BUnit-3B BE

UNIT-3BBAProduction & Cost
Introduction
Production is the process of converting inputs into outputs. The initial factors of
production results in final goods in the process of production. Production is a very
important concept in economics because it is the running force. Without
production, economics cannot be complete as economics starts with the
production function and derives the other factors from it.
Meaning of Production: What is the concept of production?
Any human initiative that creates a good for use can be called production. It
requires four factors as inputs, namely, land, labor, entrepreneurship, and capital
to complete the initial phase of production. The end product or goods are known
as outputs in economics.
Production can result in output in the form of goods and services. Goods are
products we can view and touch with our hands such as mobiles, shirts, rice,
utensils, etc. while we cannot see services but can feel their use or presence.
Teaching, medical services, transportation, etc., are forms of various services
Definition of Production
According to Bates and Parkinson:

“Production is the organised activity of transforming resources into finished
products in the form of goods and services; the objective of production is to
satisfy the demand for such transformed resources”.
Three Types of Production:

For general purposes, it is necessary to classify production into three
main groups:
1. Primary Production:
Primary production is carried out by ‘extractive’ industries like agriculture,
forestry, fishing, mining and oil extraction. These industries are engaged in such
activities as extracting the gifts of Nature from the earth’s surface, from beneath
the earth’s surface and from the oceans.
2. Secondary Production:
This includes production in manufacturing industry, viz., turning out semi-finished
and finished goods from raw materials and intermediate goods— conversion of
By Vimla SharmaPage 1
flour into bread or iron ore into finished steel. They are generally described as
manufacturing and construction industries, such as the manufacture of cars,
furnishing, clothing and chemicals, as also engineering and building.
3. Tertiary Production:
Industries in the tertiary sector produce all those services which enable the
finished goods to be put in the hands of consumers. In fact, these services are
supplied to the firms in all types of industry and directly to consumers. Examples
cover distributive traders, banking, insurance, transport and communications.
Government services, such as law, administration, education, health and defence,
are also included.
Factors of Production:
Production of a commodity or service requires the use of certain resources or
factors of production. Since most of the resources necessary to carry on
production are scarce relative to demand for them they are called economic
resources.
Resources, which we shall call factors of production, are combined in various

ways, by firms or enterprises, to produce an annual flow of goods and services.
Anything that helps in production is the factor of production. These are the
various factors by mean any resource is transformed into a more useful
commodity or service.
They are the inputs for the process of production. They are the starting point of
the production process. Factors of production are the parameters which affect the
output of production.
Types of Factors of Production
Factors of production have been categorized into four types.
Each factor gets a reward on the basis of its contribution to the production
process, as shown in the table.
In fact, the resources of any community, referred to as its factors of production,

can be classified in a number of ways, but it is common to group them according
to certain characteristics which they possess. If we keep in mind that the
production of goods and services is the result of people working with natural
resources and with equipment such as tools, machinery and buildings, a generally
acceptable classification can readily be derived. The traditional division of factors
of production distinguishes labour, land and capital, with a fourth factor,
enterprise, some-times separated from the rest.
The people involved in production use their skills and efforts to make things and
do things that are wanted. This human effort is known as labour. In other words,
labour represents all human resources. The natural resources people use are
called land. And the equipment they use is called capital, which refers to all man-
made resources.
Land
It refers to all natural resources. All natural resources either on the surface of the
earth or below the surface of the earth or above the surface of the earth is Land.
One uses the land to produces goods. It is the primary and natural factor of
production. All gifts of nature such as rivers, oceans, land, climate, mountains,
mines, forests etc. are land.
The payment for land is rent.
Characteristics of Land as a Factor of Production
● The land is a free gift of nature.
● The land has no cost of production.
● It is immobile.
● The land is fixed and limited in supply.
Types of Land
1. Residential
2. Commercial
3. Recreation
4. Cultivation
5. Extraction
6. Uninhabitable
Labor
All human effort that assists in production is labour. This effort can be mental or
physical. It is a human factor of production. It is the worker who applies their
efforts, abilities, and skills to produce.
The payment for labour is the wage.
Characteristic
● It is a human factor.
● One cannot store labour.
● No two types of labour are the same.
Types of Labor
1. Unskilled
2. Semi-skilled
3. Skilled
4. Professional
Capital
Capital refers to all manmade resources used in the production process. It is a
produced factor of production. It includes factories, machinery, tools, equipment,
raw materials, wealth etc.
The payment for capital is interest.
Characteristics
● Capital is a manmade factor of production.
● It is mobile.
● It is a passive factor of production.
Types of Capital
1. Fixed
2. Working
3. Venture
Entrepreneur
An entrepreneur is a person who brings other factors of production in one place.
He uses them for the production process. He is the person who decides
● What to produce
● Where to produce
● How to produce
A person who takes these decisions along with the associated risk is an
entrepreneur.
The payment for land is profit.
Characteristics
● He has imagination.
● He has great administrative power.
● An entrepreneur must be a man of action.
● An entrepreneur must have the ability to organize.
● He should be a knowledgeable person.
● He must have a professional approach.
Production Function?
The production function of an enterprise is an association between inputs utilised
and output manufactured by an enterprise. For various quantities of inputs
utilised, it gives the utmost quantity of output that can be manufactured.
Contemplate the farmer is mentioned in the introduction to the concept
Production And Costs. Let us presume that the farmer utilises only 2 inputs to
manufacture rice: labour and land. A production function explains us the utmost
quantity of rice he can manufacture for a provided amount of land that he utilises
and a given number of hours of labour that he performs. Suppose that he uses 2
hours of labour per day and 1 hectare of land to manufacture an utmost of 2
tonnes of rice. Then, a function that explains this association is called a
‘Production Function’. One feasible instance of the form this could take is: q = K
× L, Whereas, q is the amount of rice manufactured, K is the area of land in
hectares, L is the number of hours of work performed in a day.
A production function is elucidated for a provided technology. It is the
technological knowledge that regulates the utmost degrees of output that can be
manufactured using various combinations of inputs. If the technology enhances,
the utmost levels of output achievable for different input combinations go up. We
now have a new production function.
The inputs that an enterprise utilises in the production procedure are called as
factors of production. In order to manufacture output, a firm may require any
amount of different inputs. Let us contemplate a firm that manufactures output
using only 2 factors of production –
● Capital
● Labour.
Production function, explains the utmost quantity of output (q) that can be
manufactured by using different combinations of these 2 factors of production
Labour (L) and Capital (K).
We can write the production function as :
q = f (L,K)
whereas, L is labour and K is capital and q is the utmost output that can be
manufactured.
Variable factors of production
Variable factors of production are those factors of production, the application of
which changes with the change in output.
Variable factors are those that do change with output, which means more are
employed when production increases, and less when production decreases.
Typical variable factors include labour, energy, and raw materials directly used in
production.
Fixed factors of production

