Chapter III Theory of Production and Cost

8/6/2019 Chapter III Theory of Production and Cost.

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CHAPTER-IIITHEORY OF PRODUCTION AND COST

Meaning and Definition of production:Production is one of the most important economic activities. Production is anactivity directed to satisfy consumers wants through exchange. During the

process of production material goods and services are produced or utility iscreated in the materials to satisfy human wants. Production is not merelytransformation of material things or creation of utility but it involves the process ofexchange through which goods and services reach the ultimate consumers tosatisfy their wants. According to fundamental law of science Matter is neithercreated nor destroyed. Human beings can only create or add utility toexisting matter.

Definition of production:Production can be defined as creation or addition of utility.Economic production covers the complex of human activities devoted to

the creation, with limited resources of goods and services capable ofsatisfying human wants and because of their limited supply, havinglimited value. According to Peterson, Production can be defined as anyactivity that creates present and future utility.

Methods of Creation of Utility:1. Form Utility:Form utility is created when the existing matter is transformed orrearranged, so that it becomes more useful. Through increase in its utility amaterial becomes more adapted to satisfy some particular human wants. Forexample, a carpenter transforms wooden planks into furniture; a baker

converts flour into bread etc.

2. Place Utility:Place utility is created by changing the place of the resources, from theplace where they are of little or no use to another place where they areof greater use.Place utility can be obtained by (i)Extraction from earthe.g., removal of coal, iron-ore, gold-ore etc. from earth. (ii) Transferring goodsor materials from one place to another where it is more useful, e.g.,transferring sand from river bed to the place of construction work,sandalwood from forest to showroom in the city etc.

3.Time Utility :Time utility is created by all forms of storage, insurance and speculation.

There is always a time-lag between the production of goods and theirconsumption. Goods produced in the present time are available for consumptionin the future. Ensuring availability of materials at times, when they are notnormally available for production and consumption is time utility. Forexample, rice is harvested in winter, but its demand continues throughoutthe year. It is through stocking of rice that its supply can be ensuredthroughout the year, woolen garments are produced throughout the year buttheir demand is high in winter, through stocking they are made available whenneeded.

4. Natural utility:

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Natural utility is the utility available in the free goods provided bynature. For example, free natural goods are like air, water, sunshine etc.provide tremendous utility to sustain life on earth.

5. Knowledge utility:Utility can be created through spread of knowledge. A number of machines,

equipments, apparatus, tools etc., are useful only when people posses necessaryknowledge to use and operate them. For example, a personal computer or alaptop is useless for a person if he or she does not know how to operate them.

6. Person Utility:Person utility can be created by acquiring skills and talents. For example,the services ofdoctors, engineers, chartered accountants etc., are basis ofperson utility and services.

7. Possession utility:Utility is also created when a commodity is possessed by a person who

can derive satisfaction out of it. For example, books lying in the collegelibrary are not useful left alone. Once these books reach in the possession ofthe readers they can derive utility out of them.

Conditions to be fulfilled to be called production:Creation of utility is a necessary condition of production activity. Only those goodsand services will be classified in production which posses the followingcharacteristics:1.These are mainly created by human labour and capital.2.These are capable of satisfying human wants directly or indirectly, asproducers goods.

3.These are comparatively scarce, and therefore, need to be economised andhave economic value.

4.These either have a definite monetaryprice or cost or can be given one bycharge.

Activities to be excluded from being called as production:All kinds of activities directed for the production of goods and services forsatisfaction of other peoples wants are not included in production. The followingtypes of activities are excluded from production:1.Any domestic work:Any work done by a family member out oflove and affection towards family and

not with the object of earning a reward should be excluded from production.

2.Voluntary services:Any services performed by the nationals or citizens of a country out ofpatrioticfeelings and with the object of social welfare should not be included in theproduction.

3.Goods produced for self-consumption:Any goods produced for self-consumption do not constitute production. A largepart of production of agricultural produce is retained by the farmers for theirfamily consumption. It is not marketed to earn income. Therefore, it should beexcluded from production.

4.Leisure-time activities:



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Any work ofart and literature, pass-time hobbies do not fall in the ambit ofproduction because they are done for self-satisfaction.

Factors of Production:Production requires the use of certain resources. It is the co-operative effort of thevarious factors of production. They are also known as inputs. Whatevergoes into the production process to produce goods and services is called inputs.

Factors of production or inputs are divided into two categories:A. Factor inputs.B. Non-factor inputs.

A. Factor inputs:Factor inputs comprise land, labour, capital and enterprise. These are also knownas primary inputs, because without these inputs production is not possible.

B. Non-factor inputs.Production also requires certain non-factor inputs such as raw materials, semi-finished goods, and other inventories kept by the producing unit to keep the

production process going uninterrupted.1. Land:Land includes all those resources, whose total supply in the economy is fixedor inelastic.In economics, land does not mean only surface of earths soil or physical territoryalone but also all other scarce natural resources which are the free gift of naturesuch forests, mines, rivers and sea water, temperature, rainfall, etc. According toMarshall, land means the materials and the forces which nature givesfreely for mans aid, in land and water, in air and light and heat. Themoment these natural resources come under the ownership of an individual or the

society, these start earning income in the form of rent, royalty, etc.Characteristics:1. Land is free gift of nature:Human beings can neither create land nor destroy it. Land comes to humanbeings as a free gift of nature, there is no need to pay any price for it so long asit is not owned and controlled by someone.

2. Inelastic Supply:The supply of land is fixed. Human being can simply change the uses of land;they can neither expand nor contract the land area.

3. Immobility of Land:Land is a static a factor of production. It cannot be shifted from one place toanother like labour and capital.

4. Land is a passive factor of production:Land is a passive factor of production. Land itself cannot produce anything.Active assistance of labour and capital is needed to make land productive. Itwould not yield any result unless deployed usefully through human ingenuity andeffort.

5. Lands differ is fertility.Land differs in fertility. No two pieces of land posses the same fertility Mineral

resources, river system, forest resources, mountain formation, fertility of soil, etc.,differ from one region to another.



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6. Specific factor of production:Land is a specific factor of production because without land we cannot produceanything.

7. Indestructible:According to Ricardo, land is an indestructible factor of production because it

cannot be destroyed.

2. Labour:Labour is a physical or mental effort of human being in the process ofproduction for economic purpose. Any work done for the sake of pleasure oflove does not represent labour in economics. Marshall defines labour as anyexertion of the body or mind undertaken wholly or partly with someobject other than the pleasure derived from the labour itself.It is the human element which distinguishes it from other factors, for it givesrise to special problems regarding mobility, efficiency, unemployment andpsychological attitudes.

