THEORY OF PRODUCTION AND COST 3.

35
v

UNIT - 2: THEORY OF COST

LEARNING OUTCOMES

AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:

 Explain the Meaning and Different Types of Costs.

 Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function.
 Explain the linkages between the Production Function and the Cost
Function.
 Explain Economies and Diseconomies of Scale and Reasons for Their
Existence.

In the previous unit, we have discussed the relationship between inputs and output in
physical quantities. However, as we are aware, business decisions are generally based on
cost of production i.e. the money value of inputs and output is considered. Cost analysis
refers to the study of behaviour of cost in relation to one or more production criteria,
namely, size of output, scale of operations, prices of factors of production and other
relevant economic variables. In other words, cost analysis is concerned with the financial
aspects of production relations as against physical aspects which were considered in
production analysis. In order to have a clear understanding of the cost function, it is
important for a businessman to understand various concepts of costs.

2.0 COST CONCEPTS

Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of
production which he employs for production. He thus pays wages to workers employed,
prices for the raw materials, fuel and power used, rent for the building he hires and interest
on the money borrowed for doing business. All these are included in his cost of production
and are termed as accounting costs. Accounting costs relate to those costs which involve
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and

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includes all the payments and charges made by the entrepreneur to the suppliers of various
productive factors. Accounting costs are expenses already incurred by the firm. Accountants
record these in the financial statements of the firm.

However, it generally happens that an entrepreneur invests a certain amount of capital in his
business. If the capital invested by the entrepreneur in his business had been invested
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an
entrepreneur may devote his time to his own work of production and contributes his
entrepreneurial and managerial ability to do business. Had he not set up his own business,
he would have sold his services to others for some positive amount of money. Accounting
costs do not include these costs. These costs form part of economic cost. Thus, economic
costs include: (1) the normal return on money capital invested by the entrepreneur himself
in his own business; (2) the wages or salary not paid to the entrepreneur, but could have
been earned if the services had been sold somewhere else. Likewise, the monetary rewards
for all factors owned by the entrepreneur himself and employed by him in his own business
are also considered a part of economic costs. Economic costs take into account these
accounting costs; in addition, they also take into account the amount of money the
entrepreneur could have earned if he had invested his money and sold his own services and
other factors in the next best alternative uses. Accounting costs are also called explicit costs
whereas the cost of factors owned by the entrepreneur himself and employed in his own
business is called implicit costs. Thus, economic costs include both accounting costs and
implicit costs. Therefore, economic costs are useful for businessmen while making decisions.
The concept of economic cost is important because an entrepreneur must cover his
economic cost if he wants to earn normal profits. Normal profit is part of implicit costs. If
the total revenue received by an entrepreneur just covers both implicit and explicit costs,
then he has zero economic profits. Super normal profits or positive economic profits
(abnormal profits) are over and above these normal profits. In other words, an entrepreneur
is said to be earning positive economic profits (abnormal profits) only when his revenues are
greater than the sum of his explicit costs and implicit costs.
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on,
say, wages, materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned
with the cost of the next best alternative opportunity which was foregone in order to pursue
a certain action. It is the cost of the missed opportunity and involves a comparison between
the policy that was chosen and the policy that was rejected. For example, the opportunity
cost of using capital is the interest that it can earn in the next best use with equal risk.
A distinction between outlay costs and opportunity costs can be drawn on the basis of the
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and
hence are recorded in the books of account. Opportunity cost is the amount or subjective

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 THEORY OF PRODUCTION AND COST 3.37
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value that is foregone in choosing one activity over the next best alternative. It relates to
sacrificed alternatives; it is, in general not recorded in the books of account.
The opportunity cost concept is generally very useful for business managers and therefore it
has to be considered whenever resources are scarce and a decision involving choice of one
option over other(s) is involved. e.g., in a cloth mill which spins its own yarn, the opportunity
cost of yarn to the weaving department is the price at which the yarn could be sold. This has
to be considered while measuring profitability of the weaving operations.
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating
the cost of higher education, it is not the tuition fee and cost of books alone that are
relevant. One should also take into account the earnings foregone, other foregone uses of
money which is paid as tuition fees and the value of missed activities etc. as the cost of
attending classes.
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those
which have direct relationship with a component of operation like manufacturing a product,
organizing a process or an activity etc. Since such costs are directly related to a product,
process or machine, they may vary according to the changes occurring in these. Direct cos ts
are costs that are readily identified and are traceable to a particular product, operation or
plant. Even overhead costs can be direct as to a department; manufacturing costs can be
direct to a product line, sales territory, customer class etc. We must know the purpose of
cost calculation before considering whether a cost is direct or indirect.

Indirect costs are those which are not easily and definitely identifiable in relation to a plant,
product, process or department. Therefore, such costs are not visibly traceable to specific
goods, services, operations, etc.; but are nevertheless charged to different jobs or products
in standard accounting practice. The economic importance of these costs is that these, even
though not directly traceable to a product, may bear some functional relationship to
production and may vary with output in some definite way. Examples of such costs are
electric power and common costs incurred for general operation of business benefiting all
products jointly.
Incremental costs and Sunk costs: Theoretically, incremental costs are related to the
concept of marginal cost. Incremental cost refers to the additional cost incurred by a firm as
result of a business decision. For example, incremental costs will have to be incurred by a
firm when it makes a decision to change its product line, replace worn out machinery, buy a
new production facility or acquire a new set of clients. Sunk costs refer to those costs which
are already incurred once and for all and cannot be recovered. They are based on past
commitments and cannot be revised or reversed if the firm wishes to do so. Examples of
sunk costs are expenses incurred on advertising, R& D, specialised equipments and fixed

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facilities such as railway lines. Sunk costs act as an important barrier to entry of firms into
business.
Historical costs and Replacement costs: Historical cost refers to the cost incurred in the
past on the acquisition of a productive asset such as machinery, building etc. Replacement
cost is the money expenditure that has to be incurred for replacing an old asset. Instability
in prices make these two costs differ. Other things remaining the same, an increase in price
will make replacement costs higher than historical cost.
Private costs and Social costs: Private costs are costs actually incurred or provided for by
firms and are either explicit or implicit. They normally figure in business decisions as they
form part of total cost and are internalised by the firm. Social cost, on the other hand, refers
to the total cost borne by the society on account of a business activity and includes private
cost and external cost. It includes the cost of resources for which the firm is not required to
pay price such as atmosphere, rivers, roadways etc. and the cost in terms of dis-utility
created such as air, water and environment pollution.
Fixed and Variable costs: Fixed or constant costs are not a function of output; they do not
vary with output upto a certain level of activity. These costs require a fixed expenditure of
funds irrespective of the level of output, e.g., rent, property taxes, interest on loans and
depreciation when taken as a function of time and not of output. However, these costs vary
with the size of the plant and are a function of capacity. Therefore, fixed costs do not vary
with the volume of output within a capacity level.
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on.
They can be avoided only when the operations are completely closed down. These are, by
their very nature, inescapable or uncontrollable costs. But, there are some costs which will
continue even after the operations are suspended, as for example, for storing of old
machines which cannot be sold in the market. These are called shut down costs. Some of the
fixed costs such as costs of advertising, etc. are programmed fixed costs or discretionary
expenses, because they depend upon the discretion of management whether to spend on
these services or not.
Variable costs are costs that are a function of output in the production period. For example,
wages of casual labourers and cost of raw materials and cost of all other inputs that vary
with output are variable costs. Variable costs vary directly and sometimes proportionately
with output. Over certain ranges of production, they may vary less or more than
proportionately depending on the utilization of fixed facilities and resources during the
production process.

