Introduction

• A business firm is an
economic unit. It is
also called as a
production unit.
Production is one of
the most important
activities of a firm in
the circle of economic
activity. The main
objective of production
is to satisfy the
demand for different
kinds of goods and
services of the
community.
• The term “Production” means transformation of
physical “Inputs” into physical “Outputs”.
• The term “Inputs” refers to all those things or items which
are required by the firm to produce a particular product.
Four factors of production are land, labor, capital
and organization.
• In addition to four factors of production, inputs also
include other items like raw materials of all kinds, power,
fuel, water, technology, time and services like transport
and communications, warehousing, marketing, banking,
shipping and Insurance etc.
• It also includes the ability, talents, capacities, knowledge,
experience, wisdom of human beings. Thus, the term
inputs have a wider meaning in economics. What we get
at the end of productive process is called as “Outputs”.
In short, “Outputs” refer to finished products.
• Production always results in either creation of new
utilities or addition of values. It is an activity that
increases consumer satiability of goods and services.
Production is undertaken by producers and basically it
depends on cost of production.
• Production analysis is always made in physical terms
and it shows the relationship between physical inputs
and physical outputs.
• It is to be noted that higher levels of production is an
index of progress and growth of an organization and that
of a society. It leads to higher income, employment and
economic prosperity. Production of different types of
goods and services in different nations indicates the
nature of economic inter dependence between different
nations.
 Production Function
• “A production Function” expresses the technological or
engineering relationship between physical quantity of inputs
employed and physical quantity of outputs obtained by a firm.
It specifies a flow of output resulting from a flow of inputs
during a specified period of time.
• It may be in the form of a table, a graph or an equation
specifying maximum output rate from a given amount of
inputs used. Since it relates inputs to outputs, it is also called
“Input-output relation.” The production is purely physical in
nature and is determined by the quantum of technology,
availability of equipments, labor, and raw materials, and so on
employed by a firm.
• It can be represented in the form of a mathematical model or
equation as Q = f (L, N, K….etc) where Q stands for quantity
of output per unit of time and L N K etc are the various factor
inputs like land, capital, labor etc which are used in the
production of output.
 Factor inputs
• 1. Fixed Inputs. Fixed inputs are those factors the
quantity of which remains constant irrespective of
the level of output produced by a firm. For example,
land, buildings, machines, tools, equipments, superior
types of labor, top management etc.
• 2. Variable inputs. Variable inputs are those factors
the quantity of which varies with variations in the
levels of output produced by a firm For example, raw
materials, power, fuel, water, transport and
communication etc.
• The distinction between the two will hold good only in the
short run. In the long run, all factor inputs will become
variable in nature.
• Short run is a period of time in which only
the variable factors can be varied while fixed
factors like plants, machineries, top
management etc would remain constant.
Time available at the disposal of a producer to
make changes in the quantum of factor inputs is
very much limited in the short run.
• Long run is a period of time where in the
producer will have adequate time to make
any sort of changes in the factor
combinations.
• Production function is assumed to be a
continuous function, i.e. it is assumed that a
change in any of the variable factors produces
corresponding changes in the output.
 1. Short Run Production Function

1. Quantities of all inputs both fixed and

variable will be kept constant and only
one variable input will be varied. For
example, Law of Variable Proportions.
2. Quantities of all factor inputs are kept
constant and only two variable factor
inputs are varied. For example, Iso-
Quants and Iso-Cost curves.
2. Long Run Production Function
• The producer will vary the quantities of all factor inputs,
both fixed as well as variable in the same proportion.
E.g. law of returns to scale.
• Each firm has its own production function which is
determined by the state of technology, managerial
ability, organizational skills etc of a firm. If there are any
improvements in them, the old production function is
disturbed and a new one takes its place. It may be in the
following manner –
1. The quantity of inputs may be reduced while the quantity
of output may remain same.
2. The quantity of output may increase while the quantity of
inputs may remain same.
3. The quantity of output may increase and quantity of
inputs may decrease.
 Uses of Production Function
1. To calculate the least cost input combination for a given output
or the maximum output-input combination for a given cost.
2. It is useful in working out an optimum, and economic
combination of inputs for getting a certain level of output. The
utility of employing a unit of variable factor input in the
production process can be better judged with the help of
production function. Additional employment of a variable factor
input is desirable only when the marginal revenue productivity of
that variable factor input is greater than or equal to cost of
employing it in an organization.
3. Production function also helps in making long run decisions. If
returns to scale are increasing, it is wise to employ more factor
units and increase production. If returns to scale are
diminishing, it is unwise to employ more factor inputs & increase
production. Managers will be indifferent whether to increase or
decrease production, if production is subject to constant returns
to scale.
Production Function with

