UNIT-3

Production Concept
The production concept in economics and business focuses on the efficient production of goods
and services. It is based on the belief that consumers prioritize products that are widely available
and affordable. Consequently, businesses following this concept emphasize maximizing
production efficiency, reducing costs, and achieving economies of scale.
Historically, this approach was prominent during the industrial age, especially for standardized
goods that required mass production, such as textiles or automobiles. Even today, it’s commonly
used for industries with high fixed costs, where large-scale production helps lower per-unit costs.
Key Elements of the Production Concept
1. Focus on Production Efficiency: The primary aim is to optimize production processes,
minimize waste, and reduce production costs.
2. Economies of Scale: By increasing production volume, firms aim to reduce average
costs per unit, achieving lower costs through mass production.
3. Resource Optimization: Efficient use of resources—labor, machinery, raw materials,
and energy—is prioritized to minimize costs.
4. Product Availability and Affordability: The ultimate goal is to ensure products are
available at lower prices, attracting more consumers.
Production Analysis
Production analysis involves examining how different inputs—like labor, capital, and raw
materials—affect the level of output. This analysis helps businesses understand their production
processes, identify bottlenecks, and find ways to improve efficiency.
Key aspects of production analysis include:
1. Production Function: A mathematical representation of the relationship between input
quantities and output. It shows how much output can be produced given certain inputs
and helps identify the most efficient input combinations.
Q=f(L,K,M)Q = f(L, K, M)Q=f(L,K,M)
Where:
o QQQ = Output quantity
o LLL = Labor input
o KKK = Capital input
o MMM = Materials and other resources

Cobb–Douglas production function

In economics and econometrics, the Cobb–Douglas production function is a particular
functional form of the production function, widely used to represent the technological
relationship between the amounts of two or more inputs (particularly physical capital and labor)
and the amount of output that can be produced by those inputs. The Cobb–Douglas form was
developed and tested against statistical evidence by Charles Cobb and Paul Douglas between
1927 and 1947
2. Law of Diminishing Returns: States that as additional units of a variable input (like
labor) are added to a fixed input (like machinery), the additional output produced will
eventually decrease. This concept helps managers understand the optimal levels of input
to avoid inefficiencies.
In its most standard form for production of a single good with two factors, the function is
given by:
where:
• Y = total production (the real value of all goods produced in a year or 365.25 days)
• L = labour input (person-hours worked in a year or 365.25 days)
• K = capital input (a measure of all machinery, equipment, and buildings; the value of
capital input divided by the price of capital)
• A = total factor productivity
• Capital and labour are the two "factors of production" of the Cobb–Douglas production
function.

