TOPPERS INSTITUTE KANPUR

THEORY OF PRODUCTION AND COST

THEORY OF PRODUCTION
MEANING OF PRODUCTION
♦ Production is one of the important economic activity that takes place in any economy apart
from consumption and investments.
♦ An individual firm is the micro-economic unit which undertake the production of goods and
services.
♦ A firm's survival depends upon whether it is able to achieve optimum efficiency in
production by minimizing the cost of production.
♦ Production is the transformation of resources into goods and services. In other
words, production is the act of transformation of INPUTS into OUTPUT which satisfies
the wants of some people.
E.g.- Inputs of sugarcane, capital and labour are used to produce SUGAR.
Production also includes production of SERVICES like those of lawyers, teachers, doctors,
etc.
♦ The amount of goods and services that an economy is able to produce determines
whether it is rich or poor. A country like U.S.A. is a rich country as its production level is high.
♦ Man cannot create or destroy matter.
♦ In Economics, the term production means creation of economic utilities in the matter i.e.
in the things that already exist.
♦ Thus, production means creation of those goods and services which have economic
utilities
i.e. exchange value.
♦ According to James Bates and J.R. Parkinson, “Production is the organized activity
of transforming resources into finished products in the form of goods and services;
and the objective of production is to satisfy the demand of such transformed
resources.”
♦ Professor J. R. Hicks has defined production “as any activity whether physical or
mental, which is directed to the satisfaction of other people’s wants through
exchange.”
♦ The definition indicates that the term production covers the whole process from creation of
utilities till the satisfaction of human wants.
♦ Utilities may be created or added in many ways, such as
1. Form Utility.
■ It is created by changing the form of raw materials into finished goods for man's use.
■ E.g. converting raw cotton into cotton fabric.
■ Form utility is created by manufacturing industries.
2. Place Utility.
■ It is created by transporting goods from one place to another.
■ E.g. when goods are taken from factory to marketplace, place utility is created.
■ Transport services are involved in creation of place utility.
3. Time Utility.
■ It is created by making things available when they are required.
■ E.g. Banks create time utility by granting overdraft facilities.
4. Service Utility (Personal Utility).
■ It is created by providing personal services to the customers by professionals likes
lawyers, doctors, bankers, shopkeepers, teachers, transporters, etc.
FACTORS OF PRODUCTION
Land:
♦ Generally, land means earth's surface.
♦ However, in economics land refers to all the free gifts of nature i.e. natural resources. Land
includes natural resources:
1. on the surface of earth; E.g. Soil, forest, plots of land, etc.;
2. below the surface of earth, E.g. mineral deposits, etc. and
3. above the surface of earth, E.g. climate, sunshine, rain, etc.
♦ Land has the following characteristics
1. Primary Factor. Land is the original and primary or natural factor of production. It
provides various natural resources for production.
2. Free Gift of Nature. Land is the creation of nature and not man made. It is a free gift of
nature to mankind.
3. Inelastic Supply. Land is fixed in supply. Its supply cannot be either increased or
decreased by any human efforts. However, its supply is relatively elastic from the point of
view of a firm.
4. Lacks Geographical Mobility. Land cannot be moved bodily from one place to another.
However, land is said to be mobile in the sense it can be put to many alternative uses.
5. Passive Factor. Land does not yield any result unless human efforts and capital are
employed.
6. Heterogeneous. Land differs in nature, fertility, uses and productivity from one place to
another.
7. Permanent. It means that land cannot be destroyed. The productive power of soil is
original and indestructible according to RICARDO.
8. Diminishing Returns. The land is subject to the Law of Diminishing Returns more quickly
in the cultivation of land.
Labour:
♦ Labour in economics means any work whether physical or mental done in exchange for
some monetary reward.
■ E.g. converting raw cotton into cotton fabric.
■ Form utility is created by manufacturing industries.
2. Place Utility.
■ It is created by transporting goods from one place to another.
■ E.g. when goods are taken from factory to marketplace, place utility is created.
■ Transport services are involved in creation of place utility.
3. Time Utility.
■ It is created by making things available when they are required.
■ E.g. Banks create time utility by granting overdraft facilities.
4. Service Utility (Personal Utility).
■ It is created by providing personal services to the customers by professionals likes
lawyers, doctors, bankers, shopkeepers, teachers, transporters, etc.
FACTORS OF PRODUCTION
Land:
♦ Generally, land means earth's surface.
♦ However, in economics land refers to all the free gifts of nature i.e. natural resources. Land
includes natural resources:
1. on the surface of earth; E.g. Soil, forest, plots of land, etc.;
2. below the surface of earth, E.g. mineral deposits, etc. and
3. above the surface of earth, E.g. climate, sunshine, rain, etc.
♦ Land has the following characteristics
1. Primary Factor. Land is the original and primary or natural factor of production. It
provides various natural resources for production.
2. Free Gift of Nature. Land is the creation of nature and not man made. It is a free gift of
nature to mankind.
3. Inelastic Supply. Land is fixed in supply. Its supply cannot be either increased or
decreased by any human efforts. However, its supply is relatively elastic from the point of
view of a firm.
4. Lacks Geographical Mobility. Land cannot be moved bodily from one place to another.
However, land is said to be mobile in the sense it can be put to many alternative uses.
5. Passive Factor. Land does not yield any result unless human efforts and capital are
employed.
6. Heterogeneous. Land differs in nature, fertility, uses and productivity from one place to
another.
7. Permanent. It means that land cannot be destroyed. The productive power of soil is
original and indestructible according to RICARDO.
8. Diminishing Returns. The land is subject to the Law of Diminishing Returns more quickly
in the cultivation of land.
Labour:
♦ Labour in economics means any work whether physical or mental done in exchange for
some monetary reward.
♦ Anything done out of love and affection is not labour in economic sense.
♦ Labour has the following peculiarities (characteristics) which makes it different from other
factors:
1. Labour is inseparable from labourer.
♦ All other suppliers of factors can be separated from the factors which they supply. E.g.
Land can be separated from its owner.
♦ However, the labourer cannot be separated from the work which he performs. E.g. A
doctor has to attend his patients in person. Labour is connected with HUMAN EFFORTS.
2. Human Factor.
♦ It is a live factor of production. Hence, labour has feelings and temperament.
♦ So it is very much affected by surroundings, working, conditions, motivation, leisure,
recreation, working hours, etc.
3. Highly perishable.
♦ Labour cannot be stored for future use. It is highly perishable.
♦ A day lost without work means a day’s work gone forever.
♦ Hence, labourer has weak bargaining power and has to accept even low wages.
4. The labourer sells his services and not himself.
♦ In the labour market it is labour which is brought and sold and not the labourer.
5. Heterogeneous.
♦ Labour power differs from labourer to labourer.
♦ Labour power depends upon physical strength, education, skill, training, efficiency, etc.
♦ Hence, labour can be classified as unskilled, semi-skilled and skilled labour.
♦ The skilled labour is called as human capital.
6. Mobile.
♦ Labour is a mobile factor.
♦ Labour is much less mobile than capital.
♦ Labourer is human being and hence has attachment with his family, custom, religion,
culture, etc. and so is hesitant to move from one place to another.
7. Active Factor.
♦ Labour is the most active factor of production. Other factors are made operative with the
use of labour.
8. Labour has sociological characteristics.
♦ Employment of labour involves problems relating to labour welfare.
♦ E.g. Social security like provident fund, gratuity, medical benefits, pension, etc.
♦ Other factors do not have such characteristics.
9. Supply curve of labour is backward sloping.
10. The supply of labour is inelastic in short run.
Capital:
♦ In ordinary language, capital is used in the sense of money.
♦ But in economics the term 'Capital' means man made stock of goods like factories,
machines, tools, equipments, raw materials, dams, canals, transport vehicles, etc. which are
used in production.
♦ Thus, 'Capital' in economics is used in the sense of real capital i.e. capital goods.
♦ Capital has therefore, been rightly defined as ‘‘produced means of production" and as
“man made instrument of production".
♦ Land and labour are primary or original factors of production. But capital is produced by
man working with nature to help in the production of further goods. Following are the main
characteristics of capital:-
1. Capital is man made.
♦ Capital is not produced by nature. It is artificial as it is produced by man.
2. Capital is productive.
♦ Use of capital increases the overall productivity in a given process. It provides tools and
implements to labour for production.
3. Supply of capital is elastic.
♦ The supply of capital can be adjusted to demand.
♦ The stock of capital depends on capital formation.
♦ Thus, by raising the rates of savings and investments the supply of capital can be
increased.
4. All capital is wealth.
♦ Capital is that part of wealth which is used in further production of wealth.
♦ Hence, capital has all the characteristics of wealth like utility, scarcity, transfer- ability and
price.
5. Capital is a passive factor.
♦ It alone is unable to produce anything. It is ineffective without the use of labour and land.
6. Capital is the most mobile factor.
♦ It has both place as well as occupational mobility.
7. Capital is durable.
♦ Physical capital assets like plant and machinery, factory buildings, etc. last over a long
time in the process of production. However, they are subject to depreciation.
8. Capital involves social cost.
♦ In the creation of capital, the money to be used for present consumption has to be
diverted.
♦ Sacrifice of present consumption and enjoyment of the people is treated as a social cost.
Types of capital

Types of Capital

On the basis On the On the basis On the basis of

of basis of of NATURE OWNERSHIP
DURABILITY MOBILITY
(1) Fixed capital (3) Sunk (5) Real (10) Individual
capital capital capital
(2) Circulating
capital (4) Floating (6) Human (11) Social capital
capital capital
(7) Tangible
capital
(8) Intangible
capital
(9) Money
capital