One Variable Input

Case
The Law of Variable Proportions
• All factor inputs are not available in plenty. Hence, in
order to expand the output, scarce factors must be kept
constant and variable factors are to increased in greater
quantities. Additional units of a variable factor on the
fixed factors will certainly mean a variation in output. The
law of variable proportions or the law of non-proportional
output will explain how variation in one factor input give
place for variations in outputs.
• The law can be stated as the following. As the quantity
of different units of only one factor input is
increased to a given quantity of fixed factors,
beyond a particular point, the marginal, average and
total output eventually decline.
• The law of variable proportions is the new name
for the famous “Law of Diminishing Returns”
of classical economists. This law is stated by
various economists in the following manner –
According to Prof. Benham, “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”1.
• The same idea has been expressed by
Prof.Marshall in the following words. An increase
in the quantity of a variable factor added to fixed
factors, at the end results in a less than
proportionate increase in the amount of product,
given technical conditions.
 Assumptions of the Law

1. Only one variable factor unit is to be varied

while all other factors should be kept constant.
2. Different units of a variable factor are
homogeneous.
3. Techniques of production remain constant.
4. The law will hold good only for a short and a
given period.
5. There are possibilities for varying the
proportion of factor inputs.
Illustration
• Fixed factors = 1 Acre of land + Rs 5000-00
capital. Variable factor = labor.
• Total Product  or Output:(TP) It is the output
derived from all factors units, both fixed &
variable employed by the producer. It is also a
sum of marginal output.
• Average Product or Output: (AP) It can be
obtained by dividing total output by the number
of variable factors employed.
• Marginal Product or Output: (MP) It is the
output derived from the employment of an
additional unit of variable factor unit
 Trends in output
• From the table, one can observe the following
tendencies in the TP, AP, & MP.
• 1. Total output goes on increasing as long as
MP is positive. It is the highest when MP is zero
and TP declines when MP becomes negative.
• 2. MP increases in the beginning, reaches the
highest point and diminishes at the end.
• 3. AP will also have the same tendencies as the
MP. In the beginning MP will be higher than AP
but at the end AP will be higher than MP.
Diagrammatic Representation
 Stage Number I. The Law of
Increasing Returns
• The total output increases at an increasing rate (More than
proportionately) up to the point P because corresponding to this
point P the MP is rising and reaches its highest point. After the
point P, MP decline and as such TP increases gradually.
• The first stage comes to an end at the point where MP curve
cuts the AP curve when the AP is maximum at N.
• The I stage is called as the law of increasing returns on
account of the following reasons.
1. The proportion of fixed factors is greater than the quantity of
variable factors. When the producer increases the quantity of
variable factor, intensive and effective utilization of fixed factors
become possible leading to higher output.
2. When the producer increases the quantity of variable factor,
output increases due to the complete utilization of the “Indivisible
Factors”.
3. As more units of the variable factor is employed, the efficiency of
variable factors will go up because it creates more opportunity
for the introduction of division of labor and specialization
resulting in higher output.
 Stage Number II. The Law of
Diminishing Returns
• In this case as the quantity of variable inputs is
increased to a given quantity of fixed factors,
output increases less than proportionately. In
this stage, the T.P increases at a diminishing
rate since both AP & MP are declining but they
are positive. The II stage comes to an end at the
point where TP is the highest at the point E and
MP is zero at the point B. It is known as the
stage of “Diminishing Returns” because both the
AP & MP of the variable factor continuously fall
during this stage. It is only in this stage, the firm
is maximizing its total output.
• Diminishing returns arise due to the following reasons:
1. The proportion of variable factors is greater than the
quantity of fixed factors. Hence, both AP & MP decline.
2. Total output diminishes because there is a limit to the
full utilization of indivisible factors and introduction of
specialization. Hence, output declines.
3. Diseconomies of scale will operate beyond the stage of
optimum production.
4. Imperfect substitutability of factor inputs is another
cause. Up to certain point substitution is beneficial.
Once optimum point is reached, the fixed factors cannot
be compensated by the variable factor. Diminishing
returns are bound to appear as long as one or more
factors are fixed and cannot be substituted by the
others.
 The III Stage The Stage of
Negative Returns:
• In this case, as the quantity of variable input is increased to a
given quantity of fixed factors, output becomes negative.
During this stage, TP starts diminishing, AP continues to
diminish and MP becomes negative. The negative returns are
the result of excessive quantity of variable factors to a
constant quantity of fixed factors.
• The producer being rational will not select either the stage I
(because there is opportunity for him to increase output by
employing more units of variable factor) or the III stage
(because the MP is negative). The stage I & III are described
as NON-Economic Region or Uneconomic Region. Hence, the
producer will select the II stage (which is described as the
most economic region) where he can maximize the output.
The II stage represents the range of rational production
decision.
• It is clear that in the above example, the most ideal or
optimum combination of factor units = 1 Acre of
land+ Rs. 5000 – 00 capital and 9 laborers.
• All the 3 stages together constitute the law of variable
proportions. Since the second stage is the most
important, in practice we normally refer this law as the
law of Diminishing Returns.

