UNIT 3 PRODUCTION FUNCTION

THEORY OF PRODUCTION
When you go to the market to buy commodities such as note-books, fountain pens, shirts, bread, butter, fruits,
vegetables etc. do you ever think about how these things came into the market. In previous lessons, you have
studied about consumers, who constitute one part of the market and demand goods and services to satisfy their
wants. Now, you will study the other part of the market - the producers or firms who produce goods and services
for the satisfaction of consumers wants. A producer or firm combines various factors inputs like land, labours,
capital, entrepreneurship and other inputs like raw material, fuel etc. to produce goods and services that are
demanded by the consumers. Man can neither produce a physical product nor can he distruct. Man can change
only the form of a physical product. He can create utilities only. Thus production means creation or addition of
utility. Any activity that makes a product more useful is collect production. Production may be defined as a process
through which a firm transforms inputs into output. It is the process of creating goods and services with the help
of factors of production or inputs for satisfaction of human wants. In other words, transformation of inputs into
output whereby value is added, is broadly called production.

(a) Short run and long run

short run refers to a time period in which a firm does not have sufficient time to increase the scale of output. It
can increase only the level of output by increasing the quantity of a variable factor and making intensive use of
the existing fixed factors. On the other hand long run refers to the time period in which the firms can increase the
scale of output by increasing the quantity of all the factor inputs simultaneously and in the same proportion.
The distinction between fixed and variable factors is relevant only in the short run but this distinction disappears
in the long run.
(b) Fixed factors and variable factors
Fixed factors are those factors of production whose quantity can not be hanged with change in the level of output.
For example, the quantity of land, machinery etc. can not be hanged during short run.
On the other hand, variable factors are those factors of production whose quantity can easily be hanged with
change in the level of output. For example, we can easily change the quantity of labour to increase or decrease
the production.
(c) Level of production and scale of production
When any firm increases production by increasing the quantity of one factor input where as the quantity of other
factor inputs keeping constant; it increases the level of production. But on the other hand, when the firms
increases production by increasing the quantity of all the factors of production simultaneously and in the same
proportion, it increases the scale of production.

Production Function: -
In economics, production function refers to the physical relationship between inputs and output under given
technology. In other words production function is a mathematical functional/technical/engineering relationship
between inputs and output such that with a given combination of factor inputs and technology at a given period
of time, the maximum possible output can be produced. Such as land, labour capital and entrepreneurship.

The production function can be expressed in form of an equation in which the output is the dependent variable and
inputs are the independent variables. The equation is expressed as follows:
QX = f (L, K, Tn)
Where, QX = Output
L = Labour
K = Capital
T = Level of Technology
n = Other Inputs Employed in Production

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Here two points are worth considering. Firstly, production function must be considered with reference to
particular period of time i.e. short period and long period. Secondly, production function is determined by state
of technology.

Assumptions of Production Function

The production function is based on the following set of assumptions:

The level of technology remains constant.
The firm uses its inputs at maximum level of efficiency.
It relates to a particular unit of time.
A change in any of the variable factors produces a corresponding change in the level of output. The inputs
are divisible into most viable units.
There are two types of production function - short run production function and long run production function.
Short run is defined as that time period over which a firm is unable to vary the quantities of all inputs. In contrast,
long run is defined as that time period over which a firm can vary quantities of all factors of production and therefore,
can switch between different scales. In the long run production function all inputs are variable. There are two
alternative theories to these production functions i.e.
Law of Diminishing Returns or Laws of Variable Proportions (to analyze production in the short period)
Law of Returns to Scale (to analyze production in the long period)

Types of Production-Function
Before analysing the types of production-function it will be useful to understand the meaning of following
important terms :
A. Fixed Factors and Variable Factors
Factors of production are broadly classified into two categories i.e. fixed and variable factors:
(i) Fixed Factors - The factor inputs which cannot be varied in the short-
period, as and when required are called fixed factors.
Examples of Fixed Factors are: Plant, machinery, heavy equipments, factory building, land etc.
(ii) Variable Factors - The factor inputs which can easily be varied, in the
short-period as and when required, are called variable factors.
Examples of variable factors are : labour, raw material, power, fuel etc.
The distinction between fixed factors and variable factors appears only in the short-period. In the long-
run, all the factors of production become variable factors.

LAW OF VARIABLE PROPORTIONS

The law of variable proportions is a short period production law. It is also called returns to a factor. Let
us first understand the meaning of variable proportions. In a production process when only one factor is
varied and all other factors remain constant, as more and more units of variable factor are employed, the
proportion between fixed and variable factors goes on changing. So it is termed as the law of variable
proportions. This law states that if you go on using more and more units of variable factor (labour) with
fixed factor (capital), the total output initially increases at an increasing rate but beyond a certain point, it
increases at a diminishing rate and finally it falls. This law was initially called the law of diminishing
returns Marshall who applied the law only in agriculture sector but modern economist called it the law of
variable proportion and proposed its applicability to all the sectors of the economy.

Assumption of the law

The law operates under the following assumptions:

(i) The firm operates in the short run.

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(ii) There is no change in technology of production.
[ ]
(iii) The production process allows the different factor ratios to produce different levels out output.
(iv) All the units of variable factor are equally efficient.
(v) Full substitutability of factors of production is not possible.
According to the law when we employ more and more units of a variable factor with the fixed quantity of other
factors and technology, the marginal product of the variable factor first increases and then decreases. In other
words, with employment of more and more units of a variable factor with fixed quantity of other factors, the total
product first increases and then starts decreasing. It means that in short run labour is the only variable factor,
Return to labour or marginal product of labour initially increases but as more units of labour are employed its
MPP declines and may also become negative. There are three phases of returns to a variable factor which are
discussed below

this law can also be explained with the help of figure given below.

