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PRODUCTION AND COSTS 45

PRODUCER BEHAVIOUR
AND SUPPLY
7 1 6 1 1 1
INTRODUCTORY MICROECONOMICS 46
In Chapter 2 we studied the consumers
behaviour. In Chapters 3 and 4 we will be
concerned with the producers behaviour. In
this chapter in particular, we study important
concepts associated with production and
costs.
A producer or a firm is in business to
maximise profit.
1
By definition, profit earned
by a firm is equal to its total revenues minus
the total costs. As an example, suppose that
you are in the business of making hammers,
and, during a month, you produce and sell
500 hammers. They are selling at the price of
Rs. 20 each. Then the total revenues
generated are equal to price

quantity, that
is, Rs. 20 500 = Rs. 10,000.
Producing hammers requires inputs such
as labour, building, equipment and raw
materials. This is a technological relationship.
In turn, inputs have to be paid. The sum total
of payments to all inputs is the total cost of
production. Let the total cost of making 500
hammers over the month be Rs. 6,500.
Then your profit is equal to Rs. 10,000
Rs. 6,500 = Rs. 3,500.
1
In this chapter and others, we will use the term profit
or profits. Both are correct uses.
PRODUCTION AND COSTS
CHAPTER 3

3.1 Production
3.2 Costs

PRODUCTION AND COSTS 47


The above example is illustrative of
some important linkages. On one hand,
the amount produced, or, what is called
output, is linked to total revenues in
the product market. On the other hand,
output is linked to inputs via
technology, which is called production
function (to be defined in a moment),
and, the employment of inputs leads to
their payments. This chain links output
to costs.
output. In section 3.2, we will analyse
that between output and payments to
inputs. The link between output and
revenues will be examined in Chapter
4 (and in Chapter 6 also).
3.1 PRODUCTION
3.1.1 Production Function
The most basic concept here is what
is called the production function,
defined as a technological relationship
that tells the maximum output
producible from various combinations
of inputs.
For instance, a firm employs only
two factors or inputs, say, labour
(measured in hours) and land (in
acres), and, Table 3.1 lists some factor
combinations and the corresponding
output levels. 1 hour of labour and
2 acres of land produce at the most
5 units output, 2 hours of labour and
4 acres of land produce at the most
Table 3.1 Production Function
Labour Land Output
(in hours) (in acres) (in units)
A 0 0 0
B 1 2 5
C 2 4 11
D 3 6 18
E 4 8 24
F 5 10 30
G 6 12 35
H 7 14 40
Fig. 3.1 Linkages
These linkages are depicted in
fig. 3.1. In Section 3.1, we will study
the relationship between inputs and
INTRODUCTORY MICROECONOMICS 48
11 units of output, and so on. It is
normally assumed that inputs work to
the best of their efficiency. Hence,
instead of maximum output, we just
say output, e.g., 2 hours of labour
combined with 4 acres of land produce
11 units of output.
2
Note that the notion of production
function is not just confined to two
inputs. There can be other inputs like
capital, raw material etc.
3
3.1.2 Returns to an Input
A production function given in the
tabular form such as in Table 3.1 does
not reveal much about the contribution
of a single factor towards production.
A reasonable way to assess this will be
to vary the employment of one input
while keeping the employment of other
inputs fixed. Three concepts arise in this
experiment.
One is total product or total
physical product, denoted by TPP. It
simply defines the total output at a
particular level of employment of an
input when the employment of all
other inputs is unchanged. The next
one is marginal product or marginal
physical product (MPP). This is
defined as the increase in the total
physical product per unit increase in
the employment of an input when the
employment of other inputs is given.
4
When the employment of an input
changes, we call it a variable input.
Finally, we define Average Product
or Average Physical Product (APP) as
the TPP per unit employment of the
variable input, i.e., APP = TPP/L, where
L is the level of employment of the
variable input.
These are also respectively called
total, marginal and average returns
to an input.
A numerical example showing a
TPP schedule is given in Table 3.2,
where the variable input, L, is called
labour. If we graph a TPP schedule, we
get a total physical product curve.