♦ Fixed Capital. Those durable physical assets which can be repeatedly used in the
process of production for long periods are called fixed capital. E.g. Machinery, Plant, Tools,
Factories, Railways, etc.
♦ Circulating or Working Capital. Working capital refers to those goods which are used up
in the single act of production. Such goods are used only ONCE in production. E.g. raw
materials, power, fuel, etc. They are single use producer's goods.
♦ Sunk Capital. Sunk capital is the capital which is used to produce only one single
commodity. It can be put to a single specialized use only. E.g. A brick kiln can be used only
to bake brick and nothing else. Sunk capital therefore, lacks occupational mobility.
♦ Floating Capital. Floating capital is that which can be put to several uses. E.g. electricity,
money, leather, etc.
♦ Real Capital. Real capital refers to the physical capital goods like machinery, raw material,
factory buildings, etc. which help in production.
♦ Human Capital. The human capital is in the form of people who are equipped with
education, skills, training, good health, etc. A faster economic growth can be achieved with
the accumulation of human capital.
♦ Tangible Capital. Tangible capital is one which can be seen and touched. E.g. machinery,
tools, etc. in other words, it is real capital.
♦ Intangible Capital. It cannot be seen or touched. It can only be felt. E.g. goodwill, etc.
♦ Money Capital. It is in the form of shares, debentures, bonds, stock certificates, etc.
Money is invested in expectations of returns.
♦ Individual Capital. Capital resources having personal or private ownership of an individual
or group of individuals is called individual capital. E.g. Tata Enterprises.
♦ Social Capital. The capital which is owned by the society as a whole is called as social
capital. E.g. roads, railways, schools, dams, canals, etc.
Capital Formation
♦ Capital formation means a sustained increase in the stock of real capital in a country.
♦ It is thus, an addition of capital goods like machines, tools, factories, transport facilities,
power, etc. in the country.
♦ Such capital goods are used for further production of goods and thus increases the
production capacity of the country.
♦ Capital formation is also known as investment.
♦ Capital formation plays an important role in the development of an economy generally,
higher the rate of capital formation, more economically developed an economy would be.
♦ There are mainly three stages of capital formation which are as follows:-
1. Savings.
■ Savings represents that part of income which is not consumed. Level of savings in a
country depends on - (i) ability to save, and (ii) willingness to save.
(i) - Ability to save depends upon the income of an individual.
- Higher the income, higher is the savings.
- This is because with the increase in income the propensity to consume falls and propensity
to save increases.
- This is true in case of both the individuals and the economy.
(ii) - A person with ability to save must also have willingness to save.
- Willingness to save depends upon individual’s concern about future. If a person is
foresighted and wants to make future secure, he will save more.
- Willingness to save also depends upon family affection, desire for the growth and
promotion of business, desire for prestige and power habits, sound banking system, stability
in the money value, State's taxation policy,
' etc.
2. Mobilization of Savings.
■ The money so saved by the households must enter into circulation i.e. must be mobilized
and make them available to the businessmen or entrepreneurs who require it for investment
purposes.
■ This requires a network of banks, financial institutions (like UTI, IDBI, etc.), insurance
companies, etc.
■ Such facilities help to promote high rate of mobilization and canalization of savings.
3. Investments.
■ The final stage is the investment of savings into capital assets like machinery, tools,
buildings, dams, etc.
■ Investment requires a large number of honest, dynamic, daring, efficient and skilled
entrepreneurs in the economy.
■ Investments also depends upon the factors like expected profits, rate of interest, size of
market, stability in the money value, internal peace and security, fear of foreign aggression,
etc.
Entrepreneur:
♦ The most important factor in production i.e. enterprise is provided by entrepreneur.
♦ An entrepreneur is a person or group of persons who bring together the different factors of
production i.e. land, labour and capital at one place; combine them in right proportions;
initiate the process of production by making them work together and bear the risks and
uncertainty involved in it.
♦ He is therefore also called the organizer, the manager or risk bearer. An entrepreneur
performs the following functions:-
1. Initiating a business enterprise.
■ The first function of an entrepreneur is to start a business. For this he brings together the
different factors of production like land, labour and capital.
■ He pays them their respective remuneration i.e. rent for land, wages to labour and interest
to capital.
■ Any surplus left after factor payment is his reward i.e. profit which is not fixed.
■ If his planning goes wrong he may also incur losses.
2. Risk and Uncertainty bearing.
■ Main function of an entrepreneur is to bear risk and uncertainty. According to Prof. F. H.
Knight there are two types of risks namely -
(i) Foreseeable or insurable risks e.g. risk of fire, thefts, accidents, etc.
(ii) Unforeseeable or non-insurable risk e.g. technological risks due to inventions,
fluctuations in demand due to change in fashion etc., trade cycles, changes in govt, policies,
etc.
■ Foreseeable risks can be predicted and hence can be insured. Such risks do not cause
uncertainty and thus do not give rise to profits.
■ Unforeseeable risks involve uncertainty and give rise to profits.
■ True entrepreneurship lies in bearing non-insurable risks and uncertainties.
3. Innovations.
■ Prof. Joseph A. Schumpeter considers innovation as the true function of the
entrepreneur.
■ Innovation refers to all those changes in the production process the objective of which is to
reduce the cost of production and increase profits.
■ Innovations in wider sense includes introduction of new or improved production methods, a
new machine, a new plant, use of a new source of raw material, change in the internal
organizational set-up, etc.
■ Such innovations give rise to profits but temporarily because once these are adopted by
other firms, the profits could disappear.
■ Hence, entrepreneur has to continuously introduce new innovations and contribute to
technological progress and economic growth of the country.
Enterprise’s objectives and constraints
♦ Earning profit is considered to be the prime objective of every business. However, earning
profit cannot be the only objective of the business because an enterprise functions in the
economic, social, political and cultural environment. Hence, an enterprise has to set us
objectives in relation to such environment. The objectives of an enterprise are as follows:
(1) Organic objectives: The basic purpose of all kinds of enterprises is to SURVIVE and
EXIST i.e. to stay alive. This is possible only when it is able to recover its costs and earn
profits. Once the enterprise is assured of its survival, it will aim at growth and expansion.
■ Growth as on obj ective has gained importance with the rise of professional managers.
H.L. Marris’s and other economists assert that managers of a corporate firm are interested
in maximizing the growth rate rather than in profit maximization.
■ Owners are interested in profits, capital, market share and public reputation.
■ For growth and expansion of the firm it is necessary that adequate profits are made so
as to provide internal funds for further investment.
■ Growth and profit are both positively related to the size of the firm. Both of the
objectives converge in one namely A STEADY GROWTH IN THE SIZE OF THE FIRM.
■ Managers prefer balanced rate of growth over profits. The growth rate and growth is
measured in terms of sales, number of branches, number of employees, etc.
(2) Economic Objectives: The basic and important objective of every business is to earn
profit. Accordingly therefore, the firm determines the price and output policy in a manner
that profits can be maximized.
■ Investors expect sufficient returns from their company. Similarly, creditors and
employees are also interested in profitable enterprise.
■ The definition of profits in economic sense has different meaning than accountants’
definition of profits.
■ Accounting Profit = Total Revenue - Accounting Cost (Explicit Cost)
■ Economic Profit = Total Revenue - Economic Cost (i.e. Explicit + Implicit Cost)
■ Profit maximization objective has been criticized because all firms do not aim to maximize
profits. E.g.-
(0 Some firm try to achieve SECURITY with reasonable level of profit.
(ii) Some firms may try to MAXIMISE SALES (Prof. Baumol)
(Hi) Some economists point that owners and managers of a company try to MAXIMISE
THEIR UTILITY rather than profit.
(3) Social Objectives: A business enterprise is an integral part of society. It lives in a
society. It cannot grow unless it meets the needs of the society. It makes use of resources of
society. Therefore, it owes something to society. Some of the important social objectives of
business are-
■ To maintain continuous and desired quantity of unadulterated goods of standard quality.
■ To avoid unfair trade practices.
■ To avoid profiteering and anti-social practices.
■ To create opportunities for gainful employment for the people in the society. A business
should specially consider the handicapped, disabled and poor people.
* To avoid air, water or noise pollution.
(4)Human Objectives: Employees are precious resources who contribute abundantly to the
success in business. Therefore, the overall development of its employees, keep them
motivated and taking care of employees should be major objectives of an organization. The
common human objectives are-
■ To provide fair deal to the employees at different levels.
■ To provide good working conditions.
■ To pay competitive and satisfactory wages and salaries.
■ To impart training to employees and keep updating their knowledge.
M To provide opportunities to employees in decision making process on the matters affecting
them.
(5) National Objectives: An enterprise should try to fulfil the nations need and aspirations. It
should work towards implementation of national plans and policies. Some of the national
objectives are-
■ To remove inequality of opportunities and provide opportunities to all irrespective of caste
and religion to work and to progress.
■ To produce according to national priorities.
■ To help country achieve self-sufficiency in production of all types of goods and thus reduce
dependence on other countries.
■ To provide education and training to young men to bring about skill formation for achieving
growth and development.
■ All the enterprises have multiple objectives and therefore, the need to set priorities by
balancing of the objectives.
■ In the pursuit of the above objectives an enterprise’s action may get constrained in
following ways-
(i) Lack of knowledge and information about many variable that affect business.
(ii) Constraints may be experienced due to governments' restrictions on the production, price
and movement of factors.
(iii) There may be infrastructural bottleneck.
(iv) Changes in business and economic conditions; change in government policies about
location, prices, taxes, etc.; natural calamities like fire, flood, famine, etc.
(v) Constraints are also faced due to inflation, rising interest rates, unfavourable exchange
rate, capital and labour costs, etc.
Enterprise’s Problems
♦ A business enterprise face many problem from its start, through its life time till it is closed
down. Following are the main problems:
(1) Problems relating to objectives: An enterprise functions in the economic, social,
political
and cultural environment. Therefore, it has a set of many objectives in relation to its
environment.
■ These multifarious objectives many times conflict with one another. Hence, the enterprise
faces the problem of choosing and striking balance between them.
E.g.- Social responsibility objective may run into conflict with expansion of
production activity resulting in pollution.
(2) Problems relating to location and size of the plant: An enterprise has to decide about
the LOCATION of its plant. In doing so, it has to consider many costs like cost of labour,
facilities and cost of transportation to decide where its plant should be located.
■ Another problem faced is about SIZE of the firm, whether it should be a small scale or
large scale unit. Before deciding upon the scale of operations several aspects will have to be
considered like technical, managerial, marketing, financial, etc.
(3) Problems relating to selecting and Organising physical facilities: A firm has to
decide about the nature of production process to be used and the type of equipments
required
for it. This will depend upon the required volume of production
■ This choice will be based on-
(i) the evaluation of costs of different equipments, and
(ii) efficiency
■ It has also to prepare layout of plant.
(4) Problems relating to Finance: A firm also has to do good financial planning. For this an
enterprise will have to determine-
■ amount of funds required,
■ demand and cost of its products,
■ profits on investments, and
■ capital structure
(5) Problems relating to Organisation Structure: An enterprise faces problem relating to
organizational structure. It has to divide the total work of the enterprise by creating different
departments in order to carry on the specialized functions by each department.
■ It has to clearly define the roles and relationships of all positions also.
(6) Problems relating to Marketing: For survival and growth, a firm has to properly do
marketing of its products and services.
■ It has to identify its actual and potential customers, tools of marketing, etc.
■ After identifying the market, the firm has to decide upon product, promotion, price and
place aspects.
(7) Problems relating to Legal Formalities: Many legal formalities are to be carried out at
the time of formation, during the life time and at closure.
■ E.g.- assessing various taxes and paying, maintenance of records, filing various
returns, adhering to laws formulated by Govt., etc.
(8) Problems relating to Industrial Relations: This problem relates to winning worker's co-
operation, enforcing discipline among workers, workers participation in management, dealing
with trade unions, etc.
PRODUCTION FUNCTION
♦ Output is a function of inputs i.e. factor services such as land, labour and capital which are
used in production. In other words, production is a transformation of PHYSICAL INPUTS into
PHYSICAL OUTPUT.
♦ The functional relationship between physical inputs and physical output, per unit of time
under a given state of technology is called production function.
♦ It can also be expressed in the form of a mathematical equation in which output is the
dependent variable and inputs are the independent variables.
Q = f (a, b, c n)
Where -
Q denotes quantity of output of a commodity per unit of time
f stands for function of i.e. depends on a, b, c,... n denotes quantity of various inputs.
Assumptions of Production Function: The production function is based on the following
assumptions:
1. It is specified with reference to a specified period of time.
2. It is assumed that the state of technology remains the same, during the period of time.
3. It is assumed that the firm uses best and most efficient technique available in production.
4. It is assumed that the factors of production are divisible into viable units.
♦ The production function can be explained under two heads:
1. The short run production function in which input - output relations are analysed where -
■ One input is variable, all other inputs are fixed, (described as the Law of Variable
Proportions) OR
■ Two inputs are variable, all other factors are fixed (explained with the help of isoquants)
2. The long run production function in which input- output relations are analysed where all
the inputs are variable (described as the Law of Returns to Scale).
Cobb-Douglas Production Function
Q = f (L, K). Where - Q = Output; L = Labour; K = Capital
♦ Paul H. Douglas and C.W. Cobb of the U.S.A. studied the production function of the
American manufacturing industries. This production function applies to the whole of
manufacturing in U.S.A. rather than to an individual firm. In this case, output is
manufacturing production and inputs used are labour and capital.
♦ The conclusion of study is that labour contributed 3/4th and capital about 1 /4th in the
manufacturing production.
FIXED INPUTS (FIXED FACTORS) AND VARIABLE INPUTS (VARIABLE FACTORS)

