Managerial Economics Unit 5

Unit 5 Production Analysis

Structure:
5.1 Introduction
Objectives
5.2 Meaning of Production and Production Function
5.3 Cost of Production
5.4 Summary
5.5 Terminal Questions
5.6 Answer

5.1 Introduction
A business firm is an economic unit. It is also called as a production unit.
Production is one of the most important activities of a firm in the circle of
economic activity. The main objective of production is to satisfy the demand
for different kinds of goods and services of the community.
Learning Objectives:
After studying this unit, you should be able to
1. Explain the concept of production, production function and its
managerial uses.
2. Analyze short term and long term production function with illustrations.
3. Describe the various dimensions, advantages and demerits of large
scale production.
4. Define Meaning, different cost concepts and managerial uses of cost of
production
5. Utilize the short run and long run cost-output relationships In arriving at
the production decision.

5.2 Meaning of Production and Production Function

The concept of production can be represented in the following manner.

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Inputs
Transformation
Process Outputs

Entry into
Firms Exit of Firms

The term “Production” means transformation of physical “Inputs” into

physical “Outputs”.
The term “Inputs” refers to all those things or items which are required by
the firm to produce a particular product. Four factors of production are
land, labor, capital and organization. In addition to four factors of
production, inputs also include other items like raw materials of all kinds,
power, fuel, water, technology, time and services like transport and
communications, warehousing, marketing, banking, shipping and Insurance
etc. It also includes the ability, talents, capacities, knowledge, experience,
wisdom of human beings. Thus, the term inputs have a wider meaning in
economics. What we get at the end of productive process is called as
“Outputs”. In short, “Outputs” refer to finished products.
Production always results in either creation of new utilities or addition of
values. It is an activity that increases consumer satiability of goods and
services. Production is undertaken by producers and basically it depends
on cost of production. Production analysis is always made in physical terms
and it shows the relationship between physical inputs and physical outputs.
It is to be noted that higher levels of production is an index of progress and
growth of an organization and that of a society. It leads to higher income,
employment and economic prosperity. Production of different types of goods
and services in different nations indicates the nature of economic inter
dependence between different nations.
Production Function
The entire theory of production centre round the concept of production
function. “A production Function” expresses the technological or engineering

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relationship between physical quantity of inputs employed and physical

quantity of outputs obtained by a firm. It specifies a flow of output resulting
from a flow of inputs during a specified period of time. It may be in the form
of a table, a graph or an equation specifying maximum output rate from a
given amount of inputs used. Since it relates inputs to outputs, it is also
called “Input-output relation.” The production is purely physical in nature
and is determined by the quantum of technology, availability of equipments,
labor, and raw materials, and so on employed by a firm.
A production function can be represented in the form of a mathematical
model or equation as Q = f (L, N, K….etc) where Q stands for quantity of
output per unit of time and L N K etc are the various factor inputs like land,
capital, labor etc which are used in the production of output. The rate of
output Q is thus, a function of the factor inputs L N K etc, employed by the
firm per unit of time.
Factor inputs are of two types
1. Fixed Inputs. Fixed inputs are those factors the quantity of which
remains constant irrespective of the level of output produced by a
firm. For example, land, buildings, machines, tools, equipments,
superior types of labor, top management etc.
2. Variable inputs. Variable inputs are those factors the quantity of
which varies with variations in the levels of output produced by a
firm For example, raw materials, power, fuel, water, transport and
communication etc.
The distinction between the two will hold good only in the short run. In the
long run, all factor inputs will become variable in nature.
Short run is a period of time in which only the variable factors can be
varied while fixed factors like plants, machineries, top management etc
would remain constant. Time available at the disposal of a producer to
make changes in the quantum of factor inputs is very much limited in the
short run. Long run is a period of time where in the producer will have
adequate time to make any sort of changes in the factor combinations.
It is necessary to note that production function is assumed to be a
continuous function, i.e. it is assumed that a change in any of the variable
factors produces corresponding changes in the output.

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Generally speaking, there are two types of production functions. They

are as follows.
1. Short Run Production Function
In this case, the producer will keep all fixed factors as constant and change
only a few variable factor inputs. In the short run, we come across two kinds
of production functions:
1. Quantities of all inputs both fixed and variable will be kept constant and
only one variable input will be varied. For example, Law of Variable
Proportions.
2. Quantities of all factor inputs are kept constant and only two variable
factor inputs are varied. For example, Iso-Quants and Iso-Cost curves.
2. Long Run Production Function
In this case, the producer will vary the quantities of all factor inputs, both
fixed as well as variable in the same proportion. For Example, The laws of
returns to scale. „
Each firm has its own production function which is determined by the state
of technology, managerial ability, organizational skills etc of a firm. If there
are any improvements in them, the old production function is disturbed and
a new one takes its place. It may be in the following manner –
1. The quantity of inputs may be reduced while the quantity of output may
remain same.
2. The quantity of output may increase while the quantity of inputs may
remain same.
3. The quantity of output may increase and quantity of inputs may
decrease.
Uses of Production Function
Though production function may appear as highly abstract and unrealistic, in
reality, it is both logical and useful. It is of immense utility to the managers
and executives in the decision making process at the firm level.
There are several possible combinations of inputs and decision makers
have to choose the most appropriate among them. The following are some
of the important uses of production function.
1. It can be used to calculate or work out the least cost input combination
for a given output or the maximum output-input combination for a given
cost.
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2. It is useful in working out an optimum, and economic combination of

inputs for getting a certain level of output. The utility of employing a unit
of variable factor input in the production process can be better judged
with the help of production function. Additional employment of a variable
factor input is desirable only when the marginal revenue productivity of
that variable factor input is greater than or equal to cost of employing it
in an organization.
3. Production function also helps in making long run decisions. If returns to
scale are increasing, it is wise to employ more factor units and increase
production. If returns to scale are diminishing, it is unwise to employ
more factor inputs & increase production. Managers will be indifferent
whether to increase or decrease production, if production is subject to
constant returns to scale.
Thus, production function helps both in the short run and long run decision -
making process.
Production Function with One Variable Input Case
The Law of Variable Proportions
This law is one of the most fundamental laws of production. It gives us one
of the key insights to the working out of the most ideal combination of factor
inputs. All factor inputs are not available in plenty. Hence, in order to expand
the output, scarce factors must be kept constant and variable factors are to
increased in greater quantities. Additional units of a variable factor on the
fixed factors will certainly mean a variation in output. The law of variable
proportions or the law of non-proportional output will explain how variation in
one factor input give place for variations in outputs.
The law can be stated as the following. As the quantity of different units
of only one factor input is increased to a given quantity of fixed
factors, beyond a particular point, the marginal, average and total
output eventually decline.
The law of variable proportions is the new name for the famous “Law of
Diminishing Returns” of classical economists. This law is stated by
various economists in the following manner – According to Prof. Benham,
“As the proportion of one factor in a combination of factors is
increased, after a point, first the marginal and then the average
product of that factor will diminish”1.
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The same idea has been expressed by Prof.Marshall in the following words.
An increase in the quantity of a variable factor added to fixed factors, at the
end results in a less than proportionate increase in the amount of product,
given technical conditions.
Assumptions of the Law
1. Only one variable factor unit is to be varied while all other factors should
be kept constant.
 Different units of a variable factor are homogeneous.
 Techniques of production remain constant.
 The law will hold good only for a short and a given period.
 There are possibilities for varying the proportion of factor inputs.
Illustration
A hypothetical production schedule is worked out to explain the operation of
the law.
Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor = labor.

Units of Variable inputs TP in AP in MP in

(Labor) units units units
0 0 0 0
1 10 10 10 I Stage

2 24 12 14
3 39 13 15
4 52 13 13
5 60 12 8
6 66 11 6
II Stage
7 70 10 4
8 72 9 2
9 72 8 0
10 70 7 -2 III Stage

Total Product or Output:

(TP) It is the output derived from all factors units, both fixed & variable
employed by the producer. It is also a sum of marginal output.

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Average Product or Output: (AP) It can be obtained by dividing total

output by the number of variable factors employed.
Marginal Product or Output: (MP) It is the output derived from the
employment of an additional unit of variable factor unit
Trends in output
From the table, one can observe the following tendencies in the TP, AP, &
MP.
1. Total output goes on increasing as long as MP is positive. It is the
highest when MP is zero and TP declines when MP becomes negative.
2. MP increases in the beginning, reaches the highest point and diminishes
at the end.
3. AP will also have the same tendencies as the MP. In the beginning MP
will be higher than AP but at the end AP will be higher than MP.
Diagrammatic Representation

80
E
70

60
TP

50
P
Level of Output

40 Series1
Series2
30 Series3
Stage 1 Stage 2 Stage 3
20

10
B AP
0
MP
1 2 3 4 5 6 7 8 9 10
-10
No. of Units of variable inputs

In the above diagram along with OX axis, we measure the amount of

variable factors employed and along OY - axis, we measure TP, AP & MP.
From the diagram it is clear that there are III stages.

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Stage Number I. The Law of Increasing Returns

The total output increases at an increasing rate (More than proportionately)
up to the point P because corresponding to this point P the MP is rising and
reaches its highest point. After the point P, MP decline and as such TP
increases gradually.
The first stage comes to an end at the point where MP curve cuts the AP
curve when the AP is maximum at N.
The I stage is called as the law of increasing returns on account of the
following reasons.
1. The proportion of fixed factors is greater than the quantity of variable
factors. When the producer increases the quantity of variable factor,
intensive and effective utilization of fixed factors become possible
leading to higher output.
2. When the producer increases the quantity of variable factor, output
increases due to the complete utilization of the “Indivisible Factors”.
3. As more units of the variable factor is employed, the efficiency of
variable factors will go up because it creates more opportunity for the
introduction of division of labor and specialization resulting in higher
output.
Stage Number II. The Law of Diminishing Returns
In this case as the quantity of variable inputs is increased to a given quantity
of fixed factors, output increases less than proportionately. In this stage, the
T.P increases at a diminishing rate since both AP & MP are declining but
they are positive. The II stage comes to an end at the point where TP is the
highest at the point E and MP is zero at the point B. It is known as the stage
of “Diminishing Returns” because both the AP & MP of the variable factor
continuously fall during this stage. It is only in this stage, the firm is
maximizing its total output.
Diminishing returns arise due to the following reasons:
1. The proportion of variable factors is greater than the quantity of fixed
factors. Hence, both AP & MP decline.
2. Total output diminishes because there is a limit to the full utilization of
indivisible factors and introduction of specialization. Hence, output
declines.