Table 3.2 A Total Physical
Product Schedule
Labour Hours Total Physical
employed (L) Product (TPP)
0 0
1 10
2 22
3 33
4 43
5 51
6 56
7 56
8 48
9 36
2
Table 3.1 gives only some, not all, possible combinations of inputs and output.
3
Also, we can differentiate between unskilled labour and skilled labour.
4
These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.
PRODUCTION AND COSTS 49
Fig. 3.2 shows the TPP curve for the TPP
schedule given in Table 3.2.
Fig. 3.2 The Total Physical Product Curve
Corresponding to Table 3.2
the MPP at L = 2, which is 12, is equal
to the difference between TPP at L = 2,
which is 22, and TPP at L = 1, which is
10. The MPP schedule corresponding
to the TPP schedule in Table 3.2 is given
in column (2) of Table 3.3. Likewise, the
APP schedule, given in column (3) of
Table 3.3, is obtained through dividing
TPP by L in Table 3.2. The graphs of an
MPP schedule and an APP schedule are
respectively called the marginal
physical product curve and the
average physical product curve. These
graphs corresponding to Table 3.3 are
given respectively in figs. 3.3 and 3.4.
Note the following :
1. It is not true that the concepts of
TPP, MPP and APP are applicable to
Table 3.3 Marginal Physical and Average Physical Product Schedules
Labour Marginal Average
Hours Physical Physical
employed (L) Product (MPP) Product (APP)
0
1 10 10
2 12 11
3 11 11
4 10 10.75
5 8 10.20
6 5 9.33
7 0 8
8 -8 6
9 -12 4
The marginal physical product,
MPP, is derived from the total physical
product, TPP, just as marginal utility is
obtained from total utility. For instance,
INTRODUCTORY MICROECONOMICS 50
one particular input (e.g. labour)
and not to others (e.g. land or
variable input increases. This
relationship is verified from TPP
and MPP schedules. In Table 3.2,
TPP increases up to L = 6; from
Table 3.3, we see that MPP is
positive in this range. In Table 3.2,
TPP decreases from L = 8 onwards;
in Table 3.3, MPP is negative in this
range.
4. Although we have derived MPP and
APP from TPP above, in general,
given any one of these, we can
derive the other two. Suppose
MPPs are given to us. Then we can
get TPP by adding MPPs (as TPP is
the sum of MPPs). Once we get TPP,
we can readily obtain APP by
applying its definition. Similarly, if
the APPs are known, we get TPP
by multiplying APP with the level
of employment. Then MPPs are
obtained by applying its definition.
Law of Variable Proportions and Law
of Diminishing Returns
As we will see later in this chapter and
in the next, the most important
schedule (curve) from our viewpoint is
the marginal physical product schedule
(curve). We notice from fig. 3.3 that the
MPP initially increases with an increase
in the employment of the input in
question, then it diminishes and finally
it becomes negative. This pattern of MPP
is called the Law of Variable
Proportions. Put differently, this law
outlines three stages of production. In
stage I, when the level of an inputs
employment is sufficiently low, its MPP
increases. In stage II, it decreases but
remains positive, and, finally, in stage
Fig. 3.3 The Marginal Physical Product
Curve Corresponding to Table 3.3
Fig. 3.4 The Average Physical Product
Curve Corresponding to Table 3.3
equipment). It is applicable to all
inputs, but one at a time.
2. Since MPPs are additions to the TPP,
TPP is the sum of MPPs ( just as total
utility is the sum of marginal
utilities). For example, in Table 3.2,
the TPP at L = 3 is equal to 33. In
Table 3.3, the MPPs at L = 1, 2 and
3 add up to 33.
3. The MPPs being additions to the
TPP also implies that if MPP is
positive, TPP must be increasing
and if MPP is negative, TPP must
be decreasing as the level of the
PRODUCTION AND COSTS 51
III, it becomes negative. In our example,
stage I holds till L = 2, stage II is
operative between L = 3 and L = 7, and,
stage III sets in at L = 8.
