Meaning of Production Function

How a rational prodUINll\ makes his productio n

decis ions to maximise t,_..profits in order to attain
equilibrium Is deternt)ed by producer theory

Production Cost
Theory Theory

How much to produ ce? How to minimise cost?

• Production function is the relationship between physical input such as labour, capital a nd physical
output of a good. It is expressed in the following fonn:
Jax=f(L,K}I
where
Ox: Units of output x produced
L: Units of labour used
K: Units of capital used

• Based on period, the production function can be classified into 2 types:

o Short run production function
The time period In which a firm makes changes In Its production by changing only Its variable
factors but not its fixed factors is termed as short run i.e. one factor is fixed, rest all are variable.
O x=f(L,K)
o Long run production function
The time period In which a firm can change all the factors of production is termed as long run i.e.
all fac tors are variable.
Q x:a:f(L,K)
Factors of production
Factors of production are the inputs used in the product.ion process. These factors are classified into:

Variable Fixed
Factors o·f Factors of
Production Production

Varies with the ch,ange In Remain constant wlth the

output level change In output level
Labour and raw material Capital such as building,
machinery

Concept of Product

Product refers to the amount of goods and services produced by a firm or an Industry during a
particular period of time.

Product : TP, AP and MP

• Total Product (TP)/ Total Physical Product (TPP) is
the sum tota l of output produced by firm with fixed and
variable factors.
= =
TP l:Q or TP l:,MP
y
Units of Units of TP MP
Fixed Variable
Factor Factor
1 0 0 0
1 1 4 4
1 2 20 16
1 48 28 0.
3 I-
1 4 68 20
1 5 80 10
1 6 84 4
1 7 84 0
1 8 80 -4
0 Labour Input (units) X

• Marginal Product (MP)/ Marginal Physical Product

(M PP) is the additional output attributed to an
additional unit of the variable factor.
MP =ATP
AL
MPn = TPn - TPn - 1
 y
Units of Units of TP MP
Fixed Variable
Factor Factor
·1 0 0 0
1 1 4 4 M
1 2 20 16
1 3 48 28
1 4 68 20
1 5 80 10
1 6 84 4
1 7 84 0
1 8 80 -4 0 X
Labour lrnput (units)
MP
• Average Product (AP)/ Average Physical Product
(APP) Is the output produced by per unit of variable
input.
AP=TP y
L
Units of Units of TP MP AP
Fixed Variable
Factor Factor
1 0 0 0
1 1 4 4 4 a.
1
1
1
2
3
4
20
48
68
16
28
20
10
16
17
I
1 5 80 10 16 AP
1 6 84 4 14
1 7 84 0 12
0 Variable Inputs X
1 8 80 -4 10
 Relationship between Relationship between Relationship between
TP, AP and MP TPand MP AP and MP
• Positive and rising TP • TP increase at an increasing • When MP is greater than AP ,
indicates that AP and MP are rate indicates that MP AP Increases.
positive. Increases at increasing rate • When AP is max.imum , then
• When AP is maximum at point • When TP increases at AP is equal to MP.
B, MP Is equal to AP at point decreasing rrate, MP starts • When MP Is less than AP, AP
A. declining decreases
• When TP is maximum TP, MP • When TP is maximum, MP • When AP and MP fall, then
Is equal too at poin t N. becomes zero MP becomes zero and then
• When TP falls, MP becomes • When TP falls, MP becomes negative. However, AP
negative negative and continues to fall. remains positive.
• Both AP and MP are derived
from TP and are inverse U-
shaped curve.

II' n•
D
60

~
K ,\ I
~ rr
J'J'
,a
y
JO A

20

,a TJ1ht•1r l11p11I
.111' (unita)
Cl.
ij I l J 4 0 7 N J.1.1bu1.1r IJtput
(11mh,
E
Cl.
MP
M <
.'U

! I)
R

It)
0 Variable lnpuls X
N
I •bn11r lnpul Lubour h1pul
All' lwutl) Ml' (111111,,)

Law of Variable Proportions

States that as more and more of the variable factor is combined with the fixed factor, then Initially the
Total Product (TP) will increase but gradually after a point, the Total Product (TP) will start declining.
Assumptions of law of variable proportions are
 Constant Technology

Variable factors are

equally productive
· Phase I
TP increases at increasing rate
One of Inputs Is fixed MP increases
• Phase II
Changes in TP TP increases at decreasing rate
and MP MP decreases and remains positive
No change In Input Prices · Phase Ill
TPdeclmes
Different units of variable MP becomes negative
factor combined with
fixed factor
After a limit, factors of
production become
imperfect substitutes

Units of Units of TP MP AP Stages

Fixed Factor Variable Factor

1 0 0 - - Increasing MP and AP

1 1 10 10 10 (Increasing returns to a factor)

1 2 30 20 15
1 3 45 15 15 Diminishing MP and AP

" (Diminishing returns to a factor)

1 4 52 7 13
1 5 52 0 10.40'
Negative MP and decreasing AP
1 6 48 -4 8 (Negative returns to a factor)