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3. Diseconomies of scale will operate beyond the stage of optimum

production.
4. Imperfect substitutability of factor inputs is another cause. Up to certain
point substitution is beneficial. Once optimum point is reached, the
fixed factors cannot be compensated by the variable factor. Diminishing
returns are bound to appear as long as one or more factors are fixed
and cannot be substituted by the others.
The III Stage The Stage of Negative Returns:
In this case, as the quantity of variable input is increased to a given quantity
of fixed factors, output becomes negative. During this stage, TP starts
diminishing, AP continues to diminish and MP becomes negative. The
negative returns are the result of excessive quantity of variable factors to a
constant quantity of fixed factors. Hence, output declines. The proverb “Too
many cooks spoil the broth” and “ Too much is too bad” aptly applies to this
stage. Generally, the III stage is a theoretical possibility because no
producer would like to come to this stage.
The producer being rational will not select either the stage I (because there
is opportunity for him to increase output by employing more units of variable
factor) or the III stage (because the MP is negative). The stage I & III are
described as NON-Economic Region or Uneconomic Region. Hence, the
producer will select the II stage (which is described as the most economic
region) where he can maximize the output. The II stage represents the
range of rational production decision.
It is clear that in the above example, the most ideal or optimum
combination of factor units = 1 Acre of land+ Rs. 5000 - 00 capital and
9 laborers.
All the 3 stages together constitute the law of variable proportions. Since the
second stage is the most important, in practice we normally refer this law as
the law of Diminishing Returns.
Practical application of the law
1. It helps a producer to work out the most ideal combination of factor
inputs or the least cost combination of factor inputs.
2. It is useful to a businessman in the short run production planning at the
micro-level.

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3. The law gives guidance that by making continuous improvements in

science and technology, the producer can postpone the occurrence of
diminishing returns.
Production function with Two Variable Inputs
ISO-Quants and ISO-Costs
The prime concern of a firm is to workout the cheapest factor combinations
to produce a given quantity of output. There are a large number of
alternative combinations of factor inputs which can produce a given quantity
of output for a given amount of investment. Hence, a producer has to select
the most economical combination out of them. Iso-product curve is a
technique developed in recent years to show the equilibrium of a producer
with two variable factor inputs. It is a parallel concept to the indifference
curve in the theory of consumption.
Meaning and Definitions
The term “Iso – Quant” has been derived from „Iso‟ meaning equal and
„Quant‟ meaning quantity. Hence, Iso – Quant is also called Equal Product
Curve or Product Indifference Curve or Constant Product Curve. An Iso –
product curve represents all the possible combinations of two factor inputs
which are capable of producing the same level of output. It may be defined
as – “ a curve which shows the different combinations of the two inputs
producing the same level of output .”
Each Iso – Quant curve represents only one particular level of output. If
there are different Iso–Quant curves, they represent different levels of
output. Any point on an Iso – Quant curve represents same level of output.
Since each point indicates equal level of output, the producer becomes
indifferent with respect to any one of the combinations.
Equal Product Combination

Combinations Factor X Factor Y Total Output in units

(Labor) Capital
A 12 1 100
B 8 2 100
C 5 3 100
D 3 4 100
E 2 5 100

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In the above schedule, all the five factor combinations will produce the equal
level of output, i.e.100 units. Hence, the producer is indifferent with respect
to any one of the combinations mentioned above.
Graphic Representation
Y

12 A

Factor 8 B
X
5 C
3 D
2
E
IQ

0 X

1 2 3 4 5
Factor Y

In the diagram, if we join points ABCDE (which represents different

combinations of factor x and y) we get an Iso-quant curve IQ. This curve
represents 100 units of output that may be produced by employing any one
of the combinations of two factor inputs mentioned above. It is to be noted
that an Iso-Product Curve shows the exact physical units of output that can
be produced by alternative combinations of two factor inputs. Hence,
absolute measurement of output is possible.
Iso – Quant Map
A catalogue of different combinations of inputs with different levels of output
can be indicated in a graph which is called equal product map or Iso-quant
map. In other words, a number of Iso Quants representing different
amount of out put are known as Iso-quant map.

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Factor X Capital 3000 IQ3

2000
IQ2
1000
IQ1
0 Factor Y Labor X

Marginal Rate of Technical Substitution (MRTS)

It may be defined as the rate at which a factor of production can be
substituted for another at the margin without affecting any change in
the quantity of output. For example, MRTS of X for Y is the number of
units of factor Y that can be replaced by one unit of factor X quantity of
output remaining the same.

Combinations Factor Factor MRTS of

X Y x for y
A 12 1 Nil
B 8 2 4:1
C 5 3 3:1
D 3 4 2:1
E 2 5 1:1

In the above example, we can notice that in the second combination the
producer is substituting 4 units of X for 1 unit of Y. Hence, in this case
MRTS of Y for X is 4:1.
Generally speaking, the MRTS will be diminishing. In the above table, we
can observe that as the quantity of factor Y is increased relative to the
quantity of X, the number of units of X that will be required to be replaced by
one unit of factor Y will diminish, quantity of output remaining the same. This
is known as the law of Diminishing Marginal Rate of Technical Substitution
(DMRTS).

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Properties of Iso- Quants:

1. An Iso-Quant curve slope downwards from left to right.
2. Generally an Iso-Quant curve is convex to the origin.
3. No two Iso-product curves intersect each other.
4. An Iso-product curve lying to the right represents higher output and vice-
versa.
5. Always one Iso-Quant curve need not be parallel to other.
6. It will not touch either X or Y – axis.
ISO-Cost Line or Curve
It is a parallel concept to the budget or price line of the consumer. It
indicates the different combinations of the two inputs which the firm can
purchase at given prices with a given outlay. It shows two things (a) prices
of two inputs (b) total outlay of the firm. Each Iso-cost line will show various
combinations of two factors which can be purchased with a given amount of
money at the given price of each input. We can draw the Iso-cost line on
the basis of an imaginary example.
Let us suppose that a producer wants to spend Rs. 3,000 to purchase factor
X and Y. If the price of X per unit Rs. 100 he can purchase 30 units of X.
Similarly if the price of factor Y is Rs. 50 then he can purchase 60 units of Y.
When 30 units of factor X are represented on OY – axis and 60 units of
factor Y are represented on OX- axis, we get two points A & B. If we join
these two points A and B, then we get the Iso-Cost line AB. This line
represents the different combinations of factor X and Y that can be
purchased with Rs. 3,000.

A
3000=00
30 Units of Factor X

0 B X
60 Units of Factor Y

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The Iso-Cost line will shift to the right if the producer increase his outlay
from Rs. 3,000 to Rs. 4,000. On the contrary, if his outlay decreases to
Rs. 2,000, there will be a backward shift in the position of Iso-cost line.
The slope of the Iso-cost line represents the ratio of the price of a unit of
factor X to the price of a unit of factor Y. In case, the price of any one of
them changes there would be a corresponding change in the slope and
position of Iso-cost line.

Factor X Rs. 4,000/-

P

Rs. 3,000/-
A

Rs. 2,000/-

0 X

Factor y

PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost

combination).
The optimal combination of factor inputs may help in either minimizing cost
for a given level of output or maximizing output with a given amount of
investment expenditure. In order to explain producer‟s equilibrium, we have
to integrate Iso-quant curve with that of Iso-cost line. Iso-product curve
represent different alternative possible combinations of two factor inputs
with the help of which a given level of output can be produced. On the other
hand, Iso-cost line shows the total outlay of the producer and the prices of
factors of production.
The intention of the producer is to maximize his profits. Profits can be
maximized when he is producing maximum output with minimum production
cost. Hence, the producer selects the least cost combination of the factor

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inputs. Maximum output with minimum cost is possible only when he

reaches the position of equilibrium. The position of equilibrium is indicated at
the point where Iso-Quant curve is tangential to Iso-Cost line. The following
diagram explains how the producer reaches the position of equilibrium.

M
E1
A

25 Units R
E Point of equilibrium
Factor “X”  E2
IQ

0 X
S B N
50 Units
Factor “Y”

It is quite clear from the diagram that the producer will reach the position of
equilibrium at the point E where the Iso-quant curve IQ and Iso-cost line AB
is tangent to each other. With a given total out lay of Rs. 5,000 the producer
will be producing the highest output, i.e. 500 units by employing 25 units of
factors X and 50 units of factor Y. (assuming Rs. 2,500 each is spent on X
and Y)
The price of one unit of factor X is Rs.100-00 and that of Y is Rs. 50-00..
Rs.100 x 25 units of 2500 - 00 and Rs. 50 x 50 units of Y = 2500 - 00. He
will not reach the position of equilibrium either at the point E1 and E2
because they are on a higher Iso-cost line. Similarly, he cannot move to the
left side of E, because they are on a lower Iso-Cost line and he will not be
able to produce 500 units of output by any combinations which lie to the left
of E.
Thus, the point at which the Iso-Quant is tangent to the Iso-Cost line
represents the minimum cost or optimum factor combination for producing a
given level of output. At this point, MRTS between the two points is equal to
the ratio between the prices of the inputs.