3. Short-Run vs. Long-Run Production:

o Short-Run: At least one input is fixed (e.g., factory size). Firms can adjust labor
and materials, but fixed assets remain constant.
o Long-Run: All inputs are variable, allowing businesses to adjust capacity, expand
facilities, or invest in new technologies.
4. Total, Average, and Marginal Product:
o Total Product (TP): Total quantity produced.
o Average Product (AP): Output per unit of a particular input, calculated as
AP=TP/units of inputAP = TP / \text{units of input}AP=TP/units of input.
o Marginal Product (MP): The additional output generated by one more unit of
input, calculated as MP=ΔTP/Δunits of inputMP = \Delta TP / \Delta \text{units
of input}MP=ΔTP/Δunits of input.
Applications of Production Analysis in Managerial Decision-Making
1. Cost Optimization: By understanding the production function, managers can choose
input combinations that minimize costs, enabling more efficient resource allocation.
2. Capacity Planning: Production analysis helps determine the capacity requirements
needed to meet demand. It also guides decisions on when to expand or scale down
production.
3. Efficiency Improvements: Identifying inefficiencies and bottlenecks allows for
streamlining processes, increasing productivity, and potentially lowering per-unit costs.
 4. Pricing and Output Decisions: Knowing the production costs and output levels at
various stages enables managers to set prices competitively, while ensuring profitable
output levels.
5. Investment Decisions: Production analysis guides decisions on capital investment, such
as whether to invest in technology to increase output or reduce dependency on costly
inputs.
Short run and long run concept-
In economics, the terms long run and short run refer to different timeframes in which firms can
adjust production inputs to meet changes in demand, cost conditions, or other market factors.
These concepts help analyze how firms respond to changes and make strategic decisions
regarding production, capacity, and costs.
Short Run
In the short run, at least one input is fixed. This typically means that capital assets (like
machinery, factory space, or land) cannot be easily adjusted due to time constraints or high costs.
However, firms can still vary other inputs, such as labor or raw materials, to respond to changing
demand.
Characteristics of the Short Run
1. Fixed and Variable Inputs: At least one input (usually capital) is fixed, while others
(like labor and materials) can be adjusted.
2. Capacity Constraints: Since firms cannot change their physical capacity, they face
limits in expanding production.
3. Diminishing Marginal Returns: As more units of a variable input are added to a fixed
input, the additional output (marginal product) eventually decreases, a principle known as
the law of diminishing returns.
4. Cost Structure: Costs are split between fixed costs (which don’t change with output
level) and variable costs (which vary directly with output).
Examples
• A factory increasing the number of workers to meet a short-term spike in demand without
expanding the physical plant size.
• A restaurant hiring additional staff for a holiday season while keeping its seating capacity
constant.
Long Run
In the long run, all inputs are variable, meaning that firms can change all aspects of their
production process. This includes adjusting capital by building new facilities, investing in
advanced machinery, or increasing land size. In the long run, firms can fully adjust their
production capacity to meet demand, achieving optimal efficiency.
Characteristics of the Long Run
1. All Inputs Are Variable: Firms can adjust labor, capital, and other resources, enabling
flexibility in production.
 2. No Fixed Costs: Since all inputs can be adjusted, all costs are considered variable in the
long run.
3. Returns to Scale: Firms experience returns to scale, which examines how output
responds to proportional changes in all inputs. Returns to scale can be:
o Increasing Returns to Scale: Doubling inputs results in more than double the
output.
o Constant Returns to Scale: Doubling inputs results in exactly double the output.
o Decreasing Returns to Scale: Doubling inputs results in less than double the
output.
4. Economies of Scale: In the long run, firms may achieve economies of scale by
expanding production, leading to lower average costs per unit due to increased efficiency
and bulk purchasing.
Fixed Factor
A fixed factor is an input that cannot be easily adjusted or changed in the short run. Fixed factors
are typically associated with capital assets such as land, buildings, or machinery, which require
significant time, planning, and expense to alter. Because they are fixed, these factors remain
constant regardless of changes in production levels over the short run.
Characteristics of Fixed Factors
1. Constant in the Short Run: Fixed factors do not vary with output in the short run; they
stay the same whether production levels are high or low.
2. Cost Incurred Regardless of Output: The cost associated with fixed factors, known as
fixed costs, is incurred even if production is zero.
3. Long-Run Variability: While fixed in the short run, fixed factors can be changed in the
long run, allowing for expansions, relocations, or technological upgrades.
Examples of Fixed Factors
• Land: A factory or office location typically remains fixed for a business in the short run.
• Buildings: Warehouses, retail stores, or production facilities are fixed assets and do not
change as production varies day-to-day.
• Heavy Machinery: Large, expensive equipment, like industrial machinery, is considered
fixed because it cannot be quickly or cost-effectively added or removed.
Variable Factor
A variable factor, on the other hand, is an input that can be easily adjusted or changed in
response to changes in production needs. These factors are directly related to the production
level and can be scaled up or down based on demand, making them more flexible.
Characteristics of Variable Factors
1. Responsive to Output Changes: Variable factors can be increased or decreased as
production levels change, allowing firms to respond quickly to fluctuations in demand.
2. Cost Varies with Output: The costs associated with variable factors, known as variable
costs, rise or fall in direct proportion to the quantity produced.
 3. Short-Run Adjustments: Variable factors are adjustable in both the short and long run,
but they play a particularly crucial role in managing production levels in the short run.
Examples of Variable Factors
• Labor: The number of employees or hours worked can often be adjusted based on
production needs.
• Raw Materials: Materials needed for production, like wood, steel, or fabric, are ordered
in quantities matching production levels.
• Energy Consumption: Electricity or fuel used in production processes varies with the
intensity of production.
Comparison of Fixed and Variable Factors

Aspect Fixed Factors Variable Factors

Adjustability Not adjustable in the short run Adjustable in the short run

Cost Type Fixed costs (do not vary with output) Variable costs (vary with output)

Fixed in the short run; adjustable in the long Adjustable in both short and long
Timeframe
run run

