ChapterIII Theory of Production and Cost

7/29/2019 ChapterIII Theory of Production and Cost.

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General Economics 4.1 Theory of production and cost.

CHAPTER-III

THEORY OF PRODUCTION AND COSTMeaning and Definition of production:Production is one of the most important economic activities. Production is an activity directedto satisfy consumers wants through exchange. During the process of production materialgoods and services are produced or utility is created in the materials to satisfy human wants.Production is not merely transformation of material things or creation of utility but it involvesthe process of exchange through which goods and services reach the ultimate consumers tosatisfy their wants.According to fundamental law of science Matter is neither created nor destroyed. Humanbeings can only create or add utility to existing matter.

Definition of production:Production can be defined as creation or addition of utility.

According to Paul studenski, Economic production covers the complex of human activitiesdevoted to the creation, with limited resources of goods and services capable of satisfyinghuman wants and because of their limited supply, having limited value.According to Peterson, Production can be defined as any activity that creates present andfuture utility.

Methods of Creation of Utility:1. Form Utility:Form utility is created when the existing matter is transformed or rearranged, so that itbecomes more useful. Through increase in its utility a material becomes more adapted to

satisfy some particular human wants. For example, a carpenter transforms wooden planksinto furniture; a baker converts flour into bread etc.

2. Place Utility:Place utility is created by changing the place of the resources, from the place where they areof little or no use to another place where they are of greater use. Place utility can beobtained by (i)Extraction from earth e.g., removal of coal, iron-ore, gold-ore etc. from earth.

(ii) Transferring goods or 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 forestto showroom in the city etc.

3. Time Utility :Time utility is created by all forms of storage, insurance and speculation. There is always atime-lag between the production of goods and their consumption. Goods produced in thepresent time are available for consumption in the future. Ensuring availability of materials attimes, when they are not normally available for production and consumption is timeutility. For example, rice is harvested in winter, but its demand continues throughout theyear. It is through stocking of rice that its supply can be ensured throughout the year, woolengarments are produced throughout the year but their demand is high in winter, throughstockingthey are made available when needed.


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4. Natural utility:Natural utility is the utility available in the free goods provided by nature. For example,free natural goods are like air, water, sunshine etc. provide tremendous utility to sustain lifeon 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 necessary knowledge to use andoperate them. For example, a personal computer or a laptop is useless for a person if he or shedoes 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 of person utility and services.

7. Possession utility:Utility is also created when a commodity is possessed by a person who can derivesatisfaction out of it. For example, books lyingin the college library are not useful left alone.Once these books reach in the possession of the 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 goods andservices will be classified in production which posses the following characteristics:1.These are mainly created by human labour and capital.2.These are capable of satisfying human wantsdirectly or indirectly, as producers goods.3.These are comparatively scarce, and therefore, need to be economised and have economic

value.

4.These either have a definite monetaryprice or cost or can be given one by charge.Activities to be excluded from being called as production:All kinds of activities directed for the production of goods and services for satisfaction ofother peoples wants are not included in production. The following types of activities areexcluded from production:1.Any domestic work:Any work done by a family member out of love and affection towards family and not withthe 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 of patriotic feelings andwith the object of social welfare should not be included in the production.

3.Goods produced for self-consumption:Any goods produced for self-consumption do not constitute production. A large part ofproduction of agricultural produce is retained by the farmers for their family consumption. Itis not marketed to earn income. Therefore, it should be excluded from production.

4.Leisure-time activities:Any work of art and literature, pass-time hobbies do not fall in the ambit of productionbecause they are done for self-satisfaction.


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Factors of Production:Production requires the use of certain resources. It is the co-operative effort of the variousfactors of production. They are also known as inputs. Whatever goes into the productionprocess to produce goods and services is called inputs. Factors of production or inputs aredivided into two categories:

A. Factor inputs.B. Non-factor inputs.A. Factor inputs:Factor inputs comprise land, labour, capital and enterprise. These are also known as primaryinputs, 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 goinguninterrupted.

1.Land:Land includes all those resources, whose total supply in the economy is fixed or inelastic.In economics, land does not mean only surface of earths soil or physical territory alone butalso all other scarce natural resources which are the free gift of nature such forests, mines,rivers and sea water, temperature, rainfall, etc. According to Marshall, land means thematerials and the forces which nature gives freely for mans aid, in land and water, in airand light and heat. The moment these natural resources come under the ownership of anindividual 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 human beings as a freegift of nature, there is no need to pay any price for it so long as it is not owned and controlledby someone.