• Stage I
As more units of factor input are used, MP tends to rise till 2 units of factor input are used and attains
maxi1mum point B. Here, the total product increases at an Increasing rate from O to A which is called
Increasing returns to the factor input. AP continues to increase throughout this Stage.
Reas ons
o The units of labour are not sufficiently used with the available fixed factors. So the firm increase
the number labour units with the fixed factor to increase the level of output.
o This facilitates the division of labour and hence the producUvity level Increases.
o This In turn Increases the specialisation of labour and therefore it leads to Improved efficiency of
labour with high productivity_
• Stage II
However, when the 3 rd unit of factor input is used, the diminishing returns set in , where MP starts
decreasing and It cuts AP from its maximum point C. TP Increa ses from A at a decreasing rate and
attains maximum point at D. Diminishing MP reduces to zero. The total output Is the maximum when
the marginal output is zero. Al' initially increases and attains its maximum and then decreases.
Reasons
o The units of labour are used more to use the fixed factors at the maximum level.
o There Is no perfect substitut'/on exists between labour and capital and hence the diminishing
returns take place.
o Once the optimum combination reached, the total product is maximum. Hence , the marginal return
to variable factor starts to diminish.
y
1st s1age 2 nd Stage 3rd ! Stag e
60
50
TP

i
0..
40
30
I-
2U
10

3 4 6
u, its or variable r c lo r ►

60
~o
i 40

-
0..
2
0 ..
<(
30

20
B

10

0 1 2 3

Units of variable factor- - -

• Stage Ill
When MP Is negative, TP starts declining from D when the 6th unit is employed and MP is negative.
AP continues to decrease and approaches the x-axis.
Reasons
o Over-utilisation of the fixed factors leads to negative returns to a factor.
o Here the cost of additional unit of labour is higher than Its contribution to the total production.
o It becomes inefficient to manage more units of labour in the production system.
A stage at which rational producer operate is
• A rational producer operates in Stage II of the law of variable proportions as:
o TP > O, AP > O and MP > O
o All factors are fully utilised
o P roductivity of factors Is maximum
• In Stage I
MP of every variable factor is positive implying hiring additional unit of variable factor will increase the
output and hence there is scope for more profits by increasing the production in Stage 1.
• In Stage Ill
MP of every variable unit is negative and hence no rational producer will operate in this· Stage
because of techn ica l inefficiency.

Law of diminishing returns

• States that as more and more of the variable factor is combined with the fixed factor, then initially the
Marginal Product (MP) of variab·l e factor will fall but gradually after a point, the MP will become
zero and then negative. This law is also known as law of diminishing marginal product.

Units of Units of TP MP y
Fixed Factor Variable Factor
16
1 1 12 12
12

1 2 22 10
1 3 30 8 - MP

1 4 36 6
1 5 30 5
X
1 2 3 4 5
Units of Variable factor

• Here MP falls as more and more units of variable factor inputs used with the fixed factor land. This law
emphasize only falling stage of MP and does not take into account the stage of rising MP .
• Law of variable proportion is an extension of law of diminishing returns because it also take into
account o f rising MP along with falling MP.
• Both the laws explain the same concept but from two different perspectives.

Costs and Revenue

Cost
• Cost refers to expenditure incurred in producing goods. It is the sum of explicit cost and implicit
cost.
o Explicit cost is the expendaure incurred or payments made to outsiders for their factor
services. It is recorded in the books of account. Examples: Payment of wages, Rent and
Insurance premium.
o Implicit cost Is the opportun~y cost of using the firm 's own resources . It is not recorded In
the books of account. Examples: Imputed value of the services of the owner of the firm and
imputed rent of the owner occupied building.
• Cost function is the functional relationship between the cost and output. It gives the least cost
combinations of inputs corresponding to various levels of output.

ICOST I
I
I I

Long Run

-
Short Run
Cost
- - Cos,t

Cost Incurred during

....
Cost incurred during
short run and includes long run and includes
fixed & variable costs var/able costs only

✓ Total Cost (TC) or ✓ Long Run Total Cost (L TC)

Short Rurn Total Cost (STC)
✓ long Run Average Cost (LAC)
✓ Average Cost (AC) o r
Short Run Average Cost (SA C) ✓ long Run Marginal Cost (f..MQ)
✓ Marginal Cost (MC) or
Short Run Marginal Cost (SMC)

Total Cost
TFC+ TVC=TC
Total Fixed Cost Horizontal straight line
0 It is the expenditure incurred on the purchase y,'
or hiring of fixed factors of production.
0 It does not change with change in quantity of 20
output. .......
(;_ 15 •
~

~ 10· ·

5 TFC

0
. . . . .
r

1 2 3 4 5 X
Output (Units)
Total Variable Cost Inverse S- shaped curve
0 It is the expenditure incurred on the use of y, ~ TVC

,/
variable factors of production. 50 •
0 It changes with change in quantity of output.
40
-
"'
~ 30 •