Comparison Fixed Inputs Variable Inputs

(i) Meaning ♦ The factors which cannot be easily ♦ The factors which can be easily
and quickly changed and require long and quickly changed and readily
time to make adjustment in them with adjusted with the changes in the
the changes in the level of output are level of output are called variable
called fixed inputs or fixed factors of inputs or variable factors of
production. production.
♦ In other words, factor inputs whose ♦ In other words, factor inputs whose
quantity does not vary from day-to-day quantity may vary from day-to-day
are called as fixed inputs. are called as variable inputs.

(ii) Examples ♦ Examples of fixed inputs - ♦Examples of variable inputs -

buildings, machinery, plant, top ordinary labour, raw-material, power,
management, etc. fuel chemicals, etc.
♦ It requires long time to make ♦ It can be readily changed.
variations in them.
♦ E.g. To construct a new factory
building with a larger area and
capacity.

(iii) Relation ♦ Fixed inputs do not vary with the level ♦ Variable inputs vary directly with
with Output of output. the level of output.
♦ Its q uantity remains the same, ♦ Such factors are required more,
whether the output is more or less or when output is more; less, when
zero in SHORT RUN output is less and zero, when output
is zero in SHORT RUN.

(iv) Cost ♦ The cost of the fixed inputs is called ♦ The cost of the variable inputs is
FIXED COST. called VARIABLE COST.
♦ In the short run the firm has to bear ♦ Since variable inputs vary directly
the fixed cost even if the output is zero. with the level of output, variable
costs are also positively related with
♦ Since the quantity of fixed inputs
output. If output is zero, variable cost
remains the same, fixed cost remains
is also zero.
the same whatever be the level of
output. ♦ If output is increased variable cost
also increases and vice-versa.
Short Run (Short Period) & Long Run (Long Period)

Comparison Short Run Long Run

(i) Meaning ♦ The short run is defined as the period ♦ The long run is defined as the
of time in which some factors of period of time in which all factors
production or at least one factor is fixed may vary.
i.e. does not vary with output.

♦ Thus, in the short period some factors ♦ In the long run, all factors
are FIXED FACTORS E.g. Factory become
building, machinery, management, etc.
variable and so there is no
and some are VARIABLE FACTORS
distinction between fixed and
E.g. Labour, raw-material, power, fuel,
variable factors.
etc.

(ii) Scale of ♦ In the short run, the output is produced ♦ In the long run, the output is
Production OR with a GIVEN SCALE OF produced with the CHANGE IN THE
Size of the PRODUCTION i.e. the size of plant or SCALE OF PRODUCTION i.e. the
Firm firm (and so the production capacity) size of plant or firm can be
remains unchanged. increased (and so the production
capacity).
♦ Hence, production can be increased or
decreased only by changing the amount ♦ Hence, production can be
of variable factors. increased by varying all factors i.e.
fixed factors (of short period) as well
as variable factors.

(iii) Production ♦ The production function which is ♦ The produc tion function which is
Law studied in the short run period is called studied in the long run period is
as the Law of Variable Proportions. called as the Law of Returns to
Scale.

(iv) Decisions ♦ The decisions to change the amount of ♦ The decisions to change the
about Change variable factors (like raw material, amount of fixed factors i.e. scale of
in factors labour, etc.) are taken very frequently production or to close down the firm
depending upon changes in demand of are taken only once in a while.
the commodity.
♦ Hence, long run is the
♦ Hence, short run is the ‘ACTUAL ‘PLANNING PERIOD’.
PRODUCTION PERIOD’ during which
♦ Thus, firms plan in the long run
some factors are fixed while some are
period.
variable.
♦ Thus, firms operate in the short run
period.

(v) Nature of ♦ In the short run period, supply can be ♦ In the long run period, supply can
Supply adjusted upto a limited extent as per be fully adj usted as per changes in
changes in demand. demand.
♦ In other words, supply is relatively ♦ In other words, supply is relatively
inelastic. elastic.
(vi) Nature of ♦ In short run period, cost is classified as ♦ In long run period ALL COSTS
Cost FIXED COST and VARIABLE COST. ARE VARIABLE.
♦ Fixed cost is the cost of fixed inputs ♦ Variable cost is the main
and Variable cost is the cost of variable feature of long run period.
inputs.
♦ Fixed cost is the main feature of
short run period

(vii) Effect on ♦ In short-run, the price determination of ♦ In long-run, the price

Price a commodity is more influenced by - determination of a commodity is
more influenced by-
(a) The demand forces than supply
forces because supply in short-run is (a) The supply forces than demand
relatively inelastic, and forces because supply in long-run is
relatively elastic, and
(b) The UTILITY of the commodity.
(b) The COST OF PRODUCTION of
♦ The short-run price is called SUB-
NORMAL PRICE the commodity.
♦ The long-run price is called
NORMAL PRICE.

(viii) Average ♦ The short-run average cost curve is 'U' ♦ The long-run average cost curve
Cost Curve shaped. is also U shaped.
♦ Its U-shape is explained with the Law ♦ But its U- shape is not as
of Variable Proportions. prominent as short-run average cost
curve.
♦ Its U-shape is explained with the
Law of Returns to Scale.
♦ Long-run average cost curve is
also called 'PLANNING CURVE'
and 'ENVELOPE CURVE’.

(ix) Profit of ♦ In the short-run period - ♦ In the long run period-

Firms
(a) The firms under perfect competition (a) The firms under perfect
on being at equilibrium may earn normal competition earn only NORMAL
profits, super normal profits or incur PROFITS and operate at optimum
losses; level.
(b) The monopoly firm on being at (b) The monopoly firm can earn
equilibrium may earn normal profits, SUPER NORMAL PROFITS and
super normal profits or incur losses; operate at sub-optimum level.
(c) The firms under monopolistic (c) The firms under monopolistic
competition on being at equilibrium may competition earn only NORMAL
earn normal profits, super normal profits PROFITS and operate at sub-
or incur losses. optimum level.

