Module_II

Production decisions, Cost of Production and Revenue analysis

3.1 Production Function: Production in the Short Run :Law of Variable Proportions ,Long Run Production
Function: Law of Returns to scale , Economies and Diseconomies of scale. 3.2 Cost Concepts Accounting
and economics cost, implicit and explicit cost, fixed and variable cost. Total, average and marginal cost.
3.3 Revenue concepts: Types Average, marginal and total revenue

MEANING OF PRODUCTION

The term ‘production’ is a very important and broader concept in economics. To meet the daily
demand of consumer production is an essential part. Production is a process by which various
inputs are combined and transformed into output of goods and services, for which there is a
demand in the market.

PRODUCTION FUNCTION

Dr. M.R
In economics, a production function is the functional relationship between physical output of a
production process to physical inputs or factors of production. In other words, production function
denotes an efficient combination of input and output. The factors which are used in the production
of goods and services are also called agents of production. Production function of a business firm
is determined by the state of technology. More specifically, the production function shows the
maximum volume of physical output available from a given set of inputs, or the minimum set of
inputs necessary to produce any given level of output.

Definition: With the above statements we can define the production function as: “A production
function refers to the functional relationship, under the given technology, between physical rates
of input and output of a firm, per unit of time”.

Mathematically, the production function can be expressed as: Q = f (N, L, K, E, T, etc.)

TYPES OF PRODUCTION FUNCTION

I. The production function can be broadly categorised into two based on the time period i.e.
a) Short run production function and b) long run production function.
A) Short run production function: The short run is defined as the period during which at least
one of the inputs is fixed. According to the following short-run production function, labour is the
only variable factor input while the rest of the inputs are regarded as fixed. In other words, the
short run is a period in which the firm can adjust production by changing variable factors such as
materials and labour but cannot change fixed factors such as land, capital, etc. Thus, in the
short-run some factors are fixed and some are variable.

B) Long run production function: The long run production function is defined as the period of
time in which all factors of production are variable. In the long run there is no distinction between
the fixed or variable factor as all factors in the long run are variable.

II. The production function can also be classified on the basis of factor proportion i.e.
a) Fixed proportion production function and b) Variable proportion production function.

A. Fixed proportion production function: The fixed proportion production function, also known
as a Leontief Production Function which implies the fixed factors of production function such as
land, labour, raw materials are used to produce a fixed quantity of an output and these factors of
production function cannot be substituted for the other factors. In other words, in such factors of
production function fixed quantity of inputs is used to produce the fixed quantity of output. All
factors of production are fixed and cannot be substituted for one another
B. Variable proportion production function: The variable proportion production function
supposes that the ratio in which the factors of production such as labour and capital are used in a
variable proportion. Also, the different combinations of factors can be used to produce the given
quantity, thus, one factor can be substituted for the other factor. In the case of variable proportion
production function, the technical Coefficient of production function is variable, i.e. the important

Dr. M.R
quantity of output can be achieved through the combination of different quantities of factors of
production, such as these factors can be varied by substituting one factors to the other/ factors in
its place.

LAW OF VARIABLE PROPORTION

The law of variable proportion is a short run production function theory. This law plays a very
important role in economic theory, which examines the production function with one variable
factor keeping the other factors input fixed. This law is explained by the classical economists to
explain the behaviour of agricultural output. In other words, it examines the behaviour of the
production in the short-run when the quantity of one factor is varied, keeping the quantity of other
factor’s constant. Thus, the law of variable proportion is the new name for the famous theory “The
Law of Diminishing Marginal Returns” of classical economist.

Alfred Marshall, had discussed the law in relation to agriculture, according to him, “an increase in
the capital and labour applied in the cultivation of land causes in general a less than proportionate
increase in the amount of product raised unless it happens to coincide with an improvement in the
art of agriculture”. Marginal productivity of labour in agriculture is zero.