Examples Land, buildings, machinery Labor, raw materials, utilities

Importance of Fixed and Variable Factors in Production

1. Cost Management: Knowing which costs are fixed and variable helps firms budget and
manage costs effectively, especially when planning production and pricing strategies.
2. Production Planning: Fixed factors define the limits of production capacity in the short
run, while variable factors provide the flexibility needed to meet changing demand.
3. Profit Maximization: By balancing fixed and variable inputs, firms can optimize
production levels to maximize profitability without incurring unnecessary costs.
4. Investment Decisions: Understanding the role of fixed factors aids in long-term
planning, such as decisions on purchasing equipment or expanding facilities, which can
enhance production capacity.
In summary, fixed and variable factors represent different levels of flexibility and cost behavior
in production. Fixed factors provide the stable foundation of production capacity, while variable
factors offer adaptability to meet short-term changes in demand.
Factors of production
1. Land
Land encompasses all natural resources used in production. This includes not only land itself but
also other natural resources like minerals, forests, water, and even air, which are all considered
essential inputs that come from nature. Unlike other factors, land is often limited and cannot be
reproduced or increased.
• Characteristics: Fixed in supply, often location-dependent.
• Examples: Farmland, forests, oil, water, minerals, and fisheries.
 • Economic Return: Rent is the income earned from land and natural resources.
2. Labor
Labor refers to human effort used in the production process. It includes both physical and
intellectual contributions made by workers. The productivity and skills of the labor force are
essential for efficient production and often depend on factors like education, experience, and
motivation.
• Characteristics: Labor is variable, as firms can adjust the workforce size. It is also
influenced by training, skill level, and motivation.
• Examples: Factory workers, engineers, teachers, doctors, and software developers.
• Economic Return: Wages and salaries are the payments made to labor in return for their
work and expertise.
3. Capital
Capital includes man-made resources that aid in the production process. Unlike land, capital is
not naturally occurring but is created by humans to improve productivity. It encompasses
machinery, buildings, equipment, and technology. There are two primary types of capital:
• Physical Capital: Tangible assets like machinery, tools, factories, and infrastructure.
• Financial Capital: Money and other financial resources used to purchase physical
capital.
• Characteristics: Can be increased through investment, unlike land. Often requires
upfront costs and maintenance.
• Examples: Machinery, factories, office buildings, computers, and vehicles.
• Economic Return: Interest or dividends are often considered the returns on capital,
though profits on investments in capital also contribute.
4. Entrepreneurship
Entrepreneurship is the initiative to combine land, labor, and capital to create and market goods
and services. Entrepreneurs organize, manage, and assume the risks of a business. They innovate,
make strategic decisions, and are often driven by the pursuit of profit. Entrepreneurship is crucial
for economic growth, as it drives new ideas, products, and industries.
• Characteristics: Requires risk-taking, innovation, and leadership. Entrepreneurs are the
decision-makers who determine how other factors of production are utilized.
• Examples: Business founders, startup leaders, inventors, and investors.
• Economic Return: Profit is the primary reward for entrepreneurship, as entrepreneurs
earn returns based on their successful management and risk-taking.
Importance of Factors of Production
1. Resource Allocation: These factors determine how resources are allocated in the
economy. Effective use of each factor leads to efficient production and maximized
output.
2. Economic Growth: Increased availability and quality of production factors, especially
capital and entrepreneurship, drive innovation and economic growth.
3. Pricing and Costs: The cost of each production factor influences product pricing and
production costs, affecting profitability and market competition.
4. Employment and Wages: Labor as a factor is directly related to employment levels and
wage determination, impacting the overall economic well-being of a population.

