Production Concepts & Analysis

Production is a process of combining various inputs to produce an output for consumption. It

is the act of creating output in the form of a commodity or a service which contributes to the
utility of individuals.

In other words, it is a process in which the inputs are converted into outputs.

The basic proposition of the production concept is that customers will choose products and
services that are widely available and are of low cost. So business is mainly concerned with
making as many units as possible. By concentrating on producing maximum volumes, such a
business aims to maximise profitability by exploiting economies of scale.

Managers try to achieve higher volume with low cost and intensive distribution strategy. This
seems a viable strategy in a developing market where market expansion is the survival
strategy for the business. Companies interested to take the benefit of scale economies pursue
this kind of orientation.

In a production-orientated business, the needs of customers are secondary compared with the
need to increase output. Such an approach is probably most effective when a business
operates in very high growth markets or where the potential for economies of scale is
significant. It is natural that the companies cannot deliver quality products and suffer from
problems arising out of impersonal behavior with the customers.

Do note, the production concept is a thing of the past and was used when there was very less
competition. At such times, the more you produced, the more will be the consumption of the
product. An example in this case is FORD, which manufactured huge number of automobiles
through its manufacturing assembly line which was the first of its kind.

Production is a process of transformation of the factors of production into the economic

goods. So in term of production analysis we are dealing with the physical relationships
between inputs and outputs (i.e. we are observing the dependence of physical production
volume on physical quantity of the inputs).

PRODUCTION ANALYSIS

Production analysis basically is concerned with the analysis in which the resources such as
land, labor, and capital are employed to produce a firm’s final product. To produce these
goods the basic inputs are classified into two divisions −

1. Variable Inputs

Inputs those change or are variable in the short run or long run are variable inputs.

2. Fixed Inputs

Inputs that remain constant in the short term are fixed inputs.
Production Function and Types of
Production Function
In simple words, production function refers to the functional relationship between the
quantity of a good produced (output) and factors of production (inputs).

“The production function is purely a technical relation which connects factor inputs and
output.” Prof. Koutsoyiannis

Defined production function as “the relation between a firm’s physical production (output)
and the material factors of production (inputs).” Prof. Watson

In this way, production function reflects how much output we can expect if we have so much
of labour and so much of capital as well as of labour etc. In other words, we can say that
production function is an indicator of the physical relationship between the inputs and output
of a firm.

The reason behind physical relationship is that money prices do not appear in it. However,
here one thing that becomes most important to quote is that like demand function a
production function is for a definite period.

It shows the flow of inputs resulting into a flow of output during some time. The production
function of a firm depends on the state of technology. With every development in technology
the production function of the firm undergoes a change.

The new production function brought about by developing technology displays same inputs
and more output or the same output with lesser inputs. Sometimes a new production function
of the firm may be adverse as it takes more inputs to produce the same output.

Mathematically, such a basic relationship between inputs and outputs may be expressed as:

Q = f( L, C, N )
Where Q = Quantity of output

L = Labour

C = Capital

N = Land.

Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N)
available to the firm. In the simplest case, where there are only two inputs, labour (L) and
capital (C) and one output (Q), the production function becomes.

Q =f (L, C)

Features of Production Function

Following are the main features of production function:

1. Substitutability

The factors of production or inputs are substitutes of one another which make it possible to
vary the total output by changing the quantity of one or a few inputs, while the quantities of
all other inputs are held constant. It is the substitutability of the factors of production that
gives rise to the laws of variable proportions.

2. Complementarity

The factors of production are also complementary to one another, that is, the two or more
inputs are to be used together as nothing will be produced if the quantity of either of the
inputs used in the production process is zero.

The principles of returns to scale is another manifestation of complementarity of inputs as it

reveals that the quantity of all inputs are to be increased simultaneously in order to attain a
higher scale of total output.

3. Specificity

It reveals that the inputs are specific to the production of a particular product. Machines and
equipment’s, specialized workers and raw materials are a few examples of the specificity of
factors of production. The specificity may not be complete as factors may be used for
production of other commodities too. This reveals that in the production process none of the
factors can be ignored and in some cases ignorance to even slightest extent is not possible if
the factors are perfectly specific.

Production involves time; hence, the way the inputs are combined is determined to a large
extent by the time period under consideration. The greater the time period, the greater the
freedom the producer has to vary the quantities of various inputs used in the production
process.
In the production function, variation in total output by varying the quantities of all inputs is
possible only in the long run whereas the variation in total output by varying the quantity of
single input may be possible even in the short run.

TYPES OF PRODUCTION FUNCTIONS

Production function is the mathematical representation of relationship between physical

inputs and physical outputs of an organization.

There are different types of production functions that can be classified according to the
degree of substitution of one input by the other.

1. Cobb-Douglas Production Function

Cobb-Douglas production function refers to the production function in which one input can
be substituted by other but to a limited extent. For example, capital and labor can be used as a
substitute of each other, but to a limited extent only.

Cobb-Douglas production function can be expressed as follows:

Q = AKaLb

Where, A = positive constant

a and b = positive fractions

b=1–a

Therefore, Cobb- Douglas production function can also be expressed as follows:

Q = akaL1-a

The characteristics of Cobb- Douglas production function are as follows:

(i) Makes it possible to change the algebraic form in log linear form, represented as follows:

log Q = log A + a log K + b log L

This production function has been estimated with the help of linear regression analysis.

