Module II-Topics
1. Production and cost
2. Production function
3. Law of variable proportion
4. Economies of scale
5. Internal and external economies
6. Isoquants, Isocost line
7. Producer’s equilibrium
8. Expansion path
9. Technical progress and its implications
10. Cobb-Douglas production function
11. Cost concepts - Social cost, Private cost and external cost , Explicit and
implicit cost , Sunk cost
12. Short run cost curves
13. Long run cost curves
14. Revenue (concepts)
15. Shutdown point
16. Break-even point
Production
Production may be defined as creation of
value, which can be of two varieties, namely
use value (value of the functions performed)
and exchange value (measure of all features
of the product which make the product
possible of being traded).
Production is the activity which creates or
adds utility and value.
Factors of production
The factors of production have been traditionally classified as land,
labour, capital and organization.
1. Land – Land represents all the gifts of nature, including soil, forests,
rives, air, rain, light, etc. Therefore, land represents everything which
is not made by man.
2. Capital – Capital stands for assets available for use in the production
of further assets. Capital is wealth in the form of money or property
owned by a person or business and human resources of economic
value.
3. Organization or Enterprise – An enterprise is composed of
individuals and physical assets with a common goal of generating
profits.
Theory of production
Inputs
Labour Outputs
Material Transformation Goods and
Equipment process Services
Capital
Production process
Theory of production basically determines, how the producer, given the state of
technology combines various inputs economically to produce a definite amount of
output in an efficient manner.
Production function
The functional relationship between input and output is known as production
function.
The production function can be expressed in form of an equation in which the
output is the dependent variable and inputs are the independent variables.
The equation is expressed as follows.
Q f ( L, K , T ,...n)
; where,
Q = Level of output,
L = Labour,
K = Capital,
T = Level of technology and
n = Other inputs employed in
production.
Fixed and variable proportion production function
1.Fixed proportion production function – A
fixed proportion production function is one in
which the technology requires a fixed
combination of inputs, say capital and labour,
to produce a given level of output.
2.Variable proportions production function –
In this case, a given level of output can be
produced by several alternative combinations
of factors of production, say capital and
labour.
Time horizon of analysis
1.Short run – The period of time in which labor
and material can be changed, but all inputs
cannot be changed simultaneously.
2.Long run – Long run is defined as that time
period over which a firm can vary quantities
of all factors of production.
The law of variable proportions
The law of variable proportion states that, if one factor is used more and more
(variable), keeping the other factors constant, the total output will increase at an
increasing rate in the beginning and then at a diminishing rate and eventually
decreases provided there is no change in technology.
Units of Units of Total Marginal Average
Land Labour Product Product Product
1 1 2 – 2
1 2 5 3 2.5
1 3 9 4 3
1 4 12 3 3
1 5 14 2 2.8
1 6 15 1 2.5
1 7 15 0 2.1
1 8 14 –1 1.7
Stages of production
The law of variable proportion suggests the
behaviour of output when varying the quantity
of one factor combined with fixed quantities of Y
B
TP,AP and MP
the others can be divided into three distinct A
stages. TP
1. Stage I – Stage of increasing returns –
During this stage, the Total Product, the
Average Product and the Marginal Stage I Stage II Stage III
Product are increasing.
S
2. Stage II – Stage of decreasing returns –
In the second stage, the Total Product AP
X
continues to increase but at a diminishing O P M
MP Labour
rate. Law of Variable Proportions
3. Stage III – Stage of negative returns – In
this stage, the Total Product starts to
decline.
Returns to a factor
The return to a factor is the relationship between output and variation in one input
while keeping the other factor inputs constant.
This relationship is also known as productivity of a factor of production.
Factor productivities are of three types.
1. Total Product (TP) – Total Product is the total quantity of output a firm obtains
from a given quantity of that factor input, while all the other factors are constant.
2. Average Product (AP) – The Average Product (AP) of a factor of production is
the Total Product of that factor divided by the quantity of that factor such as
labour (L), capital (K), etc., while all the remaining factors are held constant.
TP TP
APLabour APCapital
L K
3. Marginal Product (MP) – It is the change in Total Product that results from a
one unit increase in that factor of production, keeping all other inputs constant.
Marginal Product = TPn – TPn–1
Marginal product of a factor is the change in total physical product obtained
due to the use of one additional unit dofTPthat factor of production, while all
d TP
other inputs are kept constant. MPL dL MPK
dK
Returns to scale
In the long run, all factors of production become variable as the firm is able to alter its
stock of inputs in long run which is not the case in short run.