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 THEORY OF PRODUCTION AND COST 3.39
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2.1 COST FUNCTION

Cost function refers to the mathematical relation between cost of a product and the vario us
determinants of costs. In a cost function, the dependent variable is unit cost or total cost
and the independent variables are the price of a factor, the size of the output or any other
relevant phenomenon which has a bearing on cost, such as technology, level of capacity
utilization, efficiency and time period under consideration. Cost function is a function which
is obtained from production function and the market supply of inputs. It expresses the
relationship between costs and output. Cost functions are derived from actual cost data of
the firms and are presented through cost curves. The shape of the cost curves depends
upon the cost function. Cost functions are of two kinds: They are short-run cost functions
and long-run cost functions.

2.2 SHORT RUN TOTAL COSTS

Total, fixed and variable costs: There are some factors which can be easily adjusted with
changes in the level of output. A firm can readily employ more workers if it has to increase
output. Similarly, it can purchase more raw materials if it has to expand production. Such
factors which can be easily varied with a change in the level of output are called variable
factors. On the other hand, there are some factors such as building, capital equipment, or
top management team which cannot be so easily varied. It requires comparatively longer
time to make changes in them. It takes time to install new machinery. Similarly, it takes time
to build a new factory. Such factors which cannot be readily varied and require a longer
period to adjust are called fixed factors.
Corresponding to the distinction between variable and fixed factors, we distinguish between
short run and long run periods of time. Short run is a period of time in which output can be
increased or decreased by changing only the amount of variable factors such as, labour, raw
materials, etc. In the short run, quantities of fixed factors cannot be varied in accordance
with changes in output. If the firm wants to increase output in the short run, it can do so
only by increasing the variable factors, i.e., by using more labour and/or by buying more raw
materials. Thus, short run is a period of time in which only variable factors can be varied,
while the quantities of fixed factors remain unaltered. On the other hand, long run is a
period of time in which the quantities of all factors may be varied. In other words, all factors
become variable in the long run.
Thus, we find that fixed costs are those costs which are independent of output, i.e., they do
not change with changes in output. These costs are a “fixed amount” which is incurred by a
firm in the short run, whether the output is small or large. Even if the firm closes down for

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some time in the short run but remains in business, these costs have to be borne by it. Fixed
costs include such charges as contractual rent, insurance fee, maintenance cost, property
taxes, interest on capital employed, managers’ salary, watchman’s wages etc. The fixed cost
curve is presented in figure 5.

Output

Fig. 5 : Completely Fixed Cost

Variable costs, on the other hand are those costs which change with changes in output.
These costs include payments such as wages of casual labour employed, prices of raw
material, fuel and power used, transportation cost etc. If a firm shuts down for a short
period, it may not use the variable factors of production and therefore, will not therefore
incur any variable cost. Figure 6 presents completely variable cost curve drawn under the
assumption that variable costs change linearly with changes in output.

Fig. 6 : Completely Variable Cost

There are some costs which are neither perfectly variable, nor absolutely fixed in relation to
the changes in the size of output. They are known as semi-variable costs. It is well reflected
in the Fig. 7. Example: Electricity charges include both a fixed charge and a charge based on
consumption.

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 THEORY OF PRODUCTION AND COST 3.41
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Fig. 7: Semi Variable Cost

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over
certain range of output; but suddenly jump to a new higher level when output goes beyond
a given limit. E.g. Costs incurred towards the salary of foremen will have a sudden jump if
another foreman is appointed when the output crosses a particular limit.

Fig. 8: A Stair-step Variable Cost

Fig. 9: Short run Total Cost Curves

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 3.42 BUSINESS ECONOMICS

The total cost of a business is defined as the actual cost that must be incurred for producing
a given quantity of output. The short run total cost is composed of two major elements
namely, total fixed cost and total variable cost. Symbolically TC = TFC + TVC. We may
represent total cost, total variable cost and fixed cost diagrammatically.
In the diagram above, the total fixed cost curve (TFC) is a horizontal straight line parallel to
X-axis as TFC remains fixed for the whole range of output. This curve starts from a point on
the Y-axis meaning thereby that fixed costs will be incurred even if the output is zero. On
the other hand, the total variable cost curve rises upward indicating that as output increases,
total variable cost increases. The total variable cost curve starts from the origin because
variable costs are zero when the output is zero. It should be noted that the total variable
cost initially increases at a decreasing rate and then at an increasing rate with increases in
output. This pattern of change in the TVC occurs due to the operation of the law of
increasing and diminishing returns to the variable inputs. Due to the operation of
diminishing returns, as output increases, larger quantities of variable inputs are required to
produce the same quantity of output. Consequently, variable cost curve is steeper at higher
levels of output. The total cost curve has been obtained by adding vertically the total fixed
cost curve and the total variable cost curve. The slopes of TC and TVC are the same at every
level of output and at each point the two curves have vertical distance equal to total fixed
cost. Its position reflects the amount of fixed costs and its slope reflects variable costs.

Short run average costs

Average fixed cost (AFC): AFC is obtained by dividing the total fixed cost by the number of
TFC
units of output produced. i.e. AFC= where Q is the number of units produced. Thus,
Q
average fixed cost is the fixed cost
per unit of output. For example, if a firm is producing with a total fixed cost of ` 2,000/-.
When output is 100 units, the average fixed cost will be ` 20. And now, if the output
increases to 200 units, average fixed cost will be ` 10. Since total fixed cost is a constant
amount, average fixed cost will steadily fall as output increases. Therefore, if we draw an
average fixed cost curve, it will slope downwards throughout its length but will not touch
the X-axis as AFC cannot be zero. (Fig. 10)
Average variable cost (AVC): Average variable cost is found out by dividing the total
TVC
variable cost by the number of units of output produced, i.e. AVC= where Q is the
Q
number of units produced. Thus, average variable cost is the variable cost per unit of output.
Average variable cost normally falls as output increases from zero to normal capacity output
due to occurrence of increasing returns to variable factors. But beyond the normal capacity

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output, average variable cost will rise steeply because of the operation of diminishing
returns (the concepts of increasing returns and diminishing returns have already been
discussed earlier). If we draw an average variable cost curve, it will first fall, then reach a
minimum and then rise. (Fig. 10)

Fig. 10: Short run Average and Marginal Cost Curves

Average total cost (ATC): Average total cost is the sum of average variable cost and
average fixed cost. i.e., ATC = AFC + AVC. It is the total cost divided by the number of units
produced, i.e. ATC = TC/Q. The behaviour of average total cost curve depends upon the
behaviour of the average variable cost curve and the average fixed cost curve. In the
beginning, both AVC and AFC curves fall, therefore, the ATC curve will also fall sharply.
When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues to fall.
This is because, during this stage, the fall in AFC curve is greater than the rise in the AVC
curve, but as output increases further, there is a sharp rise in AVC which more than offsets
the fall in AFC. Therefore, ATC curve first falls, reaches its minimum and then rises. Thus, the
average total cost curve is a “U” shaped curve. (Fig. 10)

