CHAPTER 3

PRODUCTION AND COSTS

 Production Function
The production function of a firm depicts the relationship between the inputs used
in the production process and the final output, with a given level of technology.
Production function is written as
Qx = f (L, K)
Where,
L = Units of labour
K = Units of capital
Qx = Units of output of x produced
 Types of factors of Production
The various types of factors of production are classified as:
1) Variable factors of production
Those factors which can be increased or decreased, according to the need of
increase or decrease in the output, are called variable factors. For example,
labour.
2) Fixed factors of production
Those factors which remain constant with the change in the output are called
fixed factors of production. For example, capital
 SHORT RUN AND LONG RUN
In short run, the output can be increased (decreased) only by employing more (less)
of variable factors like labour, with a given level of fixed factor. The law which
explains this concept of short run is called law of variable proportions or returns to
factors. The short run production function is expressed as Qx = f (L, K )
In long run, the output can be increased (decreased) by employing more (less) of
both the inputs – variable and fixed factors. In the long run, all inputs (including
 capital) are variable and can be changed according to the required change in the
level of output. The law which explains this concept of long run is called returns to
scale. The long run production function is expressed as Qx = f (L, K)
 Isoquant/Iso-product curve
The curve which depicts different input combinations to yield the same maximum
possible level of output, with a given level of technology is called isoquant curve.
Throughout an isoquant curve, we have the same level of output produced but with
different input combinations.
 Marginal rate of technical substitution (MRTS) is that rate at which one
input (say labour) can be substituted for other input (say capital) for producing the
same level of production. MRTS is the slope of isoquant curve. It is represented as
K
MRTS 
L
K = change in units of capital
L = change in units of labour
 Properties of Isoquant curve
1) Negative slope from left to right.
2) Convex to the origin because of the diminishing marginal rate of technical
substitution.
3) Higher isoquant curve from the origin represent higher output level.
Total Product
It is defined as the sum total of output produced by a firm with all the units of
inputs- both variable and fixed factors. Total product is also called as total physical
product (TPP).
TP = Qx
 Average Product
It is defined as the output produced by per unit of variable factor employed, i.e.,
labour.
 TP
AP =
L
 Marginal Product
It is defined as an additional output due to the employment of an additional unit of
labour.
TP Change in output
MPL  
L Change in labour unit
or MPL = TPn – TPn–1
 Relationship between TP, AP and MP curves.
1) TP increases at an increasing rate till the point of inflexion. Later, it increases
but at a decreasing rate. At inflexion point, MP attains its maximum and
thereafter, falls, while AP continues to rise.
2) AP attains its maximum point where MP intersects AP and AP = MP.
3) TP continues to rise but at a decreasing rate and becomes constant at its
maximum point, while MP on the same time is zero, i.e. when TP is maximum
MP is zero.
4) When TP starts falling, MP is negative.
5) Both AP and MP are derived from TP.
TP
AP = , MP = TPn – TPn–1 and both AP and MP are inverse U–Shaped curves
L
 Law of Variable Proportions– Returns to a Factor
According to this law, if more and more of variable factor (labour) is combined with
the same quantity of fixed factor (capital) then initially the total product will
increase. However, after a certain point of time, total product will become smaller
and smaller.
 Law of Diminishing Marginal Product
According to this law, if the employment of variable factor keeps on increasing
along with the constant level of fixed factor, then initially marginal product will
increase but after a point the marginal product of the variable factor starts to fall..
After this point the marginal product of any additional variable factor can be zero or
even negative.
 Assumptions of Law of Variable Proportions
1) Technology level remains constant
2) The units of variable factors are homogeneous.
3) One of the inputs must be fixed.
4) No change in the input prices – wages and interests.
 Stages of Production
Stages Stage’s TP AP MP Range
Name

MP also rises
Increasing TP increases at an but at a faster
AP continues From 0 to
I Returns to a increasing rate rate than AP and
to increases point K
factor till K becomes
maximum.

MP cuts AP
Increases at a
Diminishing from at its
decreasing rate AP becomes From K
II Returns to a maximum point
and attains maximum to point B
factor and then falls to
maximum
become zero.