The Law of Variable Proportions

The law of variable proportions is a new name for the law of diminishing returns, a concept
of classical economics. But before getting on with the law, there is a need to understand the
total product (TP), marginal product (MP) and average product (AP).
• Total Product: Total product is the total output obtained from the combined efforts of all
the factors of production. Further, if we wish to find the effect of one factor of
production, say labour, on the total product, we need to keep all the other factors
constant. In this case, the total product would vary with the factor kept variable.
• Marginal Product: The change in the total product when one more unit is added to the
variable factor is known as the marginal product.
• Average Product: Average product is the total product per unit of the variable factor. In
other words, it is the ratio of total product to the quantity of variable factor.
The Relationship between Average Product and Marginal Product
• When there is a rise in the average product due to an increase in the quantity of the
variable input, the marginal product is more than the average product.
• The maximum average product is equal to the marginal product. Simply put, the
maximum point of the average product curve is also a point on the marginal product
curve, a point where both of these curves intersect.
• When the average product falls, the marginal product is less than the average product.
The Law of Diminishing Returns
The law of diminishing returns operates in the short run when we can’t change all the factors
of production. Further, it studies the change in output by varying the quantity of one input.
Technically, the law states that as we increase the quantity of one input which is combined
with other fixed inputs, the marginal physical productivity of the variable input must
eventually decline.
In simpler words, the total productivity, for a given state of technology, is bound to increase
with an increase in the quantity of a variable input. However, as the quantity of the inputs
keeps on increasing, the marginal product rises to a maximum, then starts to decline and
eventually becomes negative.
This is because the crowding of inputs eventually leads to a negative impact on the output.
Lastly, The law of diminishing returns also comes with some assumptions:
• We assume the state of technology to be constant. A variable state of technology would
impact the marginal and average product. In that case, we would not be able to accurately
study the relationship between output and the fixed input.
• Only one input should be variable. keeping other inputs constant. This law does not apply
to cases when all the inputs vary proportionately. In that case, the returns to scale comes
to the rescue.
• The law does not apply to a production scenario where we require specifically fixed
proportions of inputs. In such a case, an increase in any input would not have any impact
on production, since the marginal product will be equal to zero.
• We consider only physical inputs and outputs and not economic profitability in monetary
terms.
We can divide the behavior of output when varying one input, keeping other inputs fixed in
the short run, into three stages.
labour Land TP MP
0 - 10 10
1 1 30 20
2 1 45 15
3 1 52 7
4 1 52 0
5 1 48 -4

Stage I: Increasing Returns

We characterize this stage with the total output increasing at an increasing rate with each
additional unit of the variable input. This continues to point A on the TP curve. Further, the
MP curve rises to the point X corresponding to the point B on the TP curve, also known as
the point of inflexion.
After point B, the TP curve continues to rise but now at a decreasing rate. The MP also starts
to fall but is positive. The end of this stage sees the maximum point of the average product,
where the AP and MP curves intersect.
We get increasing returns in the first stage because initially, the fixed factors are abundant
relative to the variable factor. The introduction of additional units of the variable factor leads
to the effective utilisation of the fixed factors. Evidently, production increases at an
increasing rate.
For example, if a machine requires four workers for its optimum utilisation, and in the
current scenario is two workers are operating the machine, the factor would be underutilised.
Addition of another worker would definitely lead to an increase in the output. Further
addition of a worker would lead to optimum utilisation and hence production would increase.
Now we cannot divide the fixed factor (here the machine) to suit the availability of the
variable factor (here the workers) because generally the fixed factors are indivisible.
Indivisibility of a fixed factor means that due to technological requirements, a minimum
amount of the factor must be employed whatever the level of output.
Another reason for rising returns is the increase in the efficiency of the variable factor itself.
This is because, with a sufficient quantity of variable factor, the introduction of specialisation
and division of labour becomes possible which leads to higher productivity.
Stage II: Diminishing Returns
Throughout the stage of diminishing returns, the total product keeps on increasing. However
unlike the stage of increasing returns, here the total product increases at a diminishing rate.
This happens because the marginal product falls and becomes less than the average product,
which also sees a downwards slope.
Thus, this stage is known as the stage of diminishing returns. The end of this stage is marked
by the total product attaining its maximum value and the marginal product becoming zero.
Further, this stage is very important because the firm will seek to produce in its range.
After the addition of a certain amount of variable inputs which lead to the optimum and
efficient utilisation of fixed input, the output starts diminishing. This is because any further
addition to the variable factor after the point of efficient utilisation renders the fixed factor
inadequate relative to variable factor. Again, this is the reason why the marginal and average
product decline at this stage.
In other words, the contribution of extra variable inputs is actually nil. This further means
that the fixed indivisible factor is being worked too hard. Another reason for the law of
diminishing returns is the lack of availability of a perfect substitute.
In case of the availability of a perfect substitute, an increase in its quantity would have made
up for the scarcity of the fixed factor. This, in turn, would have prevented the ineffective
utilisation.
Stage III: Negative Returns
The origin of stage 3 starts from the maximum point of the TP curve. In this stage, the TP
curve now starts to decline. Moreover, the MP curve becomes negative coupled with a fall in
the AP curve.
The excessive addition of variable inputs leads to negative returns at this stage. This is
because of the crowding of the variable factors. The variable and fixed factors now start
getting into each other’s ways. Effectively, there is no coordination and hence the output
falls.
The law of Return to Scale in Production Functions
Changes in output when all factors change in the same proportion are referred to as the law
of return to scale. This law applies only in the long run when no factor is fixed, and all
factors are increased in the same proportion to boost production.
There are three stages in all.
• Increasing the scale’s return
• Constant scale returns
• Decrease in Returns on the scale