CONCEPTS OF PRODUCT
♦ Product i.e. output refers to the volume of goods produced by a firm in a particular period
of time.
♦ There are three concepts relating to the physical production by factors namely-
1. Total Product (TP),
2. Average Product (AP), and
3. Marginal Product (MP).
1. Total Product (TP).
♦ The total output produced by all the factors per unit of time is called total product.
♦ Total product increases with an increase in the variable factor input.
♦ Column Nos. (1) and (2) of the following table shows a total product schedule.
2. Average Product (AP):
♦ The average product means the total product per unit of a variable factor.
♦ In other words, it is the total product divided by the number of units of a variable factor.
Total Product
Average Product =
No.of units of variable factor
TP
OR AP=
QVF

♦ Column No. (3) of the following table shows the average product of variable factor.
3. Marginal Product (MP):
♦ The marginal product means addition made to total product by the use of an extra unit of
variable factor.
♦ It may be stated as- MPn = TPn – TPn-1
where,
MPn = Marginal product when ‘n ’ units of variable factors are used
TP = Total Product
n = number of units of variable factors used.
♦ Marginal Product may also be defined as the change in total output due to use of
additional unit of variable factor
∆TP
MP=
∆QVF

Where -
Δ = a small change Column No. (4) of the following table shows the marginal product
schedule.
Table : Product Schedule

Units of Variable Average Product Marginal Product

Total Product (TP)
factor E.g. LABOUR (AP) (MP)

1 10 10 10

2 30 15 20

3 60 20 30

4 80 20 20

5 90 18 10
 6 90 15 0

7 85 12.1 -5

♦ Average product and Marginal product are related to one another.

(i) - When average product of the variable factor is rising, marginal product of the variable
factor is more than its average product.
- So when average product curve is rising, the marginal product curve will lie somewhere
above it.
(it) - When average product of the variable factor is falling, marginal product of the variable
factor is less than its average product.
- So when average product curve is falling, the marginal product curve will lie somewhere
below it.
(Hi) - When average product of the variable factor is maximum and constant, marginal
product is equal to average product.
- In other words, the marginal product curve cuts the average product curve at its maximum
point.
LAW OF VARIABLE PROPORTIONS
♦ The Law of Variable Proportions examines the production function i.e. the input-output re- |
lation in short run where one factor is variable and other factors of production are fixed.
♦ In other words, it examines production function when the output is increased by varying the
j quantity of one input.
♦ Thus, the law examines the effect of change in the proportions between fixed and variable
I factor inputs on output in three stages viz. Increasing returns, diminishing returns and
neg- | ative returns.
♦ Statement of the Law
“As the proportion of one factor in a combination of factors is increased, after a point
first | the marginal and then the average product of that factor will diminish”. (F.
Benhan)
♦ The law operates under some assumptions which are as follows:-
1. There is only one factor which is variable. All other factors remain constant.
2. All units of variable factor are homogeneous
3. It is possible to change the proportions in which the various factors are combined.
4. The state of technology is given and is constant.
♦ The three stages of the law can be explained with the help of the following schedule and
diagram.
Table : Law of variable proportions

Units of Units of Ratio of Total Average Marginal Stages of the Law

Fixed Variable Factors
Product Product Product
Factor factor
CAPITAL LABOUR

10 1 10:1 10 10 10 Stage I
 Increasing Returns to
10 2 10:2 30 15 20
Factor
10 3 10:3 60 20 30

10 4 10:4 80 20 20 Stage II
Diminishing Returns to
10 5 10:5 90 18 10
Factor
10 6 10:6 90 15 0

10 7 10:7 85 12.1 -5 Stage III

Negative Returns to
Factor

Figure : Law of variable proportions

♦ Stage I: The Law of Increasing Returns to Factor -
■ During this stage, total product (TP) increases at an increasing rate upto the point of
inflexion T and thereafter it increases at diminishing rate.
■ This is because marginal product (MP) of the variable factor increases upto point 'M* on
MP curve and then start falling.
■ Rising MP also pulls up average product (AP), which goes on rising, in the first stage.
a Rising AP indicates increase in the efficiency of variable factor i.e. labour.
■ Stage I ends where AP is maximum and is equal to MP as shown by point ‘C’ in the
diagram.
The law of increasing returns operates because of the following two reasons:
1. Indivisibility of fixed factors
a Due to indivisibility, the quantity of fixed factors is more than the quantity of variable
factors.
■ So when the quantity of variable factors is increased to work with fixed factors, output
increases speedily due to full and effective utilisation of fixed factors.
■ In other words, efficiency of fixed factors increases.
2. Efficiency of Variable Factor Increases
■ Due to increase in the quantity of variable factor, it becomes possible to introduce
DIVISION OF LABOUR leading to SPECIALISATION. This results in more output per
worker.
♦ Stage II: The Law of Diminishing Returns to Factor -
- In second stage, TP continues to increase at diminishing rate. It reaches the maximum at
point ‘D' in the diagram, where the second stage ends.
- In this stage, both AP and MP of variable factor are falling though remains positive. That is
why this stage is called as the stage of diminishing returns.
- At the end of this stage MP becomes, zero as shown by point ‘B’ in the diagram and
corresponding to highest point ‘D’ on TP curve.
The law of diminishing returns operate due to the following two reasons:
1. Indivisibility of fixed factors
■ Once the optimum proportion between indivisible fixed factors and variable factors is
reached (as in Stage I) with any further increase in the quantity of Variable factor, the fixed
factors become inadequate and are overutilised.
■ The fine balance between fixed and variable factor gets disturbed. This causes AP and MP
to diminish.
2. Imperfect Substitutability of factors
■ Variable factors are not perfect substitute of fixed factors.
■ The elasticity of substitution between factors is not infinite.
♦ Stage III: The Law of Negative Returns to Factor -
- In third stage, TP falls and so, TP curve slopes downward. MP becomes negative and the
MP curve goes below the X-axis. AP continues to fall.
- As the MP of variable factor becomes negative, this stage is called the stage of negative
returns.
- In this stage the efficiency of fixed and variable factors fall and factor ratio becomes highly
sub-optimal.
The law of negative returns operate due to the following reasons:
1. The quantity of the variable factor becomes too excessive compared to fixed factors. They
get in each other's way and so TP falls and MP becomes negative.
2. Too large number of variable factors also reduce the efficiency of fixed factors.
♦ Conclusion -Where to operate?
- A rational firm will not produce either in Stage I or in Stage III.
- In stage I, the marginal product of fixed factor is negative as its quantity is more than
variable factor.
- In stage III, the marginal product of variable factor is negative as its quantity is too large
than fixed factor.
- Therefore, firm would seek to produce in Stage II where both AP and MP of Variable factor
are falling.
- At which point to produce in this stage will depend on the prices of factor inputs.
LAW OF RETURNS TO SCALE.
♦ The Law of Returns to Scale examines the production function i.e. the input - output
relation in long run where increase in output can be achieved by varying the units of ALL
FACTORS IN THE SAME PROPORTION.
♦ Thus, in long run all factors become variable.
♦ It means that in long run the scale of production and the size of the firm can be increased.
♦ The law of returns to scale analyse the effects of scale on the level of output as-
1. Increasing Returns to Scale:
■ When the output increases by a greater proportion than the proportion increases in all the
factor inputs, it is increasing returns to scale.
■ E.g. When all inputs are increased by 10% and output rises by 30%.
■ The reasons of increasing returns to scale are - internal and external economies of scale;
indivisibility of fixed factors; improved organisation; division of labour and specialisation;
better supervision and control; adequate supply of productive factors, etc.
2. Constant Returns to Scale:
■ When the output increases exactly in the same proportion as that of increase in all factor
inputs, it is constant returns to scale.
■ E.g. - When all inputs are increased by 10% and output also rises by 10%.
■ The reason of constant returns to scale is that beyond a certain point, internal and external
economies are NEUTRALISED by growing internal and external diseconomies.
3. Diminishing Returns to Scale:
■ When the output increases by a lesser proportion than the proportion increase in all the
factor inputs, it is diminishing returns to scale.
E.g. When all inputs are increased by 20% but output rises by 10%.
■ The reason of diminishing returns to scale is increased internal and external diseconomies
of production.
■ Internal diseconomies like difficulties in management, lack of supervision and control,
delay in decision-making etc.
■ External diseconomies like insufficient transport system, high freights, high prices of raw
materials, power cuts, etc.
♦ The law of returns to scale can also be illustrated with the help of the following schedule
and diagram.
Table : Law of returns to scale

Units of Labour & Marginal Product

Total Product (Units) Remarks
Capital (Units)

1 200 200 Stage I

Increasing Returns
2 300 500

3 400 900 Stage II

Constant Returns
4 400 1300

5 400 1700

6 300 2000 Stage III

Diminishing Returns.
7 200 2200
 8 100 2300

Figure : Returns to Scale

RETURNS TO FACTOR AND RETURNS TO SCALE

Returns to Factor Returns to Scale

1. Meaning - Returns to factor refers to the - Returns to scale refers to the various
various production sizes where one production sizes where increase in
factor is variable and other factor of output can be achieved by varying the
production are fixed. units of ALL FACTORS in the SAME
PROPORTIONS.
- In other words, it examines
production function when the output is - It show the effects on output when all
increased by varying the quantity of factor inputs are varied in the same
one input. proportion simultaneously.
- It examines the effect of CHANGE IN
THE PROPORTIONS between inputs
on output.

2. Nature of - Quantities of some inputs are fixed - Quantities of all inputs can be varied.
Inputs while the quantities of other inputs
- In other words, all factors of
vary.
production are VARIABLE.
- In other words, there are FIXED and
VARIABLE factors of production.

3. Time - Returns to factor is called a SHORT - Returns to scale is called a LONG

Element RUN production function. RUN production function.

4. Application - It does not apply where the factors - It does apply where the factors must
must be used in fixed proportion to be used in fixed proportions to
produce a commodity. produce a commodity.
5. Stages of - The law has three stages namely - - The law has three stages namely -
Law {a) Increasing Returns to factor,
(a) Increasing Returns to Scale,
(b) Diminishing Returns to Factor, &
(b) Constant Returns to Scale,
(c) Negative Returns to factor
(c) Diminishing Returns to Scale.
- Of the three stages, diminishing
- All the three stages of return appear.
returns pre-dominate.