• Practical application of the law

• 1. It helps a producer to work out the most ideal
combination of factor inputs or the least cost combination
of factor inputs.
• 2. It is useful to a businessman in the short run
production planning at the micro-level.
• 3. The law gives guidance that by making continuous
improvements in science and technology, the producer
can postpone the occurrence of diminishing returns.
Production function with

Two Variable Inputs

 ISO-Quants and ISO-Costs
• The prime concern of a firm is to workout the
cheapest factor combinations to produce a given
quantity of output. There are a large number of
alternative combinations of factor inputs which
can produce a given quantity of output for a
given amount of investment. Hence, a producer
has to select the most economical combination
out of them. Iso-product curve is a technique
developed in recent years to show the
equilibrium of a producer with two variable factor
inputs.
 Meaning and Definitions
• The term “Iso – Quant” has been derived from ‘Iso’
meaning equal and ‘Quant’ meaning quantity. Hence, Iso
– Quant is also called Equal Product Curve or Product
Indifference Curve or Constant Product Curve. An Iso –
product curve represents all the possible combinations of
two factor inputs which are capable of producing the
same level of output. It may be defined as – “ a curve
which shows the different combinations of the two inputs
producing the same level of output .”
• Each Iso – Quant curve represents only one particular
level of output. If there are different Iso–Quant curves,
they represent different levels of output. Any point on an
Iso – Quant curve represents same level of output. Since
each point indicates equal level of output, the producer
becomes indifferent with respect to any one of the
combinations.
 Equal Product Combination
Combination Factor X Factor Y Total output

A 12 1 100

B 8 2 100

C 5 3 100

D 3 4 100

E 2 5 100
Graphic Representation
 Marginal Rate of Technical
Substitution (MRTS)
• It may be defined as the rate at which a
factor of production can be substituted
for another at the margin without
affecting any change in the quantity of
output. For example, MRTS of X for Y is
the number of units of factor Y that can be
replaced by one unit of factor X quantity of
output remaining the same.
 Equal Product Combination
Combination Factor X Factor Y MRTS of x
for y
A 12 1 -