Characteristics of Labour:Labour is basically different from other factors of production. Unlike the otherfactors it is a living factor. The following are the main characteristics of labouras a factor of production:

1.Labour is an active factor of production:Without the active participation of labour, land and capital cannot produce

anything.

2.Labour is perishable:

It cannot be stored. If the labourer does not work on a particular day, that dayslabour goes for good. It implies that the labourer cannot store his labour and so hehas no reserve price for his labour.

3.Labour is inseparable from the labourer:The labourer has to present himselfphysically at a place where productionactivities take place. It implies that the labourer embodies the services heperforms. Labourer is the source of his own labour power.

4.Labour is directly connected with human efforts:All labour is manifestation of human efforts both physically and mentally.

5.Productivity of labour can improve:

Through education, training, use of better machinery and equipment theproductivity of labour can improved.

6.Labour makes a choice between the hours of labour and hours ofleisure:

The labourer has to make a choice between the hours of labour and hoursof leisure. The supply of labour and wage rate is directly related. It implies thatas wage rate rises, the labourer tends to increase the supply of labour by reducingthe hours of leisure. However, beyond a minimum level of income the labourerreduces the supply of labour and increases the hours of leisure in response to afurther rises in the wage i.e., hence, the supply curve of labour is backwardbending.

7.supply of labour is inelastic during the short run:



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The supply of labour is related to population. It takes a child more than 15 yearsto develop into a labourer; therefore, supply of labour will be inelastic.

8.Labour differs in productivity.Efficiency and productivity of one labourer differ from another. On the basislabour power, labour may be classified as unskilled labour, semi-skilled labour andskilled labour.

9.Labour in mobile:As compared to other factors, labour is more mobile. Labour can easily movefrom one place of work to another.

10. Labour has intelligence and Judgment:The labourer has the capacity to think, apply mind and act in the best interest of

self and the organisation.

Types of labour:Mental and Physical labour:The labour that applies more of mind and less of muscle power is calledmental labour. The work of a teacher, an advocate, doctor, engineer, research

scholar, etc., falls under the category metal labour. Conversely, the labour thatuses more of muscle power and less of mental power is called physicallabour. For example, the work of a collie, rickshaw-puller, mason, blacksmith etc.,is put under the category of physical labour.

Division of labour:According to Prof. Watson, Production by division of labour consists insplitting up the productive process into its component parts.In the words of Taussing, The division of labour means those people whocarry on several operations of a given branch of industry combined forbringing about final results.

Division of labour occurs when a labourer confines himselfto the production of asingle commodity or single sub-process and leaves the production of othercommodities or processes to others. Division of labour implies two things;a.Specialization of functions, andb.Co-operation between different labourers.

Types of Division of Labour:The following are the different forms of division of labour:

1. Product-based division of labour:It is also known as simple division of labour. In the primitive or traditionaleconomies, a worker specialized in the production ofsingle good such as cloth,

furniture, ornaments, etc.2. Process-based division of labour:

It is also known as complex division of labour. In a modern economy, largebusiness enterprises divided and sub-divided the process of production of asingle commodity and each worker performance one or two of the severalprocesses involved in the production of commodity.

3. Territorial Specialization:This type of specialization occurs when a particular area gets specialized inthe production of a specific commodity. For example, labour at Surat hasspecialized in diamond work, at Srinagar in shawl-embroidery etc.

Merits of Division of Labour:



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1. Increase in productivity and reduction in wastage.2. Better quality products can be manufactured at less cost in short period of

time.3. Scope for Mechanization, innovation and development widens.4. Inventions may take place due to expertise of labour in a particular area of

specialization.

5. It leads to high degree of Specialization.6. It leads to better understanding among workers.

Demerits of Division of Labour:1. Loss ofPride and Responsibility.2. Monotony in work.3. Immobility of Labour.4. Fear ofover production increases.

Efficiency of labour:Efficiency of labour means the amount of work which a labourer can dowithin a given time. The efficiency of labour refers to productivity of labour,

both quantitative and qualitative during a given time. Efficiency of labour is arelative concept therefore; it is always understood and measured in relation tosome predetermined standards. Efficiency of labour differs from one labourer toanother and is subject to change over time. Efficiency of Labour depends upon;1. Conditions of Work,2. Quantity of production, and3. Quality of production

Advantages or significance of Efficiency of Labour.1. Increase in National Income.2. Better Employment Opportunities.

3. Less chance of Wastage.4. Low Price and More Profits.5. Innovations may take place in the course of time.6. Less Supervision.

Efficiency of Labour in a country depends upon the various factors.1. Climatic conditions, Health and Strength of workers.2. Personal Qualities, Education and Standard of living.3. Social and political security, Level of wages and working conditions4. Labour laws and Hours of work.5. Mobility of labour.

Mobility of Labour:Mobility of labour can take any of the following forms:1.Territorial Mobility:It is also known as geographical mobility of labour. It relates of the movement oflabour from one place to another.

2.Occupational Mobility:When a labourer leaves one occupation to join the other it is calledoccupational mobility. For example: If a worker leaves a cotton textile mill to join ajute mill it is called occupational mobility.

3.Grade mobility:



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When a worker moves from one position to another in the same or otheroccupation, it is called Grade mobility. Grades are form according to differentwage-groups. Grade mobility can assume two forms:

a.Horizontal mobility:When a labourer moves from one occupation to another on the same grade it iscalled Horizontal mobility.

b.Vertical mobility:When a labourer moves from one occupation to another for a higher position itis called Vertical mobility.

3.Capital:Capital is man-made material factor of production. It is stockconcept. All capitalis wealth but all wealth is not capital. According to J.S. Mill Capital is theaccumulated; product of past labour destined for the production offurther wealth.Capital comprises man-made materials which are used for the further production.Goods produced with the help of different factors of production are broadlyclassified into two categories:

1) Consumer goods2) Producers goods

Capital consists of producers goods and stocks of consumer goods not yet in thehands of consumers. Capital consists of following:

1. Structures, such as private residential houses, factory buildings,commercial buildings, Government buildings etc.

2. Equipments that includes three types of goods,a.Durable consumer goods, like furniture, TV sets, etc. which are yet reach

consumers.

b.Durable Capital goods, like machinery, plant, tools, roads, bridges, dams etc.

c. Inventories, such as stock of Raw-materials, intermediate goods and finishedgoods lying unsold with the wholesalers and Retailers

3. Money used for production purposes.

Characteristics of Capital:1. Capital is the result ofpast labour.2. Capital is the result ofSavings.3. Capital is prospective.

4. Capital is a highly mobile factor of production.5. Capital is not a Free Gift.

Functions of Capital:1. Capital increases the productivity of labour.2. Capital Secures Continuity in production.3. It is helpful for further Capital Formation.4. It acts as Source of research and Development.