~ 20 •
~
/
;,
10 •
,,,
,/ ' ' . . . '
0 1 2 j 4 5 X
Oulpu1(Units)
Relationship between TC, TFC and TVC
y
o TC is obtained by vertically adding TFC and
lVC curves 80
TC
55
o TC starts from 5 and is parallel to TVC curve 50 1VC
o Gap between TC and iVC curves represents 45
TFC 40
g .. 35
111 30
8 25
20
15
10
5

X
Output (UnltS)

Average Cost
ATC=AFC + AVC
Average Fixed Cost Rectangular hyperbola
It is fixed cost per unit of output. TVC
(Rs)
AFC= TFC 5
Q
4

AFC

0 2 3 4 5 Oulplll (Units)

Average Variable Cost U-shaped curve

It is variable cost per unit of output. AVC
(Rs)
AVC=TVC 10 ~ AVC
Q
9
8
7
6
5
4
3
2
1
0
2 3 4 5 Output (Units)
 ru.. h,
Average Total Cost ( It >-)
15
o AC is obtained by vertically adding AFC and
AVC CUNes.
...
11

o AVC decreases along with decrease in AFC ll

= AC decreases. II
I (I
o As AFC becomes smaller and smaller, AVC ..,
increases = AC increases. ll
o AC Is a U-shaped curve since AVC Is also a 7

U-shaped curve due to the Law of Variable "5

Proportions. .0

o Distance between AC and AVC cuNes tends :,

to diminish, but two curves would never meet 2

each other. ,4F C

0 , , ~ ~ U u rpu t nm.io;J

Marginal Cost
MC= TC - TC
n n n•I

o Change In total cost when an additional unit u-shaped curve

of output is produced
o Also U-shaped curve In accordance with the .HC:
law of variable proportions

MC = TC - TC
n n
Or
MC;;:;LiTC =LiTVC
LiQ LiQ
o MC Is not affected by TFC. This is because in
s hort run one factor remains fixed, so any
additional increase in the cost should be on 0 OuJJ1111
(nni ts)
the cost on the employing an additional
variable factor.
I:MC = TVC
Relation ship between AC and MC
o AC decreases =MC decreases at a faster COStS
cR , I AC
ra te & MC< AC
o AC Is at its minimum point (z)= MC ;;:; AC
o AC increases = MC increases at a faster
rate and MC > AC
o MC curve cuts AC curve at its minimum point
0 AC and MC are both U-shaped CUNe = Law
of Variable Proportions
o AC includes variable and fixed cost, whereas,
MC Includes only variable cost
o AC a nd MC are both derived from TC.

0 ( hJtj'Ul t
( t 1111to
 Relationship between AVC and MC
o AVC decreases => MC decreases at a faster
Costs MC
rate and MC < A VC (Rs)
o AVC is at its minimum point => MC = AVC
o AVC increases => MC Increases at a faster
rate and MC > A VC
o MC curve cuts AVC curve at its minimum
point
o Minimum point of MC curve lie left to
minimum point of AVC curve
o AVC and MC are both derived from TVC
..__ _ _ X
_ _ _ _ _ _ _,. X

O Output
(Units)
Relationship between TC and MC
o TC Increases at decreasing ra te=> MC
decreases
o TC stops increasing at decreasing rate i.e. ati
'N'=> MC reaches its minimum point (x).
o TC increases at an increasing rate=> MC
increases
o TC consists of both variable as well as of
fixed costs, MC consists of only variable
costs
o TC curve Is an Inverse S-shaped curve, MC
UUtput
curve ls inverted U-shaped curve (uu1l•)
o MC is derived from TC MC
MC

u UU'tpUI
(umts)
Revenue
It is the income generated by a firm from the sale of a given quantity of goods in the market.

Revenue

Total Revenue Average Revenue Marginal Revenue

(liR) (AR) (MR)

Total sale proceeds of a Revenue earned per unit of Change In total revenue
producer output sold due to sale of one more
unit of output
I.B. =P xQ
AR =W=P M R = ~ TR (Or)
~Q
MB.o = IBJJ - IRa-1

Relationship between TR, AR and MR

• TR Is positively sloped straight line and increases at a constant rate (as MR is constant)
• Ave rage Revenue (AR) is constant as firm is price taker and price is fixed by the industry
• MR is also constant and equal to AR

AR/1vIR AR/MR
(<) ~
TR
25 5
D = AR = MR
20 4

15

10 2
5

011tp11t 0 Oulpul
2 3 4 5 2 3 4 5
(units) (units)

Break-even point
• A firm is said to be at the break-even point when it is just able to cover all its costs, i.e. when price ls
equal to average cost.
• According to the diagram, the break-even point is at Point R where price (OP) is equal to average
cost (OQ).
 y '

0 Q X
OulPUI
Shut-down point
• A firm is said to be at the shut-down point when it is just able to cover only the variable costs.
• At this point, price is equal to average variable cost. As the firm is not able to cover the fixed cost, it is
incurring loss equal to fixed costs.
• However, the firm will continue production till It can cover the fixed costs.
• According to the diagra m, the break-even point is at Point R where price (OP) Is equal to average
variable cost (OQ).

!l
I
rr Pi - - - - - - - - - - AR-MR
ii
8

0 Q X
Output