B 8 2 4:1

C 5 3 3:1

D 3 4 2:1

E 2 5 1:1
• In the above example, we can notice that in the
second combination the producer is substituting
4 units of X for 1 unit of Y. Hence, in this case
MRTS of Y for X is 4:1.
• Generally speaking, the MRTS will be
diminishing. In the above table, we can observe
that as the quantity of factor Y is increased
relative to the quantity of X, the number of units
of X that will be required to be replaced by one
unit of factor Y will diminish, quantity of output
remaining the same. This is known as the law of
Diminishing Marginal Rate of Technical
Substitution (DMRTS).
 Properties of Iso- Quants
1. An Iso-Quant curve slope downwards from left
to right.
2. Generally an Iso-Quant curve is convex to the
origin.
3. No two Iso-product curves intersect each other.
4. An Iso-product curve lying to the right
represents higher output and vice-versa.
5. Always one Iso-Quant curve need not be
parallel to other.
6. It will not touch either X or Y – axis.
 ISO-Cost Line or Curve
• It indicates the different combinations of the
two inputs which the firm can purchase at given
prices with a given outlay. It shows two things
1. prices of two inputs
2. total outlay of the firm.
• Each Iso-cost line will show various
combinations of two factors which can be
purchased with a given amount of money at the
given price of each input.
 E.g.
• Let us suppose that a producer wants to spend
Rs. 3,000 to purchase factor X and Y. If the price
of X per unit Rs. 100 he can purchase 30 units
of X. Similarly if the price of factor Y is Rs. 50
then he can purchase 60 units of Y.
• When 30 units of factor X are represented on
OY – axis and 60 units of factor Y are
represented on OX- axis, we get two points A &
B. If we join these two points A and B, then we
get the Iso-Cost line AB. This line represents the
different combinations of factor X and Y that can
be purchased with Rs. 3,000.
• The Iso-Cost line will shift
to the right if the producer
increase his outlay from
Rs. 3,000 to Rs. 4,000.
On the contrary, if his
outlay decreases to
Rs. 2,000, there will be a
backward shift in the
position of Iso-cost line.
• The slope of the Iso-cost
line represents the ratio
of the price of a unit of
factor X to the price of a
unit of factor Y. In case,
the price of any one of
them changes there
would be a corresponding
change in the slope and
position of Iso-cost line.
 PRODUCERS EQUILIBRIUM
• Optimum factor combination or least cost
combination.
• In order to explain producer’s equilibrium, we
have to integrate Iso-quant curve with that of
Iso-cost line. Iso-product curve represent
different alternative possible combinations of two
factor inputs with the help of which a given level
of output can be produced. On the other hand,
Iso-cost line shows the total outlay of the
producer and the prices of factors of production.
• The intention of the producer is to maximize his
profits. Profits can be maximized when he is
producing maximum output with minimum
production cost.
• The producer selects the least cost combination
of the factor inputs. Maximum output with
minimum cost is possible only when he reaches
the position of equilibrium. The position of
equilibrium is indicated at the point where Iso-
Quant curve is tangential to Iso-Cost line.
• At this point, MRTS between the two points is
equal to the ratio between the prices of the
inputs.
• It is quite clear from the
diagram that the producer
will reach the position of
equilibrium at the point E
where the Iso-quant
curve IQ and Iso-cost line
AB is tangent to each
other. With a given total
out lay of Rs. 5,000 the
producer will be
producing the highest
output, i.e. 500 units by
employing 25 units of
factors X and 50 units of
factor Y. (assuming Rs.
2,500 each is spent on X
and Y)
 Long Run Production Function
• Laws of Returns to Scale
• The concept of returns to scale is a long run
phenomenon. In this case, we study the change
in output when all factor inputs are changed or
made available in required quantity. An increase
