MODULE II: PRODUCTION AND

COST ANALYSIS

By Asst. Prof. (Eco)

Mrs Tapaswini Nayak.
PRODUCTION ANALYSIS
• Introduction
• Production process involves the transformation of inputs into
output. The inputs could be land, labour, capital, entrepreneurship
etc. and the output could be goods or services. Factors of
production include resource inputs used to produce goods and
services. Economist categorizes input factors into four major
categories such as land, labour, capital and organization.
• Land: Land is heterogeneous in nature. The supply of land is fixed
and it is a permanent factor of production but it is productive only
with the application of capital and labour.
• Labour: The supply of labour is inelastic in nature but it differs in
productivity and efficiency and it can be improved.
• Capital: is a manmade factor and is mobile but the supply is elastic.
It refers to the wealth which is used to produce further
wealth.(Money+ Machine)
• Organization: Management
• Production Function
• Suppose we want to produce apples. We need land, seedlings,
fertilizer, water, labour, and some machinery. These are called
inputs or factors of production. The output is apples. In general a
given output can be produced with different combinations of
inputs. A production function is the functional relationship
between inputs and output. In general, we can represent the
production function for a firm as: Q = f (x1, x2, ....,xn)
• Where Q is the maximum quantity of output, x1, x2, ....,xn are the
quantities of various inputs, and f stands for functional relationship
between inputs and output.
• For the sake of clarity, let us restrict our attention to only one
product produced using either one input or two inputs. If there are
only two inputs, capital (K) and labour (L), we write the production
function as: Q = f (L, K) This function defines the maximum rate of
output (Q) obtainable for a given rate of capital and labour input.
• Economic Efficiency and Technical Efficiency
• We say that a firm is technically efficient
when it obtains maximum level of output
from any given combination of inputs. On the
other hand, we say a firm is economically
efficient, when it produces a given amount of
output at the lowest possible cost for a
combination of inputs provided that the prices
of inputs are given.
• Short Run and Long Run
• All inputs can be divided into two categories: i) fixed inputs
and ii) variable inputs. A fixed input is one whose quantity
cannot be varied during the time under consideration. Such
inputs are classified as fixed and include plant and
equipment of the firm.
• On the other hand, a variable input is one whose amount
can be changed during the relevant period. For example, in
the construction business the number of workers can be
• increased or decreased on short notice. Many ‘builder’
firms employ workers on a daily wage basis and frequent
change in the number of workers is made depending upon
the need. The amount of milk that goes in the production
of butter can be altered quickly and easily and
• is thus classified as a variable input in the
production process. Whether or not an input is
fixed or variable depends upon the time period
involved
• In contrast, the long run is that period over which
all the firms’ inputs are variable. In other words,
the firm has the flexibility to adjust or change its
environment. In the long run, input proportions
can be varied considerably. Long-run production
function shows the maximum quantity of output
that can be produced by a set of inputs, assuming
the firm is free to vary the amount of all the
inputs being used.
• Production Function with One Variable Input
• Consider the simplest two input production process -
where one input with a fixed quantity and the other
input with is variable quantity. Suppose that the fixed
input is the service of machine tools, the variable input
is labour, and the output is a metal part. The
production function in this case can be represented as:
Q = f (K, L) Where Q is output of metal parts, K is
service of five machine tools (fixed input), and L is
labour (variable input). The variable input can be
combined with the fixed input to produce different
levels of output Total, Average, and Marginal Products.
• The concept of Average, Marginal & Total Product
• Total Product: It is the total output resulting from the efforts
of all the factors of production combined together at any
time.
• Average Product: It is the total product per unit of variable
factor or ratio of total product to the total quantity of an input
used to produce the product.
• Marginal Product: It is the change in total product per unit
due to change in the quantity of variable factors. Marginal
product (MP)
• Marginal product (MP) = change in output (Total Product)
resulting from a unit change in a variable input
• Average product (AP) = Total Product per unit of input used

• Relationship between TP, MP and AP Curves

• Both average product and marginal product are derived from the
total product. Average product is obtained by dividing total
product by the number of units of variable factor and marginal
product is the change in total product resulting from a unit
increase in the quantity of variable factor. The various points of
relationship between average product and marginal product can
be summed up as follows: (i) when average product rises as a
result of an increase in the quantity of variable input, marginal
product is more than the average product. (ii) When average
product falls, marginal product is less than the average product.
(iii) when average product is maximum, marginal product is
equal to average product. In other words, the marginal product
curve cuts the average product curve at its maximum.
• In short:
• When AP rises, MP > AP
• When AP falls, MP < AP
• When AP is maximized, MP=AP
• The Law of Variable Proportion
• The law of variable proportions or the law of
diminishing returns examines the production function
with one factor variable, keeping quantities of other
factors fixed. In other words, it refers to input-output
relationship, when the output is increased by varying
the quantity of one input. This law operates in the
short run ‘when all the factors of production cannot be
increased or decreased simultaneously (for example,
we cannot build a plant or shift a plant in the short
run).
• Assumptions of the Law
• The state of technology is assumed to be given and
unchanged.
• There must be some inputs whose quantity is kept fixed.
• It is assumed that all variable factors are equally efficient.
• The law is not applicable when two inputs are used in a
fixed proportion
• The law states that as we increase the quantity of one input
which is combined with other fixed inputs, the output of
the variable factor may increase more than proportionately
in the initial stage of production but finally, it will not
increase proportionately. Which means the marginal
physical productivity of the variable input eventually
decline. In other words, as additional units of a variable
input are combined with a fixed input, after some point the
additional output (i.e., marginal product) starts to diminish.
• Explanation: When the various factors are required to
be used in rigidly fixed proportions, then the increase
in one factor would not lead to any increase in output,
that is, the marginal product of the factor will then be
zero and not diminishing. It may, however, be pointed
out that products requiring fixed proportions of factors
are quiet uncommon. Thus, the law of variable
proportion applies to most of the cases of production
in the real world.
• The law of variable proportions is illustrated in Table
16.1.and Fig. 16.3. We shall first explain it by
considering Table 16.1. Assume that there is a given
fixed amount of land, with which more units of the
variable factor labour, is used to produce agricultural
output.
• With a given fixed quantity of land, as a farmer
raises employment of labour from one unit to 7
units, the total product increases from 80
quintals to 504 quintals of wheat. Beyond the
employment of 8 units of labour, total product
diminishes. It is worth noting that up to the use
of 3 units of labour, total product increases at an
increasing rate.
• This fact is clearly revealed from column 3 which
shows successive marginal products of labour as
extra units of labour are used. Marginal product
of labour, it may be recalled, is the increment in
total output due to the use of an extra unit of
labour.
• It will be seen from Col. 3 of Table 16.1, that the
marginal product of labour initially rises and beyond
the use of three units of labour, it starts diminishing.
Thus when 3 units of labour are employed, marginal
product of labour is 100 and with the use of 4th and
5th units of labour marginal product of labour falls to
98 and 62 respectively.
• Beyond the use of eight units of labour, total product
diminishes and therefore marginal product of labour
becomes negative. As regards average product of
labour, it rises up to the use of fourth unit of labour
and beyond that it is falling throughout.
• Three Stages of the Law of Variable Proportions:
• The behaviour of output when the varying quantity of
one factor is combined with a fixed quantity of the
other can be divided into three distinct stages. In order
to understand these three stages it is better to
graphically illustrate the production function with one
factor variable.
• This has been done in Fig. 16.3. In this figure, on the X-
axis the quantity of the variable factor is measured and
on the F-axis the total product, average product and
marginal product are measured. How the total product,
average product and marginal product a variable factor
change as a result of the increase in its quantity, that is,
by increasing the quantity of one factor to a fixed
quantity of the others will be seen from Fig. 16.3.
• In the top panel of this figure, the total product
curve TP of variable factor goes on increasing to a
point and alter that it starts declining. In the
bottom pane- average and marginal product
curves of labour also rise and then decline;
marginal product curve starts declining earlier
than the average product curve.
• The behaviour of these total, average and
marginal products of the variable factor as a
result of the increase in its amount is generally
divided into three stages which are explained
below:
• Stage 1: Stage of Increasing Returns :
• In this stage, total product curve TP increases at an
increasing rate up to a point. In Fig. 16.3. from the
origin to the point F, slope of the total product curve TP
is increasing, that is, up to the point F, the total product
increases at an increasing rate (the total product curve
TP is concave upward up to the point F), which means
that the marginal product MP of the variable factor is
rising.
• From the point F onwards during the stage 1, the total
product curve goes on rising but its slope is declining
which means that from point F onwards the total
product increases at a diminishing rate (total product
curve TP is concave down-ward), i.e., marginal product
falls but is positive.
