UNIT-III

PRODUCTION
• In Economics the term production means process by which a commodity(or commodities) is transformed in
to a different usable commodity.
• In other words, production means transforming inputs into an output.

PRODUCTION FUNCTION

The production function can be mathematically written as:

Q = f(L, K, T…..n)
Where,
Q = Output T = Level of technology
L = Labour n = Other inputs employed in production
K = Capital

Types

Short –Run Long – Run

(Inputs kept constant
(Varying all inputs)
One input (Labour) is varied)

Law of variable Law of returns to

proportion scale
Law of Production
– Law of Diminishing Returns or Law of Variable Proportion
– Laws of Return to Scale
SHORT-RUN PRODUCTION FUNCTION
( THE LAW OF VARIABLE PROPORTIONS)
• The law examines the relationship between one variable factor and output, keeping the quantities of
other factors fixed.
Definition
As the proportion of one factor in a combination of factors is increased, after a point, first the marginal
and then the average product of that factor will diminish
Schedule:
The law of variable proportion is explained with the help of the following schedule:
Units of variable Marginal product Total product (TP ) Average product stages
L
factor (L) (MP ) (AP )
L L
1 2 2 2 I

2 4 6 3

3 6 12 4

4 4 16 4 II

5 2 18 3.6

6 0 18 3 III

7 -2 16 2.28

The number of workers are measured on X-axis while TPL, APL and MPL on Y-axis. The above diagram shows
the three stages also obtained from the schedule.
• Stage I:
 – At this stage MPL increases up to 3rd worker and its curve is higher than the average product, so that
total product is increasing at increasing rate.
• Stage II:
– At this stage, MPL decreases up to 6th unit of labor where MPL curve intersects the X-axis. At 4the
unit of labor MPL = APL after this, MPL curve is lower than the APL. TPL increases at decreasing
rate.
• Stage III:
– At 6the unit of labor the MPL becomes negative, the APL continues falling but remains positive.
After the 6th unit, TPL declines with the employment of more units of variable factor (L).
THREE PHASES OF RETURNS TO SCALE
• The changes in output as a result of changes in the scale can be studied in 3 phases. They are
– Increasing returns to scale
– Constant returns to scale
– Decreasing returns to scale
• Increasing returns to scale
If the increase in all factors leads to a more than proportionate increase in output, it is called increasing
returns to scale. For example, if all the inputs are increased by 5%, the output increases by more than
5% i.e. by 10%. In this case the marginal product will be rising.
• Constant returns to scale
If we increase all the factors (i.e. scale) in a given proportion, the output will increase in the same proportion
i.e. a 5% increase in all the factors will result in an equal proportion of 5% increase in the output.
Here the marginal product is constant.
• Decreasing returns to scale
If the increase in all factors leads to a less than proportionate increase in output, it is called decreasing
returns to scale i.e. if all the factors are increased by 5%, the output will increase by less than 5% i.e.
by 3%. In this phase marginal product will be decreasing.
Total Marginal Phases
S.No Scale
product Product

1 1 machine + 1 labour 4 4 I
Increasing
2 2 machine + 2 labour 10 6 returns

3 3 machine + 3 labour 18 8

4 4 machine + 4 labour 28 10

5 5 machine + 5 labour 38 10 II
Constant
6 6 machine + 6 labour 48 10 returns

7 7 machine + 7 labour 56 8 III

Decreasing
8 8 machine + 8 labour 62 6 returns
 COST
• It refers to the monetary expenditure which a firm has to incur in order to purchase or hire the factors
of production.
• It is the expense of purchasing or hiring factor services for production and other business activities.
COST FUNCTION
• The cost function expresses a functional relationship between costs and output that determine it.
Symbolically, the cost function is
C = f (Q)
where
– C = Cost
– Q = Output

COST-OUTPUT RELATIONSHIP IN THE SHORT-RUN

In the short-run there will not be any change in Total Fixed C0st. Hence change in total cost implies
change in Total Variable Cost only.

Marginal
(TVC
TVC)
(TFC

(TFC
Outp

varia

varia

AVC
TVC
fixed

fixed

AFC
Average

Average

Average
Units

TFC

(TC/
ut Q

cost

cost

cost

cost

cost

cost
/ Q)

/ Q)