6. Causes of - Increasing returns to factor is due to - Increasing returns to scale is due to

Operation indivisibility of fixed factors and increased internal and external
division of labour and specialisation. economies.
- Diminishing returns is due to non- - Constant returns to scale is due to
optimal factor proportion and the fact that internal and external
imperfect substitutability of factors. economies are neutralised by growing
internal and external diseconomies.
- Negative returns fall in the efficiency
of fixed and variable factors. - Diminishing returns is due to internal
and external diseconomies of scale.

7. Scale of - The scale of output is unchanged - The scale of output can be increased
Production and the production plant or the size and so the size of the firm too can be
and efficiency of the firm remain expanded.
constant.
- This is because all factors are
- This is because, only one factor is variable and hence can be increased
variable and all other factors are fixed. in the same proportion simultaneously.

PRODUCTION OPTIMISATION:
Isoquants:
An iso-product curve or isoquant is a curve, which represents the various combinations of
two variable inputs that give the same level of output. As all combinations on the iso-product
curve give the same level of output, the producer becomes indifferent to these combinations.
That is why iso-product curve are also called ‘production indifference curve' or ‘equal
product curve'. To understand consider the following production isoquant schedule.

Schedule I Schedule II

Units of Units of Units of Units of Units of Units of

Combinations Combinations
CAPITAL LABOUR OUTPUT CAPITAL LABOUR OUTPUT

A 1 12 100 F 2 15 200

B 2 8 100 G 3 11 200

C 3 5 100 H 4 8 200

D 4 3 100 I 5 6 200

E 5 2 100 J 6 5 200

In the schedule I above, the producer is indifferent whether he gets combination A, B, C, D

or E. This is because all the combinations of capital and labour give the same level of output
i.e. 100 units.
By plotting the above combinations on a graph, we can derive an iso-product curve as
shown in the following figure:

In the diagram, quantity of capital is measured on X-

axis and quantity of labour on Y-axis.
The various combinations A, B, C, D, E of capital
and labour are plotted and on joining them we
derive an iso-product curve. All combinations lying
on the iso-product curve yield the same level of
output i.e. 100 units and hence technically equally
efficient.
If the production schedule II is also plotted on the
graph, we will get another iso-product curve IQ200.
This will lie above the IQ100 as the combinations
contain greater quantities of capital and labour. A
set of iso-product curves is called iso-product curve
map.

In the diagram, it can be observed that each iso-

product curve is labelled in terms of output. All
combinations lying of IQ100 give the output of 100
units and all the combinations lying on IQ200 give
the output of 200 units. Higher iso-product curve
represent higher level of output. Also it indicates
how much more output can be achieved.
Marginal Rate of Technical Substitution
The rate at which one factor of production is
substituted in place of the other factor without any
change in the level of output is called as the
marginal rate of technical substitution. Consider the
following schedule.

Marginal Rate of
Units of Units of Technical Units of
Combinations
CAPITAL (K) LABOUR (L) 𝚫𝐋 OUTPUT
substitution. MRTS=
𝚫𝐊

A 1 12 - 100

B 2 8 4L: IK 100

C 3 5 3L: IK 100

D 4 3 2L: IK 100

E 5 2 1L: IK 100

Each of the factor combinations in the table above yields same level of output. Moving from
combination A to B, one unit of capital replaces 4 units of labour. Similarly, moving from B to
C, one unit of capital now replaces only 3 units of labour and so on. It implies that labour and
capital are imperfect substitutes. That is why MRTSKL is continuously diminishing. We can
measure MRTSKL on an iso-product curve.
‘Iso-Cost Line’ OR ‘Equal Cost Lines’
Iso-cost line (also known Equal Cost Line; Price Line; Outlay Line; Factor Price Line) shows
the various combinations of two factor inputs which the firm can purchase with a given outlay
(i.e. budget) and at given prices of two inputs.
Example. A firm has with itself Rs. 1,000 which it would like to spend on factor 'X' and factor
'Y'. Price of factor 'X' is Rs. 20 per unit.
Price of factor 'Y' is Rs. 10 per unit.
Therefore, if the firm spends the whole amount on factor X, it can buy 50 units of X and if the
whole amount is spent on factor Y, it can buy 100 units of Y. However, in between these two
extreme limits, it can have many combinations of X and Y for the outlay of Rs. 1,000.
Graphically it can be shown as follows -

In the diagram OP shows 100 units of Y and OM shows 50 units

of X. When we join the two points P and M, we get the iso-cost
line. All the combinations of factor X and factor Y lying on iso-
cost line can be purchased by the firm with an outlay of Rs.
1,000. If the firm increases the outlay to Rs. 2,000, the iso-cost
line shifts to the right, if prices of two factors remains
unchanged. The slope of the iso-cost line is equal to the ratio of
the prices of two factors. Thus,
Price of X
Slope of line PM =
Price of Y

Producer’s Equilibrium OR Production Optimization.

A firm always try to produce a given level of output at minimum cost. For this it has to use
that combination of inputs which minimizes the cost of production. This ensures
maximization of profits and produce a given level of output with least cost combination of
inputs. The least-cost combination of inputs or factors is called producer's equilibrium or
production optimization. This is determined with the help of (a) isoquants, & (b) iso-cost line.
An isoquant or iso-product curve is a curve which shows the various combinations of two
inputs that produce same level of output. The isoquants are negatively sloped and convex to
origin. The slope of isoquants shows the marginal rate of technical substitution which
diminishes. Thus, MRTSxy
∆y MPx
= Slope = =
∆x MPy

Iso-cost line shows the various combination of two factor inputs which the firm can purchase
with a given outlay and at given prices of inputs. There can be different outlays and hence
P
different iso-cost lines. Slope of iso-cost line shows the ratio of the price of two inputs i.e. x.
Py
 Which will be the least cost combination can be
understood with the help of following figure.
Suppose firm wants to produce 300 units of a
commodity. It will first see the isoquant that
represents 300 units.
In the adjoining diagram we find that all
combinations a, b, c, d and e can produce 300
units of output. In order to produce 300 units firm
with try to find out least cost combination. For this
it will super impose the various iso-cost lines on
isoquant as shown in the diagram. The diagram
shows that combination ‘C’ is the least cost
combination as here isoquant is tangent to iso-cost
line HI. All other combinations a, b, d and e lying
on isoquant cost more as these points lie on higher
iso-cost lines. Hence, the point of tangency of
isoquant and iso-cost line shows least cost
combination. At the point of tangency.

