UNIT –III

THEORY OF PRODUCTION

Syllabus

• Production function, Law of variable proportions-short-run and long-run Laws of returns,

economies of scale, lso-quants, locusts, production equilibrium

• Cost-opportunity cost, Real cost, Types-short-run, long-run-Average, Marginal, Fixed, Variable

(with diagrams), Long run cost curve

• Revenue-Average, Marginal

Production Function
Production function may be defined as the functional relationship between inputs (i.e. factors of
production) and outputs (i.e. quantity of goods produced). A production function is a purely
technical relation which connects factor inputs and outputs. It represents the technology of a
firm, an industry or the economy as a whole. It includes all the technically efficient methods of
production:
a. The same output can be produced with less of one factor or
b. More output can be produced with the same inputs.
For example, 6 units of a commodity can be produced with either 2L and 3K or 3L and 3K.
A B
L 2 3
K 3 3
A is more technically efficient and B is technically inefficient.
If a process A uses less of some factor and more of some others compared to B, they can’t be
directly compared on the criterion of technical efficiency.
A B
L 2 1
K 3 4

In this case, both are considered as technically efficient and included in the production function.
Which one will be chosen is based on the prices of the factors.
For simplicity, assume that all inputs or factors of production can be grouped into two broad
categories, labor (L) and capital (K). The general equation for production function is
Q = f (K, L)
This function defines the maximum rate of output (Q) per unit of time obtainable from a given
quantity of labor and capital.
Economist use a variety of functional forms to describe production.
A production table shows the maximum rate of output associated with each combinations of
inputs, given a production function. Three important relationships can be observed from a
production table:
1. There are a variety of combinations to produce a particular rate of output. For example,
if 100 units of a commodity can be produced with any of the following combinations:
(6K, 1L), (3K, 2L), (2K, 3L) or (1K, 6L). This implies that there is substitutability
between the factors of production. The firm can use capital intensive procedure as the
first combination or a labor-intensive process as the last combination or an intermediate
process characterized by the other two combinations.
2. If the input rates are doubled, the output rates also increases. For example, with (1K, 4L)
Q =200. Doubling the inputs to (2K, 8L) Q = 400. The relationship between output
change and proportionate change in both the inputs is called returns to scale. The above
example is that of constant returns to scale (i.e. when input rates double output also
doubles). In other production functions, the output may increase more or less than in
proportion to change in inputs. When output increases more than in proportion to increase
in inputs, there is increasing returns to scale and if the output increases less than
proportionately to increase in inputs there is decreasing returns to scale.
3. In contrast to the concept of returns to scale, when output changes because one input
changes while other remains constant, the changes in the output rates are referred to as
returns to a factor. If the rate of one input is held constant while the other is increased,
output increases but the successive increments become smaller. This relationship holds
for all production processes and is the basis for an important economic principle known
as the law of diminishing marginal returns,
Although the production table and function provides considerable information on production
possibilities, it does not allow for the determination of the profit-maximizing rate of output or
even the best way to produce some specified rate of output. Thus, while production function is a
fundamental part of the decision-making process, it is an engineering relationship and must be
combined with data on price of capital, labor and output to determine the optimal allocation of
resources in the production process.
Laws of Production

Laws of Production

Long-run Short-run
(Law of returns to scale) (Laws of returns / Law of variable proportions)

Laws of Returns (Short-run Production)

In the short-run, all the factors are not variable. One factor is variable and the other is kept
constant. One factor can be kept fixed and the output can be increased by increasing the variable
factor until the full capacity of fixed factor is utilized.
Production with one variable input: total, Average and Marginal product
Total product of labor: the total amount of output that can be produced with a given amount of
labour, keeping all other factors constant.
Average product of labor: total product (TP) divided by the number of units of labor used.
APL = TP/L
Marginal product of labor: MPL is given by the change in total product per unit change in the
quantity of labor used.
MPL = ∆TP/∆L
The shapes of the APL and the MPL curves are determined by the shape of the corresponding TP
curve. The APL at any point on the TP curve is given by the slope of the straight line from the
origin to that point on the TP curve. The APL curve usually rises at first, reaches a maximum and
then falls, but it remains positive as long as the TP is positive. The MPL between two points on
the TP curve is equal to the slope of the TP curve between the two points. The MPL curves also
rises at first, reaches a maximum before the APL reaches the maximum and then declines. The
MPL becomes zero when the TP is maximum ( i.e. the slope of TP curve at its highest point is
zero) and negative when TP begins to decline. The falling portion of the MPL curve illustrates
the law of diminishing returns. MPL is plotted halfway between the quantities of labor used since
it is the change in TP per unit change in quantity of labor used.
The laws of returns are three aspects of one law, viz., the law of variable proportions. There are
three laws of returns: the laws of diminishing, increasing and constant returns. As equal
increments of one input are added, the inputs of other factors being held constant, there is
increasing, decreasing or constant returns depending on whether the marginal product will
increase, decrease or remain unchanged. In terms of cost, an industry is subject to increasing,
decreasing or constant returns depending on whether the marginal cost of production falls, rises
or remains the same, respectively, with the expansion of an industry.
Law of Variable proportions
The law of variable proportions is also called the law of proportionality. The law of variable
proportions/ the law of diminishing returns states that, “As equal increments of one input are
added, the inputs of other productive services being held constant, beyond a certain point, the
increments of product will decrease, i.e., the marginal products will diminish.” The law of
variable proportions states that as the quantity of one factor is increased, keeping the other
factors fixed, the marginal product of that factor will eventually decline. This means that up to
the use of a certain amount of variable factor, marginal product of the factor may increase and
after a certain stage it starts diminishing. When the variable factor becomes relatively abundant,
the marginal product may become negative.
Assumptions: The law of variable proportions holds good under the following conditions:
1. Constant State of Technology: First, the state of technology is assumed to be given and
unchanged. If there is improvement in the technology, then the marginal product may rise
instead of diminishing.
2. Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is
kept fixed. It is only in this way that we can alter the factor proportions and know its
effects on output. The law does not apply if all factors are proportionately varied.
3. Possibility of Varying the Factor proportions: Thirdly, the law is based upon the
possibility of varying the proportions in which the various factors can be combined to
produce a product. The law does not apply if the factors must be used in fixed
proportions to yield a product.
Illustration of the Law: The law of variable proportions is illustrated in the following table and
figure. Suppose there is a given amount of land in which more and more labour (variable factor)
is used to produce wheat.
Units of Total Product Marginal Average Product
Labour Product