Distinction between capital and other related concepts:1. Capital and Money:

Money is anything that is generally accepted by the people as medium ofexchange and a measure of value, and is also used to meet other kinds of



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business obligations. But, all money is not capital, that part of money whichused further production is called capital.

2. Capital and Income:Earnings regularly drawn either from the ownership assets or by doing domeeconomic activity are called income. That part of income which is saved andused for further production is called capital. Capital is a stock, whereas

income is flow.

3. Capital and Wealth:Wealth comprises the stock of all reproducible and irreproducible goods. Allwealth is not capital. That part of wealth which is used for furtherproduction of wealth is called capital; on the other hand, all capital iswealth.

Classification of capital:Capital assists in production if different ways. Capital, on the basis of its use, canbe conveniently classified in the following forms:

1. Fixed and Circulating Capital:

Fixed capital is one which is durable and which is used in production fora considerable long time. The examples of fixed capital are machines, plants,equipment, factory buildings, dams, irrigation canals, etc. Circulating capitalrefers to the capital which is used only one once in production. It loses itsutility after single use. The examples of the circulating capital are raw materials,seeds, coal, petrol, gas etc. It regularly needs replacement.

2. Material and Personal Capital:Material capital consists of objects which exist in concrete and tangibleform and are capable of being transferred from one person to another.Examples of the material capital are machines, tools, transformers, etc. Personal

capital comprises all those energies, faculties and habits whichcontribute to make labour efficient. It includes all the personal qualitiesof an individual which are non-transferable. Examples of personal capitalare art of dancing and singing, art of painting, art of oratory, etc.

3. Sunk and Floating Capital:Sunk or specialized capital is one which can be used in a specificoccupation. Once invested in a particular business, it cannot be withdrawn.Examples of sunk capital are railway bridges, factory buildings, roads, dams etc.Capital is said to be floating or free when it can be changed at will foremployment in any branch of industry and can at any time assume a

different form. Examples of floating capital are wood, raw materials, electricityetc.

4. Remuneratory and Auxiliary Capital :Remuneratory or wage capital is one which is applied to the payment oflabour engaged in production. Auxiliary capital is that which assists thelabour to carry out their duties smoothly. Machines, tools, equipment, etc., arethe examples of the auxiliary capital.

5. Production and Consumption Capital:Production capital comprises all those articles which help the labourdirectly in production. Examples of production capital are raw materials,

machines, tools, equipment, etc. Production capital may be material as well as



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personal. Consumption capital consists of those materials whichindirectly assist in the process of production. Examples of consumptioncapital are food, clothes, residential accommodation, vehicles, etc.

6. Internal and External Capital:This classification of capital is based upon the criterion of place. The capital whichis the result ofdomestic savings in the country is called internal capital.

Capital which is imported or invited from abroad and used in recipientcountry is called external capital. The capital received in India from the WorldBank, International Finance Corporation etc., is an example of external capital.

Capital Formation:Production is a continuous process. Whatever goods and services are produced inan accounting year are not consumed instantaneously. A part of currentproduction is consumed, while the remaining part is retained for furtherproduction. We may define capital formation as The surplus of productionover consumption in an accounting year which is used for furtherproduction.

Capital formation is regarded as a social process whereby a societys capital stockincreases during a given period. According to Prof. Nurkse, The meaning ofcapital formation is that society does not apply the whole of its currentproductive activity to the needs and desires of immediate consumption,but directs a part of it to the making of capital goods, tools andinstruments, machines and transport facilities, plant and equipment allthe various forms of real capital that can so greatly increase efficacy ofproductive effort.Capital formation plays a vital role in the development of an economy. Generallyspeaking, higher the rate of capital formation more economically

developed an economy would be. It determines the production potential of aneconomy.

Stages of Capital Formation:There are mainly three stages of capital formation, which are as under:

1. Real Savings:Savings is the foundation stone upon which the edifice of capital formation is

erected. A part of the resources is withdrawn from current consumption so as toincrease the real savings of a community. The magnitude of the real savingdepends upon the will to save, power to save and the facilities to save.

(a)Will to save:

How much a person would be willing to save depends upon the individualsnature. If an individual is foresighted and wants to make his old age secure, hewill save more. Some persons are miserly by nature, and whatever the hardshipsthey will save a certain proportion of their money income. Out of family affectionpeople may like to save more with a view to have comfortable future of theirdependents. Sometimes people save more in order to command greater respect inthe society. Allurement to earn a high rate of interest may also induce peopleto save more.

(b) Power of save:It is the capacity, or the ability to save that depends upon the income of an

individual. Higher incomes are generally followed by higher savings. Theavailability of abundant natural resources and high level of economic development



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will create and lead to greater wealth in a country, and therefore the capacity tosave will increase. If the distribution of wealth is equitable, everyone will havemore money income, and therefore, the power to save will increase.

(c)Facilities to save:If the country is free from internal disturbances and threat of foreignaggression, people will have opportunities to save. Stability of money value also

facilitates savings. Frequent fluctuations in the money value, and particularlyinflation reduce the purchasing power of the people, as a result, savings getdiscouraged. Facilities of investment in productive activities encourage saving.

2. Moblilisation of Savings:In case people save money but it is hoarded or does not enter into circulation, itwill not facilitate the process of capital formation. There should be a widespreadnetwork of banking and other financial institutions to collect public saving andtake them to prospective investors.

3. Investment:

Process of capital formation gets completed only when real savings getconverted into real capital assets. A country should have an entrepreneurialclass which is prepared to bear the risk of business and invest the saving inproductive occupations so as to create new capital assets.If the process of capital formation is to succeed, all these stages should beinterlinked. In the absence or slackness of any of these stages the process ofcapital formation will remain incomplete.

4. Enterprise:Business is full of risks and uncertainties. The task of bearing risks is calledenterprise. The man who bears the risk of business is called an entrepreneur.

Several types of risks are involved in business. Sometimes, the demand falls shortof supply; at another time, the supply fall short of demand. The marketfluctuations may cause heavy losses therefore; the services of entrepreneurs arerequired to bear all such risks of business.

Functions of entrepreneur:Besides risk bearing, the entrepreneur has to perform several other importantfunctions which are as follows:1.Risk-bearing function:The most important function of an entrepreneur is to bear the risk of business.There is always a time-lag between production and consumption of goods. The

goods produced in present are consumed in the future. Therefore, heavy risk isinvolved in equating the current production to future demand. No other factorproduction except the entrepreneur bears the risk of the business.