(ii) Makes it possible to change the algebraic form in log linear form, represented as follows:
log Q = log A + a log K + b log L

This production function has been estimated with the help of linear regression analysis.

(iii) Acts as a homogeneous production function, whose degree can be calculated by the value
obtained after adding values of a and b. If the resultant value of a + b is 1, it implies that the
degree of homogeneity is 1 and indicates the constant returns to scale.

(iv) Makes use of parameters a and b, which signifies the elasticity’ coefficients of output for
inputs, labor and capital, respectively. Output elasticity coefficient refers to the change
produced in output due to change in capital while keeping labor at constant.

(v) Represents that there would be no production at zero cost.

2. Leontief Production Function

Leontief production function uses fixed proportion of inputs having no substitutability

between them. It is regarded as the limiting case for constant elasticity of substitution.

The production function can be expressed as follows:

q= min (z1/a, Z2/b)

Where, q = quantity of output produced

Z1 = utilized quantity of input 1

Z2 = utilized quantity of input 2

a and b = constants

For example, tyres and steering wheels are used for producing cars. In such case, the
production function can be as follows:

Q = min (z1/a, Z2/b)

Q = min (number of tyres used, number of steering used).

3. CES Production Function

CES stands for constant elasticity substitution. CES production function shows a constant
change produced in the output due to change in input of production.

It can be represented as follows:

Q = A [aKβ + (1-a) L-β]-1/β

Or,

Q = A [aL-β + (1-a) K-β]-1/β

CES has the homogeneity degree of 1 that implies that output would be increased with the
increase in inputs. For example, labor and capital has increased by constant factor m.

In such a case, production function can be represented as follows:

Q’ = A [a (mK)-β + (1-a) (mL)-β]-1/β

Q’ = A [m-β {aK-β + (1-a) L-β}]-1/β

Q’ = (m-β)-1/β .A [aK-β + (1-a) L-β)-1/β

Because, Q = A [aK-β + (1-a) L-β]-1/β

Therefore, Q’ = mQ

This implies that CES production function is homogeneous with degree one.

Laws of Production
The laws of production describe the technically possible ways of increasing the level of
production. Output may increase in various ways.

Output can be increased by changing all factors of production. Clearly this is possible only in
the long run. Thus the laws of returns to scale refer to the long-run analysis of production.

In the short run output may be increased by using more of the variable factor(s), while capital
(and possibly other factors as well) are kept constant.

The marginal product of the variable factors) will decline eventually as more and more
quantities of this factor are combined with the other constant factors. The expansion of output
with one factor (at least) constant is described by the law of (eventually) diminishing returns
of the variable factor, which is often referred to as the law of variable proportions.

Laws of Production in economics deals with the concepts of cost and producers equilibrium.
It is an important aspect of economics as it helps a business determine the level of output that
leads to maximum profits. It also defines the various variable and fixed costs of the firm.

Law of Diminishing Returns

The law of diminishing returns also referred to as the law of diminishing marginal returns,
states that in a production process, as one input variable is increased, there will be a point at
which the marginal per unit output will start to decrease, holding all other factors constant. In
other words, keeping all other factors constant, the additional output gained by another one
unit increase of the input variable will eventually be smaller than the additional output gained
by the previous increase in input variable. At that point, the diminishing marginal returns take
effect.

Assumptions of Law of Diminishing Returns

The assumptions of the law of diminishing returns are as follows:

(i) Units of capital and labor are used as variable factors.

(ii) The prices of the factors do not change.

(iii) All units of variable factors are equally efficient.

(iv) There is no change in technique of production.

(v) Best combination of factors of production has crossed the level of optimum point.

(vi) There is no change in the fixed factor of production.

A Farmer Example of Diminishing Returns

Consider a corn farmer with one acre of land. In addition to land, other factors include
quantity of seeds, fertilizer, water, and labor. Assume the farmer has already decided how
much seed, water, and labor he will be using this season. He is still deciding on how much
fertilizer to use. As he increases the amount of fertilizer, the output of corn will increase. It
may also reach a point where the output actually begins to decrease since too much fertilizer
can become poisonous.

The law of diminishing returns states that there will be a point where the additional output of
corn gained from one additional unit of fertilizer will be smaller than the additional output of
corn from the previous increase in fertilizer. This table shows the output of corn per unit of
fertilizer:

As the farmer increases from one to two units of fertilizer, total output increases from 100 to
250 ears of corn. Therefore the marginal, or additional, ears of corn gained from one more
unit of fertilizer is 150 (250 – 100). From two to three units of fertilizer, the total output
increases from 250 to 425 ears of corn, a 175 marginal increase.

At what point does the law of diminishing returns set in? Look for the point at which the
marginal increase is at the highest point and the next marginal increase is less. In this
example, that occurs after the farmer adds the third unit of fertilizer. At three units, the
marginal output in ears of corn is 175, but when the fourth unit is added, the marginal output
drops to 125.
Again, this does not mean the total production starts to decrease. In fact, the total production
is still increasing, as shown in the total ears of corn column. Also note that at the sixth unit of
fertilizer, the farmer starts to experience negative returns, where the increase in fertilizer
actually decreases the total output and the marginal output becomes negative.