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Long Run Production Function [Change In All Factor Inputs In The

Same Proportion]
Laws of Returns to Scale
The concept of returns to scale is a long run phenomenon. In this case, we
study the change in output when all factor inputs are changed or made
available in required quantity. An increase in scale means that all factor
inputs are increased in the same proportion. In returns to scale, all the
necessary factor inputs are increased or decreased to the same extent so
that whatever the scale of production, the proportion among the factors
remains the same.
Three Phases of Returns to Scale
Generally speaking, we study the behavior pattern of output when all factor
inputs are increased in the same proportion under returns to scale. Many
economists have questioned the validity of returns to scale on the ground
that all factor inputs cannot be increased in the same proportion and the
proportion between the factor inputs cannot be kept uniform. But in some
cases, it is possible that all factor inputs can be changed in the same
proportion and the output is studied when the input is doubled or tripled or
increased five-fold or ten-fold. An ordinary person may think that when the
quantity of inputs is increased 10 times, output will also go up by 10 times.
But it may or may not happen as expected.
It may be noted that when the quantity of inputs are increased in the same
proportion, the scale of output or returns to scale may be either more than
equal, equal or less than equal. Thus, when the scale of output is increased,
we may get increasing returns, constant returns or diminishing returns.
When the quantity of all factor inputs are increased in a given proportion and
output increases more than proportionately, then the returns to scale are
said to be increasing; when the output increases in the same proportion,
then the returns to scale are said to be constant; when the output increases
less than proportionately, then the returns to scale are said to be
diminishing.

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Sl. Scale Total Marginal

No. Product Product in
in Units units
1 1 Acre of land + 3 labor 5 5
2 2 Acre of land + 5 labor 12 7
3 3 Acre of land + 7 labor 21 9
4 4 Acre of land + 9 labor 32 11
5 5 Acre of land + 11 labor 43 11
6 6 Acre of land + 13labor 54 11
7 7 Acre of land + 15 labor 63 9
8 8 Acre of land + 17 labor 70 7

It is clear from the table that the quantity of land and labor (Scale) is
increasing in the same proportion, i.e. by 1 acre of land and 2 units of labor
throughout in our example. The output increases more than proportionately
when the producer is employing 4 acres of land and 9 units of labor. Output
increases in the same proportion when the quantity of land is 5 acres and
11units of labor and 6 acres of land and 13 units of labor. In the later stages,
when he employs 7 & 8 acres of land and 15 & 17 units of labor, output
increases less than proportionately. Thus, one can clearly understand the
operation of the three phases of the laws of returns to scale with the help of
the table.
Diagrammatic representation
In the diagram, it is clear that the marginal returns curve slope upwards from
A to B, indicating increasing returns to scale. The curve is horizontal from B
to C indicating constant returns to scale and from C to D, the curve slope
downwards from left to right indicating the operation of diminishing returns to
scale.

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II Stage
Y C. Rtns
B C
10 

I Stage
8  III Stage
D. Rtns
I. Rtns
Marginal Returns

6  D
A

4 
2 
        X
1 2 3 4 5 6 7 8

Factor units Employed

Increasing Returns to Scale:
Increasing returns to scale is said to operate when the producer is
increasing the quantity of all factors [scale] in a given proportion, output
increases more than proportionately. For example, when the quantity of all
inputs are increased by 10%, and output increases by 15%, then we say
that increasing returns to scale is operating. In order to explain the operation
of this law, an equal product map has been drawn with the assumption that
only two factors X and Y are required. In the diagram, Factor X is
represented along OX- axis and factor Y is represented along OY axis. The
scale line OP is a straight line passing through the origin on the Iso Quant
map indicating the increase in scale as we move upward. The scale line OP
represent different quantities of inputs where the proportion between factor
X and factor Y is remains constant. When the scale is increased from A to
B, the return increases from 100 units of output to 200 units. The scale line
OP passing through origin is called as the “Expansion path”. Any line
passing through the origin will indicate the path of expansion or increase in
scale with definite proportion between the two factors. It is very clear that

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Y
Managerial Economics Unit 5

the increase in the quantities of factor X and Y [scale] is small as we go up

the scale and the output is larger. The distance between each Iso Quant
curve is progressively diminishing. It implies that in order to get an increase
in output by another 100 units, a producer is employing lesser quantities of
inputs and his production cost is declining. Thus, the law of increasing
returns to scale is operating.

P
Factor„Y‟ Capital)

Scale Line

F 600
E 500
D 400
C
300
B
200
A
100

X
0 Factor „X‟ (Labour)

Causes for Increasing Returns to Scale

Increasing returns to scale operate in a firm on account of several reasons.
Some of the most important ones are as follows:
1. Wider scope for the use of latest tools, equipments, machineries,
techniques etc to increase production and reduce cost per unit.
2. Large-scale production leads to full and complete utilization of indivisible
factor inputs leading to further reduction in production cost.
3. As the size of the plant increases, more output can be obtained at lower
cost.

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4. As output increases, it is possible to introduce the principle of division of

labor and specialization, effective supervision and scientific
management of the firm etc would help in reducing cost of operations.
5. As output increases, it becomes possible to enjoy several other kinds of
economies of scale like overhead, financial, marketing and risk-bearing
economies etc, which is responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies
of scale in case of increasing returns to scale.
Constant Returns to Scale
Constant returns to scale is operating when all factor inputs [scale] are
increased in a given proportion, output also increases in the same
proportion. When the quantity of all inputs is increased by 10%, and output
also increases exactly by 10%, then we say that constant returns to scale
are operating.In the diagram, it is clear that the successive Iso Quant curves
are equi distant from each other along the scale line OP. It indicates that as
the producer increases the quantity of both factor X and Y in a given
proportion, output also increases in the same proportion. Economists also
describe Constant returns to scale as the Linear homogeneous Production
function. It shows that with constant returns to scale, there will be one input
proportion which does not change, what ever may be the level of output.
Y
P

Scale
Factor „Y‟ (Capital)

Line

E
D 500 units
C 400 units
B 300 units
A 200 units
100 units

0 X
Factor „X‟ (Labour)

Causes for Constant Returns to Scale

In case of constant returns to scale, the various internal and external
economies of scale are neutralized by internal and external diseconomies.
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Thus, when both internal and external economies and diseconomies are
exactly balanced with each other, constant returns to scale will operate.
Diminishing Returns to Scale
Diminishing returns to scale is operating when output increases less than
proportionately when compared the quantity of inputs used in the production
process. For example, when the quantity of all inputs are increased by 10%,
and output increases by 5%, then we say that diminishing returns to scale is
operating.
In the diagram, it is clear that the distance between each successive Iso
Quant curve is progressively increasing along the scale line OP. It indicates
that as the producer is increasing the quantity of both factor X and Y, in a
given proportion, output increases less than proportionately. Thus, the law
of Diminishing returns to scale is operating.

Y
P
Scale Line

F
Factor „Y‟ (Capital)

E 600 units
D
500 units
C
B 400 units
A 300 units
200 units
100 units
0 X
Factor „X‟ (Labour)
Causes for Diminishing Returns to Scale
Diminishing Returns to Scale operate due to the following reasons-
1. Emergence of difficulties in co-ordination and control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mis-management due to over growth and expansion of
the firm.
5. Productivity and efficiency declines unavoidably after a point.

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Thus, in this case, diseconomies outweigh economies of scale. The result is

the operation of diminishing returns to scale.
The concept of Returns to Scale helps a producer to work out the most
desirable combination of factor inputs so as to maximize his output and
minimize his production cost. It also helps him, to increase his production,
maintain the same level or decrease it depending on the demand for the
product.
Economies of Scale
The study of economies of scale is associated with large scale production.
To-day there is a general tendency to organize production on a large scale
basis. Mass production of standardized goods has become the order of the
day. Large scale production is beneficial and economical in nature. “The
advantages or benefits that accrue to a firm as a result of increase in
its scale of production are called „Economies of Scale‟. They have close
relationship with the size of the firm. They influence the average cost over
different ranges of output. They are gain to a firm. They help in reducing
production cost and establishing an optimum size of a firm. Thus, they help
a lot and go a long way in the development and growth of a firm. According
to Prof. Marshall these economies are of two types, viz Internal Economies
and External Economics. Now we shall study both of them in detail.
I. Internal Economies or Real Economies
Internal Economies are those economies which arise because of the actions
of an individual firm to economize its cost. They arise due to increased
division of labor or specialization and complete utilization of indivisible factor
inputs. Prof. Cairncross points out that internal economies are open to a
single factory or a single firm independently of the actions of other firms.
They arise on account of an increase in the scale of output of a firm and
cannot be achieved unless output increases. The following are some of the
important aspects of internal economies.
1. They arise “with in” or “inside” a firm.
2. They arise due to improvements in internal factors.
3. They arise due to specific efforts of one firm.
4. They are particular to a firm and enjoyed by only one firm.
5. They arise due to increase in the scale of production.
6. They are dependent on the size of the firm.

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7. They can be effectively controlled by the management of a firm.

