CHAPTER 3

PRODUCTION
Productionanis the process bylike
whichservice.
inputsIn transformed
are into
outpu Output can be
the creation of utility. When
a

product or intangible item a other words it is

Taw inputs are transformed into finished which
products human wants,
satisfy we are

creating utility.

3.1 Factors of Production

There are four majorfactors of production. These are the primary factors.
. Land-Land is the free gift of nature. In economics it includes not only the surface
area but also the vegetation, air, water, minerals etc. around it. The reward of land
in production is rent.
2. Labour - It is the physical or mental effort that put in production. Labour is
perishable because labour power cannot be stored. If a worker is not working one
day that days labour is lost forever. The reward of labour is wages.
3. Capital-It is the produced means ofproduction. It can be in the form of machinery,
equipment, building etc. The reward of capital is interest. Modern economic theory
also speak about human capital. It is the stock of knowledge, skill, experience etc.
used in production. It can be increased by education and training.
4. Entrepreneurship-Entrepreneur is the person who combinesthe services of other
factors and organise production. Production involves risk and this risk is taken by
the entrepreneur. Therefore the reward of entrepreneurship is profit.
3.2 Production function
In simple words(production function refers to the functional relationship between inputs
and output) According to Koutsoyiannis "The production function is purely a technical
relation which connects factor inputs and output."
In its general form a production function can be written as
C0-LKN.)
(Where L - labour, K - capital, N- natural resources including land, T- technology.)

Thus output is a function of these four factors.

Short run production function or variable proportion
n the short run output can be increased by increasing the quantities of the variable factors
in
production Further, in the short run certain factors like machinery, building etc.(capital)
are considered as fixed. Their quantities cannot be changed in the short period. On the other
hand labour, raw material etc. are considered as variable. In the short run production can
De increased by increasing the quantities of these variable factors.

43
 Industrial Economics and Foreign Trade Production
constant and the
quantities.Df
factors remains
of fixed
Thus in the short run quantitiesincrease Here the factor proportion, that is tho 1All units of the variable factor employed are equally efficient.
the output.
variable factors are increased to changes and hence th 2Technology remains constant
variable and fixed factors are combined
proportion in which the 3. The proportion of inputs can be varied
called variable proportion
short run production function is
The law can be explained with a schedule. Suppose a farmer has a
or fixed proportion fixed area of land and
Long run production function land is considered as the fixed factor. Labour is the variable factor and the
farmer is
suficient to increase the
It is the period which is employing more and more units of labour. The changes in TP, MP and AP are given in the
In the long run all factors are variable) be increased by increasing the quantities of following schedule.
quantities of all the factors. Hence output
can

When all the inputs are increased or decreased in the No. of units of Total
all the factors in the same proportion.
remains constant. Hence the long run production Product
Marginal Average
same proportion, the factor proportion Labour Product Product
function is also called fixed proportion. 8
1
3.3 Law of variable proportion or returns to a factor or production function with one
2 18 10
variable input
30 12 10 Increasingretums
Caw of variable proportion describes the changes in output when more and more units of
one variable factor is employed while keeping the quantities of other factors constant.)Since 4 40 10 10
the law analyses the changes in output when there is a change in the quantities of only one
5 45
variable input it is also called returns(output) to a factor or production function with one
variable input. This happens in the short run and hence it is short run production function. 6 48 3
To explain the law we must be familiar with the following concepts.
49 1
Total Produet of a factor(TP- t is the total physical ouput produced by employing a
8 49 6.1 Diminishimg reurns
certain quantity of that factor) For example total product of labour means that when a
certain amount of labour is combined with fixed quantities of other factors, the total output 9 45 4
produced is the total product of labour. Suppose labour and capital are the two factors 10 40 4 Negative returns
employed then total product function of labour can be written as
The law of variable proportion can also be explained with the help of the following
TPL-RL) diagram.
Marginal product of a factor(MP) - It is the addition to total product by employing one
more unit of that factor) For example marginal product of labour means addition to TP
when one more labour is employed. That is

MP- AL or ddTP)
Average product of a factor(AP)Ht is the output per unit of that factor employed. It is
obtained by dividing the TP by the number of units of that
factor employed. For example
AP of labour
can be written as
APL
The law states that when more and more units of one variable
factor is employed with fxeu
quantities of other factors, initially MP increases, then it decreases and finally it becomes
negative.)ln other words initially the total product increases at an
nereases at a
decreasing rate and
increasing rate, then
finally it starts declining. It is similar to the law O
diminishing returns. It states that with increase in the
marginal and average product eventually declines. Thequantity law is
of one variable
factor
based the following
(assumptions.) on

44 45
 and Foreign Trade
Industrial Economics Production
Relation between MP and TP

point of When MP increases TP increases at an

increasing rate
infienonn

2When MP decreases but remains positive TP increases at a decreasing rate

P
Stagel 3When MP becomes negative TP declines
Stage l
Relation between MP and AP
Stage
I When MP>AP, AP increases
2 When MP = AP, AP is maximum

-AP 3 When MP<AP, AP decreases

Reasons for different returns
Variable Factor - mp In production there is an optimal combination in combining various inputs. When
production process move towards the optimal combination, efficiency of factors
increases and hence the producer gets increasing returns. When production goes
Fig. 3.1 The Law of variable proportion. beyond the optimal combination, gradually efficiency decreases and diminishing
returns as
well as negative retums will come in operation. This is the general cause
of the operation of different returns while the law operates.
The schedule and diagram shows three stages while the law operates
Specifically increasing returns operates because of two reasons. In the beginning
Stage 1: This is the stage of increasing returns. During this stage while MP there will be large quantity of fixed factor and less of the variable factor. When
increases, TP increases at an increasing rate In the schedule till of
the employment more and more units of the variable factor is combined with the fixed factor,
the 3d labour MP is increasing. In the diagram till the point K, that is the point of
efficiency of the fixed factors increases.
inflexion, this situation prevails. First stage continues till MP=AP. During this stage
AP is also increasing. Another reason is that, when the number of units of the variable factor increases