Application of Law of Diminishing Returns

The law of diminishing returns has its wide application. But is especially applicable to
agricultural sector. In this sector, there is the supremacy of nature plays in production
corresponds to diminishing returns. Due to the following reasons, the agricultural sector is
subject to law of diminishing returns.

1. The natural factors have more role than human factors in agricultural sector and
marginal productivity decreases.
2. The sector has very wide area and supervision cannot be very effective.
3. Scope of specialized machinery is limited.
4. There are other limitations of seasonal nature e.g. rain, climate changes etc.
5. The fertility land also declines

The application of this law is not confined to agriculture but it applies everywhere. If the
industry is expanded too much, the supervision will become inefficient and costs will go up.
In agriculture it sets in earlier and in industry much later. Agriculture has also increasing
returns in the beginning.

Law of Returns to Scale

The law of returns to scale describes the relationship between outputs and scale of inputs in
the long-run when all the inputs are increased in the same proportion. In the words of Prof.
Roger Miller, “Returns to scale refer to the relationship between changes in output and
proportionate changes in all factors of production. To meet a long-run change in demand, the
firm increases its scale of production by using more space, more machines and labourers in
the factory’.

Assumptions
(i) All factors (inputs) are variable but enterprise is fixed.

(ii) A worker works with given tools and implements.

(iii) Technological changes are absent.

(iv) There is perfect competition.

(v) The product is measured in quantities.

Explanation

Given these assumptions, when all inputs are increased in unchanged proportions and the
scale of production is expanded, the effect on output shows three stages: increasing returns to
scale, constant returns to scale and diminishing returns to scale.

1. Increasing Returns to Scale

Returns to scale increase because the increase in total output is more than proportional to the
increase in all inputs.

The table reveals that in the beginning with the scale of production of (1 worker + 2 acres of
land), total output is 8. To increase output when the scale of production is doubled (2 workers
+ 4 acres of land), total returns are more than doubled. They become 17. Now if the scale is
trebled (3 workers + о acres of land), returns become more than three-fold, i.e., 27. It shows
increasing returns to scale. In the figure RS is the returns to scale curve where R to С portion
indicates increasing returns.

Causes of Increasing Returns to Scale

Returns to scale increase due to the following reasons:

(i) Indivisibility of Factors

Returns to scale increase because of the indivisibility of the factors of production.

Indivisibility means that machines, management, labour, finance, etc. cannot be available in
very small sizes. They are available only in certain minimum sizes. When a business unit
expands, the returns to scale increase because the indivisible factors are employed to their
maximum capacity.

(ii) Specialization and Division of Labour

Increasing returns to scale also result from specialization and division of labour. When the
scale of the firm is expanded there is wide scope of specialization and division of labour.
Work can be divided into small tasks and workers can be concentrated to narrower range of
processes. For this, specialised equipment can be installed. Thus with specialization,
efficiency increases and increasing returns to scale follow.

(iii) Internal Economies

As the firm expands, it enjoys internal economies of production. It may be able to install
better machines, sell its products more easily, borrow money cheaply, procure the services of
more efficient manager and workers, etc. All these economies help in increasing the returns
to scale more than proportionately.

(iv) External Economies

A firm also enjoys increasing returns to scale due to external economies. When the industry
itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry.

When a large number of firms are concentrated at one place, skilled labour, credit and
transport facilities are easily available. Subsidiary industries crop up to help the main
industry. Trade journals, research and training centres appear which help in increasing the
productive efficiency of the firms. Thus these external economies are also the cause of
increasing returns to scale.

2. Constant Returns to Scale

Returns to scale become constant as the increase in total output is in exact proportion to the
increase in inputs. If the scale of production in increased further, total returns will increase in
such a way that the marginal returns become constant. In the table, for the 4th and 5th units of
the scale of production, marginal returns are 11, i.e., returns to scale are constant. In the
figure, the portion from С to D of the RS curve is horizontal which depicts constant returns to
scale. It means that increments of each input are constant at all levels of output.
Causes of Constant Returns to Scale

Returns to scale are constant due to:

(i) Internal Economies and Diseconomies: But increasing returns to scale do not continue
indefinitely. As the firm expands further, internal economies are counterbalanced by internal
diseconomies. Returns increase in the same proportion so that there are constant returns to
scale over a large range of output.

(ii) External Economies and Diseconomies: The returns to scale are constant when external
diseconomies and economies are neutralised and output increases in the same proportion.

(iii) Divisible Factors: When factors of production are perfectly divisible, substitutable, and
homogeneous with perfectly elastic supplies at given prices, returns to scale are constant.

3. Diminishing Returns to Scale

Returns to scale diminish because the increase in output is less than proportional to the
increase in inputs. The table shows that when output is increased from the 6th, 7th and 8th
units, the total returns increase at a lower rate than before so that the marginal returns start
diminishing successively to 10, 9 and 8. In the figure, the portion from D to S of the RS curve
shows diminishing returns.

