Cross elasticity of demand Cross elasticity of demand measures the responsiveness of a commodity's

quantity demanded to changes in another commodity's price. For instance, tea demand increases with
coffee price increase, indicating high cross elasticity. If two goods are substitutes, they have positive
cross elasticity, while complementary goods may have negative cross elasticity. The formula calculates
the responsiveness of one commodity to a change in another's price.

Substitute goods:

Positive cross elasticity of demand implies that X and Y are substitute goods, with a larger positive
coefficient indicating greater substitutability between the two products, as seen in the example of Coca-
Cola.

Complementary goods: When cross elasticity is negative, X and Y are complementary goods, with larger
negative coefficients indicating greater complementarity between the two goods.

Independent goods: A zero cross elasticity suggests that the two products are unrelated

Or they are independent goods.

Unit 3

Theories of Production and Cost

Introduction

Production is a scientific process that converts raw materials into desired products or services, adding
economic value by transforming resources like labor, materials, services, and machines.

Production Function

The production function is a mathematical formula that outlines the maximum output a firm can
produce for a given combination of inputs, such as labor and capital, and allows for various
combinations of inputs.

Short Run Production Function

The short-run refers to the period of time when at least one production factor is fixed, such as land and
capital. In a simple production process, capital is the fixed factor and labor is the variable factor.

Production with one variable input:

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A farmer's production involves one variable input, labor, with other inputs like land, capital, and
technology being fixed. This short-run phenomenon is a factor.

That is to say: QQ = FF(LL, LL̅aa, KK̅, TT̅ )

Where, Q=Quantity (output), L = Labor, La = Land, K = Capital, T = Technology, and the bar implies
constant.

The bar implies constant.

The short run production function measures the impact of a farmer's labor change on wheat production,
keeping land, capital, and technology constant. It consists of three basic concepts: total physical product
(TP), average physical product (AP), and marginal physical product (MP). TP represents the total output
produced by a variable input, while AP is calculated by dividing total output by workers.

The average product of labor (APL), total product (TP), and marginal product (MP) are all interrelated
measures of output per worker. The marginal product (MP) is the extra output obtained with one extra
unit of input, while the total product (TP) is the total output.

The Law of Diminishing Marginal Productivity

The law of diminishing returns states that increasing the amount of variable inputs with fixed capital
leads to an eventual decline in the marginal contribution of additional labor to total output. This is
because the production capacity goes to exhaustion as the number of labor employed increases,
resulting in a loss or negative contribution.

Stages of production

The production function demonstrates that a firm's output can be varied by efficiently utilizing different
labor units, with total production (TP) or total quantity (Q) being a function of labor (L). A hypothetical
example illustrates this relationship.

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Stages of Production: as table 3.1 shows, the total product goes through three

Different stages.

I Stage I (increasing returns stage): this stage includes the range of variable inputs at which the MPL
continues to rise, i.e., up to the point of MPL.

Stage II (the diminishing returns stage): this stage includes the value over which MPL is positive but
decreasing.

Stage III (negative returns stage): defined as a range of negative MPL or decreasing TP.

In this stage of production, since MPL is negative, additional units of variable inputs (L) actually cause a
decrease in TP.

From table 3.1, we can sketch the graph to show the relationships between the variables, and also to
explain the law of diminishing marginal returns.

Production curves and stages of production

The graph demonstrates that as labor units are added, the total product initially increases, then reaches
its maximum and starts to fall. This relationship is also evident for MPL and APL. MPL increases with
increasing labor rate, while APL reaches its maximum before it. The MPL curve reaches its maximum
before the APL curve, and when APL is rising, it is above it. To increase APL, the addition to TP must be
greater than the previous APL.

The Long-Run Production Function

In the long-term analysis of production, a firm can change the quantity of all inputs, requiring any
number of different inputs. If a firm produces output using only labor and capital, it can usually produce
a given level of output by combining different amounts of labor and capital.

Isoquant

An isoquant is a curve that shows all possible efficient combinations of inputs that canyield equal level of
output. If both labor and capital are variable inputs, the production function will have the following
form.

Q = f (L, K); given this production function, the equation of an isoquant, where output is held constant at
Q is Q = f (L, K)

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In the long-term analysis of production, isoquants demonstrate the flexibility firms have in making
production decisions by substituting one input for another. The production isoquant can take various
shapes depending on factor substitutability, with the smooth or convex isoquant being commonly used
in traditional economic theory.