The term returns to scale refers to the changes in output when all factor-inputs change
by the same proportion in the long run.
There are three cases to return to scale.
1. Increasing returns to scale – When inputs are increased in a given proportion
and output increases in a greater proportion, the phenomenon is known as
increasing returns to scale.
2. Constant return to scale – When inputs are increased in a given proportion and
output increases in the same proportion, the returns to scale is said to be
constant.
3. Decreasing returns to scale – If the firm continues to expand beyond the stage
of constant returns, the stage of diminishing returns to scale will start to operate.
Isoquants
Capital
18 a
16
14
12 b
10 c
8
6 d
Q = 10
4 e Q=8
2 f
g Q =6
O
2 4 6 8 10 12 14 16 18
Labour
An isoquant is a locus of points showing all the technically efficient ways of
combining factors of production to produce a fixed level of output.
In case of two variable factors, labour and capital, an isoquant appears as a curve
on a graph the axes of which measure quantities of the two factors.
The curve shows the efficient alternative techniques of production or alternative
combinations of two factors that can produce a fixed level of output.
Characteristics of isoquants
18
Capital
16 K 5, L 1
Capital
20
14
Capital
12 15 K 4, L 1
d
10 b K 4, L 1
12
8 c a
6 Q = 10
C 9 100 units
4 Q=8 A
2 B 4
Q =6
O O 1 2 3 4
2 4 6 8 10 12 14 16 18 Labour Labour
Labour
A higher isoquant represents Isoquants do not intersect Isoquants are convex to the
a higher output origin
Capital
Capital
Capital
Q4
Q3
Q2
O Q1
Labour Labour Labour
Isoquants never touch the axes Isoquants need not be parallel to each other
Isocost line
150
15
Capital
10
100
10
10
50 5K+10L
5 a
10
O 50 100 150
10 20 30
5 5 5
Labour
An isocost line is a line that represents all combinations of a firm’s factors of
production that have the same total cost.
Factors of production are generally classified as either capital (K) or labour (L).
Producer’s equilibrium
K
Capital
G R
E
C M
O
L F H P
Labour
Producer’s equilibrium
Isoquant curves, show us input combinations that we can employ to produce certain
levels of output.
Isocost lines help us determine combinations of two factors in which we can invest our
outlays to produce output.
A combination of these two graphs is what gives us the optimum production level, i.e.,
the producer’s equilibrium.
Expansion path
Capital
C
B Expansion path
A
O
Labour
Expansion path
When a family of isoquants is superimposed on the various possible budget lines,
all the isocosts will be tangential to some particular isoquant.
We will thus have a number of least cost combinations, one each for every output
level.
If all the points of tangency between the isocosts and isoquants, representing
different output levels are joined, the resultant curve is known as an expansion
path.
Technical progress and its implications
Q QL Q Q
Q1
Capital
Capital
Capital
QK
Q Q Q
Q1 QK
QL
O O O
Labour Labour Labour
(a) (b) (c)
Technical progress
Technological progress refers to the discovery of new and improved methods of
producing goods allowing more output to be produced from the same quantities of
factor inputs, capital (K) and labour (L).
Prof.Hicks has identified three types of technological progress.
1. Neutral technical progress
2. Labour augmenting technical progress
3. Capital augmenting technical progress
Cobb Douglas function
The Cobb-Douglas production function describes the real output in monetary
terms as under:-
Q A La K b
; where,
L = Labour,
K = Capital,
A = Total factor productivity,
A = Output elasticity of labour
and
b = Output elasticity of
capital.
Cost concepts
In producing a commodity (or service), a firm has to
employ an aggregate of various factors of production
such as land, labour and capital.
All these factors involve the price, which the firm
has to pay for them.
Thus the cost of production of a commodity is the
aggregate of price paid for the factors of production
used in producing the commodity.
Types of costs
1. Explicit cost and implicit costs – Explicit costs are those expenses which are
actually paid by the firm.
2. Actual cost and opportunity cost – Actual cost is the cost of all resources used in
producing a particular good. Opportunity cost of a decision is the cost of sacrificing
the alternatives to that decision.
3. Sunk cost – Sunk cost is a cost incurred in the past and that cannot be changed by
current decisions and therefore cannot be recovered.
4. Variable cost – Variable costs are those costs that vary directly and proportionately
with the output.
