Unit 3 production

According to James Bates and J.R. Parkinson “Production is the organized activity of transfofirming
resources into finished products in the fofirm of goods and services; and the objective of
production is to satisfy the demand of such transfofirmed resources”.

Factors of production
Factors of production refer to inputs. An input is a good or service which a fifirm buys for use in its
production process. Production process requires a wide variety of inputs, depending on the nature of
output. Land, labor, capital and entrepreneurial ability are the four factors or resources which make it
possible to produce goods and services.

 Land
The tefirm ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s surface alone,
but

refers to all free gifts of nature which would include besides land in common parlance, natural
resources,

fertility of soil, water, air, light, heat natural vegetation etc. It becomes difficult at times to state
precisely as to what part of a given factor is due solely to gift of nature and what part belongs to human
effort made

on it in the past. Therefore, as a theoretical concept, we may list the following characteristics which
would

qualify a given factor to be called land:

(i) Land is a free gift of nature: No human effort is required for making land available for production. It

has no supply price in the sense that no payment has been made to mother nature for obtaining land

(ii) Supply of land is fifixed: Land is strictly limited in quantity. It is different from other factors of
production

in that, no change in demand can affect the amount of land in existence. In other words, the total supply

of land is perfectly inelastic from the point of view of the economy. However, it is relatively elastic from

the point of view of a fifirm.

(iii) Land is pefirmanent and has indestructible powers: Land is pefirmanent in nature and cannot be

destroyed. According to Ricardo, land has certain original and indestructible powers and these

properties of land cannot be destroyed.

(iv) Land is a passive factor: Land is not an active factor. Unless human effort is exercised on land, it
does

not produce anything on its own.

(v) Land is immobile: in the geographical sense. Land cannot be shifted physically from one place to

another. The natural factors typical to a given place cannot be shifted to other places.

(vi) Land has multiple uses: and can be used for varied purposes, though its suitability in all the uses is
not the same.

(vii) Land is heterogeneous: No two pieces of land are alike. They differ in fertility and situation.

 Labour
The tefirm ‘labour’, means any mental or physical exertion directed to produce goods or services.

Characteristics of labour:

(1) Human Effort: Labour, as compared with other factors is different. It is connected with human efforts

whereas others are not directly connected with human eorts. As a result, there are certain human and

psychological considerations which may come up unlike in the case of other factors. Therefore, leisure,

fair treatment, favourable work environment etc. are essential for labourers.

(2) Labour is perishable: Labour is highly ‘perishable’ in the sense that a day’s labour lost cannot be

completely recovered by extra work on any other day. In other words, a labourer cannot store his
labour.

(3) Labour is an active factor: Without the active participation of labour, land and capital may not
produce

anything.

(4) Labour is inseparable from the labourer: A labourer is the source of his own labour power. When a

labourer sells his service, he has to be physically present where they are delivered. The labourer sells his

labour against wages, but retains the capacity to work.

(5) Labour power differs from labourer to labourer: Labour is heterogeneous in the sense that labour

power differs from person to person. Labour power or efficiency of labour depends upon the labourers’

inherent and acquired qualities, characteristics of work environment, and incentive to work.

(6) All labour may not be productive: (i.e.) all efforts are not sure to produce resources.

(7) Labour has poor bargaining power: Labour has a weak bargaining power. Labour has no reserve

price. Since labour cannot be stored, the labourer is compelled to work at the wages offered by the
employers. For this reason, when compared to employers, labourers have poor bargaining power

and can be exploited and forced to accept lower wages.

(8) Labour is mobile: Labour is a mobile factor. Apparently, workers can move from one job to another
or

from one place to another. However, in reality there are many obstacles in the way of free movement of

labour from job to job or from place to place.

(9) There is no rapid adjustment of supply of labour to the demand for it: The total supply of labour

cannot be increased or decreased instantly.

(10) Choice between hours of labour and hours of leisure: A labourer can make a choice between the

hours of labour and the hours of leisure. This feature gives rise to a peculiar backward bending shape to
the supply curve of labour. The supply of labour and wage rate is directly related. It implies that, as the

wage rate increases the labourer tends to increase the supply of labour by reducing the hours of leisure.

However, beyond a desired level of income, the labourer reduces the supply of labour and increases the

hours of leisure in response to further rise in the wage rate. That is, he prefers to have more of rest and

leisure than earning more money.

 Capital
Capital has been rightly defined as ‘produced means of production’ or ‘man-made instruments of
production’.

In other words, capital refers to all man made goods that are used for further production of wealth.
This

definition distinguishes capital from both land and labour because both land and labour are not
produced

factors. They are primary or original factors of production, but capital is not a primary or original factor;
it is

a produced factor of production. It has been produced by man by working with nature. Machine tools
and

instruments, factories, dams, canals, transport equipment etc., are some of the examples of capital. All
of

them are produced by man to help in the production of further goods.

Types of Capital:
Fifixed capital is that which exists in a durable shape and renders a series of services over a period of
time.
For example tools, machines, etc.

