, and lines of communication gets longer. There may
be lack of personal involvement by management.
 workers may feel 'alienated ' if their jobs are boring and repetitive, and if they
feel an insignificantly small part of a large organization. Poor motivation may
lead to shoddy work.
The optimum combination of factors:


the marginal product approach
the isoquant / isocost approach
(A) The Marginal Product Approach
i)
The simple two-factor case
 assume that a firm uses just 2 factors:
labour (L) and capital (K)
The least-cost combination of the two will be where
MPL MPK

PL
PK
 where the extra product (MPP) from the last dollar spent on each factor is equal.
ii)
The multi-factor case
 Where a firm uses many different factors, the least-cost combination of factors will be
where:
MPa MPb MPc
MPn


.......... 
Pa
Pb
Pc
Pn
(B) The Isoquant / Isocost Approach
A firm’s choice of optimum technique can be shown graphically. This graphical analysis
takes the simplest case of just 2 variable factors - e.g. : labour and capital
 this is done with the construction of isoquants and isocosts
The Isoquant
 The isoquant or producer’s indifference curve can be defined as the various possible
combination between two inputs (x and y) that yield the same level of output.
 A series of isoquant is called an isoquant map. Figure 5.2 shows an isoquant map
with 3 isoquants.
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 It is downward sloping because of the concept of opportunity cost, i.e. the more of
input x being used would mean less of input y.
capital
5
4
3
2
21 sweaters
1
10 sweaters
0
1
2
3
4
5
15 sweaters
labour
Figure 5.2 Isoquant map
 The marginal rate of technical substitution is the magnitude of the slope of the
isoquant .
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 Figure 5.3 shows the relationship . The MRTS of labour for capital at point a is the
magnitude of the slope of the straight line that is tangent to the isoquant at point a
capital
5
4
MRS = 2
3
a
2
MRS = 0.5
b
1
13 sweaters
0
1
2
3
4
5
labour
Figure 5.3 The Marginal Rate of Substitution
 The magnitude of the slope at point a is 5/2.5 = 2 . Thus , at point a the MRTS of
labour for capital is 2 .
 The MRTS at point b is found from the slope of the line tangential to the isoquant at
that point. Thus, the MRTS at point b is 2.5/5 = ½ .
 The isoquant becomes less steep as more labour is used because, in accordance of law
of diminishing marginal rate of substitution, labour becomes less and less able to
substitute for capital.
 Hence, the law of DMRS accounts for the “bowed-toward-the origin ” shape of the
isoquant.
 Isoquants cannot intersect because of the assumption of transitivity,i.e. it is illogical
to produce 2 different levels of output using the same amount of input combination.
Isocost Lines
 An isocost line shows all the combinations of capital and labour that can be purchased
for a specific total cost.
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capital
5
a
4
b
3
c
2
d
1
e
0
1
2
3
4
5
labour
Figure 5.4 Isocost Line
 If labour and capital cost RM25 a day each , for a total cost RM100 , the
combinations of capital and labour are shown by points a through e . The line passing
through these points is an isocost line
 In terms of equation , the isocost equation is
 TC = ( PL ) ( L ) + ( PK ) ( K )
 where TC is total cost , PL is the price of labour (the wage rate), L is the amount of
labour employed , PK is the price of capital , and K is the amount of capital utilised .
 With labour on the horizontal axis and capital on the vertical, the slope of the isocost
line is PL / PK
 The slope of the isocost line depends on the relative input prices.
 An increase in the price of labour (capital) rotates the isocost line, making it steeper
(less steep).
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capital
4
3
2
C
A
1
B
0
1
2
3
4
labour
Figure 5.5 Input Prices and Isocost Line
 The slope of the isocost line depend on the relative price input prices .
 If the prices of labour and capital are RM25 each , the isocost line is A .
 If price of labour rises to RM50 , but the price of capital remains unchanged , the
isocost line becomes steeper and is line B .
 If the price of capital rises to RM50 and the price of labour remains unchanged , the
isocost line becomes flatter and is line C .
Isoquant and isocosts can now be put on the same diagram. The diagram can be used to
answer either of two questions:
a) What is the least-cost way of producing a particular level of output?
b) What is the highest output that can be achieved for a given cost of production?
a) The Least-Cost Technique


HH
The least-cost technique (or economically efficient technique) is the combination of
inputs that minimizes the total cost of producing a given amount of output .
Figure 5.6 shows the least-cost combination of labour and capital, as L and K, which
is where the isoquant is tangent to the isocost .
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DEC5015 (Microeconomics) / Production, Inputs and Costs
capital
K
isoquant
isocost line
L
labour
Figure 5.6 The Least-Cost Combination


At the least-cost combination , the slope of the isoquant equals the slope of the isocost
.
Hence, the marginal rate of technical substitution (the magnitude of the slope of the
isoquant) equals the relative input price (the magnitude of the slope of the isocost
line).
b) Highest output for a given cost of production
The point at which the isocost touches the highest isoquant will give the factor
combination yielding the highest output for that level of cost.
The slope of the isocost and isoquant are the same:
PL
 MRS
PK
If the prices of factors change, new isocosts will have to be drawn. If wages rises, less
labour can be used for a given sum of money. The isocost will swing inward round point
x. The isocost will get steeper. Less labour will now be used relative to capital.
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K
h
L
Figure 5.7 Maximizing output for a given total cost
Marginal Rate of Technical Substitution and Marginal Products





The marginal rate of technical substitution and marginal products of the inputs are
linked: The marginal rate of technical substitution of labour for capital equals the
marginal product of labour divide by the marginal product of capital .
To see this result, note that the change in output resulting from changing the amount
of capital and labour is (MPL)(L) + ( MPK)(K).
Along an isoquant , the change in output is defined as 0 , so along an isoquant (MP L)
(L) = - (MPK)(K) .
Rearranging the last equality yields MPL / MPK = - K / L.
Because K / L equals the marginal rate of technical substitution of labour for
capital, the last equality shows that the marginal rate of technical substitution equals
the ratio of the marginal products .
Mathematical proof:
MPL=
TP
L
MPK=
TP  (MPL X L )+ (MPK X K )
Along an isoquant, TP  0
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TP
K
DEC5015 (Microeconomics) / Production, Inputs and Costs
Therefore, MPL X L = - MPK X K
K
 MPL = MPK
L
x
Since
K
= MRTSLK
L
Therefore, MRTSLK = MPL
MPK
Comparison with the marginal productivity approach:
MPL MPK

PL
PK
Least-cost combination is where the isoquant is tangential to an isocost. Thus their slope
MP L
is the same. The slope of the isoquant equals MRS, which equals
and the slope of
MP K
PL
isocost equal
PK

MPL PL

MPK PK
MPL MPK

PL
PK
 the two approaches yield the same result
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