An isoquant schedule is a tabular representation of different combinations of two variable inputs, such
as labor and capital that yield the same output level, as illustrated in hypothetical table 3.2.

Factor Combinations to Produce a Given Level of Output (Isoquant Schedule)

Table 3.2 shows that input combination A, consisting of 1 unit of labor (L) and 11units of capital (K),
produces 100 units of output. While combination B consists of 2 units of labor and 7 units of capital.
Similarly, combination C consists of 3 units of labor and 4 units of capital, and so on. Figure 3.3 is
constructed from Table 3.2 by joining the points of different combinations of labor and capital required
to produce100 units of output.

Capital side technical progress:

Technical progress impacts production function by shifting output with less or more inputs. There are
three types: capital side, labor side, and neutral technical progress. Capital side increases marginal
product more than profit, while labor side increases marginal product more.

Properties of isoquants

I. Isoquants are down ward sloping: implying that if more of one factor is used, less of the other factor is
needed for producing the same level of output. II . The further an isoquant lays away from the origin,
the greater the level of output it denotes. III . Isoquants do not cross each other. IV . Isoquants are
convex to the origin.

The slope of an isoquant/ marginal rate of technical substitution (MRTS):

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The slope of an isoquant (∆K/∆L) indicates the substitutability of production factors. As the slope
decreases, the marginal rate of technical substitution (MRTS) decreases, indicating a firm's ability to
substitute between labor and capital in its production process.

Returns to Scale

This section explores how input quantity increases impact a firm's output. It discusses three cases of
returns to scale: increasing, constant, and decreasing. Increased returns increase output more than
input proportion, constant returns increase output proportionally, and decreasing returns decrease
output proportionally.

Technology Change and the Position of Production Curves.

Technological progress enhances production efficiency, allowing firms to achieve higher output from the
same labor and capital combinations. This progress results in new, more efficient methods of
production, resulting in an upward shift in the production function. Technical progress can also alter the
shape and shift of the isoquant, with three types depending on the rate of substitution of production
factors.

Technological progress is the process of making production factors more productive or efficient,
resulting in higher output from the same combination of labor and capital.

This progress is characterized by the upward movement of the total product curve, indicating that the
same output can be produced with less factor inputs or more output with the same inputs.

Technical progress refers to the development of new and more efficient production methods, which can
lead to technological changes and an upward shift in the production function.

There are three types of technical progress: capital side technical progress, labor side technical progress,
and neutral technical progress. Capital side technical progress increases the marginal product (MPK) by
more than the marginal profit (MPL), while labor side technical progress increases the MPL by more
than the MPK. Neutral technical progress increases both the MPL and MPK by the same amount.

3.2. Theory of Cost

Introduction

The cost of production refers to the expenses incurred by a firm on inputs to produce outputs. This
section explores production costs and their relationship in the short and long run, focusing on cost

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functions that describe the cheapest way to produce output, considering output, technology, and
variable and fixed factors.

Short-Run Costs

Short-run costs are fixed production factors over a period, divided into cost functions. Total cost is a
multi-variable function, determined by output, technology, and variable and fixed factors, and is divided
into two parts.

Total Fixed Cost (TFC):

TFC is a cost that remains constant regardless of output, including fixed costs like administrative staff
salaries and building depreciation and repairs.

Total variable cost (TVC): TVC is a cost that varies with output volume, encompassing variable costs such
as raw material and labor costs.

Total Cost (TC): Total cost of production is the sum of all fixed and variable costs incurred in producing a
given output.

The total variable cost initially increases at a decreasing rate at the initial stage of production, as more of
the variable factors are employed. When the productivity of the variable input falls, larger and larger
units of the variable input will be needed to increase output by the same unit, and thus TVC and TC
increase at increasing rates.

By adding the TFC and TVC, we can obtain the TC of the firm. From the total-cost curves, we obtain
average cost curves.

AFC (Average Fixed Cost): AFC is the total fixed cost divided by the amount of output,

Average Variable Cost (AVC): The average variable cost is the per-unit cost of the variable factors of
production. It is obtained by dividing the total variable cost by the total units of output.

ATC (Average Total Cost) is the per-unit cost of both fixed and variable factors of production. It is
obtained by dividing the total cost by the total units of output.

Marginal Cost (MC): Marginal Cost is the extra or additional total cost that results from producing one
more unit of output; or it is the change in total cost resulting from a percentage change in output i.e.