Circulating capital is another fofirm of capital which perfofirms its function in production in a single use
and

is not available for further use. For example, seeds, fuel, raw materials, etc.

Real capital refers to physical goods such as building, plant, machines, etc.

Human capital refers to human skill and ability. This is called human capital because a good deal of

investment has gone into creation of these abilities in humans.

Tangible capital can be perceived by senses whereas intangible capital is in the fofirm of certain rights
and

benefits which cannot be perceived by senses. For example, patents, goodwill, patent rights, etc.

Individual capital is personal property owned by an individual or a group of individuals.

Social Capital is what belongs to the society as a whole in the fofirm of roads, bridges, etc.

Capital Fofirmation: Capital fofirmation means a sustained increase in the stock of real capital in a
country.

In other words, capital fofirmation involves production of more capital goods like, machines, tools,
factories,

transport equipments, electricity etc. which are used for further production of goods. Capital
fofirmation is

also known as investment. The need for capital fofirmation or investment is realised not merely for

replacement and renovation but for creating additional productive capacity.

 Entrepreneur:

Having explained the three factors namely land, labour and capital, we now turn to the description of

the fourth factor of production, namely, the entrepreneur. It is not enough to say that production is a

function of land, capital and labour. There must be some factor which mobilises these factors, combines

them in the right proportion, initiates the process of production and bears the risks involved in it. This

factor is known as the entrepreneur. He has also been called the organiser, the manager or the risk

taker. But, in these days of specialisation and separation of ownership and management, the tasks

perfofirmed by a manager or organiser have become different from that of the entrepreneur. While
organisation and management involve decision-making of routine and non-routine types, the task of

the entrepreneur is to initiate production work and to bear the risks involved in it.

Functions of an entrepreneur:

In general, an entrepreneur perfofirms the following functions:

Initiating business enterprise and resource co-ordination: An entrepreneur senses business

opportunities, conceives project ideas, decides on scale of operation, products and processes and builds

up, owns and manages his own enterprise. The first and the foremost function of an entrepreneur is to

initiate a business enterprise. An entrepreneur perceives opportunity, organizes resources needed for

exploiting that opportunity and exploits it

Risk bearing or uncertainty bearing: The ultimate responsibility for the success and survival of business

lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not come true and

the actual course of events may dier from what was anticipated and planned. The economy is dynamic

and changes occur every day. The demand for a commodity, the cost structure, fashions and tastes of

the people and government’s policy regarding taxation, credit, interest rate etc. may change. All these

changes bring about changes in the cost and/or demand conditions of a business firm. Thus, the

entrepreneur has to bear these nancial risks.

Innovations: the true function of an entrepreneur is to introduce innovations.Innovation refers to

commercial application of a new idea or invention to better fullment of business

requirements. But innovations involve risks and only a few individuals in the society are capable of

introducing new innovations. The greater the innovating ability, the greater the supply of entrepreneurs

in the economy, and greater will be the rate of technological progress.

Enterprise’s objectives
The objectives of an enterprise may be broadly categorised under the following heads:

 Organic objectives

 Economic objectives

 Social objectives

 Human objectives

 National objectives

Organic objectives: The basic minimum objective of all kinds of enterprises is to survive or to stay alive.

An enterprise can survive only if it is able to produce and distribute products or services at a price which

enables it to recover its costs. If an enterprise does not recover its costs of staying in business, it will not

be in a position to meet its obligations to its creditors, suppliers and employees with the result that it

will be forced into bankruptcy. Therefore, survival of an enterprise is essential for the continuance of its

business activity. Once the enterprise is assured of its survival, it will aim at growth and expansion.

Some of the organic business business objectives include:

 Using profits to raise capital or strengthen the business

 Using growth models to contribute to business's success

 Creating demand for products

 Looking after the interest of the people who make a business successful

 Earning profit by working under rules and regulations or by following ethical practices

Economic objectives: Economic objectives refer to the objective of earning the profit and also other

objectives which are necessary to be pursued to achieve the profit objective. This includes - creation of

the customers, regular innovations and best possible use of the available resources.
Social objectives: Since an enterprise lives in a society, it cannot grow unless it meets the needs of the

society. Some of the important social objectives of business are:

 To maintain a continuous and sufficient supply of unadulterated goods and articles of

standard Quality

 To avoid profiteering and anti-social practices.

 To create opportunities for gainful employment for the people in the society.

 To ensure that the enterprise’s output does not cause any type of pollution - air, water or

noise.

Human objectives: Human beings are the most precious resources of an organisation. If they are

ignored, it will be di-cult for an enterprise to achieve any of its other objectives. Therefore, the

comprehensive development of its human resource or employees should be one of the major objectives

of an organisation. Some of the important human objectives are:

 To provide fair deal to the employees at different levels

 To develop new skills and abilities and provide a work climate in which they will grow as mature

and productive individuals.

 To provide the employees an opportunity to participate in decision-making in matters affecting

them.

 To make the job contents interesting and challenging. If the enterprise is conscious of its duties

towards its employees, it will be able to secure their loyalty and support.