Slope of iso-quant = Slope of iso-cost line

Px
∴MRTSxy =
Py

Thus, the firm will choose OM units of factor X and ON units of factor Y and be at equilibrium
as the marginal physical products of two factors are proportional to the factor prices.
INTERNAL ECONOMIES AND DISECONOMIES
♦ Internal economies are those benefits which accrue to a firm when it expands the scale
of production.
♦ Internal economies are the result of the firm's own efforts independent of the actions of
other firms.
♦ These economies are particular to the individual firms and are different for different firms
depending upon the size of the firm.
♦ The main types of internal economies are as follows :-
1. Technical Economies :
- The large scale production is associated with technical economies.
- As the firm increases its scale of production, it becomes possible to use better plant,
machinery, equipment and techniques of production.
- Following are the main forms (causes/reasons) of technical economies
■ Economies of superior techniques.
- A large sized firm can use sophisticated and costly machines and equipments.
- Use of superior techniques reduces the cost of production per unit and increases
aggregate output.
■ Economies of increased dimensions.
- A large firm can get the mechanical advantage in using large machines and other
mechanical units to produce more output.
- E.g. A Large boiler, large furnace, etc. can be operated by same team as required by
smaller boiler, furnace, etc.
■ Economies of linked processes.
- A large sized firm can develop its own sources of raw material, means of transportation,
distribution system, etc.
■ Economies of the use of By-products.
- A large sized firm can avoid all kinds of wastage of materials. The firm can use its by-
products and waste material to produce another material.
- E.g.- Sugar industry can make alcohol out of the molasses.
■ Economies of specialization.
- A large sized firm can introduce greater degree of division of labour and specialisation.
2. Managerial Economies :
- Large sized firms can introduce division of labour in managerial tasks.
- They can employ business executive of high skill and qualification to look after the
functioning of various departments like production, finance, sales, advertising, personnel,
etc.
- This helps to increase the efficiency and productivity of managers resulting in reduction in
managerial costs.
3. Commercial Economies :
- A large sized firm is able to reap economies of bulk purchases.
- It can get discounts from suppliers, railways, transport companies, etc.
- It enjoys prompt and regular supply of raw materials.
- A large sized firm can also afford to spend large amount of money on advertising, publicity,
etc.
- It can also give various concessions to wholesale and retail dealers and customers and
thus capture markets for its product.
4. Financial Economies :
- A big firm enjoys goodwill among lenders or investors.
- For raising finance it can either borrow from bank as it can offer better security or it can
raise finance by issuing shares, debentures and by inviting public deposits. Such
opportunities are not available to small firms.
5. Risk Bearing Economies :
- A large firm is better placed to face the uncertainties and risks of business.
- A big firm producing many variety of goods is in a better position to withstand economic
ups and downs. Therefore, it enjoys economies of risk bearing.
♦ Internal diseconomies means all those factors which raise the cost of production per unit
of a particular firm when the scale of production is expanded beyond the point of optimal
capacity.
♦ Such diseconomies of scale are as follows
1. Production Diseconomies :
- Production diseconomies sets in when expansion of firm’s production beyond optimum size
leads to rise in the cost per unit of output.
- E.g. Use of inferior or less efficient factors due to non-availability of efficient factors raises
the per unit cost of output.
2. Managerial Diseconomies :
- As the scale of production increases burden on management also increases.
- Co-ordination of work among different departments becomes difficult. Supervision and
control over the activities of subordinates becomes difficult, decision taking is delaved, etc.
- As a result, wastage increase and the efficiency and productivity decrease.
- Per unit cost starts rising.
3. Technical Diseconomies :
- Every equipment has an optimum point at which it works more efficiently and economically.
- Beyond optimum point they are overworked and may result in breakdowns, heavy cost of
maintenance, etc.
4. Financial Diseconomies:
- Expansion of production beyond the optimum scale results in increase in the cost of capital.
- It may be due to increased dependence on external finances.
5. Marketing Diseconomies :
- Selling diseconomies set in if the scale of production is expanded beyond optimum level.
- The advertisement expenditure and marketing overheads increase more proportionately
with the scale.
EXTERNAL ECONOMIES AND DISECONOMIES
♦ External economies are those benefits which accrue to all the firms operating in a given
industry from the growth and expansion of that industry.
♦ External economies are not related to an individual firm's own cost reduction efforts.
♦ These are common to all the firms in an industry and shared by many firms or industries.
♦ The main types of external economies are as follows
1. Technological Economies :
- When the whole industry expands, it may result in the discovery of new technical
knowledge, firms pool manpower and finance for research and development resulting in new
and improved methods of production and new inventions.
- Use of improved and better machinery improves production function and cost of production
per unit fails.
2. Economies of Localization :
- When in an area, many firms producing the same commodity are set up, it is called
localization of an industry.
* Due to localization there is expansion of railways, post & telegraph, banking services,
insurance, setting up of booking offices by transport, companies, setting up of powerful
transformer by electricity department, etc.
- All the firms get these facilities at low prices.
3. Economies of Information :
- As pointed earlier, firms pool their resources for research and development.
- All firms get the benefit of the research in terms of market information, technical
information, information about governments economic policies, information about availability
of new source of raw material, etc.
- Also, specialized journals give information about latest developments.
4. Cheaper Inputs :
- When an industry expands its needs for raw materials, machines, etc. also expand.
- This may result in exploration of new and cheaper sources of raw materials, machinery,
etc.
- Also, the industries producing such inputs also expand in scale.
- Therefore, they can supply these inputs at lower prices.
- As a result the cost of production per unit of the firm using these inputs falls.
5. Growth of Ancillary Industries :
- With the growth of an industry, many firms specialized in the production of inputs like raw
material, tools, machinery, etc. come up.
- Such firms are called ancillary units which provides inputs at lower cost to the main
industry.
- Likewise, some firms may get developed by processing the waste products of the industry.
- Thus, wastes are converted into by-products. This reduces the cost of production in
general.
6. Development of Skilled Labour:
- When an industry expands specialized institutions like colleges, training centers,
management institutes, etc. develop.
- This results in continuous availability of skilled labour like technicians, engineers,
management experts, etc.
7. Better transportation & Marketing Facilities :-
- When an industry expands many specialized transporters also develop.
- The firm in need of specialized transport service can get them easily at cheaper rates.
- Also many new marketing outlets and specialized marketing institutions develop. The firm
need not spend on developing its own marketing outlets.
- This reduces the cost.
♦ The growth and expansion of an industry in a particular area beyond optimum level results
in many disadvantages for firms in the industry.
♦ Such disadvantages increases the costs of production of each firm.
♦ Therefore, they are called external diseconomies. Some of the external diseconomies
are as follows :-
1. Diseconomies of Scarcity of Inputs :
- When an industry expands its need for raw materials, machines, tools and equipments, etc.
also expands.
- Some inputs are such which cannot be totally substituted.
- The firms supplying these inputs come under pressure and may supply inputs at a higher
price.
- This raises the cost of production per unit of the firm who uses these inputs.
2. Diseconomies of Strains on Infrastructure :
- Due to concentration of firms in an area infrastructural facilities become inadequate over a
time.
- E.g. Excessive pressure on transport system results in delayed transportation of raw
materials and finished goods.
- Other facilities like electric power supply, communication system, water supply, etc. are
also over taxed.
- This puts strain on infrastructural facilities resulting in increased cost of production.
3. Diseconomies of High Factor Prices :
- With the concentration of an industry in a particular area, the demand for factors of
production rises.
Thus, the prices of the factors of production go up resulting in increased cost of production.
4. Diseconomies of Expenditure on Advertising :
- Expansion of an industry also means increase in the number of firms.
- Likewise, some firms may get developed by processing the waste products of the industry.
- Thus, wastes are converted into by-products. This reduces the cost of production in
general.
6. Development of Skilled Labour:
- When an industry expands specialized institutions like colleges, training centers,
management institutes, etc. develop.
- This results in continuous availability of skilled labour like technicians, engineers,
management experts, etc.
7. Better transportation & Marketing Facilities :-
- When an industry expands many specialized transporters also develop.
- The firm in need of specialized transport service can get them easily at cheaper rates.
- Also many new marketing outlets and specialized marketing institutions develop. The firm
need not spend on developing its own marketing outlets.
- This reduces the cost.
♦ The growth and expansion of an industry in a particular area beyond optimum level results
in many disadvantages for firms in the industry.
♦ Such disadvantages increases the costs of production of each firm.
♦ Therefore, they are called external diseconomies. Some of the external diseconomies
are as follows :-
1. Diseconomies of Scarcity of Inputs :
- When an industry expands its need for raw materials, machines, tools and equipments, etc.
also expands.
- Some inputs are such which cannot be totally substituted.
- The firms supplying these inputs come under pressure and may supply inputs at a higher
price.
- This raises the cost of production per unit of the firm who uses these inputs.
2. Diseconomies of Strains on Infrastructure :
- Due to concentration of firms in an area infrastructural facilities become inadequate over a
time.
- E.g. Excessive pressure on transport system results in delayed transportation of raw
materials and finished goods.
- Other facilities like electric power supply, communication system, water supply, etc. are
also over taxed.
- This puts strain on infrastructural facilities resulting in increased cost of production.
3. Diseconomies of High Factor Prices :
- With the concentration of an industry in a particular area, the demand for factors of
production rises.
Thus, the prices of the factors of production go up resulting in increased cost of production.
4. Diseconomies of Expenditure on Advertising:
- Expansion of an industry also means increase in the number of firms.
- This means increase in competition among the firms.
- This forces a firm to spend more and more on advertising.
- This raises per unit cost.
INTERNAL AND EXTERNAL ECONOMIES

INTERNAL ECONOMIES EXTERNAL ECONOMIES

1. - Internal economies are the benefits which - External economies are those benefits
accrue to a firm when it expands the scale of which accrue to all the firms operating in a
production. given industry from the growth and
expansion of that industry.

2. - Internal economies are called' internal' - External economies are called ‘ external'
because these arise due to the internal because they accrue to a firm as a result of
efforts of the firm. factors that are entirely outside the firm i.e.
from the expansion of the industry.
- These economies are specific to the
individual firm and are different for different
firms depending upon the size of the firm.

3. - Internal economies are the result of the - External economies are independent of
firm’s OWN EFFORTS INDEPENDENT OF firm's own efforts and output.
THE ACTIONS OF OTHER FIRMS.
- They are dependent on the general
- These economies are peculiar to each firm. development of the industry.
- It reflects the working pattern of the firm. - They are not restricted to a single firm but
are shared by a number of firms.

4. - Internal economies cause the long-run - External economies and diseconomies

average cost to fall in the initial stage and cause the LAC curve to shift down or up as
internal diseconomies cause the long-run the case may be.
average cost to rise at the later stage.
- When external economies increase, the
- Thus, the shape of LAC curve is cost per unit of output falls.
determined by internal economies and
- So, LAC curve shift downwards.
diseconomies as scale expands.
- When external diseconomies are more,
the cost per unit of output rises.
- So, LAC curve shift upwards.
5.

6. - If every thing is effectively managed, - External economies depend upon the

internal economies can be of long term in conditions of the entire industry and
nature. economy.
- Thus, it can be of short term in nature.

7. - Internal economies are in the form of - External economies are in the form of
technical economies like superior cheaper inputs; discovery of new technical
techniques, use of by- products, etc.; knowledge; development of skilled labour;
managerial economies; commercial economies of information; growth of
economies; financial economies and risk- ancillary units; better transport and
bearing economies. marketing facilities.