Stage2:This is the stage of diminishing returns. During this stage MP decreases there is the possibility for division of labour and specialisation. Each worker can
specialise in one particular task and this increases his eficiency and productivity.
and hence TP increases at a diminishing rate)This can be seen in the schedule. With This gives increasing returns.
each addition of labour MP decreases and this continues till the employment of the Once production attain maximum efficiency with optimal combination of inputs
8 labour where MP becomes zero. Thus the second stage ends when MP=0. This further increase in the variable factor will add less to the total product. In other
can also be seen in the diagram where in the second stage MP curve is sloping
down. When MP touches the X-axis(MP=0) TP curve has its highest Words marginal product starts declining or there will be diminishing returnms. The
point. In other main reason for diminishing returns is that factors are not perfect substitutes. That
words When MP=0, TP is the maximum.
is increase in one variable factor alone cannot compensate for the other factors.
Stage 3:This is the stage of negative retums where MP becomes negative and TP
starts declining, In the schedule the Negative returns or negative marginal product is the result of the employment of
employment of the 9th labour mark the
beginning of the third stage. From this point onwards TP declines and the TP curve the variable factor to a meaningless extent that results in the decrease of total
comes down. The MP curve goes below the X-axis. product. The stage of negative returns can also be viewed as a stage of increasing
cost. That is employment of the variable factor incur additional cost without any
additional benefits.

46 4T
 Industrial Economics and Foreign Trade
Production
In which stage a producer will produce?
third 2Technology remains constant.
in the first stage or in the stage. In
A sensible producer will not produce Cumbolicaly different returns to scales can be shown as in the
of the variable factor is increasing will be
it
first stage since marginal product following diagram.
factor. Third stage is not at
profitable for the producer employ returns.
to more of that all
Therefore a producer will prodh
feasible as it is the stage of negative
more and more units of th
somewhere in the second stage. Or he can employ
from an additional unit of that factor eaual
variable factor till the marginal benefit
increasing returns
the additional cost incurred. t scale

Significance of the law Constant returns to scale

applicability. It can be applied to the fields agricult1re

of
The law has universal
In an industry in the short period
fishing, mining etc. and even to industries. to Decreasing
machinery building etc. are fixed. Suppose 100
labours are required work with a returns to scale
more than 100 workers may result in diminishing returns.
machine employing
But the law can be earmestly applied in the field of agriculture especially in the
developing countries where there is population pressure and agriculture is
overwhelmed with labour.
Percentage change in inputs
3.4 Returns to scale or Fixed proportion or Long-run production
function
In the long run all the factors are variable. Therefore output can be increased by Increasing and decreasing returns to scale operate mainly because of the operation of
increasing the quantities of all the factors in the same proportion. Since in the long economies of scale and diseconomies of scale.
run all the factors are increased in the same proportion to increase the output, factor
proportion remains the same and hence the long run production function is also Economies of Scale
called fixed proportion. When all the inputs are increased in the same proportion Economies of scale mean advantages of largescale production which help in reducing the
the production capacity as well as the scale of production also increases. Hence the average cost of productionThe economies of scale can be broadly classified as i) Intermal
long run production function is also called returns to scale economies ii) External economies
Thus, the long run production function describes the changes in output when all Internal Economies
the inputs are varied at the same proportion, When all the inputs are varied at the within the
Internal economies depend on the size of the firm) These advantages emerge
same proportion, initially the producer gets increasing returns to scale, then constant Internal economies are entirely enjoyable by
firm itself as its scale of production increases.
returns to scale and finally decreasing returns to scale. Increasing returns to scale
the firm itself. There are different forms of intermal economies.
means that output increases at a greater proportion than the increase in inputs. That
it increases
is when there is a 10% increase in inputs Increased production allows division of labour and
output increases more than 10%. When 1 Labour economies: fims can attract more efficient labour
there is constant returns to scale output increases at the same efficiency and productivity of workers. Further large
proportion of the
increase in inputs. A 10% increase inputs leads to a 10% increase in because of the better it can offer to the workers.
prospects
output.
Decreasing returns to scale means output increases at a lesser proportion. use the latest technology and machinery.
2. Technical economies: As a firm expands it can
The long run production function is also based on the This increases efficiency and reduces cost of production. Similarly, the firm can enjoy the
followinglassumptions
1,All units of the inputs used are homogeneous
49
48
 Industrial Economics and Foreign Trade Production
can be arranged in a conti.
activities ues
That is production ction and
economies of linked process. average cost of producti limit the further
loss of time. of diseconomies. expansion of the firm. The following
the important types
without any are
process
result of indivisibility of managerial
factors, the cost nes
economies: As a
3 Managerial increases. When there is large scale production nifficulties of management: As a firm expands problems of management
unit of management will fall as output and this increases overal
era
nd limit,a it will be very difficult for
the
arises.
be appointed in different departnments manager to control the
specialist
managers can
Cervision becomes complex and it leads to mismanagement and
organisation.
efficiency. the average
cost of production. vwastage. This increases
4Marketing economies: These are buying (of raw materials) and sellino
economies of