2.Decision-taking function:Decision-taking is an important function of an entrepreneur an entrepreneur has

to take decisions as regards the followings matters:a.Selection of the product:An entrepreneur would choose a trade which seems to be more profitable, subjectto such qualification as his personal interest, the degree of risk involved histemperament, his technical knowledge, the amount of capital required andestimate of his own ability.

b. Selection of the type of the firm:

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The entrepreneur has to decide whether he would prefer sole proprietorship,partnership or a joint stock company. Further, he has to decide whether it shouldbe private limited company or a public limited company.

c. Selection of the location of plant:The entrepreneur has to decide where to install the plant, so that advantages oflocation can be obtained. Economic and non-economic factors, both are essential

while making choice about the location of a plant.

d. Selecting techniques of production:An entrepreneur aims maximising his output and minimise the cost of production.He has to decide about the most suitable combination of land, labour and capitalso as to obtain maximum production.

e.Selection of the size of the firm:The entrepreneur has also to decide whether to produce on a large scale, or on asmall scale. He will have to take into account the cost of production, returns toscales, economies of scale, and profitability, while taking any decision as regardsthe size of the firm.

3. Distributive function:Peaceful and congenial atmosphere inside the factory premises is essential forsmooth production activity. The entrepreneur has to keep all factors of productioncontended. He has to decide about the share that each factor of productionshould receive from the total produce.

4. Innovative function:Innovation is considered as an important as an important function of anentrepreneur. Innovation is defined as the commercial use invention. Individualsand experts working for corporation conduct basic research and invent new

products, new technology, new sources of energy, and soon the entrepreneurmakes use of these inventions for commercial purposes. Innovation is never static.A progressive and talented entrepreneur should always take a lead to introduce anew product or a new technique of production. It does involve some risk but risk-bearing is prime function of entrepreneur. Innovations help a firm to earn largeprofits..In modern economies, the role of organizing the factors of production is regardedas a managerial function, which can be performed by a paid manager i.e. by ahighly skilled form of labour. What really distinguishes enterprise from otherfactors of production is that it has to carry all the risks and uncertainties, and is

rewarded for bearing these, in the form of profits.Qualities of a good Entrepreneur:1. Far-sightedness.2. Courage.3. Quality of leadership4. Quality of organizing the labour.5. Experience.6. Knowledge of business.7. Moral qualities.8. Knowledge of psychology.



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Concept of Production function and Laws of production:Introduction:Production is a continuous process. Goods and services are produced by a firm. Apart of it is consumed and the remaining is retained for further production.Production of the commodities is the outcome of combined efforts of variousfactors of production and the quantity of production depends directly uponquantity of these factors. Production is defined as the transformation ofinputs into output. Production includes production of physical goods andproduction services. The producer combines the various factors of production

in a technical proportion to maximize the output and minimize the cost by meansof the least cost combination of factors of production.

Production function:The term Production function means physical relationship between inputs usedand the output produced. Production function is purely a technical andfunctional relation which connects which connects quantity of inputsrequired to produce a good to the quantity of output produced. Productionfunction is the process of getting maximum output from given quantity of inputs ina particular time period.

Characteristics of production function:1. Production function is a physical concept:

Production function establishes technical relationship between inputs andoutputs expressed in physical terms and not in terms of a monetary unit suchrupees.

2. Production function is a flow concept:Production function is a flow concept. It relates to the flow of inputs and theresulting flows of output of a commodity during a period of time.

3. Production function is functional relationship between inputs andoutput:



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Production function is a functional relationship between inputs and resultingoutput. Change in input by one unit has an effect on the output of the firm.

4. Production function is determined by the state of technology andinputs:

Production function is dependent on the state of technology and inputsavailable with the firm. Technology refers to the sum total of knowledge of the

means and methods of producing goods and services. Input is anything that isused by the firm in the process of production. Thus, input includes every type ofproductive resource available with the firm.

5. Change in inputs determines nature of output:Change in inputs is essential to change production function. The proportion ofchange in inputs and output is not same always.

6. Production function includes only technically efficient combinationsof inputs:

Production function in economic analysis refers to combination factor inputs whichmaximise the output and minimise the cost of production.

Mathematical expression of general production function:Production function can be expressed in the form of a mathematical equationwhich shows that the output is a dependent variable and inputs are independentvariables.

P = f (La, Lb, C, E)

Where,P is the level ofoutput.La is the land input.

Lb is the labour input.C is the capital input.E is role ofenterprise.

Types of production function:There are two types of production function:

1. Short-run production function:Shortrun production function refers to production in the short-run where thereare some fixed factors and some variable factors. In the short-run, production willincrease when more units of variable factors are used with fixed factors.

2. Long-run production function:Long-run production function refers to production in the long-run where all factorsare in variable supply. In the long-run, production will increase when all factors areincreased in the same proportion.

Short-run and long-run:1. Short-run:

Short-run refers to a period in which some of the factors of production like landand capital are in fixed supply and others like labour are in variable supply.

2. Long-run:



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Long-run refers to a period long enough to permit changes in all the factors ofproduction. A firm has enough time to install a new plant or raise a new building inresponse to increased demand.

Fixed factors of production and variable factors of production:1. Fixed factors of production:

Fixed factors of production refer to those factors whose supply cannot be changed

during short-run. For example, land, plant & machinery, equipment, building etc.remain in fixed supply during short-run.

2. Variable factors of production:Variable factors of production refer to those factors whose supply can be varied orchanged. For example, raw materials, labour, power, fuel etc. are in variablesupply in the short-run as well as in the long-run. The distinction between fixedand variable factors disappears in the long-run as all factors are in variable supplyin the long-run.

Level of production and scale of production:

1. Level of production:Level of production can be changed by changing the quantity of variable factorslike raw materials, labour, fuel etc. level of production is related to short-run.

2. Scale of production:Scale of production is related to capacity of production. Scale of production can bechanged by changing the quantity of all variable factors of production. Scale ofproduction is related to long-run.

Production in the short-run:1. Total Production (TP):Total product is defined as the total quantity of goods produced by afirm during a specified period of time. Total Product is the total outputresulting from the efforts of all the factors of production combined together at anytime. Total product can be increased by employing more and more units of thevariable factor.

2. Average Production (AP):Average product or average physical product may be defined as the amount ofoutput per unit of the variable factor input employed. Average product measuresthe productivity of the firms labour in terms of how much output each labourproduces on an average.

3. Marginal Production (MP):Marginal product is defined as the change in total product resulting from theemployment of an additional unit of a variable factor. Marginal Product is thechange in Total Product due to change in the quantity of variable factor i.e.,labour. The knowledge of marginal product helps the firm in its decision makingprocess as it tells the firm how much will be the addition in output by adding onemore unit of labour.