• The point F where the total product stops
increasing at an increasing rate and starts
increasing at the diminishing rate is called the
point of inflection. Vertically corresponding to
this point of inflection marginal product is
maximum, after which it starts diminishing. Thus,
marginal product of the variable factor starts
diminishing beyond OL amount of the variable
factor. That is, law of diminishing returns starts
operating in stage 1 from point D on the MP
curve or from OL amount of the variable factor
used.
• Thus, during stage 1, whereas marginal
product curve of a variable factor rises in a
part and then falls, the average product curve
rises throughout. In the first stage, the
quantity of the fixed factor is too much
relative to the quantity of the variable factor
so that if some of the fixed factor is
withdrawn, the total product will increase.
Thus, in the first stage marginal product of the
fixed factor is negative.
• Stage 2: Stage of Diminishing Returns:
• In stage 2, the total product continues to increase
at a diminishing rate until it reaches its maximum
point H where the second stage ends. In this
stage both the marginal product and the average
product of the variable factor are diminishing but
remain positive.
• At the end of the second stage, that is, at point M
marginal product of the variable factor is zero
(corresponding to the highest point H of the total
product curve TP). Stage 2 is very crucial and
important because as will be explained below the
firm will seek to produce in its range.
• Stage 3: Stage of Negative Returns:
• In stage 3 with the increase in the variable factor the total product
declines and therefore the total product curve TP slopes downward.
As a result, marginal product of the variable factor is negative and
the marginal product curve MP goes below the X-axis. In this stage
the variable factor is too much relative to the fixed factor. This stage
is called the stage of negative returns, since the marginal product of
the variable factor is negative during this stage.
• It may be noted that stage 1 and stage 3 are completely
symmetrical. In stage 1 the fixed factor is too much relative to the
variable factor. Therefore, in stage 1, marginal product of the fixed
factor is negative. On the other hand, in stage 3 the variable factor
is too much relative to the fixed factor. Therefore, in stage 3, the
marginal product of the variable factor is negative.
• The 3rd phases of the law starts when the number of a variable,
factor becomes, too excessive relative, to the fixed factors, A
producer cannot operate in this stage because total production
declines with the employment of additional labor.
• As far as the applicability of the law of variable proportions is concerned,
it has been found to be more relevant to agriculture.
• Importance:
• The law of variable proportions has vast general applicability. Briefly:
• (i) It is helpful in understanding clearly the process of production. It
explains the input output relations. We can find out by-how much the
total product will increase as a result of an increase in the inputs.
• (ii) The law tells us that the tendency of diminishing returns is found in all
sectors of the economy which may be agriculture or industry.
• (iii) The law tells us that any increase in the units of variable factor will
lead to increase in the total product at a diminishing rate. The elasticity of
the substitution of the variable factor for the fixed factor is not infinite.
From the law of variable proportions, it may not be understood that there
is no hope for raising the standard of living of mankind. The fact, however,
is that we can suspend the operation of diminishing returns by continually
improving the technique of production through the progress in science
and technology.
• Production Function with Two Variable Inputs
• In the long run, a firm has enough time to change
the amount of all its inputs. In the long run,
supply of both the inputs is supposed to be
elastic and firms can hire larger quantities of both
labour and capital. With larger employment of
capital and labour, the scale of production
increases. The technological relationship
between changing scale of inputs and output is
explained under the law of returns to scale. The
laws of return to scale can be explained through
the production function and isoquant curve
technique.
• Iso-Quant Curve : Definitions, Assumptions and
Properties
• The term Iso-quant or Iso-product is composed of two
words, Iso = equal, quant = quantity or product =
output.
• Thus it means equal quantity or equal product.
Different factors are needed to produce a good. These
factors may be substituted for one another.
• Definitions:
• “The Iso-product curves show the different
combinations of two resources with which a firm can
produce equal amount of product.” Bilas
• “Iso-product curve shows the different input
combinations that will produce a given output.”
Samuelson
• Assumptions:
• The main assumptions of Iso-quant curves are as follows:
• 1. Two Factors of Production:
• Only two factors are used to produce a commodity.
• 2. Divisible Factor:
• Factors of production can be divided into small parts.
• 3. Constant Technique:
• Technique of production is constant or is known before hand.
• 4. Possibility of Technical Substitution:
• The substitution between the two factors is technically possible.
That is, production function is of ‘variable proportion’ type rather
than fixed proportion.
• 5. Efficient Combinations:
• Under the given technique, factors of production can be used with
maximum efficiency.
• Iso-Product Schedule:
• Let us suppose that there are two factor inputs—
labour and capital. An Iso-product schedule
shows the different combination of these two
inputs that yield the same level of output as
shown in table 1.
• The table 1 shows that the five combinations of
labour units and units of capital yield the same
level of output, i.e., 200 meters of cloth. Thus,
200 meters cloth can be produced by combining.
• (a) 1 units of labour and 15 units of capital
• (b) 2 units of labour and 11 units of capital
• (c) 3 units of labour and 8 units of capital
• (d) 4 units of labour and 6 units of capital
• (e) 5 units of labour and 5 units of capital
• Iso-Product Curve:
• From the above schedule iso-product curve
can be drawn with the help of a diagram. An.
equal product curve represents all those
combinations of two inputs which are capable
of producing the same level of output. The
Fig. 1 shows the various combinations of
labour and capital which give the same
amount of output. A, B, C, D and E.
• Iso-Product Map or Equal Product Map:
• An Iso-product map shows a set of iso-product curves.
They are just like contour lines which show the
different levels of output. A higher iso-product curve
represents a higher level of output. In Fig. 2 we have
family iso-product curves, each representing a
particular level of output.
• The iso-product map looks like the indifference of
consumer behaviour analysis. Each indifference curve
represents particular level of satisfaction which cannot
be quantified. A higher indifference curve represents a
higher level of satisfaction but we cannot say by how
much the satisfaction is more or less. Satisfaction or
utility cannot be measured.
• An iso-product curve, on the other hand,
represents a particular level of output. The
level of output being a physical magnitude is
measurable. We can therefore know the
distance between two equal product curves.
While indifference curves are labeled as IC1,
IC2, IC3, etc., the iso-product curves are
labelled by the units of output they represent
-100 meters, 200 meters, 300 meters of cloth
and so on.
• Properties of Iso-Product Curves:
• The properties of Iso-product curves are
summarized below:
• 1. Iso-Product Curves Slope Downward from Left
to Right:
• They slope downward because MRTS of labour
for capital diminishes. When we increase labour,
we have to decrease capital to produce a given
level of output.
• The downward sloping iso-product curve can be
explained with the help of the following figure:
• The Fig. 3 shows that when the amount of labour is
increased from OL to OL1, the amount of capital has to be
decreased from OK to OK1, The iso-product curve (IQ) is
falling as shown in the figure.
• The possibilities of horizontal, vertical, upward sloping
curves can be ruled out with the help of the following
figure 4:
• (i) The figure (A) shows that the amounts of both the
factors of production are increased- labour from L to Li
and capital from K to K1. When the amounts of both
factors increase, the output must increase. Hence the
IQ curve cannot slope upward from left to right.
• (ii) The figure (B) shows that the amount of labour is
kept constant while the amount of capital is increased.
The amount of capital is increased from K to K 1. Then
the output must increase. So IQ curve cannot be a
vertical straight line.
• (iii) The figure (C) shows a horizontal curve. If it is
horizontal the quantity of labour increases, although
the quantity of capital remains constant. When the
amount of capital is increased, the level of output must
increase. Thus, an IQ curve cannot be a horizontal line.
• 2. Isoquants are Convex to the Origin:
• Like indifference curves, isoquants are convex to the origin. In order
to understand this fact, we have to understand the concept of
diminishing marginal rate of technical substitution (MRTS), because
convexity of an isoquant implies that the MRTS diminishes along
the isoquant. The marginal rate of technical substitution between L
and K is defined as the quantity of K which can be given up in
exchange for an additional unit of L. It can also be defined as the
slope of an isoquant.
• It can be expressed as:
• MRTSLK = – ∆K/∆L = dK/ dL
• Where ∆K is the change in capital and AL is the change in labour.
• Equation (1) states that for an increase in the use of labour, fewer
units of capital will be used. In other words, a declining MRTS refers
to the falling marginal product of labour in relation to capital. To put
it differently, as more units of labour are used, and as certain units
of capital are given up, the marginal productivity of labour in
relation to capital will decline.
• This fact can be explained in Fig. 5. As we move from
point A to B, from B to C and from C to D along an
isoquant, the marginal rate of technical substitution
(MRTS) of capital for labour diminishes. Every time
labour units are increasing by an equal amount (AL) but
the corresponding decrease in the units of capital (AK)
decreases.
• Thus it may be observed that due to falling MRTS, the
isoquant is always convex to the origin.
• 3. Two Iso-Product Curves Never Cut Each Other:
• As two indifference curves cannot cut each other,
two iso-product curves cannot cut each other. In
Fig. 6, two Iso-product curves intersect each
other. Both curves IQ1 and IQ2 represent two
levels of output. But they intersect each other at
point A. Then combination A = B and combination
A= C. Therefore B must be equal to C. This is
absurd. B and C lie on two different iso-product
curves. Therefore two curves which represent
two levels of output cannot intersect each other.