Causes of Diminishing Returns to Scale

Constant returns to scale is only a passing phase, for ultimately returns to scale start
diminishing. Indivisible factors may become inefficient and less productive. Business may
become unwieldy and produce problems of supervision and coordination. Large management
creates difficulties of control and rigidities. To these internal diseconomies are added external
diseconomies of scale.

These arise from higher factor prices or from diminishing productivities of the factors. As the
industry continues to expand, the demand for skilled labour, land, capital, etc. rises. There
being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to
raise costs and the expansion of the firms leads to diminishing returns to scale so that
doubling the scale would not lead to doubling the output.

For the management increasing, decreasing or constant returns to scale reflect changes in pro-
duction efficiency that result from scaling up productive inputs. But returns to scale is strictly
a production and cost concept. Management’s decision on what to produce and how much to
produce must be based upon the demand for the product. Therefore, demand and other factors
must also be considered in decision making.

Cost Concept and analysis: Cost and Types

of Costs
Cost analysis is all about the study of the behavior of cost with respect to various production
criteria like the scale of operations, prices of the factors of production, size of output, etc. It is
all about the financial aspects of production. In order to understand the cost function well, in
this article, we will look at various cost concepts.

Type of Cost

1. Private Cost or Social Cost

Private cost refers to the cost of Production to an individual producer. Social Cost refers to
the cost of producing commodity to society in the form of resources that are used to produce
it.

From the social point of view, the economy has a certain volume of resources in the form of
capital, land etc., which it would be like to put to the best uses.

This depends upon the efficient and full utilization of resources and also the specific list of
commodities to be produced. It would be ideal if the social cost coincided with the private
costs of producing commodity.

2. Actual Cost and Opportunity Cost

Actual Costs or Outlay Costs or Absolute Costs mean the actual amount of expenses incurred
for producing or acquiring a good or service. These are the costs which are generally
recorded in the books of accounts for cost or financial purposes such as payment for wages,
raw-materials purchased, other expenses paid etc.

3. Past Costs and Future Costs

Actual costs or historical costs are records of past costs.

Future costs are based on forecasts. The costs relevant for most managerial decisions are
forecasts of future costs or comparative conjunctions concerning future situations.

Forecasting of future costs is required for expense control, projection of future income
statements; appraisal of capital expenditures, decision on new projects and on an expansion
programme and pricing.

4. Explicit Cost and Implicit Cost

“The total cost of production of any particular goods can be said to include expenditure or
explicit costs and non-expenditure or implicit costs.” Expenditure or Outlay or Explicit Costs
are those costs which are paid by the employer to the owners of the factor units which do not
belong to the employer itself.

These costs are in the nature of contractual payments and they consist of wages and salaries
paid; payments for raw materials, interest on borrowed capital funds, rent on hired land and
the taxes paid to the Government.
Non-expenditure or Implicit Costs arise when factor units are owned by the employer
himself. The employer is not obligated to anyone in order to obtain these factors. Expenditure
costs are explicit; since they are paid to factors outside the firm while non-expenditure or
implicit costs are imputed costs.

But the latter are costs in the real sense of the term, since the factor units owned by the
organizer himself can be supplied to other producers for a contractual sum if they are not
used in the business of the organizer.

5. Incremental Costs or (Differential Costs) and Sunk Costs

(a) Incremental Cost

Is the additional cost due to change in the level or nature of business activity.

The change may take several forms e.g.,:

(i) Addition of new product line,

(ii) Changing the channel of distribution,

(iii) Adding a new machine,

(iv) Replacing a machine by a better one, and

(v) The expansion into additional markets etc.

(b) Sunk Cost

Is one which is not affected or altered by a change in the level or nature of business activity.
It will remain the same whatever the level of activity may be.

For Example: The amortization of past expenses e.g., depreciation.

6. Short-Run and Long-Run Costs

Short-run Costs are costs that vary with output or sales when fixed plant and capital
equipment remain the same.

Long-run Costs are those which vary with output when all output factors including plant and
equipment vary.

Short-run costs become relevant when a firm has to decide whether to produce more or not in
the immediate future and when setting up of a new plant in ruled out and the firm has to
manage with the existing plant.

Long-run costs become relevant when the firm has to decide whether to set up a new plant or
not. Long-run cost can help the businessman in planning the best scale of plant or the best
size of the firm for his purposes.
Thus, long-run costs can be helpful both in the initiation of new enterprises as well as the
expansion of existing ones.

7. Fixed and Variable Costs

Fixed Costs remain constant in total regardless of changes in volume of production and sales,
up to certain level of output. There is an inverse relationship between volume and fixed costs
per unit. If volume of production increases, the fixed costs per unit decreases. Thus, total
fixed costs do not change with a change in volume but vary per unit of volume inversely.

Variable Costs vary in total in direct proportion to changes in volume. An increase in the
volume means a proportionate increase in the total variable costs and a decrease in volume
results in a proportionate decline in the total variable costs.

There is a linear relationship between volume and variable costs. They are constant per unit.
Many costs fall between these two extremes. They are called as semi-variable costs. They are
neither perfectly variable nor absolutely fixed in relation to changes in volume.

They change in the same direction as volume but not in direct proportion there to. For
Example— Electricity bills often include both fixed charge and a charge based on
consumption.