Negative MP continues to
AP continues From B
III Returns to a TP starts to fall fall and becomes
to fall onwards
factor negative.
 Reasons for Increasing Returns to a Factor
1) Underutilisation of fixed factor
2) Increasing specialisation of labour
This stage is known as non-economic zone.
 Reasons for Decreasing Returns to a Factor
1) Fuller utilisation of fixed factor
2) Imperfect substitutability between labour and capital
This stage is called economic zone as any rational producer would always like to
operate in this zone.
 Exception to the Law of Variable Proportion
1) Appreciation of level of technology
2) Discovery of substitutes of fixed factors.
 Viable and Feasible Stage of Production
 The viable and feasible stage of production refers to the economically efficient phase
of production. While in the first stage, the MP of labour is positive, production can
be increased by employing more labour with the same quantity of fixed factor. On
the other hand, in the third stage, the MP of labour is negative, which implies that
production can be increased by reducing or shedding the number of labour. Thus, it
can be seen that the stage second is the only viable and economically feasible stage
where MP and AP both falls but remains positive and hence, a producer or firm
would always like to operate.
 Return to Scale
According to the law of returns to scale, when all the inputs are increase in the same
proportion, the output also increases. However, this increase may be at an
increasing, constant or at a decreasing rate.
Three aspects of the Law of Returns to Scale are :
1) Increasing Returns to Scale (IRS);
2) Constant Returns to Scale (CRS); and
3) Decreasing Returns to Scale (DRS).
Let Qx = f (L, K)
Now if both the inputs are increased ‘n’ times, the new output Qx will be
Qx = f (nL, nK)
If f (nL, nK) > n  f (L, K), then the production function shows IRS.

If f (nL, nK) = n  f (L, K), then the production function shows CRS

If f (nL, nK) < n  f (L, K), then the production function shows DRS

 Causes for Increasing Returns to Scale

Increasing returns to scale implicitly implies reducing costs of production which
may be attributed to economies of scale, which can be further categorised into two
types:
1) Internal Economies
 These refer to those cost reduction efforts which are created by the firm itself
when output increases. These are limited and specific to a particular firm as
these exist due to expansion in the firm’s size.
Types of Internal Economies
a) Technical Economies
b) Managerial Economies
c) Financial Economies
d) Marketing Economies
e) Risk and Survival Economies
2) External Economies
These economies are not specific to any one firm and are shared by all the firms
within an industry, when the scale of industrial production increases. These
economies are exogenous to a particular firm and are beyond the control of the
firm.
Types of External Economies
a) Economies of Concentration
b) Economies of Information.
c) Economies of Disintegration
 Causes for Decreasing Returns to Scale
Decreasing returns to scale implies increasing cost of production. This may be
caused by diseconomies of scale. Diseconomies of scale exist when firm grows and
expands beyond its optimum capacity.
Diseconomies of scale can be categorised into two categories:
1) Internal diseconomies
2) External diseconomies
 Difference between Returns to Factor and Returns to Scale

Basis of Differences Returns to a Factor Returns to Scale

 1. Time Period This law is applicable only in This law is applicable only in
short run, when output can be long run, when output can
varied only by varying variable be varied by varying all
factors of production. factors of production.

2. Production According to this law, level of According to this law, scale

production can be changed. of production can be
changed.

3. Different Stages of There exists three stages - There exists three stages-
Production increasing returns, diminishing increasing returns, constant
returns and negative returns to a returns, and decreasing
factor. returns to a scale.

4. Factor Ratio In this law, we assume that In this law, we assume that
factor ratio remains constant. factor ratio needs to change.

5. Nature of Production This law refers to variable This law refers to constant
Function proportion types of production proportion types of
function. production function.

 Cost function
The algebraic form which depicts the functional relationship between cost of
production and output is called cost function. It is expressed as:
C = f (Qx)
Where,
C = cost of production
Qx = Units of output x produced
 Cost Curve in Different Time Horizons
According to different time horizons, the cost of production can be categorised into
two different categories:
1) Short-run costs
Costs which are incurred in the short run for producing output are called short
run costs.
a) Total Fixed Cost (TFC) / Overhead costs- Those costs which are
incurred on fixed factors are called fixed costs. In short run, fixed factors
cannot be varied. Thus, the fixed costs remain same (constant) throughout
all output levels. For example, cost of machinery, buildings, depreciation on
fixed assets, etc.
b) Total Variable Cost (TVC) / Direct Costs - Those costs which are
incurred on variable factors are called variable costs or total variable costs.
c) Total Cost (TC or STC) = TFC + TVC

d) Average Cost
Average cost is defined as the total cost per unit of producing output.
TC
AC =
Q
AC is the sum total of average fixed cost and average variable cost.
AC = Average Fixed Cost + Average Variable Cost
e) Average Fixed Cost
 It is defined as the fixed cost per unit of output.
TFC
AFC 
Q
f) Average Variable Cost
It is defined as the variable cost per unit of output.
TVC
AVC 
Q
g) Average Cost
Superimposing the AFC and AVC in one figure, we get Average Cost.