in scale means that all factor inputs are
increased in the same proportion. In returns to
scale, all the necessary factor inputs are
increased or decreased to the same extent so
that whatever the scale of production, the
proportion among the factors remains the same.
SI Scale Tot Product Marginal
No in units Product
1 1 Acre + 3 labor 5 5
2 2 Acre + 5 labor 12 7
3 3 Acre + 7 labor 21 9
4 4 Acre + 9 labor 32 11
5 5 Acre + 11 labor 43 11
6 6 Acre + 13 labor 54 11
7 7 Acre + 15 labor 63 9
8 8 Acre + 17 labor 70 7
• When the quantity of all factor inputs are increased in a
given proportion and output increases more than
proportionately, then the returns to scale are said to be
increasing; when the output increases in the same
proportion, then the returns to scale are said to be
constant; when the output increases less than
proportionately, then the returns to scale are said to be
diminishing.
• The output increases more than proportionately when
the producer is employing 4 acres of land and 9 units of
labor. Output increases in the same proportion when the
quantity of land is 5 acres and 11units of labor and 6
acres of land and 13 units of labor. In the later stages,
when he employs 7 & 8 acres of land and 15 & 17 units
of labor, output increases less than proportionately.
Diagrammatic representation
• It is clear that the
marginal returns curve
slope upwards from A to
B, indicating increasing
returns to scale. The
curve is horizontal from B
to C indicating constant
returns to scale and from
C to D, the curve slope
downwards from left to
right indicating the
operation of diminishing
returns to scale.
Increasing Returns to Scale
• Increasing returns to scale operate in a firm on account
of several reasons. Some of the most important ones are
as follows:
1. Wider scope for the use of latest tools, equipments,
machineries, techniques etc to increase production and
reduce cost per unit.
2. Large-scale production leads to full and complete
utilization of indivisible factor inputs leading to further
reduction in production cost.
3. As the size of the plant increases, more output can be
obtained at lower cost.
4. As output increases, it is possible to introduce the
principle of division of labor and specialization, effective
supervision and scientific management of the firm etc
would help in reducing cost of operations.
5. As output increases, it becomes possible to enjoy several
other kinds of economies of scale like overhead,
financial, marketing and risk-bearing economies etc,
which is responsible for cost reduction.
Constant Returns to Scale
• In case of constant returns to scale, the
various internal and external economies of
scale are neutralized by internal and
external diseconomies. Thus, when both
internal and external economies and
diseconomies are exactly balanced with
each other, constant returns to scale will
operate.
Diminishing Returns to Scale
 Causes for Diminishing Returns
to Scale
• Diminishing Returns to Scale operate due to
the following reasons-
1. Emergence of difficulties in co-ordination and
control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mis-management due to over
growth and expansion of the firm.
5. Productivity and efficiency declines
unavoidably after a point.
Economies of Scale
• The study of economies of scale is associated with large
scale production. To-day there is a general tendency to
organize production on a large scale basis. Mass
production of standardized goods has become the order
of the day. Large scale production is beneficial and
economical in nature. “The advantages or benefits
that accrue to a firm as a result of increase in its
scale of production are called ‘Economies of Scale’.
• They influence the average cost over different ranges of
output. They are gain to a firm. They help in reducing
production cost and establishing an optimum size of a
firm. Thus, they help a lot and go a long way in the
development and growth of a firm. According to Prof.