Unit of Unit of % increase in Total % increase Stages

Labour capital labour and production in TP
capital

1 3 – 10 – increasing

2 6 100% 30 200%

3 9 50% 60 100%

4 12 33% 80 33% constant

5 15 25% 100 25%

6 18 20% 110 10% diminishing

7 21 16.6% 120 8.3%

Increasing returns to scale

It describes a condition in which all of the factors of production are raised, resulting in a
higher rate of output. For example, if inputs are raised by 10%, the output will be increased
by 20%.
Reasons
• Due to the economy of scale
• Specialisation through better division of labour
Constant returns to scale
It describes a condition in which all of the factors of production are increased at the same
time, resulting in a steady growth in output. For example, if inputs are raised by 10%, the
output is also increased by 10%.
Reasons
As the firm’s production grows, it reaches a point where all of the economy’s resources have
been fully utilised, and output equals input.
Diminishing returns to scale
When all of the production factors are increased simultaneously, output grows at a slower
rate. For example, if inputs are raised by 10%, the output will be increased by 5%.
Reasons
• The major cause of diminishing returns to scale is large-scale economies, diseconomies
of scale occur when a company has grown to such a size that it is difficult to manage
• Lack of coordination
Assumptions of Return to scale
The following are the returns to scale assumptions: Capital and labour are the only two
variables of production used by the company. In a fixed proportion, labour and capital are
integrated. Factor prices do not fluctuate, and the State of technology remains the same.
Difference between return to scale and return to a factor
• Return to factor has only one variable while the rest of the factors remain constant,
whereas return to scale has all of the variables changing
• In return for factor, the factor proportion changes as more and more variable factor units
raise production
• In return to scale, the factor proportion remains constant when factors are re-added in the
same proportion to increase output
• When you return to a factor, you get a negative return. Returning to scale has the effect of
decreasing returns
• Return to scale is a long-term phenomenon, whereas return to a factor is a one-time event
Difference between variable factor and fixed factor
• Variable factors can be modified in the short run, whereas fixed factors cannot be
changed in the short run
• Variable factors fluctuate immediately with output, whereas fixed factors do not vary
directly with output
• Variable factors include raw materials, casual labour, power, and fuel, whereas fixed
factors include expenses related to buildings, plant and machinery, components, etc
What do you mean by short run and long run?
 In the short run, the output can be modified by altering only variable factors, whereas, in the
long run, the output may be changed by changing all production factors. In the long run, all
factors are changeable. However, the production factors are increased simultaneously.
Demand is active in price determination in the short run since supply cannot be raised
quickly with a rise in demand. However, in the long run, both demand and supply play equal
roles in the determination of price because both may be increased.
Conclusion
Return to scale is a metric that evaluates the change in productivity after increasing all
production inputs over time. The rate at which output changes when all inputs are adjusted
simultaneously is referred to as returns to scale.
Return to scale is important to study as it is a metric in economics that is used to measure its
efficiency. A company’s production is efficient if it can maintain its current output while
utilising fewer inputs or resources or increase output while using the same amount of input.
THEORY OF COST MEANING OF COST-
Cost may be defined as the monetary value of all sacrifices made to achieve an objective i.e.
to produce goods and services. Cost are very important in business decision making. Cost of
production provides the floor to pricing. It helps manager to take correct decision, such as
what price to quote, whether to place particular order for inputs or not whether to abandon or
add a product to the existing product line and so on. Ordinarily, cost refer to the money
expenses incurred by a firm in the production process. Cost also included imputed value of
the entrepreneur’s own resources and services, as well as salary of the owner-manager.
DETERMEAINTS OF COST- Factors determining the cost are:
Size of plant: There is an inverse relationship between size of plant and cost. As size of plant
increases, cost falls and vice versa
Factors determining the cost are:

(a) Size of plant: There is an inverse relationship between size of plant and cost. As size of
plant increases, cost falls and vice versa.
 (b) Level of Output: There is a direct relationship between output level and cost. More the
level of output, more is the cost ( i. e., total cost) and vice Versa.