2. Inelastic Supply:The supply of land is fixed. Human being can simply change the uses of land; they canneither 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 to another 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 assistanceof labour and capital is needed to make land productive. It would not yield any result unlessdeployed usefully through human ingenuity and effort.

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 regionto another.


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

7. Indestructible:According to Ricardo, land is an indestructible factor of production because it cannot bedestroyed.

2.Labour:Labour is a physical or mental effort of human being in the process of production foreconomic purpose. Any work done for the sake of pleasure of love does not represent labourin economics. Marshall defines labour as any exertion of the body or mind undertakenwholly or partly with some object other than the pleasure derived from the labour itself.It is the human element which distinguishes it from other factors, for it gives rise to specialproblems regarding mobility, efficiency, unemployment and psychological attitudes.

Characteristics of Labour:Labour is basically different from other factors of production. Unlike the other factors it is aliving factor. The following are the main characteristics of labour as 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 days labour goesfor good. It implies that the labourer cannot store his labour and so he has no reserve price forhis labour.

3.Labour is inseparable from the labourer:The labourer has to present himself physically at a place where production activities takeplace. It implies that the labourer embodies the services he performs. Labourer is the sourceof 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 the productivity oflabour can improved.

6.Labour makes a choice between the hours of labour and hours of leisure:The labourer has to make a choice between the hours of labour and hours of leisure . Thesupply of labour and wage rate is directly related. It implies that as wage rate rises, thelabourer tends to increase the supply of labour by reducing the hours of leisure. However,beyond a minimum level of income the labourer reduces the supply of labour and increasesthe hours of leisure in response to a further rises in the wage i.e., hence, the supply curve oflabour is backward bending.

7.supply of labour is inelastic during the short run:The supply of labour is related to population. It takes a child more than 15 years to developinto a labourer; therefore, supply of labour will be inelastic.


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

9.Labour in mobile:As compared to other factors, labour is more mobile. Labour can easily move from one placeof 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 theorganisation.

Types of labour:Mental and Physical labour:The labour that applies more of mind and less of muscle power is called mental labour. Thework of a teacher, an advocate, doctor, engineer, research scholar, etc., falls under the

category metal labour. Conversely, the labour that uses more of muscle power and less ofmental power is called physical labour. 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 in splitting up theproductive process into its component parts.In the words of Taussing, The division of labour means those people who carry on severaloperations of a given branch of industry combined for bringing about final results.Division of labour occurs when a labourer confines himself to the production of a singlecommodity or single sub-process and leaves the production of other commodities 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 traditional economies, aworker specialized in the production of single 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, large businessenterprises divided and sub-divided the process of production of a single commodity andeach worker performance one or two of the several processes involved in the production ofcommodity.

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


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Merits of Division of Labour: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 of Pride and Responsibility.2. Monotony in work.3. Immobility of Labour.4. Fear of over production increases.Efficiency of labour:Efficiency of labour means the amount of work which a labourer can do within a given

time. The efficiency of labour refers to productivity of labour, both quantitative andqualitative during a given time. Efficiency of labour is a relative concept therefore; it isalways understood and measured in relation to some predetermined standards. Efficiencyof labour differs from one labourer to another and is subject to change over time. Efficiency ofLabour depends upon;1. Conditions of Work,2. Quantity of production, and3. Quality of productionAdvantages 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 of labour fromone place to another.

2.Occupational Mobility:When a labourer leaves one occupation to join the other it is called occupational mobility. For

example: If a worker leaves a cotton textile mill to join a jute mill it is called occupationalmobility.


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3.Grade mobility:When a worker moves from one position to another in the same or other occupation, it iscalled Grade mobility. Grades are form according to different wage-groups. Grade mobilitycan assume two forms:

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

b.Vertical mobility:When a labourer moves from one occupation to another for a higher position it is calledVertical mobility.

3.Capital:Capital is man-made material factor of production. It is stock concept. All capital is wealth butall wealth is not capital. According to J.S. Mill Capital is the accumulated; product of pastlabour destined for the production of further wealth.

Capital comprises man-made materials which are used for the further production. Goodsproduced with the help of different factors of production are broadly classified into twocategories:

1)Consumer goods2)Producers goods

Capital consists of producers goods and stocks of consumer goods not yet in the hands ofconsumers. Capital consists of following:(a)Structures, such as private residential houses, factory buildings, commercial buildings,

Government buildings etc.