produced goods). When a firm purchase a large quantity of raw materials, it can get the Difficulties of co0ordination: In a big organisation there will be
number of a

raw materials at a cheaper

rate. Similarly, largescale marketing
will reduce average denartments. When the size of the organisation becomes too large, proper coordination
een these department will be difficult. It will affect the overall
marketing expenses. performance.
5.Financial economies: Big firms are usually regarded
as less isky by investor and hence Difficulties in decision making: In a large firm, before taking decision it has to
a

they will be willing to lend funds to such fims even at a lower rate of interest. Thus, the consult various departments and decision making will be delayed. Hence, firm cannot
co a
take quick decisions and make quick changes.
cost of capital will be less.
6. Risk minimising economies: When there is largescale production, risk can be 4Communication Problems: In a large firm it is
very difficult to communicate the
minimised by diversification of output, diversification of markets etc. decisions taken by the top management to the lower levels.

External Economies 5Labour Diseconomies: Because of extreme division of labour there will be an
impersonal atmosphere in large firms and contact between
management and workers
Extemal economies mean gains available to all the firms in an industry from the growth of become less. This may lead to industrial disputes.
that industryJThat is advantages accruing to a firm due to localisation of the industry. The
following are the important types of external economies. 6.Scarcity of Inputs: When there are a large number big firms in a locality, scarcity of
factors may be experienced. There will be competition between the fims for labour and
LEconomies of localisation: When number of firms in the industry are located in one
other inputs and this will push the price up.
place, all ofthem derive mutual advantages. This can be in the form of availability of skilled
labour, provision of better transport facilities etc. 7. Marketing Diseconomies: When the firms expand competition becomes very stiff.
2. Economies of Information: In It necessitates huge expenses on advertisement and other sales promotion activities.
industry, research work can be done jointly.
an

Statistical, technical, and other market information becomes more readily available when Isoquants
a large number of firms are located at one
place.
An isoquant is a curve which shows various combinations of two inputs which give the
3 Economies of Vertical
Disintegration: Localisation of an industry may lead to the same level
of output)'Iso' means equal and quant means quantity. That is equal quantity
establishment of new subsidiary industry in the area to fulfil the needs of the main of outputIsoquants are also called isoproduct curves or equal product curves) The
For
industry.
example, in the area of textile industry a chemical fim may start a colour construction of an isoquant can be explained with the help of the following schedule.
manufacturing unit.
4. Economies of by-product: The availability of waste material in
large quantity from the
industry may facilitate the starting up of fims in the area which produce
using this waste materials. by-products by
Diseconomies of Scale
Diseconomies of scale
disadvantages of large production) Beyond a certain limit,
means
diseconomies surpass internal and external economies.
These diseconomies increase the
50 51
 Trade
Industrial
Economics and Foreign Production

MRTStK= 4
That is, AL
Output of Cloth
Combinations of
Units of Capital
Units of (meters) Erom the diagram, it can be understood that
Labour and Labour (L) (K) amount capital replaced by one
AK, the
Capital additional unit of labour is going on
100
9 decreasing, AK
A
100
6 BL
10
B remains constant along the
Since output
100 the loss in output due to the
15 isoquant,
replacement of capital should be 100
100 compensated by the additional output
D 20
produced with the help of the extra amount of
labour employed.
That is
Labour

and capital -AK *MPK +AL*MPL = 0

In the above schedule labour
are taken as the two inputs. All the given (Where MPK and MPL are the marginal productivity of labour and capital)
combinations of labour and capital produce
the same level of output, that is 100 meters MPL
Therefore
of cloth. The graphical representation of AL MPK
the schedule gives an isoquant. This is intersect. Each isoquant represents a particular level of output.
given below.
3. Two isoquants never

When isoquants intersect, the intersecting point will be

two common and it can be two

different levels of output. Logically this is not correct

100
4 Higher isoquants represents higher levels
of output. A set of isoquants drawn is calledan
isoquants map. In isoquants map higher
Labour
isoquant represents higher levels of output.
Properties of an Isoquant
The following are the
important features or properties of isoquants. 300
JAsoquants negatively sloped. An isoquant represents a particular level of output.
are 200
Hence, when the quantity of one factor input is increased, the quantity of the other input 100
has to be decreased in order to keep the output constant.
Therefore, isoquants are negatively
sloped. Labour

2. soquants are convex to the origin. This is because along the isoquant MRTSLK
(Marginal rate of technical substitution of labour for capital) goes on Special type of isoquants
is the rate at which one decreasing. MRTSLK
input is replaced by the employment of additional units of the other
factor. In other words, how much of The shape of isoquants depends elasticity of substitution, that is to what extent the inputs
on
capital is replaced by the employment of an additional when the inputs are
unit of labour. This is the are substitutes. Usually, isoquants are downward sloping. However,
slope of the isoquant. Slope of the isoquant is AKIAL the isoquant will be a downward
perfect substitutes, an isoquant will be linear. Here,
52 53
 Industrial Economics and Foreign Trade Production
line. On
sloping straight
the other hand, when the
inputs are perfect
complements, an isoquant
will be right angled.
Which means that there is lq3 -lq3 AL
zero substitutability. In lq2 - lq2
other words, only one
combination (cormer) is lq1
possible.