MC
AC
TC
ble

ble

cost
Q)
of

Total

Total

Total

0 – – 60 – – – –

1 60 20 80 20 60 80 20

2 60 36 96 18 30 48 16

3 60 48 108 16 20 36 12

4 60 64 124 16 15 31 16

5 60 90 150 18 12 30 26

6 60 132 192 22 10 32 42
 The above table represents the cost-output relationship.
 The table is prepared on the basis of the law of diminishing marginal returns. The fixed cost Rs. 60
May include rent of factory building, interest on capital, salaries of permanently employed staff,
insurance etc.
 The table shows that fixed cost is same at all levels of output but the average fixed cost, i.e., the fixed
cost per unit, falls continuously as the output increases. The expenditure on the variable factors (TVC)
is at different rate.
 If more and more units are produced with a given physical capacity the AVC will fall initially, as per
the table declining up to 3rd unit, and being constant up to 4th unit and then rising.
 It implies that variable factors produce more efficiently near a firm’s optimum capacity than at any
other levels of output and later rises.
 But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising from the 5th unit
onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’ declines ‘AC’ also will
decline.
 ‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’ is more than the decline in
‘AFC’, the total cost again begin to rise.
 Thus there will be a stage where the ‘AVC’, the total cost again begin to rise thus there will be a stage
where the ‘AVC’ may have started rising, yet the ‘AC’ is still declining because the rise in ‘AVC’ is
less than the droop in ‘AFC’.

Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns
or diminishing cost in the second stage and followed by diminishing returns or increasing cost in the
third stage.

The short-run cost-output relationship can be shown graphically as follows.

 In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over more
and more units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due to the
operation of the law of variable proportions.
 The behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the
initial stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a
certain point ‘AVC’ starts rising.
 If the rise in variable cost is less than the decline in fixed cost, ATC will still continue to decline
otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-shape.
 That is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’ curve indicates the least-cost
combination of inputs.
 Where the total average cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not
be the maximum output level rather it is the point where per unit cost of production will be at its lowest.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
3. ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
4. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
5. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

COST-OUTPUT RELATIONSHIP IN THE LONG-RUN

 Long run is a period, during which all inputs are variable including the one, which are fixes in the short-
run.

 In the long run a firm can change its output according to its demand. Over a long period, the size of the
plant can be changed, unwanted buildings can be sold staff can be increased or reduced.

 The long run enables the firms to expand and scale of their operation by bringing or purchasing larger
quantities of all the inputs. Thus in the long run all factors become variable.

 The long-run cost-output relations therefore imply the relationship between the total cost and the total
output. In the long-run cost-output relationship is influenced by the law of returns to scale.

 In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of
production or plant size, the firm has an appropriate short-run average cost curves.

 The short-run average cost (SAC) curve applies to only one plant whereas the long-run average cost
(LAC) curve takes in to consideration many plants.

 The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.
 To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves.
 In the above figure it is assumed that technologically there are only three sizes of plants – small,
medium and large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large
size plant.
 If the firm wants to produce ‘OP’ units of output, it will choose the smallest plant. For an output beyond
‘OQ’ the firm wills optimum for medium size plant.
 It does not mean that the OQ production is not possible with small plant. Rather it implies that cost of
production will be more with small plant compared to the medium plant.
 For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with
medium plant. Thus the firm has a series of ‘SAC’ curves.
 The ‘LCA’ curve drawn will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve
touches each ‘SAC’ curve at one point, and thus it is known as envelope curve.
 It is also known as planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future.
 With the help of ‘LAC’ the firm determines the size of plant which yields the lowest average cost of
producing a given volume of output it anticipates.
Cost Control
Def:- The processof monitoring and regulating the expenditure of funds is know as cost
control. In other words , it means to regulate/control the operating costs in a business firm.
Features of Cost control
• Cost control process involves setting targets and standards, ascertaining the actual performance,
comparing the actual performance with standard, investigating the variances and taking corrective
action.
• It aims at achieving the standard.
• It is a preventive function.
• In cost control, costs are optimized before they are incurred.
• It is generally applicable to items which have standards.
• It contains guidelines and directive management such as, how to do a thing.
 Main Areas of cost control
• Materials
• Labor
• Overheads
• Sales
• Energy
Factors hampering cost control in India
• Cost of raw materials and other intermediate products is high.
• High foreign commodity prices, particularly oil.
• Power shortages and underutilization of capacity.
• Delay in the issue of licenses.
• High rates of taxes tend to raise the overall costs of production in India.
Techniques of cost control
• Budgetary control
• Standard costing
• Inventory control
• Ratio analysis
• Variance analysis

Cost Reduction
Def:-The process of identifying and eliminating unnecessary costs to improve the profitability of a
business is know as cost reduction.
Features of Cost reduction
• Cost reduction is not concerned with setting targets and standards. Cost reduction is the final result in
the cost control process.
• Cost reduction aims at improving the standards.
• It is continuous, dynamic and innovative in nature, looking always for measures and alternative to
reduce costs.
• It is a corrective function.
• This is applicable to every activity of the business.
• It adds thinking and analysis to action at all levels of management.
Techniques of cost reduction
• Organization and methods
• Work study
• Material handling
• Automation
• Value analysis
• Variety reduction
• Production control
• Design
• Materials control
• Quality control
Meaning and Definition of Market
Market generally means a place or a geographical area, where buyers with
money and sellers with their goods meet to exchange goods for money. In
Economics market refers to a group of buyers and sellers who involve in the transaction
of commodities and services.