5. Fixed costs – The cost which does not vary but remains constant within a given
period of time inspite of the fluctuations in production is known as fixed cost.
6. Shut down cost – Shut down cost is the cost incurred if the firm temporarily stops
its operation.
7. Direct costs and indirect cost – Direct costs are expenses that a company can easily
connect to a specific ‘cost object’, which may be a product, department or project.
Short run costs
Cost
TC
TVC
TFC
O Output
Total Cost of a firm
There are two categories of costs in short run viz., fixed cost and variable cost.
Total Cost (TC) is the summation of Total Fixed Costs (TFC) and Total Variable
Costs (TVC).
Total Fixed Cost Curve (TFC) runs parallel to X-axis as shown in the figure.
Total Variable Costs (TVC) and Total Output are positively related.
Short run costs
Cost
MC
AC
AVC
AFC
O
Average and Marginal Cost of a firm Output
Average Variable Cost (AVC) – As output increases total variable cost also increases.
Average Cost (AC) – Average cost is equal to Total Cost (TC) divided by the number
of goods produced. Average Cost is expressed as, TC
AC
Q
Marginal Cost (MC) – The Marginal Cost is the cost of producing one more unit of a
good.
Shut down point
Y
MC
AC
Price
Shutdown AVC
point
P AR =MR
A
O X
Q Quantity
Shutdown point
A shutdown point is a point of operations where a company experiences no benefit
for continuing operations.
This happens when the market price for the product is equal to the Average Variable
Cost in the short run.
At this point the firm can minimize losses only by not producing.
Long run costs
Y
Average Cost
Short-run Average Cost
(SAC )
Long Run Average Cost
(LAC )
X
Q Output
Long-run cost-output relationship
Long-run cost-output relationship explores the behaviour of cost to the changes in
output when even the plant size is varying, i.e., all the factors inputs are variable.
In each of the Short-Run Average Total Cost (SAC) curves shown in the figure, the
lowest point of the curve denotes the optimal combination of inputs for a particular plant
size or scale of operations.
Concept of revenue
Revenue of a firm is the money received from the sale of their product. Revenue
can be classified as follows.
1. Total Revenue (TR) – The revenue that a firm gets by selling a given
quantity of product is called Total Revenue.
2. Marginal Revenue (MR) – Marginal Revenue is the change in total
revenue which results from the sale of one more or less unit of a
commodity.
3. Average Revenue – Average Revenue (AR) refers to revenue per unit of
output sold. Average Revenue is expressed as follows.
TR
Average Revenue AR
Q
Concept of revenue
Revenue
Revenue
AR = MR
AR
MR
O O
Output Output
Relationship between AR and MR
MR pertains to change in TR only on account of the last unit sold, while AR
is based upon all the units sold by the firm.
Therefore, any change in AR results in a much bigger change in MR.
Economies of scale and diseconomies of scale
Economies of scale are defined as the cost advantages that an organization can
achieve by expanding its production in the long run.
Economies and diseconomies of scale are broadly divided into two categories,
viz., internal economies and diseconomies of scale and external economies and
diseconomies of scale.
1. Internal economies of scale – The internal economies arise within a firm
as a result of its own expansion, not because of the size and expansion of
the industry.
2. External economies of scale – Expansion of an industry may lead to the
availability of new and cheaper raw materials, tools and machinery, and to
the discovery and use of a superior technical knowledge.
3. Internal diseconomies of scale – In the long run, a number of factors may
cause an addition to average cost of a firm.
4. External diseconomies of scale – With the expansion of the firm,
particularly when all the firms of the industry are expanding, the discounts
and concessions that are available on bulk purchase of inputs and
concessional finance come to an end.
Breakeven analysis
A break-even analysis indicates at what level of output, costs and
revenues are equal.
The concept of Break Even Point is based on the behavior of
costs, i.e., fixed cost and variable costs.
Fixed costs are those costs that remain constant irrespective of
the changes in the volume of production.
Variable costs are the costs that vary with the level of production.
Break Even Point (BEP) is that point of sales volume where total
revenues and total expenses are equal.
Breakeven analysis
Breakeven chart
Cost and Revenue
nue
e
ev
R
l
ota it
T of
Pr
Co st
l
BEP Tota
Variable Cost
Total Fixed Cost
s s
Lo
Fixed Cost
Production/Sales volume
Breakeven chart
Breakeven chart