(c) Price of Inputs: There is a direct relationship between price of inputs and cost. As the
price of inputs rises, cost rises and vice versa.

(d) State of technology: More modern and upgraded the technology implies lesser cost and
vice versa.

(e) Management and administrative efficiency: Efficiency and cost are inversely related.
More the efficiency in management and administration better will be the product and
less will be the cost. Cost will increase in case of inefficiencies in management and
administration.
COST CONCEPT-

The concept of cost is central to business decision making. To make effective business decisions,
the business manager needs to be aware of a number of cost concepts and their respective uses.
Opportunity Cost- The opportunity cost is measured in terms of the forgone benefits from the
next best alternative use of a given resource. For example the inputs which are used to
manufacture a car may also be used in the productions of military equipment. Main points of
opportunity cost are:

1. The opportunity cost of any commodity is only the next best alternative forgone.
2. The next best alternative commodity that could be produced with the same value
of the factors, which are more or less the same.
 3. It helps in determining relative prices of factor inputs at different places.
4. It helps in determining the remuneration to services.

5. It helps the manager to decide what he should produce in the factory.

Explicit cost- An explicit cost is a cost that is directly incurred by the firm, company or
organization during the production. The explicit cost is kept on record by the accountant of the
firm. Salaries, wages, rent, raw material are few example of the explicit cost. The explicit cost is
also known as out- pocket cost. This cost is handy in calculating both accounting and economic
profit.
Implicit cost- The implicit cost is directly opposite to it, as it is the cost that is not directly
incurred by the firm or company. In implicit cost outflow of cash doesn’t take place. It is not in
the record and is heard to be traced back. The interest on owner’s capital or the salary of the
owner are the prominent example of the implicit cost. The implicit cost is also known as imputed
cost. Through implicit cost , only the economic profit is calculated.
Sunk Cost- Sunk costs are costs which cannot be altered in any way. Sunk costs are costs which
have already been uncured. For example, cost incurred in constructing a factory. When the
factory building is constructed cost have already been incurred. The building has to be used for
which originally envisaged. It can not be altered when operation are increased or decreased .
Investment of machinery is an example of sunk cost.
Fixed Cost- Fixed cost are the amount spent by the firm on fixed inputs in the short run. Fixed
cost are thus, those costs which remain constant, irrespective of the level of output. These costs
remain unchanged even if the output of the firm is nil. Fixed costs therefore, are known as
Supplementary costs or Overhead costs.

Variable Costs- Variable costs are those cost that change directly as the volume of output
changes. As the production increases variable cost also increases, and as the product decreases
variable costs also decreases, and when the production stops variable cost is zero.
Total cost-Total cost is the total expenditure incurred in the production of goods and services.
TC= TFC+TVC

Average cost- Average cost is not actual cost, It is obtained by dividing the total cost by the total
output.
AC= Total Cost/Units Produced

Marginal cost- The cost incurred on producing one additional unit of commodity is known as
marginal cost. Thus it shown a change in total cost when one more or less unit is produced.

MC= TCn – TC(n-1 )

Cost function-

The cost output relationship plays an important role in determining the optimum level of
production.
TC=F(Q)

Where, TC= Total cost

Q= Quantity produced F= Function
The cost function can be classified as:

Short run cost- Short run is a period where the time is too short to expand the size of industry
and the increased demand has to be met within the existing size of industry because there are
certain factors which cannot be changed in short run. So short run costs are those which vary
with output when fixed plant a capital equipments remain unchanged.
Long run costs- In the long run the size of an industry can be expanded to meet the increased
demand for products such as in long run all the factors of production can be increased according
to need. Hence long run costs are those which vary with output when all input factors including
plants equipment vary.

Cost output relationship in short run-

In the short-run a change in output is possible only by making changes in the variable inputs like
raw materials, labour etc. Inputs like land and buildings, plant and machinery etc. are fixed in the
short-run. It means that short-run is a period not sufficient enough to expand the quantity of fixed
inputs. Thus Total Cost (TC) in the short-run is composed of two elements – Total Fixed Cost
(TFC) and Total Variable Cost (TVC).