8. They are called as “Business Secrets “of a firm.
Kinds of Internal Economies:
1. Technical Economies
These economies arise on account of technological improvements and its
practical application in the field of business. Economies of techniques or
technical economies are further subdivided into five heads.
a) Economies of superior techniques: These economies are the result of
the application of the most modern techniques of production. When the size
of the firm grows, it becomes possible to employ bigger and better types of
machinery. The latest and improved techniques give place for specialized
production. It is bound to be cost reducing in nature. For example,
cultivating the land with modern tractors instead of using age old wooden
ploughs and bullock carts, use of computers instead of human labor etc.
b) Economies of increased dimension: It is found that a firm enjoys the
reduction in cost when it increases its dimension. A large firm avoids
wastage of time and economizes its expenditure. Thus, an increase in
dimension of a firm will reduce the cost of production. For example,
operation of a double decker instead of two separate buses.
c) Economies of linked process: It is quite possible that a firm may not
have various processes of production with in its own premises. Also it is
possible that different firms through mutual agreement may decide to work
together and derive the benefits of linked processes, for example, in diary
farming, printing press, nursing homes etc.
d) Economies arising out of research and by - products: A firm can
invest adequate funds for research and the benefits of research and its
costs can be shared by all other firms. Similarly, a large firm can make use
of its wastes and by-products in the most economical manner by producing
other products. For example, cane pulp, molasses, and bagasse of sugar
factory can be used for the production of paper, varnish, distilleries etc.
e) Inventory Economies. Inventory management is a part of better
materials management. A big firm can save a lot of money by adopting
latest inventory management techniques. For example, Just-In-Time or zero
level inventory techniques. The rationale of the Just-In-Time technique is

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that instead of having huge stocks worth of lakhs and crores of rupees, it
can ask the seller of the inputs to supply them just before the
commencement of work in the production department each day.
2. Managerial Economies:
They arise because of better, efficient, and scientific management of a firm.
Such economies arise in two different ways.
a) Delegation of details: The general manager of a firm cannot look after
the working of all processes of production. In order to keep an eye on each
production process he has to delegate some of his powers or functions to
trained or specialized personnel and thus relieve himself for co-ordination,
planning and executing the plans. This will enable him to bring about
improvements in production process and in bringing down the cost of
production.
b) Functional Specialization: It is possible to secure economies of large
scale production by dividing the work of management into several separate
departments. Each department is placed under an expert and the rest of the
work is left into the hands of specialists. This will ensure better and more
efficient productive management with scientific business administration.
This would lead to higher efficiency and reduction in the cost of production.
3. Marketing or Commercial economies:
These economies will arise on account of buying and selling goods on large
scale basis at favorable terms. A large firm can buy raw materials and other
inputs in bulk at concessional rates. As the bargaining capacity of a big firm
is much greater than that of small firms, it can get quantity discounts and
rebates. In this way economies may be secured in the purchase of different
inputs.
A firm can reduce its selling costs also. A large firm can have its own sales
agency and channel. The firm can have a separate selling organization,
marketing department manned by experts who are well versed in the art of
pushing the products in the market. It can follow an aggressive sales
promotion policy to influence the decisions of the consumers.

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4. Financial Economies
They arise because of the advantages secured by a firm in mobilizing
huge financial resources. A large firm on account of its reputation, name
and fame can mobilize huge funds from money market, capital market, and
other private financial institutions at concessional interest rates. It can
borrow from banks at relatively cheaper rates. It is also possible to have
large overdrafts from banks. A large firm can float debentures and issue
shares and get subscribed by the general public. Another advantage will be
that the raw material suppliers, machine suppliers etc., are willing to supply
material and components at comparatively low rates, because they are likely
to get bulk orders. Thus, a big firm has an edge over small firms in securing
sufficient funds more easily and cheaply.
5. Labor Economies
These economies will arise as a result of employing skilled, trained, qualified
and highly experienced persons by offering higher wages and salaries. As a
firm expands, it can employ a large number of highly talented persons and
get the benefits of specialization and division of labor. It can also impart
training to existing labor force in order to raise skills, efficiency and
productivity of workers. New schemes may be chalked out to speed up the
work, conserve the scarce resources, economize the expenditure and save
labor time. It can provide better working conditions, promotional
opportunities, rest rooms, sports rooms etc, and create facilities like
subsidized canteen, crèches for infants, recreations. All these measures will
definitely raise the average productivity of a worker and reduce the cost per
unit of output.
6. Transport and Storage Economies
They arise on account of the provision of better, highly organized and
cheap transport and storage facilities and their complete utilization. A
large company can have its own fleet of vehicles or means of transport
which are more economical than hired ones. Similarly, a firm can also have
its own storage facilities which reduce cost of operations.
7. Over Head Economies
These economies will arise on account of large scale operations. The
expenses on establishment, administration, book-keeping, etc, are more or
less the same whether production is carried on small or large scale. Hence,
cost per unit will be low if production is organized on large scale.
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8. Economies of Vertical integration

A firm can also reap this benefit when it succeeds in integrating a
number of stages of production. It secures the advantages that the flow
of goods through various stages in production processes is more readily
controlled. Because of vertical integration, most of the costs become
controllable costs which help an enterprise to reduce cost of production.
9. Risk-bearing or survival economies
These economies will arise as a result of avoiding or minimizing
several kinds of risks and uncertainties in a business. A manufacturing
unit has to face a number of risks in the business. Unless these risks are
effectively tackled, the survival of the firm may become difficult. Hence many
steps are taken by a firm to eliminate or to avoid or to minimize various
kinds of risks. Generally speaking, the risk-bearing capacity of a big firm will
be much greater than that of a small firm. Risk is avoided when few firms
amalgamate or join together or when competition between different firms is
either eliminated or reduced to the minimum or expanding the size of the
firm. A large firm secures risk-spreading advantages in either of the four
ways or through all of them.
 Diversification of output Instead of producing only one particular
variety, a firm has to produce multiple products. If there is loss in one
item, it can be made good in other items.
 Diversification of market: Instead of selling the goods in only one
market, a firm has to sell its products in different markets. If consumers
in one market desert a product, it can cover the losses in other markets.
 Diversification of source of supply: Instead of buying raw materials
and other inputs from only one source, it is better to purchase them from
different sources. If one person fails to supply, a firm can buy from
several sources.
 Diversification of the process of manufacture: Instead adopting only
one process of production to manufacture a commodity, it is better to
use different processes or methods to produce the same commodity so
as to avoid the loss arising out of the failure of any one process.
II. External Economies or Pecuniary Economies
External economies are those economies which accrue to the firms as
a result of the expansion in the output of whole industry and they are
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not dependent on the output level of individual firms. These economies

or gains will arise on account of the overall growth of an industry or a region
or a particular area. They arise due to benefit of localization and specialized
progress in the industry or region. Prof. Stonier & Hague points out that
external economies are those economies in production which depend on
increase in the output of the whole industry rather than increase in the
output of the individual firm The following are some of the important aspects
of external economies.
1. They arise „outside‟ the firm.
2. They arise due to improvement in external factors.
3. They arise due to collective efforts of an industry.
4. They are general, common & enjoyed by all firms.
5. They arise due to overall development, expansion & growth of an
industry or a region.
6. They are dependent on the size of industry.
7. They are beyond the control of management of a firm.
8. They are called as “open secrets” of a firm.

Kinds of External Economies

1. Economies of concentration or Agglomeration
They arise because in a particular area a very large number of firms
which produce the same commodity are established. In other words,
this is an advantage which arises from what is called „Localization of
Industry‟. The following benefits of localization of industry is enjoyed by all
the firms-provision of better and cheap labor at low or reasonable rates,
trained, educated and skilled labor, transport and communication, water,
power, raw materials, financial assistance through private and public
institutions at low interest rates, marketing facilities, benefits of common
repairs, maintenance and service shops, services of specialists or outside
experts, better use of by-products and other such benefits. Thus, it helps in
reducing the cost of operation of a firm.
2. Economies of Information
These economies will arise as a result of getting quick, latest and up to
date information from various sources. Another form of benefit that
arises due to localization of industry is economies of information. Since a
large number of firms are located in a region, it becomes possible for them

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to exchange their views frequently, to have discussions with others, to

organize lectures, symposiums, seminars, workshops, training camps,
demonstrations on topics of mutual interest. Revolution in the field of
information technology, expansion in inter-net facilities, mobile phones,
e-mails, video conferences, etc. has helped in the free flow of latest
information from all parts of the globe in a very short span of time. Similarly,
publication of journals, magazines, information papers etc have helped a lot
in the dissemination of quick information. Statistical, technical and other
market information becomes more readily available to all firms. This will help
in developing contacts between different firms. When inter-firm relationship
strengthens, it helps a lot to economize the expenditure of a single firm.
3. Economies of Disintegration
These economies will arise as a result of dividing one big unit in to
different small units for the sake of convenience of management and
administration. When an industry grows beyond a limit, in that case, it
becomes necessary to split it in to small units. New subsidiary units may
grow up to serve the needs of the main industry. For example, in cotton
textiles industry, some firms may specialize in manufacturing threads, a few
others in printing, and some others in dyeing and coloring etc. This will
certainly enhance the efficiency in the working of a firm and cut down unit
costs considerably.
4. Economies of Government Action
These economies will arise as a result of active support and
assistance given by the government to stimulate production in the
private sector units. In recent years, the government in order to encourage
the development of private industries has come up with several kinds of
assistance. It is granting tax-concessions, tax-holidays, tax-exemptions,
subsidies, development rebates, financial assistance at low interest rates
etc.
It is quite clear from the above detailed description that both internal and
external economies arise on account of large scale production and they are
benefits to a firm and cost reducing in nature.
5. Economies of Physical Factors
These economies will arise due to the availability of favorable physical
factors and environment. As the size of an industry expands, positive

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physical environment may help to reduce the costs of all firms working in the
industry. For example, Climate, weather conditions, fertility of the soil,
physical environment in a particular place may help all firms to enjoy certain
physical benefits.
6. Economies of Welfare
These economies will arise on account of various welfare programs
under taken by an industry to help its own staff. A big industry is in a
better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local governments
for setting up housing colonies for the workers. It may also establish health
care units, training centers, computer centers and educational institutions of
all types. It may grant concessions to its workers. All these measures would
help in raising the overall efficiency and productivity of workers.
Diseconomies of Scale
When a firm expands beyond the optimum limit, economies of scale will be
converted in to diseconomies of scale. Over growth becomes a burden.
Hence, one should not cross the limit. On account of diseconomies of scale,
more output is obtained at higher cost of production. The following are some
of the main diseconomies of scale
1. Financial diseconomies. . As there is over growth, the required amount
of fiancée may not be available to a firm. Consequently, higher interest
rates are to be paid for additional funds.
2. Managerial diseconomies. Excess growth leads to loss of effective
supervision, control, management, coordination of factors of production
leading to all kinds of wastages, indiscipline and rise in production and
operating costs.
3. Marketing diseconomies. Unplanned excess production may lead to
mismatch between demand and supply of goods leading to fall in prices.
Stocks may pile up, sales may decline leading to fall in revenue and
profits.
4. Technical diseconomies. When output is carried beyond the plant
capacity, per unit cost will certainly go up. There is a limit for division of
labor and specialization. Beyond a point, they become negative. Hence,
operation costs would go up.