(b)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 finished goods lying

unsold with the wholesalers and Retailers

(c)Money used for production purposes.Characteristics of Capital:1. Capital is the result of past labour.2. Capital is the result of Savings.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.


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Distinction between capital and other related concepts:1. Capital and Money:Money is anything that is generally accepted by the people as medium of exchange and ameasure of value, and is also used to meet other kinds of business obligations. But, all moneyis not capital, that part of money which used further production is called capital.

2. Capital and Income:Earnings regularly drawn either from the ownership assets or by doing dome economicactivity are called income. That part of income which is saved and used for furtherproduction 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. All wealth is notcapital. That part of wealth which is used for further production of wealth is called capital;on the other hand, all capital is wealth.

Classification of capital:Capital assists in production if different ways. Capital, on the basis of its use, can beconveniently classified in the following forms:1. Fixed and Circulating Capital:Fixed capital is one which is durable and which is used in production for a considerablelong time. The examples of fixed capital are machines, plants, equipment, factory buildings,dams, irrigation canals, etc. Circulating capital refers to the capital which is used only oneonce in production. It loses its utility after single use. The examples of the circulating capitalare 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 tangible form and arecapable of being transferred from one person to another. Examples of the material capitalare machines, tools, transformers, etc. Personal capital comprises all those energies,faculties and habits which contribute to make labour efficient. It includes all the personalqualities of an individual which are non-transferable. Examples of personal capital are artof 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 specific occupation. Once investedin a particular business, it cannot be withdrawn. Examples of sunk capital are railwaybridges, factory buildings, roads, dams etc. Capital is said to be floating or free when it canbe changed at will for employment in any branch of industry and can at any time assume adifferent form. Examples of floating capital are wood, raw materials, electricity etc.

4. Remuneratory and Auxiliary Capital :Remuneratory or wage capital is one which is applied to the payment of labour engaged inproduction. Auxiliary capital is that which assists the labour to carry out their dutiessmoothly. Machines, tools, equipment, etc., are the examples of the auxiliary capital.

5. Production and Consumption Capital:Production capital comprises all those articles which help the labour directly in production.Examples of production capital are raw materials, machines, tools, equipment, etc.Production capital may be material as well as personal. Consumption capital consists of


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those materials which indirectly assist in the process of production. Examples ofconsumption capital 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 which is theresult of domestic savings in the country is called internal capital.Capital which is imported or invited from abroad and used in recipient country is calledexternal capital. The capital received in India from the World Bank, International FinanceCorporation etc., is an example of external capital.

Capital Formation:Production is a continuous process. Whatever goods and services are produced in anaccounting year are not consumed instantaneously. A part of current production is consumed,while the remaining part is retained for further production. We may define capital formationas The surplus of production over consumption in an accounting year which is used forfurther production.

Capital formation is regarded as a social process whereby a societys capital stock increasesduring a given period. According to Prof. Nurkse, The meaning of capital formation is thatsociety does not apply the whole of its current productive activity to the needs and desiresof immediate consumption, but directs a part of it to the making of capital goods, tools andinstruments, machines and transport facilities, plant and equipment all the various formsof real capital that can so greatly increase efficacy of productive effort.Capital formation plays a vital role in the development of an economy. Generally speaking,higher the rate of capital formation more economically developed an economy would be. Itdetermines the production potential of an economy.

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 partof the resources is withdrawn from current consumption so as to increase the real savings of acommunity. The magnitude of the real saving depends upon the will to save, power tosave and the facilities to save.

(a)Will to save:How much a person would be willing to save depends upon the individuals nature. If anindividual is foresighted and wants to make his old age secure, he will save more. Some

persons are miserly by nature, and whatever the hardships they will save a certain proportionof their money income. Out of family affection people may like to save more with a view tohave comfortable future of their dependents. Sometimes people save more in order tocommand greater respect in the society. Allurement to earn a high rate of interest may alsoinduce people to save more.

(b)Power of save:It is the capacity, or the ability to save that depends upon the income of an individual. Higherincomes are generally followed by higher savings. The availability of abundant naturalresources and high level of economic development will create and lead to greater wealth in acountry, and therefore the capacity to save will increase. If the distribution of wealth isequitable, everyone will have more money income, and therefore, the power to save willincrease.