• 4. Higher Iso-Product Curves Represent
Higher Level of Output:
• A higher iso-product curve represents a
higher level of output as shown in the figure
7 given below:
• In the Fig. 7, units of labour have been taken on OX axis while on
OY, units of capital. IQ 1 represents an output level of 100 units
whereas IQ2 represents 200 units of output.
• 5. Isoquants Need Not be Parallel to Each Other:
• It so happens because the rate of substitution in different isoquant
schedules need not be necessarily equal. Usually they are found
different and, therefore, isoquants may not be parallel as shown in
Fig. 8. We may note that the isoquants Iq1 and Iq2are parallel but
the isoquants Iq3 and Iq4 are not parallel to each other.
• 6. No Isoquant can Touch Either Axis:
• If an isoquant touches X-axis, it would mean that the
product is being produced with the help of labour alone
without using capital at all. These logical absurdities for OL
units of labour alone are unable to produce anything.
Similarly, OC units of capital alone cannot produce anything
without the use of labour. Therefore as seen in figure 9, IQ
and IQ1 cannot be isoquants.
• 7. Each Isoquant is Oval-Shaped.
• It means that at some point it begins to recede from each axis. This
shape is a consequence of the fact that if a producer uses more of
capital or more of labour or more of both than is necessary, the
total product will eventually decline. The firm will produce only in
those segments of the isoquants which are convex to the origin and
lie between the ridge lines. This is the economic region of
production. In Figure 10, oval shaped isoquants are shown.
• Curves OA and OB are the ridge lines and in between them
only feasible units of capital and labour can be employed to
produce 100, 200, 300 and 400 units of the product. For
example, OT units of labour and ST units of the capital can
produce 100 units of the product, but the same output can
be obtained by using the same quantity of labour T and less
quantity of capital VT.
• Thus only an unwise entrepreneur will produce in the
dotted region of the iso-quant 100. The dotted segments of
an isoquant are the waste- bearing segments. They form
the uneconomic regions of production. In the up dotted
portion, more capital and in the lower dotted portion more
labour than necessary is employed. Hence GH, JK, LM, and
NP segments of the elliptical curves are the isoquants.
• Principle of Marginal Rate of Technical Substitution :
• The principle of marginal rate of technical substitution (MRTS or
MRS) is based on the production function where two factors can be
substituted in variable proportions in such a way as to produce a
constant level of output. The marginal rate of technical substitution
between two factors C (capital) and L (labour), MRTS LC is the rate at
which L can be substituted for C in the production of good X
without changing the quantity of output.
• As we move along an isoquant downward to the right, each point
on it represents the substitution of labour for capital. MRTS is the
loss of certain units of capital which will just be compensated for by
additional units of labour at that point. In other words, the marginal
rate of technical substitution of labour for capital is the slope or
gradient of the isoquant at a point. Accordingly, slope = MRTS LC =
AC/AL. This can be understood with the aid of the isoquant
schedule, in Table 2.
• The above table 2 shows that in the second
combination to keep output constant at 100
units, the reduction of 3 units of capital requires
the addition of 5 units of labour, MRTSLC = 3 : 5. In
the third combination, the loss of 2 units of
capital is compensated for by 5 more units of
labour, and so on.
• In Fig. 11 at point B, the marginal rate of technical
substitution is AS/SB, t point G, it is BT/TG and at H, it is
GR/RH. The isoquant AH reveals that as the units of labour
are successively increased into the factor- combination to
produce 100 units of good X, the reduction in the units of
capital becomes smaller and smaller.
• It means that the marginal rate of technical
substitution is diminishing. This concept of the
diminishing marginal rate of technical substitution
(DMRTS) is parallel to the principle of diminishing
marginal rate of substitution in the indifference curve
technique. This tendency of diminishing marginal
substitutability of factors is apparent from Table 2 and
Figure 11.
• The MRTSLc continues to decline from 3: 5 to 1: 5
whereas in the Figure 11 the vertical lines below the
triangles on the isoquant become smaller and smaller
as we move downward so that GR < BT < AS. Thus, the
marginal rate of technical substitution diminishes as
labour is substituted for capital. It means that the
isoquant must be convex to the origin at every point.
• Iso-Cost Line:
• The iso-cost line is similar to the price or budget line of
the indifference curve analysis. It is the line which
shows the various combinations of factors that will
result in the same level of total cost. It refers to those
different combinations of two factors that a firm can
obtain at the same cost. Just as there are various
isoquant curves, so there are various iso-cost lines,
corresponding to different levels of total output.
• Definition:
• Iso-cost line may be defined as the line which shows
different possible combinations of two factors that the
producer can afford to buy given his total expenditure
to be incurred on these factors and price of the factors.
• Explanation: The concept of iso-cost line can be explained
with the help of the following table 3 and Fig. 12. Suppose the
producer’s budget for the purchase of labour and capital is
fixed at Rs. 100. Further suppose that a unit of labour cost the
producer Rs. 10 while a unit of capital Rs. 20.
• From the table cited above, the producer can
adopt the following options:
• (i) Spending all the money on the purchase of
labour, he can hire 10 units of labour (100/10 =
10)
• (ii) Spending all the money on the capital he may
buy 5 units of capital.
• (iii) Spending the money on both labour and
capital, he can choose between various possible
combinations of labour and capital such as (4, 3)
(2, 4) etc.
• Diagram Representation:
• In Fig. 12, labour is given on OX-axis and capital on OY-axis. The
points A, B, C and D convey the different combinations of two
factors, capital and labour which can be purchased by spending Rs.
100. Point A indicates 5 units of capital and no unit of labour, while
point D represents 10 units of labour and no unit of capital. Point B
indicates 4 units of capital and 2 units of labour. Likewise, point C
represents 4 units of labour and 3 units of capital.
• Iso-Cost Curves:
• After knowing the nature of isoquants which represent the output
possibilities of a firm from a given combination of two inputs. We
further extend it to the prices of the inputs as represented on the
isoquant map by the iso-cost curves.
• These curves are also known as outlay lines, price lines, input-price
lines, factor-cost lines, constant-outlay lines, etc. Each iso-cost
curve represents the different combinations of two inputs that a
firm can buy for a given sum of money at the given price of each
input.
• Figure 13 (A) shows three iso-cost curves each represents a total
outlay of 50, 75 and 100 respectively. The firm can hire OC of capital
or OD of labour with Rs. 75. OC is 2/3 of OD which means that the
price of a unit of labour is 1/2 times less than that of a unit of
capital.
• The line CD represents the price ratio of capital and labour. Prices of
factors remaining the same, if the total outlay is raised, the iso-cost
curve will shift upward to the right as EF parallel to CD, and if the
total outlay is reduced it will shift downwards to the left as AB.
• The iso-costs are straight lines because factor prices remain the
same whatever the outlay of the firm on the two factors.
• The iso-cost curves represent the locus of all combinations of the
two input factors which result in the same total cost. If the unit cost
of labour (L) is w and the unit cost of capital (C) is r, then the total
cost: TC = wL + rC. The slope of the iso-cost line is the ratio of prices
of labour and capital i.e., w/r.
• The point where the iso-cost line is tangent to an isoquant shows the least
cost combination of the two factors for producing a given output. If all
points of tangency like LMN are joined by a line, it is known as an output-
factor curve or least-outlay curve or the expansion path of a firm.
• It shows how the proportions of the two factors used might be changed as
the firm expands. For example, in Figure 13 (A) the proportions of capital
and labour used to produce 200 (IQ1) units of the product are different
from the proportions of these factors used to produce 300 (IQ2) units or
100 units at the lowest cost.
• Like the price-income line in the indifference curve analysis, a relative
cheapening of one of the factors to that of another will extend the iso-cost
line to the right. If one of the factors becomes relatively dearer, the iso-
cost line will contract inward to the left.
• Given the price of capital, if the price of labour falls, the isocost line EF in
Panel (B) of figure 13 will extend to the right as EG and if the price of
labour rises, the iso-cost line EF will contract inward to the left as EH, if
the equilibrium points L, M, and N are joined by a line. It will be called the
price-factor curve.
• Producer’s Equilibrium or Optimization (With
Diagram)
• Producer’s equilibrium or optimization occurs when he
earns maximum profit with optimal combination of
factors. A profit maximization firm faces two choices of
optimal combination of factors (inputs).
• 1. To minimize its cost for a given output; and
• 2. To maximize its output for a given cost.
• Thus the least cost combination of factors refers to a
firm producing the largest volume of output from a
given cost and producing a given level of output with
the minimum cost when the factors are combined in an
optimum manner. We study these cases separately.
