1. Topic 6 : Production and Cost

2. The Production Process
(Short Run)
K L Q        

3. Q
102
100 90 70 45 25 10 L

4. Q
The Total
Product (TP)
Curve L

5. Diminishing Returns to Labour set in from the 5th unit onwardsQ
Diminishing Returns to Labour
set in from the 5th unit onwards 25 20 20 15 10 10 2 L

6. Q
The Marginal
Product (MP)
Curve L

7. AP Q MP 20 25 20 15 10 10 L

8. If MP > AP, then AP is risingQ
If MP < AP, then AP is falling
If MP = AP, then AP is stationary AP MP L

9. From Production to Cost where W is a fixed and known
MC = W/MP
where W is a fixed and known
wage rate

10. MC
AVC Q

11. MC
AVC Q

12. If MC < AVC, then AVC is falling
If MC > AVC, then AVC is rising
If MC = AVC, then AVC is stationary MC
AVC Q

13. .
The graph of AFC . . . . . .
AFC Q

14. . . . . . . . . . .
ATC . . .
AVC .
AFC Q

15. . . . . . MC . .
ATC
AVC Q

16. If MC < ATC, then ATC is falling
If MC > ATC, then ATC is rising
If MC = ATC, then ATC is stationary MC
ATC Q

17. The Short Run Average Cost
(SAC) for a given value of
Capital (K = K*)
SAC Q O

18. SAC2
SAC1
SAC4
SAC3 Q O

19. The Long Run Average Cost (LAC) envelopes the SAC curves
The Long Run Average Cost (LAC) envelopes the SAC curves
LAC Q O

20. Construction of the LMC
SMC4
SMC3
SMC1
SMC2
LMC
LAC Q O

21. The Production Process
(Long Run)
An isoquant is the path joining points in the L-K space that represent input combinations that produce the same amount of output
It is derived from the long run production function by fixing the output level.
It is a concept similar to that of an indifference curve introduced earlier.

22. The isoquants are drawn downward sloping as long as inputs have a positive marginal product.
That is, the isoquants must slope downwards if adding a factor of production (holding the other factor constant) adds to output.
Question: How would the isoquants shape if some factor (say L) has a negative marginal product?

23. These curves are drawn convex to the origin to reflect DIMINISHING MRTSKL .
As more L is used to substitute, it becomes increasingly more difficult to substitute K by L.

24. Constant Returns to Scale
OA=AB= BC k C 30 B A 20 10 o l
Constant Returns to Scale

25. Decreasing Returns to Scale
OA=AB= BC k C B A 20 10 o l
Decreasing Returns to Scale

26. Increasing Returns to Scale
OA=AB= BC k C B A 20 10 o l
Increasing Returns to Scale

27. Expansion Path
(Long Run) k 4 3 2 1 o l
180
240
100

28. Long Run Total
Cost (LTC)
240
180
100 O Q 1 2 3

29. Long Run
Average
Cost (LAC) and
Marginal Cost
(LMC)
100
LAC 90 80 60
LMC Q 1 2 3 O

30. At Q < Q*, SMC < LMC
At Q*, SMC = LMC
SAC
SMC
LMC
LAC Q* Q O
At Q > Q*, SMC > LMC

31. 280 200 Expansion Path (Long Run) Expansion Path 100 3 (Short Run) 1 2k
280
200
Expansion Path
(Long Run)
Expansion
Path
(Short Run)
100 3 1 2 o l
340
120

32. SMC of 3rd unit
= ( ) = 140
LMC of 3rd unit
= ( ) = 80
At Q > Q*,SMC > LMC
LMC of 1st unit
= ( ) = 100
SMC of 1st unit
= ( ) = 60
At Q < Q*,
SMC < LMC

33. Decreasing Returns to Scale (DRS) and Diminishing Returns to a Factor (DRF)
DRS is a long run concept so that all factors are changeable.
DRF is a short–run concept, with the existence of fixed factors of production.
Does DRS imply DRF?

34. Instead, suppose we fix K at 1 and only treble L.
K L Q
Instead, suppose we fix K at 1 and only treble L.
If K has a positive marginal productivity, Q will be less than 2.
This production process exhibits DRS
DRS implies DRF

35. EXAMPLE 1
Short Run Production (K is fixed at 1)
 L Q
Long Run Production (K is variable)
 L K Q

36. EXAMPLE 2
Short Run Production function (K is fixed at 1)
L Q
1 2
2 3
Long Run Production (K is variable)
 L K Q  

37. The first of the two numerical examples shows that DRF may not always lead to DRS;
the second shows that DRF may sometimes lead to DRS.
DRF does not necessarily imply DRS