1 2 - 2

2 6 4 3

3 12 6 4

4 16 4 4

5 18 2 3.6

6 18 0 3

7 14 -4 2

8 8 -6 1

It can be seen from the table that up to the use of 3 units of labour, total product increases at an
increasing rate and beyond the third unit total product increases at a diminishing rate. This fact is
shown by the marginal product, which is the addition made to the total product as a result of
increasing the variable factor i.e. labour.
It can be seen from the table that the marginal product of labour initially rises and beyond the use
of three units of labour, it starts diminishing. The use of six units of labour does not add anything
to the total production of wheat. Hence, the marginal product of labour has fallen to zero.
Beyond the use of six units of labour, total product diminishes and therefore marginal product of
labour becomes negative. Regarding the average product of labour, it rises up to the use of third
unit of labour and beyond that it is falling throughout.
Three Stages of the Law of Variable Proportions: These stages are illustrated in the following
figure where labour is measured on the X-axis and output on the Y-axis.
Stage 1. Stage of Increasing Returns: In this stage, total product increases at an increasing rate
up to a point. This is because the efficiency of the fixed factors increases as additional units of
the variable factors are added to it. In the figure, from the origin to the point F, slope of the total
product curve TP is increasing i.e. the curve TP is concave upwards up to the point F, which
means that the marginal product MP of labour rises. The point F where the total product stops
increasing at an increasing rate and starts increasing at a diminishing rate is called the point of
inflection. Corresponding vertically to this point of inflection marginal product of labour is
maximum, after which it diminishes. This stage is called the stage of increasing returns because
the average product of the variable factor increases throughout this stage. This stage ends at the
point where the average product curve reaches its highest point.