TPP
and TPP
A
MPP
PhaseI PhaseII PhaseIII

D
O X
Units of labour
( Variable input )
MPP
Y
Fig. 17.2

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LAW OF RETURNS TO SCALE
Law of Returns to Scale is a long run concept. In the long run, all factors of production become variable as the firm
is able to alter its stock of inputs in long run which is not the case in short run. When all factors are changed in
some proportion, the behaviour of output is analyzed with the help of laws of returns to scale. Thus, this law takes
into consideration not the varying units of inputs but changing scale of production. The scale of production of the
firm is determined by those input factors which cannot be changed in the short period. If the firm increases the units
of both factors labour and capital, its scale of production increases.
A return to scale is the rate at which the output increases with the increase in all inputs proportionately. There are
three cases of returns to scale:
Increasing Returns to Scale
Constant Returns to Scale
Diminishing Returns to Scale
Increasing Returns to Scale: When inputs are increased in a given proportion and output increases in a greater
proportion, the returns to scale are said to be increasing. In other words, proportionate increase in all factors of
production results in a more than proportionate increase in output is a case of increasing returns to scale. Thus, if
all inputs are doubled then total output is more than doubled.
For example, if the inputs are increased by 40% and output increases by 50%, return to scale are increasing. It is
the first stage of production. If the industry is enjoying increasing returns, then its marginal product increases. As
the output expands, marginal costs come down.
Constant Return to Scale: When inputs are increased in a given proportion and output increases in the same
proportion, the returns to scaleare said tobe constant. Thus, if all inputs are doubled then total output is also
doubled. For example, if inputs are increased by 40% and output also increases by 40%, the returns to scale are
said to be constant.
Decreasing Returns to Sale: If the firm continues to expand beyond the stage of constant returns, the stage of
diminishing returns to scale will start to operate. If a proportionate increase in all inputs results in less than
proportionate increase in output, the returns to scale are said to be decreasing. Thus, if all inputs are doubled then
total output is less than doubled.
For example, if inputs are increased by 40%, but output increases by only 30%, it is a case of decreasing returns
to scale. Decreasing return to scale implies increasing costs.
Units of Units of Total % Change % Change Returns to
Capital Labour Output in Inputs in Output Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing

Increasing Returns: % change in output > %

change in inputs
Constant Returns: % change in output = %
change in inputs
Decreasing Returns: % change in output < %
change in inputs

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 [ ]

Isoquant Curve

Introduction:-
An Iso-cost line is a line which represents those various combinations whose costs are equal. In other words,
this line represents various combinations of two factors which can be obtained by a firm on equal cost. Like
various Isoquant curves, there are various iso-cost lines which represent various level of production.

What is an Isoquant Curve?

In the unit of Production Function and Principle of Production, we have already studied regarding a firm that it
increases its production by using more variable factors or using all factors. In this unit, we would study about that
firm which increases its production by using those two variable factors which are substitutes of each other. To
get this, one production function is added with two variable factors. Suppose that these factors are labour and
capital. The production function of firm can be represented like

Y = f (K, L)
(Here Y = Production; K = Capital and L = Labour)
The variable factors are substitutable and the decreasing return to a factor law amplifies on each factors. In this
functional function, Y is a dependent variable and L and K are independent elements. So if we draw relation
between all three elements (Labour, Capital and Production) then this type of drawing can only be obtained by
three dimensional drawing, which is very complex. To draw this image it is easier to suppose production Y as
stable element. Then this functional relation states that how stable level of production is created by using the
combinations of two variable factorscapital and labour. The Isoquant curve is called the geometric
representation of this functional relation. The Isoquant Curve is a technical relation showing how inputs are
converted into outputs. It is also an efficiency relation showing the maximum amount of output with a given
amount of inputs. In other words, if the quantity of factors and prices are given then it represents the
minimization of cost or the combination of factors in its optimum level.
Isoquant or Isoproduct has been derived from two words, Iso = Equal and Quant = Quantity or Product = Output.
So it means equal quantity or equal production. To produce a product, factors are required. These factors can be
substituted to each other. For example, production of 100 watches can be produced by using 90 units of capital
and 10 units of labour. So the production of 100 watches can also be made by using other combinations of labour
and capital like 60 units of capital and 20 units of labour or 40 units of capital and 30 units of labour. If the
combinations of two factors are represented into a curve to produce an equal amount, then this type of curve is
called Isoquant or Iso-product curve. Isoquant curve is that curve which shows the different possible
combinations of two factor inputs yielding the same amount of output. The Isoquant curves can also be called
equal product curve or iso-product curve or marginal curve. The Isoquant curve is called marginal curve because
it amplifies the marginal curve analysis of theory of consumption to theory of production.
Assumptions
The main assumptions of Isoquant curve are
1. Two Factors of Production: To draw these curves, in view of simplicity, it assumes that only two factors of
production are used to produce a product. Both the factors are variable.
2. Constant Technique: It assumes that the production technique is constant or given.
3. Divisible Factor: It assumes that the factor of production is divisible or it can be used in small quantity.
4. Possibility of Technical Substitution: It must be assumed that there is possibility of technical substitution
between two factors. Means the production calculation is Variable Proportion Type and not Fixed Proportion
Type.
5. Efficient Combination: It also assumes that in given technique, the factor of production is used in its efficient
combination.
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Explanation
The Isoquant curve can be described by following table which represents various combinations of two factors
(labour and capital) for production.
Table 1: Isoquant Schedule

Combination Product Capital (K) Labour

(Watch) (L)
A 100 90 10

B 100 60 20

C 100 40 30

D 100 30 40
Above table indicates that 100 watches can be made by following combinations of labour and capital
(A) 90 units of capital and 10 units of labour
(B) 60 units of capital and 20 units of labour
(C) 40 units of capital and 30 units of labour
(D) 30 units of capital and 40 units of labour

In the above table, the combination of capital and labour can be represented by figure or graph too. capital is
shown on axis OY and labour is shown on axis OX. Point A represents that 100 units of watches can be produced
by 90 units of capital and 10 units of labour. While point B indicates that this same quantity of watches can be
produced by 60 units of capital and 20 units of labour. Thus the point C indicates that the production of 100
watches can occur by 40 units of capital and 30 units of labour. While point D represents that the same quantity
of watches can be produced by 30 units of capital and 40 units of labour. Thus A, B, C and D represent various
combinations of labour and capital which produce the similar quantity of watches (100). So the IQ curve which
comes by adding the point A, B, C and D is called Equal Product Curve or Isoquant Curve. This Isoquant curve
describes that to produce a fixed quantity of product, there are various combinations of factors.