Note that in stages I and II, TPP
increases with the employment of the
variable input as MPP in this range is
positive. But in stage III, it decreases
since MPP is negative.
Closely associated with this law is
another important law, called the law
of diminishing marginal product or
the law of diminishing marginal
returns (which is similar to the law of
diminishing marginal utility). More
briefly, it goes by the name of the law
of diminishing returns. This says
that, the employment of other inputs
remaining the same, as more of a
particular input is used in production,
after a certain level, its marginal
physical product decreases with
further employment of it.
Fig. 3.5 illustrates these laws more
clearly. Suppose that the input can be
measured continuously like points on
a line, not just in integer units like 1,
2, 3 etc. Then the resulting TPP, MPP
and APP curves will look smooth. A
smooth MPP curve is drawn in fig. 3.5.
We observe that the MPP increases
between 0 to A. This region marks stage
I. The MPP diminishes but remains
positive between A to B, which marks
stage II. From the point B onwards, it
is the stage III, wherein the MPP is
negative. Diminishing returns holds in
stages II and III.
The reason behind the law of
variable proportions or the law of
diminishing returns is fundamentally
the same. As the employment of a
particular input gradually increases
while all other inputs are kept
unchanged, the factor proportions
become initially more suitable for
production, but, after a certain level,
the variable factor can work with other
given inputs only less efficiently, that
is, factor proportions become
increasingly unsuitable for
production.
The significance of these stages of
production is that a profit-maximising
firm will never operate in stage III. It is
because, by entering stage III, a firm
will have to incur higher costs on one
hand (as it is hiring more of the input),
and, at the same time, since output is
falling, in the output market, it will get
less revenues. This implies that profits
will be less.
It is not obvious at this point, but
we will learn in Chapter 7 that a profit-
Fig. 3.5 Three Stages of Production and
Diminishing Returns
maximising firm will not operate in
stage I either. That leaves out only stage
II, in which the marginal returns to an
INTRODUCTORY MICROECONOMICS 52
constant: the output always increases
when all inputs are increased.
5
The production function outlined
in Table 3.1 contains stages showing
all three types of returns to scale. For
example, from B to D there are
increasing returns to scale. Why? In
combination B, 1 unit of labour and 2
units of land produce 5 units of
output. Compared to B, the
combination C has double the amount
of each input, but output (equal to 11)
is more than double of the output at
combination B. Similarly, from C to D,
inputs increase by 50% but output
increases by more than 50% (as 18 is
more than 50% higher than 11).
Likewise, you can calculate that,
in the range from D to F, there are
constant returns, and, finally from F
onwards there are decreasing returns
to scale.
3.2 COSTS
We now move on to discuss some cost
concepts. As fig. 3.1 suggests, cost
concepts are very much related to
concepts associated with the production
function. This point will be clearer as
we go along.
3.2.1 Short Run
Fixed and Variable Costs
At a given point of time, a firm faces
two types of costs: fixed costs and
variable costs. Fixed costs are those
that do not vary with the level of
output. (These are also called overhead
input is positive but diminishing. From
the viewpoint of the operation of the firm,
this is the most relevant stage.
Finally, note that the law of
diminishing returns implies that the
MPP curve is inverse U-shaped. In
turn, this implies that the APP curve
is inverse U-shaped also.
3.1.3 Returns to Scale
Suppose that, instead of increasing
one input at a time, you increase the
employment of all inputs by the same
proportion (e.g. by 20%). The effect
of this change on output is captured
by the notion of returns to scale. Of
course, the output is going to
increase. But by how much? Will it
increase (a) by more than 20%,
(b) by less than 20% or (c) exactly by
20%? The possibilities (a), (b) and (c)
respectively illustrate increasing
returns to scale, decreasing or
diminishing returns to scale and
constant returns to scale.
In other words, suppose all inputs
are increased by a given proportion.
Increasing (respectively decreasing)
returns to scale hold when output
increases more (respectively less) than
proportionately. Constant returns to
scale hold when output increases
exactly by the proportion in which
inputs are increased.
You should not make the mistake
that the terms decreasing,
diminishing or constant mean that
the output decreases or remains
5
This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.
