Unit – 2

Production functions
1. Law of Variable Proportions
2. Theory of the Firm - Production Functions in the Short
and Long Run. Functions – Determinants of Costs Cost
Forecasting - Short Run and Long Run
3. Costs –Type of Costs

4. Analysis of Risk and Uncertainty.

.
Factors of production

Economists divide factors of production into several

categories:
 Natural Resources
 Labour
 Capital
 Technology
 Entrepreneurship
Fixed and Variable inputs in the
restaurant
FIXED INPUTTS -(Fixed inputs are those that can't easily be
increased or decreased in a short period of time.)
Land/ building, equipment's/machinery, rent

VARIABLE INPUTS- (A variable input is a resource or factor

of production which can be changed in the short run by a
firm as it seeks to change the quantity of output produced.
Most firms use several variable inputs in short-run production)
Labour, raw material, energy, electricity
production

 Production is the process (or processes) a

firm uses to transform inputs (e.g. labour,
capital, raw materials) into outputs, i.e.
the goods or services the firm wishes to
sell.

 Theprocess of combining inputs to

produce outputs, ideally of a value greater
than the value of inputs.
Production function types

 Short run Production function

 Long run Production function
 Short and long run

 The short run is the period of time during which at

least some factors of production are fixed. . During
the period of the pizza restaurant lease, the pizza
restaurant is operating in the short run, because it is
limited to using the current building—the owner can’t
choose to shift to a larger or smaller building.

 The long run is the period of time during which all

factors are variable. Once the lease expires for the
pizza restaurant, the shop owner can move to a larger
or smaller place.
Production function

 Mathematical equation that tells how much

output a firm can produce with given amounts of
the inputs.
 Q=f(L,K)
 Where L= Land, K= Capital
 Where L represents all variable inputs and K
represents all the fixed inputs.
Production function in the short run

 Q=f(L,K)
 Thisequation simply indicates that since
capital is fixed, the amount of output
depends only on the amount of labour
employed.
 Eg:
In case of lumberjacks using a 2 person
saw to cut a wooden log.
 TP, AP and MP
Terminologies Description
Production Function As we know, production implies the transformation of physical
inputs into physical outputs. Therefore, the production function
explains the interrelationship between the factor input and
output.

Total Product (TP) Total Product (TP) is also known as total output. Following varied
values of a physical variable input along with a fixed amount of
input, this process gives us the value of TP.

Average Product (AP) Average Product equals the Total Product (TP) divided by the Total
Number of Variable Inputs. In other words, AP is the output per
unit.
Marginal Product (MP) Marginal Product or output is derived when the producer employs
additional units of inputs in variable factors.
Which further means, that it is a rate at which the TP rises.
Understanding Marginal Output

 Marginal product is the additional output of one more

worker.
 Mathematically MP is the change in total product
divided by the change in labour:

MP =
For your restaurant ….

 Letssay You are paying Rs. 10/hr, so around Rs.

80/day per worker is variable inputs.

 Fixed Input = Grill, Kitchen, Building , Furniture,

Cutlery Lets say comes to 100/day.
Short run production function of
sandwiches
Chefs Number of Average Marginal
sandwiches Product Product
(TP) (AP) (MP)
1 40 40 (40/1) 40 (40-0)

2 90 45 (90/2) 50 (90-40)

3 120 40 (120/3) 30 (120-90)

4 135 33.75 (135/4) 15 (135-120)

Short Run Production for trees

Number of Number of Marginal Average

Lumber trees (TP) Production Production
Jacks (MP) (AP)
1 4 4 4
2 10 6 5

3 12 2 4
4 13 1 3.2
Law of Diminishing Marginal Utility/
Law of Variable Proportions
 Law of diminishing marginal utility or Law
of Variable Proportion states that as the
quantity of a factor is increased while
keeping other factors constant, the Total
Product(TP) first rises at an incremental
rate, then at a decremental rate and lastly
the total production begins to fall.
Assumptions of the Law of Variable Proportions
 It operates in short run as factors are classified as variable and fixed
factor.
 The law applies to all fixed factors including land.
 Under law of variable proportions different units of variable factor can
be combined with fixed factor.
 This law applies to the field of production only.
 The effect of change in output due to change in variable factor can be
easily determined.
 It is assumed that factors of production become imperfect substitutes
of each other beyond a certain limit.
 The state of technology is assumed to be constant during the operation
of this law.
 It is assumed all variable factors are equally efficient.
Example