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 [ ]

Principle of Marginal Rate of Technical Substitution

The principle of marginal rate of technical substitution (MRTS or MRS) is based on the production function where

two factors can be substituted in variable proportions in such a way as to produce a constant level of output. The

marginal rate of technical substitution between two factors C (capital) and L (labour), MRTSLC is the rate at which

L can be substituted for C in the production of good X without changing the quantity of output.

As we move along an isoquant downward to the right each point on it represents the substitution of labour for

capital. MRTS is the loss of certain units of capital which will just be compensated for by additional units of labour

at that point. In other words, the marginal rate of technical substitution of labour for capital is the slope or

gradient of the isoquant at a point. Accordingly, slope = MRTSLC = AC/AL. This can be understood with the aid of

the isoquant schedule, in Table 2.

The above table 2 shows that in the second combination to keep output constant at 100 units, the reduction of

3 units of capital requires the addition of 5 units of labour, MRTSLC = 3 : 5. In the third combination, the loss of 2

units of capital is compensated for by 5 more units of labour, and so on.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines which show the different

levels of output. A higher iso-product curve represents a higher level of output. In Fig. 2 we have family iso-product

curves, each representing a particular level of output. The iso-product map looks like the indifference of consumer

behaviour analysis. Each indifference curve represents particular level of satisfaction which cannot be quantified.

A higher indifference curve represents a higher level of satisfaction but we cannot say by how much the

satisfaction is more or less. Satisfaction or utility cannot be measured.

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An iso-product curve, on the other hand, represents a particular level of output. The level of output being a

physical magnitude is measurable. We can therefore know the distance between two equal product curves.

While indifference curves are labeled as IC1, IC2, IC3, etc., the iso-product curves are labelled by the units of

output they represent -100 metres, 200 metres, 300 metres of cloth and so on.

Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to

decrease capital to produce a given level of output.

The downward sloping iso-product curve can be explained with the help of the following figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the amount of capital has to be

decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in the figure.

The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the help of the following

figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are increased- labour from L to Li and

capital from K to K1. When the amounts of both factors increase, the output must increase. Hence the IQ curve

cannot slope upward from left to right.

(ii) The figure (B) shows that the amount of labour is kept constant while the amount of capital is increased. The

amount of capital is increased from K to K1. Then the output must increase. So IQ curve cannot be a vertical straight

line.

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 [
(iii) The figure (C) shows a horizontal curve. If it is horizontal
the quantity ]
of labour increases, although the quantity

of capital remains constant. When the amount of capital is increased, the level of output must increase. Thus, an

IQ curve cannot be a horizontal line.

2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to

understand the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an

isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of technical substitution

between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. It

can also be defined as the slope of an isoquant.

It can be expressed as:

MRTSLK = K/L = dK/ dL

Where K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other words, a

declining MRTS refers to the falling marginal product of labour in relation to capital. To put it differently, as more

units of labour are used, and as certain units of capital are given up, the marginal productivity of labour in relation

to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C to D along an isoquant,

the marginal rate of technical substitution (MRTS) of capital for labour diminishes. Everytime labour units are

increasing by an equal amount (AL) but the corresponding decrease in the units of capital (AK) decreases.

Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves cannot cut each other. In Fig. 6, two Iso-

product curves intersect each other. Both curves IQ1 and IQ2 represent two levels of output. But they intersect

each other at point A. Then combination A = B and combination A= C. Therefore B must be equal to C. This is

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absurd. B and C lie on two different iso-product curves. Therefore two curves which represent two levels of output

cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown in the figure 7 given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital. IQ1 represents an output

level of 100 units whereas IQ2 represents 200 units of output.

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal.

Usually they are found different and, therefore, isoquants may not be parallel as shown in Fig. 8. We may note

that the isoquants Iq1 and Iq2 are parallel but the isoquants Iq3 and Iq4 are not parallel to each other.

6. No Isoquant can Touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone

without using capital at all. These logical absurdities for OL units of labour alone are unable to produce anything.

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 [
Similarly, OC units of capital alone cannot produce anything without
the use of]
labour. Therefore as seen in figure

9, IQ and IQ1 cannot be isoquants.

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a

producer uses more of capital or more of labour or more of both than is necessary, the total product will

eventually decline. The firm will produce only in those segments of the isoquants which are convex to the origin

and lie between the ridge lines. This is the economic region of production. In Figure 10, oval shaped isoquants are

shown.

Curves OA and OB are the ridge lines and in between them only feasible units of capital and labour can be

employed to produce 100, 200, 300 and 400 units of the product. For example, OT units of labour and ST units of

the capital can produce 100 units of the product, but the same output can be obtained by using the same quantity

of labour T and less quantity of capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The dotted segments

of an isoquant are the waste- bearing segments. They form the uneconomic regions of production. In the up

dotted portion, more capital and in the lower dotted portion more labour than necessary is employed. Hence GH,

JK, LM, and NP segments of the elliptical curves are the isoquants.