Marginal cost: Marginal cost is the addition made to the total cost by the production of an
additional unit of output. In other words, it is the total cost of producing t units instead of t-
1 units, where t is any given number. For example, if we are producing 5 units at a cost of `
200 and now suppose the 6th unit is produced and the total cost is ` 250, then the marginal
cost is ` 250 - 200 i.e., ` 50. And marginal cost will be ` 24, if 10 units are produced at a
total cost of ` 320 [(320-200) / (10-5)]. It is to be noted that marginal cost is independent of
fixed cost. This is because fixed costs do not change with output. It is only the variable costs
which change with a change in the level of output in the short run. Therefore, marginal cost
is in fact due to the changes in variable costs. Symbolically marginal cost may be written as:
TC
MC =
Q
TC = Change in Total cost

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Q = Change in Output
or
MCn = TCn – TCn-1

Marginal cost curve falls as output increases in the beginning. It starts rising after a certain
level of output. This happens because of the influence of the law of variable proportions.
The MC curve becomes minimum corresponding to the point of inflexion on the total cost
curve. The fact that marginal product rises first, reaches a maximum and then declines
ensures that the marginal cost curve of a firm declines first, reaches its minimum and then
rises. In other words marginal cost curve of a firm is “U” shaped (see Figure 10).
The behaviour of these costs has also been shown in Table 3.
Table 3 : Various Costs

Units Total Total Total Average Average Average Marginal

of fixed variable cost fixed cost variable total cost
output cost cost cost cost
0 1000 0 1000 - - - -
1 1000 50 1050 1000.00 50.00 1050.00 50
2 1000 90 1090 500.00 45.00 545.00 40
3 1000 140 1140 333.33 46.67 380.00 50
4 1000 196 1196 250.00 49.00 299.00 56
5 1000 255 1255 200.00 51.00 251.00 59
6 1000 325 1325 166.67 54.17 220.83 70
7 1000 400 1400 142.86 57.14 200.00 75
8 1000 480 1480 125.00 60.00 185.00 80
9 1000 570 1570 111.11 63.33 174.44 90
10 1000 670 1670 100.00 67.00 167.00 100
11 1000 780 1780 90.91 70.91 161.82 110
12 1000 1080 2080 83.33 90.00 173.33 300

The above table shows that:

(i) Fixed costs do not change with increase in output upto a given level. Average fixed
cost, therefore, comes down with every increase in output.

(ii) Variable costs increase, but not necessarily in the same proportion as the increase in
output. In the above case, average variable cost comes down gradually till 4 units are
produced. Thereafter it starts increasing.

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 THEORY OF PRODUCTION AND COST 3.45
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(iii) Marginal cost is the additional cost divided by the additional units produced. This
also comes down first and then starts increasing.

Relationship between Average Cost and Marginal Cost: The relationship between
marginal cost and average cost is the same as that between any other marginal-average
quantities. The following are the points of relationship between the two.

(1) When average cost falls as a result of an increase in output, marginal cost is less than
average cost.
(2) When average cost rises as a result of an increase in output, marginal cost is more
than average cost.
(3) When average cost is minimum, marginal cost is equal to the average cost. In other
words, marginal cost curve cuts average cost curve at its minimum point (i.e.
optimum point).
Figure 10 confirms the above points of relationship.

2.3 LONG RUN AVERAGE COST CURVE

As stated above, long run is a period of time during which the firm can vary all of its inputs;
unlike short run in which some inputs are fixed and others are variable. In other words,
whereas in the short run the firm is tied with a given plant, in the long run the firm can build
any size or scale of plant and therefore, can move from one plant to another; it can acquire
a big plant if it wants to increase its output and a small plant if it wants to reduce its output.
The long run being a planning horizon, the firm plans ahead to build the most appropriate
scale of plant to produce the future level of output. It should be kept in mind that once the
firm has built a particular scale of plant, its production takes place in the short run. Briefly
put, the firm actually operates in the short run and plans for the long run. Long run cost of
production is the least possible cost of producing any given level of output when all
individual factors are variable. A long run cost curve depicts the functional relationship
between output and the long run cost of production.
In order to understand how the long run average cost curve is derived, we consider three
short run average cost curves as shown in Figure 11. These short run average cost curves
(SACs) are also called ‘plant curves’. In the short run, the firm can be operating on any short
run average cost curve, given the size of the plant. Suppose that there are the only three
plants which are technically possible. Given the size of the plant, the firm will be increasing
or decreasing its output by changing the amount of the variable inputs. But in the long run,
the firm chooses among the three possible sizes of plants as depicted by short run average
curves (SAC 1, SAC2, and SAC 3). In the long run, the firm will examine with which size of plant

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or on which short run average cost curve it should operate to produce a given level of
output, so that the total cost is minimum. It will be seen from the diagram that up to OB
amount of output, the firm will operate on the SAC 1, though it could also produce with SAC 2.
Up to OB amount of output, the production on SAC 1 results in lower cost than on SAC 2. For
example, if the level of output OA is produced with SAC 1, it will cost AL per unit and if it is
produced with SAC 2 it will cost AH and we can see that AH is more than AL. Similarly, if the
firm plans to produce an output which is larger than OB but less than OD, then it will not be
economical to produce on SAC 1. For this, the firm will have to use SAC 2. Similarly, the firm
will use SAC 3 for output larger than OD. It is thus clear that, in the long run, the firm has a
choice in the employment of plant and it will employ that plant which yields minimum
possible unit cost for producing a given output.

Fig. 11: Short Run Average Cost Curves Fig. 12: Long Run Average Cost Curves
Suppose, the firm has a choice so that a plant can be varied by infinitely small gradations so
that there are infinite number of plants corresponding to which there are numerous average
cost curves. In such a case the long run average cost curve will be a smooth c urve
enveloping all these short run average cost curves.
As shown in Figure 12, the long run average cost curve is so drawn as to be tangent to each
of the short run average cost curves. Every point on the long run average cost curve will be a
tangency point with some short run AC curve. If a firm desires to produce any particular
output, it then builds a corresponding plant and operates on the corresponding short run
average cost curve. As shown in the figure, for producing OM, the corresponding point on
the LAC curve is G and the short run average cost curve SAC 2 is tangent to the long run AC
at this point. Thus, if a firm desires to produce output OM, the firm will construct a plant
corresponding to SAC 2 and will operate on this curve at point G. Similarly, the firm will
produce other levels of output choosing the plant which suits its requirements of lowest
possible cost of production. It is clear from the figure that larger output can be produced at
the lowest cost with larger plant whereas smaller output can be produced at the lowest cost
with smaller plants. For example, to produce OM, the firm will be using SAC 2 only; if it uses
SAC3, it will result in higher unit cost than SAC 2. But, larger output OV can be produced most
economically with a larger plant represented by the SAC 3. If we produce OV with a smaller