8. Direct and Indirect Costs or Traceable and Common Costs

A Direct or Traceable Cost is one which can be identified easily and indisputably with a unit
of operation, i.e., costing unit/cost centre. Indirect or Common Costs are not traceable to any
plant, department or operation as well as those that are not traceable to indirect final products.

For example: The salary of a Divisional Manager, when a Division is a costing unit, will be
a direct cost. The monthly salary of the General Manger when one of the divisions is a
costing unit would be an indirect cost.

Cost of Multiple Products

In some manufacturing enterprises two or more different products emerge from a single raw
material.

For example: A variety of petroleum products are derived from the refining of crude oil. In a
cigarette factory different parts of the tobacco leaves are used for different qualities and
products. They are identifiable as separate products only at the conclusion of common
processing generally known as the SPLIT OFF POINT.

Common Costs

The costs incurred up to the Split off Point are common costs. Costs which cannot be traced
to separate products in any direct or logical manner. These costs should not be identified with
individual products if it is not meaningful and useful to identify them.

In this existing product line some common costs are unaffected by the change that how to be
decided upon i.e., cost of factory building. Fixed common costs need not be allocated since
they are irrelevant for any decision and will remain constant. Common costs that vary with
the decision must be allocated to individual products.

9. Sunk, Shut-Down and Abandonment Costs

(i) Sunk Cost

A Past Cost resulting from a decision which can no more be revised is called a Sank Cost. It
is usually associated with the commitment of funds to specialised equipment or other
facilities not readily adaptable to present or future e.g., brewing plant in times of prohibition.

(ii) Shut-Down Costs

Are these costs which would be incurred in the event of suspension of the plant operation and
which would have been saved if the operations had continued, e.g., for storing exposed
property. Further additional expenses may have to be incurred when operations are re-started.

(iii) Abandonment Costs

Are the costs of retiring altogether a plant from service. Abandonment arises when there is
complete cessation of activities. These costs become important when management is faced
with the alternatives of either continuing the existing plant or suspending its operation or
abandoning it altogether.

10. Out of Pocket and Book Cost

Refer to costs that involve current cash payments to outsiders. On the other hand book costs
such as depreciation, do not require current cash payments. Book costs can be converted into
out of pocket costs by selling the assets and having them on hire. Rent would then replace
depreciation and interest, while understanding expansion; book costs do not come into the
picture until the assets are purchased.

11. Historical Costs and Replacement Costs

Mean the cost of an asset or the price originally paid for it. Replacement cost means the price
that would have to be paid currently for acquiring the same plant. The assets are usually
shown in the conventional financial accounts at their historical costs.

But during the period of changing price levels historical costs may not be correct basis for
projecting future costs. Historical costs must be adjusted to reflect current or future price
levels.

12. Controllable and Non-Controllable Costs

(i) Controllable

A Controllable Cost is one which is reasonably subject to regulation by the executive with
whose responsibility that cost is being identified.

(ii) Un-controllable Cost

Un-controllable cost is that cost which is uncontrollable at one level of responsibility may be
regarded as controllable at some other higher level. The controllability of certain costs may
be shared by two or more executives. The distinction is important for controlling the
expenses and efficiency.

13. Average Cost, Marginal Cost and Total Cost

(i) Average Cost is the total cost divided by the total quantity produced.

(ii) Marginal Cost is the extra cost of producing one additional unit. It may at times be
impossible to measure marginal cost. For example, if a firm produces 10,000 metres of cloth,
it can become impossible to determine the change in cost involved in producing 10,001
metres of cloth. The difficulty can be solved by taking units of significant size. In general,
economist’s marginal cost is cost account cost.

(iii) The Total Costs of a firm are the sum of total fixed costs and total variable costs.

Symbolically:

Total Cost or TC = TFC + TVC

Average Cost or AC = TC + TQ

Marginal Cost or MC = TCn -TCn-1

Cost Output Relationship in Short Run

Time element plays an important role in price determination of a firm. During short period
two types of factors are employed. One is fixed factor while others are variable factors of
production. Fixed factor of production remains constant while with the increase in
production, we can change variable inputs only because time is short in which all the factors
cannot be varied.

Raw material, semi-finished material, unskilled labour, energy, etc., are variable inputs which
can be changed during short run. Machines, capital, infrastructure, salaries of managers and
technical experts are included in fixed inputs. During short period an individual firm can
change variable factors of production according to requirements of production while fixed
factors of production cannot be changed.

Cost-Output Relationship in the Short Run:

(i) Average Fixed Cost Output

The greater the output, the lesser the fixed cost per unit, i.e., the average fixed cost. The
reason is that total fixed costs remain the same and do not change with a change in output.

The relationship between output and fixed cost is a universal one for all types of business.
Thus, average fixed cost falls continuously as output rises. The reason why total fixed costs
remain the same and the average fixed cost falls is that certain factors are indivisible.
Indivisibility means that if a smaller output is to be produced, the factor cannot be used in a
smaller quantity. It is to be used as a whole.

(ii) Average Variable Cost and Output

The average variable costs will first fall and then rise as more and more units are produced in
a given plant. This is so because as we add more units of variable factors in a fixed plant, the
efficiency of the inputs first increases and then decreases. In fact, the variable factors tend to
produce somewhat more efficiently near a firm’s optimum output than at very low levels of
output.