TFC remains the same throughout the period and is not influenced by the level of activity. The
firm will continue to incur these costs even if the firm is temporarily shut down. Even though
TFC remains the same fixed cost per unit varies with changes in the level of output.
On the other hand TVC increases with increase in the level of activity, and decreases with
decrease in the level of activity. If the firm is shut down, there are no variable costs. Even though
TVC is variable, variable cost per unit is constant.
So in the short-run an increase in TC implies an increase in TVC only. Thus:
TC = TFC + TVC TFC = TC – TVC TVC = TC – TFC
TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.

In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line parallel to
X-axis, because TFC does not change with increase in output.
TVC curve is upward rising from the origin because TVC is
zero when there is no production and increases as production increases. The shape of TVC curve
depends upon the productivity of the variable factors. The TVC curve above assumes the Law of
Variable Proportions, which operates in the short-run.
TC curve is also upward rising not from the origin but from the TFC line. This is because even if
there is no production the TC is equal to TFC.
It should be noted that the vertical distance between the TVC curve and TC curve is constant
throughout because the distance represents the amount of fixed cost which remains constant.
Hence TC curve has the same pattern of behavior as TVC curve.
Short-run Average Cost and Marginal Cost
The concept of cost becomes more meaningful when they are expressed in terms of per unit cost.
Cost per unit can be computed with reference to fixed cost, variable cost, total cost and marginal
cost.

The following Table and diagram illustrates cost output relationship in the short-run, with
reference to different concepts of cost.
Average Fixed Cost (AFC): Average fixed cost is obtained by dividing the TFC by the
number of units produced. Thus:

AFC = TFC/Q where, ‘Q’ refers quantity of production.

Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as output
goes on increasing. The AFC curve is downward sloping towards the right throughout its length,
with a steep fall at the beginning.

Average Variable Cost (AVC): Average Variable Cost is obtained by dividing the TVC by the
number of units produced. Therefore:

AVC = TVC / Q

Due to the operation of the Law of Variable Proportions AVC curve slopes downwards till it
reaches a certain level of output and then begins to rise upwards.

Average Total Cost (ATC): Average Total Cost or simply Average Cost is obtained by dividing
the TC by the number of units produced. Thus:

ATC = TC / Q
 The ATC curve is very much influenced by the AFC and AVC curves. In the beginning both AFC
curve and AVC curve decline and therefore ATC curve also declines. The AFC curve continues
the trend throughout, though at a diminishing rate. AVC curve continues the trend till it reaches a
certain level and thereafter it starts rising slowly. Since this rise initially is at a rate lower than
the rate of decline in the AFC curve, the ATC curve continues to decline for some more time and
reaches the lowest point, which obviously is further than the lowest point of the AVC curve.
Thereafter the ATC curve starts rising because the rate of rise in the AVC curve is greater than
the rate of decline in the AFC curve.

Marginal Cost (MC): Marginal Cost is the increase in TC as a result of an increase in output by
one unit. In other words it is the cost of producing an additional unit of output.

MC is based on the Law of Variable Proportions. A downward trend in MC curve shows

decreasing marginal cost (i.e. increasing marginal productivity) of the variable input. Similarly
an upward trend in MC curve shows increasing marginal cost (i.e. decreasing marginal
productivity). MC curve intersects both AVC and ATC curves at their lowest points.
The relationship between AVC, AFC, ATC and MC can be summed up as follows.

1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC
2. When AFC falls and AVC rises (a) ATC will fall where the drop in AFC is more than the rise
in AVC (b) ATC remains constant if the drop in AFC = the rise in AVC, and (c) ATC will rise
where the drop in AFC is less than the rise in AVC.

3. ATC will fall when MC is less than ATC and ATC will rise when MC is more than ATC. The
lowest ATC is equal to MC.
Cost output relationship in the long run-
In order to study the cost output relationship in the long run it is necessary to know the meaning
of long run. As known in the long run the size of an industry can be expanded to meet the
increased demand for products as such in the long run all the factors of production can be varied
according to the need. Hence long run costs are those which vary with output when all the input
factors including plant and equipment vary.

As per the above figure suppose that at a given time the firms operate under plant SAC2 and
produces output OQ. If the firm decides to produce output OR and continues with the current
plant SAC2 its average cost will be uR. But if the firm decides to increase the size of the plant to
plant SAC3 its average cost of producing OR output would then be TR. Since cost TR is less
than the cost on old plant uR, therefore new plant SAC3 is preferable and should be adopted.
Thus the long run cost of producing OR output will be TR which can be obtained by increasing
the plant size.
Features of LAC curve
To draw long run average cost curve(LAC) we start with a number of short run average
cost(SAC) curves, each such curve representing a particular size of plant including the optimum
plant. One can now draw a LAC curve which is tangential to all SAC curves. In this connection
following features are highlighted:

1- The LAC curve envelopes the SAC curves and is therefore called as envelope curve.
2- Each point of the LAC is a point of tangency with the corresponding SAC curve.
3- The points of tangency on the falling part of SAC curve for points lying to the left of
minimum point of LAC.