• Cost-Minimization for a Given Output:
• In the theory of production, the profit maximization
firm is in equilibrium when, given the cost-price
function, it maximizes its profits on the basis of the
least cost combination of factors. For this, it will choose
that combination which minimizes its cost of
production for a given output. This will be the optimal
combination for it.
• Assumptions:
• This analysis is based on the following assumptions:
• 1. There are two factors, labour and capital.
• 2. All units of labour and capital are homogeneous.
• 3. The prices of units of labour (w) and that of capital (r) are given
and constant.
• 4. The cost outlay is given.
• 5. The firm produces a single product.
• 6. The price of the product is given and constant.
• 7. The firm aims at profit maximization.
• 8. There is perfect competition in the factor market.
• Explanation:
• Given these assumptions, the point of least-cost combination of
factors for a given level of output is where the isoquant curve is
tangent to an iso-cost line. In Figure 17, the iso-cost line GH is
tangent to the isoquant 200 at point M.
• The firm employs the combination of ОС of capital and OL of labour
to produce 200 units of output at point M with the given cost-
outlay GH. At this point, the firm is minimizing its cost for producing
200 units.
• Any other combination on the isoquant 200, such as R or T, is on the
higher iso-cost line KP which shows higher cost of production. The
iso-cost line EF shows lower cost but output 200 cannot be attained
with it. Therefore, the firm will choose the minimum cost point M
which is the least-cost factor combination for producing 200 units
of output.
• M is thus the optimal combination for the firm. The point of
tangency between the iso-cost line and the isoquant is an
important first order condition but not a necessary condition for
the producer’s equilibrium.
• There are two essential or second order conditions for the
equilibrium of the firm:
• 1. The first condition is that the slope of the iso-cost line must equal
the slope of the isoquant curve. The slope of the iso-cost line is
equal to the ratio of the price of labour (w) to the price of capital (r)
i.e.… W/r. The slope of the isoquant curve is equal to the marginal
rate of technical substitution of labour and capital (MRTS LC) which
is, in turn, equal to the ratio of the marginal product of labour to
the marginal product of capital (MPL/MPC).
• Thus the equilibrium condition for optimality can be written as:
• W/r = MPL/MPC = MRTSLC
• 2. The second condition is that at the point of tangency, the isoquant
curve must he convex to the origin. In other words, the marginal rate of
technical substitution of labour for capital (MRTSLC) must be diminishing
at the point of tangency for equilibrium to be stable. In Figure 18, S cannot
be the point of equilibrium, for the isoquant IQ1 is concave where it is
tangent to the iso-cost line GH.
• At point S, the marginal rate of technical. substitution between the two
factors increases if move to the right or left on the curve lQ1 .Moreover,
the same output level can be produced at a lower cost CD or EF and there
will be a corner solution either at С or F. If it decides to produce at EF cost,
it can produce the entire output with only OF labour. If, on the other hand,
it decides to produce at a still lower cost CD, the entire output can be
produced with only ОС capital.
• Both the situations are impossibilities because nothing can be produced
either with only labour or only capital. Therefore, the firm can produce the
same level of output at point M where the isoquant curve IQ is convex to
the origin and is tangent to the iso-cost line GH. The analysis assumes that
both the isoquants represent equal level of output IQ = IQ1 = 200.
• Output-Maximization for a given Cost:
• The firm also maximizes its profits by maximizing its output,
given its cost outlay and the prices of the two factors. This
analysis is based on the same assumptions, as given above.
• The conditions for the equilibrium of the firm are the same,
as discussed above.
• 1. The firm is in equilibrium at point P where the isoquant
curve 200 is tangent to the iso-cost line CL in Figure 19.
• At this point, the firm is maximizing its output level of 200
units by employing the optimal combination of OM of
capital and ON of labour, given its cost outlay CL. But it
cannot be at points E or F on the iso-cost line CL, since both
points give a smaller quantity of output, being on the
isoquant 100, than on the isoquant 200.
• The firm can reach the optimal factor combination level of
maximum output by moving along the iso-cost line CL from
either point E or F to point P. This movement involves no
extra cost because the firm remains on the same iso-cost
line.
• The firm cannot attain a higher level of output such as
isoquant 300 because of the cost constraint. Thus the
equilibrium point has to be P with optimal factor
combination OM + ON. At point P, the slope of the isoquant
curve 200 is equal to the slope of the iso-cost line CL. It
implies that w/r = MPL/MPC = MRTSLC
• 2. The second condition is that the isoquant curve must be
convex to the origin at the point of tangency with the iso-
cost line, as explained above in terms of Figure 18.
• Expansion Path:
• As financial resources of a firm increase, it would like
to increase its output. The output can only be
increased if there is no increase in the cost of the
factors. In other words, the level of total output of a
firm increases with increase in its financial resources.
• By using different combinations of factors a firm can
produce different levels of output. Which of the
optimum combinations of factors will be used by the
firm is known as Expansion Path. It is also called Scale-
line.
• “Expansion path is that line which reflects least cost
method of producing different levels of output.”
Stonier and Hague
• Expansion path can be explained with the help of Fig. 16. On OX-
axis units of labour and on OY-axis units of capital are given.
• The initial iso-cost line of the firm is AB. It is tangent to IQ at point E
which is the initial equilibrium of the firm. Supposing the cost per
unit of labour and capital remains unchanged and the financial
resources of the firm increase.
• As a result, firm’s new iso-cost-line shifts to the right as CD. New
iso-cost line CD will be parallel to the initial iso-cost line. CD touches
IQ1 at point E1 which will constitute the new equilibrium point. If
the financial resources of the firm further increase, but cost of
factors remaining the same, the new iso-cost line will be GH.
• It will be tangent to Iso-quant curve IQ2 at point E2 which will be
the new equilibrium point of the firm. By joining together
equilibrium points E, E1 and E2, one gets a line called scale-line or
Expansion Path. It is because a firm expands its output or scale of
production in conformity with this line.
• Law of Return to Scale and It’s Types (With Diagram)
• The law of returns to scale explains the proportional
change in output with respect to proportional change
in inputs.
• In other words, the law of returns to scale states when
there are a proportionate change in the amounts of
inputs, the behavior of output also changes.
• The degree of change in output varies with change in
the amount of inputs. For example, an output may
change by a large proportion, same proportion, or
small proportion with respect to change in input.
• On the basis of these possibilities, law of returns can be
classified into three categories:
• i. Increasing returns to scale
• ii. Constant returns to scale
• iii. Diminishing returns to scale
• 1. Increasing Returns to Scale:
• If the proportional change in the output of an organization
is greater than the proportional change in inputs, the
production is said to reflect increasing returns to scale. For
example, to produce a particular product, if the quantity of
inputs is doubled and the increase in output is more than
double, it is said to be an increasing returns to scale. When
there is an increase in the scale of production, the average
cost per unit produced is lower. This is because at this stage
an organization enjoys high economies of scale.
• Figure- 3.20 shows the increasing returns to
scale:
• The distance between consecutive multiple-isoquants decreases. By
doubling the inputs, output is more than doubled. In figure 3.20 doubling
K and L leads to point b’ which lies on an isoquant above the one denoting
2X. Returns to scale are usually assumed to be the same everywhere on
the production surface, that is, the same along all the expansion-product
lines. All processes are assumed to show the same returns over all ranges
of output either constant returns everywhere, decreasing returns
everywhere, or increasing returns everywhere.
• Some of the factors are as follows:
• i. Technical and managerial indivisibility:
• Implies that there are certain inputs, such as machines and human
resource, used for the production process are available in a fixed amount.
These inputs cannot be divided to suit different level of production. For
example, an organization cannot use the half of the turbine for small scale
of production.
• Similarly, the organization cannot use half of a manager to achieve small
scale of production. Due to this technical and managerial indivisibility, an
organization needs to employ the minimum quantity of machines and
managers even in case the level of production is much less than their
capacity of producing output. Therefore, when there is increase in inputs,
there is exponential increase in the level of output.
• ii. Specialization:
• Implies that high degree of specialization of man and machinery helps in
increasing the scale of production. The use of specialized labor and
machinery helps in increasing the productivity of labor and capital per
unit. This results in increasing returns to scale.
• iii. Concept of Dimensions:
• Refers to the relation of increasing returns to scale to the concept of
dimensions. According to the concept of dimensions, if the length and
breadth of a room increases, then its area gets more than doubled.
• For example, length of a room increases from 15 to 30 and breadth
increases from 10 to 20. This implies that length and breadth of room get
doubled. In such a case, the area of room increases from 150 (15*10) to
600 (30*20), which is more than doubled.
• 2. Constant Returns to Scale:
• The production is said to generate constant returns to scale when the
proportionate change in input is equal to the proportionate change in
output. For example, when inputs are doubled, so output should also be
doubled, then it is a case of constant returns to scale.
• Figure-3.18 shows the constant returns to
scale:
• Along any isocline the distance between
successive multiple- isoquants is constant.