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plant, it will result in higher cost per unit. Similarly, if we produce larger output with a
smaller plant it will involve higher costs because of its limited capacity.
It is to be noted that LAC curve is not tangent to the minimum points of the SAC curves.
When the LAC curve is declining, it is tangent to the falling portions of the short run cost
curves and when the LAC curve is rising, it is tangent to the rising portions of the short run
cost curves. Thus, for producing output less than “OQ” at the lowest possible unit cost, the
firm will construct the relevant plant and operate it at less than its full capacity, i.e., at less
than its minimum average cost of production. On the other hand, for outputs larger than OQ
the firm will construct a plant and operate it beyond its optimum capacity. “OQ” is the
optimum output. This is because “OQ” is being produced at the minimum point of LAC and
corresponding SAC i.e., SAC 4. Other plants are either used at less than their full capacity or
more than their full capacity. Only SAC 4 is being operated at the minimum point.
The long run average cost curve is often called as ‘planning curve’ because a firm plans to
produce any output in the long run by choosing a plant on the long run average cost curve
corresponding to the given output. The long run average cost curve helps the firm in the
choice of the size of the plant for producing a specific output at the least possible cost.
Explanation of the “U” shape of the long run average cost curve: As has been seen in
the diagram LAC curve is a “U” shaped curve. This shape of LAC curve has nothing to do
with the U shaped SAC which is due to variable factor ratio because in the long run all
factors are variable. U shaped LAC arises due to returns to scale. As discussed earlier, when
the firm expands, returns to scale increase. After a range of constant returns to scale, the
returns to scale finally decrease. On the same line, the LAC curve first declines and then
finally rises. Increasing returns to scale cause fall in the long run average cost and
decreasing returns to scale result in rise in long run average cost. Falling long run average
cost and increasing economies of scale result from internal and external economies of scale
and rising long run average cost and diminishing returns to scale result from internal and
external diseconomies of scale. (Economies of scale will be discussed in the next section.)
The long run average cost curve initially falls with increase in output and after a certain
point it rises making a boat shape. The long-run average cost (LAC) curve is also called the
planning curve of the firm as it helps in choosing an appropriate a plant on the decided
level of output. The long-run average cost curve is also called “Envelope curve”, because it
envelopes or supports a family of short run average cost curves from below.
The above figure depicting long-run average cost curve is arrived at on the basis of
traditional economic analysis. It is flattened ‘U’ shaped. This type of curve could exist only
when the state of technology remains constant. But, empirical evidence shows modern firms
face ‘L-shaped’ cost curve over a considerable quantity of output. The L-shaped long run
cost curve implies that initially when the output is increased due to increase in the size of

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plant (and associated variable factors), per unit cost falls rapidly due to economies of scale.
The long-run average cost curve does not increase even after a sufficiently large scale of
output as it continues to enjoy economies of scale.

2.4 ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production
Production on a large scale is a very important feature of modern industrial society. As a
consequence, the size of business undertakings has greatly increased. Large-scale
production offers certain advantages which help in reducing the cost of production.
Economies arising out of large-scale production can be grouped into two categories; viz.,
internal economies and external economies. Internal economies are those economies of
production which accrue to the firm when it expands its output, so that the cost of
production would come down considerably and place the firm in a better position to
compete in the market effectively. Internal economies arise purely due to endogenous
factors relating to efficiency of the entrepreneur or his managerial talents or the type of
machinery used or the marketing strategy adopted. These economies arise within the firm
and are available exclusively to the expanding firm. On the other hand, external economies
are the benefits accruing to each member firm of the industry as a result of expansion of the
industry.
Internal Economies and Diseconomies: We saw that returns to scale increase in the initial
stages and after remaining constant for a while, they decrease. The question arises as to why
we get increasing returns to scale due to which cost falls and why after a certain point we
get decreasing returns to scale due to which cost rises. The answer is that initially a firm
enjoys internal economies of scale and beyond a certain limit it suffers from internal
diseconomies of scale. Internal economies and diseconomies are of the following main
kinds:
(i) Technical economies and diseconomies: Large-scale production is associated with
economies of superior techniques. As the firm increases its scale of operations, it
becomes possible to use more specialised and efficient form of all factors, specially
capital equipment and machinery. For producing higher levels of output, there is
generally available a more efficient machinery which when employed to produce a
large output yields a lower cost per unit of output. The firm is able to take advantage
of \composite technology whereby the whole process of production of a commodity
is done as one composite unit. Secondly, when the scale of production is increased
and the amount of labour and other factors become larger, introduction of greater
degree of division of labour and specialisation becomes possible and as a result cost

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 THEORY OF PRODUCTION AND COST 3.49
v

per unit declines. There are some advantages available to a large firm on account of
performance of a number of linked processes. The firm can reduce the inconvenience
and costs associated with the dependence on other firms by undertaking various
processes from the input supply stage to the final output stage.
However, beyond a certain point, a firm experiences net diseconomies of scale. This
happens because when the firm has reached a size large enough to allow utilisation
of almost all the possibilities of division of labour and employment of more efficient
machinery, further increase in the size of the plant will bring about high long-run
cost because of difficulties of management. When the scale of operations becomes
too large, it becomes difficult for the management to exercise control and to bring
about proper coordination.

(ii) Managerial economies and diseconomies: Managerial economies refer to reduction

in managerial costs. When output increases, specialisation and division of labour can
be applied to management. It becomes possible to divide its management into
specialised departments under specialised personnel, such as production manager,
sales manager, finance manager etc. If the scale of production increases further, each
department can be further sub-divided; for e.g. sales can be split into separate
sections such as for advertising, exports and customer service. Since individual
activities come under the supervision of specialists, management’s efficiency and
productivity will greatly improve. Decentralisation of decision making and
mechanisation of managerial functions further enhance the efficiency and
productivity of managers. Thus, specialisation of management enables large firms to
achieve reduction in managerial costs.

However, as the scale of production increases beyond a certain limit, managerial

diseconomies set in. Communication at different levels such as between the
managers and labourers and among the managers become difficult resulting in
delays in decision making and implementation of decisions already made.
Management finds it difficult to exercise control and to bring in coordination among
its various departments. The managerial structure becomes more complex and is
affected by greater bureaucracy, red tapism, lengthening of communication lines and
so on. All these affect the efficiency and productivity of management and that of the
firm itself.