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5. Diseconomies of risk and uncertainty bearing. If output expands

beyond a limit, investment increases. The level of inventory goes up.
Sales do not go up correspondingly. Business risks appear in all fields
of activities. Supply of factor inputs become inelastic leading to high
prices.
6. Labor diseconomies. An unwieldy firm may become impersonal.
Contact between labor and management may disappear. Workers may
demand higher wages and salaries, bonus and other such benefits etc.
Industrial disputes may arise. Labor unions may not cooperate with the
management. All of them may contribute for higher operation costs.
II. External diseconomies. When several business units are concentrated
in only one place or locality, it may lead to congestion,, environmental
pollution, scarcity of factor inputs like, raw materials, water, power, fuel,
transport and communications etc leading to higher production and
operational costs.
Thus, it is very clear that a firm can enjoy benefits of large scale production
only up to a limit. Beyond the optimum limit, it is bound to experience
diseconomies of scale. Hence, there should be proper check on the growth
and expansion of a firm.
Internalization of External Economies
It implies that a firm will convert certain external benefits created by the
government or the entire society to its own favor with out making any
additional investments. A firm may start a new unit in between two big
railway stations or near the air port or near the national high ways or a port
so that it can enjoy all the infrastructure benefits. Similarly, a new computer
firm can commence its operations where there is 24 hours supply of
electricity. Hence, they are also called as privatization of public benefits.
Such type of efforts is to be encouraged by the government.
Externalization of Internal Diseconomies
In this case, a particular firm on account of its regular operations will pass
on certain costs on the entire society. A firm instead of taking certain
precautionary measures by spending some amount of money will escape
and pass on this burden to the government or the society. For example, a
firm may throw chemical or industrial wastes, dirt and filth either to open air
or rivers leading to environmental pollution. In that case, the government is
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forced to spend more money to clean river water or prevent environmental

pollution. This is a clear case of externalized internal diseconomies. It is to
be avoided at all costs.
Economies of Scope
It is a common factor to observe that when a single-product firm expands its
volume of output, it would enjoy certain economies of scale. As a result,
production cost per unit declines and more output is obtained at lower cost
of production. Sometimes they would enjoy certain other external benefits
due to the overall improvements in the entire area or city in which operates.
Apart from these two types of benefits, we also come across another type of
benefits in recent years. They are popularly known as economies of scope.
Economies of scope may be defined as those benefits which arise to a
firm when it produces more than one product jointly rather than
producing two items separately by two different business units. In this
case, the benefits of the joint output of a single firm are greater than the
benefits if two products are produced separately by two different firms. Such
benefits may arise on account of joint use of production facilities, joint
marketing efforts, or use of the same administrative office and staff in an
organization. Sometimes, production of one product automatically results in
the production of another by-product leading to a reduction in average cost
of production.
Economies of scope results in saving production costs. It can be measured
with the help of the following equation.
C [Q1]  C [ Q2] - C [ Q1and Q2]
SC 
C [Q1 and Q2]
Where SC = Saving Cost, C Q1 = cost of producing output Q1, C Q2 = cost
of producing outputQ2 and C [Q1, Q2] = joint cost of producing both
outputs.
Ilustration
A firm produces product A & B separately. Cost of producing 100 units of A
is Rs. 8000 – 00 and cost of producing 100 units of B is Rs. 5,000-00. If the
firm produces both products A & B jointly, in that case, its total cost would
be Rs. 10,000 - 00.

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Now one can find out saving cost by substituting the values to the above
mentioned formula.
8,000 - 00  5,000 - 00 - 10,000 - 00] 3,000.00
SC    0.3
10,000 - 00 10,000.00

In this case, the joint cost [10,000-00] is less than a sum of individual costs
[13,000-00]. Thus, a firm can save 3% cost if it produces both products A &
B jointly. Hence, the SC is more than zero.
Diseconomies of Scope
Diseconomies of scope may be defined as those disadvantages which
occur when cost of producing two products jointly are costlier than
producing them individually. In this case, it would be profitable to produce
two goods separately than jointly. For example, with the help of same
machinery, it is not possible to produce two goods together. It involves
buying two different machineries. Hence, production costs would certainly
go up in this case.
Difference between Economies of Scale and Economies of Scope
Economies of scale Economies of scope
1. It is connected with increase 1. It is connected with increase or
or decrease in scale of decrease in distribution &
production marketing.
2. It shows change in output of 2. It shows a change in output of
a single product more than one products.
3. it is associated with supply 3. It is associated with demand side
side changes in output. changes in output
4. It indicates savings in cost 4. It indicates savings in cost due to
owing to increase in volume production of more than one
of output product.

Self Assessment Questions

1. Production creates _____ or ___ of value.
2. Production function explain ___ or ____ relationship between inputs and
outputs.
3. In the short period only ___________ factor inputs are changed.
4. When marginal product is zero toal product will be _________.

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5. An ISO _ Quant curve shows different alternative combinations of inputs

which helps to produce same level of output where as an ISO-Cost
curve shows __ combination of two inputs that can be purchased with a
given amount of investment expenditure while prices of two factor inputs
remain constant.
6. When all inputs are increased by 8% and output increases by 13% then
its is a case of laws of ____.
7. Internal economies depend on the growth of a ___ and external
economies depend on the growth of the ____.
8. Economies of scope refers to the benefits which arise to a firm when it
produces more than _______ rather than producing ________
separately by two firms.

5.3 Cost of Production

Meaning:
Cost is analyzed from the producer‟s point of view. Cost estimates are made
in terms of money. Cost calculations are indispensable for management
decisions.
In the production process, a producer employs different factor inputs. These
factor inputs are to be compensated by the producer for the services in the
production of a commodity. The compensation is the cost. The value of
inputs required in the production of a commodity determines its cost of
output. Cost of production refers to the total money expenses (Both
explicit and implicit) incurred by the producer in the process of
transforming inputs into outputs. In short, it refers total money expenses
incurred to produce a particular quantity of output by the producer. The
knowledge of various concepts of costs, cost-output relationship etc.
occupies a prominent place in cost analysis.
Managerial uses of Cost Analysis
A detailed study of cost analysis is very useful for managerial decisions. It
helps the management –
1. To find the most profitable rate of operation of the firm.
2. To determine the optimum quantity of output to be produced and
supplied.
3. To determine in advance the cost of business operations.

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4. To locate weak points in production management to minimize costs.

5. To fix the price of the product.
6. To decide what sales channel to use.
7. To have a clear understanding of alternative plans and the right costs
involved in them.
8. To have clarity about the various cost concepts.
9. To decide and determine the very existence of a firm in the production
field.
10. To regulate the number of firms engaged in production.
11. To decide about the method of cost estimation or calculations.
12. To find out decision making costs by re-classifications of elements,
repricing of input factors etc, so as to fit the relevant costs into
management planning, choice etc.
Different Kinds of Cost Concepts.
1. Money Cost and Real Cost
When cost is expressed in terms of money, it is called as money cost.
It relates to money outlays by a firm on various factor inputs to
produce a commodity. In a monetary economy, all kinds of cost
estimations and calculations are made in terms of money only. .Hence, the
knowledge of money cost is of great importance in economics. Exact
measurement of money cost is possible.
When cost is expressed in terms of physical or mental efforts put in by
a person in the making of a product, it is called as real cost. It refers to
the physical, mental or psychological efforts, the exertions, sacrifices, the
pains, the discomforts, displeasures and inconveniences which various
members of the society have to undergo to produce a commodity. It is a
subjective and relative concept and hence exact measurement is not
possible.
2. Implicit or Imputed Costs and Explicit Costs
Explicit costs are those costs which are in the nature of contractual
payments and are paid by an entrepreneur to the factors of production
[excluding himself] in the form of rent, wages, interest and profits,
utility expenses, and payments for raw materials etc. They can be
estimated and calculated exactly and recorded in the books of accounts.

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Implicit or imputed costs are implied costs. They do not take the form of
cash outlays and as such do not appear in the books of accounts. They are
the earnings of owner-employed resources. For example, the factor
inputs owned by the entrepreneur himself like capital that can be utilized by
himself or can be supplied to others for a contractual sum if he himself does
not utilize them in the business. It is to be remembered that the total cost is
a sum of both implicit and explicit costs.
3. Actual costs and Opportunity Costs
Actual costs are also called as outlay costs, absolute costs and acquisition
costs. They are those costs that involve financial expenditures at some time
and hence are recorded in the books of accounts. They are the actual
expenses incurred for producing or acquiring a commodity or service
by a firm. For example, wages paid to workers, expenses on raw materials,
power, fuel and other types of inputs. They can be exactly calculated and
accounted without any difficulty.
Opportunity cost of a good or service is measured in terms of revenue
which could have been earned by employing that good or service in
some other alternative uses. In other words, opportunity cost of anything
is the cost of displaced alternatives or costs of sacrificed alternatives. It
implies that opportunity cost of anything is the alternative that has
been foregone. Hence, they are also called as alternative costs.
Opportunity cost represents only sacrificed alternatives. Hence, they can
never be exactly measured and recorded in the books of accounts.
The knowledge of opportunity cost is of great importance to management
decision. They help in taking decisions among alternatives. While taking a
decision among several alternatives, a manager selects the best one which
is more profitable or beneficial by sacrificing other alternatives. For example,
a firm may decide to buy a computer which can do the work of 10 laborers.
If the cost of buying a computer is much lower than that of the total wages to
be paid to the workers over a period of time, it will be a wise decision. On
the other hand, if the total wage bill is much lower than that of the cost of
computer, it is better to employ workers instead of buying a computer. Thus,
a firm has to take a number of decisions almost daily.