National objectives: : An enterprise should endeavour for fullment of national needs and aspirations

and work towards implementation of national plans and policies. Some of the national objectives are:
  To remove inequality of opportunities and provide fair opportunity to all to work and to

progress.

 To produce according to national priorities.

 To help the country become self-reliant and avoid dependence on other nations.

 To train young men as apprentices and thus contribute in skill fofirmation for economic growth

and development.

Production function

The production function is a statement of the relationship between a firm’s scarce resources (i.e. its

inputs) and the output that results from the use of these resources. More specically, it states

technological relationship between inputs and output. The production function can be algebraically

expressed in the fofirm of an equation in which the output is the dependent variable and inputs are the

independent variables. The equation can be expressed as:

Q = f (a, b, c, d …….n) Where ‘Q’ stands for the rate of output of given commodity and a, b, c, d…….n, are

the dierent factors (inputs) and services used per unit of time.

The production function can be defined as: The relationship between the maximum amount of output

that can be produced and the input required to make that output. It is defined for a given state of

technology i.e., the maximum amount of output that can be produced with given quantities of inputs

under a given state of technical knowledge.

Assumptions of Production Function: There are three main assumptions underlying any production

function:

 First, we assume that the relationship between inputs and outputs exists for a specific period of

time. In other words, Q is not a measure of accumulated output over time.

  Second, it is assumed that there is a given “state-of-the-art” in the production technology. Any

innovation would cause change in the relationship between the given inputs and their output.

For example, use of robotics in manufacturing or a more efficient software package for financial

analysis would change the input-output relationship.

 Third assumption is that whatever input combinations are included in a particular function, the

output resulting from their utilization is at the maximum level.

Short-Run Vs Long-Run Production Function

The production function of a firm can be studied in the context of short period or long period. It is to be

noted that in economic analysis, the distinction between short-run and long-run is not related to any

particular measurement of time (e.g. days, months, or years). In fact, it refers to the extent to which a -

fifirm can vary the amounts of the inputs in the production process. A period will be considered short-

run period if the amount of at least one of the inputs used remains unchanged during that period. Thus,

short-run production function shows the maximum amount of a good or service that can be produced

by a set of inputs, assuming that the amount of at least one of the inputs used remains unchanged.

Generally, it has been observed that during the short period or in the short run, a firm cannot install a

new capital equipment to increase production. It implies that capital is a fixed factor in the short run.

Thus, in the short-run, the production function is studied by holding the quantities of capital fixed, while

varying the amount of other factors (labour, raw material etc.) This is done when the law of variable

proportion is studied. The production function can also be studied in the long run. The long run is a

period of time (or planning horizon) in which all factors of production are variable. It is a time period

when the firm will be able to install new machines and capital equipments apart from increasing the

variable factors of production. A longrun production function shows the maximum quantity of a good or

service that can be produced by a set of inputs, assuming that the firm is free to vary the amount of all
the inputs being used. The behaviour of production when all factors are varied is the subject matter of

the law of returns to scale.

The Law of Variable Proportions or The Law of Diminishing Returns:

In short run the input output relation is studies by keeping some factors of production at constant while

some other factors vary. The law of production under these condition is named as law of variable

proportion(as the behavior of output is studied by changing the proportion in which inputs are

combined) or law of diminishing returns

The law states that as we increase the quantity of one input which is combined with other fixed

inputs, the marginal physical productivity of the variable input must eventually decline. In other

words, an increase in some inputs relative to other fixed inputs will, in a given state of technology,

cause output to increase; but after a point, the extra output resulting from the same addition of extra

input will become less and less.

Total Product (TP): Total product is the total output resulting from the efforts of all the factors of

production combined together at any time. If the inputs of all but one factor are held constant, the total

product will vary with the quantity used of the variable factor.

Average Product (AP): Average product is the total product per unit of the variable factor.

Marginal Product (MP): Marginal product is the change in total product per unit change in the quantity

of variable factor. In other words, it is the addition made to the total production by an additional unit of

input. Symbolically,
Relationship between Average Product and Marginal Product:

Both average product and marginal product are derived from the total product. Average product is

obtained by dividing total product by the number of units of the variable factor and marginal product is

the change in total product resulting from a unit increase in the quantity of variable factor.

(i) when average product rises as a result of an increase in the quantity of variable input,

marginal product is more than the average product.

(ii) (ii) when average product is maximum, marginal product is equal to average product. In

other words, the marginal product curve cuts the average product curve at its maximum.

(iii) (iii) when average product falls, marginal product is less than the average product

The Law of Variable Proportions or the Law of Diminishing Returns examines the production function

with one factor variable, keeping quantities of other factors fifixed. In other words, it refers to input-

output relationship, when the output is increased by varying the quantity of one input. This law operates

in the short run ‘when all factors of production cannot be increased or decreased simultaneously.

Assumptions

 The state of technology is assumed to be given and unchanged. If there is any improvement in

technology, then marginal product and average product may rise instead of falling.