(iii) Commercial economies and diseconomies: Production of large volumes of goods

requires large amount of materials and components. A large firm is able to place bulk
orders for materials and components and enjoy lower prices for them. Economies can
also be achieved in marketing of the product. If the sales staff is not being worked to
full capacity, additional output can be sold at little or no extra cost. Moreover, large

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firms can benefit from economies of advertising. As the scale of production increas es,
advertising costs per unit of output fall. In addition, a large firm may also be able to
sell its by-products or process it profitably; something which might be unprofitable
for a small firm. There are also economies associated with transport and storage.
These economies become diseconomies after an optimum scale. For example,
advertisement expenditure and other marketing overheads will increase more than
proportionately after the optimum scale.
(iv) Financial economies and diseconomies: A large firm has advantages over small
firms in matters related to procurement of finance for its business activities. It can,
for instance, offer better security to bankers and avail of advances with greater ease.
On account of the goodwill enjoyed by large firms, investors have greater confidence
in them and therefore would prefer their shares which can be readily sold on the
stock exchange. A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after the
optimum scale of production. This may happen because of relatively greater
dependence on external finances.
(v) Risk bearing economies and diseconomies: It is said that a large business with
diverse and multi-production capability is in a better position to withstand economic
ups and downs, and therefore, enjoys economies of risk bearing. However, risk may
increase if diversification, instead of giving a cover to economic disturbances,
increases these.
External Economies and Diseconomies: Internal economies are economies enjoyed by a
firm on account of use of greater degree of division of labour and specialised machinery at
higher levels of output. They are internal in the sense that they accrue to the firm due to its
own efforts. Besides internal economies, there are external economies which are very
important for a firm. External economies and diseconomies are those economies and
diseconomies which accrue to firms as a result of expansion in the output of the whole
industry and they are not dependent on the output level of individual firms. They are
external in the sense that they accrue to firms not out of their internal situation but from
outside i.e. due to expansion of the industry. These are available to one or more of the firms
in the form of:
1. Cheaper raw materials and capital equipment: The expansion of an industry may
result in exploration of new and cheaper sources of raw material, machinery and
other types of capital equipments. Expansion of an industry results in greater
demand for various kinds of materials and capital equipments required by it. The firm

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 THEORY OF PRODUCTION AND COST 3.51
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can procure these on a large scale at competitive prices from other industries. This
reduces their cost of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result
in the discovery of new technical knowledge and in accordance with that, the use of
improved and better machinery and processes than before. This will change the
technical co-efficient of production and enhance productivity of firms in the industry
and reduce their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers
in that area are well accustomed with the different productive processes and tend to
learn a good deal from experience. As a result, with the growth of an industry in an
area, a pool of trained labour is developed which has a favourable effect on the level
of productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a
number of ancillary industries which specialise in the production and supply of raw
materials, tools, machinery, components, repair services etc. Input prices go down in
a competitive market and the benefits of it accrue to all firms in the form of
reduction in cost of production. Likewise, new units may come up for processing or
recycling of the waste products of the industry. This will tend to reduce the cost of
production in general.
5. Better transportation and marketing facilities: The expansion of an industry
resulting from entry of new firms may make possible the development of an efficient
transportation and marketing network. These will greatly reduce the cost of
production of the firms by avoiding the need for establishing and running these
services by themselves. Similarly, communication systems may get modernised
resulting in better and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology, labour,
prices and products may be easily and cheaply made available to the firms on
account of publication of information booklets and bulletins by industry associations
or by governments in public interest.
However, external economies may cease if there are certain disadvantages which may
neutralise the advantages of expansion of an industry. We call them external diseconomies.
External diseconomies are disadvantages that originate outside the firm, especially in the
input markets. An example of external diseconomies is rise in various factor prices. When an
industry expands the requirement of various factors of production, such as raw materials,
capital goods, skilled labour etc increases. Increasing demand for inputs puts pressure on
the input markets. This may result in an increase in the prices of factors of production,

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especially when they are short in supply. Moreover, too many firms in an industry at one
place may also result in higher transportation cost, marketing cost and high pollution
control cost. The government may also, through its location policy, prohibit or restrict the
expansion of an industry at a particular place.

SUMMARY
 Cost analysis refers to the study of behaviour of cost in relation to one or more
production criteria. It is concerned with the financial aspects of production.
• Accounting costs are explicit costs and includes all the payments and charges
made by the entrepreneur to the suppliers of various productive factors.
• Economic costs take into account explicit costs as well as implicit costs. A firm
has to cover its economic cost if it wants to earn normal profits.
• Outlay costs involve actual expenditure of funds.
• Opportunity cost is concerned with the cost of the next best alternative
opportunity which was foregone in order to pursue a certain action.
• Direct costs are those which have direct relationship with a component of
operation. They are readily identified and are traceable to a particular
product, operation or plant.
• Indirect costs are those which cannot be easily and definitely identifiable in
relation to a plant, product, process or department. They not visibly traceable
to any specific goods, services, processes, departments or operations.
• Incremental cost refers to the additional cost incurred by a firm as a result of
a business decision.
• Sunk costs are already incurred once and for all, and cannot be recovered.
• Historical cost refers to the cost incurred in the past on the acquisition of a
productive asset.
• Replacement cost is the money expenditure that has to be incurred for
replacing an old asset.
• Private costs are costs actually incurred or provided for by firms and are either
explicit or implicit.
• Social cost, on the other hand, refers to the total cost borne by the society on
account of a business activity and includes private cost and external cost.

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 THEORY OF PRODUCTION AND COST 3.53
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 The cost function refers to the mathematical relation between cost and the various
determinants of cost. It expresses the relationship between cost and output.
 Economists are generally interested in two types of cost functions; the short run cost
function and the long run cost function.
 Short-run cost functions are
• Fixed or constant costs which are not a function of output. These are
inescapable or uncontrollable.
• Variable costs are a function of output in the production period.
• Short run is a period of time in which output can be increased or decreased
by changing only the amount of variable factors such as, labour, raw material,
etc.
• Long run is a period of time in which the quantities of all factors may be
varied. In other words, all factors become variable in the long run.
• Semi-variable costs are neither perfectly variable, nor absolutely fixed in
relation to the changes in the size of output.
• Stair-step costs remain fixed over certain range of output; but suddenly jump
to a new higher level when output goes beyond a given limit.
• Total cost of a business is defined as the actual cost that must be incurred for
producing a given quantity of output.
• AFC is obtained by dividing the total fixed cost by the number of units of
output produced.
• Average variable cost is found out by dividing the total variable cost by the
number of units of output produced.
• Average total cost is the sum of average fixed cost and average variable cost.
• Marginal cost is the addition made to the total cost by the production of an
additional unit of output.
 Long run cost of production is the least possible cost of producing any given level of
output when all individual factors are variable.
• A long run cost curve depicts the functional relationship between output and
the long run cost of production.
• The long run average cost curve, often called a planning curve, is so drawn as
to be tangent to each of the short run average cost curves.

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• LAC curve is not tangent to the minimum points of the SAC curves.
• Empirical evidence shows that the state of technology changes in the long-
run. Therefore, modern firms face ‘L-shaped’ cost curve over a considerable
quantity of output.
 Economies of scale are of two kinds - external economies of scale and internal
economies of scale.
• External economies of scale accrue to a firm due to factors which are external
to a firm.
• Internal economies of scale accrue to a firm when it engages in large scale
production.
• Increase in scale, beyond the optimum level, results in diseconomies of scale.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Which of the following is considered production in Economics?
(a) Tilling of soil.

(b) Singing a song before friends.

(c) Preventing a child from falling into a manhole on the road.
(d) Painting a picture for pleasure.

2. Identify the correct statement:

(a) The average product is at its maximum when marginal product is equal to
average product.

(b) The law of increasing returns to scale relates to the effect of changes in factor
proportions.
(c) Economies of scale arise only because of indivisibilities of factor proportions.

(d) Internal economies of scale can accrue when industry expands beyond
optimum.
3. Which of the following is not a characteristic of land?

(a) Its supply for the economy is limited.

(b) It is immobile.

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 THEORY OF PRODUCTION AND COST 3.55
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(c) Its usefulness depends on human efforts.