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Expansion Path:
As financial resources of a firm increase, it would like to increase its output. The output can only be increased if

there is no increase in the cost of the factors. In other words, the level of total output of a firm increase with

increase in its financial resources. By using different combinations of factors a firm can produce different levels of

output. Which of the optimum combinations of factors will be used by the firm is known as Expansion Path. It is

also called Scale-line. Expansion path is that line which reflects least cost method of producing different levels of

output. Stonier and Hague

Expansion path can be explained with the help of Fig. 16. On OX-axis units of labour and on OY-axis units of capital

are given. The initial iso-cost line of the firm is AB. It is tangent to IQ at point E which is the initial equilibrium of

the firm. Supposing the cost per unit of labour and capital remains unchanged and the financial resources of the

firm increase.

Economies and Diseconomies of Scale

We have already said that the U-shape of LAC curve is because of returns to scale. And returns to scale
is the result of economies and diseconomies of scale. With the expansion of the scale of production firms
get certain advantages, these are termed as economies of large scale production. But when the scale
of production exceeds a certain limit, it leads to disadvantages or diseconomies of scale to the firms. Thus
the firms get economies and diseconomies of scale with the expansion of output. These are termed as
economies and diseconomies of large scale production. Economies refer to the saving in per unit cost as
output increases. On the other hand, diseconomies refer to the disserving in the per unit cost as output
increases.
Economies and diseconomies of scale are broadly classified into two groups:
(A) Internal economies and diseconomies
(B) External economies and diseconomies.
These are discussed as below:
(A) Internal Economies and Diseconomies
Economies and diseconomies that accrue to a firm out of its internal situation when its scale increase are
termed as internal economies and diseconomies. Now we shall discuss them in detail.
Internal Economies
Internal Economies that accrue to a particular firm with the expansion of its output and scale are
termed is internal economies. Internal economies of a firm are independent of the action of other

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 firms. They are internal in the sense that they are limited to a firm when its output increase. They
[ ]
are not shared by other firms in the industry. Following are the main types of internal economies:
(i) Labour Economies Division of labour and specialization are possible more in large-scale
operations. Different types of workers can specialize and do the job for which they are more
suited. A worker acquires greater skill by devoting his attention to a particular job. As a result
of this quality and speed of work both improve.
(ii) Technical Economies The main technical economies result from the indivisibilities.
Several capital goods, because of the strength and weight required, will work only if they
are of a certain minimum size. There is a general principle that as the size of a capital good
is increased, its total output capacity increases far more rapidly than the cost of making it.
(iii) Marketing Economies Marketing economies arise from the large scale purchase of raw
materials and other inputs. A firm may receive large discounts on the purchase of bigger
volume of raw materials and intermediate goods. Marketing economies can also be reaped
by the firm in its sales promotion activities. Advertising space (in newspapers and magazines)
and time (on television and radio), and the number of salesmen do not have to rise
proportionately with the sales. Thus per unit selling cost may also fall with the increase in
output.
(iv) Managerial Economies Managerial economies arise from specialization of management
and mechanisation of managerial functions. Large firms make possible the division of
managerial tasks. This division of decisionmaking in large firms has been found very
effective in the increase of the efficiency of management.
(v) Financial Economies Large firms can easily raise timely and cheap finance from banks and
other financial institutions and also from the general public by issue of shares and
debentures.
(vi) Risk-bearing Economies A large firm can more successfully withstand the risks of business.
With the product diversification and by operating in several markets a large firm can
withstand the risk of changing consumers tastes and preferences.
(vii) Economies Related to Transport and Storage Costs Large firms are able to enjoy freight
concessions from railways and road transport. Because a large firm uses its own transport
means and large vehicles, the per unit transport costs would fall. Similarly, a large firm can
also have its own storge godowns and can save storage costs.
(viii) Other Economies A large firm may also enjoy some other economies with the expansion of
its output. Prominent among them are economies on conducting research and
development activities and economies of employee welfare schemes.
As a result of all these internal economies firms long-run average and marginal cost decline with
the increase in output and scale of production.
Internal Diseconomies

Internal Diseconomies are those disadvantages which are internal to the firm and accure to the firm
when it over expands its scale of production. The main internal diseconomies of scale are as
follows: -

(i) Management Diseconomies and Diseconomies Related to Division of Labour These

diseconomies occur primarily because of increasing managerial difficulties with too large a
scale of operations. It becomes difficult for the top management to exercise control and to
bring about proper coordination.

(ii) Technical Diseconomies If a firm frequently changes in it technologies and uses new
technologies and new machines, it may increase its costs. After a certain limit, the large size
or volume of the plant and machinery may also prove disadvantageous.

(iii) Risk-taking Diseconomies The business cannot be expanded indefinitely because of the
principle of increasing risk. The risk of the firm increases because of reduction in demand,
change in fashion and introduction of new substitutes in the market.

(iv) Marketing Diseconomies A large firm is forced to spend more on bringing and storing of
raw materials and selling of finished goods in the distant markets.

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 (v) Financial Diseconomies A large firm has to borrow a large amount of money even at higher
rate of interest. It imposes a burden on the financial position of the firm.

Impact of Internal Economies and Diseconomies on the LAC Curve

When a firm accrues internal economies with the expansion of its scale of output, the LAC curve
would fall. And when after a certain point, a firm receives internal diseconomies with the
expansion of its scale of output, the LAC curve would rise.

Thus, internal economies causes the LAC to fall and internal diseconomies cause the LAC to rise.
Hence the internal economies and diseconomies are responsible for the U-shaped of the LAC
curve. It is shown in the diagram.

(B) External Economies and Diseconomies

Economies which accrue to the firms as a result of the expansion in the output of the whole industry are
termed external economies. They are external in the sense that they accrue to the firms not out of its
internal situation but from outside it i.e., from expansion of the industry. Jacob Vinor has defined
external economies as those which accrue to particular concerns as the result of expansion of
output by the industry as a whole and which are independent of their own individual output.
Following are the main forms of external economies.
(i) Economies of Localisation/Concentration - When an industry develops in a particular region,
it brings with it all the advantages of localization. All the firms of this industry get the following
main advantages:

(a) Easy availability of skilled manpower;

(b) Improvement in transportation and communication facilities;

(c) Availability of banking, insurance and marketing services;

(d) Better and adequate sources of energy-electricity and power;

(e) Development of ancillary industries.