Marshall these economies are of two types, viz Internal
Economies and External Economics
 I. Internal Economies or Real Economies
• Internal Economies are those economies which arise
because of the actions of an individual firm to economize
its cost. They arise due to increased division of labor or
specialization and complete utilization of indivisible factor
inputs. Prof. Cairncross points out that internal economies
are open to a single factory or a single firm independently
of the actions of other firms
• 1. They arise “with in” or “inside” a firm.
• 2. They arise due to improvements in internal factors.
• 3. They arise due to specific efforts of one firm.
• 4. They are particular to a firm and enjoyed by only one
firm.
• 5. They arise due to increase in the scale of production.
• 6. They are dependent on the size of the firm.
• 7. They can be effectively controlled by the management of
a firm.
• 8. They are called as “Business Secrets “of a firm.
 Important aspects of external
economies
• 1. They arise ‘outside’ the firm.
• 2. They arise due to improvement in external factors.
• 3. They arise due to collective efforts of an industry.
• 4. They are general, common & enjoyed by all firms.
• 5. They arise due to overall development, expansion &
growth of an industry or a region.
• 6. They are dependent on the size of industry.
• 7. They are beyond the control of management of a firm.
• 8. They are called as “open secrets” of a firm.
Kinds of External Economies
• 1. Economies of concentration or Agglomeration
• 2. Economies of Information
• 3. Economies of Disintegration
• 4. Economies of Government Action
• 5. Economies of Physical Factors
• 6. Economies of Welfare
 Diseconomies of Scale
1. Financial diseconomies. For growth, the unavailability of finance
may force firm to pay higher interest rates additional funds.
2. Managerial diseconomies. Excess growth leads to loss of control,
supervision, management, coordination of factors of production
leading to all kinds of wastages, indiscipline and rise in costs.
3. Marketing diseconomies. Unplanned excess production lead to
mismatch between demand and supply leading to fall in prices.
Stocks piles up, sales declines leading to fall in revenue and profits.
4. Technical diseconomies. When output is carried beyond the plant
capacity, per unit cost will certainly go up. There is a limit for division
of labor and specialization. Beyond a point, they become negative.
Hence, operation costs would go up.
5. Diseconomies of risk and uncertainty bearing. If output expands
beyond a limit, investment increases. Inventory level goes up. Sales
do not go up . Business risks appear in all fields of activities. Supply
of factor inputs become inelastic leading to high prices.
6. Labor diseconomies. Contact between labor and management
may disappear. Workers may demand higher wages and salaries,
bonus and other such benefits etc. Industrial disputes may arise.
Labor unions may not cooperate with the management. All of them
may contribute for higher operation costs.
Economies of Scope
 Meaning & Def’n
• Economies of scope may be defined as those
benefits which arise to a firm when it produces more
than one product jointly rather than producing two
items separately by two different business units. In
this case, the benefits of the joint output of a single firm
are greater than the benefits if two products are
produced separately by two different firms. Such benefits
may arise on account of joint use of production facilities,
joint marketing efforts, or use of the same administrative
office and staff in an organization. Sometimes,
production of one product automatically results in the
production of another by-product leading to a reduction
in average cost of production.
 Illustration
• A firm produces product A & B separately. Cost of
producing 100 units of A is Rs. 8000 – 00 and cost of
producing 100 units of B is Rs. 5,000-00. If the firm
produces both products A & B jointly, in that case, its total
cost would be Rs. 10,000 – 00.