Stage 2. Stage of Diminishing Returns: In this stage, total product continues to increase but at a
diminishing rate until it reaches its maximum point H where the second stage ends. In this stage
both the marginal product and average product of labour are diminishing but are positive. This is
because the fixed factor becomes inadequate relative to the quantity of the variable factor. At the
end of the second stage, i.e., at point M marginal product of labour is zero which corresponds to
the maximum point H of the total product curve TP. This stage is important because the firm will
seek to produce in this range.
Stage 3. Stage of Negative Returns: In stage 3, total product declines and therefore the TP
curve slopes downward. As a result, marginal product of labour is negative and the MP curve
falls below the X-axis. In this stage the variable factor (labour) is too much relative to the fixed
factor.
Importance and Applicability of the Law of Variable Proportion:
The Law of Variable Proportion has universal applicability in any branch of production. It forms
the basis of a number of doctrines in economics.
The law is of fundamental importance for understanding the problems of underdeveloped
countries. In such agricultural economies the pressure of population on land increases with the
increase in population. This leads to declining or even zero or negative marginal productivity of
workers. This explains the operation of the law of diminishing returns in LDCs in its intensive
form.
Law of Diminishing Returns (applicability in agriculture)
The law of diminishing returns is supposed to have special application to agriculture.it is the
practical experience of every farmer that successive applications of labour and capital to a given
area of land must ultimately, other things remaining constant, yield a less than proportionate
increase in produce. Marshall stated the law as “An increase in capital and labour applied in the
cultivation of land causes in general less than proportionate increase in the amount of produce
raised, unless it happens to coincide with an improvement in the arts of agriculture.”
Limitations of the Law of Diminishing Returns
The law of diminishing returns does not apply in all the situations. There are several exceptions
to the law as it applies in agriculture:
1. Improved methods of cultivation: the operation of this law can be counteracted by
improving the technique of cultivation. Scientific rotation of crops, improved seeds,
modern implements, artificial manures and better irrigation facilities etc. are bound to
give increasing returns. But science cannot keep pace with the increasing demand for
food. The niggardliness o9f nature will ultimately assert itself and the law must operate
sooner or later.
2. New soil: when a virgin soil is brought under cultivation, the additional return for each
successive labour and capital may increase for a time. But after a point, the tendency to
diminishing returns will set in.
3. Insufficient capital: if capital applied hitherto has not been insufficient, increased
application will, at first, yield more than proportionate increase. Later, however, the
marginal return will diminish. The early stage is an exception to the law of diminishing
return.
Why the Law specially applies to agriculture
The law of diminishing returns has got wide applicability. But it specially applies to agriculture
and other extractive industries like fishing, mining etc. agriculture, where nature is supreme, is
subject to diminishing returns, while industry, where man is supreme, is subject to increasing
returns.
There are several reasons why agriculture is subject to the law of diminishing returns:
 1. The agricultural operations are spread out over a wide area, and consequently supervision
cannot be very effective.
2. Scope for the use of specialised machinery is also very limited. Therefore, economies of
large scale production cannot be reaped.
3. There are further limitations rising from the seasonal nature of agriculture. Agricultural
operations are likely to be interrupted by rain and other climatic changes. Man is not a
complete master of nature and no wonder the law of diminishing returns operates in
agriculture.
But it is wrong to say agriculture is always subject to diminishing returns and manufacturing
always to increasing returns. The law of diminishing returns applies everywhere. If the industry
is expanded too much and becomes unwieldy, supervision will become lax and costs will go up
and diminishing returns will set in. the only difference is that in agriculture it sets in earlier and
in industry much later. A prudent industrialist may not allow that stage to come at all. In
agriculture, too, in the beginning, there is increasing returns.
Law of Increasing Returns
The law of increasing returns is also called the law of diminishing costs. Law of increasing
return states that when more and more units of a variable factor is employed, while other factor
remain fixed, there is an increase in production at a higher rate. The tendency of the marginal
return to rise per unit of variable factors employed in fixed amounts of other factors by a firm is
called the law of increasing return. An increase of variable factor, holding constant the quantity
of other factors, leads generally to improved organization. The output increases at a rate higher
than the rate of increase in the employment of variable factor.
The increase in output faster than inputs continues so long as there is not deficiency of an
essential factor in the process of production. As soon as there occurs shortage or a wrong or
defective combination in productive process, the marginal product begins to decline. The law of
diminishing return begins to operate. We can, therefore, say that there are no separate
laws applicable to agriculture and to industries. It is only the law of variable proportions which
applies to all the different industries. However, the duration of stages in each productive
undertaking will vary. They will depend upon the availability of resources, their combination in
right proportions, etc.
Application of the Law of Increasing Returns in Industries: There are certain manufacturing
industries where the factors of production can be combined and substituted up to a certain limit,
where the law of increasing returns operates. In the words of Prof. Chapman: “The expansion of
an industry in which there is no dearth of necessary agents of production tends to be
accompanied, other things being equal, by increasing returns”. The increasing returns mainly
arise from the fact that large scale production is able to secure certain economies of production,
both internal and external. When an industry is expanded, it reaps advantages of division of
labour, specialized machinery, commercial advantages, buying and selling wholesale, economies
in overhead expenses, utilization of by-products, use of •extensive publicity and advertisement,
availability of cheap credit, etc.
The law of increasing returns also operates so long as a factor consists of large indivisible units
and the plant is producing below its capacity. In that case, every additional investment will result
in the increase of marginal productivity and so in lowering the cost of production of the
commodity produced. The increase in the marginal productivity continues till the plant begins to
produce to its full capacity.
Law of Constant Returns
An industry is subject to the law of constant returns when, whatever the output or scale of
production, the cost per unit remains unaltered or increased investment of labour and capital
results in a proportionate increase in output.

Law of Returns to Scale

The Law of Returns to Scale examines the relationship between output and the scale of inputs in
the long run when all the inputs are increased in the same proportion. Returns to Scale means the
behaviour of production or returns when all the productive factors are increased simultaneously
in the same ratio, which happens in the long run. In other words, in returns to scale, we analyse
the effect of doubling, trebling, and quadrupling and so on of all inputs of productive resources
on the output of the product. The Law of Return to Scale states that “ other things being equal
in the long run, as the firm increases the quantities of all factors employed, the output may rise
either more than proportionately, less than proportionately or in exactly same proportion of the
change in quantities of inputs.”
Assumptions:
1. All factors of production (such as land, labour and capital) but organization are variable.
2. The law assumes constant technological state. i.e., there is technological change during
the time period considered.
3. The market is perfectly competitive.
4. Outputs or returns are measured in physical terms.
Three Phases of Returns to Scale:
When we increase the scale, i.e., all the factors of production together to the same extent, the
marginal product or return increases at first, i.e., up to a point, then stays constant for some
further increases in the scale, and ultimately starts declining when the scale of production is
increased still further. In other words, there are three distinct phases of, or stages in, the behavior
of the marginal product.
Let us take a numerical example to explain the behavior of the returns to scale in the table below:
‘W’ stands for Workers and ‘A’ stands for Acres of land.