 There must be some inputs whose quantity is kept fifixed. This law does not apply to cases when

all factors are proportionately varied. When all the factors are proportionately varied, laws of

returns to scale are applicable.

 The law does not apply to those cases where the factors must be used in fifixed proportions to

yield output. When the various factors are required to be used in fifixed proportions, an
 increase in one factor would not lead to any increase in output i.e., marginal product of the

variable factor will then be zero and not diminishing.

 We consider only physical inputs and outputs and not economic profitability in monetary

tefirms.

The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of

the others can be divided into three distinct stages or laws. In this gure, the quantity of variable factor is

depicted on the X axis and the Total Product (TP), Average Product (AP) and Marginal Product (MP) are

shown on the Y-axis. As the gure shows, the TP curve goes on increasing upto to a point and after that it

starts declining. AP and MP curves rst rise and then decline; MP curve starts declining earlier than the AP

curve. The behaviour of these Total, Average and Marginal Products of the variable factor consequent

on the increase in its amount is generally divided into three stages (laws) which are explained below.

Stage 1: The Stage of Increasing Returns: In this stage, the total product increases at an increasing rate

upto a point (in gure upto point F), marginal product also rises and is maximum at the point

corresponding to the point of inexion and average product goes on rising. From point F onwards during

the stage one, the total product goes on rising but at a diminishing rate. Marginal product falls but is

positive. The stage 1 ends where the AP curve reaches its highest point. Thus in the rst stage, the AP

curve rises throughout whereas the marginal product curve rst rises and then starts falling after reaching

its maximum. The law of increasing return states that: The tendency of the marginal return to rising per
unit of variable factors employed in fifixed amounts of other factors by a fifirm is called the law of

increasing return"

Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues to increase at a

diminishing rate until it reaches its maximum at point H, where the second stage ends. In this stage,

both marginal product and average product of the variable factor are diminishing but are positive. At the

end of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the

marginal product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns

because both the average and marginal products of the variable factors continuously fall during this

stage. This stage is very important because the firm will seek to produce within its range. The law of

diminishing returns states that increasing one factor of production while keeping all other factors

constant will eventually result in a lower unit of output per incremental unit of input. This law is also

known as the law of diminishing marginal productivity

Stage 3: Stage of Negative Returns: In Stage 3, total product declines, MP is negative, average product is

diminishing. This stage is called the stage of negative returns since the marginal product of the variable

factor is negative during this stage. The law of negative returns states that producing an additional unit

of output will result in a loss. This happens when the effectiveness of each additional unit of input

decreases

Returns of scale

Returns of scale deals with the behavior of output to the proportionate change of scale. A change in

scale means that all factors of production are increased or decreased in the same proportion. Change in
scale is dierent from changes in factor proportions. Changes in output as a result of the variation in

factor proportions fofirm the subject matter of the law of variable proportions. On the other hand, the

study of changes in output as a consequence of changes in scale fofirms the subject matter of returns to

scale which is discussed below. It should be kept in mind that the returns to scale faced by a fi firm are

solely technologically detefirmined and are not inuenced by economic decisions taken by the firm or by

market conditions. Returns to scale may be constant, increasing or decreasing. If we increase all factors

i.e., scale in a given proportion and output increases in the same proportion, returns to scale are said to

be constant. Thus, if doubling or trebling of all factors causes a doubling or trebling of output, then

returns to scale are constant. But, if the increase in all factors leads to more than proportionate

increase in output, returns to scale are said to be increasing. Thus, if all factors are doubled and output

increases more than double, then the returns to scale are said to be increasing. On the other hand, if

the increase in all factors leads to less than proportionate increase in output, returns to scale are

decreasing.

Constant Returns to Scale:

As stated above, constant returns to scale means that with the increase in the scale in some proportion,

output increases in the same proportion. Constant returns to scale, otherwise called as “Linear

Homogeneous Production Function”, may be expressed as follows: kQx = f( kK, kL) = k (K, L) If all the

inputs are increased by a certain amount (say k) output increases in the same proportion (k). It has been

found that an individual firm passes through a long phase of constant returns to scale in its lifetime.

Increasing return to scale

• increasing returns to scale means that output increases in a greater proportion than the

increase in inputs. When a fifirm expands, increasing returns to scale are obtained in the
 beginning. For example, a wooden box of 3 ft. cube contains 9 times greater wood than the

wooden box of 1 foot-cube. But the capacity of the 3 foot- cube box is 27 times greater than

that of the one foot cube. Many such examples are found in the real world. Another reason for

increasing returns to scale is the indivisibility of factors. Some factors are available in large and

lumpy units and can, therefore, be utilised with utmost eciency at a large output. If all the

factors are perfectly divisible, increasing returns may not occur. Returns to scale may also

increase because of greater possibilities of specialisation of land and machinery.

Decreasing Returns to Scale:

When output increases in a smaller proportion with an increase in all inputs, decreasing returns to scale

are said to prevail. When a firm goes on expanding by increasing all inputs, decreasing returns to scale

set in. Decreasing returns to scale eventually occur because of increasing di-culties of management,

coordination and control. When the firm has expanded to a very large size, it is di-cult to manage it with

the same e-ciency as before.

ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale and diseconomies of scale are concepts in business that describe how a company's

costs change as its output increases.

Economies of scale Occur when a company's average cost per unit decreases as its total output

increases. For example, a large retail store can buy in bulk to lower its cost per unit.

Diseconomies of scale Occur when a company's average cost per unit increases as its total output

increases. For example, if a company's output increases so much that its cost per unit starts increasing.

Companies must balance economies of scale and diseconomies of scale when they are looking to grow.
Internal Economies and Diseconomies:

 Technical economies and diseconomies:

 Managerial economies and diseconomies:

 Commercial economies and diseconomies:

 Financial economies and diseconomies:

 Risk bearing economies and diseconomies

Technical economies and diseconomies: Large-scale production is associated with economies of

superior techniques. As the firm increases its scale of operations, it becomes possible to use more

specialised and e-cient fofirm of all factors, specially capital equipment and machinery. For producing

higher levels of output, there is generally available a more e-cient machinery which when employed to

produce a large output yields a lower cost per unit of output. The firm is able to take advantage of

composite technology whereby the whole process of production of a commodity is done as one

composite unit. Secondly, when the scale of production is increased and the amount of labour and other

factors become larger, introduction of greater degree of division of labour and specialisation becomes

possible and as a result cost per unit declines. There are some advantages available to a large firm on

account of perfofirmance of a number of linked processes. The firm can reduce the inconvenience and

costs associated with the dependence on other firms by undertaking various processes from the input

supply stage to the nal output stage. However, beyond a certain point, a firm experiences net

diseconomies of scale. This happens because when the firm has reached a size large enough to allow

utilisation of almost all the possibilities of division of labour and employment of more e-cient machinery,

further increase in the size of the plant will bring about high long-run cost because of di-culties of

management. When the scale of operations becomes too large, it becomes di -cult for the management

to exercise control and to bring about proper coordination.

Managerial economies and diseconomies: Managerial economies refer to reduction in managerial costs.

When output increases, specialisation and division of labor can be applied to management. It becomes

possible to divide its management into specialised departments under specialised personnel, such as

production manager, sales manager, nance manager etc. Thus, specialisation of management enables

large firms to achieve reduction in managerial costs. , as the scale of production increases beyond a

certain limit, managerial diseconomies set in. Communication at dierent levels such as between the

managers and labourers and among the managers become di-cult resulting in delays in decision making

and implementation of decisions already made. Management nds it di-cult to exercise control and to

bring in coordination among its various departments. The managerial structure becomes more complex

and is aected by greater bureaucracy, red tapism, lengthening of communication lines and so on. All

these aect the e-ciency and productivity of management and that of the firm itself.

External economies and diseconomies

External economies and diseconomies are those economies and diseconomies which accrue to fifirms as

a result of expansion in the output of the whole industry and they are not dependent on the output

level of individual fifirms.

Cheaper raw materials and capital equipment: The expansion of an industry may result in exploration of

new and cheaper sources of raw material, machinery and other types of capital equipments. Expansion

of an industry results in greater demand for various kinds of materials and capital equipments required

by it. The firm can procure these on a large scale at competitive prices from other industries. This

reduces their cost of production and consequently the prices of their output.

 Development of skilled labour

 Technological external economies

 Growth of ancillary industries

  Better transportation and market facilities

Cost concepts

Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria.

Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of production

which he employs for production. He thus pays wages to workers employed, prices for the raw

materials, fuel and power used, rent for the building he hires and interest on the money borrowed for

doing business. All these are included in his cost of production and are tefirmed as accounting costs.

Accounting costs relate to those costs which involve cash payments by the entrepreneur of the firm.

Thus, accounting costs are explicit costs and includes all the payments and charges made by the

entrepreneur to the suppliers of various productive factors.

Economic Cost Also known as opportunity cost, economic cost is the value you give up when you choose

one economic activity over the next best economic activity. economic costs include both accounting

costs and implicit costs.

Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, say, wages,

materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned with the cost of the next

best alternative opportunity which was foregone in order to pursue a certain action. It is the cost of the

missed opportunity

Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those which have direct

relationship with a component of operation like manufacturing a product, organizing a process or an

activity etc. Since such costs are directly related to a product, process or machine, they may vary

according to the changes occurring in these. Direct costs are costs that are readily identified and are

traceable to a particular product, operation or plant. Indirect costs are those which are not easily and
definitely identifiable in relation to a plant, product, process or department. Therefore, such costs are

not visibly traceable to specific goods, services, operations, etc.; but are nevertheless charged to dierent

jobs or products in standard accounting practice. The economic importance of these costs is that these,

even though not directly traceable to a product, may bear some functional relationship to production

and may vary with output in some definite way. Examples of such costs are electric power and common

costs incurred for general operation of business benefiting all products jointly.

Incremental costs and Sunk costs: Theoretically, incremental costs are related to the concept of

marginal cost. Incremental cost refers to the additional cost incurred by a firm as result of a business

decision. Sunk costs refer to those costs which are already incurred once and for all and cannot be

recovered.