Assumptions: The law of variable proportion is based on the following assumptions:

a. The state of technology is assumed to be given and constant.

b. There must be some inputs whose quantity must be kept as fixed or constant. Such input
factors are called fixed factors.

c. All units of variable factors inputs are homogenous.

d. The law is based upon the possibility of varying the proportions in which the various factors
can be combined to produce the level of output.
Let us assume labour is the variable factor in our explanation.
Units of Variable Total
factor Average
(LABOUR) Marginal
Product (TP)
Product (AP)
Product (MP)

0 00-

1 555

2 12 6 7

3 27 9 15

4 48 12 21

5 75 15 27

6 80 13.33 15

91 13 11
.R
 8

M
98 12.5 7

10 92 9.2 -6

9 98 10.8 0
Dr.

Explanation of the table:

M.R
Dr.
In the above table the labour is considered a variable factor and all other factors are
assumed to be constant according to the law. With the increase in the variable factor i.e.
labour there is a change in the level of TP, AP, and MP.

Total product: The total product is the total amount of output produced by using all the
variable input in a fixed proportion in production. The total product increases with the
increase in the unit of labour and reaches to the maximum and they’re after decline with
further more increase in the variable factor.

Average product: The average product is the per unit of product produced by the firm
with the per unit of variable factor inputs. It is obtained by dividing the total product by
the unit of total variable factor. The average product increases initially and then declines.

Marginal product: Marginal product is the additional output produced by an additional

unit of variable factor. Marginal product increases and thereafter falls when TU becomes
maximum MU becomes zero and further becomes negative.

Diagram: the law of diminishing marginal returns can be explained with the following
diagram:
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Phase 1: In phase 1 the total product is increasing at an increasing rate where the average
product also increases at a diminishing rate and reaches at its maximum and marginal
product increases initially and then decreases.

Phase 2: In phase 2 the total product increases at a diminishing rate and reaches its
maximum point. Where the average product starts declining and the marginal product
diminishes and becomes zero.

Phase 3: In this phase total product starts declining. Where the average product is
continuously declining and the marginal product becomes negative.

LAW OF RETURNS TO SCALE

As the law of variable proportion is a short run production function theory, law of returns to
scale is a long run production function theory. In this theory all factors of production are variable,
no factors are fixed. With the change in the factors of production, the scale of production will
change accordingly.

According to Koutsoyiannis “The term returns to scale refers to the changes in output as all
factors change by the same proportion.”

Types of return to scale:

The concept of returns to scale assumes only two factors of productions i.e.
capital and labour. This analysis enables us to understand the change or scale in
production due to change in the factors of production in terms of isoquants or equal
product curves.

Increasing returns to scale: Increasing returns to scale means an increase in a level of

output more than the increase in the inputs. For example, if an output increases by 35%
with an increase in all inputs by only 15% increasing returns to scale prevails. In other
words, a proportionate change in output brings about less proportionate change in inputs;
it is called increasing returns to scale. Where, OA>AB>BC.
 Dr. M.R
Decreasing returns to scale: Decreasing returns to scale means an increase in a
level of output less than the increase in the inputs. For example, if an output
increase by 25% with an increase in all inputs by 35% decrease in returns to
scale prevails. In other words, a proportionate change in output brings more
proportionate change in inputs; it is called decreasing returns to scale. Where
OA<AB<BC.

Constant returns to scale: Constant returns to scale means an increase in a level of

output is constant than the increase in the inputs. For example, if an output increase by
25% with an increase in all inputs by 25% constant in returns to scale prevails. In other
words, a proportionate change in output brings constant change in inputs; it is called
constant returns to scale. Where OA=AB=BC.
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ECONOMIES OF SCALE AND DISECONOMIES OF SCALE

Economies of scale is a real phenomenon to the real-world situation which helps to understand the
real situation in the world economy. In microeconomics, economies of scale is a cost advantage
method of production where the firm operates its level of output by producing the scale of
operation with cost per unit of output decreases with the increasing scale of output. Where the
diseconomies of scale are the opposite of economies of scale.

ECONOMIES OF SCALE According to Alfred Marshall Economies of scale are broadly classified into
Internal economies of scale and external economies of scale. In large-scale production, the cost of
production should be low, which is called economies of scale. A firm enjoy internal economies of scale
when he expands his size or scale of production in the economy by making changes in the internal factors
of production. Where on the other hand a firm enjoys internal economies of scale when he expands his
size of production in economy by making changes in the external factors of production.