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4. Direct costs and indirect costs

Direct costs are those costs which can be specifically attributed to a
particular product, a department, or a process of production. For
example, expenses on raw materials, fuel, wages to workers, salary to a
divisional manager etc are direct costs. On the other hand, indirect costs are
those costs, which are not traceable to any one unit of operation. They
cannot be attributed to a product, a department or a process. For example,
expenses incurred on electricity bill, water bill, telephone bill, administrative
expeneses etc.
5. Past and future costs.
Past costs are those costs which are spent in the previous periods. On the
other hand, future costs are those which are to be spent in the future. Past
helps in taking decisions for future.
6. Marginal and Incremental costs
Marginal cost refers to the cost incurred on the production of another or one
more unit .It implies additional cost incurred to produce an additional
unit of output It has nothing to do with fixed cost and is always associated
with variable cost.
Incremental cost on the other hand refers to the costs involved in the
production of a batch or group of output. They are the added costs due to a
change in the level or nature of business activity. For example, cost involved
in the setting up of a new sales depot in another city or cost involved in the
production of another 100 extra units.
7. Fixed costs and variable costs.
Fixed costs are those costs which do not vary with either expansion or
contraction in output. They remain constant irrespective of the level of
output. They are positive even if there is no production. They are also
called as supplementary or over head costs.
On the other hand, variable costs are those costs which directly and
proportionately increase or decrease with the level of output
produced. They are also called as prime costs or direct costs.
8. Accounting costs and economic costs
Accounting costs are those costs which are already incurred on the
production of a particular commodity. It includes only the acquisition

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costs. They are the actual costs involved in the making of a commodity. On
the other hand, economic costs are those costs that are to be incurred
by an entrepreneur on various alternative programs. It involves the
application of opportunity costs in decision making.
Determinants of Costs
Cost behavior is the result of many factors and forces. But it is very difficult
to determine in general the factors influencing the cost as they widely differ
from firm to firm and even industry to industry. However, economists have
given some factors considering them as general determinants of costs. They
have enough importance in modern business set up and decision making
process. The following factors deserve our attention in this connection.
1. Technology
Modern technology leads to optimum utilization of resources, avoid all kinds
of wastages, saving of time, reduction in production costs and resulting in
higher output. On the other hand, primitive technology would lead to higher
production costs.
2. Rate of output: (the degree of utilization of the plant and machinery)
Complete and effective utilization of all kinds of plants and equipments
would reduce production costs and under utilization of existing plants and
equipments would lead to higher production costs.
3. Size of Plant and scale of production
Generally speaking big companies with huge plants and machineries
organize production on large scale basis and enjoy the economies of scale
which reduce the cost per unit.
4. Prices of factor inputs
Higher market prices of various factor inputs result in higher cost of
production and vice-versa.
5. Efficiency of factors of production and the management
Higher productivity and efficiency of factors of production would lead to
lower production costs and vice-versa.
6. Stability of output
Stability in production would lead to optimum utilization of the existing
capacity of plants and equipments. It also brings savings of various kinds of

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hidden costs of interruption and learning leading to higher output and

reduction in production costs.
7. Law of returns
Increasing returns would reduce cost of production and diminishing returns
increase cost.
8. Time period
In the short run, cost will be relatively high and in the long run, it will be low
as it is possible to make all kinds of adjustments and readjustments in
production process.
Thus, many factors influence cost of production of a firm.
Cost-Output Relationship: Cost Function.
Cost and output are correlated. Cost output relations play an important role
in almost all business decisions. It throws light on cost minimization or profit
maximization and optimization of output. The relation between the cost
and output is technically described as the “COST FUNCTION”. The
significance of cost-output relationship is so great that in economic analysis
the cost function usually refers to the relationship between cost and rate of
output alone and we assume that all other independent variables are kept
constant. Mathematically speaking TC = f (Q) where TC = Total cost and Q
stands for output produced.
However, cost function depends on three important variables.
1. Production function
If a firm is able to produce higher output with a little quantity of inputs, in that
case, the cost function becomes cheaper and vice-versa.
2. The market prices of inputs
If market prices of different factor inputs are high in that case, cost function
becomes higher and vice-versa.
3. Period of time
Cost function becomes cheaper in the long run and it would be relatively
costlier in the short run.
Types of cost function
Generally speaking there are two types of cost functions.
1. Short run cost function.
2. Long run cost function.

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Cost-Output Relationship and Cost Curves in the Short-Run

It is interesting to note that the relationship between the cost and output is
different at two different periods of time i.e. short-run and long run.
Generally speaking, cost of production will be relatively higher in the short-
run when compared to the long run. This is because a producer will get
enough time to make all kinds of adjustments in the productive process in
the long run than in the short run. When cost and output relationship is
represented with the help of diagrams, we get short run and long run cost
curves of the firm. Now we shall make a detailed study of cost output
relations both in the short-run as well as in the long run.
Meaning of Short Run
Short-run is a period of time in which only the variable factors can be
varied while fixed factors like plant, machinery etc. remains constant.
Hence, the plant capacity is fixed in the short run. The total number of firms
in an industry will remain the same. Time is insufficient either for the entry of
new firms or exit of the old firms. If a firm wants to produce greater
quantities of output, it can do so only by employing more units of variable
factors or by having additional shifts, or by having over time work for the
existing labor force or by intensive utilization of existing stock of capital
assets etc. Hence, short run is defined as a period where adjustments to
changed conditions are only partial.
The short run cost function relates to the short run production function. It
implies two sets of input components – (a) fixed inputs and (b) variable
inputs. Fixed inputs are unalterable. They remain unchanged over a period
of time. On the other hand, variable factors are changed to vary the output
in the short run. Thus, in the short period some inputs are fixed in amount
and a firm can expand or contract its output only by changing the amounts
of other variable inputs. The cost-output relationship in the short run refers
to a particular set of conditions where the scale of operation is limited by the
fixed plant and equipment. Hence, the costs of the firm in the short run are
divided into fixed cost and variable costs. We shall study these two
concepts of costs in some detail
1. Fixed costs
These costs are incurred on fixed factors like land, buildings, equipments,
plants, superior type of labor, top management etc. Fixed costs in the short

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run remain constant because the firm does not change the size of plant and
the amount of fixed factors employed. Fixed costs do not vary with either
expansion or contraction in output. These costs are to be incurred by a firm
even output is zero. Even if the firm close down its operation for some time
temporarily in the short run, but remains in business, these costs have to be
borne by it. Hence, these costs are independent of output and are referred
to as unavoidable contractual cost.
Prof. Marshall called fixed costs as supplementary costs. They include such
items as contractual rent payment, interest on capital borrowed, insurance
premiums, depreciation and maintenance allowances, administrative
expenses like manager‟s salary or salary of the permanent staff, property
and business taxes, license fees, etc. They are called as over-head costs
because these costs are to be incurred whether there is production or not.
These costs are to be distributed on each unit of output produced by a firm.
Hence, they are called as indirect costs.
2. Variable costs
The cost corresponding to variable factors are discussed as variable
costs. These costs are incurred on raw materials, ordinary labor,
transport, power, fuel, water etc, which directly vary in the short run.
Variable costs directly and proportionately increase or decrease with the
level of output. If a firm shuts down for some time in the short run; then it will
not use the variable factors of production and will not therefore incur any
variable costs. Variable costs are incurred only when some amount of
output is produced. Total variable costs increase with increase in the level of
production and vice-versa. Prof. Marshall called variable costs as prime
costs or direct costs because the volume of output produced by a firm
depends directly upon them.
It is clear from the above description that production costs consist of both
fixed as well as variable costs. The difference between the two is
meaningful and relevant only in the short run. In the long run all costs
become variable because all factors of production become adjustable and
variable in the long run.
However, the distinction between fixed and variable costs is very significant
in the short run because it influences the average cost behavior of the firm.
In the short run, even if a firm wants to close down its operation but wants to

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remain in business, it will have to incur fixed costs but it must cover at least
its variable costs.
Cost-output relationship and nature and behavior of cost curves in the
short run
In order to study the relationship between the level of output and
corresponding cost of production, we have to prepare the cost schedule of
the firm. A cost-schedule is a statement of a variation in costs resulting
from variations in the levels of output. It shows the response of cost
to changes in output. A hypothetical cost schedule of a firm has been
represented in the following table.
in Rs.
Output TFC TVC TC AFC AVC AC MC
in Units
0 360 – 360 – – – –
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.75 45
5 360 420 780 72 84 156 105
6 360 630 990 60 105 165 210

On the basis of the above cost schedule, we can analyse the relationship
between changes in the level of output and cost of production. If we
represent the relationship between the two in a geometrical manner, we get
different types of cost curves in the short run. In the short run, generally we
study the following kinds of cost concepts and cost curves.
1. Total fixed cost (TFC)
TFC refers to total money expenses incurred on fixed inputs like plant,
machinery, tools & equipments in the short run. Total fixed cost
corresponds to the fixed inputs in the short run production function. TFC
remains the same at all levels of output in the short run. It is the same when
output is nil. It indicates that whatever may be the quantity of output,
whether 1 to 6 units, TFC remains constant. The TFC curve is horizontal
and parallel to OX-axis, showing that it is constant regardless of out put per
unit of time. TFC starts from a point on Y-axis indicating that the total fixed

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cost will be incurred even if the output is zero. In our example, Rs 360=00
is TFC. It is obtained by summing up the product or quantities of the fixed
factors multiplied by their respective unit price.