Doubling the factor inputs achieves double the
level of the initial output; trebling inputs achieves
treble output, and so on (figure 3.18).
• 3. Diminishing Returns to Scale:
• Diminishing returns to scale refers to a situation
when the proportionate change in output is less
than the proportionate change in input. For
example, when capital and labor is doubled but
the output generated is less than doubled, the
returns to scale would be termed as diminishing
returns to scale.
• Figure-3.19 shows the diminishing returns to
scale:
• The distance between consecutive multiple-
isoquants increases. By doubling the inputs,
output increases by less than twice its original
level. In figure 3.19 the point a’, defined by 2K
and 2L, lies on an isoquant below the one
showing 2X.
• Diminishing returns to scale is due to
diseconomies of scale, which arises because of
the managerial inefficiency. Generally, managerial
inefficiency takes place in large-scale
organizations. Another cause of diminishing
returns to scale is limited natural resources. For
example, a coal mining organization can increase
the number of mining plants, but cannot increase
output due to limited coal reserves.
 COST ANALYSIS:
• In managerial economics another area which is of great
importance is cost of production. The cost which a firm
incurs in the process of production of its goods and
services is an important variable for decision making.
Total cost together with total revenue determines the
profit level of a business. In order to maximize profits a
firm endeavors to increase its revenue and lower its
costs.
• Cost Concepts: Costs play a very important role in
managerial decisions especially when a selection
between alternative courses of action is required. It
helps in specifying various alternatives in terms of their
quantitative values. Following are various types of cost
concepts:
• TYPES OF COSTS
• Costs can be categorized into seven types:
• 1) Accounting and economic costs: To an accountant or any
other individual other than an economist, cost refers to the
monetary expenses incurred by a firm in the course of
producing a commodity. Accounting cost (money or
explicit) is the total monetary expenses incurred by a firm
in producing a commodity and this is what an entrepreneur
takes into consideration in making payments for various
items including factors of production (wages and salaries
of labour), purchase of raw materials, expenditures on
machine, including on capital goods, rents on buildings,
interest on capital borrowed, expenditure on power, light,
fuel, advertisement, etc. Money costs are known also as
explicit costs that an accountant records in the firm's books
of account. Explicit costs are the payments to outside
suppliers of inputs.
• To the economists, the cost of any good or service is
the totality of all sacrifices made to bring the good or
service into existence. Therefore, the “economic cost”
(opportunity cost of production) is made up of both
the explicit and the implicit cost. Implicit cost, are the
imputed value of the entrepreneur’s own resources
and services. According to Salvatore, “implicit costs are
the value of owned inputs used by the firm in its
production process”. These include the salary of the
owner-manager who is content with having normal
profits but does not receive any salary, the estimated
rent of the building (if it belongs to the entrepreneur),
etc. While explicit cost is monetarily valued, implicit
cost is the forgone alternative or opportunity cost
which the accounting cost didn't take note of.
• 2) Production cost: In the production process, many fixed
and variable factors (inputs) usually capital equipments are
used. They are being employed at various prices. The
expenditures incurred on them are the total costs of
production of a firm. Such costs are divided into two: total
variable cost and total fixed costs
• 3) Real costs: It tells us what lies behind money cost, since
money cost are expenses of production from the point of
view of the producer. Thus, according to Marshall, the
efforts and sacrifices made by various members of the
society in producing a commodity are the real costs of
production. The efforts and sacrifices made by business
men to save and invest, workers foregoing leisure, and by
the landlords in the use of land, all these constitute real
cost.
• 4) Opportunity cost: This is the cost of the resources
foregone, in order to get or obtain another. The
opportunity cost of anything is the next best alternative
that could be produced instead by the same factors or by
an equivalent group of factors, costing the same amount of
money. E.g. the real cost of labour is what it could get in
some alternative employment. Opportunity cost includes
both explicit and implicit cost.
• 5) Private and social cost: Private costs are the costs
incurred by a firm in producing a commodity or service. It
includes both implicit and explicit cost. However, the
production activities of a firm may lead to economic benefit
or harm for others. For instance, production of
commodities like steel, rubber and chemical pollute the
environment which leads to social costs. The society suffers
some inconveniences as a result of the production exercise
embarked upon by the firm.
• 6) Sunk costs: A sunk cost is a cost which has already been spent
but not recoverable in any case and future business decisions
should not be affected by past spent.
• Spending on researching, equipment or machinery buying, rent,
payroll, marketing or advertising expenses is the main examples of
sunk cost. Equipment or machinery which only produces only
specific products or spending of processes for customized products
for specific customers are examples of sunk cost.
• Some industries such as drug manufacturing, research companies,
heavy machinery manufacturing would have more sunk costs, so it
would have a major barrier of entry for new entrants in these
industries.
• Sunk cost should not be taken into account when making any
future decision for the same or different product or service.
• 7) Incremental cost: The Incremental Cost refers to the additional
cost that a company incurs in undertaking certain actions such as
expanding the level of production or adding a new variety of
product to the product line, etc. s
• The concept of incremental cost is quite similar to the concept of
marginal cost, but with a relatively wider connotation. The marginal
cost refers to the addition in the total cost due to the production of
one more unit of a product, generally the next unit. But the
incremental costs refers to the total additional cost incurred in
taking a certain action, for example, changing the production level,
not necessarily producing the next unit of a product but instead any
‘nth’ unit of a product.
• The incremental cost is more realistic as it is based on the fact that
due to the lack of divisibility of the inputs it is not possible to use
separate factors for each unit of output. Besides, in the long where
firm expands its production hires more manpower, material,
machine and equipment, the expenditure incurred on these factors
are the incremental cost and not the marginal cost.
• The firm incurs the incremental cost when it undertakes any of the
activities: changing the product line, introducing a new product,
replacing obsolete machinery or equipment, replacing the old
methods of production with the new one, etc.
COST FUNCTIONS
• Cost functions are derived functions. They are
derived from the production function which
describes the available efficient methods of
production at any given period of time. Cost
function expresses a functional relationship
between total cost and factors that determine it.
Usually, the factors that determine total cost of
production (C) of a firm are the output (Q), level
of technology (T), the prices of factors (Pf), and
the fixed factors (K). Economic theory
distinguishes between short-run costs and long-
run costs.
• The short run is a period in the production process, which is
too short for a firm to vary all its factors of production.
Short-run costs are the cost over a period during which
some factors of production (usually capital equipment and
management) are fixed. It is the cost at which the firm
operates in any one period, where one or more factors of
production are in fixed quantity.
• On the other hand, the long-run costs are costs over a
period long enough to permit a change in all factors of
production. The long-run costs are planning costs or ex ante
costs, in that they present the optimal possibilities for
expansion of the output and thus help the entrepreneurs to
plan their future activities. In the long-run, there are no
fixed factors of production and hence, no fixed costs. In the
long-run, all factors are variable, all costs are also variable.
Symbolically, we may write the long-run cost function as:
• C = f (Q,T,Pf,) and short-run cost function as;
• C = f (Q,T,Pf,K)
• Where C is total cost, Q is output, T is technology, Pf is prices of
factor inputs, and K is fixed factors of production
• Graphically, costs are shown on two-dimensional diagrams. Such
curves imply that cost is a function of output, i.e. C = f(Q), ceteris
paribus. The clause ceteris paribus implies that all other factors
which determine costs are held constant. If these factors do
change, their effect on costs is shown graphically by a shift of the
cost curve. This is the reason why determinants of cost, other than
output, are called shift factors.
• Mathematically, there is no difference between the various
determinants of costs. The distinction between movements along
the cost curve (when output changes) and shifts of the curve (when
the other determinants change) is convenient only pedagogically,
because it allows the use of two-dimensional diagrams. But it can
be misleading when studying the determinants of costs. It is
important to remember that if the cost curve shifts, this does not
imply that the cost function is indeterminate.
• The factor technology is itself a multidimensional
factor, determined by the physical quantities of factor
inputs, the quality of the factor inputs, the efficiency of
the entrepreneur, both in organizing the physical side
of the production (technical efficiency of the
entrepreneur), and in making the correct economic
choice of techniques (economic efficiency of the
entrepreneur). Thus any change in these determinants
(e.g. the introduction of a better method of
organization of production, the application of an
educational programme to the existing labour) will
shift the production function, and hence will result in a
shift of the cost curve.
• Similarly, the improvement of raw materials, or the
improvement in the use of some raw materials will
lead to a shift of the cost function.
• ASSUMPTIONS OF THE COST- FUNCTION
• In order to simplify the cost-analysis, certain assumptions
are made
• 1. Firms produce a single homogeneous good (X) with the
help of certain factors of production.
• 2. Some of these factors are employed in fixed quantities,
whatever the level of output of the firm in the short-run. So
they are assumed to be given.
• 3. The remaining factors are variable whose supply is
assumed to be known and available at fixed market prices.