Fixed factors of production are those factors of production, the application of
which does not change with the change in output.
Fixed factors are those that do not change as output is increased or decreased,
and typically include premises such as offices and factories, and capital
equipment such as machinery and computer systems.
Law of Variable Proportion is regarded as an important theory in Economics. It is
referred to as the law which states that when the quantity of one factor of
production is increased, while keeping all other factors constant, it will result in
the decline of the marginal product of that factor.
Law of variable proportion is also known as the Law of Proportionality. When the
variable factor becomes more, it can lead to negative value of the marginal
product.
The law of variable proportion can be understood in the following way.
When variable factor is increased while keeping all other factors constant, the
total product will increase initially at an increasing rate, next it will be increasing
at a diminishing rate and eventually there will be decline in the rate of
production.
Assumptions of Law of Variable Proportion

Law of variable proportion holds good under certain circumstances, which will be
discussed in the following lines.
1. Constant state of Technology: It is assumed that the state of technology will

be constant and with improvements in the technology, the production will
improve.
2. Variable Factor Proportions: This assumes that factors of production are
variable. The law is not valid, if factors of production are fixed.
3. Homogeneous factor units: This assumes that all the units produced are
identical in quality, quantity and price. In other words, the units are
homogeneous in nature.
4. Short Run: This assumes that this law is applicable for those systems that
are operating for a short term, where it is not possible to alter all factor
inputs.
Stages of Law of Variable Proportion

The Law of Variable proportions has three stages, which are discussed below.
1. First Stage or Stage of Increasing returns: In this stage, the total product
increases at an increasing rate. This happens because the efficiency of the
fixed factors increases with addition of variable inputs to the product.
2. Second Stage or Stage of Diminishing Returns: In this stage, the total
product increases at a diminishing rate until it reaches the maximum point.
The marginal and average product are positive but diminishing gradually.
3. Third Stage or Stage of Negative Returns: In this stage, the total product
declines and the marginal product becomes negative.
Why is it called the Law of Variable Proportions?
As one input varies and all others remain constant, the factor ratio or the factor
proportion varies. Let’s look at an example to understand this better:
Let’s say that you have 10 acres of land and 1 unit of labour for production.
Therefore, the land-labour ratio is 10:1. Now, if you keep the land constant but
increase the units of labour to 2, the land-labour ratio becomes 5:1.
Therefore, as you can see, the law analyses the effects of a change in the factor
ratio on the amount of out and hence called the Law of Variable Proportions.
Law of Variable Proportions Explained

Let’s understand this law with the help of another example:
In this example, the land is the fixed factor and labour is the variable factor. The
table shows the different amounts of output when you apply different units of
labour to one acre of land which needs fixing.
The following diagram explains the law of variable proportions. In order to make
a simple presentation, we draw a Total Physical Product (TPP) curve and a
Marginal Physical Product (MPP) curve as smooth curves against the variable
input (labour).
hree Stages of the Law