PRODUCTION AND COSTS 53
costs.) For example, you operate a
garment factory. You pay a fixed rent
for the factory building, fixed insurance
payments for your machinery against
fire etc. These are independent of how
many garments per month you
produce.
There is a time element in
interpreting these costs as fixed. That
is, even if these costs are fixed at any
given point of time or within a short
time period, in a long run horizon, you
can think of renting more or less space,
having more or less number of
machinery depending on your
business outlook for the future. Hence
the rent and insurance costs etc. that
are fixed in the short run can vary in
the long run. In other words, fixed costs
are present only in the short run, not
in the long run.
Note that these notions of short run
and long run do not refer to any
particular calendar time. They refer
only to different periods of planning
horizon by producers in an industry.
Hence, they can vary from one industry
to another.
Having noted this difference, we
return to the short run situation.
Besides fixed cost, there are variable
costs those that change with the level
of output, e.g., labour costs and costs
of raw materials. If you want to
produce more garments, you have to
buy more cotton and other raw
materials, hire more workers and so
on. Variable costs increase with
output.
Instead of being termed simply fixed
and variable cost, these are formally
called Total Fixed Cost (TFC) and
Total Variable Cost (TVC). Total cost
(TC) is then, by definition, total fixed
costs + total variable costs. Table 3.4
presents a numerical example. Notice
that TFC, given in column (2), do not
change with output. But TVC, given in
column (3), does. The columns (2) and
(3) against column (1) are respectively
total fixed cost and total variable cost
schedules.
Graphs of these schedules are the
total fixed cost curve and the total
variable cost curve respectively.
Figure 3.6 depicts these, together
with the total cost curve that graphs the
TC schedule, given in the last column
of Table 3.4. The TFC curve is horizontal
because fixed costs do not change with
the output. However, since TVC and TC
increase with the output, these curves
are upward sloping. By definition, the
total cost curve is the vertical
summation of the total fixed and total
variable cost curves. Notice that, at the
zero level of output, TC = TFC, because
TVC is zero when output is zero.
Average Costs
If we divide total fixed cost and total
variable cost by output, we respectively
get the Average Fixed Cost (AFC) and
the Average Variable Cost (AVC). That
is, AFC = TFC/Output and AVC = TVC/
Output. Similarly, by dividing total cost
by output, we obtain the Average Total
Cost (ATC), i.e., ATC = TC/Output. Note
that, by definition, ATC = AFC + AVC.
Average total cost is sometimes loosely
called average cost only. The AFCs, the
AVCs and the ATCs corresponding to
INTRODUCTORY MICROECONOMICS 54
Table 3.4 Total Fixed Costs and Total Variable Costs
Output Total Fixed Costs Total Variable Costs Total Costs
(Rs.) (Rs.) (Rs.)
0 10 0 10
1 10 8 18
2 10 13 23
3 10 16 26
4 10 20 30
5 10 26 36
6 10 35 45
7 10 47 57
8 10 63 73
9 10 83 93
Fig. 3.6 TFC, TVC and TC Curves
corresponding to Table 3.4
Table 3.4 are given in Table 3.5, and
fig. 3.7 graphs them. The AFC curve
continuously decreases as output
increases, because the numerator of the
ratio TFC/Output is constant while the
denominator increases. The AVC and
ATC curves slope downwards initially
and then upwards, i.e, they are
U-shaped. The reason behind this
shape will be discussed later.
Marginal Costs
There is another important cost
concept, the marginal cost (MC). Similar
to marginal utility or marginal product,
this is defined as the increase in total
cost when one extra unit is produced.
Thus, it is the (additional) cost of
producing an extra unit. In the example
given in Table 3.4, suppose that the
current level of output is 7. The MC of
this output level is Rs. 12. It is because
the 7
th
unit of output costs Rs. 57
Rs. 45 = Rs. 12. The MC schedule
corresponding to Table 3.4 is given in
Table 3.6.
PRODUCTION AND COSTS 55
Table 3.5 AFC, AVC and ATC Schedules (Based on Table 3.4)
Output AFC (Rs.) AVC (Rs.) ATC (Rs.)