INTERNAL ECONOMIES OF SCALE:

Internal economies of scale are an increase in the scale or size of production or output of a firm; these are
solely enjoyable by a firm independently by making changes in the input factors of production into his
business. The internal economies of scale have various different types which are as follows:

1) Labour economies:. Economies of labour also implies the benefit which is arising in the scale of the
economy due to division of labour. Division of labour increases the efficiency in production which leads
to increase in the size of output. Division of labour brings specialisation in labour skills and also saves
time which in turn increases the level or scale of output. Thus, with the specialisation of division of labour
the firm produces large scale of production.

2) Technical economies: Technique of production also increases the scale of production. In other words,
technical economies refer to increase in the scale of production due to change in technical or methods of
production which reduces the cost of production. Technical economies increase the dimension of firms
where the average cost of production decreases and average revenue will be high.

3) Managerial economies: Manager plays an important role in managing business activities. Managerial
economies refer to the specialisation of managerial function which increases the level of output. It is a
manager's duty to carry out all the managerial decisions efficiently and effectively in the business
organisation. Division of managerial activities increases the management of the business efficiently.

4) Financial economies: finance plays an important role in the process of production. It is one of the
important and essential factors of production. It is always observed that the large firms enjoy the benefit of
a better credit facility from banks then the small- scale firm. They also get the credit quickly and easily
then the small firm or producer.

5) Marketing economies: marketing economies deal with the process of buying raw materials and selling
finished goods. A large firm has great bargaining power. By using firm raw material at cheaper cost
because it buys in bulk then the small firm. This in turn helps him to produce more at less cost and sell a

Dr. M.R
larger amount of output in the market than the small firm.

6) Transport and storage: The large-scale firm has its own transport and storage facility which reduces its
transportation and storage cost. This reduces the average cost of large-scale firms and increases the scale
of output or revenue. Where small-scale firms hire or pay rent for the use of transport and storage
facilities.

INTERNAL DISECONOMIES OF SCALE

If the firm is unable to manage the level of output or the scale of operation, diseconomies of scale occur. If
firms do not understand the importance of the specialisation of division of labour and specialisation of
division management activities the level of output or scale of operation decreases leads to diseconomies of
scale in economy. Suppose a firm takes a huge amount of loan from a financial institution or banks to
expand his level of output. Such loans increase the burden on firms to prove their credit leads to financial
diseconomies of scale.

EXTERNAL ECONOMIES OF SCALE

External economies of scale refer to those economies which provide benefits and facilities to all firms of a
given industry. It is an economy which is enjoyed by all firms of industry irrespective of their size of
operation. External economies of scale are also of various types which are follows:

1) Localisation economies: When a number of firms are located in one place with an objective of deriving
the mutual benefits of training of skilled labour, provision of better transport facility etc. all these
advantages help the firm to reduce cost of production. Thus,localisation economies refer to concentration
of a particular industry in one area which results in the development of conditions of industry which will
reap the mutual benefits of all firms in the economy.

2) Disintegration economies: Disintegration means firms splitting up its operation and the process of
manufacturing and handing over the specialised agency and institution is called economies of
disintegration. There are two types of disintegration such as vertical and horizontal disintegration of
economies. The firm which operates on disintegration of economies of scale will be able to get economies
of scale when it operates on a large scale.

3) Information economies: Proper information in the economy plays an important role for the producer to
grow his economy. Networking with each other enables firms to make marketing and technical
information easily.

4) By-product economies: to manufacture by-products a large- scale firm makes use of waste material.
This will help all the firms in the industry to reduce the waste in the economy and make efficient use of
resources. This will ultimately reduce the cost of production and increase the level of output.

EXTERNAL DISECONOMIES OF SCALE

External diseconomies of scale results when there is an increase in the total cost of production beyond the
control of a company and it reduces the level of output. The increase in costs can be due to increase in the
market price of factors of production. The external diseconomies are not suffered by a single firm but by
whole firms operating in a given industry. These diseconomies arise due to much concentration and
localization of industries beyond a certain stage. For example, Localization may lead to an increase in the
demand for transport and, therefore, transport costs rise and it leads to diseconomies of scale in the
economy.