THEORY OF COST
♦ In the production analysis we had considered quantitative relationship between inputs and
outputs.
♦ In the cost analysis we are concerned with financial side of production i.e. the cost
behaviour in relation to size of output, scale of operations, prices of factors of production,
etc.
♦ Therefore, a businessman must have a clear understanding of various concepts of costs.
COST CONCEPTS
♦ Accounting Costs and Economic Costs.
1. Accounting costs are those cash payments which firms make to outsiders for purchasing
or hiring the services of various productive factors which do not belong to the entrepreneur.
2. The accounting costs are in the nature of contractual payments to the factor suppliers.
E.g. - Contractual payments like wages, rent on hired land, interest on borrowed capital, cost
of power and fuel, purchase of raw-materials, insurance premium, transportation,
advertising, taxes, etc.
3. These costs are recorded in firm's account book.
4. All these money expenses are also known as EXPLICIT COSTS or accounting costs
as they form part of the cost of production and accounted by the firm.
5. Economists take a broader view of the cost concept. Economist's cost refer to what may
be called FULL COSTS or ECONOMIC COSTS.
6. Economic Costs = Explicit costs (or accounting costs) + Implicit costs (or imputed costs)
7. Thus, economic cost is the sum total of accounting costs (also called explicit costs) and
implicit cost (also called imputed costs or opportunity cost)
8. Implicit costs are costs of self owned and self supplied resources by an entrepreneur
which are generally not recorded in the firm’s account book. There is no contractual
obligation for payment to any body else.
E.g.- An entrepreneur may utilise his own building or his own capital or may act as a
manager of his firm himself.
9. For these productive services, he does not pay rent or interest or salary to himself
although the payments accrue to him.
10. These are implicit or imputed (estimated) costs of various factors owned and supplied
by the owner himself.
11. When an entrepreneur invests capital in his business, devotes his time and skills in his
business, he has to forego the opportunity of investing his, capital, time and skills elsewhere.
12. Implicit costs involves the sacrifice of alternatives that have been foregone in the
production of a commodity.
13. Hence, implicit costs are also called "opportunity cost” and forms part of the economic
costs.
14. A firm earns economic profits or normal profit when it recovers both explicit costs as
well as implicit costs.
15. Thus, normal profit is a part of implicit cost. Profit earned over and above normal profit is
called super normal profit.
♦ Outlay Cost and Opportunity Cost.
1. Outlay costs involve actual outlay of funds on wages, material, rent, interest etc. Outlay
costs involve financial expenditure at some time and thus are recorded in the books of
account.
2. Our wants are unlimited and resources are scarce but have alternative uses. Hence, the
problem of choice among the alternative uses of a given resource for particular purpose
arises.
3. This is because, the use of a resource in producing a commodity always involves the loss
of opportunity of production of some other commodity.
4. The sacrifice or loss of alternative use of a given resource is termed as “
opportunity cost."
5. Thus, the opportunity cost is measured in terms of the foregone benefits from the next
best alternative use of a given resource.
E.g.- The opportunity cost of producing a car is production of 10 scooters sacrificed, which
could have been produced with the same amount of factors that make a car.
6. Hence, opportunity costs relate to sacrificed alternatives. They are NOT RECORDED
in the
books of account.
7. The concept of opportunity cost is useful in the determination of relative prices of goods,
normal remuneration to a factor, in decision making and in analysing optimum allocation of
resources.
♦ Direct (or Traceable) Costs and Indirect (or Non-Traceable) Costs.
1. A direct or traceable cost is one which can be identified easily and indisputably with a unit
of operation,
E.g.- a product, a department, a plant or a process..
E.g.- In the production of shoes, the cost of leather is a direct cost.
2. ' Indirect Costs or Non-Traceable Costs or Common Costs are those costs that are not
traceable
to plant, department and operation as well as those that are not traceable to individual final
products but are charged to jobs or products in standard accounting practice.
3. Such costs although not directly traceable to the product may bear some functional
relationship to production and may vary with output in some definite way.
E.g.- ELECTRIC POWER. Such common costs which are incurred for general operation of
business and benefits all products jointly are called indirect cost.
♦ Incremental costs and Sunk Costs:
1. Incremental costs are related to the concept of marginal cost. While marginal cost refer
to additional cost of producing an extra unit of output, incremental cost refers to the total
additional cost when business decisions are taken like-to expand the production, hire more
workers, materials, machinery, equipment, replace old plant and machinery, etc.
2. Sunk costs refer to the costs which has been already incurred in the past and cannot be
recovered. It also includes an expenditure that has to be made in future under past
commitments or contractual agreements. Sunk costs are irrelevant for decision making as
it cannot be recovered. Sunk costs do not vary with the changes in business activity.
Such costs also act as an important barrier to entry of firms into business. E.g.- expenses
on advertising, R&D, special equipments, etc.
♦ Historical costs and Replacement costs:
1. Historical costs are those costs on purchase of assets in the past.
2.Replacement costs refer to the expenditure to be made for replacing old assets.
3. Instability in asset prices make the two costs differ.
♦ Private costs and Social costs:
1. Private costs are those costs which are incurred or provided for by firms. These may be
either explicit or implicit since they form part of total cost of production, it implies they figure
in business decisions. Therefore, private costs are internalized cost.
2. Social costs refer to the total cost to the society due to business activity. Social costs
include both private cost and the external cost. It includes resources for which the firm is
not required to pay the price like - atmosphere, rivers, lakes, roads, etc. and the cost in
terms of disutility created like pollution of all types.
COST FUNCTION
♦ Cost function is the functional relation between COSTS and OUTPUT.
♦ The PRODUCTION FUNCTION of a firm and the PRICES it pays for the inputs determine
the firm’s cost function.
♦ Thus, cost function refers to the relation between COST OF A PRODUCT and the various
DETERMINANTS OF ITS COST.
♦ It can also be expressed in the form of a mathematical equation in which unit cost or total
cost is the dependent variable and the prices of various inputs are independent variables.
C = f (O,S,T,U,P------ )
Where –
C is cost
O is the level of output
S is the size of plant
T is time under consideration
P is the prices of factors of production.

♦ Production function determines the cost function.

♦ Therefore, the behaviour of cost of production and the shapes of the cost curves depend
upon the laws of returns.
♦ The LAW OF RETURNS TO FACTOR determine the shapes of short - period cost curves
while the LAW OF RETURNS TO SCALE determine the shapes of long - period cost curves.
SHORT RUN TOTAL COSTS
♦ TOTAL COST (in short run) = TOTAL FIXED COST + TOTAL VARIABLE COST

Points FIXED COST VARIABLE COST

1. Meaning - Fixed costs are incurred on the use - Variable costs are incurred on the
of the fixed inputs. use of the variable inputs.
- Fixed inputs cannot be varied in the - Variable inputs can be varied in the
short run. short run.
- Therefore, fixed costs do not - Therefore, variable costs changes
change with changes in output in with the changes in output i.e. they
short run. increase or decrease when output
rises or falls.
- Fixed costs are thus,
INDEPENDENT of output. - Variable costs thus, DEPEND on
output.
- These include both EXPLICIT
COSTS and IMPLICIT COSTS.

2. Can Be Zero - Fixed cost can never be zero. - Variable cost can become zero.
Or Not?
- If the level of output falls to ZERO, - If the level of output falls to zero,
fixed costs are to be incurred in the variable costs also falls to zero.
short run.
- In other words, if a firm shuts down
- In other words, if firm closes down for some time in short run, it will not
for sometime in short run but remains incur any variable cost as it will not
in business, these costs have to be use variable factors of production.
borne by it

3. Examples - E.g. Contractual rent, maintenance - E.g.- wages of labour employed,

cost, property taxes, interest on prices of raw materials, power and
capital invested, wages of permanent fuel, expenses on transport, etc.
staff, depreciation, etc.

4. Determinant - The examples of fixed cost above - The examples of variable cost
Factors have no bearing on the volume of above are closely related to the
production. volume of production.
- Hence variable costs are the
determinant factor.
5. Relation With - Fixed cost have no relation with - Variable costs are positively related
Output output in short run because these with output.
costs remain constant whatever be
- If output is zero, variable cost is also
the level of output.
zero.
- If output is increased variable cost
also rises FIRST at diminishing rate
due to increasing return to factor
AND THEN at an increasing rate due
to diminishing returns to factor.

6. Function Of ? - Fixed Costs are therefore function - Variable Costs are therefore
of TIME. function of OUTPUT.

7.Price - In short run, the firm do not bother - In short run, the firm must recover
Determination about recovering the fixed costs as it the variable costs to remain in
has to bear these costs even at zero business.
level of output.
- In other words firm's Average
Revenue > Average Variable cost

8. Other Names - Fixed costs are also known as - Variable costs are also known as
OVERHEAD COSTS as these costs PRIME or DIRECT COSTS as all the
are common to all the units of units produced depend directly on
commodity produced. them.
- They are also known as
SUPPLEMENTARY COSTS
because the volume of output
produced does not directly depend
upon them.

9. Table Total cost

Output Total Fixed cost (Rs.)+ Total Variable Cost (Rs.) =
(Rs.)

0 unit 60 0 60

1 unit 60 40 100

2 units 60 76 136

3 units 60 102 162

4 units 60 132 192

5 units 60 170 230

6 units 60 222 282

10. Diagram

- Graphically, the TFC curve is a - Graphically, the TVC curve is positively

horizontal straight line parallel to sloped.
X- axis.
- It indicates that variable cost increases
- It indicates that fixed cost with the increase in output.
remains unchanged at all levels.
- TVC curve originates from 0 i.e. origin
TFC curve originates from F on Y-
indicating that Variable cost is zero at
axis indicating that fixed cost is to
zero level of output.
be borne even at zero level of
output. - TC reflect the behaviour of TVC.
- Hence, at zero output TC is not - Hence, the shape of TC resembles
zero. It equals TFC. TVC.

Semi Variable Cost Stair-step Variable Cost Short run average cost
♦ For the purpose of making decisions about operations, unit cost functions or average costs
are more useful than the total cost functions.
♦ We examine here three of these unit cost functions namely -
1. Average Fixed Cost (AFC),
2. Average Variable Cost (AVC),
3. Average Total Cost (ATC).
1. Average Fixed Cost:
- Average Fixed Cost is the fixed cost per unit of output. Thus,
Total Fixed Cost
- Average Fixed Cost =
Total Output
TFC
- OR AFC =
Q

Table : Average Fixed Cost Fig. : Average Fixed Cost Curve

Output TFC AFC

(Rs.) (Rs.)
(units)

0 60 -

1 60 60
 2 60 30

3 60 20

4 60 15

5 60 12

6 60 10

- The above table shows that as the output increases, AFC goes on falling.
- The reason being TFC is spread over larger quantities of output.
- When graphed, the AFC curve slopes downwards from left to right throughout its length.
- The AFC curve comes closer and closer to the X - axis but not touch the X-axis as TFC can
never be zero.
- AFC curve will not touch Y-axis also because at zero level of output, TFC is a POSITIVE
VALUE. Any positive value divided by zero will provide infinite value.
- The AFC curve is a RECTANGULAR HYPERBOLA because mathematically it shows the
same level of TFC at all its points and geometrically the area of every rectangle on this curve
at all points will be equal to the area of every other rectangle.
2. Average Variable Cost:
- Average variable Cost is the variable cost per unit of output. Thus,
Total variable Cost
- Average variable Cost =
Total Output
TVC
- OR AVC =
Q

Table : Average Variable Cost Fig. : Average Variable Cost Curve

Output
TVC (Rs.) AVC (Rs.)
(units)

0 0 -

1 40 40

2 76 38

3 102 34

4 132 33

5 170 34

6 222 37
- The above table shows that as the output expands, average variable cost falls initially due
to increasing returns to the variable factor.
- It is minimum at the optimum capacity output.
- Beyond optimum capacity average variable cost rises very sharply due to diminishing
returns to variable factor.
- Thus, AVC and AVERAGE PRODUCT of variable factor are inversely related.
- When graphed, AVC curve declines over some range of output, reaches the minimum at
optimum capacity, as at point 'M' in the above diagram and then goes on rising as output
increases.
- Thus, AVC curve is U-shaped indicating three phases decreasing phase, constant phase
and increasing phase corresponding to the three phases of AVERAGE PRODUCT of
variable factor in the law of Variable Proportions.
3. Average Total Cost: (Or Simply Average Cost):
- Average Total Cost is the cost per unit of output. Thus,
Total Cost
- Average Total Cost or Average Cost =-
Total Output
TC
- ATC or AC =
Q
TFC TVC
- ATC or AC = +
Q Q

- ATC or AC = AFC + AVC

Table : Average Total Cost Fig.: Average Total Cost Curve

Output (units) TC (Rs.) ATC (Rs.)