0 - - -
1 10 8 18
2 5 6.50 11.50
3 3.33 5.33 8.66
4 2.50 5 7.50
5 2 5.20 7.20
6 1.66 5.84 7.50
7 1.43 6.71 8.14
8 1.25 7.875 9.125
9 1.11 9.22 10.33
MCs (just as total utility is the sum of
marginal utilities). For example, the
TVC of producing 2 units is Rs. 13,
and, this is the sum of the MC of
producing one unit (= Rs. 8) and that
of producing two units (= Rs. 5).
Fig. 3.8 graphs the MC schedule
given in Table 3.6. It is the marginal cost
curve.
Assuming that the output is
perfectly divisible, a smooth
(hypothetical) marginal cost curve is
drawn in fig. 3.9. Recall that the TVC
is sum of the marginal costs. This
implies a property associated with a
smooth marginal cost. That is, the TVC
is equal to the area under the marginal
cost curve. For example, at output q
0
,
the TVC is equal to the area 0ABq
0
.
This result will be used in Chapter 4.
Fig. 3.7 AFC, AVC and ATC Curves
Corresponding to Table 3.5
Note that, since total costs and
total variable costs differ only by a
constant term (equal to the total fixed
cost), MC can be equivalently defined
as the increase in the total variable
cost when one extra unit is produced.
Moreover, TVC is equal to the sum of
INTRODUCTORY MICROECONOMICS 56
As you see from fig. 3.8 or fig. 3.9,
the MC curve is initially decreasing in
output and then it is increasing, i.e, it
is U-shaped. The reason behind the U-
shape of the MC curve is the law of
diminishing returns. As you recall, this
law says that, as other inputs are kept
Output
Costs
in Rs
.
MC
0
5
10
15
20
25
0 1 2 3 4 5 6 7 8 9 10
Fig. 3.8 The MC Curve corresponding to
Table 3.6
Table 3.6 Marginal Costs (based
on Table 3.4)
Output Marginal Cost (Rs.)
0 -
1 8
2 5
3 3
4 4
5 6
6 9
7 12
8 16
9 20
unchanged, an increase in any given
input leads first to an increase in its
marginal physical product, and, then,
after certain point, leads to a decrease
in its marginal physical product. Let us
suppose that this particular input is
the only variable input, so that the total
payment to it is equal to the total
variable cost. Similarly, interpret the
other inputs, which are kept
unchanged, as the fixed factors, the
total payment to which is the total fixed
cost.
Fig. 3.9 A Smooth Marginal Cost
Let us now turn around the
statement of the law of diminishing
returns and say equivalently that, as
more and more output is produced,
initially, the rate of increase in the
requirement of the variable input will
be less and less, and, after a certain
point, it will be more and more. This
implies that, initially, the rate of increase
in the variable cost which is same as
the marginal cost will be less and less
as output increases, and then, it will
be more and more when output
PRODUCTION AND COSTS 57
increases further. This explains the U-
shape of the MC curve.
6
Once we know that the MC curve
is U-shaped, it follows that the AVC
and the ATC curves are U-shaped also.
There is indeed another relationship
that holds between AVC, ATC and MC
curves. Consider fig. 3.10, which
depicts smooth AVC, ATC and MC
curves. Observe that the MC curve cuts
the AVC and ATC curves at their
minimum points. The reason behind
this is mathematical, not economic,
and, it can be understood through the
following example.
7
Consider the game of cricket.
Suppose that you are interested in
calculating the average score of
batsmen out as wickets continue to fall.
Begin to calculate this after, say, 3
wickets are down. The runs scored by
those already out are say 40, 105
and 2. The average is (40 + 105 + 2)/3
= 49. The game goes on and the fourth
wicket falls. You calculate the average
again and find that it has increased
from 49 runs. Has then the fourth
batsman, who got out, scored more or
less than 49? The answer is more.
Why, because otherwise the average
wouldnt have increased. Similarly, if the
average had fallen from 49, the fourth
batsman must have scored less than
49. This simple deduction means the
following.