In the graph AFC curve is continuously falling whereas the AVC graph
initially falls, then stabilises and thereafter, increases. Vertically summing up
AVC and AFC we derive AC curve.
 U-Shaped Short Run Average Cost Curve
Short run average cost curve is a U-shaped curve which implies that initially AC falls
and reaches its minimum point and beyond this point, it raises. The reason behind
AC being U-shaped can be attributed to the law of variable proportions.
Falling AVC together with falling AFC, contributes together to falling AC curve. However,
later, as AFC becomes smaller and smaller, rising AVC leads to rising AC curve. Thus AC curve
is a U-shaped curve.
 Marginal Cost
It is defined as the additional cost to the total cost or total variable cost which is
incurred for producing one more unit of output. It is calculated in two ways:
 1) MCn = TCn – TCn – 1
Where,
TUn = Total utility achieved by consuming n units of a commodity
TUn–1 = Total utility achieved by consuming (n – 1) units of a commodity
MUn = Marginal utility achieved by consuming nth units of a commodity
TC
2) MC 
Q
It can also be said that the sum total of marginal cost is the total variable cost. That is
MC = TVC

Geometrically, area (shaded region) under MC curve corresponding to different

output levels indicates the TVC at that output level.
n
TVC = area of MNOP =  MC
i 1

Where,
i refers to the units of variable factors and ranges from one to n
 Relationship between AFC, AVC, AC and MC curves
 Relationship between AC and MC
1) When AC is falling, MC falls at a faster rate and MC remains below AC.
2) When AC is rising, MC rises at a faster rate and remains above AC.
3) When AC is at its minimum point, (z), MC is equal to AC.
4) MC curve intersects AC curve at its minimum point.
5) AC and MC are both U-shaped curves reflecting the law of variable proportions.
6) AC includes variable and fixed costs whereas MC includes only variable cost.
7) AC and MC are both derived from TC.
TC TC
i.e. AC = and MC =
Q Q

 Relationship between AVC and MC curves

1) When AVC is falling, MC falls at a faster rate and remains below AVC curve.
2) When AVC is rising, MC rises at a faster rate and remains above AVC curve.
3) When AVC is at minimum point (y), MC is equal to AVC.
4) MC curve cuts AC at its minimum point (z).
5) The minimum point of MC curve (x) will always lie left to the minimum point
of AVC curve (y).
6) AVC and MC are both derived from TVC.

TVC TVC TC

AVC = and MC = or
Q Q Q
 Relationship between TC and MC curve
1) When TC rises at a decreasing rate, marginal cost is decreasing.
2) When TC rises at an increasing rate, MC rises.
3) When TC becomes constant and reaches its maximum point, MC becomes zero.
4) While TC consists of both variable and fixed costs (i.e. TVC and TFC), MC
consists of only variable costs.
5) TC curve is an inverse S-shaped curve, whereas MC curve is inverted U-shaped.
6) MC is derived from TC,i.e.
TC
MC 
Q
MC is the slope of TC curve.
 Long Run Costs
The costs which are incurred in the long run for producing output are called long
run costs. As in long run all factors of production are variable, i.e., the output level
can be varied by varying capital and/or labour, so there is no concept of fixed costs
in the long run and all costs are variable costs. Three important long run costs are:
1) Long Run Total Cost (LTC)
2) Long Run Average Cost (LAC)
3) Long Run Marginal Cost (LMC)

Note: It should be noted that unlike short run TC, the LTC starts from origin when output
is zero, as there are no fixed costs in the long run.
 Long-Run Average Cost
 LAC shows the cost of producing per unit of commodity when all factors are
variable.
 U-Shaped LAC
The U-shape of LAC can be attributed to the law of returns to scale. Initially LAC falls
due to IRS and attains its minimum point at M (which represents optimum capacity)
corresponding to Q1 level of output due to CRS and finally rises due to DRS.

 Long-run Marginal Cost

LMC is the additional cost to the long-run total cost which is incurred to produce
one more unit of output when all factors are variables. LMC curve is also U-shaped
curve due to returns to scale.
 Relationship between LMC and LAC

1) When LAC is falling, LMC is also falling but at a faster rate and remains below
LAC.
2) When LAC is rising, LMC is also rising but at a faster rate and remains above
LAC.
3) When LAC is constant (i.e. at minimum point M) LMC equals LAC.
4) LMC cuts LAC at its minimum point.