0 60 -

1 100 100

2 136 68

3 162 54

4 192 48

5 230 46

6 282 47

- The above table shows that as output increases, ATC falls initially, reach its minimum and
then rises due to the Law of variable proportions.
- Since, ATC = AFC + AVC, it follows that the behaviour and shape of the ATC curve
depends upon the behaviour of AVC curve and AFC curve.
- In the beginning, the ATC curve falls sharply when output expands. REASON being,
initially both AVC and AFC curves fall.
- When AVC curve starts rising, but AFC curve continue to fall steeply, the ATC will continue
to fall. REASON being, fall in AFC curve is MORE than the RISE in AVC curve.
- As output further increases, ATC curve rises. REASON being, there is sharp rise in AVC
which offsets the, fall in AFC. Thus, ATC curve first fall, reach its minimum and then rise.
- Therefore, ATC curve is TJ∵ shaped for the same reasons for which the AVC is a 'U' -
shaped curve.
4. Marginal Cost.
- Marginal Cost is addition to the total cost caused by producing one more unit of output.
- Thus, marginal cost is the cost of the additional unit of output.
- It is measured by the change in total cost resulting from a unit increase in output. Thus,
∆TC
MCn = TCn– TCn-1Or MC = where, Δ — change
∆Q

- E.g.- If 5 units are produced, total cost = Rs. 206 If 6 units are produced, total cost = Rs.
236 Marginal Cost of 6th unit of output = Rs. 30
- The Marginal Cost is INDEPENDENT OF FIXED COST.
- In the short period, total fixed cost are constant for all levels of output.
- The only change in total cost when output changes is CHANGE IN VARIABLE COST.
Hence, marginal cost is affected only by the variable cost.
- Therefore, marginal cost can also be defined as a change in TVC as a result of a unit
change in output. This can be proved as follows -
MCn = TCn– TCn-1
since, TC = TFC + TVC
MCn = (TVCn + TFCn) - (TVC n-1 + TFCn-1)
= TVCn + TFCn - TVC n-1 + TFCn-1
= TVCn –TVCn-1
Table : Marginal Cost Fig. : Marginal Cost Curve

Output TFC TC MC
TVC (Rs.)
(unit) (Rs.) (Rs.) (Rs.)

1 30 50 80 -

2 30 90 120 40

3 30 120 150 30

4 30 170 200 50

5 30 250 280 80

6 30 360 390 110

- The above table shows that as the output increases, MC initially falls due to increasing
returns to factor but finally MC rises due to diminishing returns to factor.
- Thus, marginal cost is the inverse of the marginal product of the variable factor.
- When graphed, the MC curve first declines, reaches minimum and then goes on rising as
output increases.
- Thus, MC curve is U - shaped, this is due to the operation of the law of returns to factor and
due to TC or TVC (AC or AVC).
- MC curve passes through the minimum points of AVC and ATC curves
- MC curve reaches its minimum point earlier to the minimum points of AVC and ATC
curves.

Figure : Different Cost Curves

Relationship between Average Cost and Marginal Cost.
♦ Average Total Cost or Average Cost is the Cost per unit of output. Thus,
Total Cost
.Average Total Cost =
Total Output
TC
or AC =
Q

E.g.- Suppose the total cost of producing 5 units of a commodity is Rs. 230, then average
Rs.230
costwill be = Rs. 46
5 units

♦ Marginal Cost is addition to the total cost caused by producing one more unit of output.
Thus, marginal cost is the cost of the additional unit of output. Symbolically,
MCn = TCn– TCn-1
E.g.- The total cost of producing 5 units is Rs. 206 and that of 6 units is Rs. 236. Then,
marginal Cost of producing one more unit = Rs. 236 - Rs. 206 = Rs. 30.
♦ The relationship between Average Total Cost and Marginal Cost can be illustrated with the
help of following table and graph.
Table : Relationship between Average Cost and Marginal Cost

Output TC ATC MC
(unit) (Rs.) (Rs.) (Rs.)

1 10 10.00 10
 2 19 9.50 9

3 27 9.00 8

4 35 8.75 8

5 44 8.80 9

6 54 9.00 10

7 65 9.28 11

8 77 9.62 12

♦ Both the table and diagram above bring out the relationship between average cost and
marginal cost clearly as follows :-
1. Both AC and MC are derived from total cost of production. They are derived from the
same source
Total Cost
Average Cost =
Total Output
Change in Total Cost
Marginal Cost =
Change in units of Output

2. - When average cost falls with increase in output, marginal cost also falls and is
less than average cost.
- It means that marginal cost falls faster.
- Thus, when AC curve is falling, MC curve will be below AC curve.
- MC curve reaches minimum point 'C earlier then AC curve.
- Then, MC curve start rising from point ‘C to point T' even when the AC curve is falling
3. - The MC curve cuts the AC curve at its minimum point. 'P' in the diagram.
- It is the minimum point on AC curve i.e. point of optimum capacity where the average cost
is minimum.
- Points 'A' and 'B' on the AC curve shows higher average cost due to under and over
utilization of plant capacity at respective points.
- At point 'P' where the MC curve cuts the AC curve i.e. at point of optimum capacity, MC =
AC.
4. - When AC rises, with increase in output, MC also rises and is higher than AC. It
means that MC rises faster.
- Thus, when AC curve is rising, MC curve will be above the AC curve.
5. -At zero level of output, MC is indeterminate.
6. - Between AC and MC, it is MC which brings about changes (i.e. rise or fall) in AC
and not other way round.
- Thus -
(a) When MC < AC, it pulls down AC and AC falls,
(b) When MC = AC, AC is constant and at its minimum, and
(c) When MC > AC, it pulls up AC and AC rises.
7. - The concept of MC is more significant in finding out equilibrium output while
that of AC in finding profit and loss.
LONG RUN AVERAGE COST CURVE :
♦ Long run is a period of time during which the firm can vary all inputs.
♦ In short run we have seen that, some inputs are fixed and others can be varied to increase
the level of output.
♦ But in long run all inputs are variable.
♦ In the short run, the size of the plant is fixed. The size of plant cannot be increased or
reduced.
♦ However, in the long run the firm has sufficient time to bring about changes in the size of
plant (i.e. machinery building etc.) in order to expand or contract output.
♦ Thus, in the long run the firm moves from one plant to another. It can increase the size of
plant to increase its output or can have smaller plant if it has to reduce output.
♦ The long run average cost curve shows the minimum possible average cost for producing
various levels of output.
♦ Consider the following figure -

Figure : Long Run Average Cost Curve

♦ In the fig., a smooth long run average cost curve has been shown which has been labelled
as LAC.
♦ The LAC curve envelopes infinite short run average cost curves each representing a plant.
Hence, SACs are also called plant curves.
♦ In the fig., the LAC curve is derived as a tangent to all the short run average cost curve
from SAC, to SAC7. Thus, it is U- shaped.
♦ In the long run, a firm can produce a particular output by building a relevant size of plant
and operate on the corresponding SAC.
♦ It selects that size of plant i.e. SAC which gives the lowest cost of producing the given
output.
♦ In the fig., seven short run average cost curves SAC,, to SAC7 corresponding to seven
different plants are drawn.
♦ In the fig., if the firm wants to produce OA level of output, it will operate on SAC, at a cost
of AG per unit.
♦ If the firm produce OA level of output with SAC, it will cost AK per unit to produce which is
more.
♦ Similarly, if the firm wants to produce OB level of output with SAC, it will cost more i.e. BL
per unit.
♦ So the firm to produce OB output will have to increase the size of plant and operate with
SAC, where the cost per unit is less i.e. BH per unit.
♦ Thus, larger outputs can be economically produced i.e. at lowest cost with the
bigger plants and small output can be economically produced i.e. at lowest cost with
smaller plants.
♦ In the fig., OQ is the optimum output as it is being produced at the minimum point of LAC
and corresponding SAC i.e. SAC4. Thus, the long run average cost is minimum at output
OQ.
♦ If the firm is producing less than optimum output OQ, the other plants are underutilized
than their full capacity.
♦ If the firm is producing more than optimum output OQ, the other plants are overutilized t
han their full capacity.
♦ The fig., shows that LAC curve is not tangent to the minimum points of the SAC curves.
- When LAC curve is sloping downwards, it is tangent to falling portions of SACs.
- When LAC curve is rising upwards, it is tangent to rising portions of SACs.
♦ LAC curve is also called planning curve. Thus is because firm plans output in the long run
but operates in the short run i.e. by choosing a plant on LAC corresponding to the given
output.
♦ Thus, LAC helps the firm to make choice about the size of plant for producing a particular
output at minimum cost.
♦ However, modern firms face ‘L’ shaped cost curve.
Why Long Run Average Cost Curve is of U-shape ?
♦ As seen in the fig., LAC curve is U-shaped.
♦ The shape of LAC curve depends on the Law of Returns to Scale.
♦ As the firm expands, there is increasing returns to scale which means fall in long run
average cost due to economies of scale.
♦ When decreasing returns to scale occur it means rise in long run average cost due to
diseconomies of scale.
♦ This explains why LAC curve is U-shaped.