4. Relationship Between AP and MP:Both AP and MP can be calculated by TP.

When AP rises them MP also rises but MP>AP.

3. When AP is maximum then MP = AP.



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When AP falls then MP also falls but MP < AP.

5. There may be a situation when MP decreases but AP increasesbut opposite never happened.

5. Relationship Between TP, AP And MP:1. All the three curves i.e. TP, AP and MP curve start from the origin and rise

sharply become maximum and then start declining.

2.TP curve in the beginning increases at an increasing rate then at a diminishingrate and after becomes maximum starts declining. Both AP and MP curves risesharply, AP curve becomes maximum and starts declining but never becomenegative. MP curve becomes maximum and starts declining sharply and reacheszero and thereafter becomes negative.

3. When TP curve is maximum, MP curve touches zero.

4. When TP curve is falling, MP curve is negative.

5. As long as TP curve is positive, AP curve is positive.

6. All the three curves are inverted U shaped.

6. Relationship Between TP, AP And MP:1. When both AP and MP curves are rising, MP curve rises at a faster rate.

2. When AP curve is maximum, MP curve cuts AP curve i.e. MP curve =AP curve.

3. When both AP and MP curves are falling, MP curve falls at a faster rate.

4. There is a situation when AP curve is rising and MP curve is falling but AP curvefalling and MP curve rising never happens.

5. AP curve never becomes negative but MP curve can become negative.

Schedule showing Total, Average and Marginal product:

Labour TP

AP

MP

Analysis

1 2 2 2 MP & AP both increases; MP >APTP also increases

2 5 2.5

3

3 9 3 44 1

23 3 MP = AP, AP = Maximum

5 14 2.

8

2 MP & AP both decreases,

MP < AP; TP increasesMP = 0, TP = maximum6 15 2.

51

7 15

2.1

0

8 14 1.7

-1 AP > MP both decreasesTP decreases

9 12 1.3

-2

Law of Variable Proportion:



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Law of Variable Proportions occupies an important place in economic theory.Keeping other factors fixed, the law explains the production function with onefactor variable. In the short run when output of a commodity is sought to beincreased, the law of variable proportions comes into operation. Therefore, whenthe number of one factor of production is increased or decreased while otherfactors of production are constant, the proportion between the factors is altered.

Due to change in the proportion of factors there will also emerge a change is totaloutput at different rates. This tendency in economics is called the Law of Variableproportions.

Assumptions:The law of variable proportions is based on following assumptions:1. Constant technology:The state of technology is assumed to be given and constant. If there is anImprovement in technology the production function will move upward.

2. Factor proportions are variable:The law assumes that factor proportions are variable, if factors of production are

to be combined in a fixed proportion, the law has no validity.

3. Homogeneous factor units:The units of variable factor are homogeneous. Each unit of variable factor isidentical in terms quality and quantity with every other unit.

4. Short-run:The law of variable proportions operates in the short-run when it is not possibleto vary all factor inputs available with the firm.

5. Except one all the other inputs are fixed:There are many fixed inputs and only one variable input.

6. Only physical input and output are considered:The law explains only the physical inputs and output in the production function.

Statement of the law:Law of variable proportion states that when total output or productionof a commodity is increased by adding units of a variable input, while thequantities of other inputs are held constant, the increase in totalproduction becomes, after some point, smaller and smaller.In other words, as more and more units of a variable factor are combined withsame quantity of fixed factors, total product first increases at an increasing

rate then at diminishing rate and finally starts diminishing. It implies thatmarginal product first rises and then diminishes eventually.

Law of variable proportions has three stages:Stage: I Law of increasing returns;Stage: II Law of decreasing returns; andStage: III Law of Negative returns.

Law of variable proportion has Three stages:Labour TP AP MP Analysis1 2 2 2 Stage I Law of increasing returns

2 5 2.5 33 9 3 4



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AP = MP and AP is maximumStage II Law of decreasing returns

MP = 0, TP is maximumStage III Law of Negative returns

4 12 3 35 14 2.8 26 15 2.5 17 15 2.1 08 14 1.7 -19 12 1.3 -2

The position of three stages can also be explained as under:Stages Total Product (TP) Marginal Product

(MP)Average Product(AP)

Stage I Increases at anincreasing rate, thenincreases atdiminishing rate.

Increases and reachesat maximum point andbegins to decrease.

Increases andreaches itsmaximum point

Stage II Increases atdiminishing rate andreaches its maximum

point

Decreases and becomeszero

After reaching itsmaximum point,begins to decrease

StageIII

Begins to fall Becomes Negative Continues todiminish

Explanation of increasing returns:1.Indivisibility of fixed factors:The fixed factors employed in the production process are indivisible, i.e. theycannot be divided into smaller parts. Thus, when more units of variable factor arecombined with fixed factor, output keeps increasing.2. Fuller Utilisation of fixed factors:

In the initial stages of the production the fixed factors are underutilised in relationtovariable factor employed on it. Fuller utilisation of fixed factors calls forgreater application of the variable factor which in turn leads to increasein total and marginal product.

3.Division of labour and specialization:Due to increase the scale of production, it enables the firm to adopt division oflabour and specialisation. Division of labour & specialisation enables increasein skill, efficiency of labourers, saving of time and innovation in the application oftechnique of production in the production process by the workers which leads toincreasing returns to scale.

4. Perfect combination between fixed and variable factors:With the increase in the variable inputs in the production process the firm tries toachieve the perfect combination of fixed and variable factors input ratio inthe production process which increases the productivity at an increasing rate.

Explanation of diminishing returns:1.Fixity and Inadequate relative of fixed factors:Once the point is reached at which the amount of variable factor is sufficient toensure the efficient utilization of the fixed factor, then further increases in thevariable factor will cause marginal and average product to decline because the

fixed factor then becomes inadequate relative to the quantity of variable factors.



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2.Imperfect substitutability:According to Mrs. Joan Robinson factors of production are not perfect substitutesof each other. There is a limit to the extent to which one factor of production canbe substituted for another. Beyond this limit perfect ratio between various factorsgets disturbed and productivity tends to increase at a diminishing rate.

Explanation of Negative returns:1. Too excessive quantity of variable factor:In this stage the quantity of variable factor becomes too excessive relative to the

fixed factor so that they get in each others way with a result that the total outputfalls instead of rising. In such a situation a reduction in the units of the variablefactor will increase the total output.Stage of Operation:The three stages together constitute the law of variable proportions. Since thesecond stage is the most important. So stage II will be stage of operation andbecause of that in practice we normally refer to the law of variable proportion asthe law of diminishing returns.

Production in the long-run:Law of Returns to Scale:The law of returns to scale is applicable in the long-run, where all the factors ofproduction are in variable supply. In the long-run output can be increased byincreasing all the factors of production or scale of production.