Historical costs and Replacement costs: Historical cost refers to the cost incurred in the past on the

acquisition of a productive asset such as machinery, building etc. Replacement cost is the money

expenditure that has to be incurred for replacing an old asset. Instability in prices make these two costs

differ. Other things remaining the same, an increase in price will make replacement costs higher than

historical cost.

Private costs and Social costs: Private costs are costs actually incurred or provided for by firms and are

either explicit or implicit. They nofirmally gure in business decisions as they fofirm part of total cost and

are internalised by the firm. Social cost, on the other hand, refers to the total cost borne by the society

on account of a business activity and includes private cost and external cost. It includes the cost of

resources for which the firm is not required to pay price such as atmosphere, rivers, roadways etc. and

the cost in tefirms of dis-utility created such as air, water and environment pollution.

Fifixed and Variable costs: Fifixed or constant costs are not a function of output; they do not vary with

output upto a certain level of activity. These costs require a fixed expenditure of funds irrespective of
the level of output, e.g., rent, property taxes, interest on loans and depreciation when taken as a

function of time and not of output. However, these costs vary with the size of the plant and are a

function of capacity. Therefore, fixed costs do not vary with the volume of output within a capacity level.

Fifixed costs cannot be avoided. These costs are fixed so long as operations are going on. They can be

avoided only when the operations are completely closed down. Variable costs are costs that are a

function of output in the production period. For example, wages of casual labourers and cost of raw

materials and cost of all other inputs that vary with output are variable costs. Variable costs vary directly

and sometimes proportionately with output.

COST FUNCTION

Cost function refers to the mathematical relation between cost of a product and the various

detefirminants of costs. In a cost function, the dependent variable is unit cost or total cost and the

independent variables are the price of a factor, the size of the output or any other relevant

phenomenon which has a bearing on cost, such as technology, level of capacity utilization, e -ciency and

time period under consideration. Cost function is a function which is obtained from production function

and the market supply of inputs. It expresses the relationship between costs and output. Cost functions

are derived from actual cost data of the firms and are presented through cost curves. The shape of the

cost curves depends upon the cost function. Cost functions are of two kinds: They are short-run cost

functions and long-run cost functions.

SHORT RUN TOTAL COSTS

Total, Fifixed and variable costs: There are some factors which can be easily adjusted with changes in the

level of output. A firm can readily employ more workers if it has to increase output. Similarly, it can

purchase more raw materials if it has to expand production. Such factors which can be easily varied with
a change in the output is called variable factors,on the other hand factors which cannot be varied easily

is know as fifixed cost. Short run is a period of time in which output can be increased or decreased by

changing only the amount of variable factors such as, labour, raw materials, etc. In the short run,

quantities of fixed factors cannot be varied in accordance with changes in output. If the firm wants to

increase output in the short run, it can do so only by increasing the variable factors, i.e., by using more

labour and/or by buying more raw materials. Thus, short run is a period of time in which only variable

factors can be varied, while the quantities of fixed factors remain unaltered. On the other hand, long run

is a period of time in which the quantities of all factors may be varied. In other words, all factors become

variable in the long run.

There are some costs which are neither perfectly variable, nor absolutely fixed in relation to the changes

in the size of output. They are known as semi-variable costs. Example: Electricity charges include both a -

fixed charge and a charge based on consumption.

There are some costs which may increase in a stair-step fashion, i.e., they remain fixed over certain

range of output; but suddenly jump to a new higher level when output goes beyond a given limit. E.g.

Costs incurred towards the salary of foremen will have a sudden jump if another foreman is appointed

when the output crosses a particular limit.

Total cost

The total cost of a business is dened as the actual cost that must be incurred for producing a given

quantity of output. The short run total cost is composed of two major elements namely, total fixed cost

and total variable cost. Symbolically TC = TFC + TVC. We may represent total cost, total variable cost and

fixed cost diagrammatically.

Short run average costs

Average fixed cost (AFC) : AFC is obtained by dividing the total fixed cost by the number of units of

output produced. i.e. TFC AFC Q = where Q is the number of units produced. Thus, average fixed cost is

the fixed cost per unit of output. For example, if a firm is producing with a total fixed cost of ` 2,000/-.

When output is 100 units, the average fixed cost will be ` 20. And now, if the output increases to 200

units, average fixed cost will be ` 10. Since total fixed cost is a constant amount, average fixed cost will

steadily fall as output increases. Therefore, if we draw an average fixed cost curve, it will slope

downwards throughout its length but will not touch the X-axis as AFC cannot be zero. (Fig. 10)

Average variable cost (AVC) : Average variable cost is found out by dividing the total variable cost by the

number of units of output produced, i.e. TVC AVC Q = where Q is the number of units produced. Thus,

average variable cost is the variable cost per unit of output. Average variable cost normally falls as

output increases from zero to normal capacity output due to occurrence of increasing returns to

variable factors.