Isocost line

An isocost line shows various

B2
combinations of labour and capital Labour 31 abour B1
(two inputs) that can be purchased
for a given expenditure of the firm,
In other words, it shows various Y/PK
combinations of labour and capital Least Cost Combination -

Producer's Equilibrium
that is available to the firm at the A Droducer will be in equilibrium when he is able to
produce a given quantity of output
same cost and at given prices of the with least cost or when he
inputs. If Y' is the total money produces maximum output
resources of the firm it can purchase with a given amount of inputs
Y/PK amount of capital or Y/PL In other words, least cost
amount of labour. A price line is combination of inputs is that
shown in the diagram.
Labour Y/PL
combination which cost least
The slope of the price line AlB is OA/OB or PL/PK. Since price of labour is wage (w) and to the fim in producing a
price of capital is interest (r), the slope can be written as w/r. certain quantity of output. It is
attained at that point where the
When the money resources of the fim increase, with given prices of
inputs, the price line isoquant is tangent to the
PL shifts upwards parallelly. When price of labour decreases,
point B shifts rightwards and isocost line. This is shown in K
vice versa. Similar is the case of capital.
the diagram. a3
02
Q1

Labour

ne diagram, producer is in equilibrium at point E, where the highest possible isoquant

is tangent to the isocost line. He is able to produce the maximum output with the available
Tesources. In other words, output Q2 is produced with the least cost.

54 55
 Industrial Economics and Foreign Trade roduction
of the price line are the
of the isoquant and the slope produced with the same level of inputs. In other words
At the point of tangency, the slope PL
which implies that same
the isoquant whic e will
MPL
and slopeofthe isocost line is Therefore output is produced with lesserbe a downward shit of
same. Slope of the isoquant is quantities of inputs.
Technicairal progress may be embodied and
at the equilibrium point new capital disembodied. It is embodied or
(machinery) is used in the investnent
estment neutral, when output increases production
without any increaseprocess.
That is the ratio of marginal It is disembodied
MPLPL This is the condition for producer equilibrium. on
in investment
innovation through research.
MPK PK
should be equal to the ratio of their prices.
It can also be but by an
productivity of labour and capital There are three types of technological progress
MPL MP That is the ratio marginal productivity of labour to its price is
written aspI
PL PK
1. Neutral technical progress: it is
neutral when
to its price. In other words, the change in the
the ratio of marginal productivity of capital
equal to anital are same due to the technical progress. In this marginal product of labour
marginal benefit from the last rupee spend on labour and capital should be equal. of the case there will be a
downward shiftin isoquant. In this case slope of the parallel
isoquant
equal reduction in both the inputs in MRTSLx
or remains
In other vwords, there is an
Expansion Path the same.

a certain quantity of output. the production

of
combinations as the scale of
production
Expansion path is a line connecting optimal input combinations at
expands In other words, it gives the least cost inputs every level of output. Labour Augmenting Technical Progress: It means the
It is a long run concept.We can obtain the expansion path by joining the point of tangency marginal product of labour
increases faster than the marginal product of capital. Here, the new
between isoquants and isocost lines of a firm) An expansion path is shown in the diagram. isoquant
becomes more
steeper.

3.Capital Augmenting Technical Progress: the

means marginal product of capital
increases faster than the marginal product of labour. In this case, the new
more flatter.
isoquant becomes
A3

A2 Capital Augmenting
Expansion path Technical Progress
Neutral Technical
Labour Augmenting
Al Technical Progress
ProgressS
QK

03
a2
a1
81 B2 83
Labour Labour Labour Labour

Technical Progress and its Implications

When there is a change in technical
progress, the production function will change. There
will be an upward shift in the
production function which means that more output is

56 57
 Iraue

and Foreign
Industrial
Economics Production

Decreasing
returns to scale Decreasing returns to scale means output
returns to scales
nartion than
lesserproportion thanithe increase in inCTeases : ta
inputs)A production function with decreasing
Isoquants
and different
terms of the isoquants. to scale.is
depicted in the following diagram. returns
in
also be explained diagram the first 100 units
to scale
can

The laws of
returns
that
scale means a. In the
returns to is produced with 2 units
Increasing af output
Increasing
returns to scale
increase in inputs)
The following dio and capital. But the
than the of labour
increasesat a greaterproportion next 100 units 1s produced by
retums to scale.
an additional 3 units
depicts increasing employing
and capital. The third
of labour -300
is produced
100 units of output
4 units of labour and
by using
first 100 units of In the expansion path
In the diagrarn the capital. 200
with 3 units of OA<AB<BC. Thus, a larger
output is produced
100
are needed to
and labour. The next 100 amount of inputs
capital additional units of Labour
2 additional units of produce
5C
unitsneed only 300 the production
The third 100 output. Hence,
labour and capital. 30 200 function shows decreasing returns to scale.
units of output is produced with
an

3.5 Cobb-Douglas production function

100
additional one unit of labour and
6L
capital. In the expansion path O 3L 5L
Cobb-Douglas production function is widely used to represent the technological
OAPAB BC. This kind of Labour

production function sbows relationshipbetween the amounts of two inputs, particularly capital and labour, and
the amount of output that can be produced by those inputg) It was proposed by Knut
increasing returms to scale. Wicksell and tested empirically by Charles Cobb and Paul Douglas in the 1930s
Constant returns to scale means the inputs and the output
(Constant returns to scale-
In its most standard form for production of a single good with two factors the
increases at the same proportion) Increasing returns to scale can be explained with the help
function is written as
of the following diagram.
QALK
where: Q= Total output, L= Labour, K Capital,
=
A= Total factor productivity
The diagram shows that the
first 100 units of output is a and Bare the output elasticitiesof labour and capital respectively
produced with 3units of capital real output per unit of input. It
Total factor productivity A can be interpreted as
and 3 units of labour. The
second hundred as well as the can be written as A=
6C
-300 LaK the
third hundred is also produced the value of A higher would be
with an additional 3 units of The value of A depends on technology. Higher
200 level of output Q.
labour and capital respectively.
available technology.Output
In the expansion path 100 constants determined by
OA-AB=BC. Thus, there is an utput elasticities are of output to a change in quantities
of either

equal proportionate increase in

O 3L 6L 9L Clasticity measures the responsivenessFor example, if a =0.45, it means that a 1%
Labour DOur or capital used in production.
inputs and output.
59
58
 Industrial
Economics and Foreign
Trade
Production

increase in labourusage
while keeping the quantity
of capital
ould lead
constant woula
Therefore K 4 Therefore K 16 =