But once the optimum capacity is reached, any further increase in output will undoubtedly
increase average variable cost quite sharply. Greater output can be obtained but at much
greater average variable cost. For example, if more and more workers are appointed. It may
ultimately lead to overcrowding and bad organization. Moreover, workers may have to be
paid higher wages for overtime work.

(iii) Average Total Cost and Output

Average total costs, more commonly known as average costs, will decline first and then rise
upward. The significant point to note here is that the turning point in the case of average cost
comes a little later in the case of average variable cost.

Average cost consists of average fixed cost plus average variable cost. As we have seen,
average fixed cost continues to fall with an increase in output while average variable cost first
declines and then rises. So long as average variable cost declines the average total cost will
also decline. But after a point, the average variable cost will rise. Here, if the rise in variable
cost is less than the drop in fixed cost, the average total cost will still continue to decline.

It is only when the rise in average variable cost is more than the drop in average fixed cost
that the average total cost will show a rise. Thus, there will be a stage where the average
variable cost may have started rising yet the average total cost is still declining because the
rise in average variable cost is less than the drop in average fixed cost. The net effect being a
decline in average cost.

The least cost-output level is the level where the average total cost is the minimum and not
the average variable cost. In fact, at the least cost-output level, the average variable cost will
be more than its minimum (average variable cost). The least cost- output level is also the
optimum output level. It may not be the maximum output level. A firm may decide to
produce more than the least cost-output level.

(iv) Short-Run Output Cost Curves

The cost-output relationships can also be shown through the use of graphs. It will be seen that
the average fixed cost curve (AFC curve) falls as output rises from lower levels to higher
levels. The shape of the average fixed cost curve, therefore, is a rectangular hyperbola.
However, the average variable cost curve (AVC curve) starts rising earlier than the ATC
curve. Further, the least cost level of output corresponds to the point LT on the ATC curve
and not to the point LV which lies on the AVC curve.

Another important point to be noted is that in Fig. the marginal cost curve (MC curve)
intersects both the AVC curve and ATC curve at their minimum points. This is very simple to
explain. If marginal cost (MC) is less than the average cost (AC), it will pull AC down. If the
MC is greater than AC, it will pull AC up. If the MC is equal to AC, it will neither pull AC
up nor down. Hence, MC curve tends to intersect the AC curve at its lowest point.

Similar is the position about the average variable cost curve. It will not make any difference
whether MC is going up or down. LT is the lowest point of total cost and LV is the lowest
point of variable cost.

The inter-relationships among AVC, ATC, and AFC can be summed up as follows:

1. If both AFC and AVC fall, ATC will also fall.

2. If AFC falls but AVC rises

(a) ATC will fall where the drop in AFC is more than the rise in AVC.

(b) ATC will not fall where the drop in AFC is equal to the rise in AVC.

(c) ATC will rise where the drop in AFC is less than the rise in AVC.

Cost Output Relationship in Long run

The long run is a period long enough to make all costs variable including such costs as are
fixed in the short run. In the short run, variations in output are possible only within the range
permitted by the existing fixed plant and equipment. But in the long run, the entrepreneur has
before him a number of alternatives which includes the construction of various kinds and
sizes of plants.
Thus, there are no fixed costs since the firm has sufficient time to fully adapt its plant. And
all costs become variable. In view of this, the long-run costs will refer to the costs of
producing different levels of output by changes in the size of plant or scale of production.
The long-run cost-output relationship is shown graphically by the long- run cost curve—a
curve showing how costs will change when the scale of production is changed.

The concept of long-run costs can be further explained with the help of an illustration.
Suppose that at a particular time, a firm operates under average total cost curve U 2 and
produces OM. Now it is desired to produce ON. If the firm continues under the old scale, its
average cost curve will be NT. If the scale of firm is altered, the new cost curve will be U 3.
The average cost of producing ON will then be NA.

NA is less than NT. So the new scale is preferable to the old one and should be adopted. In
the long run, the average cost of producing ON output is NA. This may be called as the long-
run cost of producing ON output. It may be noted here that we shall call NA as the long-run
cost only so long as the U3 scale is in the planning stage and has not actually been adopted.
The moment the scale is installed, the NA cost will be the short-run cost of producing ON
output.

To draw a long-run cost curve, we have to start with a number of short-run average cost
curves (SAC curves), each such curve representing a particular scale or size of the plant,
including the optimum scale. One can now draw the long-run cost curve which tangential to
the entire family of SAC curves, that is, it touches each SAC curve at one point.

Estimation of Revenue
2–3 minutes

Revenue estimation involves calculating the amount of money our business is likely to earn.
We can work this out by forecasting your business growth rate, the number of customers we
have (and will have) and the prices of our products and services.

Revenue estimation is usually calculated over a fixed accounting period, such as a quarter or
even a financial year.

A new business should prepare revenue projections every three months, but after a couple of
years we’ll have a better idea of our annual business growth rate and our revenue estimation
will be more accurate.

How can revenue estimation help protect our business?

Revenue estimation is particularly important for protecting your earnings through business
interruption insurance, which we call “Back in Business”. This type of insurance can protect
your revenue against an unpredictable event that may stop your revenue completely, such as a
fire, storm or cyclone.