Average total cost (ATC): Average total cost is the sum of average variable cost and average xed cost.

i.e., ATC = AFC + AVC. It is the total cost divided by the number of units produced, i.e. ATC = TC/Q.The

behaviour of average total cost curve depends upon the behaviour of the average variable cost curve

and the average xed cost curve. In the beginning, both AVC and AFC curves fall, therefore, the ATC curve

will also fall sharply. When AVC curve begins to rise, but AFC curve still falls steeply, ATC curve continues
to fall. This is because, during this stage, the fall in AFC curve is greater than the rise in the AVC curve,

but as output increases further, there is a sharp rise in AVC which more than osets the fall in AFC.

Therefore, ATC curve First falls, reaches its minimum and then rises. Thus, the average total cost curve is

a “U” shaped curve. (Fig. 10) Marginal cost: Marginal cost is the addition made to the total cost by the

production of an additional unit of output. In other words, it is the total cost of producing t units instead

of t-1 units, where t is any given number. For example, if we are producing 5 units at a cost of ` 200 and

now suppose the 6th unit is produced and the total cost is ` 250, then the marginal cost is ` 250 - 200

i.e., ` 50. MC = ∆TC/ ∆Q

DTC = Change in Total cost

DQ = Change in Output or MCn = TCn – TCn-1

Marginal cost curve falls as output increases in the beginning. It starts rising after a certain level of

output. This happens because of the influence of the law of variable proportions. The MC curve

becomes minimum corresponding to the point of inflexion on the total cost curve. The fact that

marginal product rises first, reaches a maximum and then declines ensures that the marginal cost

curve of a firm declines first, reaches its minimum and then rises. In other words marginal cost curve

of a firm is “U” shaped.

Break-even point

The break-even point is the point at which total revenue and total cost are equal. Break-even analysis

determines the number of units or amount of revenue that’s needed to cover your business’s total

costs.

break-even analysis helps you to determine at what point your business – or a new product or

service – will become profitable, investors also use it to determine the point at which they’ll recoup
 their investment and start making money.it helps you to decide whether the idea is viable. it

provides you with information you can use when designing your pricing strategy.

In addition, it’s a good idea to do a break-even analysis when you’re creating a new product,

particularly if it’s particularly cost-intensive. Finally, whenever you make any kind of adjustment to

your business – such as adding a new sales channel or switching your distribution model – your costs

can change dramatically, so it’s always a good idea to do a break-even analysis

Break even quantity= fixed price/ (sales price per unit)- (variable cost per unit)

Strengths /weaknesses of Break-even analysis

Strength

• Pricing

• Setting revenue targets

• Mitigate risk

• Gaining funding

Weakness

• Doesn’t predict demand

• Depends on reliable data

• Too simple

• Ignores competition

Application marginal cost

. Profitable Product Mix 2.

Problem of Limiting Factors 3. Make or Buy Decision 4. Diversification of Production 5. Fixation of

Selling Price 6. Alternative Methods of Manufacturers

7. Operate or Shut Down Decision 8. Maintaining a Desired Level of Profit 9. Alternative Courses of
Action 10. Profit Planning 11. Appraisal of Performance.
Price
Prices of goods express their exchange value. Prices are also used for expressing the value of various

services rendered by different factors of production such as land, labour, capital and organization in

the form of rent, wages, interest and profit. In an open competitive market, it is the interaction

between demand and supply that tends to determine equilibrium price and quantity. . In the

context of market analysis, the term equilibrium refers to a state of market in which the quantity

demanded of a commodity equals the quantity supplied of the commodity. In an equilibrium state,

the aggregate quantity that all -rms wish to sell equals the total quantity that all buyers in the

market wish to buy and therefore, the market clears. Equilibrium price or market clearing price is

the price at which the quantity demanded of a commodity equals the quantity supplied of the

commodity i.e. at this price there is no unsold stock or no unsupplied demand.

CHANGES IN DEMAND AND SUPPLY

The above analysis of market equilibrium was done by us under the ceteris paribus assumption. The

facts of the real world, however, are such that the determinants of demand other than price of the

commodity under consideration (like income, tastes and preferences, population, technology, prices

of factors of production etc.) always change causing shifts in demand and supply. Such shifts aect

equilibrium price and quantity. The four possible changes in demand and supply are:

(i) An increase (shift to the right) in demand;

(ii) A decrease (shift to the left) in demand;

(iii) An increase (shift to the right) in supply;

(iv) A decrease (shift to the left) in supply

(i) An increase in demand

 Thus, we see that, with an increase in demand, there is

an increase in equilibrium price, as a result of which

the quantity supplied rises. As such, the quantity sold and

purchased also increases

(ii) A decrease in demand

Thus, with a decrease in demand, there is a decrease in the

equilibrium price and quantity demanded and supplied.

(iii) An increase in supply

Thus, as a result of an increase in supply with demand

remaining the same, the equilibrium price will go down

and the quantity demanded will go up.