0.45% increase in output.

to approximately function
function is a homogeneous
production Itm
3
e oiven as Q= 3L"K"" If labour is increased
Cobb-Douglas production factor A then output Q
would be multi increase in output? by 10% what will be the %
multiplied by a given
and K Cobb-Douglas production fune Log Q=log 3+1/21og L+1/2 log K
are
that ifL of a+B.
raised to the power ction
by the same factor A function of degree atß.
is a homogeneous production
scale) Here production functi-
is the case of constant returns to are increased by a factor 2, onhction
ao-0dLak
( If a+ß =1 it If both the inputs utput
becomes linearly homogeneous.
That is, if the inputs are increased by 110
=%*10+0 =5%
same factor .
will also increase by the
increase by 10 times. Cobb-Douglas production function:s
times, output will also
homogeneous as a+ß =1.
linearly
(If a+B>1 it is the case of increasing returns to scale. In this case outputincreases at
than the increase in inputs
a greater proportion
decreasing returns to scale. Here output increases at
Ifa+B<1 it is the case ofincrease
a

in inputs.
lesser proportion than the
Numerical Examples
1. Production function is given as Q=AL"K° . Derive marginal product of
labour and capital.

MP AalLK =
ALK"a=a.APL
MPxAK L*=ALK-B=BAPk
2. Suppose the production function is given as Q=2K2L2.
a) What will be the output when K=16 and L=36?
b) What is the marginal product oflabour when K=16 and L =36?
c)What is the average product ofcapital when K=16 and L =367
d) Find the number units of capital required to produce 40 units of output
ifL =25?
a) When K = 16 and L =36 Q = 2*16/2 362=2*4*6 =48

Q
b) MP -A aL K"=2* *36 I*1612=36\2 4== *
dL
6
c) AP of Capital Q/K=48/16 =3
dWhen Q- 40 and L 25, =
40 2 *K2 *2512 ie 40 =2 * K/2 * 5

0 61
 Cost
Chapter 4 oducer in buyin
hiring factor servvices.
or
ofthe
produced. may damages to the environment
cause However, when a
Cost of Production in the m.modity is
pollution etc. These are the
external cost and it is metform of air pollution,
the production of a commodiy by the society.
Cost is the expenditure incurred by a firm in T.
To 6. Replacement cost
labour, building etc. The
produce a commodity a firm needs raw materials, cost is the cost incurred when an
Replacement
asset
expenses of these items are termed as cost.
vith the
n e w asse That is replacement cost or depreciates and it is replaced
4.1 Cost Concepts et. Buying a new machine to expenditure does not increase
the t
total a s s e t .
replace the old one or
replace the old car is an example of replacement cost. buying a new car to
1. Explicit and implicit cost
7. Sunk cost
Explicit cost is the expenses actually met by the producer while producing
commodity) In other words these are the payments incurred by the producer for unk cost is the cost which has already been incurred and cannot be
outsiders who supply labour, raw materials, electricity etc. These items are
recordei
other words it is totally irretrievable. It is not used for future decisionrecovered In
in the books of account of a firm. amnle when an oil well is abandoned the money spent on it is lost. making. For
But the
decision to abandon the well is made on the basis of poor cash flows and not on
On the other hand implicit cost is the opportunity cost of the factor services basis of sunk cost.
the
supplied by the organisation itself JSometimes a firm will be running in a
which is owned by the producer himself. Hence an
building Short run and Long run
expense like rent does not arise
but a value can be imputed for this. This is
implicit cost. Such items will not be Short run is a period in which a firm can increase its output only by employing more
recorded.
of the variable factors such as labour and raw materials) In the short run fixed factors
2. Real cost such as building, machinery etc. remains the same.

This is the actual pain and On the otherhand, in the long run all factors are variable. Hence, the size of plant
suffering involved in the production of a commodity.
When a person is involved in the and building can be increased. Thus output can be increased by increasing the
and he is not able to
production of a commodity he sacrifices leisure
spend this time with his family. The value of these quantities of all the factors.
cannot be measured in sufferings
money terms and they 4.2 Short run costs
are
psychological in nature.
3. Accounting cost Since in the short run certain factors are fixed
and certain other factors are variable, a firm
Accounting cost is the money cost that can be recorded in the books of account
This is same as incur fixed cost and variable cost.
explicit cost. For
purpose of
considered, which can be identified, measured and accounting only those items are TFC

accounted.
5. Social cost
Total Fixed Cost(TFC)-It is the cost which
Social cost does not
is the sum of private cost and external
vary with the level of outpuf.In other
incurred by the
producer in the production of a cost,) Private cost is the cos Words it has to be met even at zero level COST

commodity. These are the expens Fig. 4.1 TFC

curve

62
63
 and Foreign Trade Cost
Industrial Economics

interest payment, salary of permanent Average fixed cost(AFC) -It is the fixed
output. Rent of factory building,
fixed cost. Since fixed
cost remains :
the same per
cost
unit
of output. AFC is obtained by
employees etc. are examples of dividing TFC by the mber of units of
line parallel to the quantity avi
the short period TFC curve is a horizontal straight
output() produced
cost(TVc) Variable
Total variable
-

