Unit 3 Production And Cost

Meaning of Production-
In simple sense, production refers to
the creation of any physical thing, but
from the scientific point of view man
can neither create nor destroy any
thing. Man can only use the things
given by nature to make it useful.
Therefore, production is the creation
or increase of utility in a commodity.
Definitions Of Production
Ely- " Production means
creation of economic utility."
Thomas- "Production is best
defined as the addition of
values."
H. Smith- " Production is the
process that creates utility in
goods."
Three Concepts Of Production
(1) Total Product (2) Marginal Product
(3) Average Product
(1) Total Product- It is the total amount
of goods and services produced in a
given period by using various factors
of production. It is related to marginal
product and average product. It can
explain by following method-
TP = Total Quantity of Goods or Total
of Marginal Product or AP × L
Fixed factors Variable Total
factors Product
1 1 40
1 2 90
1 3 130
1 4 160
1 5 180
1 6 180
1 7 160
(2) Marginal Product-
The difference in the total product
by using one additional unit of a
variable factor is called the
marginal product of that unit.It can
explain by following method-
MP = ∆TP/ ∆L or TPn - TP (n-1)
∆TP = Change in Total Product
∆L = Change in Variable Factors
Variable Total Marginal
factors Product Product
1 40 40-0 = 40
2 90 90-40 = 50
3 130 130-90 = 40
4 160 160-130 = 30
5 180 180-160 = 20
6 180 180-180 = 0
7 160 160-180 =
-20
(3) Average Product-
The product per unit of variable
factor is called average product. In
other words, the amount obtained by
dividing total product by variable
factors is called average product. It is
also called productivity per unit. It is
expressed by the following formula -
AP = TP ÷ L TP = Total Product
L = Variable Factors
Variable Total Average
factors Product Product
1 40 40/1 = 40
2 90 90/2 = 45
3 130 130/3 = 43.3
4 160 160/4 = 40
5 180 180/5 = 36
6 180 180/6 = 30
7 160 160/7 = -22.8
 Production Function
The functional relation of factors and
products is called production
function. It tells us how and to what
extent the production has changed
due to the change of factors in a
given period of time. The physical
relationship between the quantity of
these factors and the quantity
produced is called the production
function.
 Definitions
Watson- "Production function is
the relationship between a firm's
production and the material
factors of production."
Leftwich- "The term production
function refers to physical
relationship between a firm's
inputs of resources and its output
of goods or services per unit of
time leaving prices aside."
 Assumptions of Production
Function
(1) There is a fixed technology, which
is given.
(2) Factor prices remain the same.
(3) Production function is related to a
definite time period.
(4) Combination of factors of
production can be changed to
an extent only.
(5) Factors of production are
homogeneous.
(6) Factors of production are
variable.
(7) Process of changes in factors is
applicable one by one only.
(8) Substitutability of factors of
production is up to limited extent.
(9) Supply of fixed factor is inelastic
in the short term.
(10) The objective of production
function is profit or output
maximization.
(11) Factors of production are used
efficiently.
Types of Production Function
(1) Short Run Production Function
(2) Long Run Production Function
(1) Short Run Production Function-
In this, there is a tendency to change
in the use of the factors of production
at different levels of production. In
the short run, the proportion of use of
the resources changes because in the
short run all the means of production
cannot be changed. In the short run
the units of labor can be variable.
Characteristics of Production
Function
(1) Production function is an
engineering concept.
(2) Production function is a flow
between factors and output.
(3) It represents the relationship
between changed output and
factors of production.
(4) It expresses the physical
relationship between input and
output.
(5) Production function relates to a
fixed time factor.
(6) in a production function on 18 of
labour can be substituted with
another unit of labour.
(7) It is related with given
technology.
(8) Prices of input and output are
not included in production
function.
(9) Production function may be
short termed or long termed.
(2) Long Run Production Function-
In Equal Ratio Production Function,
the proportion of use of factors of
production remains the same at
each stage of production. Long run
refers to the long period of time in
which the firm can change all the
factors of production used in its
area of production. In other words,
no means of production remains
fixed in the long run.
 Law of Returns
(1) Increasing Returns to a Factor or
Law of Increasing Returns - In the
initial stage of production, the law of
increase in production is applicable.
When the quantity of a factor is
changed keeping most of the factors
of production constant, then there is an
increase in production, then it is called
the law of increase in production.
Benham- "Increasing returns to a factor states
that as the proportion of one factor in a
combination of factors is increased upto a point,
the marginal productivity of the factor will
increase."
Explanation:- Progressive use of units of
resources leads to organizational
improvements, increase in efficiency of
resources and achieves large scale internal and
external savings, due to which optimum use of
fixed and indivisible resources becomes
possible, due to which marginal productivity
(MP). ) and average productivity (AP) both
begin to increase..
Unit(L) TP AP MP
1 4 4/1= 4 4-0= 4