It can also provide financial relief for some events that impact your revenue, such as a nearby
shop burning down, which means your customers can’t get to your premises for a few weeks,
or where parts of your city are severely damaged by a storm and you can’t deliver your
services.

When disaster strikes and halts your revenue, business expenses such as wages, rent and loan
repayments must still be paid.

The ability to estimate future revenue and net income of a company is important in the
budgeting process. But because of the diversity of influences on company income and
expenses, it can be challenging to develop accurate future-period estimates. Established small
businesses can look to previous financial statements and trends to inform their estimates,
adding at least a statistical reliability to the process. Using previous financials can allow you
to project past and current trends into the future, and it gives you a starting point for
estimating actual revenue and net income figures.
Average Revenue
Price paid by the consumer for the product forms the revenue or income of the seller. The
whole income received by the seller from selling a given amount of the product is called total
revenue. If a seller sells 15 units of a product at price Rs. 10 per unit and obtains Rs. 150
from this sale, then his total revenue is Rs. 150.

Thus total revenue can be obtained from multiplying the quantity of output sold by the
market price of the product (P.Q). On the other hand, average revenue is revenue earned per
unit of output. Average revenue can be obtained by dividing the total revenue by the number
of units sold. Thus,

Average revenue = total revenue/total output sold

AR = TR/Q

Where AR stands for average revenue, TR for total revenue and Q for total output produced
and sold. In our above example, when total revenue Q equal to Rs. 150 is received from
selling 15 units of the product, the average revenue will be equal to Rs. 150/15 = Rs. 10. Rs.
10 is here the revenue earned per unit of output.

Now the question is whether average revenue is different from price or these two concepts
mean the same thing. If a seller sells various units of a product at the same price, then average
revenue would be the same thing as price. But when he sells different units of a given product
at different prices, then the average revenue will not be equal to price.
An example will clarify this point. Suppose a seller sells two units of a product, both at a
price of Rs. 10 per unit. Total revenue of the seller will be Rs. 20 and the average revenue
will be 20/2 = Rs. 10. Thus average revenue is here equal to the price of the product.

Now suppose that the seller sells the two units of his product, one unit to the consumer A at
price Rs. 12 and one unit to the consumer B at price Rs. 10. His total revenue from the sale of
two units of the product will be Rs. 22. Average will be here equal to 22/2 = Rs. 11. Thus in
this case when two units of the product are sold at different prices, average revenue is not
equal to the prices charged for the product.

But in the actual life we find that different units of a product are sold by the seller at the same
price in the market (except when he discriminates and charges different prices for different
units of the good), average revenue equals price. Thus in economics we use average revenue
and price as synonyms except when we are discussing price discrimination by the seller.

Since the buyer’s demand curve represents graphically the quantities demanded or purchased
by the buyers at various prices of the good, it also, therefore, shows the average revenue at
which the various amounts of the good are sold by the seller. This is because the price paid
by the buyer is revenue from seller’s point of view. Hence, average revenue curve of the firm
is really the same thing as the demand curve of the consumers.

Marginal Revenue
Marginal revenue is the net revenue earned by selling an additional unit of the product. In
other words, marginal revenue is the addition made to the total revenue by selling one more
unit of a commodity. Putting it in algebraic expression, marginal revenue is the addition made
to total revenue by selling n units of a product instead of n – 1 where n is any given number.

If a producer sells 10 units of a product at price Rs. 15 per unit, he will get Rs. 150 as the
total revenue. If he now increases his sales of the product by one unit and sells 11 units,
suppose the price falls to Rs. 14 per unit. He will, therefore, obtain total revenue of Rs. 154
from the sale of 11 units of the good. This means that 11th unit of output has added Rs. 4 to
the total revenue. Hence Rs. 4 is here the marginal revenue.

Total revenue when 10 units are sold at price of Rs. 15 = 10 x 15 =Rs. 150

Total revenue when 11 units are sold at price of Rs. 14 = 11 x 14 = Rs. 154

Marginal revenue = 154- 150 = Rs. 4

The word net in the first definition of marginal revenue given above is worth noting. The full
understanding of the word ‘net’ in the definition will reveal why the marginal revenue is not
equal to the price. The question is, taking our above numerical example, why the marginal
revenue due to the 11th unit is not equal to the price of Rs. 14 at which the 11th unit is sold.
The answer is that the 10 units which were sold at the price of Rs. 15 before will now all have
to be sold at the reduced price of Rs. 14 per unit.

This will mean the loss of one rupee on each of the previous 10 units and total loss on the
previous 10 units due to price fall will be equal to Rs. 10. The loss in revenue incurred on the
previous units occurs because the sale of additional 11th unit reduces the price to Rs. 14 for
all.

Thus in order to find out the net addition made to the total revenue by the 11th unit, the loss
in revenue (Rs. 10) on previous units should be deducted from the price of Rs. 14 at which
the 11th unit is sold along with others. The marginal revenue in this case will, therefore, be
equal to Rs. 14 – 10 = 4. Marginal revenue is thus less than the price at which the additional
unit is sold.