(iv) A decrease in supply

Decrease in Supply Causing an Increase in the Equilibrium

Price and a fall in Quantity Demanded

SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

Till now, we were considering the eect of a change either in demand or in supply on the

equilibrium price and quantity sold and purchased. It sometimes happens that events shift both
the demand and supply curves at the same time. This is not unusual; in real life, supply curves

and demand curves for many goods and services typically shift quite often because of

continuous change in economic environment.

Fig. Simultaneous Change in Demand and Supply

Fig. shows simultaneous change in demand and supply and its eects on the equilibrium price. In

the -gure, the original demand curve DD and the supply curve SS meet at E at which OP is the

equilibrium price and OQ is the quantity bought and sold.

Fig. (a) shows that increase in demand is equal to increase in supply. The new demand curve D1

D1 and S1 S1 meet at E1 . The new equilibrium price is equal to the old equilibrium price (OP).

However, equilibrium quantity is more.

Fig.(b) shows that increase in demand is more than increase in supply. Hence, the new

equilibrium price OP1 is higher than the old equilibrium price OP. The opposite will happen i.e.

the equilibrium price will go down if there is a simultaneous fall in demand and supply and the

fall in demand is more than the fall in supply.

Fig. (c) shows that supply increases in a greater proportion than demand. The new equilibrium

price will be less than the original equilibrium price. Conversely, if the fall in the supply is more

than proportionate to the fall in the demand, the equilibrium price will go up.
 We can summarise the two possible outcomes when the supply and demand curves shift in the

same direction as follows:

• When both demand and supply increase, the equilibrium quantity increases but the

change in equilibrium price is uncertain.

• When both demand and supply decrease, the equilibrium quantity decreases but the

change in equilibrium price is uncertain.

Effect On Equilibrium Price And Quantity When Demand And Supply Curves Shift In Opposite

Directions

, when supply and demand shift in opposite directions, we cannot predict what the ultimate eect will be

on the quantity bought and sold.

We can summarise the two possible outcomes when the supply and demand curves shift in the opposite

directions as follows:
 • When demand increases and supply decreases, the equilibrium price rises but nothing certain

can be said about the change in equilibrium quantity.

• When demand decreases and supply increases, the equilibrium price falls but nothing certain

can be said about the change in equilibrium quantity

PRICE-OUTPUT DETERMINATION UNDER DIFFERENT MARKET FORMS

The price of a commodity and the quantity exchanged per time period depend on the market demand

and supply functions and the market structure. The market structure characterises the way the sellers

and buyers interact to determine equilibrium price and quantity. The existence of dierent forms of

market structure leads to dierences in demand and revenue functions of the -rms. The market structure

mostly determines a -rm’s power to -x the price of its product. The level of pro-t maximising price is

generally dierent in dierent kinds of markets due to dierences in the nature of competition

PERFECT COMPETITION

• (i) There are large number of buyers and sellers who compete among themselves. The number is

so large that the share of each seller in the total supply and the share of each buyer in the total

demand is too small that no buyer or seller is in a position to inuence the price, demand or

supply in the market.

• (ii) The products supplied by all firms are identical or are homogeneous in all respects so that

they are perfect substitutes. Thus, all goods must sell at a single market price. No firm can raise

the price of its product above the price charged by other firms without losing most or all of its

business. Buyers have no preference as between different sellers and as between different units

of commodity odered for sale; also sellers are quite indifferent as to whom they sell.
• (iii) Every firm is free to enter the market or to go out of it. There are no legal or market related

barriers to entry and also no special costs that make it difficult for a new firm either to enter an

industry and produce, if it sees profit opportunity or to exit if it cannot make a profit. If the

above three conditions alone are fullled, such a market is called pure competition.

• The essential feature of pure competition is the absence of the element of monopoly.

• (iv) There is perfect knowledge of the market conditions on the part of buyers and sellers. Both

buyers and sellers have all information relevant to their decision to buy or sell such as the

quantities of stock of goods in the market, the nature of products and the prices at which

transactions of purchase and sale are being entered into.

• (v) Perfectly competitive markets have very low transaction costs. Buyers and sellers do not

have to spend much time and money finding each other and entering into transactions.

• (vi) Under prefect competition, all firms individually are price takers. The firms have to accept

the price determined by the market forces of total demand and total supply. The assumption of

price taking applies to consumers as well. When there is perfect knowledge and perfect

mobility, if any seller tries to raise his price above that charged by others, he would lose his

customers.

Price Determination under Perfect Competition

• Equilibrium of the Industry: An industry in economic terminology consists of a large number of

independent firms. Each such unit in the industry produces a homogeneous product so that

there is competition amongst goods produced by different units. When the total output of the

industry is equal to the total demand, we say that the industry is in equilibrium; the price then
 prevailing is equilibrium price. A firm is said to be in equilibrium when it is maximising its profits

and has no incentive to expand or contract production.

• Equilibrium of the Firm: The firm is said to be in equilibrium when it maximizes its profit. The

output which gives maximum profit to the firm is called equilibrium output. In the equilibrium

state, the firm has no incentive either to increase or decrease its output.

• Firms have to accept this price as given and as such they are price-takers rather than price-

makers.