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(c)Facilities to save:If the country is free from internal disturbances and threat of foreign aggression, people willhave opportunities to save. Stability of money value also facilitates savings. Frequentfluctuations in the money value, and particularly inflation reduce the purchasing power of thepeople, as a result, savings get discouraged. 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, it will notfacilitate the process of capital formation. There should be a widespread network of bankingand other financial institutions to collect public saving and take them to prospective investors.

3.Investment:Process of capital formation gets completed only when real savings get converted into realcapital assets. A country should have an entrepreneurial class which is prepared to bear therisk of business and invest the saving in productive occupations so as to create new capital

assets.If the process of capital formation is to succeed, all these stages should be interlinked. In theabsence or slackness of any of these stages the process of capital formation will remainincomplete.

4.Enterprise:Business is full of risks and uncertainties. The task of bearing risks is called enterprise. Theman who bears the risk of business is called an entrepreneur.Several types of risks are involved in business. Sometimes, the demand falls short of supply;at another time, the supply fall short of demand. The market fluctuations may cause heavy

losses therefore; the services of entrepreneurs are required to bear all such risks of business.Functions of entrepreneur:Besides risk bearing, the entrepreneur has to perform several other important functions whichare as follows:1.Risk-bearing function:The most important function of an entrepreneur is to bear the risk of business. There is alwaysa time-lag between production and consumption of goods. The goods produced in presentare consumed in the future. Therefore, heavy risk is involved in equating the currentproduction to future demand. No other factor production except the entrepreneur bears therisk of the business.

2.Decision-taking function:Decision-taking is an important function of an entrepreneur an entrepreneur has to takedecisions as regards the followings matters:a.Selection of the product:An entrepreneur would choose a trade which seems to be more profitable, subject to suchqualification as his personal interest, the degree of risk involved his temperament, histechnical knowledge, the amount of capital required and estimate of his own ability.

b. Selection of the type of the firm:The entrepreneur has to decide whether he would prefer sole proprietorship, partnership or a

joint stock company. Further, he has to decide whether it should be private limited companyor a public limited company.


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c. Selection of the location of plant:The entrepreneur has to decide where to install the plant, so that advantages of location canbe obtained. Economic and non-economic factors, both are essential while making choiceabout the location of a plant.

d.Selecting techniques of production:An entrepreneur aims maximising his output and minimise the cost of production. He has todecide about the most suitable combination of land, labour and capital so as to obtainmaximum production.

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

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

4.Innovative function:Innovation is considered as an important as an important function of an entrepreneur.Innovation is defined as the commercial use invention. Individuals and experts working forcorporation conduct basic research and invent new products, new technology, new sources ofenergy, and soon the entrepreneur makes use of these inventions for commercial purposes.Innovation is never static. A progressive and talented entrepreneur should always take a leadto introduce a new 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 large profits..In modern economies, the role of organizing the factors of production is regarded as amanagerial function, which can be performed by a paid manager i.e. by a highly skilled formof labour. What really distinguishes enterprise from other factors of production is that it hasto carry all the risks and uncertainties, and is rewarded for bearing these, in the form ofprofits.

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. A part of it isconsumed and the remaining is retained for further production. Production of thecommodities is the outcome of combined efforts of various factors of production and the

quantity of production depends directly upon quantity of these factors. Production is definedas the transformation of inputs into output. Production includes production of physicalgoods and production services. The producer combines the various factors of production in atechnical proportion to maximize the output and minimize the cost by means of the least costcombination of factors of production.

Production function:The term Production function means physical relationship between inputs used and theoutput produced. Production function is purely a technical and functional relation whichconnects which connects quantity of inputs required to produce a good to the quantity of

output produced. Production function is the process of getting maximum output from givenquantity of inputs in a particular time period.

Characteristics of production function:1. Production function is a physical concept:Production function establishes technical relationship between inputs and outputs expressedin physical terms and not in terms of a monetary unit such rupees.

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

3. Production function is functional relationship between inputs and output:Production function is a functional relationship between inputs and resulting output. Changein input by one unit has an effect on the output of the firm.

4. Production function is determined by the state of technology and inputs:Production function is dependent on the state of technology and inputs available with thefirm. Technology refers to the sum total of knowledge of the means and methods ofproducing goods and services. Input is anything that is used by the firm in the process ofproduction. Thus, input includes every type of productive resource available with the firm.