2 10 10/2= 5 10-4= 6

3 19 19/3=6.3 19-10= 9

4 33 33/4=8.25 33-19= 14

5 51 51/5=10.2 51-33= 18

6 76 76/6= 12.7 76-51= 25

(2) Constant Returns to a Factor
or Law of Constant Returns
Equal returns to a factor mean the
situation in which their marginal
productivity does not increase by
using additional units of the variable
factor. In this situation marginal
production becomes constant. As a
result, total output increases at the
same rate.
The link between the law of
growth and the law of diminishing
generation is called the law of
equality of origin. In the event of
termination of the law of growth,
the law of equality of origin is
present for the momentary stage
and immediately the law of
decrease of generation becomes
active.
Hanson- “Constant returns to a
factor occurs when additional
application of the variable factor
increases output only at a constant
rate."
Thus, the law of equality of
production shows that tendency of
production which is related to the
established optimum or ideal
combination between the factors of
production.
According to this law, as we increase
the quantity of the variable factor, the
total productivity is in the same
proportion. increases in the proportion
we increase the resources. Thus, in the
law of equality of production, average
productivity (AP) and marginal
productivity (MP) are found to be equal
at the same point, but this trend of
activity of the equality of production
law is only a temporary phase.
Unit(L) TP AP MP
1 30 30/1= 30 30-0= 30

2 60 60/2= 30 60-30=30

3 90 90/3=30 90-60=30

4 120 120/4=30 120-90=30

5 150 150/5=30 150-120=30

6 180 180/6=30 180-150=30

(3) Decreasing Returns to a Factor
or Law of Diminishing Returns
A condition of diminishing returns to
a factor arises when the marginal
product (MP) of the variable factor
decreases and as a result of which
the total product (TP) increases at a
decreasing rate. In this situation the
marginal cost of production
increases.
Modern View of Law of
Diminishing Returns- When the
quantity of variable factor is increased with
fixed factors in production, then due to
division of labor and specialization,
efficient use of indivisible factor becomes
possible and a point But the ideal
combination of means is established. After
this point, as the units of the variable factor
are increased, the marginal product (MP)
falls. Eminent economists called this
situation as the Law of Diminishing Returns.
 Assumptions of the Law
1) One means of origin is variable and
the other is constant.
2) All units of a variable factor are
homogeneous.
3) There is no change in the technical
level. 4)Fixed means are indivisible.
5) Various means of production are
imperfect substitutes.
6) Fixed resources are limited and
scarce.
Unit(L) TP AP MP
1 50 50/1= 50 50-0= 50