The law has three stages as explained below:
1. Stage I – The TPP increases at an increasing rate and the MPP increases too.
The MPP increases with an increase in the units of the variable factor.
Therefore, it is also called the stage of increasing returns. In this example, the
Stage I of the law runs up to three units of labour (between the points O and
L).
2. Stage II – The TPP continues to increase but at a diminishing rate. However,

the increase is positive. Further, the MPP decreases with an increase in
the number of units of the variable factor. Hence, it is called the stage of
diminishing returns. In this example, Stage II runs between four to six units of
labour (between the points L and M). This stage reaches a point where TPP is
maximum (18 in the above example) and MPP becomes zero (point R).
3. Stage III – Now, the TPP starts declining, MPP decreases and becomes
negative. Therefore, it is called the stage of negative returns. In this example,
Stage III runs between seven to eight units of labour (from the point M
onwards).
Significance of the three stages

Stage I
A producer does not operate in Stage I. In this stage, the marginal product
increases with an increase in the variable factor.
Therefore, the producer can employ more units of the variable to efficiently utilize
the fixed factors. Hence, the producer would prefer to not stop in Stage I but will
try to expand further.
Stage III
Producers do not like to operate in Stage III either. In this stage, there is a
decline in total product and the marginal product becomes negative.
In order to increase the output, producers reduce the amount of variable factor.
However, in Stage III, he incurs higher costs and also gets lesser revenue thereby
getting reduced profits.
Stage II
Any rational producer avoids the first as well as third stages of production.
Therefore, producers prefer Stage II – the stage of diminishing returns. This stage
is the most relevant stage of operation for a producer according to the law of
variable proportions.
Law of Returns to Scale : Definition, Explanation and Its Types!

In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the quantity of
all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors change by
the same proportion.” Koutsoyiannis
Returns to scale relates to the behaviour of total output as all inputs are varied
and is a long run concept”. Leibhafsky
Returns to scale are of the following three types:

1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
Explanation:
In the long run, output can be increased by increasing all factors in the same
proportion. Generally, laws of returns to scale refer to an increase in output due
to increase in all factors in the same proportion. Such an increase is called
returns to scale.
1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all
factors of production are increased, output increases at a higher rate. It means if
all inputs are doubled, output will also increase at the faster rate than double.
Hence, it is said to be increasing returns to scale. This increase is due to many
reasons like division external economies of scale.
There a number of factors responsible for increasing returns to scale.
Some of the factors are as follows:

i. Technical and managerial indivisibility:
Implies that there are certain inputs, such as machines and human resource, used
for the production process are available in a fixed amount. These inputs cannot be
divided to suit different level of production. For example, an organization cannot
use the half of the turbine for small scale of production.
Similarly, the organization cannot use half of a manager to achieve small scale of
production. Due to this technical and managerial indivisibility, an organization
needs to employ the minimum quantity of machines and managers even in case
the level of production is much less than their capacity of producing output.
Therefore, when there is increase in inputs, there is exponential increase in the
level of output.
ii. Specialization:
Implies that high degree of specialization of man and machinery helps in
increasing the scale of production. The use of specialized labor and machinery
helps in increasing the productivity of labor and capital per unit. This results in
increasing returns to scale.
iii. Concept of Dimensions:

Refers to the relation of increasing returns to scale to the concept of dimensions.
According to the concept of dimensions, if the length and breadth of a room
increases, then its area gets more than doubled.
For example, length of a room increases from 15 to 30 and breadth increases

from 10 to 20. This implies that length and breadth of room get doubled. In such a
case, the area of room increases from 150 (15*10) to 600 (30*20), which is more
than doubled.
2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where
if all the factors of production are increased in a given proportion, output
increases in a smaller proportion. It means, if inputs are doubled, output will be
less than doubled. If 20 percent increase in labour and capital is followed by 10
percent increase in output, then it is an instance of diminishing returns to scale.
The main cause of the operation of diminishing returns to scale is that internal
and external economies are less than internal and external diseconomies.
3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in
which output increases exactly in the same proportion in which factors of
production are increased. In simple terms, if factors of production are doubled
output will also be doubled.
In this case internal and external economies are exactly equal to internal and
external diseconomies. This situation arises when after reaching a certain level of
production, economies of scale are balanced by diseconomies of scale. This is
known as homogeneous production function. Cobb-Douglas linear homogenous
production function is a good example of this kind. This is shown in diagram 10.
In figure 10, we see that increase in factors of production i.e. labour and capital
are equal to the proportion of output increase. Therefore, the result is constant
returns to scale.
Understanding an Isoquant Curve
The term "isoquant," broken down in Latin, means “equal quantity,” with “iso”
meaning equal and “quant” meaning quantity. Essentially, the curve represents a
consistent amount of output. The isoquant is known, alternatively, as an equal
product curve or a production indifference curve. It may also be called an iso-
product curve.
Most typically, an isoquant shows combinations of capital and labor, and the
technological tradeoff between the two—how much capital would be required to
replace a unit of labor at a certain production point to generate the same output.
Labor is often placed along the X-axis of the isoquant graph, and capital along the
Y-axis.
Due to the law of diminishing returns—the economic theory that predicts that
after some optimal level of production capacity is reached, adding other factors
will actually result in smaller increases in output—an isoquant curve usually has a
concave shape. The exact slope of the isoquant curve on the graph shows the rate
at which a given input, either labor or capital, can be substituted for the other
while keeping the same output level.
The Properties of an Isoquant Curve
Property 1: An isoquant curve slopes downward, or is negatively sloped.