• 4. The technology which is used for the production of the
good is assumed to be known and fixed.
• 5. It is also assumed that the firm adjusts the employment
of variable factors in such a manner that a given output(X)
of the good 'X' is obtained at the minimum total cost, C.
Given the cost functions, we discuss the traditional and
modern theories of costs.
• TRADITIONAL THEORY OF COSTS
• The traditional theory of costs analyses the behaviour
of cost curves in the short-run and long-run and arrives
at the conclusion that both the short-run and long-run
cost curves are U-shaped but the long-run cost curves
are flatter than short-run cost curves.
• SHORT-RUN COSTS OF THE TRADITIONAL THEORY
• In the traditional theory of the firm, in the short run,
there are variable inputs and at least one fixed input.
This suggests that short run costs are divided into fixed
costs and variable costs. Thus, there are three concepts
of total cost in the short run: Total fixed costs (TFC),
total variable costs (TVC), and total costs (TC).
• TC = TFC + TVC
• 1. Total Fixed Cost: These are costs of production that do not change
(vary) with the level of output, and they are incurred whether the firm is
producing or not. They are independent of the level of output and it is the
sum of all costs incurred by the firm for fixed inputs, and it is always the
same at any level of output. It includes; (a) salaries of administrative staff
(b) depreciation (wear and tear) of machinery (c) expenses for building
depreciation and repairs (d) expenses for land maintenance and
depreciation (if any). Another element that may be treated in the same
way as fixed costs is the normal profit, which a lump sum including a
percentage return on is fixed capital and allowance for risk.
• Total Fixed Cost (TFC) is graphically denoted by a straight line parallel to
the output axis.
• 2. Total Variable Cost: These are costs of production that
change directly with output. They rise when output increases
and fall when output declines. They include (a) the raw
materials (b) the cost of direct labour (c) the running expenses
of fixed capital, such as fuel, ordinary repairs and routine
maintenance. It is the total cost incurred by the firm for
variable inputs. TVC = f (Q)…………………………… 1
• In the traditional theory of the firm, the total
variable cost (TVC) has an inverse-S-shape,
graphically shown below, and it reflects the
law of variable proportions
• 3. Total Cost: The firm's short run total cost is the sum
of the total fixed cost (TFC) and total variable cost
(TVC) at any given level of output. Total cost also varies
with the level of the firm's output.
• TC = TFC + TVC……………………………….. 2
• TC = f(Q)…………………………………………. 3
• From Equation 2, it follows that:
• TFC = TC – TVC………………………………… 4
• TVC = TC – TFC………………………………… 5
• According to the law of variable proportions, at the
initial stage of production with a given plant, as more
of the variable factor(s) is employed; its productivity
increases and the average variable cost fall. This
continues until the optimal combination of the fixed
and variable factors is reached.
• Beyond this point, as increased quantities of the
variable factor(s) are combined with the fixed
factor(s) the productivity of the variable factor(s)
decline (and the AVC rises). By adding the TFC and
TVC we obtain the TC of the firm.
• OTHER COST CONCEPTS
• From the Total-Cost curves we obtain Average-Cost curves.
• a. Average Fixed Cost (AFC): The AFC at any given level of output is
total fixed cost divided by output. In symbol, this becomes:
• AFC= TFC/Q > 0 ………………………………….6
• Graphically, the AFC is a rectangular hyperbola, showing at all its
points the same magnitude, that is, the level of TFC.

• In Figure-6 AFC curve is shown as a declining curve, which never

touches the horizontal axis. This is because fixed cost can never be
zero. The curve is also called rectangular hyperbola, which
represents that total fixed costs remain same at all the levels.
• b. Average Variable Cost (AVC): The average variable cost at
any given level of output is total variable cost divided by
output. In symbol, it becomes:
• AVC= TVC/Q ………………………..7
• The SAVC curve falls initially as the productivity of the variable
factor(s) increases, reaches a minimum when the plant is
operated optimally (with optimal combination of fixed and
variable factors), and rises beyond that point, due to law of
diminishing returns.
• Thus, the SAVC curve is therefore U-shaped as seen below
• c. Average Total Cost (ATC): In the short-run analysis, average cost
is more important than total cost. The units of output that a firm
produces do not cost the same to the firm, but must be sold at the
same price Therefore, the firm must know the per-unit cost or the
average cost. Thus, the short-run average cost of a firm is the
average fixed costs, the average variable cost and average total
costs. The short run average total cost
• (SAC) at any given output level is obtained by simply dividing total
cost by the output level:
• SAC = STC/Q ……………………..8
• Since
• STC= TFC + TVC
• Then, SAC = (TFC + TVC)/Q
SAC= TFC/Q + TVC/Q
SAC= AFC + AVC …………………………..9
• Graphically, the ATC curve is derived in the
same way as the SAVC. The shape of the ATC is
similar to that of AVC (both being U-shaped).
Initially, the ATC declines, it reaches a
minimum at the optimal operation of the
plant and subsequently rises again.
• From Equation 9 we know that the SAC can be alternatively defined as the
sum of AFC and AVC. Therefore,
• AFC = SAC - AVC …………………………………………10
• and
• AVC = SAC – AFC …………………………………………11
• The U-shape of both the AVC and the ATC reflects the law of variable
proportions or law of diminishing returns to the variable factor(s) of
production
• d. Short run Marginal Cost (SMC): Marginal
Cost is the addition to total cost resulting from
the production of an additional unit of output.
The short-run marginal cost is defined as a
change in total cost (TC) which results from a
unit change in output. Mathematically, the
Marginal Cost is the first derivative of the TC
function. Marginal Cost is the addition to Total
Cost by producing an additional unit of
output.
• Therefore, if
• However, to derive the marginal cost from a total
cost function, we
• find the derivative of total cost (TC) with respect
to output (Q):
• SMC = dTC/dQ > 0
• Graphically, the MC is the slope of the TC curve
(which of course is the same at any point as the slope
of the TVC). The slope of a curve at any one of its
points is the slope of the tangent at that point.
• Thus, the SMC curve is also U-shaped, as seen above.
Therefore, the
• traditional theory of costs postulates that in the short-
run, the costs curves (AVC, ATC and MC) are U-shaped
reflecting the law of variable proportions. In the short-
run with a fixed plant there is a phase of increasing
productivity (falling unit costs) and the phase of
decreasing productivity (increasing unit costs) of the
variable factor(s). Between these two phases of plant
operation there is a single point at which unit costs are
at a minimum. When this point on the SATC is reached
the plant is utilized optimally, that is, with optimal
combination (proportions) of fixed and variable
factors.
• b. Relation between MC and AC:
• There is a close relation between MC and AC. When
AC is falling, MC is less than AC. This can be proved
as follows:
• When AC is falling,
• The properties of the average and marginal cost curves and
their relationship to each other are as described in the
above figure. From the diagram the following relationships
can be discovered.
• (1) AFC declines continuously, approaching both axes
asymptomatically (as shown by the decreasing distance
between ATC and AVC) and is a rectangular hyperbola.
• (2) AVC first declines, reaches a minimum at Q2and rises
thereafter. When AVC is at its minimum, MC equals AVC.
• (3) ATC first declines, reaches a minimum at Q3, and rises
thereafter. When ATC is at its minimum, MC equals ATC.
• (4) MC first declines, reaches a minimum at Q1, and rises
thereafter. MC equals both AVC and ATC when these curves
are at their minimum values.
• The lowest point of the AVC curve is called the shut (close)-
down point and that of the ATC curve the break-even point.
These two concepts will be discussed in the context of
market structure and pricing. Finally, we see that MC lies
below both AVC and ATC over the range in which these
curves decline; contrarily, MC lies above them when they
are rising.
• Table 14.2 numerically illustrates the characteristics of all
the cost curves. Column (5) shows that average fixed cost
decreases over the entire range of output. Columns (6) and
(7) depict that both average variable and average total cost
first decrease, then increase, with average variable cost
attaining a minimum at a lower output than that at which
average total cost reaches its minimum. Column (8) shows
that marginal cost per 100 units is the incremental increase
in total cost and variable cost.
• If we compare columns (6) and (8) we see that marginal
cost (per unit) is below average variable and average total
cost when each is falling and is greater than each when AVC
and ATC are rising.
• Long-Run Costs: The Planning Horizon:
• We may recall from our discussion of production theory
that the long run does not refer to ‘some date in the future.
Instead, the long run simply refers to a period of time
during which all inputs can be varied.
• Therefore, a decision has to be made by the owner and/or
manager of the firm about the scale of operation, that is,
the size of the firm. In order to be able to make this
decision the manager must have knowledge about the cost
of producing each relevant level of output. We shall now
discover how to determine these long-run costs.’
• Derivation of Cost Schedules from a Production Function:
• For the sake of analysis, we may assume that the firm’s level of usage of
the inputs does not affect the input (factor) prices. We also assume that
the firm’s manager has already evaluated the production function for each
level of output in the feasible range and has derived an expansion path.