Think of the runs scored by the
fourth batsman out as marginal (i.e.
additional runs scored by the next
unit or batsman, when 3 are already
out). We are then saying that if the
average increases (respectively
decreases), the marginal should be
above (respectively below) the average.
Now go back to fig. 3.10. The AVC
curve is decreasing in the range of
output from 0 to q
0
.

Then it must be
true that, (a) at any output level in this
range, MC<AVC.

Likewise, (b) at any
output greater than q
0
, AVC is
increasing in output; hence MC >AVC.
Now, statements (a) and (b) together
imply that the MC curve must cut the
AVC curve at the AVCs minimum point.
By definition, MC is the addition to
both the TVC and the TC. Hence the
above logic applies to the relationship
6
Indeed, the MC curve is a mirror reflection of the MPP curve.
7
This is contained in Richard Manning and Kenneth Henry, The Logic of Markets, The Dunmore Press
Limited, New Zealand, 1983, Chapter 7.
Fig. 3.10 AVC, ATC and MC Curves
INTRODUCTORY MICROECONOMICS 58
between MC curve and ATC curve also.
The former cuts the latter at its
minimum point too.
3.2.2 Long Run
Recall that, in the long run, all inputs
are variable, because costs that are
fixed in the short run can be changed
i f the pl anni ng hori zon of the
producer i s l ong enough.
Accordingly, there are no TFC or AFC
curves in the long run. There is no
distinction between total costs and
total variable costs; we simply use
the term total costs. Similarly, there
is no distinction between average
total costs and average variable costs
and we will use the term long-run
average cost, denoted by LAC, where
L stands for long run. The concept of
marginal cost remains exactly the
same however; we will abbreviate it
to LMC.
In what follows, we discuss the
shapes of the LAC and LMC curves, the
reasons behind their shapes and the
relationship between them.
Like the short run average and
marginal cost curves, the LAC and LMC
curves, in general, are U-shaped, and,
the LMC curve cuts the LAC at its
minimum point. However, the reason
behind the U-shape is not the law of
diminishing returns. Instead, since all
inputs are variable, it is the pattern of
the returns to scale, which determines
the U-shape of these curves.
8
In particular, increasing returns to
scale mean that if output is increased
at a given rate (say 10%), inputs need
to be increased only by less than
proportionately (say by 7%). This
implies that the average cost must fall
as output expands. Similarly,
decreasing returns to scale imply that
the average cost must rise with output.
Finally, if returns to scale are constant,
the average cost is constant
independent of output. We can
summarise all this as follows:
Increasing returns to scale LAC
decreases with output
Constant returns to scale LAC
does not change with output
Decreasing returns to scale LAC
increases with output.
Now look at fig. 3.11. It shows a
U-shaped LAC curve. This means that,
as output is gradually increased
8
The short-run and long-run average or marginal cost curves are not unrelated however. As you will
learn in a higher course in microeconomics, the LAC curve is flatter than short-run average variable
cost curves.
Fig. 3.11 The Long-Run Average and
Marginal Cost Curves
PRODUCTION AND COSTS 59
starting from a small level, there are
increasing returns to scale (in the
output range 0 to q
0
) such that LAC
falls, then there are constant returns to
scale (at q
0
), and finally decreasing
returns to scale prevail at output levels
higher than q
0
, such that LAC increases
with output. In fig. 3.11, increasing,
constant and decreasing returns to
scale are written in short forms as
IRS, CRS and DRS respectively.
Now the question is why do IRS
occur first, followed by CRS and
DRS? Starting from a relatively small-
scale operation (output), as the scale
of operation increases, a firm would
be able to reap the advantages of (a)
division of labour and (b) volume
discounts. To cite an example in case
of f or mer, suppose that a f i r m
has onl y one manager, whose
speciality is in marketing but who is
looking into both marketing and
manufacturing. Now, as the firm
increases its production and hires
another manager who expertise is in
manufacturing, then each manager
can specialise in their expertise
and be more ef f i ci ent. Thi s i s
called division of labour, meaning
allocation of tasks according to the
specialisation of workers.