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

6. Production function includes only technically efficient combinations of inputs:Production function in economic analysis refers to combination factor inputs which maximisethe output and minimise the cost of production.

Mathematical expression of general production function:Production function can be expressed in the form of a mathematical equation which showsthat the output is a dependent variable and inputs are independent variables.

P = f (La, Lb, C, E)Where,P is the level of output.


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La is the land input.Lb is the labour input.C is the capital input.E is role of enterprise.

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 there are somefixed factors and some variable factors. In the short-run, production will increase when moreunits 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 factors are invariable supply. In the long-run, production will increase when all factors are increased in thesame proportion.

Short-run and long-run:1. Short-run:Short-run refers to a period in which some of the factors of production like land and capitalare in fixed supply and others like labour are in variable supply.

2. Long-run:Long-run refers to a period long enough to permit changes in all the factors of production. Afirm has enough time to install a new plant or raise a new building in response to increaseddemand.

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

2. Variable factors of production:Variable factors of production refer to those factors whose supply can be varied or changed.For example, raw materials, labour, power, fuel etc. are in variable supply in the short-run aswell as in the long-run. The distinction between fixed and variable factors disappears in thelong-run as all factors are in variable supply in 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 factors like rawmaterials, 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 be changed bychanging the quantity of all variable factors of production. Scale of production is related tolong-run.

Production in the short-run:


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1. Total Production (TP):Total product is defined as the total quantity of goods produced by a firm during aspecified period of time. Total Product is the total output resulting from the efforts of all thefactors of production combined together at any time. Total product can be increased byemploying more and more units of the variable factor.

2. Average Production (AP):Average product or average physical product may be defined as the amount of output perunit of the variable factor input employed. Average product measures the productivity of thefirms labour in terms of how much output each labour produces on an average.

3. Marginal Production (MP):Marginal product is defined as the change in total product resulting from the employment ofan additional unit of a variable factor. Marginal Product is the change in Total Product due tochange in the quantity of variable factor i.e., labour. The knowledge of marginal product helpsthe firm in its decision making process as it tells the firm how much will be the addition in

output by adding one more unit of labour.4. Relationship Between AP And MP:1. Both AP and MP can be calculated by TP2. When AP rises them MP also rises but MP>AP3. When AP is maximum then MP = AP or say MP curve cuts the AP curve at its maximum

point4. When AP falls then MP also falls but MP < AP5. There may be a situation when MP decreases but AP increases but opposite never

happened

Labour TP AP MP Analysis1 2 2 2 MP & AP both increases; MP > AP

TP also increases2 5 2.5 3

3 9 3 4

4 12 3 3 MP = AP, AP = Maximum

5 14 2.8 2 MP & AP both decreases,MP < AP; TP increasesMP = 0, TP = maximum

6 15 2.5 1

7 15 2.1 08 14 1.7 -1 AP > MP both decreases

TP decreases9 12 1.3 -2

Law of Variable Proportion:Law of Variable Proportions occupies an important place in economic theory. This law is alsoknown as Law of Proportionality. Keeping other factors fixed, the law explains the productionfunction with one factor variable. In the short run when output of a commodity is sought tobe increased, the law of variable proportions comes into operation. Therefore, when thenumber of one factor of production is increased or decreased while other factors ofproduction are constant, the proportion between the factors is altered.Due to change in the proportion of factors there will also emerge a change is total output atdifferent rates. This tendency in economics is called the Law of Variable proportions.

Assumptions:


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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 an Improvement intechnology 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 becombined 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 is identical interms quality and quantity with every other unit.

4. Short-run:The law of variable proportions operates in the short-run when it is not possible to vary allfactor 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 production of a commodity isincreased by adding units of a variable input, while the quantities of other inputs are heldconstant, the increase in total production becomes, after some point, smaller and smaller.In other words, as more and more units of a variable factor are combined with same quantity

of fixed factors, total product first increases at an increasing rate then at diminishing rateand finally starts diminishing. It implies that marginal product first rises and then diminisheseventually.

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 Analysis

1 2 2 2 Stage I Law of increasing returns

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

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

2 5 2.5 3

3 9 3 4

4 12 3 3

5 14 2.8 2

6 15 2.5 1

7 15 2.1 0

8 14 1.7 -1

9 12 1.3 -2

The position of three stages can also be explained as under:


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Stages Total Product (TP) Marginal Product (MP) Average Product (AP)

Stage I Increases at an increasingrate, then increases atdiminishing rate.