In the above table, we see that at the outset when we employ one worker on three acres, of land,
the total product is 2 quintals. Now to increase output, we double the scale, but the total product
increases to more than double (to 5 quintals instead of 4 quintals) and when the scale is trebled,
the total product increases from 5 quintals to 9 quintals—the increase this time being 4 quintals
as against 3 in the previous case.
In other words, the returns to scale have been increasing. If the scale of production is further
increased, the marginal product remains constant up to a certain point and, beyond it, it (the
marginal product) starts diminishing. In the above table at Serial No. 9 the marginal product or
return falls to only two quintals.
1. The Increasing Returns to Scale:
There are increasing returns to scale when a given percentage increase in input leads to a greater
relative percentage increase in output.
Causes of Increasing Returns to Scale:
a. Internal economies of scale
b. Efficiency of labour and capital
c. Improvement in large scale operation
d. Division of labour and specialization
e. Use of better and sophisticated technology
f. Economy of organization
g. .External economies of scale

2. Constant Returns to Scale

There are constant returns to scale when a given percentage increase in input leads to an equal
percentage increase in output. It shows that if inputs are doubled then the output also gets
doubled. If inputs are trebled then the output also trebles.
Causes of Constant Returns to Scale:
a. Internal economics of scale are equal to internal diseconomies of scale.
b. Balancing of external economics and diseconomies of scale
c. Factors of production are perfectly divisible substitutable, homogenous and their supply
is perfectly elastic at given prices.

3. Decreasing Returns to Scale

There are decreasing returns to scale when a given percentage increase in input leads to a smaller
percentage increase in output.
Causes of Decreasing Returns to Scale
a. Internal diseconomies of scale
b. External diseconomies of scale
c. Increase in business risk
d. Lack of entrepreneurial efficiency
e. Unhealthy management and organization
f. Imperfect factor substitutability
g. Transport bottlenecks and Marketing difficulties.

Scale of Production
The scale of production has an important bearing on the cost of production. It is the
manufacturer’s common experience that larger the scale of production, the lower is the average
cost of production. That is why the entrepreneur is tempted to enlarge the scale of production so
that he may benefit from the resulting economies of scale. There are two types of economies:
internal economies and external economies.
Economies of large scale production
The following are the benefits of large scale production:
1. Efficient use of capital: a large producer can install an up-to-date and expensive
machinery. He can have his own repairing unit. Specialized machinery can be employed
for each job. The result is that production is very economical.
2. Economy of specialized labour: in a big concern, there is ample scope for division of
labour. Specialized labour produces a larger output and of better quality.
3. Better utilization and greater specialization in management.
4. Economies of buying and selling: while purchasing raw materials and other accessories,
a big business can secure special favorable terms on account of its large custom.
5. Economy in rent: a large scale producer makes a saving in rent too. If the same factory
is made to produce a large quantity of goods, the same amount of rent is divided over a
large output.
6. Experiments and research: a large concern can afford to spend liberally on research and
experiments. In the long run these expenses more than repay.
7. Advertising: a big firm can afford to spend large amounts on advertising. Ultimately
they do bear fruit.
8. Utilization of by-products: a big business will not have to throw away any of its
by-products or waste products. It will be able to make economical use of it.
9. Cheap credit: a large business can secure credit facilities at cheap rates.

Economies of scale are of two types: internal and external economies.

Internal Economies
Internal economies are those reductions in production costs, which accrue to the firm itself when
it expands its output or enlarges its scale of production. It arises within the firm. Internal
economies are of following kinds:
1. Purchasing – firms producing on a larger scale should be able to bulk buy raw materials
or product for resale in larger quantities. They may be able to cut out wholesalers by
buying direct from producers, and transport costs per unit may also be reduced. The firm
might also be buying in large enough quantities to make very specific demands about
product quality, specifications, service and so on, so that supplies exactly match their
needs.
2. Technical – it may be cost-effective to invest in more advanced production machinery, IT
and software when operating on a larger scale.
3. Managerial – larger firms can afford to have specialist managers for different functions
within a business – such as Marketing, Finance and Human Resources. Furthermore, they
may be able to pay the higher salaries required to attract the best people, leading to better
planning and decision making.
4. Specialization – with a larger workforce, the firm may be better able to divide up the
work and recruit people whose skills very closely match the requirements of the job.
5. Marketing – more options are available for larger firms, such as television and other
national media, which would not be cost-effective for smaller producers. The marketing
cost for selling 10 million items might be no greater than to sell 1 million items. Larger
firms might find it easier to gain publicity for new launches simply because of their
existing reputation.
6. Financial – there is a wider range of finance options available to larger firms, such as the
stock market, bonds and other kinds of bank lending. Furthermore, a larger firm is likely
to be perceived by banks as a lower risk and the cost of borrowing is likely to be lower.
7. Risk bearing – a larger firm can be safer from the risk of failure if it has a more
diversified product range. A larger firm may have greater resilience in the case of a
downturn in its market because of larger reserves and greater scope to make cutbacks.
8. Social and welfare – larger firms are more likely to be able to justify additional benefits
for employees such as pension funds, healthcare, sports and social facilities, which in turn
can help attract and retain good employees.
External Economies
External economies are which accrue to each member firm as a result of the expansion of the
industry as a whole. Various types of external economies are:
1. Economies of Concentration: these economies relate to advantages arising from the
availability of skilled workers, the provision of better transport and credit facilities,
simulation of improvements, benefits from subsidiaries and so on. Scattered firms cannot
 enjoy such economies. These are the advantages of localize industry. Every firm in the
industry shares the common stock of knowledge and experience.
2. Economies of Information: these economies refer to the benefits which all the firms
engaged in an industry derive from the publication of trade and technical journals and
from central research institutions. In a localized industry, research and experiments are
centralized. Each individual firm need not incur expenditure on research. It can draw
such benefits from a common pool.
3. Economies of Disintegration: when an industry expands, it becomes possible to split up
some of the processes which are taken over by specialist firms.