9
In case of
volume discounts, for instance, a
garment factory buys 100 tons of
yarn at a certain price. If, instead, it
plans to buy 200 tons of yarn it can
negotiate a better price.
However, as the output level goes
beyond a certain limit, difficulties in
managing an enterprise crop up.
Crowding and congestion occur
typically, which lead to decreasing
returns to scale.
In between IRS and DRS, a firm
experiences constant returns to scale.
It is shown at point

q
0
in fig. 3.11. More
generally, CRS may prevail over a range
of output, rather than at a single level
of output. In this case, the LAC will have
a flat portion in the middle.
A couple of remarks are in order:
First, given that initially increasing
returns, then constant returns and
finally decreasing returns to scale occur
as output increases, the long run
average cost is minimised where
constant returns to scale prevail, such
as at point

q
0
. In some sense, this is the
level at which production is most
efficient.
Second, the U-shape of the LAC
curve implies the U-shape of the LMC
curve. This is different in nature from
the short run, where the U-shape of the
marginal cost curve implies the U-shape
of the average cost curve.
The concepts developed in this
chapter will be used very much in the
following chapters.
9
The same applies to other kinds of workers and to machinery and land. For instance, at a small scale of
operation, the firm may have only one room, which is used as a storage as well as office space for its
employees. Storing merchandise and taking them out generate traffic, which would adversely affect the
productivity of other employees. If, instead, the firm acquires an additional room, one of them can be
used as storage only and as a result the productivity of employees will improve.
INTRODUCTORY MICROECONOMICS 60
SUMMARY
TPP is equal to the sum of MPPs.
There are generally three stages of production. In the initial stage, the
MPP increases with input employment, then it diminishes but remains
positive and finally it becomes negative.
A profit-maximising firm will never employ an input at such a level that
its MPP is negative.
The MPP and APP curves are generally inverse U-shaped.
The law of diminishing returns explains why the MPP curve is inverse U-
shaped. In turn, the inverse U-shape of the MPP curve implies a similar
shape of the APP curve.
In the short run, there are fixed costs and variable costs.
In the long run, there are only variable costs.
The AFC curve is downward sloping.
The MC, AVC and ATC curves are generally U-shaped.
The sum of MCs equals the TVC.
The area under the MC curve is equal to the TVC.
The law of diminishing returns explains why the MC curve is U-shaped.
In turn, the shape of the MC curve implies the similar shape of the AVC
and ATC curves.
The MC curve cuts the AVC curve and the ATC curve at their minimum
points.
The long run marginal cost (LMC) curve and the long run average cost
(LAC) curve are generally U-shaped.
The LMC curve cuts the LAC curve at the latters minimum point.
The U-shape of the LAC curve follows from a firm experiencing increasing
returns to scale initially, followed by constant returns to scale and then
by decreasing returns to scale.
The U-shape of the LAC curve implies the U-shape of the LMC curve.
In the long run, the sources of increasing returns to scale lie in the division
of labour and volume discounts.
PRODUCTION AND COSTS 61
EXERCISES
Section I
3.1 What is a production function?
3.2 List any three inputs used in production.
3.3 What is meant by total physical product?
3.4 What is meant by average physical product?
3.5 What is meant by marginal physical product?
3.6 How is total physical product derived from the marginal physical
product schedule?
3.7 What will you say about the marginal physical product of a
factor when total physical product is falling?
3.8 What is the general shape of the MPP curve?
3.9 What is the general shape of the APP curve?
3.10 What do returns to scale refer to?
3.11 Give the meaning of increasing returns to scale.
3.12 Give the meaning of constant returns to scale.
3.13 Give the meaning of decreasing returns to scale.
3.14 Classify the following into fixed cost and variable cost.
(a) Rent for a shed.
(b) Minimum telephone bill.
(c) Cost of raw materials.
(d) Wages to permanent staff.
(e) Interest on capital.
(f) Payment for transportation of goods.
(g) Telephone charges beyond the minimum.
(h) Daily wages.