Statement of the law:The law of returns to scale states that when all factors of production areincreased in the same proportion, output will increase however, the increasemay be at increasing rate or constant rate or decreasing rate.

Three stages of returns to scale:1.Increasing Returns to scale2.Constant Returns to Scale.3.Diminishing Returns to scale.

1. Increasing Returns to Scale:Increasing returns to scale occur when a simultaneous increase in all the inputs inthe same given proportion result in a more than proportionate increase in theoutput. For example, if the input is increased by 100% however, the outputincreases by 125% then it is the situation of Increasing Returns to Scale.

2. Constant Returns to Scale:Returns to scales are said to be constant when a proportionate increase in all theinputs results in proportionate increase in output. For example if input is increasedby 100% but the output also increases by 100% then it is the situation ofConstantReturns to Scale.

3. Diminishing Returns to Scale:Diminishing returns to scale occur when a simultaneous increase in all inputs inthe same given proportion result in a less than proportionate increase in theoutput. For example, if input is increased by 100% but the output increases only

by 75% then it is the situation of Diminishing Returns to Scale.



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Economies and diseconomies of large scale production:The following are the internal and external economies and diseconomies whichare enjoyed or suffered by the firm due to large scale production.

A. Internal Economies and Diseconomies:Internal Economies:

Internal economies are those economics, which are firm specific. Theseeconomies arise because of the actions of an individual firm in the industry toeconomise its cost.

1. Technical Economies: Technical economies involve use of bigger and better types of machines toimprove the technique of production. It, thereby, reduces cost. Economies oftechniques are further sub-divide into:

a.Economies of superior techniques:When the size of the firm grows it becomes possible to have bigger and bettertype of machines to improve the technique of production and thereby reduce the

cost.b.Economies of increased dimensions:A big firm enjoys reduction in cost when it increases its dimensions. As thedimension grow, a big firm can have the various processes of productionconducted within the premises of the firm. It saves time and cost.

c. Economies of linked processes:At times it is not possible for a firm to have various processes of productionconducted within the premises of the firm. This difficulty is overcome by linkedprocesses, i.e., different firms agree to function as one single firm as far asproduction is concerned however control and ownership remains separate.

2. Managerial Economies:Managerial economies arise due effective and efficient actions of the managers inthe firm. Managerial economies arise for various reasons, the most important onesare as follows:

a. Specialisation of management:It is possible for large firms to make division of managerial task. The existence ofa finance manager, a human resource manager, a production manager, marketingand sales manager and so on is common in large firms. The division of workincreases the experience of manager in their own area of responsibility and leads

to a more efficient working of the firm. This is also called de-centralisation ofdecision making.

b.Mechanisation of managerial function:It is important for large scale firms to apply techniques of management involving ahigh degree of mechanisation such as telex machines, television screens,computers etc, these techniques save time in decision making process and speedup the processing of information, as well as increasing its amount and accuracy.

3. Marketing or commercial Economies:Marketing or commercial economies refer to such reduction in the cost ofproduction which is secured by the purchase of inputs at the lowest price and sale



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of final goods at the highest possible price. In other words, marketing economiesarise due to the following:

a.Economies of purchase:Large firms purchase raw-materials and factors of production on a large scale.Because of bulk purchases, large firms have more bargaining power to bring aboutreduction in their price. Also, large firms may employ more and better

experienced staff to deal with the purchase of raw material.

b.Economies of sale:Large firms can bring about reduction in the cost of selling by employing a highlyspecialized staff well-versed in the art of pushing up the sales. Also, large firmsmay take up more advertising activity to push up sales. Further large firms canenter into exclusive agreements with distributors and wholesalers, who undertakethe obligation of maintain a good service department for the product of themanufacturer.

4. Financial Economies:

Financial economies refer to advantages secured by a firm in matters of finance.Large firms have high creditworthiness in the market. It is in advantageousposition to secure loans at easy and lower rates. Also, large firms can get loansfrom private sources. It is also possible to have large overdrafts from the banks.

5. Risk bearing economies:Risk bearing economies may be secured in matters of risk as large firms as largefirms are in position to bear risk. Large firms can diversify their:a. Output (i.e. produce more than one product).b. Market (i.e. supply the product in more than one market).c. Sources of supply (i.e. get the supply of raw materials from more than one

source).d.Process of manufacture (i.e. to have alternative process of manufacturing

available).

6. Marketing or commercial economies:Labour economies arise for various reasons, the most important beingspecialisation and division of labour. In large firms, work is divided and eachlabourer specializes in one particular process. This improves their skill andincreases their efficiency in their field of specialisation. They are near perfect intheir field. It increases the amount of output, reduces labour cost and

Internal Diseconomies:Internal diseconomies are internal to the firm. they are defined as thosediseconomies which enable the firm to produce less efficiently at large levels ofoutput.

1.Technical Diseconomies:Technical diseconomies arise if production is increased beyond the optimum level.When production takes place beyond the optimum point, maintenance cost rises,risk of accidents are more and in case of accidents heavy losses are made.

2. Financial Diseconomies:



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Financial diseconomies arise if finance is secured beyond the optimum limit, i.e.,when too much money is taken on loan it leads to concentration of wealth andincome and too much pressure on firms to prove their credit worthiness.

3.Risk Bearing Diseconomies:Risk bearing diseconomies arise when diversification is increased beyond the

optimum limit. When too much diversification is taken up, liquidity is lost. In thatsituations, risk of strikes and lockouts are more.

4.Managerial Diseconomies:Managerial diseconomies arise when manager is overburdened with outputexceeding optimum level. There is scarcity of factors of production and there isimperfect substitution. The manager is overburdened and faces the problem ofcontrol and co-ordination. The result is that managerial problems andinefficiencies increase.

B. External Economies and Diseconomies:

External economies:External economies are external to the firm. External economies arise to a firmbecause of expansion of an industry. They are ofthree kinds:

1. Economies of concentration:Economies of concentration arise because of concentration of firms in a particulararea. It gives rise to the following economies:

a. Labour:All firms get better and more skilled labourers without doing any effort. Since theyare skilled, it saves the cost of training them.

b. Financial:All firms get better financial facilities. The facilities are easily available andcheaper in cost.

c. Transport and storage:All firms have easy access to better and cheaper transport facilities and storagefacilities. Huge storehouses are built up in such areas.

d. Marketing:All firms get better marketing facilities on account of concentration of firms in aparticular area.