Diseconomies of Scale
Diseconomies of scale means increase in long-term average cost of production as
the scale of operations increases beyond a certain level.
Internal Diseconomies of scale:
Growing beyond a certain output can cause a firm’s average costs to rise.
This is because a firm may encounter a number of problems including:
1. Difficulties controlling the firm: It can be hard for those managing a large firm to
supervise everything that is happening in the business. Management becomes more
complex. A number of layers of management may be needed and there may be a need for
more meetings. This can increase administrative costs and make the firm slower in
responding to changes in market conditions.
2. Communication problems: It can be difficult to ensure that everyone in a large firm
have full knowledge about their duties and available opportunities (like training etc.).
Also, they may not get the opportunity to effectively communicate their views and ideas
to the management team.
3. Poor industrial relations: Large firms may be at a greater risk from a lack of
motivation of workers, strikes and other industrial action. This is because workers may
have less sense of belonging, longer time may be required to solve problems and more
conflicts may arise due to the presence of diverse opinions.
External diseconomies of scale
Factors outside a company’s control which will increase his costs because of the size of the
company's operations. For example, as a business grows, it may put pressure on its suppliers,
raising the price of parts and raw materials.
COST ANALYSIS
Cost of production refers to the total sum of money needed for the production of a particular
quantity of output.

When commodities and services are produced, various expenses have to be incurred, e.g.,
purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the
expenses incurred plus the normal profit expected by the producer is called the cost of
production. The various concepts of cost are discussed below:

Nominal Cost and Real Cost:

Nominal cost is the money cost of production. The real costs of production are the pain and
sacrifices of labour involved in the process of production.

Explicit and Implicit costs:

Explicit costs are the accounting costs or contractual cash payments which the firm makes to
other factor owners for purchasing or hiring the various factors. Implicit costs are the costs of
self-owned factors which are employed by the entrepreneur in his own business. These implicit
costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur,
that is, the money incomes which these self-owned factors would have earned in their next best
alternative uses.

Accounting Costs and Economic Cost:

Accounting costs are the actual or explicit costs which are paid by the entrepreneurs to the
owners of hired factors and services. On the other hand, economic costs not only include the
explicit costs but also the implicit costs of the self-owned factors or resources which are used by
the entrepreneur in his own business.

Opportunity Cost:

The opportunity cost (or transfer earnings) of any good is the expected return from the next best
alternative good that is forgone or sacrificed. For example, if a farmer who is producing wheat
can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat
is the amount of output of potatoes given up.

Business Cost and Full Cost:

Business costs include all the expenses which are incurred in carrying out a business. The
concept of business cost is similar to the accounting or actual cost. The concept of Full cost
includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary
minimum earning which a firm must get to remain in its present occupation.
Private costs and Social Costs:

Private costs are the economic costs which are actually incurred or provided for by an individual
or a firm. It includes both explicit and implicit costs. Social cost, on the other hand, implies the
cost which a society bears as a result of production of a commodity. Social cost includes both
private cost and the external cost. External cost includes (a) the cost of free goods or resources
for which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the
cost in the form of ‘disutility’ caused by air, water, and noise pollution, etc.

Total, Average and Marginal Costs:

Total cost refers to the total outlays of money expenditure, both explicit and implicit on the
resources used to produce a given output. Average cost is the cost per unit of output which is
obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost.
Marginal cost is the addition made to the total cost as a result of producing one additional unit of
the product. Marginal cost is defined as ∆TC/∆Q.

Fixed Costs and Variable Costs:

Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory
building which remain fixed in the short run and cannot be changed. Therefore, fixed costs are
independent of output in the short run i.e., they do not vary with output in the short run. Even if
no output is produced in the short run, these costs will have to be incurred. Variable costs are
costs incurred by the firms on the employment of variable factors such as labour, raw materials,
etc., whose amount can be easily increased or decreased in the short run. Variable costs vary with
the level of output in the short run. If the firm decided not to produce any output, variable costs
will not be incurred.