3.15 How does total fixed cost change when output changes?
3.16 How is total variable cost derived from a marginal cost schedule?
3.17 How can one obtain total variable cost from a marginal cost
curve?
3.18 What is the general shape of the AFC curve?
3.19 What is the general shape of the MC curve?
3.20 What is the general shape of the AC curve?
3.21 What will happen to ATC when MC > ATC?
3.22 What does division of labour mean?
3.23 What are volume discounts?
3.24 Name two factors behind increasing returns to scale in the long
run.
INTRODUCTORY MICROECONOMICS 62
Section II
3.25 What is meant by the law of variable proportions?
3.26 Calculate the APPs and the MPPs of a factor from the following
table on its TPP schedule.
3.27 The following table gives the MPP of a factor. It is also known
that the TPP at zero level of employment is zero. Determine its
TPP and APP schedules.
Level of Factor Employment TPP
0 0
1 5
2 12
3 20
4 28
5 35
6 40
7 42
Level of Factor Employment MPP
1 20
2 22
3 18
4 16
5 14
6 6
3.28 The following table gives the APP of a factor. It is also known
that the TPP at zero level of employment is zero. Determine its
TPP and MPP schedules.
PRODUCTION AND COSTS 63
3.29 Explain the law of diminishing marginal returns. In other words,
why does the marginal product of an input decline with further
employment of it?
3.30 How does the total physical product change with the change in
the marginal physical product of an input?
3.31 What is meant by the law of diminishing returns?
3.32 Distinguish between fixed and variable costs.
3.33 With the help of a suitable diagram, explain the relationship
between TC, TFC and TVC.
3.34 Do ATC and AVC curves intersect? Give reasons.
3.35 Why is the MC curve in the short run U-shaped?
3.36 A firm is producing 20 units. At this level of output, the ATC
and AVC are respectively equal to Rs. 40 and Rs. 37. Find out
the total fixed cost of this firm.
Section III
3.37 A firms total cost schedule is given in the following table.
Level of Factor Employment APP
1 50
2 48
3 45
4 42
5 39
6 35
Output (in units) Total Cost In (Rs.)
0 40
1 120
2 170
3 180
4 210
5 260
6 340
7 440
8 550
INTRODUCTORY MICROECONOMICS 64
(a) What is the total fixed cost of this firm?
(b) Derive the AFC, AVC, ATC and MC schedules.
3.38 Complete the following table if the AFC at 1 unit of production
is Rs. 60.
3.39 A firms fixed cost is Rs. 2,000. Compute the TVC, AVC, TC and ATC
from the following table.
Output TC TVC TFC AVC AFC ATC MC
1 90
2 105
3 115
4 120
5 135
6 160
7 200
8 260
Output (in units) Marginal Cost (in Rs.)
1 2,000
2 1,500
3 1,200
4 1,500
5 2,000
6 2,700
7 3,500
PRODUCTION AND COSTS 65
3.40 Suppose that a firms total fixed cost is Rs. 100, and the marginal
cost schedule of a firm is the following.
Output (in units) Marginal Cost (in Rs.)
1 10
2 20
3 30
4 40
5 50
6 60
7 70
(a) Is the MC curve U-shaped?
(b) Derive the AVC schedule. Will the AVC curve be U-shaped?
Discuss why or why not.
3.41 Explain the relationship between ATC, AVC and MC with a
suitable illustration.
3.42 Tables A and B below outline two production technologies or
production functions. There are two factors: unskilled labour
and skilled labour. Show that the production function given in
Table A satisfies increasing returns to scale and that in Table B
satisfies decreasing returns to scale.
Table A
Unskilled Labour Skilled Labour Output
(in hours) (in hours) (in units)
8 4 2
10 5 3
12 6 4
14 7 5
INTRODUCTORY MICROECONOMICS 66
Table B
Unskilled Labour Skilled Labour Output
(in hours) (in hours) (in units)
8 4 6
10 5 7
12 6 8
14 7 9
3.43 Increasing and decreasing returns to scale respectively imply
downward and upward sloping portion of the long run average
cost curve. Defend or refute.