 Imagine you own a land wherein you

produce rice by employing more and more
labour (Variable factor). The following
table given ahead explains the situation
further:
Question – PRODUTION OF RICE
Input Production of Total Average Marginal
(Variable and rice Production production Production
fixed )
1 10 10 10 10

2 15 30 15 20

3 20 60 20 30

4 20 80 20 20

5 18 90 18 10

6 15 90 15 0

7 12.1 85 12.1 -5
 Observations in the above diagram
 Up to 3 units of labour employed, the TP is rising at an increasing rate. This constitutes
Stage 1 of the law, which is the Stage of Increasing Returns. Therefore, during the first
stage, the TP curve increases significantly.

 Beyond the 3rd unit of labour, the TP starts rising at a diminishing rate, which means the TP
curve rises at a slower rate. This eventually makes the marginal product (MP) starting to fall.
Constituting the second stage of the Law of Variable Proportion which is called the Stage of
Diminishing Returns.

 After the employment of 6 units of labour, the TP starts to fall, indicating the 3rd stage which
is the Stage of Negative Returns. Even after employing 6 units of labour, it fails to yield the
marginal product, that is when the MP comes to zero. Eventually, the TP curve starts sloping
down and the marginal product goes to negative in the x-axis.
Relation between TP, MP and AP

1. When TP increases at an increasing rate, the MP and AP also

increase. However, at this stage, MP>AP
2. When TP increases at a decreasing rate, the MP and AP start to fall.
3. When TP falls, MP goes negative and AP falls consistently
remaining above the x-axis.
4. MP intersects AP at the point where the AP is at the maximum, this
is where MP=AP.
Reasons for Law of Variable Proportions
Increasing Returns to a factor
 Better utilization of Fixed factor
 Increased Efficiency of Variable Factor
 Indivisibility of Fixed Factor
Diminishing Returns to a factor
 Optimum combination of factors
 Imperfect substitutes
 Negative Returns to a factor
Limitations of fixed factor
 Poor coordination between Variable and fixed factor
 Decrease in efficiency of Variable factor
Now arises a million dollar question. Which stage
of the Law of Variable proportion should a firm
operate in? Stage 1,2 or 3.
 As a rational firm, the optimal utilization of both the fixed and variable
inputs would take place only in Stage 2 of the Law of Variable Proportion.
That is the only time when all the inputs are used in an economical way.
 Additionally, the MP and AP of both the inputs are positive yet
diminishing. Whereas, if a firm operates in the first stage, the marginal
product of the fixed input (land) is still in a negative form. This is because
the lesser units of labour are using the land in large proportion, thereby
yielding no marginal product.
Long run production- Economies of Scale
 In the long run all factors (including Capital) are variable,
so our production function is Q=f(L,K)
 Economies of scale refers to the situation in which
increasing the scale of production reduces the unit cost of
production.
 Ifyou are travelling in a bus alone then you have to bear the
whole cost, while if you are travelling with a lot of
passengers the cost gets distributed amongst all and you
have to pay less.
Economies of Scale

 Economies of scale refers to the situation where,

as the quantity of output goes up, the cost per
unit goes down. This is the idea behind
“warehouse stores” like Costco or Walmart. In
everyday language: a larger factory can produce
at a lower average cost than a smaller factory.
Reasons-