This means that the same level of production only occurs when increasing units of
input are offset with lesser units of another input factor. This property falls in line
with the principle of the Marginal Rate of Technical Substitution (MRTS). As an
example, the same level of output could be achieved by a company when capital
inputs increase, but labor inputs decrease.
Property 2: An isoquant curve, because of the MRTS effect, is convex to its origin.
This indicates that factors of production may be substituted with one another. The
increase in one factor, however, must still be used in conjunction with the
decrease of another input factor.
Property 3: Isoquant curves cannot be tangent or intersect one another.

Curves that intersect are incorrect and produce results that are invalid, as a
common factor combination on each of the curves will reveal the same level of
output, which is not possible.
Property 4: Isoquant curves in the upper portions of the chart yield higher
outputs.
This is because, at a higher curve, factors of production are more heavily
employed. Either more capital or more labor input factors result in a greater level
of production.
Property 5: An isoquant curve should not touch the X or Y axis on the graph.
If it does, the rate of technical substitution is void, as it will indicate that one
factor is responsible for producing the given level of output without the
involvement of any other input factors.
Property 6: Isoquant curves do not have to be parallel to one another.

The rate of technical substitution between factors may have variations.
Property 7: Isoquant curves are oval-shaped.

This allows firms to determine the most efficient factors of production.
Concept of Costs
It is a commonly accepted fact that physical inputs or resources are important for
enhancing production. We, however, tend to miss out on the financial aspect of
this rule. Some of the most important decisions pertaining to business often relate
to the cost of production, instead of physical resources themselves. Hence, it is
important for producers to understand cost analysis. Let’s understand the general
concept of costs for that.
Concept of Costs in terms of Treatment
1. Accounting costs
Accounting costs are those for which the entrepreneur pays direct cash for
procuring resources for production. These include costs of the price paid for raw
materials and machines, wages paid to workers, electricity charges, the cost
incurred in hiring or purchasing a building or plot, etc. Accounting costs are
treated as expenses. Chartered accountants record them in financial statements.
2. Economic costs
There are certain costs that accounting costs disregard. These include money
which the entrepreneur forgoes but would have earned had he invested his time,
efforts and investments in other ventures. For example, the entrepreneur would
have earned an income had he sold his services to others instead of working on
his own business
Similarly, potential returns on the capital he employed in his business instead of

giving it to others, the output generated by his resources which he could have
used for others’ benefits, etc. are other examples of economic costs.
Economic costs help the entrepreneur calculate supernormal profits, i.e. profits
he would earn above the normal profits by investing in ventures other than his.
Concept of Costs in terms of the Nature of Expenses
1. Outlay costs
The actual expenses incurred by the entrepreneur in employing inputs are called
outlay costs. These include costs on payment of wages, rent, electricity or fuel
charges, raw materials, etc. We have to treat them are general expenses for the
business.
2. Opportunity costs
Opportunity costs are incomes from the next best alternative that is foregone
when the entrepreneur makes certain choices.
For example, the entrepreneur could have earned a salary had he worked for
others instead of spending time on his own business. These costs calculate the
missed opportunity and calculate income that we can earn by following some
other policy.
Concept of Costs in terms of Traceability
1. Direct costs
Direct costs are related to a specific process or product. They are also called
traceable costs as we can directly trace them to a particular activity, product or
process.
They can vary with changes in the activity or product. Examples of direct costs
include manufacturing costs relating to production, customer acquisition costs
pertaining to sales, etc.
2. Indirect costs
Indirect costs, or untraceable costs, are those which do not directly relate to a
specific activity or component of the business. For example, an increase in
charges of electricity or taxes payable on income. Although we cannot trace
indirect costs, they are important because they affect overall profitability.
Concept of Costs in terms of the Purpose
1. Incremental costs
These costs are incurred when the business makes a policy decision. For example,
change of product line, acquisition of new customers, upgrade of machinery to
increase output are incremental costs.
2. Sunk costs
Suck costs are costs which the entrepreneur has already incurred and he cannot
recover them again now. These include money spent on advertising, conducting
research, and acquiring machinery.
Concept of Costs in terms of Payers
1. Private costs
These costs are incurred by the business in furtherance of its own objectives.
Entrepreneurs spend them for their own private and business interests. For
example, costs of manufacturing, production, sale, advertising, etc.
2. Social costs
As the name suggests, it is the society that bears social costs for private interests
and expenses of the business. These include social resources for which the firm
does not incur expenses, like atmosphere, water resources and environmental
pollution.
Concept of Costs in terms of Variability
1. Fixed costs
Fixed costs are those which do not change with the volume of output. The
business incurs them regardless of their level of production. Examples of these
include payment of rent, taxes, interest on a loan, etc.
2. Variable costs
These costs will vary depending upon the output that the business generates. Less
production will cost fewer expenses, and vice versa, the business will pay more
when its production is greater. Expenses on the purchase of raw material and
payment of wages are examples of variable costs.
Concept of Cost Function:

The relationship between output and costs is expressed in terms of cost function.
By incorporating prices of inputs into the production function, one obtains the
cost function since cost function is derived from production function. However,
the nature of cost function depends on the time horizon. In microeconomic theory,
we deal with short run and long run time.
A cost function may be written as:
Cq = f(Qf Pf)
Where Cq is the total production cost, Qf is the quantities of inputs employed by
the firm, and Pf is the prices of relevant inputs. This cost equation says that cost
of production depends on prices of inputs and quantities of inputs used by the
firm.
Importance of Cost Function:

The study of business behaviour concentrates on the production process—the
conversion of inputs into outputs—and the relationship between output and costs
of production.
We have already studied a firm’s production technology and how inputs are
combined to produce output. The production function is just a starting point for
the supply decisions of a firm. For any business decision, cost considerations play
a great role.
Cost function is a derived function. It is derived from the production function

which captures the technology of a firm. The theory of cost is a concern of
managerial economics. Cost analysis helps allocation of resources among various
alternatives. In fact, knowledge of cost theory is essential for making decisions
relating to price and output.
Whether production of a new product is a wiser one on the part of a firm greatly
depends on the evaluation of costs associated with it and the possibility of earning
revenue from it. Decisions on capital investment (e.g., new machines) are made
by comparing the rate of return from such investment with the opportunity cost of
the funds used.
The relevance of cost analysis in decision-making is usually couched in terms of

short and long periods of time by economists. In all market structures, short run
costs are crucial in the determination of price and output. This is due to the fact
that the basis for cost function is production and the prices of inputs that a firm
pays.
On the other hand, long run cost analysis is used for planning the optimal scale of
plant size. In other words, long run cost functions provide useful information for
planning the growth as well as the investment policies of a firm. Growth of a firm
largely depends on cost considerations.
The position of the U-shaped long run AC of a firm is suggestive of the direction of
the growth of a firm. That is to say, a firm can take a decision whether to build up
a new plant or to look for diversification in other markets by studying its
existence on the long run AC curve. Further, it is the cost that decides the merger
and takeover of a sick firm.
Non-profit sector or the government sector must also have a knowledge of cost
function for decision-making. Whether the Narmada Dam is to be built or not, it
should evaluate the costs and benefits ‘flowing’ from the dam.
Short Run Cost

According to the short run, there are both fixed and variable costs. According to
long run, there are no fixed costs. Methodical long run cost prices are sustained
when the blend of end results that an enterprise manufactures outcomes in the
desired amount of the commodities at the lowest and inexpensive possible price.
Variable costs differ with the end results (output).
Definition
Short Run Cost is the cost price which has short-term inferences in the
manufacturing procedures, i.e., these are utilised over a short degree of end
results. These are the cost sustained once and cannot be used again, such as
payment of wages, cost price of raw materials, etc.,
The Concept of Short Run
It is key to understand the concept of the short run in order to understand short
run costs. In economics, we distinguish between short run and long run through
the application of fixed or variable inputs.
Fixed inputs (plant, machinery, etc.) are those factors of production that cannot
be changed or altered in a short span of time because the time period is ‘too
small’. This makes the short run. Here, the inputs are of two types: fixed and
variable.
In the long-run, all the inputs become variable (eg. raw materials). By this, we
mean that all inputs can be changed with a change in the volume of output. Thus,
the concept of fixed inputs applies only to the short-run. It is to short-run costs
that we now turn.
Short Run Cost Function
The cost function is a functional relationship between cost and output. It explains
that the cost of production varies with the level of output, given other things
remain the same (ceteris paribus). This can be mathematically written as:
C = f(X)
where C is the cost of production and X represents the level of output.
Total Fixed Cost