(d) It is produced by our forefathers.
4. Which of the following statements is true?
(a) Accumulation of capital depends solely on income of individuals.
(b) Savings can be influenced by government policies.
(c) External economies go with size and internal economies with location.
(d) The supply curve of labour is an upward slopping curve.
5. In the production of wheat, all of the following are variable factors that are used by the
farmer except:
(a) the seed and fertilizer used when the crop is planted.
(b) the field that has been cleared of trees and in which the crop is planted.
(c) the tractor used by the farmer in planting and cultivating not only wheat but
also corn and barley.
(d) the number of hours that the farmer spends in cultivating the wheat fields.
6. The marginal product of a variable input is best described as:
(a) total product divided by the number of units of variable input.
(b) the additional output resulting from a one unit increase in the variable input.

(c) the additional output resulting from a one unit increase in both the variable
and fixed inputs.
(d) the ratio of the amount of the variable input that is being used to the amount
of the fixed input that is being used.
7. Diminishing marginal returns implies:
(a) decreasing average variable costs.
(b) decreasing marginal costs.
(c) increasing marginal costs.
(d) decreasing average fixed costs.

8. The short run, as economists use the phrase, is characterized by:

(a) at least one fixed factor of production and firms neither leaving nor entering the
industry.
(b) generally a period which is shorter than one year.

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(c) all factors of production are fixed and no variable inputs.

(d) all inputs are variable and production is done in less than one year.
9. The marginal, average, and total product curves encountered by the firm producing in
the short run exhibit all of the following relationships except:
(a) when total product is rising, average and marginal product may be either rising
or falling.

(b) when marginal product is negative, total product and average product are
falling.
(c) when average product is at a maximum, marginal product equals average
product, and total product is rising.
(d) when marginal product is at a maximum, average product equals marginal
product, and total product is rising.
10. To economists, the main difference between the short run and the long run is that:
(a) In the short run all inputs are fixed, while in the long run all inputs are variable.
(b) In the short run the firm varies all of its inputs to find the least-cost
combination of inputs.
(c) In the short run, at least one of the firm’s input levels is fixed.
(d) In the long run, the firm is making a constrained decision about how to use
existing plant and equipment efficiently.
11. Which of the following is the best definition of “production function”?
(a) The relationship between market price and quantity supplied.

(b) The relationship between the firm’s total revenue and the cost of production.
(c) The relationship between the quantities of inputs needed to produce a given
level of output.

(d) The relationship between the quantity of inputs and the firm’s marginal cost of
production.
12. The “law of diminishing returns” applies to:

(a) the short run, but not the long run.

(b) the long run, but not the short run.
(c) both the short run and the long run.
(d) neither the short run nor the long run.

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13. Diminishing returns occur:

(a) when units of a variable input are added to a fixed input and total product falls.
(b) when units of a variable input are added to a fixed input and marginal product
falls.
(c) when the size of the plant is increased in the long run.
(d) when the quantity of the fixed input is increased and returns to the variable
input falls.
Use the following information to answer questions 14-16.

Hours of Labour Total Output Marginal Product

0 – –
1 100 100
2 – 80
3 240 –
14. What is the total output when 2 hours of labour are employed?
(a) 80
(b) 100
(c) 180

(d) 200
15. What is the marginal product of the third hour of labour?
(a) 60

(b) 80
(c) 100
(d) 240
16. What is the average product of the first three hours of labour?
(a) 60
(b) 80

(c) 100
(d) 240

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17. Which cost increases continuously with the increase in production?

(a) Average cost.
(b) Marginal cost.

(c) Fixed cost.

(d) Variable cost.
18. Which of the following cost curves is never ‘U’ shaped?

(a) Average cost curve.

(b) Marginal cost curve.
(c) Average variable cost curve.
(d) Average fixed cost curve.
19. Total cost in the short run is classified into fixed costs and variable costs. Which one of
the following is a variable cost?
(a) Cost of raw materials.
(b) Cost of equipment.
(c) Interest payment on past borrowings.

(d) Payment of rent on building.

20. In the short run, when the output of a firm increases, its average fixed cost:
(a) increases.

(b) decreases.
(c) remains constant.
(d) first declines and then rises.

21. Which one of the following is also known as planning curve?

(a) Long run average cost curve.
(b) Short run average cost curve.

(c) Average variable cost curve.

(d) Average total cost curve.
22. If a firm moves from one point on a production isoquant to another, which of the
following will not happen.
(a) A change in the ratio in which the inputs are combined to produce output.

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 THEORY OF PRODUCTION AND COST 3.59
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(b) A change in the ratio of marginal products of the inputs.

(c) A change in the marginal rate of technical substitution.
(d) A change in the level of output.
23. With which of the following is the concept of marginal cost closely related?
(a) Variable cost.
(b) Fixed cost.
(c) Opportunity cost.
(d) Economic cost.

24. Which of the following statements is correct?

(a) When the average cost is rising, the marginal cost must also be rising.
(b) When the average cost is rising, the marginal cost must be falling.
(c) When the average cost is rising, the marginal cost is above the average cost.
(d) When the average cost is falling, the marginal cost must be rising.
25. Which of the following is an example of “explicit cost”?
(a) The wages a proprietor could have made by working as an employee of a large
firm.
(b) The income that could have been earned in alternative uses by the resources
owned by the firm.
(c) The payment of wages by the firm.
(d) The normal profit earned by a firm.

26. Which of the following is an example of an “implicit cost”?

(a) Interest that could have been earned on retained earnings used by the firm to
finance expansion.
(b) The payment of rent by the firm for the building in which it is housed.
(c) The interest payment made by the firm for funds borrowed from a bank.
(d) The payment of wages by the firm.

Use the following data to answer questions 27-29.

Output (O) 0 1 2 3 4 5 6
Total Cost (TC) ` 240 ` 330 ` 410 ` 480 ` 540 ` 610 ` 690

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 3.60 BUSINESS ECONOMICS

27. The average fixed cost of 2 units of output is:

(a) ` 80
(b) ` 85
(c) ` 120
(d) ` 205
28. The marginal cost of the sixth unit of output is:

(a) ` 133
(b) ` 75
(c) ` 80
(d) ` 450
29. Diminishing marginal returns start to occur between units:
(a) 2 and 3.
(b) 3 and 4.
(c) 4 and 5.
(d) 5 and 6.

30. Marginal cost is defined as:

(a) the change in total cost due to a one unit change in output.
(b) total cost divided by output.

(c) the change in output due to a one unit change in an input.

(d) total product divided by the quantity of input.
31. Which of the following is true of the relationship between the marginal cost function
and the average cost function?
(a) If MC is greater than ATC, then ATC is falling.
(b) The ATC curve intersects the MC curve at minimum MC.

(c) The MC curve intersects the ATC curve at minimum ATC.

(d) If MC is less than ATC, then ATC is increasing.
32. Which of the following statements is true of the relationship among the average cost
functions?
(a) ATC = AFC – AVC.

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 THEORY OF PRODUCTION AND COST 3.61
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(b) AVC = AFC + ATC.

(c) AFC = ATC + AVC.
(d) AFC = ATC – AVC.
33. Which of the following is not a determinant of the firm’s cost function?
(a) The production function.
(b) The price of labour.
(c) Taxes.
(d) The price of the firm’s output.