Sunk costs:

Expenditure that has been incurred and cannot be recovered. E.g., painting a building.

Short-run Cost Curves

Total Fixed Cost: it refers to the total obligations incurred by the firm per unit of time for all
fixed inputs.

Total Variable Cost: the total obligations incurred by the firm per unit of time for all the
variable input it uses.

Total cost = TFC + TVC

Average Fixed Cost, AFC = TFC/Q

Average Variable Cost, AVC = TVC/Q

Average Total Cost, AC = AFC+ AVC or TC/Q = (TFC+TVC)/ Q

Marginal Cost, MC = ∆TC/∆Q

Geometry of Cost Curves
TFC is a straight line parallel to the output axis. The TVC has an inverse S- shape which reflects
the law of variable proportions. TC is also inverse S-shaped.

Short-Run Average Costs:

In the short run analysis of the firm, average costs are more important than total costs. The units
of output that a firm produces do not cost the same amount to the firm. But they must be sold at
the same price. Therefore, the firm must know the per unit cost or the average cost. The short-run
average costs of a firm are the average fixed costs, the average variable costs, and the average
total costs.
1. Average Fixed Costs or AFC
AFC equal total fixed costs at each level of output divided by the number of units produced:
AFC = TFC /Q
The average fixed costs diminish continuously as output increases. This is natural because when
constant total fixed costs are divided by a continuously increasing unit of output, the result is
continuously diminishing average fixed costs. Thus the AFC curve is a downward sloping curve
which approaches the quantity axis without touching it, as shown in Figure 3. It is a rectangular
hyperbola.
2. Short-Run Average Variable Costs (or SAVC)
SAVC equals total variable costs at each level of output divided by the number of units
produced:
SAVC = TVC/Q
The average variable costs first decline with the rise in output as larger quantities of variable
factors is applied to fixed plant and equipment. But eventually they begin to rise due to the law
of diminishing returns. Thus the SAVC curve is U-shaped, as shown in Figure 3.

3. Short-Run Average Total Costs (or SATC or SAC)

They are arrived at by dividing the total costs at each level of output by the number of units
produced:
SAC or SATC = TC/Q TFC/Q + TVC/Q = AFC+ AVC
Average total costs reflect the influence of both the average fixed costs and average variable
costs. At first average total costs are high at low levels of output because both average fixed
costs and average variable costs are large. But as output increases, the average total costs fall
sharply because of the steady decline of both average fixed costs and average variable costs till
they reach the minimum point.
This results from the internal economies, from better utilization of existing plant, labour, etc. The
minimum point В in the figure represents optimal capacity. As production is increased after this
point, the average total costs rise quickly because the fall in average fixed costs is negligible in
relation to the rising average variable costs.
The rising portion of the SAC curve results from producing above capacity and the appearance
of internal diseconomies of management, labour, etc. Thus the SAC curve is U- shaped, as
shown in Figure 3.
Why is SAC curve U-shaped?
The U-shape of the SAC curve can also be explained in terms of the law of variable proportions.
This law tells that when the quantity of one variable factor is changed while keeping the
quantities of other factors fixed, the total output increases but after some time it starts declining.
Machines, equipment and scale of production are the fixed factors of a firm that do not change in
the short run. On the other hand, factors like labour and raw materials are variable. When
increasing quantities of variable factors are applied on the fixed factors, the law of variable
proportions operates.
When, say the quantities of a variable factor like labour are increased in equal quantities,
production rises till fixed factors like machines, equipment, etc. are used to their maximum
capacity. In this stage, the average costs of the firm continue to fall as output increases because it
operates under increasing returns.
Due to the operation of the law of increasing returns when the variable factors are increased
further, the firm is able to work the machines to their optimum capacity. It produces the optimum
output and its average costs of production will be the minimum which is revealed by the
minimum point of the SAC curve, point В in Figure 3.
If the firm tries to raise output after this point by increasing the quantities of the variable factors,
the fixed factors like machines would be worked beyond their capacity. This would lead to
diminishing returns. The average costs will start rising rapidly. Hence, due to the working of the
law of variable proportions the short-run AC curve is U-shaped.
4. Short Run Marginal Cost:
A fundamental concept for the determination of the exact level of output of a firm is the marginal
cost.
Marginal cost is the addition to total cost by producing an additional unit of output:
SMC = ∆ТС/∆Q
Algebraically, MCn= TCn - TCn-1. Since total fixed costs do not change with output, therefore,
marginal fixed cost is zero. So marginal cost can be calculated either from total variable costs or
total costs. The result would be the same in both the cases. As total variable costs or total costs
first fall and then rise, marginal cost also behaves in the same way. The SMC curve is also
U-shaped, as shown in Figure 3.

Relationship between the cost curves

 ● The minimum point of ATC curve lies to the right of the minimum point of AVC
curve.

This is because ATC includes AFC and AVC, the latter falls continuously with
increase in output. After AVC has reached minimum and starts rising, its rise is over a
certain range offset by the falling AFC, so that ATC continues to fall despite the increase
in AVC. However, the rise in AVC eventually becomes greater than the fall in AFC, so
that AFC starts increasing. AVC approaches ATC asymptotically as output increases.