 Economies of scale is about increasing the size of a business to make

cost savings.
 E.g. if you were to manufacture a smartphone would you be able to
compete with apple, one plus etc the big giants. You will find that
lower unit costs huge marketing budget and expertise are few factors
which you will not be able to fight with.
 Reasons :
 Specialisation of labour.
 Bulk of orders,
 full utilisation of the fixed resources, such that the limited fixed costs
gets distributed amongst the total production.
 Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of
$12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per
clock. A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. Economies
of scale exist when the larger scale of production leads to lower average costs .
 Figure 7.9 illustrates the idea of
economies of scale, showing the average
cost of producing an alarm clock falling
as the quantity of output rises. For a
small-sized factory like S, with an output
level of 1,000, the average cost of
production is $12 per alarm clock. For a
medium-sized factory like M, with an
output level of 2,000, the average cost of
production falls to $8 per alarm clock. For
a large factory like L, with an output of
5,000, the average cost of production
declines still further to $4 per alarm clock.
Reasons for economies of scale -
 Specialisation of labour. – Increased scale makes division of
labour possible. Workers have narrower range of task. Doing
something all the time makes you faster and better at doing it.
Division of labour can reduce unit labour costs.
 Mass production
 fullutilisation of the fixed resources, such that the limited fixed
costs gets distributed amongst the total production.
 Technical benefits – larger firms can make savings through
investing in bigger and more cost effective machinery and
equipment.
 Purchasing economics- large firms get better deals from
suppliers.
Advantages of economies of scale
 1. Lower unit costs – this gives a business two options:
 Offer reduced price (to increase sales) or,
 Keep prices the sae and see better margin.
 Creates barrier to entry- for large business can deter or stop the
start-ups to come into the market. Foreg – a new cereal company
competing with the kellogs cereal will not survive. Microsoft
computer operating system and Johnson and Johnson are few
examples of big giant companies. Due to the large size of these
company its difficult for a new start-up to compete on the same
prices with these companies. A large company is more likely to
win a price war then a small company with much less capital and
much high unit cost.
Concept check?

 A Ltd manufacture umbrellas. The business has grown rapidly and the
directors are now ssking to build a new , much bigger actory. Briefly explain
how A ltd may obtain purchasing, technical and specialisation economies of
scale?
Costs
A cost is an expenditure incurred on the
production of a good or a service. Various
inputs like raw material, building,
electricity, machinery etc.
TC= FC+VC
Costs can be divided into -
Short run costs
Long run costs
 Costs in short run
 Inshort run we employ fixed and variable costs. TFC
and TVC.
 Where TFC is going to be charged irrespective of the
production. Meaning on 0 production there is going to
be same amount of fixed cost.
 TVC keeps on increasing with the increase in
production. At 0 production it will be 0 but as the
production increases the Variable costs also increases.
 TC= VC + FC
 Costs in the Long Run
 The long run is the period of time when all costs are variable.

 No costs are fixed in the long run. A firm can build new factories and
purchase new machinery or it can close existing facilities.

 In planning for the long run, the firm will compare alternative
production technologies. Technologies refers to all alternative methods
of combining inputs to produce desired outputs.

 The firm will search for the production technology that allows it to
produce the desired level of output at the lowest cost. After all, lower
costs lead to higher profits.
 Nature of short run and long run period.
Short run period Long run period
 Short run is the period in
 Long run is the period during
which the fixed costs cannot
be altered. which a firm has the complete
freedom to change its costs both
 There is no force or rule for fixed and variable costs.
determining the time period
 Fixed costs can be changed
of short run depends how
much time it takes to entirely in the long run and
gainfully change the fixed hence converts into Variable
assets. For some projects costs in the long run.
even 1 year is short term
while others could count a
month as a short term period
which entirely depends on
the nature of the business.
 Types of Costs
 Fixed Cost- Fixed costs are the costs of the fixed inputs (e.g. capital).
Because fixed inputs do not change in the short run, fixed costs are
expenditures that do not change regardless of the level of
production. Whether you produce a great deal or a little, the fixed
costs are the same.
 Variable costs are the costs of the variable inputs (e.g. labor). The only
way to increase or decrease output is by increasing or decreasing the
variable inputs. Therefore, variable costs increase or decrease with
output. We treat labor as a variable cost, since producing a greater
quantity of a good or service typically requires more workers or more
work hours. Variable costs would also include raw materials.
…….
 Average The Average Cost is the per unit cost of production obtained
by dividing the total cost (TC) by the total output (Q). By per
unit cost of production, we mean that all the fixed and variable cost is
taken into the consideration for calculating the average cost. Thus, it is
also called as Per Unit Total Cost.
 Marginal Cost is the cost of each individual unit produced. In
other words, Marginal cost is the cost of producing one
more unit of output. Mathematically it is the change in total
cost divided by the change in output. MC= Change in TC/
Change in Q
 Total costs are the sum of fixed plus variable costs.
TC= TVC+TFC
 Determinants of costs
The cost of production of goods and services depends on various input factors used by the organization and it
differs from firm to firm. The major cost determinants are:

1.Level of output: The cost of production varies according to the quantum of output. If the size of production is
large then the cost of production will also be more.