• For the sake of analytical simplicity, we may assume that the firm uses
only two variable factors, labour and capital, that cost Rs. 5 and Rs. 10 per
unit, respectively.
• The characteristics of a derived expansion path are shown in Columns 1, 2
and 3 of Table 14.4. In column (1) we see seven output levels and in
Columns (2) and (3) we see the optimal combinations of labour and capital
respectively for each level of output, at the existing factor prices.
• These combinations enable us to locate seven points on the expansion
path.
• Column (4) shows the total cost of producing each level of output at the
lowest possible cost. For example, for producing 300 units of output, the
least cost combination of inputs is 20 units of labour and 10 of capital. At
existing factor prices, the total cost is Rs. 200. Here, Column (4) is a least-
cost schedule for various levels of production.
• From column (5) we derive an important characteristic of long-run
average cost: average cost first declines, reaches a minimum, then
rises, as in the short-run. In Column (6) we show long-run marginal
cost figures.
• Each such figure is arrived at by dividing change in total cost by
change in output. For example, when output increases from Rs. 100
to Rs. 200, the total cost increases from Rs. 120 to Rs. 140.
Therefore, marginal cost (per unit) is Rs. 20/100 = Re. 0.20.
Similarly, when output increases from 600 to 700 units, MC per unit
is 720-560/100 =160/100 =1.60
• Column (6) depicts the behaviour of per unit MC: marginal cost first
decreases then increases, as in the short run.
• We may now show the relationship between the expansion path
and long-run cost graphically. In Fig. 14.6 two inputs, K and L, are
measured along the two axes. The fixed factor price ratio is
represented by the slope of the isocost lines I1I’1, l2l’2 and so on.
Finally, the known production function gives us the isoquant map,
represented by Q1, Q2 and so forth.
• From our earlier discussion of long-run produc-
tion function we know that, when all inputs are
variable (that is, in long-run), the manager will
choose the least cost combinations of producing
each level of output. In Fig. 14.6, we see that the
locus of all such combinations is expansion path
OP’ B’R’S’.

• Given the factor-price ratio and the production

function (which is determined by the state of
technology), the expansion path shows the
combinations of inputs that enables the firm to
produce each level of output at the lowest cost.
• We may now relate this expansion path to a long-run
total cost (LRTC) curve. Fig. 14.7 shows the ‘least cost
curve’ associated with expansion path in Fig. 14.6. This
least cost curve is the long-run total cost curve. Points
P,B,R and S are associated with points P’, B’, R’ and S’
on the expansion path. For example, in Fig. 14.6 the
least cost combination of inputs that can produce Q1 is
K1 units of capital and L1 units of labour.
• Thus, in Fig. 14.7, minimum possible cost of producing
Q1 units of output is TC1, which is K1 + wL1, i.e., the
price of capital (or the rate of interest) times K1, plus
the price of labour (or the wage rate) times L1. Every
other point on LRTC is derived in a similar way.
• Since the long run permits capital-labour substitution, the firm may
choose different combinations of these two inputs to produce
different levels of output. Thus, totally different production
processes may be used to produce (say) Q 1 and Q2 units of output
at the lowest attainable cost.
• On the basis of this diagram we may suggest a definition of the long
run total cost. The time period during which even/thing (except
factor prices and the state of technology or art of production) is
variable is called the long run and the associated curve that shows
the minimum cost of producing each level of output is called the
long- run total cost curve.
• The shape of the long-run total cost (LRTC) curve depends on two
factors: the production function and the existing factor prices. Table
14.4 and Fig. 14.7 reflect two of the commonly assumed char-
acteristics of long-run total costs. First, costs and output are directly
related; that is, the LRTC curve has a positive slope. But, since there
is no fixed cost in the long run, the long run total cost curve starts
from the origin.
• Another characteristic of LRTC is that costs first increase at a
decreasing rate (until point B in Fig. 14.7), and an increasing rate
thereafter. Since the slope of the total cost curve measures
marginal cost, the implication is that long-run marginal cost first
decreases and then increases. It may be added that all implicit costs
of production are included in the LRTC curve.
• Long-Run Average and Marginal Costs:
• We turn now to distinguish between long run average and marginal
costs.
• Long-run average cost is arrived at by dividing the total cost of
producing a particular output by the number of units produced:
• LRTC= LRTC/Q
• Long-run marginal cost is the extra total cost of producing an
additional unit of output when all inputs are optimally adjusted:
• LRTC= ∆ LRTC /∆Q
• It, therefore, measures the change in total cost per unit of output as
the firm moves along the long run total cost curve (or the
expansion path).
• Fig. 14.8 illustrates typical long-run average and marginal cost
curves. They have essentially the same shape and relation to each
other as in the short run. Long-run average cost first declines,
reaches a minimum (at Q2 in Fig. 14.8), then increases. Long-run
marginal cost first declines, reaches minimum at a lower output
than that associated with minimum average cost (Q1 in Fig. 14.8),
and increases thereafter.
• The marginal cost intersects the average cost curve at its lowest
point (L in Fig. 14.8) as in the short-run. The reason is also the
same. The reason has been aptly summarized by Maurice and
Smithson thus: “When marginal cost is less than average cost, each
additional unit produced adds less than average cost to total cost;
so average cost must decrease.
• When marginal cost is greater than average cost, each ad-
ditional unit of the good produced adds more than average
cost to total cost; so average cost must be increasing over this
range of output. Thus marginal cost must be equal to average
cost when average cost is at its minimum”.
• Why Long-Run Average Cost Curve is of U-
Shape?
• In Fig. 19.7, we have drawn the long-run average
cost curve as having an approximately U-shape. It
is generally believed by economists that the long-
run average cost curve is normally U shaped, that
is, the long-run average cost curve first declines
as output is increased and then beyond a certain
point it rises. Now, what is the proper explanation
of such behaviour of the long- run average cost
curve?
• We saw above that the U-shape of the short-run average
cost curve is explained with the law of variable proportions.
But the shape of the long-run average cost curve depends
upon the returns to scale. Since in the long run all inputs
including the capital equipment can be altered, the
relevant concept governing the shape of this long-run
average cost curve is that of returns to scale.
• Returns to scale increase with the initial increases in output
and after remaining constant for a while, the returns to
scale decrease. It is because of the increasing returns to
scale in the beginning that the long-run average cost of
production falls as output is increased and, likewise, it is
because of the decreasing returns to scale that the long-run
average cost of production rises beyond a certain point.
• Why does LAC fall in the beginning:
Economies of Scale?
• But the question is why we first get increasing
returns to scale due to which long-run average
cost falls and why after a certain point we get
decreasing returns to scale due to which long-
run average cost rises. In other words, what
are the reasons that the firm first enjoys
internal economies of scale and then beyond a
certain point it has to suffer internal
diseconomies of scale?
• Economies of scale:
• Large scale production is economical in the sense that the cost of
production is low. The low cost is a result of “economies of scale”. ‘’In
broad sense, anything which serves to minimize average cost of
production in the long run as the scale of output increases is referred to as
economies of scale ‘’. In other words, economies of scale are the cost
advantages that an enterprise obtains due to expansion. It leads to
reduction in unit costs as the scale of operations increases. It is measured
in money terms. The economies of scale may be classified as:
• a) Internal or real economies
• b) External or pecuniary economies
• Internal or real economies: internal economies also called real economies
are those that arise from the expansion of the plant size of the firm and
are internalized. Internal economies may be classified under the following
categories:
• (i) Economies in production
• (ii) Economies in marketing
• (iii) Managerial economies and
• (iv) Economies in transport and storage
• Economies in production: Economies in production arises from two
sources :(a) technological advantages and (b)advantages of division
of labour based on specialization and skill of labour.
• (a) Technological advantages: Large scale production provides an
opportunity to the expanding firms to avail themselves of the
advantages of technological advances. Technical economies refer to
the reduction in the cost of manufacturing process itself. These
relate to the methods and techniques of production, specially to
the nature and form of capital employed.
• There are various types of technical economies as follows:
• Economies of superior technique: A small firm can’t install high
quality machine which a big firm can. Small firm generally make
increasing use of ordinary machines where as a large firm generally
use big automatic machines worked by electricity. Such automatic
machines are quicker and more efficient, and there output is large
as compared to the ordinary machines. For example an automatic
loom is more economical than handloom. But a village weaver can’t
afford to have an automatic loom, which a textile mill can. The
average cost becomes low under superior technology in a large
scale production.
• Economies of linked process: A large plant usually enjoys the advantage of
the linking processes, by arranging production activities in a continuous
sequence without any loss of time. According to Prof. Cairncross, ‘’There is
generally saving in time and saving in transport cost, since two
departments of eth same factory are closer together than two separate
factories’’. For the same reason, process of editing and printing of
newspapers are generally carried out in the same premises.