(ii) Economies of Disintegration/Specialisation The industry can have advantages from the
economies of specialization when each firm specializes in different processes necessary for
producing a product. For instance in a cloth industry some firms can specialise in spinning, others
in printing etc. As a result of specialisation all the firms in the industry would be benefited.

(iii) Economies related to Information Services Firms in an industry can jointly set-up facilities for
conducting research, publication of trade journals and experimentation related to industry.
Thus, besides providing market information, the growth of the industry may help in discovering
and spreading improved technical knowledge.

(iv) Economies of Producers Organisation Firms of an industry may form an association. Such
an association can have their own transport, own purchase and marketing departments, own
research and training centres. This will help to reduce costs of production to a great extent and
shall be mutually beneficial.

External Diseconomies

Diseconomies which accrue to the firms as a result of the expansion in the output of the whole
industry are termed external diseconomies. The main external diseconomies are as follows:

COMPILED BY PROF.RUPESH R DAHAKE, COMMERCE DEPARTMENT ADARSHA MAHAVIDYALAYA DHAMANGAON RLY

 (i) Increase in input price When the industry expands, the demand for factor-inputs
[ ]
increases. As a result the input prices (such as wages, prices of raw materials and
machinery equipments, interest rates, transport and communication rates etc.) shoot up.
This causes the cost of production to rise.

(ii) Pressure on Infrastructure Facilities Concentration of firms in a particular region creates

undue pressure on the infrastructure facilities transportation, water, sanitation, power and
electricity etc. As a result, bootlenecks and delays in production process become frequent
which tend to raise per unit costs.

(iii) Diseconomies due to Exhaustible Natural Resources Diseconomies may also arise
due to exhaustible natural resources. Doubling the fishing fleet may not lead to a doubling
of the catch of fish; or doubling the plant in mining or on an oil-extraction field may not
lead to a doubling of output.

(iv) Diseconomies of disintegration When the production of a commodity is disintegrated

among various processes and sub-process, it may prove disadvantageous after a certain
limit. The problem and fault in any one unit may create limit. The problem and fault in any
one unit may create problem for whole of the industry. Coordination among different
concerns also poses a problem.

II. THEORY OF COSTS

In the process of its decision-making, in order to be able to decide the price of the product at which it would offer
the same in market; a firm needs to acquaint itself with the costs of producing the product. The cost of supplying
the product is determined by the productivity and the prices of the inputs used. The cost function of a firm shows a
relationship between output produced and the associated cost of producing it. Hence, costs are nothing but input
prices. There are four major inputs as discussed; land, labour, capital and entrepreneurship. The costs attached
with each are; rent, wages, interest and profits respectively.
Like production, costs of a firm may also be analyzed in the context of time period as follows:
Short Run Costs
Long Run Costs

Total Cost Curves in the Short Run

There are three concepts concerning total cost in the short period : Total fixed cost; total variable cost
and total cost.
(i) Total Fixed Cost (TFC) Total Fixed Costs are those costs that do not vary with the output. They
continue to be the same even if output is zero or 1 unit or 10 lakhs units. Thus, they are totally
unaffected by the changes in the rate of outputs. These costs are also often referred to as
supplementary costs or overhead costs or unavoidable costs. Examples of fixed costs are : (i) Initial
establishment expenses, (ii) Rent of the factory, (iii) Expenses on maintenance of Machinery; (iv)
Wages and salaries of the permanent staff, (v) Interests on bonds, (vi) Insurance premium.
TFC = quantities of the fixed productive service x factor price.
Total fixed cost of a firm is illustrated in the following table and diagram :

COMPILED BY PROF.RUPESH R DAHAKE, COMMERCE DEPARTMENT ADARSHA MAHAVIDYALAYA DHAMANGAON RLY

60
 Units of TFC (`)
output
0 20
1 20
2 20
3 20
4 20
5 20

Fig.1.32: Total Fixed Cost Curve

TFC curve is a horizontal line parallel to the x-axis which explains total fixed cost remains the same at
all levels of output.

(ii) Total Variable Cost (TVC) The costs that vary directly with the output and rises as more is produced
and declines as less is produced, are called total variable costs. They are also referred to as prime
costs or special costs or direct costs or avoidable costs. Examples of variable costs are : (i) wages of
temporary labourers; (ii) raw materials; (iii) fuel; (iv) electric power, etc.
TVC = quantities of the variable factor service factor price.
Total Variable Cost is illustrated in the following table and diagram :

Units of TVC (`)

output
0 0
1 18
2 30
3 40
4 52
5 65
6 82
7 106
8 140

Fig.1.33: Total Variable Cost Curve

Our above table and diagram indicate that total variable cost varies directly with the volume of output.
TVC curve starts from the origin, up to a certain range remains concave from below and then
becomes convex. It shows that in the beginning, total variable cost rises at a diminishing rate and
thereafter, it rises at increasing rates.

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(iii) Total Cost Total Cost means the total cost of producing any given amount of output. When we add
[ ]
total fixed and total variable costs at different levels of output, we get the corresponding total costs.
Thus, TC = TFC + TVC
Since, fixed costs are constant and variable costs necessarily rise as output rises, total costs also rise with
the output or, to put the point more technically, TC is a function of total product and varies directly
with it : TC = f(q).
TC (Total Cost) curve can be obtained by adding TFC and TVC curves vertically at each point.
Again, since the total fixed cost, by definition remains constant, the changes in the total costs are entirely
due to the changes in total variable costs. In other words, the rate of increase of total cost is the
same as of total variable cost, as one of the two components of total cost remains constant. TC and
TVC curves, therefore, have the similar shapes, the only difference is that TVC curve starts
from origin (O) while TC curve starts above the origin. Initially TC will include the amount of TFC and
hence it starts from the positive intercept.
The relationship between these three TFC, TVC and TC is illustrated in the following table and diagram
:
Example:
Units of Output TFC (`) TVC (`) TC (`)
0 20 0 20
1 20 18 38
2 20 30 50
3 20 40 60
4 20 52 72
5 20 65 85
6 20 82 102
7 20 106 126
8 20 140 160