4- The points of tangency occur on the rising part of the SAC curves for the points lying to
the right of minimum point of LAC.

5- The optimum scale of plant is a term applied to the most efficient of all scales of plants
available. This scale of plant is the one whose SAC curve forms the minimum point of
LAC curve. It is SAC3 in our case which is tangent to LAC curve at its minimum point
at R.

6- Both LAC ad SAC curves are U shaped but the difference between the two U shapes is
that the U shape of the LAC curve is flatter or lesser pronounced from bottom. The main
reason for this is that in the long run such economies are possible which cannot be had
in the short run, likewise some of the diseconomies which are faced in short run may not
be faced in the long run
Concept of revenue
Revenue, in simple words, is the amount that a firm receives from the sale of the output.
According to Prof. Dooley, ” The Revenue of a firm is its sales receipts or income.‘ In a
firm, revenue is of three types:
Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the
output. Therefore, the total revenue depends on the price per unit of output and the
number of units sold. Hence, we have
TR = Q x P
Where,
• TR – Total Revenue
• Q – Quantity of sale (units sold)
• P – Price per unit of output
Average Revenue
Average Revenue, as the name suggests, is the revenue that a firm earns per unit of
output sold. Therefore, you can get the average revenue when you divide the total
revenue with the total units sold. Hence, we have,
 AR=TRQ
Where,
• AR – Average Revenue
• TR – Total Revenue
• Q – Total units sold
Marginal Revenue
Marginal Revenue is the amount of money that a firm receives from the sale of an
additional unit. In other words, it is the additional revenue that a firm receives when an
additional unit is sold. Hence, we have
MR = TRn – TRn-1
Or
MR=ΔTRΔQ
Where,
• MR – Marginal Revenue
• ΔTR – Change in the Total revenue
• ΔQ – Change in the units sold
• TRn – Total Revenue of n units
• TRn-1 – Total Revenue of n-1 units
MR pertains to a change in TR only on account of the last unit sold. On the other hand,
AR is based on all the units that the firm sells. Therefore, even a small change in AR
causes a much bigger change in MR. In fact, when AR reduces, MR reduces by a far
greater margin.
Similarly, when AR increases, MR increases by a greater extent too. AR and MR are
equal only when AR is constant. It is also important to note that the firm does not sell
any unit if the TR or AR becomes either zero or negative. However, there are times
when the MR is negative (especially if the fall in price is big).
The relationship between TR, AR, and MR
In order to understand the basic concepts of revenue, it is also important to pay attention
to the relationship between TR, AR, and MR. When the first unit is sold, TR, AR, and
MR are equal.
Therefore, all three curves start from the same point. Further, as long as MR is positive,
the TR curve slopes upwards.
However, if MR is falling with the increase in the quantity of sale, then the TR curve
will gain height at a decreasing rate. When the MR curve touches the X-axis, the TR
curve reaches its maximum height.
Further, if the MR curve goes below the X-axis, the TR curve starts sloping downwards.
Any change in AR causes a much bigger change in MR. Therefore, if the AR curve has a
negative slope, then the MR curve has a greater slope and lies below it.
Similarly, if the AR curve has a positive slope, then the MR curve again has a greater
slope and lies above it. If the AR curve is parallel to the X-axis, then the MR curve
coincides with it.
Here is a graphical representation of the relationship between AR and MR:

In the left half, you can see that AR has a constant value (DD’). Therefore, the AR curve
starts from point D and runs parallel to the X-axis. Also, since AR is constant, MR is
equal to AR and the two curves coincide with each other.
In the right half, you can see that the AR curve starts from point D on the Y-axis and is a
straight line with a negative slope. This basically means that as the number of goods sold
increases, the price per unit falls at a steady rate.
Similarly, the MR curve also starts from point D and is a straight line as well. However,
it is a locus of all the points which bisect the perpendicular distance between the AR
curve and the Y-axis. In the figure above, FM=MA.