It is clear from above that marginal revenue can either be found directly by taking out the
difference between total revenue before and after selling the additional unit, or it can be
obtained by subtracting the loss in revenue on previous units due to the fall in price from the
price at which the additional unit is sold.

Therefore, marginal revenue = difference in total revenue in increasing sales from n – 1 units
to n units.

= price of the additional unit minus loss in revenue on previous units resulting from price
reduction.

It follows from above that when the price falls as additional unit is sold, marginal revenue is
less than the price. But when the price remains the same as additional unit is sold, as under
perfect competition, the marginal revenue will be equal to average revenue, since in this case
there is no loss incurred on the previous units due to the fall in price.

The relationship between average revenue and marginal revenue is the same as between any
other average and marginal values. When average revenue falls marginal revenue is less than
the average revenue. When average revenue remains the same, marginal revenue is equal to
average revenue.

If TR stands for total revenue and Q stands for output, then marginal revenue (MR)
can also be expressed as follows:

MR = ∆TR/∆Q

∆TR/∆Q indicates the slope of the total revenue curve.

Thus, if the total revenue curve is given to us, we can find out marginal revenue at various
levels of output by measuring the slopes at the corresponding points on the total revenue
curve.

Average and Marginal Revenue under Imperfect Competition

The meaning of the concepts of total, average and marginal revenues under conditions o’
imperfect competition will become clear from Table 1. As has been stated above, when
imperfect competition prevails in the market for a product, an individual firm producing that
product faces a downward sloping demand curve. In other words, as a firm working under
conditions of imperfect competition increases production and sale of its product its price falls.
Now, when all units of a product are sold at the same price, the average revenue equals price.
How marginal revenue can be obtained from the changes in total revenue and what relation it
bears to average revenue will be easily grasped.

It will be seen from the Col. Ill of the table that price (or average revenue) is falling as
additional units of the product are sold. Marginal revenue can be found out by taking out the
difference between the two successive total revenues. Thus, when 1 unit is sold, total Y
revenue is Rs. 16. When 2 units are sold, price (or AR) falls to Rs. 15 and total revenue
increases to Rs. 30.

Marginal revenue is therefore here equal to 30-16 = 14, which is recorded in Col. IV. When 3
units of the product are sold, price falls to Rs. 14 and total revenue increases to Rs. 42. Hence
marginal revenue is now equal to Rs. 42-30 = Rs. 12 which is again recorded in Col. IV.

Likewise, marginal revenue of further units can be obtained by taking out the difference
between two successive total revenues. Marginal revenue is positive as long as total revenue
is increasing. Marginal revenue becomes negative when total revenue declines. Thus when in
our table 2 quantity sold is increased from 9 units to 10 units the total revenue declines from
Rs. 72 to 70 and therefore the marginal revenue is negative and is equal to -2.

It may be noted that in all forms of imperfect competition, that is, monopolistic competition,
oligopoly and monopoly, average revenue curve facing an individual firm slopes downward
as in all these market forms when a firm lowers the price of its product, its quantity
demanded and sales would increase and vice versa.

The case, when average revenue (or price) falls when additional units of the product are sold
in the market is graphically represented in Fig. 1. In Fig. 1 it will be observed that average
revenue curve (AR) is falling downward and marginal revenue curve (MR) lies below it.

The fact that MR curve is lying below AR curve indicates that marginal revenue declines
more rapidly than average revenue. When OQ units of output are sold, AR is equal to QH or
OP and MR is equal to QS. When OM units of the product are sold, marginal revenue is zero.
If the quantity sold is increased beyond OM, marginal revenue becomes negative.

Average and Marginal Revenue under Perfect Competition

When there prevails perfect competition in the market for a product, demand curve facing an
individual firm is perfectly elastic and the price is beyond the control of a firm, average
revenue remains constant. If the price or average revenue remains the same when more units
of a product are sold, the marginal revenue will be equal to average revenue.

This is so because if one more unit is sold and the price does not fall, the addition made to the
total revenue by that unit will be equal to the price at which it is sold, since no loss in revenue
is incurred on the previous units in this case Consider the following table:
In the above table, price remains constant at the level of Rs. 16 when more units of the
product are sold. Col. Ill shows the total revenue when various quantities of the product are
sold. Total revenue has been found out by multiplying the quantity sold by the price.

It will be found from taking out the difference between two successive total revenues that
marginal revenue in this case is equal to the price i.e., Rs. 16. Thus, when two units of the
good are sold instead of one, the total revenue rises from Rs. 16 to Rs. 32, the addition made
to the total revenue i.e. marginal revenue will be equal to Rs. 32 -16 = Rs. 16.

Similarly, when three units of the product are sold, the total revenue increases to Rs. 48, and
the marginal revenue will be equal to Rs. 48 -32 = Rs. 16 Likewise, it will be found for
further units of the product sold that marginal revenue is equal to price. The case of perfect
competition when for an individual firm average revenue (or price) remains constant and
marginal revenue is equal to average revenue is graphically shown in Fig. 2 Average revenue
curve in this case is a horizontal straight line (i.e., parallel to the X-axis).

Horizontal-straight-line average revenue curve (AR) indicates that price or average remains
the same at OP level when quantity sold is increased. Marginal revenue (MR) curve coincides
with average revenue (AR) curve since marginal revenue is equal to average revenue.