CHAPTER 3 - PRODUCTION AND COSTS

• Production is the process by which inputs are transformed into ‘output’.

• Production is carried out by producers or firms. A firm acquires different inputs like labour,
machines, land, raw materials etc. It uses these inputs to produce output. This output can be
consumed by consumers, or used by other firms for further production.
• Cost of Production - To acquire inputs a firm must pay for them. This is called the cost of
production.
• Revenue for a firm - Once output has been produced, the firm sells it in the market and earns
revenue.
• Profit of a firm - The difference between the revenue and cost is called the firm’s profit.
• Production function - The production function of a firm is a relationship between inputs used and
output produced by the firm. For various quantities of inputs used, it gives the maximum quantity
of output that can be produced.
• Dependence of production function on the technology used for production -
o The production of output is done by using the available technology at that time.
o This technology decides how efficient the production process will be and how much output
will be produced.
o As and when the technology improves, the production process becomes more efficient and
can produce more output.
o The improvement in the production technology can be of various ways -
i.Usage of better inputs
ii.Usage of additional inputs which improve quality of output
iii.Improvement in the machinery used to produce the output.
iv.Better marketing techniques to reach more consumers
v.Simplification of production process leading to shorter production time
o When the technology improves, the production function which is dependent on it will also
change.
• EXAMPLE: Let us assume a company was producing T-shirts with the help of manual labour, that is,
labourers would stitch T-shirts which were then sold. With this technology, the company was able to
produce 20 T-shirts per month from 1 labourer. Later, the company purchased sewing machines,
which helped increase the speed of production of T-shirts. Now, each labourer could produce 50 T-
shirts per month due to the help of the change in technology for producing T-shirts.
• Mathematical representation of production function -
o The inputs used for production are called factors of production.
o For simplification, only two factors are considered, Labour and Capital.
o Therefore, the equation which related the maximum output (q) produced by using various
combinations of Labour (L) and Capital (K) is called “Production function”
q = f (L, K)

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• Isoquant - it is a curve like indifference curve. It is a set of combinations of two factors of production
which produces the same level of output.

• Short Run and Long Run -

o Short run - among the factors of production used, only one can be varied (changed), all
other factors of production remain constant. In our analysis, because we consider only
labour and capital, in the short run only one of them can be varied.
o Long run - all factors of production can be varied in the long run simultaneously (at the same
time). Therefore, there is no fixed factor of production in the long run.
• Total Product - when one input is varied and other inputs are held constant, the output varies
accordingly. The relation between the variable input and the total output is known as “Total
Product”. It is also called the “Total Physical Product” of the variable input. (Refer Table 1 for
example)
• Average Product - the output per unit of variable input is called the “Average Product or Average
Physical Product”. The average product can be with respect to the variable input under
consideration. (Refer Table 1 for example)

• Marginal product - it is the change in output due to change in the variable input, keeping all other
inputs constant. (Refer Table 1 for example)

Marginal product is calculated as below -

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 Table 1:
LABOUR TP AP MP

0 0 -

1 10 10 10

2 25 12.5 15

3 55 18 30

4 74 19 19

5 85 17 11

• The Law of Diminishing Marginal Product or Law of Variable Proportions: The below graph is
obtained when the values of TP, AP and MP from table 1 are plotted. Let us now see what is
happening with each of them graphically: (Graph in next page)
• The Total product first increases as more variable input (Labour) is used. But after reaching
the maximum level (Peak) it starts increasing at a slower pace. This pace of increase of Total
Product is called as the Marginal Product. Marginal product first increases but then starts
decreasing. This is known as the Law of Diminishing Marginal Product. This happens due to
varying factor proportions.
➢ Factor proportions – the ratio in which two inputs are utilized to produce output.
• When a producer starts using more and more variable input, keeping the other input
constant, the production process reached a phase where there is more of the variable input
but less fixed input. This leads to decrease in the marginal product produced, which in turn
reduces the total product.
• EXAMPLE – Suppose a farmer who has 4 hectares of land, can choose how much labour he
wants to use. If he uses only 1 worker, he has too much land for the worker to cultivate
alone. As he increases the number of workers, the amount of labour per unit land increases,
and each worker adds proportionally more and more to the total output. Marginal product
increases in this phase. When the fourth worker is hired, the land begins to get ‘crowded’.
Each worker now has insufficient land to work efficiently. So, the output added by each
additional worker is now proportionally less. The marginal product begins to fall.

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• Shape of Total Product, Average Product and Marginal Product Curves:
o Total product Curve – the output increases at an increasing rate first and then continues to
increase at a decreasing rate. The TP also starts decreasing when the MP goes below 0. the
relation between TP and MP can be as below –
1. MP is increasing = TP increases at an increasing rate
2. MP is decreasing = TP increases at a decreasing rate
3. MP is negative = TP starts decreasing
o Marginal Product Curve – as per the Law of Diminishing Marginal Product or Law of Variable
Proportions, the MP first increases and then decreases, in accordance with this, its curve
takes the shape of an inverted U.
o Average Product Curve – the AP curve follows the MP curve. It has mainly two cases -
1. When AP is increasing, MP curve stays above the AP curve. MP is also increasing.
2. When AP is decreasing, MP curve stays below the AP curve. MP is also decreasing.
1. The MP curve cuts the AP curve from above. The point of intersection of these two
curves is the maximum point of AP.
Total product Average and Marginal
Curve product Curve

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• Returns to scale –
o We have understood that due to the Law of Variable Proportions, the MP decreases over
time. This is because one input is held constant while the other increases.
o Returns to scale is a situation where, all the inputs used, in our case, two, are increased
simultaneously. But this can happen only in the long run.
o When both the inputs are increased (Scaled up), there are three possible returns that can be
expected. These returns are studied under the analysis of “Return to Scale”.
o The three outcomes are as below –
1. Increasing Returns to Scale (IRS) – when a proportional increase in the inputs leads to
an increase in the output larger than the proportion of increase of the inputs.
2. Decreasing Returns to Scale (DRS) – when a proportional increase in the inputs leads
to an increase in the output lesser than the proportion of increase of the inputs.
3. Constant Returns to Scale (CRS) – when a proportional increase in the inputs leads to
an increase in the output equal to the proportion of increase of the inputs.
o EXAMPLE - For example, suppose in a production process, all inputs get doubled. As a result,
if the output gets doubled, the production function exhibits CRS. If output is less than
doubled, then DRS holds, and if it is more than doubled, then IRS holds