34. Which of the following statements is correct concerning the relationships among the
firm’s cost functions?
(a) TC = TFC – TVC.
(b) TVC = TFC – TC.
(c) TFC = TC – TVC.
(d) TC = TVC – TFC.
35. Suppose output increases in the short run. Total cost will:
(a) increase due to an increase in fixed costs only.
(b) increase due to an increase in variable costs only.

(c) increase due to an increase in both fixed and variable costs.

(d) decrease if the firm is in the region of diminishing returns.
36. Which of the following statements concerning the long-run average cost curve is false?

(a) It represents the least-cost input combination for producing each level of
output.
(b) It is derived from a series of short-run average cost curves.
(c) The short-run cost curve at the minimum point of the long-run average cost
curve represents the least–cost plant size for all levels of output.
(d) As output increases, the amount of capital employed by the firm increases along
the curve.
37. The negatively-sloped (i.e. falling) part of the long-run average total cost curve is due
to which of the following?
(a) Diseconomies of scale.

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(b) Diminishing returns.

(c) The difficulties encountered in coordinating the many activities of a large firm.
(d) The increase in productivity that results from specialization.

38. The positively sloped (i.e. rising) part of the long run average total cost curve is due to
which of the following?
(a) Diseconomies of scale.

(b) Increasing returns.

(c) The firm being able to take advantage of large-scale production techniques as it
expands its output.

(d) The increase in productivity that results from specialization.

39. A firm’s average total cost is ` 300 at 5 units of output and ` 320 at 6 units of output.
The marginal cost of producing the 6th unit is:
(a) ` 20
(b) ` 120
(c) ` 320
(d) ` 420
40. A firm producing 7 units of output has an average total cost of ` 150 and has to pay
` 350 to its fixed factors of production whether it produces or not. How much of the
average total cost is made up of variable costs?
(a) ` 200
(b) ` 50
(c) ` 300
(d) ` 100
41. A firm has a variable cost of ` 1000 at 5 units of output. If fixed costs are ` 400, what
will be the average total cost at 5 units of output?
(a) ` 280
(b) ` 60
(c) ` 120
(d) ` 1400

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42. A firm’s average fixed cost is ` 20 at 6 units of output. What will it be at 4 units of
output?
(a) ` 60
(b) ` 30
(c) ` 40
(d) ` 20
43. Which of the following statements is true?
(a) The services of a doctor are considered production.

(b) Man can create matter.

(c) The services of a housewife are considered production.
(d) When a man creates a table, he creates matter.
44. Which of the following is a function of an entrepreneur?
(a) Initiating a business enterprise.
(b) Risk bearing.
(c) Innovating.
(d) All of the above.
45. In describing a given production technology, the short run is best described as lasting:

(a) up to six months from now.

(b) up to five years from now.
(c) as long as all inputs are fixed.

(d) as long as at least one input is fixed.

46. If decreasing returns to scale are present, then if all inputs are increased by 10% then:
(a) output will also decrease by 10%.
(b) output will increase by 10%.
(c) output will increase by less than 10%.
(d) output will increase by more than 10%.

47. The production function is a relationship between a given combination of inputs and:
(a) another combination that yields the same output.
(b) the highest resulting output.

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(c) the increase in output generated by one-unit increase in one output.

(d) all levels of output that can be generated by those inputs.
48. If the marginal product of labour is below the average product of labour, it must be
true that:
(a) the marginal product of labour is negative.
(b) the marginal product of labour is zero.

(c) the average product of labour is falling.

(d) the average product of labour is negative.
49. The average product of labour is maximized when marginal product of labour:
(a) equals the average product of labour.
(b) equals zero.
(c) is maximized.
(d) none of the above.
50. The law of variable proportions is drawn under all of the assumptions mentioned below
except the assumption that:
(a) the technology is changing.
(b) there must be some inputs whose quantity is kept fixed.
(c) we consider only physical inputs and not economically profitability in monetary
terms.
(d) the technology is given and stable.
51. What is a production function?

(a) Technical relationship between physical inputs and physical output.

(b) Relationship between fixed factors of production and variable factors of
production.

(c) Relationship between a factor of production and the utility created by it.
(d) Relationship between quantity of output produced and time taken to produce
the output.

52. Laws of production does not include ……

(a) returns to scale.
(b) law of diminishing returns to a factor.

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(c) law of variable proportions.

(d) least cost combination of factors.
53. An iso quant shows
(a) All the alternative combinations of two inputs that can be produced by using a
given set of output fully and in the best possible way.
(b) All the alternative combinations of two products among which a producer is
indifferent because they yield the same profit.
(c) All the alternative combinations of two inputs that yield the same total product.

(d) Both (b) and (c).

54. Economies of scale exist because as a firm increases its size in the long run:
(a) Labour and management can specialize in their activities more.
(b) As a larger input buyer, the firm can get finance at lower cost and purchase
inputs at a lower per unit cost.
(c) The firm can afford to employ more sophisticated technology in production.
(d) All of these.
55. The production function:
(a) is the relationship between the quantity of inputs used and the resulting
quantity of a product.
(b) Tells us the maximum attainable output from a given combination of inputs.
(c) Expresses the technological relationship between inputs and output of a
product.
(d) All the above.
56. The production process described below exhibits.

Number of Workers Output

0 0
1 23
2 40
3 50

(a) constant marginal product of labour.

(b) diminishing marginal product of labour.

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(c) increasing return to scale.

(d) increasing marginal product of labour.
57. Which of the following is a variable cost in the short run?

(a) rent of the factory.

(b) wages paid to the factory labour.
(c) interest payments on borrowed financial capital.

(d) payment on the lease for factory equipment.

58. The efficient scale of production is the quantity of output that minimizes
(a) average fixed cost.
(b) average total cost.
(c) average variable cost.
(d) marginal cost.
59. In the short run, the firm's product curves show that
(a) Total product begins to decrease when average product begins to decrease but
continues to increase at a decreasing rate.

(b) When marginal product is equal to average product, average product is

decreasing but at its highest.
(c) When the marginal product curve cuts the average product curve from below,
the average product is equal to marginal product.
(d) In stage two, total product increases at a diminishing rate and reaches
maximum at the end of this stage.

60. A fixed input is defined as

(a) That input whose quantity can be quickly changed in the short run, in response
to the desire of the company to change its production.

(b) That input whose quantity cannot be quickly changed in the short run, in
response to the desire of the company to change its production.
(c) That input whose quantities can be easily changed in response to the desire to
increase or reduce the level of production.
(d) That input whose demand can be easily changed in response to the desire to
increase or reduce the level of production.

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61. Average product is defined as

(a) total product divided by the total cost.
(b) total product divided by marginal product.
(c) total product divided by the number of units of variable input.
(d) marginal product divided by the number of units of variable input.
62. Which of the following statements is true?
(a) After the inflection point of the production function, a greater use of the
variable input induces a reduction in the marginal product.

(b) Before reaching the inevitable point of decreasing marginal returns, the
quantity of output obtained can increase at an increasing rate.
(c) The first stage corresponds to the range in which the AP is increasing as a result
of utilizing increasing quantities of variable inputs.
(d) All the above.
63. Marginal product, mathematically, is the slope of the
(a) total product curve.
(b) average product curve.
(c) marginal product curve.