Increases and reaches atmaximum point and beginsto decrease.

Increases and reachesits maximum point

Stage II Increases at diminishing

rate and reaches itsmaximum point

Decreases and becomes

zero

After reaching its

maximum point,begins to decrease

Stage III Begins to fall Becomes Negative Continues to diminish

Explanation of increasing returns:1. Indivisibility of fixed factors:The fixed factors employed in the production process are indivisible, i.e. they cannot bedivided into smaller parts. Thus, when more units of variable factor are combined with fixedfactor, output keeps increasing.

2. Fuller Utilisation of fixed factors:In the initial stages of the production the fixed factors are underutilised in relation tovariablefactor employed on it. Fuller utilisation of fixed factors calls for greater application of thevariable factor which in turn leads to increase in total and marginal product.

3. Division of labour and specialization:Due to increase the scale of production, it enables the firm to adopt division of labour andspecialisation. Division of labour & specialisation enables increase in skill, efficiency oflabourers, saving of time and innovation in the application of technique of production in theproduction process by the workers which leads to increasing 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 to achieve theperfect combination of fixed and variable factors input ratio in the production processwhich 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 to ensure theefficient utilization of the fixed factor, then further increases in the variable factor will causemarginal and average product to decline because the fixed factor then becomes inadequaterelative to the quantity of variable factors.

2. Imperfect substitutability:According to Mrs. Joan Robinson factors of production are not perfect substitutes of eachother. There is a limit to the extent to which one factor of production can be substituted foranother. Beyond this limit perfect ratio between various factors gets disturbed andproductivity tends to increase at a diminishing rate.

Explanation of diminishing returns:1. Too excessive quantity of variable factor:In this stage the quantity of variable factor becomes too excessive relative to the fixed factorso that they get in each others way with a result that the total output falls instead of rising. In

such a situation a reduction in the units of the variable factor will increase the total output.Stage of Operation:


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The three stages together constitute the law of variable proportions. Since the second stage isthe most important. So stage II will be stage of operation and because of that in practice wenormally refer to the law of variable proportion as the 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 of productionare in variable supply. In the long-run output can be increased by increasing all the factors ofproduction or scale of production.

Statement of the law:The law of returns to scale states that when all factors of production are increased in thesame proportion, output will increase however, the increase may be at increasing rate orconstant 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 in the samegiven proportion result in a more than proportionate increase in the output. For example, ifthe input is increased by 100% however, the output increases by 125% then it is the situationof Increasing Returns to Scale.

2.Constant Returns to Scale:Returns to scales are said to be constant when a proportionate increase in all the inputs resultsin proportionate increase in output. For example if input is increased by 100% but the outputalso increases by 100% then it is the situation ofConstant Returns to Scale.

3.Diminishing Returns to Scale:Diminishing returns to scale occur when a simultaneous increase in all inputs in the samegiven proportion result in a less than proportionate increase in the output. For example, ifinput is increased by 100% but the output increases only by 75% then it is the situation ofDiminishing Returns to Scale.

Causes of the application of the law of returns to scale:

Internal Economies and Diseconomies:Internal economies are those economics, which are firm specific. Those are available to thatparticular firm in the industry, which seeks to increase its level of output by way of increasingits scale of production

1. Technical Economics:Large scale production: As the firm increases its scale of operations; it becomes possible touse more specialized and efficient form of all factors, specially capital equipment andmachinery. Secondly, when the scale of production is increased and the amount of labour andother factor becomes larger, introduction of greater degree of division of labour or

specialization becomes possible and as a result cost per unit declines.


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Diseconomies: However, beyond a certain point a firm experiences net diseconomies of scale.When the firm has reached a size large enough to allow utilization of all the possibilities ofdivision of labour and the employment of more efficient machinery, further increase in thesize of the plant will entail high long run costs because of difficulties of management. Whenthe scale of operations becomes too large, it becomes difficult for the management to exercise

control.

2. Management Economies:When output increases, division of labour can be applied to management. Since individualactivities come under the supervision of specialists, managements efficiency and productivitygreatly improve.Diseconomies: However, as scale of production increases beyond a certain limit, managementfinds it difficult to exercise control and bring co-ordination among various departments. Themanagerial structure becomes more complex. All those affect the efficiency and productivityof management and the firm itself.