2. Economies of concentration:Economies of information are reaped by each firm as, without making any efforts,all necessary and crucial information regarding labour, output, profit, etc., areeasily available to them. When a firm is located in an isolated area, it is difficultfor it to know the market conditions. But a large number of firms in particular areastart a bulletin or information paper which gives vital statistics. Separate surveysand collection of data is bound to be very expensive. That is why, economies ofinformation reaped by each firm saves time and cost.

3. Economies of Disintegration:Localisation or concentration of industry gives rise to economies of disintegration.

One single firm does not produce enough wastage or by-products to enable somespecialized firm to make use of them. But if a large number of firms are



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established at one place, then it is possible to have more specialized firms makinguse of by-products. For example, comb, button, etc., are made from wastage orby-products.

External Diseconomies:External diseconomies are external of the firm. They are defined as thosedisadvantages in production which arise from increase in output of the firm.

External diseconomies arise to a firm in the form of rise in unit costs because ofexpansion of an industry. External diseconomies are external costs that spill overinto the cost of other firms, some examples of external diseconomy are:1.An industry in course of expanding its output throws so much wastage that it

increases the cost of disposing waste materials for firms in the same area.

2. Pollution of lakes and rivers creates external diseconomy for the fishing industryand health hazards for city residents.

3.Creation of a new shopping complex increases traffic, causing externaldiseconomy for the people

THEORY OF COSTCOST ANALYSIS:Cost analysis refers to the study of the behaviour of cost in relation to one or moreproduction criteria, namely, size of output, scale of operations, prices of factors ofproduction and other relevant economic variables. It is concerned with financialaspects of production.

Cost Concepts:



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1. Accounting costs and Economic costs:Accounting costs relate to those costs only, which involve cash payments by theentrepreneur of the firm. Accounting costs are also called explicit cost.Costs offactors owned by the entrepreneur himself and employed in his own business arecalled implicit costs. Implicit costs also known as Non accounting costs. Forexample,

1. Rent of self owned building.2. Interest of self owned capital.3. Wages of self owned entrepreneur.Thus, economic costs include both accounting costs and implicit costs.Economic cost = Accounting cost (Explicit cost) + Non Accounting Cost (Implicitcost)Economic Profit = Total Revenue Economic costAccounting Profit = Total Revenue Explicit cost.2. Outlay costs and Opportunity costs:Outlay costs involve actual outlay of funds on wages, material, rent and

interest etc. whereas opportunity costs refer to the profits foregone or sacrificedfrom alternative ventures not taken up as the limited factors of production areused for a particular purpose. The opportunity costs are not recorded in the booksof account as they represent only the sacrificed alternative. The opportunity costs arisewhen the factors of production can put to a number of uses and if they are used in aparticular process of production, they cannot be put to an alternative use.Opportunity cost is then defined as the maximum return that could be obtained from analternative use of resources, but is foregone by employing the resourcesin their present use.Examples of opportunity costs:

1. In a cotton-textile mill that spins its own yarn and uses it, the opportunity

cost is the revenue that could have been secured if the yarn would have been

sold.

2. At the personal level a student who decides to take-up a full-time course ofstudy, has to give up a paid occupation. His opportunity cost of studies is thepotential earning from the paid occupation sacrificed.

Opportunity cost concept is useful in incurring capital expenditure. An investor hasto calculate the profitability of different projects before investing in one of them.

He has also another alternative of investing in a project or earning interest bydepositing the money in the bank. Similarly, investment in equity shares involvesopportunity costs measurable in terms of sacrificed income from alternativeinvestment.In business decisions, the concept of opportunity costs plays a very importantrole. The business firm should not concentrate on what the business firm is doing.It has to take into consideration the other alternatives and opportunities availableto it. The success of the business is governed by the opportunity costs taken intoconsideration.Opportunity cost of factor refers to its value in its next best alternative use or it isthe cost of forgone opportunity.

3. Direct or Traceable costs and Indirect or Non-Traceable costs:



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Direct costs are costs that are readily identified and are traceable to a particularproduct, operation or plant. Example: Direct material, direct labour andmanufacturing costs. Indirect costs are not readily identified and not visiblytraceable to a particular product, operation or plan. For Example: Indirectmaterial, indirect labour and indirect expenses.

4. Fixed and variable costs:

Fixed costs are those costs which do not vary with the level of firmsoutput. They are the costs of fixed or indivisible factors. Fixed factors are thosefactors which cannot be easily varied with size of the output. It requires acomparatively longer period to make changes in them, i.e. buildings, machineryetc., these costs require a fixed expenditure irrespective of the level ofoutput e.g. rent, property taxes, interest on loans. Even if the output iszero, fixed costs must be incurred. As output expands, they remain the same.However, these costs vary with the size of the Plant and are a function of capacity.On the other hand, Variable Costs are those costs which vary directlywith the level of output. They are the cost of variable factors. Variablefactors are those factors which can be easily varied with the changes inthe level of output, e.g. operative Labour, raw-material, fuel for runningthe machines, wear, and tear on equipment, when output is Zero, variablecosts are nil. As output increases variable costs also increases.

COST FUNCTION.Cost function is a functional relationship between cost of a product andthe various determinants of cost. In cost function, cost is the dependentvariable and all the other variables are the independent variables. Costfunction is a mathematical relationship between cost of production and thevarious determinants of costs. Cost functions are derived from the productionfunction, which describes the technically efficient method of producing acommodity at any point of time. Cost function can be expressed as follows:C= f (O, S, T, P)Where,C= Cost of outputO= Size of outputS= size of plantT= Time under considerationP= Prices of factors of ProductionThus, cost is basically a function of the level of output of firm, the size of its plant,time and prices of factors or production. Cost function can be linear or curvi-linear

depending upon the behaviour of the variables under study.

Determinants of Costs:1.Size of Output:Cost is affected by the size of output. Generally, as the level of total outputincreases the total cost also increases. Average and marginal costs, in such acase, however, will fall initially but rise afterwards.

2.Size of Plant:Cost is inversely related with the size of plant. As the size of plant increases,costs decline and as the size of plant decreases, costs rise. Fixed costs, however,of bigger plant are higher than that of smaller plant.



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3.Prices of input:Higher the prices of inputs, higher will be the costs of production. However,change in cost depends upon the contribution which that factor of productionmakes to the total product. If price of factor which is negligibly used in productionincrease, cost will rise marginally only.

4.Period under Consideration:

During Short period, costs tend to rise sharply as compared to long-period duringwhich the increase is not that sharp.

5.Technology:State of technology has big influence over cost, the factor Technology is itself amultidimensional factor, determined by the physical quantities of factor inputs,the quality of factor inputs, the efficiency of the entrepreneur, both in organizingthe physical side of the production and making entrepreneur both in organizingthe physical side of the production and making the correct economic choice oftechniques.