Fig.1.34: Cost Curves

1.7.7 Unit Cost Curves in Short-Run

The short-run unit cost curves are : Average Fixed Cost (AFC) curve; Average Variable Cost (AVC) curve;
Average Total Cost (ATC) or Average Cost (AC) curve; and Marginal Cost (MC) curve. For price and
output determination, per unit cost curves are more useful than the total costs just discussed.
(i) Average Fixed Cost (AFC) Average fixed cost can be obtained by dividing total fixed cost (TFC) by
the quantity of output (Q),
AFC = TFC/Q
Since total fixed costs remain the same, as output rises, average fixed cost diminishes but never becomes
zero.

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Features of AFC (i) As output rises, the average fixed cost (AFC) goes on declining. The AFC curve is,
therefore, a downward sloping curve, (ii) As output approaches zero, average fixed cost
Units of TFC (`)
Production
0 20
1 20
2 20
3 20
4 20
5 20
6 20
table and diagram.
approaches infinity, but AFC curve never
AFC (`) touches the y-axis. On the other hand, as
output reaches very high levels, average
- fixed cost approaches zero, but it never
becomes zero, it always remains positive.
20
Hence the AFC curve never touches the
10 x-axis. Thus it follows that AFC curve never
touches either of the axis. Actually AFC
6.67 curve takes the shape of rectangular
5 hyperbola which shows that the area
under the curve (i.e. total fixed cost)
4
always remains the same.
3.33 AFC is illustrated in the following

Y
20
16
C
12
ost
8
4
AFC
0
1 2 3 4 65 X
Output

Fig.1.35: Average Fixed Cost Curve

(ii) Average Variable Cost (AVC) Average variable cost can be obtained by dividing the total variable
cost (TVC) by the quantity of output (Q).
AVC = TVC/Q

This is illustrated in the following example and diagram :

Units of TVC AVC
Producti (`) (`) Y
on AVC
20
0 0 -
1 18 18 16

2 30 15 C
os 12
3 40 13.33 t
8
4 52 13
5 65 13 4
6 82 13.67
0
7 106 15.14 1 2 3 4 5 6 7 8 X
Output
8 140 17.5

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 Fig.1.36: Average Variable Cost
[ ]
As output rises, the AVC curve first falls, reaches a minimum and then begins to rise. Thus, AVC curve has
a U-shape. In above example, AVC falls up to 5 units of output, thereafter, it starts to rise.
(iii) Average Total Cost (ATC) or Average Cost (AC) Average total cost (ATC) is obtained by dividing
the total cost (TC) by the quantity of output (Q). Thus, average cost (AC) is the per unit cost of
production of a commodity. Or, alternatively, it can also be obtained by adding average fixed cost
(AFC) and average variable cost (AVC).
ATC = TC/Q
Or, ATC = AFC + AVC
Diagrammatically the vertical summation of average fixed cost and average variable cost curves gives
us the average total cost curve. The ATC curve is also a U-shaped curve.
(iv) Marginal Cost (MC) Marginal cost is the increase in total cost resulting from one unit increase in
output. In short, it may be called incremental cost. Thus,
MC = dTC/dQ

Or, MC = TCn - TCn-1

Here, MC = Marginal Cost

TCn = Total Cost of n units of output

TCn-1 = Total Cost of n-1 units of output

Suppose the total cost of 4 units of output is ` 72 and the total cost of 3 units is ` 60, then the marginal cost
of 4 units level of output will be ` 12 (` 72 ` 60).
Actually, MC is marginal variable cost since marginal fixed cost in absurd.

i.e. MC = TVC
Q

Again, TC = TFC + TVC

Taking changes in TC with respect to output Q,

dTC dTVC
=
dQ dQ

or MC = MVC
Since a change in total cost is caused only by a change in total variable cost, marginal cost may also be
defined as the increase in total variable cost resulting from one unit increase of output. Thus, marginal
cost has nothing to do with the fixed costs.
Suppose the total variable cost of 4 units of output is ` 52 and the total variable cost of 3 units is ` 40, then
the marginal cost will be ` 12 (52-40).
The estimation of marginal cost (MC) from total cost (TC) and total variablce cost (TVC) is indicated in
the table below:
Units of TFC TVC TC (TFC + TVC) MC (TCn TCn-1)
output (`) (`) (`) (`)
(1) (2) (3) (4) (5)

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 0 20 0 20 -
1 20 18 18
38
2 20 12
3 20 30 50
10
4 20 40 60 12
5 20 13
6 20 52 72
17
7 20 65 85 24
8 20 34
82 102
106 126
140 160
The marginal cost curve based on the above table is depicted in the figure below:

Fig.1.37
The different short-run cost are illustrated in the following table and diagram below :

1.7.7.1 Why is MC curve U-shaped in the short-run?

Units of Outpt TVC (`) AVC (`) MC (`)
0 0 - -
1 18 18 18
2 30 15 12
3 40 13.33 10
4 52 13 12
5 65 13 13
6 82 13.67 17
7 106 15.14 24
8 140 17.5 34

COMPILED BY PROF.RUPESH R DAHAKE, COMMERCE DEPARTMENT ADARSHA MAHAVIDYALAYA DHAMANGAON RLY

 Fig.1.38: Cost Curves
[ ]
From the table and diagram, as output rises, the MC curve first falls reaches a minimum and then
begins to rise.
Thus, MC curve has a U-shape.
The reason behind the U-shape of the MC curve is the operation of the law of variable proportions.
The law states that with the increase in a variable factor, keeping other factors constant, the marginal
physical product (MPP) first increases, and then after a certain level of production, it starts to decline.
In the beginning the stage of increasing returns operates which increases the MPP, and after a certain
point, the stage of diminishing returns starts to operate which reduces the MPP.
On the basis of this in output, initially, the rate of increase in the requirement of variable factor is less
and less, and, after a certain point, it is more and more.
This implies that initially in the stage of increasing returns marginal cost (i.e., the rate of increase in the
variable cost) diminishes with the increase in output.
Then, after reaching a certain limit, in the stage of diminishing returns marginal cost rises with the further
increase in output.
Thus the marginal cost curve becomes U-shaped.