cost is the cost that vary

with the level TVC AFCFC As output increases
of output.JThat is, when output is zero AFC decreases and hence AFC
variable cost is also zero and as output curve is downward
sloping.
increases variable cost also increases. Graphically AFC curve is a AFC
Cost of raw materials, wages of workers, rectangular hyperbola. It is
transportation cost, fuel charges etc. are asymptotic to both axes. Even Output
Fig 4.4 AFC curve
examples of variable cost. The TVC though it come closer, it never
curve is an inverse S shaped curve.
touches the axes.
FIG 42 TVC curve OUTPUT
Initially TVC increases at a decreasing
rate and later it increases at an increasing rate. This is because of the operation of
the law of variable proportion. That is, when more and more units of variable factors
added to fixed factors, initially productivity increases hence the additional cost per Average variable cost(AVC) -I
is the
ATC
unit of output decreases. Therefore TVC increase at a decreasing rate. But beyond variable cost per unit of output. AVC is
a certain level, productivity of the variable factors decreases and hence additional obtained by dividing TVC by the number of
cost per unit of output increases. Therefore TVC increases at an increasing rate. units of output(Q). AVC=Since
Q
in the
Total Cost(TC) -Total cost is the initial stages of production TVC increases at
sum of total fixed cost and total a decreasing rate, AVC falls. But later TVC
variable cost increases at an increasing rate and hence

TC TFC+TVC AVC rises. Therefore AVC curve is U

Fig 45 AVC curve OUTPUT
shaped. Thus the basic reason behind the U
TC curve has the same shape of
shape is the law of variable proportion.
the TVC curve. But it starts fromm
the starting point of the TFC curve -TFC
because at zero level of output TC
Average cost(AC) -

AC is the cost per unit o

equals TFC. The TC curve and
output produced. It is obtained by dividing TC
TVC curves are parallel. by the number of units of output(Q) produced.
Fig 43 TC curve OUTFUT AC--+AFC+AVC
= Thus AC
Q
IS the sum of AFC and AVC. Since in the AC CURVE
OUTFU
Fig 4.6

beginning AFC and AVC are falling, AC also

64 65
 Industrial Economics
and Foreign Trade Cost
rises. However, the rate ofincreas
continue to fall but AVC run cost
falls. But later AFC 4.3 Long
than the rate of decrease
in AFC. Hence AC rises. In other
in AVC is greater a is a neriod
which sufficient to increase
is
AC falls and when TC increases at Longrun the
words when TC increases
at a decreasing rate
is la such a5
building, machinery, labour, raw materials etc.quantities of all the factors
the basic reason for the shape the
U
an increasing rate AC rises. Here also in the long run therefore there is no fixed Hence all the factors are
of variable proportion.
variable

cost
run total cost(LTC)
when one more Long
cost(MC) MC is the addition to total cost unit
f
nc

Marginal
-

i s the
minim cost at which a given level of output
output(Q) is produced can be produced in the
run) LTC curve is derived
ong
oror MC, =TCa-TCa-1 from the
short run total cost curves.
MC 8 MC on LTC is taken from a ,LTC
of Each point
MC is derived from TC. But TC is the
sum
run total cost curve
TFC and TVc. Since TFC is constant changes short

to the optimum
in TC depends on changes in TVC. Therefore corresponding
that plant
MC ultimately depends on the changes in output represented by
TVC. When TVC increases at a decreasing LTC is also inverse S shape
size.
rate each addition to TVC will be less and and the reason is returns to scale.
hence MC falls. Later when TVC increases at Output
an increasing rate each addition to TVC will be more and hence MC rises. Therefore
MC curve is also U shaped. Graphically MC is the slope of the TC(or TVC) curve.
butput

Fig. 4.9 LTC

The relation between MC and AVC

Long run average cost(LAC)
or MC and AC
AC
LACis the cost per unit of output in the long rundltis alsoderivedfromshortrun
The following are the relation MC averagecostcurves(SACS.In the short run one plant size is suitable for producing
between MC and AVC one particular level of output. For the next level of output another plant size :
AVC suitable and hence a large number of SACs can be drawn. From each SAC curve
When MC<AVC, AVC decreases. the LAC curve. Hence LAC curve is
one point is taken.Joining thesepoints get
we
2 When MC = AVC, AVC is the
envelope of SAC curves and it will be flatter when compared to the SAC
curves.
an
minimum.
For convenience we assume that only five plant sizes are available to produce
a

figure SACI
3When MC>AVC, AVC increases. commodity. Corresponding to which five SAC
curves are there. In the
more output can be
The same relations exist between MC
IS suitable to
produce up to gl level of output. Even though
Therefore it will shift to SAC2
and AC produced with same plant size cost will be higher.
of economies ofscale or advantages
output wnich comes down because of the operation Beyond
r
large scale production. It is suitable to produce up to q2 level of output.