• In this case, the joint cost [10,000-00] is less than a sum

of individual costs [13,000-00]. Thus, a firm can save
30% cost if it produces both products A & B jointly.
Hence, the SC is more than zero.
 Diseconomies of Scope
• Diseconomies of scope may be defined as
those disadvantages which occur when cost
of producing two products jointly are costlier
than producing them individually. In this case,
it would be profitable to produce two goods
separately than jointly. For example, with the
help of same machinery, it is not possible to
produce two goods together. It involves buying
two different machineries. Hence, production
costs would certainly go up in this case.
 Difference between Economies of Scale
and Economies of Scope
Economies of scale Economies of Scope
It is connected with increase It is connected with increase
or decrease in scale of or decrease in distribution &
production marketing.
It shows change in output of It shows a change in output
a single product of more than one products
It is associated with supply It is associated with demand
side changes in output side changes in output
It indicates savings in cost It indicates savings in cost
owing to increase in volume due to production of more
of output than one product.
Cost of Production
 Meaning
• In the production process, a producer employs different
factor inputs. These factor inputs are to be compensated
by the producer for the services in the production of a
commodity. The compensation is the cost. The value of
inputs required in the production of a commodity
determines its cost of output. Cost of production refers
to the total money expenses (Both explicit and
implicit) incurred by the producer in the process of
transforming inputs into outputs.
• It refers total money expenses incurred to produce a
particular quantity of output. Cost is analyzed from the
producer’s point of view
 Managerial uses of Cost Analysis
1. To find the most profitable rate of operation of the firm.
2. To determine the optimum output to be produced and supplied.
3. To determine in advance the cost of business operations.
4. To locate weak points in production mgt to minimize costs.
5. To fix the price of the product.
6. To decide what sales channel to use.
7. To know alternative plans and costs involved in them.
8. To have clarity about the various cost concepts.
9. To decide & determine the existence of a firm in the prod’n field.
10. To regulate the number of firms engaged in production.
11. To decide about the method of cost estimation or calculations.
12. To find out decision making costs by re-classifications of elements,
repricing of input factors etc, so as to fit the relevant costs into
management planning, choice etc.
 Determinants of Costs
• 1. Technology
• Modern technology leads to optimum utilization of resources, avoid
all kinds of wastages, saving of time, reduction in production costs
and resulting in higher output. On the other hand, primitive
technology would lead to higher production costs.
• 2. Rate of output: (the degree of utilization of the plant and
machinery)
• Complete and effective utilization of all kinds of plants and
equipments would reduce production costs and under utilization of
existing plants and equipments would lead to higher production
costs.
• 3. Size of Plant and scale of production
• Generally speaking big companies with huge plants and
machineries organize production on large scale basis and enjoy the
economies of scale which reduce the cost per unit.
• 4. Prices of factor inputs
• Higher market prices of various factor inputs result in higher
cost of production and vice-versa.
• 5. Efficiency of factors of production and the management
• Higher productivity and efficiency of factors of production would
lead to lower production costs and vice-versa.
• 6. Stability of output
• Stability in production would lead to optimum utilization of the
existing capacity of plants and equipments. It also brings
savings of various kinds of hidden costs of interruption and
learning leading to higher output and reduction in production
costs.
• 7. Law of returns
• Increasing returns would reduce cost of production and
diminishing returns increase cost.
• 8. Time period
• In the short run, cost will be relatively high and in the long run,
it will be low as it is possible to make all kinds of adjustments
and readjustments in production process.
 Cost-Output Relationship: Cost
Function.
• Cost and output are correlated. Cost output relations
play an important role in almost all business decisions. It
throws light on cost minimization or profit maximization
and optimization of output. The relation between the
cost and output is technically described as the
“COST FUNCTION”. The significance of cost-output
relationship is so great that in economic analysis the cost
function usually refers to the relationship between cost
and rate of output alone and we assume that all other
independent variables are kept constant. Mathematically
speaking TC = f (Q) where TC = Total cost and Q stands
for output produced.
 Cost function depends on three
important variables.
• 1. Production function
• If a firm is able to produce higher output with a
little quantity of inputs, in that case, the cost
function becomes cheaper and vice-versa.
• 2. The market prices of inputs
• If market prices of different factor inputs are high
in that case, cost function becomes higher and
vice-versa.
• 3. Period of time
• Cost function becomes cheaper in the long run
and it would be relatively costlier in the short run.
 Types of cost function
• Generally speaking there are two types of
cost functions.
1. Short run cost function.
2. Long run cost function
 Cost-Output Relationship and
Cost Curves in the Short-Run
• Relationship between the cost and output
is different at two different periods of time
i.e. short-run and long run. Generally
speaking, cost of production will be
relatively higher in the short-run when
compared to the long run. This is because
a producer will get enough time to make
all kinds of adjustments in the productive
process in the long run than in the short
run.
 Meaning of Short Run
• Short-run is a period of time in which only the
variable factors can be varied while fixed factors like
plant, machinery etc. remains constant. Hence, the
plant capacity is fixed in the short run. The total number
of firms in an industry will remain the same. Time is
insufficient either for the entry of new firms or exit of the
old firms. If a firm wants to produce greater quantities of
output, it can do so only by employing more units of
variable factors or by having additional shifts, or by
having over time work for the existing labor force or by
intensive utilization of existing stock of capital assets etc.
• The short run cost function relates to the short run
production function. It implies two sets of input
components – (a) fixed inputs and (b) variable inputs.
Fixed inputs are unalterable. They remain unchanged
over a period of time. On the other hand, variable factors
are changed to vary the output in the short run.
• Cost-output relationship and nature
and behavior of cost curves in the
short run
• In order to study the relationship between
the level of output and corresponding cost
of production, we have to prepare the cost
schedule of the firm. A cost-schedule is a
statement of a variation in costs resulting
from variations in the levels of output. It
shows the response of cost to changes in
output.
Output TFC TVC TC AFC AVC AC MC
In units
0 360 - 360 - - - -
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.75 45