1.7.7.2 Why are AVC and ATC curves U-shaped?

The shapes of AVC and ATC curves are influenced by the shape of MC curve in the short-run.
The shape of MC curve is U-shaped because of the operation of the law of variable proportions.
Consequently, AVC and ATC curves are also U-shaped.
Initially, in the stage of increasing returns when marginal cost curve falls, the AVC and ATC curves also
fall.
After a certain level of output in the stage of diminishing returns when marginal cost curve rises, the
AVC and ATC curves also rise.
Thus, because of the operation of law of variable proportions as output rises, the AVC and ATC curves
first fall, reach their minimum and the begin to rise.
So, in the short-run, MC curve, AVC curve and ATC curve all are U-shaped.

1.7.7.3 Relationship between AC and MC

Recall the meaning of AC and MC which we have discussed earlier.
Average Cost is simply the total cost (TC) divided by the number of units produced (Q) or it is the cost per
unit.
On the other hand, marginal cost is defined as the increment of total cost that comes from producing an
increment of one unit of output.
The relationship between AC and MC is illustrated in the following table and diagram below:

Units of Outpt TC AC MC
0 20 - -
1 38 38 18
2 50 25 12
3 60 20 10
4 72 18 12
5 85 17 13
6 102 17 17
7 126 18 24
8 160 20 34

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 Fig.1.39
The table and diagram reveal the relationship between AC and MC as under :
(i) When MC is less than AC (or MC curve remains below AC curve), the AC curve falls. For example
units 1 to 5 and diagram up to point B (or OM1 output) show this situation.
(ii) When MC is equal to AC, AC becomes constant. This is the minimum point of AC, and it is at this
minimum point, that MC curve cuts AC from below. In this regard 6th unit in the example and point
B in the diagram may be seen. This confirms that MC passes through the minimum point of AC.
(iii) When MC is higher than AC (or MC curve rises above the AC curve), AC starts rising. It is shown as
6th unit and thereafter in the example and point B onwards in the diagram
Thus, AC-MC relationship can be summarized as follows: So long as MC is below AC, it keeps on pulling
AC down; when MC gets to be just equal to AC, AC neither rises nor falls and is at its minimum; and when
MC goes above AC, it keeps on pulling AC up.

Long - Run Cost

In the long-run, a firm can vary its scale of plant as and when it requires. All factor-inputs are thus variable
in this period. Therefore, there are no fixed cost curves in the long-run. All cost curves in the long-run are
basically variable cost curves. Here we find the following cost curves : Long-run Total Cost (LTC) curve;
Long-run Average Cost (LAC) curve; and Long-run Marginal Cost (LMC) curve.
Long-run Average Cost Curve:
A firm has a fixed scale of plant in the short-run.
A short-run Average Cost (SAC) curve corresponds to a particular scale of plant.
In the short-run, the firm can operate only on a particular scale of plant.
In the long-run a firm can choose among possible sizes of plant or it can move from one scale of plant
to the other scale of plant.
The choosing of the scale of plant is depends on the quantity of output that a firm wants to produce.
A firm would like to produce a given level of output at the minimum possible cost.
The firm would like to build its scale of plant in accordance with the quantity of output in such a way
that it can minimise its average cost.
Suppose a firm can have three possible scales of plant which are shown by SAC 1, SAC2 and SAC3
curves in the diagram.
In the long-run, a firm can choose any scale of plant out of these three plants.
The choice of the scale of plant will depend on the quantity of output.

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 [ ]

Fig.1.40
Upto OQ1 quantity of output, the firm will operate on the SAC 1 scale of plant because it gives the
minimum average cost.
The output larger than OQ1 but less than OQ2 will be produced at SAC2 scale of plant.
If the firm wants to produce the output larger than OQ 2 (say OQ3) then it will operate on SAC3 scale
of plant.
In the long-run a firm will choose that scale of plant which yields minimum possible average cost for
producing a given level of output.
Given that only three sizes of plants (as shown in the diagram above) are possible, then the bold dark
portion of these SAC curves forms long-run average cost curve.
Thus each point on this LAC represents the least average cost for producing that level of output.

Fig.1.41
Suppose instead of three plant sizes, there are infinite number of plants corresponding to which there
will be numerous short-run average cost curves.
Here the long-run average cost (LAC) curve will be a smooth and continuous line as shown in the
diagram above.
The curve will be tangent to each of the short-run average cost curves.
The curve shows the least possible average cost of producing any output, when the scale of plants
can be varied.
The LAC curve is also called envelop curve as it envelopes a family of short-run average cost curves
from the below.
The LAC curve is also termed as planning curve because a firm plans to choose that short-run plant
which allows it to produce the expected output at the minimum cost in the long-run.

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III. THEORY OF REVENUE

Revenue or receipts of a firm are derived from the sale of its output. The basic reasoning related to cost concepts
applies here as well. There are three concepts of revenue theory namely;
Total Revenue
Average Revenue
Marginal Revenue
Total Revenue (TR) represents total sales proceeds of the firm and is equal to per unit price multiplied by the
quantity sold.
TR= Price Per Unit (P) x Quantity Sold(Q)
Average Revenue (AR) is, by definition, the per unit price of the product. AR =
TR / Q
= Price Per Unit (P)
Marginal Revenue (MR) is the addition to total revenue when the quantity sold is increased by one unit. Marginal
revenue is addition to total revenue on account of an additional unit of output sold. It is ratio of change in total
revenue to change in total units sold.