2 38 38/2= 19 38-50= -12

3 28 28/3=9.33 28-38= -10

4 20 20/4=5 20-28= -8

5 15 15/5=3 15-20= -5

6 12 12/6= 2 12-15= -3
According to the table, the law of
variable proportion can be divided
into three stages-
(1) Stage of increasing returns to
production- This first stage has two
parts. In this, both marginal productivity
and average productivity increase in the
initial part of the first stage, But
marginal productivity decrease in the
second part, the average productivity
increases.
(2) Stage of Diminishing Returns - In
the second stage both average production
(AP) and marginal production (MP) are
decreasing. This stage ends at the point
where marginal productivity (MP) becomes
zero. In this stage total output (TP) also
increases but increases at a decreasing
rate because in this stage marginal output
(MP) is decreasing but is positive. Due to
decreasing average production (AP) in this
stage, this stage is also called 'Stage of
Decreasing Average Product'.
(3) Stage of Negative Return
In this third stage of production,
Marginal Product (MP) becomes less
than zero i.e. negative. In this, due to
marginal productivity (MP) becoming
negative, some productivity (TP)
starts decreasing. Due to declining
total productivity and negative
marginal productivity, this stage is
called 'Stage of Negative Returns'.
Unit(L) TP AP MP
1 6 6/1= 6 6-0= 6
2 16 16/2= 8 16-6 = 10
3 30 30/3= 10 30-16= 14
4 40 40/4= 10 40-30= 10
5 45 45/5= 9 45-40= 5
6 48 48/6= 8 48-45 = 3
7 48 48/7= 6.8 48-48= 0
8 44 44/8= 5.5 44-48= -4
9 38 38/9= 4.2 38-44= -6
Causes of Application
of Variable Returns
(1) Fixation of one or more than
one factors of production.
(2) Indivisibility of factors.
(3) Factors ask reduction are not
perfect substitutes to each
other.
(4) Scarcity of factors.
Importance of the Law
(1) Fundamental of
Economics.
(2) Basis of Malthusian
PopulationTheory.
(3) Basis of Marginal
Productivity Theory.
(4) Effects standard of living
residing in an area.
(2) Return to a Scale
Returns to scale indicate the
long-run trend of the production
function. In the long run,
nothing remains constant along
with the origin. All the means
are changeable and they can
also be changed according to
the need.
Scale Saving- There are two types of scale
saving- Internal Saving External Saving
(1) Internal Savings- it is achieved from division of
labour and specialisation. It can be classified as
following:
 Economies of division of labour and
specialisation.
 Technological economies- use of plant
according to requirement, perfect use of
indivisible resources.
 Managerial economics- incentive to increase
efficiency, functional specialisation.
 Marketing economies
 Financial economies
(2) External Savings- These are those
savings which are present due to the expansion
of the industry and whose profit is not
concentrated to one or two firms, but all the
firms get equally in the industry. It can be
classified as following:
 Availability of skilled labor at affordable rates.
 UseUseful development of means of
transport and communication.
 Development of financial institutions.
 Development of many industries in one area.
 Increase in working efficiency of workers
through proper training.
Types of Return to Scale
a) Increasing Returns to Scale - When all
the factors of production are increased
in a certain proportion, then the output
under returns to scale increases by a
proportion greater than that fixed ratio.
For example, when a unit is increased by
10%, production increases by more than
10%. Increasing returns to scale arise
due to increased production scale,
division of labor, and specialization.
b) Constant Returns to Scale -
In this situation, the proportion in
which all the factors of
production are increased, the
output also increases in the
same proportion. If the means of
production are increased by 10%,
the output also increases by
exactly 10%.
C) Decreasing Returns to Scale
In such a situation, the proportion in
which the factors of production are
increased, the production increases in
lesser proportion. The main reason for
this situation to arise is that the size of
the scale is large, due to which the
producer experiences difficulty in the
production work. As a result, internal
and external savings are converted
into losses.
(1) Money Cost- The total
money spent by a firm in the
production of a commodity is called
money cost. In other words, if the
values of all the factors of
production are expressed in money,
then the total expenditure incurred
by the producer in obtaining the
services of these factors of
production is called monetary cost.
Items Included in Monetary Cost
Expenditure on raw materials, wages
and salaries of labour, expenditure on
indivisible large equipment and
machines, interest paid on capital, rent
of land i.e. rent, wear and tear of
machines, management,
advertisement and Transport
expenses, money paid to insurance
companies, general profit, fuel
expenses etc.
Type of Monetary Cost
a) Explicit Cost, b) Implicit Cost
c) Normal Profit
(a) Explicit Cost- All such expenses
which are to be paid by the producer
to others in the course of production
activity are called explicit costs.
Thus, what a producer incurs, i.e.
pays others, for buying or renting the
services of the source of origin, is
called explicit cost.
(b) Implicit Cost These include those
expenses of the producer which do not have
to be paid directly by the producer. It
includes the prices of those services and
resources which the producer uses but does
not pay for them directly. The cost of such
resources and services are known as
embodied costs. For example, an
entrepreneur's self-service is part of the
explicit cost as the entrepreneur does not
make any explicit or indirect payment to
himself.
(c) Normal Profit The minimum
profit required to maintain normal
profit in productive output is called
minimum profit. If this minimum
profit amount is not received by the
producer, then he will stop the
production work and try to become
a salaried himself. So the minimum
profit amount should be added to
the death cost of production.
(2) Real Cost The concept
of real cost was propounded by
Marshall. The hardships and
sacrifices involved in a production
process generate the real cost.
Real costs can also be called
social costs because society has
to face hardships in the
production of goods.
(3) Opportunity Cost Austrian
economists revised the idea of real
cost. He used opportunity cost
instead of actual cost. The
fundamental principle of economics is
that economic resources are limited by
necessity. Therefore, the meaning of
the production of one thing is to be
deprived of the production of another
commodity or things.
 Type Of Production Costs