3. Commercial Economies:For large scale production the firm places bulk orders for materials and components andenjoy lower prices for them. Economies can also be achieved in selling the product. Finally,when the business is sufficiently large, division of labour can be introduced on thecommercial side, with expert buyers and sellers being employed.Diseconomies: These economies become diseconomies after an optimum scale. For example,advertisement expenditure and other marketing overheads will increase more proportionatelyafter the optimum scale.

4. Financial economies:Large firm can offer better security to bankers and, raise money at lower cost, since investorshave confidence in it.Diseconomies: however, these financial costs will rise more proportionately after theoptimum scale of production.

5. Risk bearing economies:Large firms with diverse and multi production capability is in a better position to withstandbusiness risks.

Diseconomies: However, risk may rise if diversification results in more economicdisturbances.

External Economies:External economies are those economies, which are industry-specific;these are available to allthe firms in the industry, when the scale of operation of the industry as a whole expands.1. Cheaper raw material and capital equipment:The expansion of an industry may result in exploration of new and cheaper sources of rawmaterial, machinery and other types of capital equipment.

2. Technological external economies:When the whole industry expands, it may result in the discovery of new technical knowledgeand in accordance with that the use of improved and better machinery than before. This willreduce their cost of production.


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3. Development of skilled labour:when an industry expands in an area the labour in that area is well accustomed to do thevarious productive processes and learns a good deal from the experience, which has afavourable effect on the level of productivity and cost of the firms in that industry.

4. Growth of ancillary industries:With the growth of an industry, a number of ancillary industries may specialize in productionof raw materials, tools and machinery etc., This will tend to reduce the cost of production ingeneral.

5. Better transportation and marketing facilities:The Expansion of an industry may make possible the development of transportation,marketing and communication network which will greatly reduce cost of production of thefirms.

External Diseconomies:However, external diseconomies may arise due to expansion of an industry. An example ofexternal diseconomies is the rise in some factor prices. Moreover, too many firms in anindustry at one place may also result in higher transportation cost, marketing cost and highpollution control cost. The government may also prohibit or restrict expansion of andindustry at a particular place.


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THEORY OF COSTCOST ANALYSIS:Cost analysis refers to the study of the behaviour of cost in relation to one or more productioncriteria, namely, size of output, scale of operations, prices of factors of production and otherrelevant economic variables. It is concerned with financial aspects of production.

Cost Concepts:1. Accounting costs and Economic costs:Accounting costs relate to those costs only, which involve cash payments by the entrepreneurof the firm. Accounting costs are also called explicit cost. Costs of factors owned by theentrepreneur himself and employed in his own business are called implicit costs. Implicitcosts also known as Non accounting costs. For example,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 (Implicit cost)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 sacrificed from alternative venturesnot taken up as the limited factors of production are used for a particular purpose. Theopportunity costs are not recorded in the books of account as they represent only thesacrificed alternative. The opportunity costs arise when the factors of production can put to a

number of uses and if they are used in a particular process of production, they cannot be put toan alternative use. Opportunity cost is then defined as the maximum return that could be obtained from an alternative 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 of study, has togive up a paid occupation. His opportunity cost of studies is the potential earning from

the paid occupation sacrificed.Opportunity cost concept is useful in incurring capital expenditure. An investor has tocalculate the profitability of different projects before investing in one of them. He has alsoanother alternative of investing in a project or earning interest by depositing the money in thebank. Similarly, investment in equity shares involves opportunity costs measurable in termsof sacrificed income from alternative investment.In business decisions, the concept of opportunity costs plays a very important role. Thebusiness firm should not concentrate on what the business firm is doing. It has to take intoconsideration the other alternatives and opportunities available to it. The success of thebusiness is governed by the opportunity costs taken into consideration.Opportunity cost of factor refers to its value in its next best alternative use or it is the cost offorgone opportunity.


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3.Prices of input:Higher the prices of inputs, higher will be the costs of production. However, change in costdepends upon the contribution which that factor of production makes to the total product. Ifprice of factor which is negligibly used in production increase, cost will rise marginally only.

4.Period under Consideration:During Short period, costs tend to rise sharply as compared to long-period during which theincrease 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 offactor inputs, the efficiency of the entrepreneur, both in organizing the physical side of theproduction and making entrepreneur both in organizing the physical side of the productionand making the correct economic choice of techniques.