MR= TRn- TRn-1

Or, MR = d(TR)/dQ
For the first unit sold, TR = AR= MR.
MR pertains to change in TR only on account of the last unit sold, while AR is based upon all the units sold by the
firm. Therefore, any change in AR results in a much bigger change in MR. Reduction in MR is far bigger than that
in AR; and similarly, an increase in MR is also much bigger than the corresponding increase in AR. The two are
equal only when AR is constant.
The firm will not sell any quantity if TR or AR becomes zero or negative. However, MR can become negative if the
fall in price is big enough.
Graphically, therefore, we have the following relationships.
Since TR, AR and MR equal for the first unit sold, therefore, the three curves start from the same point. TR curve
slopes upwards so long as MR is positive. If MR is falling with an increase in the quantity of sale, then TR curve
will gain height at a decreasing rate. It reaches its maximum height when MR curve touches X-axis. TR curve
slopes downwards when MR curve goes below X-axis to become a negative figure.
A change in AR causes a much bigger change in MR. Therefore, when AR curve has a negative slope; MR curve
lies below it and has a greater slope. Similarly, when AR curve has a positive slope, MR curve lies above it and
has a greater slope. When AR curve is parallel to X-axis, MR curve coincides with it.
In case AR is a straight line, MR curve will bisect each perpendicular distance of it from Y-axis. However, if AR
curve is parallel to X-axis, then MR curve coincides with it.
The above graphical relationships between AR and MR are shown in Fig. 3.6 to Fig. 3.9. In Fig. 3.6, AR has a
constant value DD. Therefore, AR curve starts from point D and runs parallel to X-axis. Since AR is a constant,
MR is always equal to AR and the two curves coincide with each other.
In Fig. 3.7, AR curve starts from point D on Y-axis and is a straight line with a negative slope. It indicates that as
quantity of good sold increases, its per unit price falls at a given rate. Accordingly, MR curve also starts from point
D and is a straight line. However, it is a locus of all those points which bisect the perpendicular distances between
AR curve and Y-axis. For example, FM= MA.

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Fig. 3.6 : Relationship between AR and MR Fig. 3.7 : Relationship between AR and MR
[ ]

PRODUCERS EQUILIBRIUM

Producers equilibrium refers to the level of output of a commodity that gives the maximum profit to the producer of
that commodity.

Profit( ) = Total Revenue Total Cost

= TR TC
Therefore, the output level at which total revenue less total cost is maximum is called the equilibrium level of
output. There are two approaches to arrive at producers equilibrium.
TR-TC Approach
MR-MC Approach

TR TC APPROACH

According to this approach, there are two conditions of producers equilibrium:

The difference between TR and TC is maximum
Profit falls if one more unit of output is produced (that is marginal cost becomes higher than marginal
revenue if one more unit is produced)

MR MC APPROACH

MR MC approach is another way of identifying producers equilibrium.

It is derived from the TR TC approach. The two conditions of TR-TC approach when derived in terms of MR =
MC approach become: MR = MC
MC cuts the MR curve from below to become greater than MR after the MR = MC output level.
1. MR = MC
When one more unit of output is produced, MR is the gain and MC is the cost to the producer. Clearly, so long as
benefit is greater than the cost, or MR is greater than MC, it is profitable to produce more. Therefore, so long as
MR is greater than MC, the firm has not achieved equilibrium level of output where the profit is maximum. The
equilibrium is not achieved because it is possible for the firm to add to profits by producing more.
The producer is also not in equilibrium when MR is less than MC because benefit is less than the cost. By producing
less, the producer or firm can add to his profits.
When MC is equal to MR, the benefit is equal to cost, the producer is in equilibrium subject to condition that MC
becomes greater than MR beyond this level of output.
When MC equals MR, the producers profit would be less if he produces output more than or less than the MR =
MC level of output as explained above.
Therefore, for attaining equilibrium it is a necessary condition (but not sufficient) that MC equals MR.
2. MC is greater than MR after MR = MC
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MR = MC is a necessary condition but not sufficient enough to ensure equilibrium.
It is because the producer may face more than one MR = MC outputs. But out of these only that output beyond
which MC becomes greater than MR is the equilibrium output. It is because if MC is greater than MR, producing
beyond MR = MC output will reduce profits. And when it is no longer possible to add to profits the maximum profit
level is reached.
On the other hand, if MC is less than MR beyond the MR = MC output, it is possible to add to profits by producing
more. Therefore this MR = MC level is not the equilibrium level. For a producer to be in equilibrium, it is necessary
that MC equals MR as well MC becomes greater than MR if more output is produced.

Table: 3.4 Equilibrium at Prevailing Prices

Price Per Output Total Total Marginal Marginal Profits
Unit Revenue Cost Revenue Cost
8 1 8 6 8 6 2
8 2 16 14 8 8 2

8 3 24 20 8 6 4

8 4 32 28 8 8 4

8 5 40 38 8 10 2

Note that in the above illustration MR = MC condition is satisfied both at output level of 2 units and the output level
of 4 units. But the second condition, MC becomes greater than MR, is satisfied only at 4 units of output. Therefore,
equilibrium output level is attained at 4 units.

Table: 3.5 Equilibrium at Lowering Prices

Price Per Output Total Total Marginal Marginal Profits
Unit Revenue Cost Revenue Cost
8 1 8 5 8 6 3

7 2 14 8 6 5 6

6 3 18 12 4 4 6

5 4 20 15 2 3 5

4 5 20 19 0 5 1
In this illustration the two conditions of equilibrium are satisfied at 3 units of output. MC equals MR and MC is
greater than MR when more output is produced. The producer is in equilibrium when he produces 3 units of output.
When a producer can sell more only by lowering the price, the MR curve is downward sloping. The typical MC
curve is U-shaped.

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