2.Price of input factors: A rise in the cost of input factors will increase the total cost of production.

3.Productivities of factors of production: When the productivity of the input factors is high then the cost of
production will fall.

4.Size of plant: The cost of production will be low in large plants due to mass production with mechanization.

5.Output stability: The overall cost of production is low when the output is stable over a period of time.

6.Lot size: Larger the size of production per batch then the cost of production will come down because the
organizations enjoy economies of scale.
 ……
 7.Laws of returns: The cost of production will increase if the resources are not employed wisely.
 8.Levels of capacity utilization: Higher the capacity utilization, lower the cost of production.

9.Time period: In the long run cost of production will be stable.

10.Technology: When the organization follows advanced technology in their process then the cost of
production will be low.

11.Experience: over a period of time the experience in production process will help the firm to reduce
cost of production.

12.Process of range of products: Higher the range of products produced, lower the cost of production.

13.Supply chain and logistics: Better the logistics and supply chain, lower the cost of production.

14.Government incentives: If the government provides incentives on input factors then the cost of
production will be low.
 Average Fixed Cost
 TC = TFC + TVC
 AFC =
 (AVERAGE COST IS COST PER
UNIT OF OUTPUT.
 Also, where TFC is going
to be same but the
output Q will keep
changing. You are dividing
a fixed numerator with
continuously changing
denominator.
 AFC never becomes 0.
 Average Variable Cost
 AVC=
 We also know that-
 AC= AFC+AVC
 As the cost increases the
output also increases. The
proportion can vary.
 When you spend on the variable
cost initially it is not so
efficient, but as you spend more
money on variable cost, you
start getting the optimum
utilisation of the resource and
then after that the cost will
start increasing as the output is
not increasing accordingly.
 Average Cost curves.
 Now we have AVC and AFC
curves.
 If we produce OA quantity the
AC= AB+AC
 If we produce OD qty the
AC=DE +DE
 If we produce OF quantity the
AC=FG+FH
 So we get 3 points above if we
join them we get a curve AC
which decreases then comes at
a point after which it starts
increasing.
 This curve is for short run
period as the producer cannot
change his fixed assets in the
short run and hence the cost
starts rising up. Which he can
change in the long run from
the point it starts increasing.
Shapes of Long run average cost curves
 While in the short run firms are limited to operating
on a single average cost curve according to the
level of fixed costs they have chosen. But, in the
long run when all costs are variable, they can
choose to operate on any average cost curve.
 Thus,LRAC curve is actually based on a group of
short run average cost curves, each of which
represents one specific level of fixed costs. More
precisely LRAC curve will be the least expensive
average cost curve for any level of output.
 Long run Average cost curves
 The producers have full flexibility to
change variable and fixed costs with
time.
 At OA level of output the producer
notes that cost increases and he will
notice to introduce a new change or
new proportion of Fixed and Variable
inputs. So he introduces a new SRAC
curve and so on….
 If we join the minimum points of
different SRAC curves we get LRAC
curve.
 There is possibility of LRAC becomes
flat after a point. For e.g. pumping
of petrol…..
 Else, but in other cases of production
it will be as shown in the red LRAC
curve.
 Short Run Average Cost Curves to Long
Run Average Cost Curves
 The five different short-run average
cost (SRAC) curves each represents a
different level of fixed costs, from
the low level of fixed costs at to the
high level of fixed costs at SRAC1 to
SRAC5. Other SRAC curves, not in the
diagram, lie between the ones that
are here. The long-run average cost
(LRAC) curve shows the lowest cost
for producing each quantity of
output when fixed costs can vary,
and so it is formed by the bottom
edge of the family of SRAC curves. If
a firm wished to produce quantity
Q3, it would choose the fixed costs
associated with SRAC3.
The shape of the long-run cost curve, is fairly common for many industries. The left-
hand portion of the long-run average cost curve, where it is downward- sloping from
output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion
of the long-run average cost curve, larger scale leads to lower average costs.

In the middle portion of the long-run average cost curve, the flat portion of the curve
around Q3, economies of scale have been exhausted. In this situation, allowing all
inputs to expand does not much change the average cost of production. We call
this constant returns to scale. In this LRAC curve range, the average cost of
production does not change much as scale rises or falls. The following Clear It Up
feature explains where diminishing marginal returns fit into this analysis.
 ….
 Finally, the right-hand portion of the long-run average cost curve,
running from output level Q4 to Q5, shows a situation where, as
the level of output and the scale rises, average costs rise as well.
We call this situation diseconomies of scale. A firm or a factory
can grow so large that it becomes very difficult to manage,
resulting in unnecessarily high costs as many layers of
management try to communicate with workers and with each
other, and as failures to communicate lead to disruptions in the
flow of work and materials.
Marginal Cost
What is marginal cost?
What is MC of the 40th sandwich?
It is going to be the change in the total cost every time you increase
your output by 1.

MC=

MC=

So, the marginal cost of the 40th sandwich is going to be the change in
total cost over the change in output of that sandwich. The total cost went
from 100 to 180 and the change in sandwiches was from 0 to 40. So,
when you calculate that, you actually get the marginal costs of the 40 th
sandwich which is $2.
Takeaway
 So when the 2nd worker was hired the cost went down to $1.60. Its
because when you paid $80 to the first worker the increase in
output was 40.
 But when you paid same $80 to the second worker and the change
in output was 50 units, which is more. So second worker is a good
deal to you than the first worker as the second worker increased
productivity by more. The cost per unit or the cost of operation is
going down.
 When you employ third worker, the story is different, the increase
in output is worth 30 and the cost of the 120th units were actually
$2.67 which is actually increasing at an increasing rate. So now you
are paying the third worker same money $80 but the productivity is
decreasing.
 The marginal cost line intersects the average cost line exactly at the
bottom of the average cost curve.
 If MC for producing an additional unit is more than the average
total cost for producing the earlier units(where MC crosses ATC),
then producing a marginal unit will increase average costs overall.
Vice-versa,
 If MC of production is less than the AC for producing previous units
(points where MC crosses ATC) then producing one more additional
unit will reduce average costs overall.
Why breaking down costs in so many types?

 Breaking down total costs into fixed cost, marginal cost, average total cost,
and average variable cost is useful because each statistic offers its own
insights for the firm.

 Total cost, fixed cost, and variable cost each reflect different aspects of
the cost of production over the entire quantity of output produced.

 We measure these costs in Rupee. In contrast, marginal cost, average

cost, and average variable cost are costs per unit.
Question: In a restaurant which sells sandwiches, the data for number of
cooks and number of sandwiches and fixed costs is given. Find the total
costs, variable cost and marginal cost based on the information….
 Average Total Cost(ATC), Average Variable
Cost(AVC) and Marginal Cost(MC).
 We can also present the information on total costs, fixed cost, and variable cost on
a per-unit basis.
 We calculate average total cost (ATC) by dividing total cost by the total quantity
produced. The average total cost curve is typically U-shaped. ATC=TC/Q
 We calculate average variable cost (AVC) by dividing variable cost by the quantity
produced. The average variable cost curve lies below the average total cost curve
and is also typically U-shaped.
AVC=VC/Q
 We calculate marginal cost (MC) by taking the change in total cost between two
levels of output and dividing by the change in output. The marginal cost curve is
upward-sloping.
MC= Change in TC/Change in Q
Concept Check: If the wage is $80/worker/day and the fixed costs are
$100, then the Marginal Costs of 90th unit of output is: _________.
A. $2
B. $1.60
C. $8
D. None of the above

#
Marginal Fixed Variable Total
# Cooks Sandwich
Product Costs Costs Costs
es
0 0 0 $100 $0 $100
1 40 40 $100 $80 $180
2 90 90 $100 $160 $260
3 120 120 $100 $240 $340
4 135 135 $100 $320 $420
5 140 140 $100 $400 $500
6 142 142 $100 $480 $580
Concept Check:

 If the wage is $80/worker/day and the fixed costs are $100,

then the Marginal Costs of 90th unit of output is:
_________.
A. $2
B. $1.60
C. $8
D. None of the above
Correct answer

 MC=
 MC=
 MC= =1.60