COST CONCEPTS

Dr. M.R
Cost Concepts: Accounting and economics cost, implicit and explicit cost, fixed and variable cost.
Total, average and marginal cost.
CONCEPTS OF COST

A firm who wants to maximize their profit concentrates on revenue and cost of the firm. Profit of the firm
can be increased either by increasing revenue or by reducing cost. Firm generally cannot influence
revenue because it is determined by the market forces but it is possible for the firm to reduce cost by
producing maximum output or by increasing efficiency of the organization.

For managerial decision-making, cost is very important because it helps to decide price for the
commodity. It also helps to decide whether to increase the production or not. Therefore, understanding of
cost concepts is very important.

Fixed cost and Variable cost:

Fixed cost refers to the firm’s expenditure on fixed factors of production. Even if no output is produced, a
fixed cost needs to be paid. Even if output increases in the short run, fixed cost remains constant. E.g.: If a
businessman borrows money from a bank to start his business. Initially even if his output is zero, he has to
pay the interest on borrowed capital. Rent on land, insurance premium, tax payment are some of the
examples of fixed cost. Addition of all fixed costs gives Total Fixed Cost.

Variable cost on the other hand refers to the firm’s expenditure on variable factors of production. When no
output is produced, variable cost is zero. As output increases, variable cost also increases. Payment for
raw material, wages and salaries of the workers are some of the examples of variable cost. Addition of all
variable costs gives the Total Variable Cost.

Total cost, Average cost and Marginal cost:

Total cost (TC) – Firms total expenditure on all fixed and variable factors for producing a commodity is
called the Total cost of production.

Therefore TC= TFC+TVC

For zero level of output there is some total cost. It increases with an increase in the level of output.

Average Cost (AC) or Average Total Cost (ATC) – It refers to the per unit cost of producing a
commodity. It is calculated by the following formula

AC = TC/Q

Where AC = Average cost TC = Total cost Q = Number of units produced

Average cost can also be calculated by using following formula- AC or ATC = AFC+AVC

Where AC- Average Cost AFC- Average Fixed Cost AVC- Average Variable Cost
 Dr. M.R
Average Fixed Cost (AFC)- It is the per unit fixed cost of production. It can be calculated by the following
formula

AFC= TFC/Q

Where TFC= Total Fixed Cost Q = Number of units produced

Average Variable Cost (AVC) - It is the per unit variable cost of production. It can be calculated by the
following formula

AVC= TVC/Q

Where TVC= Total Variable Cost Q= Number of units produced

Marginal Cost (MC) - It is the addition made to the total cost. Or cost of producing an additional unit of
output is called the marginal cost. It can be calculated by using following formula

MC = Change in total cost/ change in output

ΔTC /ΔQ

Where, ΔTC = Change in Total Cost

ΔQ = Change in Output

OR

MC= TCn- TCn-1

Eg: If total cost of producing 2 cars is Rs. 3, 00,000 and the total cost of producing 3 cars is Rs. 4, 50,000.
Then the marginal cost is Rs. 1, 50,000 i.e. the cost of producing an additional unit of output.
Implicit Cost and Explicit Cost:

Implicit cost refers to the cost of all factors which the entrepreneur employs in the business. It includes
salary and wages for the service of entrepreneurs, interest on capital invested by the entrepreneur etc.
Implicit costs are also called indirect costs because direct cash payment is not made to own factors of
production.

If an entrepreneur sold these services to others, he would have earned money. Therefore, implicit cost is
also the opportunity cost of factors owned by him.
Explicit cost on the other hand is the direct cash payment made by the firm for purchasing or hiring of
various factors of production. E.g. rent paid for hiring of land, money spent for purchasing for raw
material, wages and salaries paid to the employees, expenditure on transport, power, advertising etc.

Accounting and Economic Cost:

Accounting cost includes only explicit cost i.e. the firm’s expenditure on purchasing of various factors of
production. For financial and tax purposes, accounting cost is important.

Economic cost on the other hand includes both explicit and implicit cost. This cost is important for
managerial decision making.

Dr. M.R
Therefore an economist who wants to take any decision considers both explicit and implicit cost.

COST AND OUTPUT RELATIONSHIP IN THE SHORT RUN

Relationship between TFC, TVC and TC in the short run

TFC is the firm’s total expenditure on fixed factors of production. For zero level of output TFC is zero. It
remains constant for all the levels of output.