Fixed cost refers to the cost of fixed inputs. It does not change with the level of
output (thus, fixed). Fixed inputs include building, machinery etc. Hence the cost
of such inputs such as rent or cost of machinery constitutes fixed costs. Also
referred to as overhead costs, supplementary costs or indirect costs, these costs
remain the same irrespective of the level of output.
Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on
the horizontal axis, we get a straight line parallel to the horizontal axis. This
indicates that these costs remain the same and that they have to be incurred even
if the level of output is zero.
Total Variable Cost

The cost incurred on variable factors of production is called Total Variable Cost
(TVC). These costs vary with the level of output or production. Thus, when
production level is zero, TVC is also zero. Thus, the TVC curve begins from the
origin.
The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is
because, in the initial stages of production, there is scope for efficient utilization
of fixed factor by using more of the variable factor (eg. Workers employing
machinery).
Hence, as the variable input employed increases, the productive efficiency of

variable inputs ensures that the TVC increases but at a diminishing rate. This
makes the first part of the TVC curve that is concave.
As the production continues to increase, more and more variable factor is

employed for a given amount of fixed input. The productive efficiency of each
variable factor falls and it adds more to the cost of production. So the TVC
increases but now at an increasing rate. This is where the TVC curve is convex in
shape. And so the TVC curve gets an inverted-S shape.
Total Cost
Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-
run. Thus, the short-run cost can be expressed as
TC = TFC + TVC
Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of
the TC curve by summing over TFC and TVC curves.
Fig.1
(Source: economicsdiscussion)
The following can be noted about the TC curve:
● The TC curve is inverted-S shaped. This is because of the TVC curve. Since
the TFC curve is horizontal, the difference between the TC and TVC curve is
the same at each level of output and equals TFC. This is explained as follows:
TC – TVC = TFC
● The TFC curve is parallel to the horizontal axis while the TVC curve is
inverted-S shaped.
● Thus, the TC curve is the same shape as TVC but begins from the point of TFC
rather than the origin.
● The law that explains the shape of TVC and subsequently TC is called the law
of variable proportions.
asically, we are focusing on two relationships: 1. Relation between Average Cost

and Marginal Cost, and 2. Relation between Total Cost and Marginal Cost.
Details are as under:
1. Relation between Average Cost and Marginal Cost:
Relation between average cost and marginal cost is explained through Table 8
and Fig. 9.
Table 8 and Fig. 9 offer the following observations with regard to the
relation between average cost and marginal cost:
(1) When AC Falls, MC is Lower than AC:

When average cost falls, marginal cost is less than AC. In Table 8, AC is falling till
it becomes Rs.8, and MC remains less than Rs.8. In Fig. 9, AC is falling till point
E, and MC continues to be lower than AC. In this case, marginal cost falls more
rapidly than the average cost. That is why when marginal cost (MC) curve is
falling, it is below the average cost (AC) curve. It is shown in Fig. 9.
(2) When AC Rises, MC is Greater than AC:
When average cost starts rising, marginal cost is greater than average cost. In
Table 8, when AC rises from Rs.8 to Rs.9, MC rises from Rs.8 to Rs.16. In Fig. 9,
AC starts rising from point E. And, beyond E, MC is higher than AC.
(3) When AC does not Change, MC is Equal to AC:
When average cost does not change, then MC = AC. It happens when falling AC
reaches its lowest point. In Table 8, at the 7th unit, average cost does not change.
It sticks to its minimum level of Rs.8. Here, marginal cost is also Rs.8. Thus, Fig. 9
shows that MC curve is intersecting AC curve at its minimum point E.
2. Relation between Total Cost and Marginal Cost:

Table 8 and Fig. 11 offer the following observations with regard to the relation
between total cost and marginal cost:
(i) Marginal cost is estimated as the difference between total costs of two
successive units of output. Thus,
MCn = TCn – TCn-1
(ii) When MC is diminishing, TC increases at a diminishing rate.
(iii) When MC is rising, TC increases at an increasing rate.
(iv) When MC reaches its lowest point (point Q in Fig. 11), TC stops increasing at
a decreasing rate (point Q* in Fig. 11).
Briefly, MC is the rate of TC.
Long Run Cost