66 67
 COst
Trade
Economics and Foreign
Industrial

certain level
of output LAC Answer
a
because of
SACsgoes up No. of units TC TFC
of scale or SAC TVC
diseconomies
Of output MC
disadvantages of
large SAC SAC

In reality 0 100 -100-

scale production. sAc
be 150
hundreds of SACs
can
-100 50- 50
drawn and from each
SAC 190 -100 -90
will be 40
curve one point 220- -100 120
these 30-
taken. By joining cost function of a fim is given
points we get LAC
is
curve.

also Uo Output
The
2. Th total
AVC and ACc
as
TC=1000+100-60+0
LAC curve a Derive TVC, MC,
the
shaped because of
returns to scales. is the TFC when output equals 500 units?
operation of different b) What
Fig. 4.10 Derivation of LAC curve
cWhat is MC
when output is 100units?
Long run marginal cost(LMC) LMC
dFind the level of output where MC is minimum.
It is the addition to total cost
when one more unit of output is
a)TVC= 10Q-60+Q" MC=10-120+30
dQ

produced in the long run.It is AVC-10-60+Q* AC=1000/Q+10-60-Q

derived from Short run marginal
cost curves. LMC curve is also U b) TFC 1000 TFC will be same for all levels ofoutput
shaped because of different c) MC 10-120+3Q When Q = 100 MC=10-12*100+3*100 =28810
returns to scales in the long run.
Output
d) MC 10-120+3Q" When MC is minimum the first derivative should
zero.

Fig. 4.11 LMC dMC dMC

curve That is
dQ
0
dQ
-12+6Q=0 Q-2
To prove that MC is minimum the second derivative should be greater than
Numerical examples zero. That is dMC 0 dMC=6 Hence the condition is proved.

1. Complete the following schedule dQ do2

No. of units TC 4.4 Revenue
TFC TVC MC
Of output Revenue is the income from the sale of outpu
0 100
fotal Revenue(TR)- It is the total receipts from the sale of a given quantity of
* *

150 50
2 p L it is obtained multiplying quantity sold) by price per unit{P).
by
40
3 120 TR P*Q
68
69
 and Foreign Trade
Cost
Industrial Economics

Hence AR, MR and price will be the

TR curve will same and it will
price.
parallel to the xX-axis.
same

line be an be a
sold. AR is ohta
s t r a i g h t

upward sloping horizontal

ping straight
s line.
t is the revenue per unit of output
Average Revenue(AR)- sold(Q).
the number of units of output
bydividing TR by P-AR = MR
TR
AR- =P Thatis AR isthe price
is the addition to total revenue by selling one
Marginal Revenue(MR)- I more
unit of output.
MR-o MRo= TRo-TRo1 Output
dQ
under imperfect competition A14 AR and MR Fig. 4.15 TR curve Output
TR, MR and AR under imperfect competition
-

seller can Sell larger

quantity at under perfect competition
(meaning is explained in the chapter market)
a a

lesser price. Hence additional revenue, that is marginal revenue goes on decreasina down point in the short run
45 Shut
of a product is less than AC. It is still
as output sold increases. Therefore AR curve as well as MR curve is downWard Suppose the price beneficial
sloping.
inue production price is greater than AVC. Because AC is theforsumthe off
continue production till

Therefore when Price is greater than AVC it AFC

and A VC. can cover
Revenue AVC as well as
RevenuC a part of
AEC Once the price equals AVC it may stop production. Therefore price=AVC is
he shutdown point of the firm. That is the minimum point of the AVC curve.

AR
Suppose price is Pl, the firm will supply a
quantity(Q1) where price equals
MR marginal cost. Since this price
Output
is greater than AC, the firm is MC
Fig 4.11 AR and MR output getting a profit. When price AC
Fig 4.12 TR
falls to P2, it is less than AC AVC
and hence there is a loss(BC).
P
Relation between MR and TR But still it is beneficial for the
fim to produce in the short run
The following relations can be observed between MR and TR
because when it produces Q2
1. When MR is positive TR increases. 2. When MR is zero TR is level of output the firm is able P2
maximum to cover its variable cost(Q2V) P3
3. When MR is and a part of the
negative TR decreases fixed
TR, MR and AR under perfect
cost(VB). Hence the loss
competition Under perfect competition will be BC
only. If it stop Q3 02
(meaning explained in the chapter market) every unit of a commodity is sold at the production loss per unit will be
Output

Once the price reaches P3 it may stop production because tne

70
71
 Industrial Economics
and Foreign Trade Cost
A l g e b r a i cM e t h o d

variable
firm is able to cover its
curve of a firm
is that portion of the MC curve
ve which is the
cost only. Thus the supply the price of product
and Qb the
down point) P be
over above the AVC curve(or the shut eak-even
Let, point total revenue equals total cost. reak-even level ofof
TR TC (TR =
P *Qb
output At the
That is
and TC=
4.6 Break-even Analysis Therefore
PQb=TFC+TVC TFC+TVC
Break-even analysis analyse the relationship he.
is amethod that is used to (TVC= AVC
organisation at different levels ofa P Qb
TFC + *Q6)
total revenue and profit ofan
Sincecost,
total utput
it gives profit at different levels of projected sales it 1s used as an impor p Qb- AVC*Qb = TFC
AVC*Qb
tool of managerial decision making. The most important aspect of break
It is the point at which total revenue of Qb=TFc
analysis is identifying the break-even point. P-AVC
firm equals total cosp In other words it is the point at which there is no prof
loss for the firm. There are different approaches to break-even analysis. t or hetween price and average variable cost
Thed i f f e r e