TVC on the other hand is the firm’s total expenditure on variable factors of production. For zero level
output TVC is zero. It increases with an increase in the level of output.

Total cost is the addition of Total Fixed Cost and Total Variable Cost.

In the following table relationship between TFC, TVC and TC is discussed for different units of output
 Dr. M.R
Explanation – In table 7.1 First column shows various levels of output starting from zero units to 8 units.
Second column shows TFC. As fixed factors of production are constant for certain level of output TFC is
also constant for all level of output. For zero level of output also TFC is Rs. 50. Third column shows TVC
which is zero for zero level of output. With an increase level of output TVC initially increases at
decreasing rate then increases at an increasing rate. This is because of the law of variable proportions.
Forth column shows TC which is the addition of TFC and TVC. TC increases with an increase level in the
output. TC increases in the same proportions as increased in TVC.

This relation between TFC, TVC and and TC can be explained with the help of following diagram.

Two curves are parallel to each other.

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By plotting different combinations of output and TFC, TVC and TC, we have TFC curve, TVC curve and
TC curves.

Diagram shows that TFC curve is a straight-line curve parallel to X axis. This is because when output is
zero, some fixed cost has to be paid and this cost remains constant for all the levels of output. TFC curve
is horizontal.

TVC curve starts at the point of origin because when output is zero, TVC is also zero. TVC curve initially
increases at a diminishing rate with an increase in the level of output and then increases at an increasing
rate.

As TC is the addition of TFC and TVC, TC curve is above TFC and TVC curves. The shape of the TC
curve is the same as the TVC curve. The gap between TC and TVC curve measures TFC.

Cost Function

Production function gives the functional relationship between the level of output and the various factor
inputs (land, labor, capital and entrepreneur). The cost of production depends on the level of output
produced, nature of technology used, prices of factors of production. Thus, the cost function is derived
from the production function. The cost function is given as

C = f (Q, T, Pf)
Where C = total cost Q = Level of output produced T = Technology Pf = Prices of factors f = Functional
relationship

If we assume that technology, prices of factors are constant, total cost increases with an increase in the
level of output i.e. C = f(Q).

Any change in production function will shift cost function either up or down. E.g. Use of better techniques
of production, use of better-quality raw material, use of efficient labors etc. will improve the
production function and thus reduce the cost function. Similarly use of poor-quality raw material,
inefficient techniques of production, unskilled labor will shift the production function up.

SHORT RUN COST- OUTPUT RELATIONSHIP

As the name suggests, a short run is a very short period where the firm produces its output by changing
only variable factors of production. This is because in the short run fixed factors of production remain
constant for all the levels of output. Following table shows the behavior of output and various costs in the
short run.

Dr.
M.R
In the above table output is shown in the (1st) column, which increases from 0 units to 8units. For all the
levels of output TFC in column (2) remain constant i.e. Rs. 50. TVC in the (3rd) column is zero for zero
level of output. And then increases with an increase in the level of output. In column (4) TC is calculated
by adding TFC and TVC.

AFC in column (5) is calculated by using the formula TFC/Q. As TFC remain constant for all the levels of
output, AFC continuously declines with an increase in the level of output.

AVC in column (6) is calculated by using formula TVC/Q. Initially AVC declines. At the third level of
output it reaches to the minimum and then increases with an increase with an increase in the level of
output.

AC in column (7) is calculated by using the formula TC/Q. AC also declines initially until it reaches the
minimum point at 4th unit of output and then increases with an increase in the level of output.

MC in column (8) is the cost of producing an additional unit of output. It is calculated by the formula

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AR is equal to price Marginal

Revenue

Dr. M.R
Marginal Revenue is the amount of money received from the sale of additional unit or in other words,
additional revenue received by the sale of an additional unit.

MR = TRn+1 – TRn

Or

MR = ΔTR / ΔQ

Where MR = Marginal Revenue, ΔTR = Change in total Revenue, ΔQ = Change in the amount of sale,
TRn = Total Revenue of n units, TRn-1 = Total Revenue of n-1 units.

MR pertains to change in TR only on account of the last unit sold, while AR is based upon all the units
sold by the firm. The firm will not sell any quantity if TR or AR becomes zero or negative. However, MR
can become negative if the fall in price is big enough.