(d) implicit product curve.

64. Suppose the first four units of a variable input generate corresponding total outputs of
200, 350, 450, 500. The marginal product of the third unit of input is:

(a) 50
(b) 100
(c) 150
(d) 200
65. Which of the following statements is false in respect of fixed cost of a firm?
(a) As the fixed inputs for a firm cannot be changed in the short run, the TFC are
constant, except when the prices of the fixed inputs change.
(b) TFC continue to exist even when production is stopped in the short run, but they
exist in the long run even when production is not stopped.

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 3.68 BUSINESS ECONOMICS

(c) Total Fixed Costs (TFC) can be defined as the total sum of the costs of all the
fixed inputs associated with production in the short run.
(d) In the short run, a firm’s fixed cost cannot be escaped even when production is
stopped.
66. Diminishing marginal returns for the first four units of a variable input is exhibited by
the total product sequence:

(a) 50, 50, 50, 50

(b) 50, 110, 180, 260
(c) 50, 100, 150, 200
(d) 50, 90, 120, 140
67. Use the following diagram to answer the question given below it

The marginal physical product of the third unit of labour is _____, the MP of the _____
labour is Negative
(a) Six; fourth

(b) Six; third

(c) Six; fifth
(d) Six; sixth
68. In the third of the three stages of production:
(a) the marginal product curve has a positive slope.
(b) the marginal product curve lies completely below the average product curve.
(c) total product increases.
(d) marginal product is positive.

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 THEORY OF PRODUCTION AND COST 3.69
v

69. When marginal costs are below average total costs,

(a) average fixed costs are rising.
(b) average total costs are falling.
(c) average total costs are rising.
(d) average total costs are minimized.
70. A firm’s long-run average total cost curve is
(a) Identical to its long-run marginal-cost curve.
(b) Also its long-run supply curve because it explains the relationship between price
and quantity supplied.
(c) In fact the average total cost curve of the optimal plant in the short run as it
tries to produce at least cost.
(d) Tangent to all the curves of short-run average total cost.
71. In the long run, if a very small factory were to expand its scale of operations, it is likely
that it would initially experience
(a) an increase in pollution level.
(b) diseconomies of scale.
(c) economies of scale.

(d) constant returns to scale.

72. A firm’s long-run average total cost curve is.
(a) Identical to its long-run marginal-cost curve as all factors are variable.

(b) Also its long-run total cost curve because it explains the relationship cost and
quantity supplied in the long run.
(c) In fact the average total cost curve of the optimal plant in the short run as it
tries to produce at least cost.
(d) Tangent to all short-run average total cost the curves and represents the lowest
average total cost for producing each level of output.

73. Which of the following statements describes increasing returns to scale?

(a) Doubling of all inputs used leads to doubling of the output.
(b) Increasing the inputs by 50% leads to a 25% increase in output.
(c) Increasing inputs by 1/4 leads to an increase in output of 1/3.

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 3.70 BUSINESS ECONOMICS

(d) None of the above.

74. The marginal cost for a firm of producing the 9th unit of output is ` 20. Average cost at
the same level of output is ` 15. Which of the following must be true?

(a) marginal cost and average cost are both falling

(b) marginal cost and average cost are both rising
(c) marginal cost is rising and average cost is falling

(d) it is impossible to tell if either of the curves are rising or falling

75. Implicit cost can be defined as
(a) Money payments made to the non-owners of the firm for the self-owned factors
employed in the business and therefore not entered into books of accounts.
(b) Money not paid out to the owners of the firm for the self-owned factors
employed in a business and therefore not entered into books of accounts.
(c) Money payments which the self-owned and employed resources could have
earned in their next best alternative employment and therefore entered into
books of accounts.
(d) Money payments which the self-owned and employed resources earn in their
best use and therefore entered into book of accounts.
76. The most important function of an entrepreneur is to ____________.
(a) Innovate
(b) Bear the sense of responsibility
(c) Finance

(d) Earn profit

77. Economic costs of production differ from accounting costs of production because
(a) Economic costs include expenditures for hired resources while accounting costs
do not.
(b) Accounting costs include opportunity costs which are deducted later to find paid
out costs.

(c) Accounting costs include expenditures for hired resources while economic costs
do not.
(d) Economic costs add the opportunity cost of a firm which uses its own resources.

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 THEORY OF PRODUCTION AND COST 3.71
v

78. In figure below, possible reason why the average variable cost curve approaches the
average total cost curve as output rises is:

(a) Fixed costs are falling while total costs are rising at rising output.
(b) Total costs are rising and average costs are also rising.
(c) Marginal costs are above average variable costs as output rises.

(d) Average fixed costs are falling as output rises.

79. Marginal cost changes due to changes in —————
(a) Total cost

(b) Average cost

(c) Variable cost
(d) Quantity of output

80. Which of the following statements is correct?

(a) Fixed costs vary with change in output.
(b) If we add total variable cost and total fixed cost we get the average cost.

(c) Marginal cost is the result of total cost divided by number of units produced.
(d) Total cost is obtained by adding up the fixed cost and total variable cost.
81. Which of the following statements is incorrect?

(a) The LAC curve is also called the planning curve of a firm.
(b) Total revenue = price per unit × number of units sold.
(c) Opportunity cost is also called alternative cost.

(d) If total revenue is divided by the number of units sold we get marginal revenue.
82. The vertical difference between TVC and TC is equal to-
(a) MC
(b) AVC

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 3.72 BUSINESS ECONOMICS

(c) TFC
(d) None of the above
83. The falling part of long run average cost curve is tangent to the ____________ of
corresponding short run average cost curve(s).
(a) falling part
(b) rising part

(c) minimum point

(d) None of the above
84. Which one of the following is an external economies of scale in long run?
(a) Risk bearing economies
(b) Financial economies
(c) Development of skill labour
(d) None of the above

ANSWERS
1. (a) 2. (a) 3. (d) 4. (b) 5. (b) 6. (b)
7. (c) 8. (a) 9. (d) 10. (c) 11. (c) 12. (a)
13. (b) 14. (c) 15. (a) 16. (b) 17. (d) 18. (d)
19. (a) 20. (b) 21. (a) 22. (d) 23. (a) 24. (c)
25. (c) 26. (a) 27. (c) 28. (c) 29. (c) 30. (a)
31. (c) 32. (d) 33. (d) 34. (c) 35. (b) 36. (c)
37. (d) 38. (a) 39. (d) 40. (d) 41. (a) 42. (b)
43. (a) 44. (d) 45. (d) 46. (c) 47. (b) 48. (c)
49. (a) 50. (a) 51. (a) 52. (d) 53. (c) 54. (d)
55. (d) 56. (b) 57. (b) 58. (b) 59. (d) 60. (b)
61. (c) 62. (d) 63. (a) 64. (b) 65. (b) 66. (d)
67. (d) 68. (b) 69. (b) 70. (d) 71. (c) 72. (d)
73. (c) 74. (b) 75. (b) 76. (a) 77. (d) 78. (d)
79. (c) 80. (d) 81. (d) 82. (c) 83. (a) 84 (c)

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© The Institute of Chartered Accountants of India