5 360 420 780 72 84 165 105

6 360 630 990 60 105 156 210
1. Total fixed cost (TFC)
2. Total variable cost (TVC)
3. Total cost (TC)
4. Average fixed cost (AFC)
5. Average variable cost: (AVC)
6. Average total cost (ATC) or
Average cost (AC)
7. Marginal Cost (MC)
 Relationship between AC & MC
Output TC in Rs AC in Rs Diff in Rs MC
1 150 150
2 190 85 40
3 220 73.33 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.33 91
8 580 72.2 165
Relation between AC and MC
From the diagram it is clear that:
1. Both MC and AC fall at a certain range of output and rise afterwards.
2. When AC falls, MC also falls but at certain range of output MC tends to rise
even though AC continues to fall. However, MC would be less than AC. This
is because MC is attributed to a single unit where as in case of AC, the
decreasing AC is distributed over all the units of output produced.
3. So long as AC is falling, MC is less than AC. Hence, MC curve lies below AC
curve. It indicates that fall in MC is more than the fall in AC. MC reaches its
minimum point before AC reaches its minimum.
4. When AC is rising, after the point of intersection, MC will be greater than AC.
This is because in case of MC, the increasing MC is attributed to a single
unit, where as in case of AC, the increasing AC is distributed over all the
output produced.
5. So long as the AC is rising, MC is greater and AC. Hence, MC curve lies to
the left side of the AC curve. It indicates that rise in MC is more than the rise
in AC.
6. MC curve cuts the AC curve at the minimum point of the AC curve. This is
because, when MC decreases, it pulls AC down and when MC increases, it
pushes AC up. When AC is at its minimum, it is neither being pulled down or
being pushed up by the MC. Thus, When AC is minimum, MC = AC. The
point of intersection indicates the least cost combination point or the optimum
position of the firm. At output Q the firm is working at its “Optimum Capacity”
with lowest AC. Beyond Q, there is scope for “Maximum Capacity” with rising
cost.
 Cost Output Relationship in the
Long Run
• Long run is defined as a period of time where
adjustments to changed conditions are complete
• As all costs are variable in the long run, the total of these
costs is total cost of production. Hence, the distinction
between fixed and variables costs in the total cost of
production will disappear in the long run. In the long
run only the average total cost is important and
considered in taking long term output decisions.
• Long run average cost is the long run total cost divided
by the level of output. In brief, it is the per unit cost of
production of different levels of output by changing the
size of the plant or scale of production.
LAC - Graph
 Important features of long run
AC curves
1. Tangent curve
2. Envelope curve
3. Flatter U-shaped or dish-shaped curve
4. Planning curve
5. Minimum point of LAC curve should be
always lower than the minimum point of
SAC curve
Cost of Production: Formulas
• TC = cost per unit x total production. Or TC =
TFC + TVC
• TFC = TC – TVC or AFC x Q
• TVC = TC – TFC or AVC x Q or addition of MC
• AFC = AC – AVC or TFC/Q
• AVC = AC – AFC or TVC/Q
• AC = AFC + AVC or TC/Q
• MC = TCn – TCn-1 or D TC / D TQ