marg1n per
unit of output sold. It is that
part of the price
(P-AVC) is the contribution
Graphical method cost and to profit of the firm, which contributes to
fixed cover
The graphical method construct the break-even chart. This method is based on tthe PV Ratio
assumption that cost and
revenue functions of the d(Profit Volume Ratio) is the ratio
of contribution
to sales which
firm are linear. Thatis indicates the contribution earned with respect to one of
sales. Ifrupee unit sales
TR curve and TC curves TR price and
variable cost are constant then PV
Ratio will be constant at per
all the levels
are straight lines. TR and
Profit TC
of output. A change in fixed cost does not affect P/V Ratio.
TC are measured along
Contribution Since
the y-axis and output E PVRatio= Sales Contribution =
Sales(S) -Variable cost(V)
along the X-axis.
Sales-Variable cost
At point E the TR curve
PV Ratio = S-V
Sales
intersects the TC curve. LOSS This ratio can also be shown in the form of
Hence, E is the break TFC percentage by multiplying by 100. Thus,
if selling price of a product is Rs. 20 and variable cost is Rs. 15
even point where the per unit, then
fim produce Qb level of PV Ratio 20-15x 10020
20 100 25%
output. The gap between (If we take total revenue and total variable cost to estimate the ratio, it will not
the TC curve and the TR
make any difference)
curve beyond the Qb output
level of output shows Qb In theabove example, for every Rs. 100
sales, Contribution of Rs. 25 is made
profit and the gap below this level towards meeting the fixed
there is no loss or of output shows loss. At the break-even point expenses and then the profit.
profit. USing PV ratio also break-even can be estimated
point(BEP)

72
73
 Trade
Economics and Foreign
industrial
Cost
TFCS
When this formula is for
BEP
TFC
pV Ratio
OR BEP s-V
of TR.
applisi 4/There is
no provisi changes in selling price.
point in Rupees,
that is in terms hased on the assumptions that whatever is
we get
break-even
produced is sold This may not
happen.
Margin of safety
beyond break
-even point. It is calculated the
ao.
assumes that the Dusiness conditions may not
the sales change which is not true
(Margin of Safety is the break-even salesTt can be
exprescea.
in Numerical examples
total sales and
difference between be expressed, as below:
number of units. It can
firm makes candles and
monetary terms
or 1 Suppose a
every month it has to pay Rs. 3000 as
Break Even SalesP
Sales rent and Rs.3000 as interest
-

Margin of Safety
=

BEP is much below the actial

charges. If the selling price of a candle is Rs. 5
which indicates that sales and variable cost per candle is Rs.2
Ifmargin of safety is large, a sound condition and reduction in sales will not
be a a) Estimate the break-even level of output
that means business is in
hand, if margin of satety is low, any lag.of
business. On the other b) If the sales is 5000 candles, what will be theprofit?
problem for the
efforts need to be made to reduce fixed cne c)To get a profit of RS. 15000 how many candles are to be produced
sales may be a serious matter. Thus,
variable costs or increasing the selling price or sales volume to impro p Ne d) If the sales is 5000 candles what is the margin of safety?
contribution.
e) Estimate profit volume ratio and break-even sales.
f I f the firm wants to bring down the break-even output to 1500 units
Uses of Break-even analysis
what should be the price charged?
I t helps in the determination of selling price which will give the desired profit,
a) TFC= 3000+3000 6000 P=5 AVC=2
GiTt helps in the fixation of sales volume to get a desired level of revenue. TFC 6000 2000 units

(ayIt helps in making inter-firm comparison of profitability BEPp-AVC 5-2

(ivyIt helps in determination of costs, revenue and profit at various levels of b) Profit =
TR-TC TR= P*Q= 5*5000 =25000
output. TC = TFC+TVC =6000+2*5000= 16000

(v)it helps in managerial decision-making TR-TC =

25000-16000 =9000
Limitations of Break-Even Analysis c) TR TC = 15000
LBreak-even analysis is based on the assumptiop that all costs and expenses can 15000 5*Q-(6000+2*Q) = 5Q-20-6000 3Q-6000
beclearly separated into fixed and variable components. In practice, however, 3Q 21000 Q=7000 Therefore 7000 candles are to be produced
may not be possible to achieve a clear-cut division to get a profit of Rs. 15000
of costs into fixed and varap
ypes.
Actual sales Break-even sales 5000-2000-3000
2. It assumes that fixed costs
d Margin of safety
-

remain constand at all levels of

fixed costs tend to vary activity. Howe units Or Rs. 15000 (5000*5-2000*5)
a beyond certain level of activity.
3. It that
variable costs vary 60%
assumes proportionately with the volume of oup e)PV ratio =(S-V)YS =
(5-2)/5 =
.6 or 0.6*100 =

practice, t may not be varying in direct Break-even sales =TFC/PV Ratio

6000/0.6 =10000
proportions
=

75
74
 Trade
Industrial Economicsnd Foreign
This the break-even sales in Kupees. To find BEP in units divide it hu
tby
price
That is 10000/5 = 2000 units

6000

f1500 ie P-2= 6000/1500 =4

P-2
Therefore P =4+2=6 The firm should charge a price of Rs.6 per
candle to bring down the break-even output to 1500 units

2. Suppose the monthly fixed cost of a firm is Rs. 20000 and its monthly total
variable cost is Rs. 30000.
a) If the monthly sales is Rs. 60000 estimate contribution and break-even
sales. b) If the firm wants to get a monthly profit of Rs.20000, what shoul
be the sales?
a) Contribution =S -V= 60000-30000 =30000
TFC
Break-even Sales =
PV Ratio

TFC 20000 S 60000 V=30000

PVRatio= (60000-30000)/60000 0.5

TFC
Break-even Sales =
20000/0.5 =
40000
PV Ratio

TFC+Desired profit
b) Sales to earn a desired profit =

PV Ratio
= (20000+20000)/0.5

80000

A relation exist between AR, MR and price elasticity of demand

e
AR = MR Where e is the elasticity of demand

16