6.Level of Capacity Utilization:Cost not only depends upon the size but also on the efficiency in utilization ofcapacity, costs, specially fixed costs tend to fall with higher utilization of capacity.

Short-Run Total CostsShort-Run:Short Run is a period in which some factors are fixed and some factors arevariable. Fixed factor have fixed cost and variable factor have Variable cost.So law of variable proportion applies here. In short-run, output can be increased ordecreased by changing variable factors only but fixed factors cannot be varied.

Long-Run:Long is a period in which all the factors can be varied. There is only variablecost. In the long run, there are no does fixed cost. So, The Law of Returns toScale applies here. In long-run output can be increased or decreased by changingall the factors. Both short period and long period cannot be quantified.

Total cost (TC):Total cost of production is the sum of all expenditure incurred in producing a givenvolume of output. In other words, TC = TFC + TVC

Total Fixed Cost (TFC):Fixed cost does not change with changes in the level of output. If plotted on graph,

TFC is parallel to Xaxis. Even at zero output, fixed cost remains the same. Forexample Rent and insurance do not change with the change in the level of output.

Total Variable Cost (TVC):Variable costs are those costs that change with changes in level of output. It hasinverse S shape. If output is zero cost is also zero and as output increases costincreases. For Ex. Raw material, power etc.

Table showing Total Costs:



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Output(Q)

TFC TVC TC

0 10 0 101 10 8 182 10 13 233 10 16 26

4 10 20 305 10 26 366 10 35 457 10 47 578 10 63 739 10 83 93

Short-run average cost1. Average Fixed Cost (AFC):Average fixed cost is the total fixed cost divided by the output. (Per unit FC) orTFC/Q. The general shape of the AFC curve is downward sloping it does not touch

the X axis as AFC cannot be zero. It is not U shape. This curve is also calledRectangular Hyperbola (R.H).

2. Average Variable Cost (AVC):Average variable cost is the total variable cost divided by the output. (Per unit VC)or TVC/Q. The average cost curve will first fall, then reach a minimum and thenrise again. It has U shape

3. Average Total Cost (ATC):Average total cost is total cost divided by the output. (Per unit TC) or TC/Q or AFC+ AVC. The ATC curve first falls, reaches its minimum and then rises. The ATCcurve is U shape due to law of variable proportions.

4. Marginal Cost (MC):Marginal cost is the change in total cost due to change in the output. Or MC = total cost / qty. produced or MC = total Variable Cost / Qty. produced. TheMC curve is also U shape.

Table showing Total and Average Costs:Output(Unit)

TotalfixedcostTFC

TotalVariableTVC

TotalCostTC

AverageFixedCostAFC

AverageVariablesAVC

Average totalAC

Marginalcost(Rs.)MC

0 10 -- 10 ---- --- ---- ---1 10 10 20 10 10 20 102 10 18 28 5 9 14 83 10 24 34 3.33 8 11.3 64 10 28 38 2.5 7 9.5 45 10 32 42 2 6.4 8.4 46 10 38 48 1.67 6.33 8 67 10 46 56 1.43 6.57 8 88 10 56 66 1.25 7 8.25 109 10 68 78 1.11 7.55 8.67 12

Relationship between Average Cost and Marginal Cost:



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Relationship between Average Cost and Marginal Cost From the above table thefollowing relations can be explained:1. MC and AC both can be calculated by TC.2. When AC falls, MC also falls but AC > MC3. When AC rises, MC also rises but now MC > AC4. When AC is minimum, the MC = AC. In other words, MC curve cuts to AC curve

at its minimum point (i.e., optimum point).5. There is also abnormal situation when AC falls then MC rises. But oppositenever happened.

Table showing Total, Average and Marginal cost:Output

TotalCost

Average TotalCost

Marginalcost

Analysis

0 10 ---- ---- AC > MC

AC decreasesMC also decreases

AC = MC is minimumAC < MC: bothincreases

1 20 20 102 28 14 83 34 11.3 6

4 38 9.5 45 42 8.4 46 48 8 67 56 8 88 66 8.25 109 78 8.67 12

Relationship between Average Cost and Marginal Cost curves:1. Both AC and MC curves are falling but MC curve is below AC curve.

2. When AC curve is minimum MC curve cuts AC curve i.e. AC=MC.

3. Both AC and MC curve are rising but MC curve is above AC curve.4. There is a situation when AC curve is falling and MC curve is rising but ACcurve rising and MC curve falling never happens.

5. AC curve is combination of AVC and AFC curves but MC curve is independentcurve.

Why AVC, ATC and MC are curves U-shaped? :

Production and Cost Function.It is due to Law of Variable Proportions. Law of variable proportions (diminishingreturns) states that as the units of variable factor is increased, MP first rises and

then falls. When MP rises, MC falls and when MP falls. When MP rises, MC falls andwhen MP falls, MC rises. It is the behaviour of MC, which determines the behaviourof AC. when MP is maximum then AC is minimum and when AP is maximum thenAC is minimum. Under 2nd stage MC and AC both raises.

Long-run average cost curve (LAC), Envelop curve or planningcurve:A long cost curve depicts the functional relationship between output and the long-run cost of production. In the long-run, all inputs are variable, because costs thatare fixed in the short run can be changed in long run. Accordingly, there are noTFC or AFC curves in the long-run. There is no distinction between TC and TVC; we

simply use the term TC. Similarly, there is no distinction between ATC and AVCand we will use the term LAC.



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In the long-run the firm will produce the output at which SAC is minimum, it isclear than in the long-run the firm has a choice in the employment of plant and itwill employ the plant, which yields minimum possible unit cost for producing agiven output.It is to be noted in the above figure, that LAC curve is not tangent at the minimumpoint of SACs.

When LAC declines SAC is tangent to the falling portion of SAC.When LAC rising - SAC is tangent to the rising portion of SAC.When LAC minimum SAC is tangent to the minimum point of SAC.The long-run average cost curve will be a smooth curve enveloping all short runaverage cost curves, so it is called enveloping curve. Long-run cost curves areoften called a Planning curve because a firm plans to produce any output in thelong-run by choosing a plant on the LAC curve corresponding to the given outputThe long-run average cost curve helps the firm in the choice of the size of theplant for producing a specific output at the least possible cost.

Explanation of the U Shape of the LAC Curve:LAC curve is a U shape curve. This shape of LAC depends upon the returns tothe scale. Returns to scale may be increasing; constant or decreasing. We cansummarize all this as follows:

Returns to scale LAC Internal & ExternalIncreasing returns toscale:

LAC decreases Economies arise here

Constant returns toscale

LAC minimum Set off economies bydiseconomies

Decreasing returns toscale

LAC increases Diseconomies arise here

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Chapter III Theory of Production and Cost