• (b) Advantages of division of labour based on specialization: When a
firm’s scale of production expands, more and more workers of varying
skills and qualifications are employed. With the employment of larger
number of workers, it becomes increasingly possible to divide the labour
according to their qualifications and skills and assign them the functions to
which they are best suited. This is known as division of labour. Division of
labour leads to a greater specialization of manpower. It increases
productivity of labour, and there by reduces cost of production. Besides,
specialized workers develop more efficient tools and techniques and gain
speed of work. These advantages of division of labour improve
productivity of labour per unit of cost and time.
• Economies in marketing: Economies in marketing arise from the
large scale purchase of raw materials and other material inputs and
large –scale selling of the firm’s own product. As to economies in
the purchase of inputs, the large –size firms normally make bulk
purchase of their inputs. The large scale purchase entitles the firm
for certain discounts in input prices and other concessions that are
not available on small purchases.
• Managerial economies: Managerial economies arise from
specialization in managerial activities, i.e., and the use of
specialized managerial personnel. For a large size firm, it becomes
possible to divide its management into specialized departments
under specialized personnel, such as production manager, sales
manager, personnel manager etc. This increases the efficiency of
management at all the levels of management because of the
decentralization of decision making. It increases production given
the cost. Large scale firm have the opportunity to use advanced
technique of production. This leads to quick decision making, help
in saving valuable time of the management and thereby, improve
the managerial efficiency.
• Economies in transport and storage: Economies in transportation costs arise from
fuller utilization of transport and storage facilities. Transportation costs are
incurred both on production and sales sides. Similarly storage costs are incurred
on both raw materials and finished products .The large size firm may acquire their
own means of transport and thereby reduce the cost of transportation .Besides
own transport facility prevents delays in transporting goods .Some large scale firms
have their own railway tracks from the nearest railway point to the factory, and
thus they reduce the cost of transporting goods in and out. For example, NALCO
has its own railway tracks .Similarly large scale firms can create their own depot in
the various center of product distribution and can save on cost of storage.
• External or pecuniary economies of scale: External economies are enjoyable by all
the firms in the industry, irrespective of their size. External economies are those
that arise outside the firm and accrue to the expanding firms. External economies
appear in the form of money saving on inputs. That is why external economies are
also called pecuniary economies. pecuniary economies accrue to the large size
firms in the form of discounts and concessions on (i)large scale purchase of raw
materials(ii)large scale acquisition of external finance, particularly from the
commercial banks(iii)massive advertisement campaigns(iv)large scale hiring of
means of transport and warehouses etc. These benefits are available to all the
firms of an industry but large scale firms benefit more than small firms.
• Diseconomies of scale: Diseconomies of scale are disadvantages that arise
due to the expansion of production scale and lead to rise in the cost of
production. These diseconomies, by raising the average cost of
production, act as a limiting factor on the further expansion of the firm.
Like economies, diseconomies may be internal and external. Let us
describe the nature of internal and external diseconomies in detail:
• Internal diseconomies: Internal diseconomies are those that are exclusive
and internal to a firm-they arise within a firm. Like everything else,
economies of scale have a limit too. This limit is reached when the
advantages of division of labour and managerial staff have been fully
exploited; excess capacity of plant, warehouses, transport and
communication system etc. is fully used, and economy in advertisement
cost tapers off.
• (a)Difficulties of management: As the firm expand the complexities and
problems of management increase. Thus after a point, the manager finds
it difficult to control the whole production organization. The entrepreneur
and management will not be able to maintain contact with each other and
check on all the departments of a very large concerned problem of
supervision becomes complex and intractable, thus leading to increasing
possibilities of mistakes and mismanagement. All these prove to be
uneconomical, for the defects in organization will lead to waist and result
in rising average cost.
• (b) Difficulties of co-ordination: The task of organization and
coordination become progressively more and more difficult with
the increasing size of the firm. The management of the firm will
gradually face numerous problems of decision making and
organization. It may therefore, not find enough time to give careful
thought to individual problems.
• (c)Difficulties in decision making: A large firm cannot take quick
decision and make quick changes as and when they are needed, for
it has to consult various departments for making any decision and
so urgent matters requiring timely decisions are inevitably delayed.
This may sometimes cause loss to the firm.
• (d)Increased risks: As the scale of production, investment also
increases, so too the risks of business. The larger the output,
obviously the greater will be the loss. To bear greater risks is an
important limitation to the expansion of the size of affirms from an
error of judgment or misfortune in business. Therefore
unwillingness to bear greater risks is an important limitation to the
expansion of the size of a firm.
• (e) Labour diseconomies: Extreme division of labour with a growing
scale of output results in lack of initiative and drive in the executive
personnel. Thus a large firm becomes more impersonal and contact
between management and a worker becomes less. As such, there
are more chances of occurrence of grievances, and industrial
disputes which prove to be costly to the large firm.
• External diseconomies: External diseconomies are the
disadvantages that originate outside the firm, especially in the input
markets and due to natural constraints, specially in agriculture
industries. With the expansion of the firm, particularly when all the
firms of the industry are expanding, the discounts and concessions
that are available on bulk purchases of inputs and concessional
finance come to an end. More than that, increasing demand for
inputs puts pressure on the input market and input prices begin to
rise causing a rising in the cost of production .these are pecuniary
diseconomies.
• (a) Scarcity of factor supplies: Due to increase in the concentration of
firms in a particular locality, each firm will find scarcity of available factors.
Hence, competition among firms in purchasing labour, raw materials, etc.,
will result in increased factor prices. Thus extreme concentration of
external economies becomes assort of diseconomy in the form of high
factor prices.
• (b) Financial difficulties: A big concern needs huge capital which cannot
always be easily obtainable. Hence the difficulty in obtaining sufficient
capital frequently prevents the further expansion of such firms.
• (c) Marketing diseconomies: When the industry expands and the firm
grows, competition in the market tends to become stiff. Thus, firms under
monopolistic competition will have to undertake extensive advertising and
sales promotion efforts and expenditure which ultimately lead to higher
costs. On the production side, the law of diminishing returns to scale come
into force due to excessive use of fixed factors. For example, excessive use
of cultivable land turn sit into barren land, pumping out water on a large
scale for irrigation causes the water level to go down resulting in rise in
cost of irrigation, extraction of minerals on a large scale soon exhausts the
mineral deposits on upper levels and mining further deep causes rise in
cost of production, extensive fishing reduces the availability of fish and the
catch, even when fishing boats and nets are increased. These kinds of
diseconomies make the LAC move upward.
• Economies of Scope:
• Definition of Economies of Scale
• Economies of Scope refers to the reduction in the
average cost per unit, by increasing the variety of
products produced. In this technique, the total cost of
producing two products (related or unrelated) is less
than the cost of producing each item individually.
• Economies of Scope focuses on better utilization of the
firm’s resources and common assets. In this way, the
utilization of assets is spread over two or more
products, i.e. shared by multiple products to decrease
the overall cost of production. As the costs are spread
over several products which lead to the decrease in the
average cost per unit of each product.
• Key Differences Between Economies of Scale and Economies of Scope
• The major points of difference between economies of scale and
economies of scope are explained below:
• A strategy used for cutting costs by increasing the volume of units
produced is known as Economies of Scale. Economies of Scope implies a
technique to lower down the cost by producing multiple products with the
same operations or inputs.
• In economies of scale is implemented, the average cost of producing a
product is reduced. On the other hand, economies of scope imply
proportionate savings in the cost of producing multiple products.
• In economies of scale, the firm gains cost effectiveness due to volume,
whereas cost effectiveness in economies of scope is due to the varieties
offered.
• Economies of scale strategy are used by organizations since a long time.
Conversely, Economies of Scope is a relatively new strategy.
• Economies of scale involve product standardization while economies of
scope involve product diversification, using the same scale of the plant.
• In economies of scale, a bigger plant is used to produce the large volume
of output. As opposed to economies of scope, in which the same plant is
used to manufacture distinct products.
• LINKAGE BETWEEN COST, REVENUE AND
OUTPUT THROUGH OPTIMIZATION
• Definition of Revenue:
• By 'revenue' of a firm is meant the total sale
proceeds or the total receipts of a firm from
the sale of the output.
• The various kinds of revenue will be discussed
here under three heads:
• (i) Total Revenue,
• (ii) Marginal Revenue,
• (iii) Average Revenue.
• Total Revenue (TR): The total amount of money
received by a firm from goods sold (or services
provided) during a certain time period.
• TR=Q.P
• Where Q= Quantity sold, P= Price per unit
• Average Revenue (AR): The revenue earned per unit of
output sold.
• AR=TR/Q= Q.P/Q=P
• Marginal Revenue (MR): The revenue a firm gains in
producing one additional unit of a commodity.
• MRQ= TRQ -TRQ-1
• Where Q is the number of units sold.
• MR= ΔTR/ΔQ= dTR/dQ
Thank you