TFC = TC - TVC.
Y
Cost of production

TFC
360

X
0 Output

2. Total variable cost (TVC)

TVC refers to total money expenses incurred on the variable factor
inputs like raw materials, power, fuel, water, transport and
communication etc, in the short run. Total variable cost corresponds to
variable inputs in the short run production function. It is obtained by
summing up the production of quantities of variable inputs multiplied by their
prices. The formula to calculate TVC is as follows. TVC = TC-TFC. TVC = f
(Q) i.e. TVC is an increasing function of out put. In other words TVC varies
with output. It is nil, if there is no production. Thus, it is a direct cost of
output. TVC rises sharply in the beginning, gradually in the middle and
sharply at the end in accordance with the law of variable proportion. The law
of variable proportion explains that in the beginning to obtain a given
quantity of output, relative variation in variable factors-needed are in less
proportion, but after a point when the diminishing returns operate, variable
factors are to be employed in a larger proportion to increase the same level
of output.
TVC curve slope upwards from left to right. TVC curve rises as output is
expanded. When out put is Zero, TVC also will be zero. Hence, the TVC
curve starts from the origin.

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TVC = TC - TFC

Cost of production
Y

TVC

0 X
Output

3. Total cost (TC)

The total cost refers to the aggregate money expenditure incurred by a
firm to produce a given quantity of output. The total cost is measured in
relation to the production function by multiplying the factor prices with their
quantities. TC = f (Q) which means that the T.C. varies with the output.
Theoretically speaking TC includes all kinds of money costs, both explicit
and implicit cost. Normal profit is included in the total cost as it is an implicit
cost. It includes fixed as well as variable costs. Hence, TC = TFC +TVC.
TC varies in the same proportion as TVC. In other words, a variation in TC
is the result of variation in TVC since TFC is always constant in the short
run.

TC
TC = TFC + TVC
Y
Cost of production

360 TFC

0 x
Output

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The total cost curve is rising upwards from left to right. In our example the
TC curve starts from Rs. 360-00 because even if there is no output, TFC is
a positive amount. TC and TVC have same shape because an increase in
output increases them both by the same amount since TFC is constant. TC
curve is derived by adding up vertically the TVC and TFC curves. The
vertical distance between TVC curve and TC curve is equal to TFC and is
constant throughout because TFC is constant.
4. Average fixed cost (AFC)
Average fixed cost is the fixed cost per unit of output. When TFC is
divided by total units of out put AFC is obtained, Thus, AFC = TFC/Q
Y
Cost of Production

AFC

0 X
Output
AFC and output have inverse relationship. It is higher at smaller level and
lower at the higher levels of output in a given plant. The reason is simple to
understand. Since AFC = TFC/Q, it is a pure mathematical result that the
numerator remaining unchanged, the increasing denominator causes
diminishing cost. Hence, TFC spreads over each unit of out put with the
increase in output. Consequently, AFC diminishes continuously. This
relationship between output and fixed cost is universal for all types of
business concerns.
The AFC curve has a negative slope. The curve slopes downwards
throughout the length. The AFC curve goes very nearer to X axis, but never
touches axis. Graphically it will fall steeply in the beginning, gently in middle
and tend to become parallel to OX-axis. Mathematically speaking as output
increases, AFC diminishes. But AFC will never become zero because the
TFC is a positive amount. AFC will never fall below a minimum amount
because in the short run, plant capacity is fixed and output cannot be
enlarged to an unlimited extent.

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5. Average variable cost: (AVC)

The average variable cost is variable cost per unit of output. AVC can
be computed by dividing the TVC by total units of output. Thus, AVC =
TVC/Q. The AVC will come down in the beginning and then rise as more
units of output are produced with a given plant. This is because as we add
more units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then it decreases.
The AVC curve is a U-shaped cost curve. It has three phases.

AVC = TVC / Q
Y
Cost of production

AVC C
A

B

X
0 Output

a) Decreasing phase
In the first phase from A to B, AVC declines, As output expands, AVC
declines because when we add more quantity of variable factors to a given
quantity of fixed factors, output increases more efficiently and more than
proportionately due to the operation of increasing returns.
b) Constant phase
In the II phase, i.e. at B, AVC reaches its minimum point. When the
proportion of both fixed and variable factors are the most ideal, the output
will be the optimum. Once the firm operates at its normal full capacity,
output reaches its zenith and as such AVC will become the minimum.
c) Increasing phase
In the III phase, from B to C, AVC rises when once the normal capacity is
crossed, the AVC rises sharply. This is because additional units of variables
factors will not result in more than proportionate output. Hence, greater
output may be obtained but at much greater AVC. The old proverb “Too
many cooks spoil the broth” aptly applies to this III stage. It is clear that as
long as increasing returns operate, AVC falls and when diminishing returns
set in, AVC tends to increase.

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6. Average total cost (ATC) or Average cost (AC)

AC refers to cost per unit of output. AC is also known as the unit cost
since it is the cost per unit of output produced. AC is the sum of AFC
and AVC. Average total cost or average cost is obtained by dividing the total
cost by total output produced. AC = TC/Q Also AC is the sum of AFC and
AVC.
In the short run AC curve also tends to be U-shaped. The combined
influence of AFC and AVC curves will shape the nature of AC curve.
ATC = AFC + AVC
Y
Cost of production

A AC

C

B
X
0 Output

As we observe, average fixed cost begin to fall with an increase in output

while average variable costs come down and rise. As long as the falling
effect of AFC is much more than the rising effect of AVC, the AC tends to
fall. At this stage, increasing returns and economies of scale operate and
complete utilization of resources force the AC to fall.
When the firm produces the optimum output, AC becomes minimum. This is
called as least – cost output level. Again, at the point where the rise in AVC
exactly counter balances the fall in AFC, the balancing effect causes AC to
remain constant.
In the third stage when the rise in average variable cost is more than drop in
AFC, then the AC shows a rise, When output is expanded beyond the
optimum level of output, diminishing returns set in and diseconomies of
scale starts operating. At this stage, the indivisible factors are used in wrong
proportions. Thus, AC starts rising in the third stage.

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The short run AC curve is also called as “Plant curve”. It indicates the
optimum utilization of a given plant or optimum plant capacity.
7. Marginal Cost (MC)
Marginal Cost may be defined as the net addition to the total cost as
one more unit of output is produced. In other words, it implies
additional cost incurred to produce an additional unit. For example, if it
costs Rs. 100 to produce 50 units of a commodity and Rs. 105 to produce
51 units, then MC would be Rs. 5. It is obtained by calculating the change
in total costs as a result of a change in the total output. Also MC is the rate
at which total cost changes with output. Hence, MC =  TC /  TQ. Where
 TC stands for change in total cost and  TQ stands for change in total
output. Also MCn = TCn –TC n-1
It is necessary to note that MC is independent of TFC and it is directly
related to TVC as we calculate the cost of producing only one unit. In the
short run, the MC curve also tends to be U-shaped.
The shape of the MC curve is determined by the laws of returns. If MC is
falling, production will be under the conditions of increasing returns and if
MC is rising, production will be subject of diminishing returns.

A MC
Cost of production

C
B


0 X
Output

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The table indicates the relationship between AC & MC

Output in Units TC in Rs. AC in Rs. Difference in Rs. MC

1 150 150 --
2 190 95 40
3 220 73.3 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.3 91
8 580 72.2 165

Relation between AC and MC

Y

AC

MC
Cost


AC=MC

X
Output

From the diagram it is clear that:

1. Both MC and AC fall at a certain range of output and rise afterwards.
2. When AC falls, MC also falls but at certain range of output MC tends to
rise even though AC continues to fall. However, MC would be less
than AC. This is because MC is attributed to a single unit where as in
case of AC, the decreasing AC is distributed over all the units of output
produced.
3. So long as AC is falling, MC is less than AC. Hence, MC curve lies
below AC curve. It indicates that fall in MC is more than the fall in AC.
MC reaches its minimum point before AC reaches its minimum.

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4. When AC is rising, after the point of intersection, MC will be greater

than AC. This is because in case of MC, the increasing MC is attributed
to a single unit, where as in case of AC, the increasing AC is distributed
over all the output produced.
5. So long as the AC is rising, MC is greater and AC. Hence, MC curve
lies to the left side of the AC curve. It indicates that rise in MC is more
than the rise in AC.
6. MC curve cuts the AC curve at the minimum point of the AC curve. This
is because, when MC decreases, it pulls AC down and when MC
increases, it pushes AC up. When AC is at its minimum, it is neither
being pulled down or being pushed up by the MC. Thus, When AC is
minimum, MC = AC. The point of intersection indicates the least cost
combination point or the optimum position of the firm. At output Q the
firm is working at its “Optimum Capacity” with lowest AC. Beyond Q,
there is scope for “Maximum Capacity” with rising cost.
Cost Output Relationship in the Long Run
Long run is defined as a period of time where adjustments to changed
conditions are complete. It is actually a period during which the quantities
of all factors, variable as well as fixed factors can be adjusted. Hence, there
are no fixed costs in the long run. In the short run, a firm has to carry on its
production within the existing plant capacity, but in the long run it is not tied
up to a particular plant capacity. If demand for the product increases, it can
expand output by enlarging its plant capacity. It can construct new buildings
or hire them, install new machines, employ administrative and other
permanent staff. It can make use of the existing as well as new staff in the
most efficient way and there is lot of scope for making indivisible factors to
become divisible factors. On the other hand, if demand for the product
declines, a firm can cut down its production permanently. The size of the
plant can also be reduced and other expenditure can be minimized. Hence,
production cost comes down to a greater extent in the long run.
As all costs are variable in the long run, the total of these costs is total cost
of production. Hence, the distinction between fixed and variables costs
in the total cost of production will disappear in the long run. In the long
run only the average total cost is important and considered in taking long
term output decisions.

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Long run average cost is the long run total cost divided by the level of
output. In brief, it is the per unit cost of production of different levels of
output by changing the size of the plant or scale of production.
The long run cost – output relationship is explained by drawing a long run
cost curve through short – run curves as the long period is made up of many
short – periods as the day is made up of 24 hours and a week is made out
of 7 days. This curve explains how costs will change when the scale of
production is varied.