● The MC curve cuts AVC and ATC curves at their lowest points.
So long as MC lies below the AC curve, it pulls the latter downwards; when the
MC rises above the AC, it pulls the latter upwards. At the point of intersection of MC
and AC, AC has reached its minimum level.

Long-run Cost Curves of the traditional theory

Long –run AC curve:
Long-run cost curve is a planning curve. It is a guide to the entrepreneur in his decision to plan
the future expansion of his output. The long-run AC curve is derived from the short-run cost
curves. Each point on the LAC corresponds to a point on a short-run cost curve, which is tangent
to the LAC at that point. Each point of LAC shows the minimum cost for producing the
corresponding level of output. In the traditional theory of the firm, the LAC curve is U-shaped
and it is often called the ‘envelope curve’ because it envelopes the SRC curves. The U- shape of
the LAC curve reflects the laws of returns to scale. The U-shaped LAC curve implies that each
plant size is designed to produce optimally a single level of output. The plant is completely
inflexible. Any departure leads to increasing costs. There is no reserve capacity. Each point of
the LAC curve is a point of tangency with the corresponding SAC curve. The point of tangency
occurs to the falling part of the SAC curves for the points lying to the left of M the point of
tangency occurs to the rising portion of SAC curves for points lying to the right of M. Only at the
minimum point M of the LAC is the corresponding SAC also at a minimum.
Long-run MC curve:
The long-run MC is derived from the SRMC curves. The LRMC is formed from the points of
intersection of the SRMC curves with vertical lines drawn from the points of tangency of the
corresponding SAC curve and the LAC curve. The LMC must be equal to SMC for the output at
which the corresponding SAC is tangent to LAC.

Modern Cost Theory

As early as 1939, George Stigler, suggested that the short-run AVC has a flat stretch over a range
of output which reflects the fact that firms build plants with some flexibility in their productive
capacity.
Short-run Cost curves
Here also, AFC is a rectangular hyperbola but it has some reserve capacity.
The SAVC curve in modern theory has a saucer-type shape, i.e., it is broadly U-shaped but has a
flat stretch over a range of output, corresponding to the built-in-the-plant reserve capacity. Over
this stretch, the SAVC is equal to the MC, both being constant per unit of output. To the left of
the flat stretch, MC lies below the SAVC while to the right of the flat stretch the MC rises above
the SAVC.
The reserve capacity makes it possible to have constant SAVC within a certain range of output. It
should be clear that this reserve capacity is planned in order to give the maximum flexibility in
the operation of the firm.X1X2 reflects the planned reserve capacity which does not lead to
increase in costs. On an average the entrepreneur expects to operate his plant within X1X2 range.
ATC is obtained by adding the AFC and AVC at each level of output. The ATC curve falls
continuously up to the level of output X2 at which the reserve capacity is exhausted. Beyond that
level ATC will start rising. The MC will intersect the ATC at its minimum point.

Long-run cost Curves

The long-run costs in the modern cost theory may be classified into production costs and
managerial costs. All costs are variable in the long run and they give rise to a long-run cost curve
which is roughly L-shaped. The production costs fall continuously with increases in output. At
very large scales of output managerial costs may rise. But the fall in production costs more than
offsets the increase in the managerial costs so that the LAC curve falls smoothly or becomes flat
at very large scales of output, thereby giving rise to the L-shape of the LAC curve.
In order to draw such an LAC curve, we take three short-run average cost curves SAC1 SA С2,
and SAC3 representing three plants with the same technology in Figure. Each SAC curve
includes production costs, managerial costs, other fixed costs and a margin for normal profits.
Each scale of plant (SAC) is subject to a typical load factor capacity so that points A, В and С
represent the minimal optimal scale of output of each plant.

By joining all such points as A, В and С of a large number of SACs, we trace out a smooth and
continuous LAC curve, as shown in the Figure. This curve does not turn up at very large scales
of output. It does not envelope the SAC curves but intersects them at the optimal level of output
of each plant.

In the modern theory of costs, if the LAC curve falls smoothly and continuously even at very
large scales of output, the LMC curve will lie below the LAC curve throughout its length, as
shown in the Figure.