6.Level of Capacity Utilization:Cost not only depends upon the size but also on the efficiency in utilization of capacity, 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 are variable. Fixedfactor have fixed cost and variable factor have Variable cost. So law of variable proportionapplies here. In short-run, output can be increased or decreased by changing variable factorsonly but fixed factors cannot be varied.

Long-Run:Long is a period in which all the factors can be varied. There is only variable cost. In the longrun, there are no does fixed cost. So, The Law of Returns to Scale applies here. In long-runoutput can be increased or decreased by changing all the factors. Both short period and longperiod cannot be quantified.

Total cost (TC):Total cost of production is the sum of all expenditure incurred in producing a given volume ofoutput. 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 isparallel to Xaxis. Even at zero output, fixed cost remains the same. For example Rent andinsurance 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 has inverse Sshape. If output is zero cost is also zero and as output increases cost increases. For Ex. Rawmaterial, power etc.


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Output (Q) TFC TVC TC

0 10 0 10

1 10 8 18

2 10 13 23

3 10 16 26

4 10 20 305 10 26 36

6 10 35 45

7 10 47 57

8 10 63 73

9 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) or TFC/Q. The

general shape of the AFC curve is downward sloping it does not touch the X axis as AFCcannot be zero. It is not U shape. This curve is also called Rectangular 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 then rise again. It has Ushape

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 ATC curve 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. The MC curve is also Ushape.

Output(Unit)

Totalfixedcost TFC

TotalVariableTVC

TotalCostTC

AverageFixed CostAFC

AverageVariablesAVC

Averagetotal AC

Marginalcost(Rs.)MC

0 10 -- 10 ---- --- ---- ---1 10 10 20 10 10 20 10

2 10 18 28 5 9 14 8

3 10 24 34 3.33 8 11.3 6

4 10 28 38 2.5 7 9.5 4

5 10 32 42 2 6.4 8.4 4

6 10 38 48 1.67 6.33 8 6

7 10 46 56 1.43 6.57 8 8

8 10 56 66 1.25 7 8.25 10

9 10 68 78 1.11 7.55 8.67 12


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Relationship between Average Cost and Marginal Cost:Relationship between Average Cost and Marginal Cost From the above table the followingrelations 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. In the figure given below

from A to E AC falls but from B to E MC rises. But opposite never happened.

Output Total Cost(Rs.) TC

Average TotalCost AC

Marginal cost(Rs.) MC

Analysis

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

AC decreasesMC also decreases

AC = MC is minimumAC < MC: both increases

1 20 20 10

2 28 14 83 34 11.3 6

4 38 9.5 4

5 42 8.4 4

6 48 8 6

7 56 8 8

8 66 8.25 10

9 78 8.67 12

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 (diminishing returns)states that as the units of variable factor is increased, MP first rises and then falls. When MPrises, MC falls and when MP falls. When MP rises, MC falls and when MP falls, MC rises. It isthe behaviour of MC, which determines the behaviour of AC. when MP is maximum then ACis minimum and when AP is maximum then AC is minimum. Under 2 nd stage MC and ACboth raises.

Long-run average cost curve (LAC), Envelop curve or planning curve: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 that are fixed in the shortrun can be changed in long run. Accordingly, there are no TFC or AFC curves in the long-run.There is no distinction between TC and TVC; we simply use the term TC. Similarly, there isno distinction between ATC and AVC and we will use the term LAC.In the long-run the firm will produce the output at which SAC is minimum, it is clear than inthe long-run the firm has a choice in the employment of plant and it will employ the plant,which yields minimum possible unit cost for producing a given output.It is to be noted in the above figure, that LAC curve is not tangent at the minimum point ofSACs.

When LAC declines SAC is tangent to thefallingportion of SAC.

When LAC rising - SAC is tangent to the risingportion of SAC.When LAC minimum SAC is tangent to the minimum point of SAC.


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The long-run average cost curve will be a smooth curve envelopingall short run average costcurves, so it is called enveloping curve. Long-run cost curves are often called a Planningcurve because a firm plans to produce any output in the long-run by choosing a plant on theLAC curve corresponding to the given output The long-run average cost curve helps the firmin the choice of the size of the plant 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 to the scale.Returns to scale may be increasing; constant or decreasing. We can summarize all this asfollows:

Returns to scale LAC Internal & External

Increasing returns to scale: LAC decreases Economies arise here

Constant returns to scale LAC minimum Set off economies by diseconomies

Decreasing returns to scale LAC increases Diseconomies arise here

Documents

ChapterIII Theory of Production and Cost