LAC

SAC 1
Cost of Production

SAC 2
SAC 3
SAC 4 SAC 5

0 Output Q X
Q
The long run-cost curves are influenced by the laws of return to scale as
against the short run cost curves which are subject to the working of law of
variable proportions.
In the short run the firm is tied with a given plant and as such the scale of
operation remains constant. There will be only one AC curve to represent
one fixed scale of output in the short run. In the long run as it is possible to
alter the scale of production, one can have as many AC curves as there are
changes in the scale of operations.
In order to derive LAC curve, one has to draw a number of SAC curves,
each curve representing a particular scale of output. The LAC curve will be

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tangential to the entire family of SAC cures. It means that it will touch each
SAC curve at its minimum point.

Production cost difference in the short run and long run

SAC 2 SAC 1 SAC 3

LAC
Cost of Production

K3
K1

 
L1  L3
L2

0 X
M1 M2 M3
Output

In the diagram, the LAC curve is drawn on the basis of three possible plant
sizes. Consequently, we have three different SAC curves – SAC1, SAC2
and SAC3. They represent three different scales of output. For output OM3
the AC will be L2M2 in the short run as well as the long run.
When output is to be expanded to OM3, it can be obtained at a higher
average cost of production. K3, M3 is the short run AC because, scale of
production would remain constant in the short run. But the same output of
OM3 can be produced at a lower AC of L3M3 in the long run since the scale
of production can be modified according to the requirements. The distance
between K3L3 represent difference between the cost of production in the
short run and long run.
Similarly, when output is contracted to OM1 in the short run, K1M1 will
become the short run AC and L1M1 will be the long run AC. Hence, K1L1
indicates the difference between short run and long run cost of production.
If we join points L1, L2 and L3 we get LAC curve.

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Important features of long run AC curves

1. Tangent curve
Different SAC curves represent different operational capacities of different
plants in the short run. LAC curve is locus of all these points of tangency.
The SAC curve can never cut a LAC curve though they are tangential to
each other. This implies that for any given level of output, no SAC curve can
ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in
the long run. Thus, LAC curve is tangential to various SAC curves.
2. Envelope curve
It is known as Envelope curve because it envelopes a group of SAC curves
appropriate to different levels of output.
3. Flatter U-shaped or dish-shaped curve
The LAC curve is also U shaped or dish shaped cost curve. But It is less
pronounced and much flatter in nature. LAC gradually falls and rises due to
economies and diseconomies of scale.
4. Planning curve
The LAC cure is described as the Planning Curve of the firm because it
represents the least cost of producing each possible level of output. This
helps in producing optimum level of output at the minimum LAC. This is
possible when the entrepreneur is selecting the optimum scale plant.
Optimum scale plant is that size where the minimum point of SAC is tangent
to the minimum point of LAC.
5. Minimum point of LAC curve should be always lower than the
minimum point of SAC curve
This is because LAC can never be higher than SAC or SAC can never be
lower than LAC. The LAC curve will touch the optimum plant SAC curve at
its minimum point.
A rational entrepreneur would select the optimum scale plant. Optimum
scale plant is that size at which SAC is tangent to LAC, such that both the
curves have the minimum point of tangency. In the diagram, OM2 is
regarded as the optimum scale of output, as it has the least per unit cost. At
OM2 output LAC = SAC.
LAC curve will be tangent to SAC curves lying to the left of the optimum
scale or right side of the optimum scale. But at these points of tangency,

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neither LAC is minimum nor will SAC be minimum. SAC curves are either
rising or falling indicating a higher cost
Managerial Use of LAC
The study of LAC is of greater importance in managerial decision making
process.
1. It helps the management in the determination of the best size of the
plant to be constructed or when a new one is introduced in getting the
minimum cost output for a given plant. But it is interested in producing a
given output at the minimum cost.
2. The LAC curve helps a firm to decide the size of the plant to be adopted
for producing the given output. For outputs less than cost lowering
combination at the optimum scale i.e., when the firm is working subject
to increasing returns to scale, it is more economical to under use a
slightly large plant operating at less than its minimum cost – output than
to over use smaller unit. Conversely, at output beyond the optimum
level, that is when the firm experience decreasing return to scale, it is
more economical to over use a slightly smaller plant than to under use a
slightly larger one. Thus, it explains why it is more economical to over
use a slightly small plant rather than to under use a large plant.
3. LAC is used to show how a firm determines the optimum size of the
plant. An optimum size of plant is one that helps in best utilization of
resources in the most economical manner.

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Long Run Marginal cost

LMC LAC

SMC 3
E
Cost of Production

SMC 1 SAC 3
SAC 1
SMC D
A 2
SAC 2

B
C

0 X
N Q R
Output

A long-run marginal cost curve can be derived from the long-run average
cost curve. Just as the SMC is related to the SAC, similarly the LMC is
related to the LAC and, therefore, we can derive the LMC directly from the
LAC. In the diagram we have taken three plant sizes (for the sake of
simplicity) and the corresponding three SAC and SMC curves. The LAC
curve is drawn by enveloping the family of SAC curves. The points of
tangency between the SAC and the LAC curves indicate different outputs for
different plant sizes.
If the firm wants to produce ON output in the long run, it will have to choose
the plant size corresponding to SAC1. The LAC curve is tangent to SAC1 at
point A. For ON output, the average cost is NA and the corresponding
marginal cost is NB If LAC curve is tangent to SAC1 curve at point A, the
corresponding LMC curve will have to be equal to SMC1 curve at point B.
The LMC will pass through point B. In other words, where LAC is equal to
SAC curve (for a given output) the LMC will have to be equal to a given
SMC.

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If output OQ is to be produced in the long run, it will be done at point c which

is the point of tangency between SAC2 and the LAC. At point C, the short –
run average cost (SAC2) and the short-run marginal cost (SMC2) are equal
and, therefore, the LAC for output OQ is QC and the corresponding LMC is
also QC. The LMC curve will, therefore pass through point C.
Finally, for output OR,at point D the LAC is tangent to SAC3. For OR output
at point E LMC is passing through SMC3. By connecting points B ,C and E,
we can draw the long-run marginal cost curve.
Cost of Production: Formulas
 TC = cost per unit x total production. Or TC = TFC + TVC
 TFC = TC - TVC or AFC x Q
 TVC = TC – TFC or AVC x Q or addition of MC
 AFC = AC – AVC or TFC/Q
 AVC = AC – AFC or TVC/Q
 AC = AFC + AVC or TC/Q
 MC = TCn - TCn-1 or  TC /  TQ.

Self Assessment Questions

9. Opportunity cost of anything is the alternative that has been _____ .
10. Marginal cost deals with changes in cost of ______ unit where as
incremental cost deals with changes in cost of ________.
11. AC minus AVC would give us _________
12. Total cost includes ___________ profits.
13. Marginal cost is associated with _________ costs.
14. In the long run all cost are ______________.

Activity: Go to a local manufacturer producing goods for local

consumption like tin boxes, baskets etc and find out how the
manufacturer ascertains the market price for his product after
taking into consideration the costs of manufacturing.

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5.4 Summary
In this unit-5 we have discussed about the meaning of production,
production function and its managerial uses. Production in economics
implies transformation of inputs into outputs for our final consumption.
Production function explains the quantitative relationship between the
amounts of inputs used to get a particular physical quantity of outputs. The
ratios between the two quantities are of great importance to a producer to
take his decisions in the production process.
There are two kinds of production functions - short run and long run. In case
of short run production function we come across a change in either one or
two variable factor inputs while all other inputs are kept constant. The law of
variable proportion explain how there will be variations in the quantity of
output when there is change in only one variable factor input while all other
inputs are kept constant. On the other hand, Iso-Quants and Iso-cost curves
explain how there will be changes in output when only two variable inputs
are changed while all other inputs are kept constant. Under long run
production function, the laws of returns to scale explain changes in output
when all inputs, both variable as well as fixed changes in the same
proportion.
Economies of scale give information about the various benefits that a firm
will get when it goes for large scale production. Economies of scope on the
other hand tells us how there will be certain specific advantages when one
firm produces more than two products jointly than two or three firms produce
them separately. Diseconomies of scale and diseconomies of scope tells us
that there are certain limitations to expansion in output Cost analysis on the
other hand, indicates the various amounts of costs incurred to produce a
particular quantity of output in monetary terms. The various kinds of cost
concepts help a manager to take right decisions. Cost function explains the
relationship between the amounts of costs to be incurred to produce a
particular quantity of output. Short run cost function gives information about
the nature and behavior of various cost curves. Long run cost function tells
us how it is possible to obtain more output at lower costs in the long run.
Thus, the knowledge of both production function and cost functions help a
business executive to work out the best possible factor combinations to
maximize output with minimum costs.

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5.5 Terminal Questions

1. Define production function and distinguish between shortrun and long
run production function.
2. Discuss the uses of production function.
3. Explain the law of variable proportions
4. Explain how a product would reach equilibrium position with the help of
ISO - Quants and ISO-Cost curve.
5. Discuss any one laws of returns to scale with example.
6. Explain either various internal or external economies of scale.
7. Explain the concept of economies of scope with suitable illustration.
8. Give a brief description of
a. Implicit and explicit cost
b. Actual and opportunity cost
9. Discuss the various determinants of costs.
10. Explain cost output relationship with reference to
a. Total fixed cost and output
b. Total variable cost and output
c. Total cost and output
11. Explain features of LAC curve with a diagram.

5.6 Answer

Answers to Self Assessment Questions

1. New utilities, addition.
2. Technological, engineering.
3. Variable.
4. Highest
5. Various alternative, particular
6. Diminishing returns
7. Firms industry
8. One product jointly
9. foregone
10. One, a group of units
11. AFC

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12. Normal
13. Variable
14. Variable

Answer to Terminal Questions

1. Refer to unit 5.2
2. Refer to unit 5.3
3. Refer to unit 5.4
4. Refer to unit 5.5
5. Refer to unit 5.6
6. Refer to unit 5.7
7. Refer to unit 5.11
8. Refer to unit 5.2.2
9. Refer to unit 5.2.3
10. Refer to unit 5.2.5
11. Refer to unit 5.2

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