Short Term Long Term

Costs Costs

LTC LAC LMC

STC SAC SMC
(1) Short Term Cost
There are three types of costs:- a)Total
Cost, b) Average Cost, c) Marginal Cost
a) Total Cost (STC)- Total Cost
of production is the sum of all expenditure
incurred by the producer in producing a
given quantity of a commodity. it has two
types-
(i) Total Fixed Cost, (ii) Toatl Variable
Cost
(i) Toatal Fixed Cost
This type of cost not affected by the
quantity of production. It is always
fixed. This cost also known as
supplementary cost or overhead
cost. These are expenses incurred
on fixed factors of production. For
example, rent of factory building,
interest insurance premium, salaries
to permanent employees etc.
(Ii) Variable Cost- Its size
depends on the quantity of production. As
output increases, so does the variable
cost. It is never constant. Marshall named
it as 'Prime Cost' these are also called
'Direct Cost' or 'Special Cost '. Variable
cost are those cost which are incursed on
the use of variable factors of production.
For example, expenses on raw material,
fuel and power charges ,wages for casual
and temporary labour, transport cost etc.
(2) Average Cost- Per unit of
a commodity is called average cost.
It is the quotient of total cost and
production quantity. In other words,
when the total cost is divided by the
quantity of production, then the
return obtained is called average
cost. It can be expressed by the
following formula-
SAC = STC / Q
It totally depends on the total cost.
For this reason it also has two types.
a) average fixed cost, b) average
variable cost.
a) Average Fixed Cost – In the
short run, if the total fixed cost of
production is divided by the quantity
produced, then the return obtained is
called average fixed cost. Average
fixed cost decreases with increase in
quantity.
It can be expressed by the following
formula-
AFC = TFC / Q
b) Average Variable Cost -
If the total variable cost of production is
divided by the quantity of production, then
the return obtained is called average
variable cost. It can be expressed by the
following formula- AVC = TVC/ Q
The average cost curve is U-shaped
because initially there is an increase in
production, then production becomes
constant and after a certain point,
production begins to decline.
(3) Marginal Cost
It is also often the cost of one additional
unit. When the total cost changes due to
production of an additional number, it is
called marginal cost of that particular
unit. In other words, the return is
obtained by dividing the change in total
cost by the change in output. This is
called marginal cost. It can be expressed
by the following formula:
SMC = ∆TC/ ∆Q or TCn- TC (n-1)
Relationship between SAC & SMC-
(1) Both are calculated on the basis of total
cost of production.
(2) Initially when SAC curve falls, SMC curve
falls to a certain extent but after a stage
begins to rise.
(3) When the SAC curve is at a minimum, the
SMC curve intersects the SAC curve and
moves upwards, in which case such and
the SMC curves are equal.
(4) When SAC curve increases, then the SMC
curve is upwards from such a curve, it
simultaneously grow faster than such a
 Long Term Costs

LTC LAC LMC

(1) Long Run Total Cost
It is the sum of the costs of all the
factors used to produce a good.
Therefore, the long run total cost
curve has the same shape as the
short run cost curve. In the short run,
even if the output is zero, the short
run total cost curve is equal to the
fixed cost. But in the long run all the
means of production are variable.
Therefore, when output becomes zero,
the long run total cost curve also
becomes zero.
(2) Long Run Average Cost
When total long run cost is divided
by the total quantity of production,
the return obtained is called long
run average cost. It can be
expressed by the following formula-
LAC = LTC / Q
LAC = Long Term Average Cost
LTC = Long Term Total Cost
Q = Quantity of Production
(3) Long Run Marginal Cost
The increase in total production cost
in producing an additional unit of
output in the long run is called
marginal cost of that additional unit.
It can be expressed by the following
formula-
LMC = ∆LTC/ ∆Q or LTCn- LTC (n-1)
LMC = Long Term Marginal Cost
∆LTC = Changes in Long Term Total Cost
∆Q = Changes in Quantity of Production
Relationship Between LAC & LMC
(1) Both are calculated on the basis of
total cost of production.
(2) When LAC decreases then LMC
more than decrease compared to LAC.
LMC > LAC
(3) LMC always intersects LAC at its
lowest point i.e. when LAC is
minimum then LAC and LMC are equal
to each other. LMC = LAC
(4) When LAC increases then LMC more
than increases compared to LAC.
LMC < LAC