If the LAC curve is downward sloping up to the point of a minimum optimal scale of plant or a
minimum efficient scale (MES) of plant beyond which no further scale economies exist, the LAC
curve becomes horizontal. In this case, the LMC curve lies below the LAC curve until the point
M is reached, and beyond this point the LMC curve coincides with the LA С curve, as shown in
the Figure below.
REVENUE AND REVENUE CURVES
Marginal and Average Revenue
Average revenue is the revenue per unit of the commodity sold. It is found by dividing total
revenue by the number of units sold. But since, different units of a commodity are sold at the
same price, in the market, average revenue equals price at which the commodity is sold. Thus,
average revenue means price. Since, the consumer’s demand curve is a graphic relation
between price and the amount demanded, it also represents the average revenue or price at which
the various amounts of a commodity are sold, because the price offered by the buyer is the
revenue from seller’s point of view. Therefore, average revenue (AR) curve of the firm is
really the same as demand curve of the consumer.
Marginal revenue at any level of firm’s output is the net revenue earned by selling an additional
unit of the product. Algebraically, MR is equal to TR n – TR n-1.
Thus, MR n = TR n – TR n-1.
Thus, Marginal Revenue is less than Average Revenue or price.
Relationship between AR and MR
Let us consider the relationship between marginal, average and total revenue with the help of the
following table.
No. of Units sold Price/AR TR= AR x Q MR
1 22 22 22
2 21 42 20
3 20 60 18
4 19 76 16
5 18 90 14
6 17 102 12
 7 16 112 10
8 15 120 8
9 14 126 6
10 13 130 4

In the above table, Column 2 shows the Average Revenue, while Column 4 shows the Marginal
Revenue. Marginal Revenue has been derived from the Total Revenue column of the table. It can
be seen from the table that when average revenue is falling, marginal revenue is less than average
revenue.
(i) Total Revenue = Price x Quantity

TR = P x Q

(ii) Average Revenue = Total Revenue

Quantity
AR = TR
Q

(iii) Marginal Revenue = Change in Total Revenue

Change in Quantity

MR = ▲TR
▲Q
1) Under Pure/Perfect Competition:
The average revenue curve is a horizontal straight line parallel to the X-axis and the marginal
revenue curve coincides with it. This is because under pure (or perfect) competition the number
of firms selling an identical product is very large.
The price is determined by the market forces of supply and demand so that only one price tends
to prevail for the whole industry, as shown in Table 1.
Price is OP as shown in panel (A) of Figure 1. Each firm can sell as much as it wishes at the
market price OP. Thus the demand for the firm’s product becomes infinitely elastic. Since the
demand curve is the firm’s average revenue curve, the shape of the AR curve is horizontal to the
X-axis at price OP, as shown in panel (B) and the MR curve coincides with it. This is also shown
in Table 1 where AR and MR remain constant at Rs.20 at every level of output. Any change in
the demand and supply conditions will change the market price of the product, and consequently
the horizontal AR curve of the firm.

(2) Under Monopoly or Imperfect Competition:

The average revenue curve is the downward sloping industry demand curve and its
corresponding marginal revenue curve lies below it. The relation between the average revenue
and the marginal revenue under monopoly can be understood with the help of Table 2. The
marginal revenue is lower than the average revenue.

Given the demand for his product, the monopolist can increase his sales by lowering the price,
the marginal revenue also falls but the rate of fall in marginal revenue is greater than that in
average revenue. In Table 2, AR falls by Rs.2 at a time whereas MR falls by Rs.4. This is shown
in Figure 2, in which the MR curve is below the AR curve and lies half way on the perpendicular
drawn from AR to the X-axis. MR has twice the slope of AR. That is, in the figure, MR curve
passes through the point B, where, AB = BC. This relation will always exist between straight line
downward sloping AR and MR curves.
Under Perfect Competition
In perfect competition, a firm can sell any amount at the ruling market price, and therefore,
marginal revenue is equal to average revenue or price since the additional units are sold at the
same price as before and there is no loss incurred on the previous units. The average revenue
curve of the firm in perfect competition is a horizontal straight line. The marginal revenue curve
coincides with the Average Revenue curve. The Average and Marginal Revenue curves of a firm
under perfect competition are shown in the figure below.
Under Imperfect Competition
If we plot the above schedule of average and marginal revenues on a graph, we will get two
downward sloping curves, with the marginal revenue curve lying below the average revenue
curve. When the firm is operating under conditions of monopoly or imperfect competition, this is
the case. That is, both the average and marginal revenue curves will be downward sloping with
marginal revenue curve lying below the average revenue curve. The MR curve lies below the
AR curve because a falling price must mean some loss on the additional units sold and therefore
MR will be less than AR.
When both the AR and MR curves are straight lines and sloping downwards, the MR curve will
lie half the way between the AR curve and Y-axis. MR has twice the slope of AR. That is, in the
figure, MR curve passes through the point B, where, AB = BC.
PRODUCER’S EQUILIBRIUM
Isoquant
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or
product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good.
These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant
curves are also known as Equal-product or Iso-product or Production Indifference curves. Since
it is an extension of Indifference curve analysis from the theory of consumption to the theory of
production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of
two factors yielding the same total product. Like, indifference curves, Iso- quant curves also
slope downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of
technical substitution (MRTS).
Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm can
produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of
producing a given level of output.” Ferguson
Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known before hand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of
‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule
shows the different combination of these two inputs that yield the same level of output as shown
in table 1.
The table 1 shows that the five combinations of labour units and units of capital yield the same
level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by combining.
(a) 1 units of labour and 15 units of capital
(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital

Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An. equal
product curve represents all those combinations of two inputs which are capable of producing the
same level of output. The Fig. 1 shows the various combinations of labour and capital which give
the same amount of output. A, B, C, D and E.
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.

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.
(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 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. 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.