The long run refers to that time period for a firm where it can vary all the factors
of production. Thus, the long run consists of variable inputs only, and the concept
of fixed inputs does not arise. The firm can increase the size of the plant in the
long run. Thus, you can well imagine no difference between long-run variable cost
and long-run total cost, since fixed costs do not exist in the long run.
Long Run Total Costs
Long run total cost refers to the minimum cost of production. It is the least cost of
producing a given level of output. Thus, it can be less than or equal to the short
run average costs at different levels of output but never greater.
In graphically deriving the LTC curve, the minimum points of the STC curves at
different levels of output are joined. The locus of all these points gives us the LTC
curve.
Long Run Average Cost Curve
Long run average cost (LAC) can be defined as the average of the LTC curve or
the cost per unit of output in the long run. It can be calculated by the division of
LTC by the quantity of output. Graphically, LAC can be derived from the Short
run Average Cost (SAC) curves.
While the SAC curves correspond to a particular plant since the plant is fixed in
the short-run, the LAC curve depicts the scope for expansion of plant by
minimizing cost.
The LAC curve suggests the long run optimization problem of the firm. The firm
can choose a plant size to operate at in the long-run where all inputs are variable.
Thus, the firm shall choose that plant at which it can minimize costs.
So, the LAC is derived by joining the minimum most points of all possible SAC
curves of the firm at different output levels. Since the LAC thus obtained almost
‘envelopes’ the SAC curves faced by the firm, it is called the envelope curve.
Derivation of the LAC Curve
Note in the figure, that each SAC curve corresponds to a particular plant size.
This size is fixed but what can vary is the variable input in the short-run. In the
long run, the firm will select that plant size which can minimize costs for a given
level of output.
You can see that till the OM1 level of output it is logical for the firm to operate at
the plat size represented by SAC2. If the firm operates at the cost represented by
SAC2 when producing an output level OM2, the cost would be more.
So in the long run, the firm will produce till OM1 on SAC2. However, till an output
level represented by OM3, the firm can produce at SAC2, after which it is
profitable to produce at SAC3 if the firm wishes to minimize costs.
(Source: test.blogspot)
Thus, the choice, in the long run, is to produce at that plant size that can
minimize costs. Graphically, this gives us a LAC curve that joins the minimum
points of all possible SAC curves, as shown in the figure. Thus, the LAC curve is
also called an envelope curve or planning curve. The curve first falls, reaches a
minimum and then rises, giving it a U-shape.
We can use returns to scale to explain the shape of the LAC curve. Returns to
scale depict the change in output with respect to a change in inputs.
During Increasing Returns to Scale (IRS), the output doubles by using less than
double inputs. As a result, LTC increases less than the rise in output and LAC will
fall.
● In Constant Returns to Scale (CRS), the output doubles by doubling the inputs
and the LTC increases proportionately with the rise in output. Thus, LAC
remains constant.
● In Decreasing Returns to Scale (DRS), the output doubles by using more than
double the inputs so the LTC increases more than proportionately to the rise
in output. Thus, LAC also rises. This gives LAC its U-shape.
Long Run Marginal Cost
Long run marginal cost is defined at the additional cost of producing an extra unit
of the output in the long-run i.e. when all inputs are variable. The LMC curve is
derived by the points of tangency between LAC and SAC.
Note an important relation between LMC and SAC here. When LMC lies below
LAC, LAC is falling, while when LMC is above LAC, LAC is rising. At the point
where LMC = LAC, LAC is constant and minimum.
Economies and Diseconomies of Scale

Economies of scale refer to these reduced costs per unit arising due to an
increase in the total output. Diseconomies of scale, on the other hand, occur when
the output increases to such a great extent that the cost per unit starts
increasing.
Internal and External Economies
When a firm opts for large-scale production, the economies arising out of it are
grouped into two categories:
1. Internal economies – economies of production that the firm accrues when it

increases the output leading to a drop in the cost of production. These arise
due to endogenous factors like entrepreneurial efficiency, talents of
the management team, type of machinery, etc. These economies arise within
the firm and help the firm only.
2. External economies – these are the benefits that each member firm of the
industry accrues due to the expansion of the entire industry.
Economies of Scale vs. Diseconomies of Scale

The existence of economies of scale vs. diseconomies of scale is determined
based on the relationship between the production and price of an item or
product. Economies of Scale is the concept referring to a business event where
the price of an item or product decreases as the production of the same item or
product increases. Diseconomies of scale defined is the inverse of economies of
scale. It is where prices of an item or product increase as output of the same item
or product decreases. Both concepts are commonly used in the business world to
describe the status of production of an item or product. These concepts can also
be used to conduct research into reasons why efficiency is being maximized in
certain areas of a business or why efficiency is lacking in other areas of a
business.
Economies and Diseconomies of Scale Graph
On a diseconomies of scale graph, the cost of a given item or product is shown

to increase as each new unit of the product is created. The y-axis in this type of
graph represents the average cost for the given product, and the x-axis
represents output or production of the given product.
This graph shows the diseconomies of scale

occurrence where AC = Average cost (Total
cost ÷ Quantity) O = Output LRAC =
Long run average cost C1, C2 = Cost
On an economies of scale graph, the cost of the product will be shown to

decrease as the output of the product increases. The y- and x-axes represent the
same variables as they do on a diseconomies of scale graph.
The average cost (left hand side y-axis) is

decreasing as the quantity produced increases
(output, bottom x-axis)
On the diseconomies of scale graph, the direction of the line trends both upwards
and to the right. On an economies of sale graph, the direction of the line trends
both downwards and to the right.
Economies of Scale Definition
Economies of scale is the concept suggesting that a business receives an

advantage in cost per product produced as its output of the product increases.
This occurs because the per-item production costs decreases overall in relation to
the total amount of products being created. This can happen for a number of
reasons:
● Businesses buy in bulk for needed supplies

● Efficient production
● Cutting wasteful spending
● Reduced marketing campaigns
● Risk is diversified
● Capital goods and investments are cheaper
● Transportation and storage is cheaper
Economies of Scale Example

When a business attempts to expand, it adds more risk, costs, and responsibilities
to its existing systems, sometimes contributing to diseconomies of scale. To
achieve an economy of scale, companies need to adjust to this increase in output
in ways that drive the cost of a product down. For example, expansion of a
product line and increase in production may allow a company to save money by
purchasing materials in bulk.
Diseconomies of Scale Definition
Diseconomies of scale is when each produced item costs more and more as a
business continues to grow and produce more. This is not what companies aim for
when expanding, and can happen when a business grows too quickly or the
growth is not properly managed.
Diseconomies of scale can occur in numerous ways and can easily exist in an
expanding business. Diseconomies of scale may be caused by the following:
● Poor leadership or management

● Communication issues across the company
● Motivation and morale has decreased as expansion can be overwhelming
● Change can cause confusion if there are not solid processes put in place
● Lost sense of direction for the company if expanding too quickly
● Too much inventory or inefficient logistics
Diseconomies of Scale Example

Diseconomies of scale examples are commonly found in businesses that are
growing and introducing new systems. New technology being introduced to a
company that has not used that piece of technology can take a lot of time in
training and installation and can slow down business. For an example, if a team of
100 type-writers is switching to personal computers in the coming year, it will
take a long time to properly introduce and train the employees on the concept of
personal computers.
First, the business will need to train all their personnel in the computer system.
Then the management team will need to properly install the computers and their
accessories. Then they will need to decide on the location where they want these
new machines and how exactly they will fit in with the business. The whole time
this is happening, the company could be losing profitability and costs may be
going up as they are paying installation teams and paying to train their
employees.
Because the company was not prepared, the increased production that could be
allowed by use of the personal computers is not taken advantage of. The cost of
producing the writing that the employees produced on the typewriters has gone
up, even as production may increase somewhat.

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UNIT-3BBAProduction & Cost

Meaning of Production: What is the concept of production?

According to Bates and Parkinson:

Three Types of Production:

Resources, which we shall call factors of production, are combined in various

Types of Factors of Production

Factors of production have been categorized into four types.

In fact, the resources of any community, referred to as its factors of production,

The payment for land is rent.

Characteristics of Land as a Factor of Production

● The land is a free gift of nature.

● The land has no cost of production.

● The land is fixed and limited in supply.

The payment for labour is the wage.

● One cannot store labour.

● No two types of labour are the same.

The payment for capital is interest.

● Capital is a manmade factor of production.

● It is a passive factor of production.

The payment for land is profit.

● He has great administrative power.

● An entrepreneur must be a man of action.

● An entrepreneur must have the ability to organize.

● He should be a knowledgeable person.

● He must have a professional approach.

Fixed factors of production

Assumptions of Law of Variable Proportion

1. Constant state of Technology: It is assumed that the state of technology will

Stages of Law of Variable Proportion

Why is it called the Law of Variable Proportions?

Law of Variable Proportions Explained

hree Stages of the Law

2. Stage II – The TPP continues to increase but at a diminishing rate. However,

Significance of the three stages

Law of Returns to Scale : Definition, Explanation and Its Types!

Returns to scale are of the following three types:

2. Constant Returns to Scale

3. Diminishing Returns to Scale

1. Increasing Returns to Scale:

There a number of factors responsible for increasing returns to scale.

Some of the factors are as follows:

iii. Concept of Dimensions:

For example, length of a room increases from 15 to 30 and breadth increases

2. Diminishing Returns to Scale:

3. Constant Returns to Scale:

Understanding an Isoquant Curve

The Properties of an Isoquant Curve

Property 1: An isoquant curve slopes downward, or is negatively sloped.

Property 3: Isoquant curves cannot be tangent or intersect one another.

Property 6: Isoquant curves do not have to be parallel to one another.

Property 7: Isoquant curves are oval-shaped.

Concept of Costs in terms of Treatment

Similarly, potential returns on the capital he employed in his business instead of

Concept of Costs in terms of the Nature of Expenses

Concept of Costs in terms of Traceability

Concept of Costs in terms of the Purpose

Concept of Costs in terms of Payers

Concept of Costs in terms of Variability

Concept of Cost Function:

A cost function may be written as: