PRODUCTION:

What is Production?
In economics, Production is a process of transforming tangible and intangible
inputs into goods or services.
Raw materials, land, labour and capital are the tangible inputs, whereas ideas,
information and knowledge are the intangible inputs. These inputs are also
known as factors of production.

Definition:

“Production is the organised activity of transforming resources into finished

products in the form of goods and services; the objective of production is to
satisfy the demand for such transformed resources”.

“Production is any activity directed to the satisfaction of other peoples’ wants

through exchange”. This definition makes it clear that, in economics, we do not
treat the mere making of things as production. What is made must be designed
to satisfy wants.

Concept:

Since the primary purpose of economic activity is to produce utility for

individuals, we count as production during a time period all activity which
either creates utility during the period or which increases ability of the society
to create utility in the future.

Business firms are important components (units) of the economic system.

They are artificial entities created by individuals for the purpose of organising
and facilitating production. The essential characteristics of the business firm is
that it purchases factors of production such as land, labour, capital, intermediate
goods, and raw material from households and other business firms and
transforms those resources into different goods or services which it sells to its
customers, other business firms and various units of the government as also to
foreign countries.

Factors of production:

Definition:

Factors of production are the resources people use to produce goods and
services; they are the building blocks of the economy.

Types of factors of production:

Land
Land is the gift of nature and includes the dry surface of the earth and the
natural resources on or under the earth’s surface, such as forests, rivers,
sunlight, etc.

Land is utilised to produce income called rent. Land is available in fixed

quantity; thus, does not have a supply price. This implies that the change in
price of land does not affect its supply. The return for land is called rent.

Characteristics which would qualify a given factor to be called land

 Land is a free gift of nature

 Land is a free gift of nature
 Land is permanent and has indestructible powers
 Land is a passive factor
 Land is immobile
 Land has multiple uses
 Land is heterogeneous
Labour
Labour is the physical and mental efforts of human beings that undertake
the production process.
It includes unskilled, semi-skilled and highly skilled labour. The supply of
labour is affected by the change in its prices. It increases with an increase in
wages. The return for labour is called wages and salary.

Characteristics of labour:

 Human Effort
 Labour is perishable
 Labour is an active factor
 Labour is inseparable from the labourer
 Labour power differs from labourer to labourer
 All labour may not be productive
 Labour has poor bargaining power
 Labour is mobile
 There is no rapid adjustment of supply of labour to the demand for it
 Choice between hours of labour and hours of leisure
Capital
Capital is the wealth created by human beings. It is one of the important factor
of production of any kind of goods and services, as production cannot take place
without the involvement of capital.
Capital is an output of a production process that goes into another production
process as an input. Capital as a factor of production is divided into two parts,
namely, physical capital and human capital.
Physical capital includes tangible resources, such as buildings, machines, tools
and equipment, etc.
Human capital includes knowledge and skills of human resource, which is
gained by education, training and experience. Return for capital is termed as
interest.
Types of Capital

 Fixed capital
 Circulating capital
 Real capital
 Human capital
 Tangible capital
 Individual capital
 Social Capital
Entrepreneur
Entrepreneurship consists of three major functions, viz., coordination,
management and supervision. An entrepreneur is a person who creates an
enterprise. The success or failure depends on the efficiency of the entrepreneur.

An enterprise is an organisation that undertakes commercial purposes or

business ventures and focuses on providing goods and services. An enterprise is
composed of individuals and physical assets with a common goal of generating
profits.

Functions of an entrepreneur

 Initiating business enterprise and resource co-ordination

 Risk bearing or uncertainty bearing
 Innovations

Knowledge:
Information technology has revolutionized business, making it possible to
quickly determine wants and needs and to respond with desired goods and
services.

Knowledge – as human capital – exhibits the skills and ability of workers.

For example, a doctor who spent 15 years studying medicine is more productive
than non-skilled workers.

Characteristics of knowledge:
 Creates competitive advantage
 Efficiency
 Effectiveness
 Innovation

Types of production:

For general purposes, it is necessary to classify production into three main

groups:
1. Primary production:
Primary production is carried out by ‘extractive’ industries like agriculture,
forestry, mining and oil extraction. These industries are engaged in such
activities as extracting the gifts of Nature from beneath the earth’s surface and
from the oceans. Primary activities refer to such things as extraction of raw
materials from the earth’s surface, e.g., coal mining or pisiculture (fishing). In
advanced countries, the primary sector is providing less employment because
machinery is replacing man power.

2. Secondary production:
This includes production in manufacturing industry, viz., turning out semi-
finished and finished goods from raw materials and intermediate goods —
conversion of flour into bread or iron ore into finished steel. These activities are
generally described as manufacturing and construction industries, such as the
manufacture of cars, furnishing, clothing and chemicals, as also engineering and
building. In short, secondary production is concerned with conversion of raw
materials into finished products, e.g., manufacturing motor cars, shirts,
medicines, food, etc.

3. Tertiary production:
Industries in the tertiary sector produce all those services which enable the
finished goods to be put in the hands of consumers. In fact, these services are
supplied to the firms in all types of industries and directly to consumers.
Examples cover distributive traders, banking, insurance, transport and
communications. Government services, such as law, administration, education,
health and defence, are also included.

Importance of Production
 Helps in creating value by applying labour on land and capital
 Improves welfare as more commodities mean more utility
 Generates employment and income, which develops the economy.
 Helps in understanding the relation between cost and output

Principles of production:
In order to produce goods and services which can be sold, and
generate revenue and profits, a firm must purchase or hire scarce inputs, which
are its factors of production. These factors can be fixed or variable.
Fixed factor inputs
Fixed factors are those that do not change as output is increased or decreased,
and typically include premises such as its offices and factories, and capital
equipment such as machinery and computer systems.

Variable factor inputs

Variable factors are those that do change with output, which means more are
employed when production increases, and less when production decreases.
Typical variable factors include labour, energy, and raw materials directly used
in production.

Time periods for the firm

The fundamental principles of production relate closely to the time periods in
question, of which there are four:

The very short run

A firm is said to be in its very short run when the only way to increase output is
by using up existing stocks of inputs.

The short run

A firm is said to be in its short run when it can increase its output by using more
variable factors, such as by hiring more workers, but not by increasing its fixed
factors. In the short run firms do not use extra fixed factors, such moving to new
premises, to increase output. Therefore, in the short run at least one factor of
production is fixed.

The long run

A firm enters its long run when it increases its scale of operations. Increasing
scale means that no factor of production is fixed, and all are variable. Typically,
this means that a firm expands by building or renting larger premises,
purchasing or leasing new machinery and employing more workers.

The very long run

A whole industry enters the very long run when there is a significant change in
the use of technology. For example, the widespread use of the internet to book
holidays has drastically altered how the holiday industry is structured.

Economic analysis tends to focus only on the short and long run, and largely
ignores the very short and very long run.

Time periods for a market

A whole market can also be considered in terms of the short and long run.

The industry short run

An industry is in its short run when its capacity is fixed. This usually means that
the number of firms in the industry is fixed, with no new firms entering or
leaving the market.

The long run

This exists when there is an increase, or decrease, in the capacity of the industry
to produce, and this usually means that the number of firms in a given market
increases, or decreases.

Production Function:

The production function expresses a functional relationship between quantities

of inputs and outputs. It shows how and to what extent output changes with
variations in inputs during a specified period of time. In the words of Stigler,
“The production function is the name given to the relationship between rates of
input of productive services and the rate of output of product.

It is the economist’s summary of technical knowledge.” Basically, the

production function is a technological or engineering concept which can be
expressed in the form of a table, graph and equation showing the amount of
output obtained from various combinations of inputs used in production, given
the state of technology. Algebraically, it may be expressed in the form of an
equation as

Q =f (L, M, N, К, T)…………. (1)

where Q stands for the output of a good per unit of time, L for labour, M for
management (or organisation), N for land (or natural resources), К for capital
and T for given technology, and refers to the functional relationship.

The production function with many inputs cannot be depicted on a diagram.

Moreover, given the specific values of the various inputs, it becomes difficult to
solve such a production function mathematically.

THE LAW OF VARIABLE PROPORTIONS OR RETURNS TO A

FACTOR:

This law exhibits the short-run production functions in which one factor varies
while the others are fixed.

Also, when you obtain extra output on applying an extra unit of the input, then
this output is either equal to or less than the output that you obtain from the
previous unit.
The Law of Variable Proportions concerns itself with the way the output changes
when you increase the number of units of a variable factor. Hence, it refers to the
effect of the changing factor-ratio on the output.

In other words, the law exhibits the relationship between the units of a variable
factor and the amount of output in the short-term. This is assuming that all other
factors are constant. This relationship is also called returns to a variable factor.

The law states that keeping other factors constant, when you increase the variable
factor, then the total product initially increases at an increases rate, then increases
at a diminishing rate, and eventually starts declining.

Its Explanation:
Given these assumptions, let us illustrate the law with the help of Table 1,
where on the fixed input land of 4 acres, units of the variable input labour are
employed and the resultant output is obtained. The production function is
revealed in the first two columns. The average product and marginal product
columns are derived from the total product column.

The average product per worker is obtained by dividing column (2) by a

corresponding unit in column (1). The marginal product is the addition to total
product by employing an extra worker. 3 workers produce 36 units and 4
produce 48 units. Thus the marginal product is 12 i.e., (48-36) units.
An analysis of the Table shows that the total, average and marginal products
increase at first, reach a maximum and then start declining. The total product
reaches its maximum when 7 units of labour are used and then it declines. The
average product continues to rise till the 4th unit while the marginal product
reaches its maximum at the 3rd unit of labour, then they also fall. It should be
noted that the point of falling output is not the same for total, average and
marginal product.

The marginal product starts declining first, the average product following it and
the total product is the last to fall. This observation points out that the tendency
to diminishing returns is ultimately found in the three productivity concepts.

The TP curve first rises at an increasing rate up to point A where its slope is the
highest. From point A upwards, the total product increases at a diminishing rate
till it reaches its highest point С and then it starts falling.
Point A where the tangent touches the TP curve is called the inflection point up
to which the total product increases at an increasing rate and from where it starts
increasing at a diminishing rate. The marginal product curve (MP) and the
average product curve (AP) also rise with TP. The MP curve reaches its
maximum point D when the slope of the TP curve is the maximum at point A.

The maximum point on the AP curves is E where it coincides with the MP

curve. This point also coincides with point В on TP curve from where the total
product starts a gradual rise. When the TP curve reaches its maximum point С
the MP curve becomes zero at point F. When TP starts declining, the MP curve
becomes negative. It is only when the total product is zero that the average
product also becomes zero. The rising, the falling and the negative phases of the
total, marginal and average products are in fact the different stages of the law of
variable proportions which are discussed below.

Three Stages of Production:

Stage-I: Increasing Returns:
In stage I the average product reaches the maximum and equals the marginal
product when 4 workers are employed, as shown in the Table 1. This stage is
portrayed in the figure from the origin to point E where the MP curve reaches
its maximum and the AP curve is still rising. In this stage, the TP curve also
increases rapidly.

Thus this stage relates to increasing returns. Here land is too much in relation to
the workers employed. It is, therefore, profitable for a producer to increase more
workers to produce more and more output. It becomes cheaper to produce the
additional output. Consequently, it would be foolish to stop producing more in
this stage. Thus the producer will always expand through this stage I.

Stage-II: Diminishing Returns:

It is the most important stage of production. Stage II starts when at point E
where the MP curve intersects the AP curve which is at the maximum. Then
both continue to decline with AP above MP and the TP curve begins to increase
at a decreasing rate till it reaches point C. At this point the MP curve becomes
negative when the TP curve begins to decline, table 1 shows this stage when the
workers are increased from 4 to 7 to cultivate the given land.

In figure 1, it lies between BE and CF. Here land is scarce and is used
intensively. More and more workers are employed in order to have larger
output. Thus the total product increases at a diminishing rate and the average
and marginal product decline. This is the only stage in which production is
feasible and profitable because in this stage the marginal productivity of labour,
though positive, is diminishing but is non-negative.

Hence it is not correct to say that the law of variable proportions is another
name for the law of diminishing returns. In fact, the law of diminishing returns
is only one phase of the law of variable proportions.

The law of diminishing returns in this sense has been defined by Prof. Benham
thus: “As the proportion of one factor in a combination of factors is increased,
after a point, the average and marginal product of that factor will diminish.”

Stage-III: Negative Marginal Returns:

Production cannot take place in stage III either. For in this stage, total product
starts declining and the marginal product becomes negative. The employment of
the 8th worker actually causes a decrease in total output from 60 to 56 units and
makes the marginal product minus 4. In the figure, this stage starts from the
dotted line CF where the MP curve is below the A’-axis. Here the workers are
too many in relation to the available land, making it absolutely impossible to
cultivate it.

The Best Stage:

In stage I, when production takes place to the left of point E, the fixed factor is
excess in relation to the variable factors which cannot be used optimally. To the
right of point F, the variable input is used excessively in Stage III. Therefore, no
producer will produce in this stage because the marginal production is negative.

Thus the first and third stages are of economic absurdity or economic nonsense.
So production will always take place in the second stage in which total output of
the firm increases at a diminishing rate and MP and AP are the maximum, then
they start decreasing and production is optimum. This is the optimum and best
stage of production.

THE LAW OF RETURNS TO SCALE:

The law of returns to scale describes the relationship between outputs and scale
of inputs in the long-run when all the inputs are increased in the same
proportion. In the words of Prof. Roger Miller, “Returns to scale refer to the
relationship between changes in output and proportionate changes in all factors
of production. To meet a long-run change in demand, the firm increases its scale
of production by using more space, more machines and labourers in the
factory’.

Explanation:
Given these assumptions, when all inputs are increased in unchanged
proportions and the scale of production is expanded, the effect on output shows
three stages: increasing returns to scale, constant returns to scale and
diminishing returns to scale. They are explained with the help of Table 2 and
Fig. 5.

1. Increasing Returns to Scale:

Returns to scale increase because the increase in total output is more than
proportional to the increase in all inputs.
The table reveals that in the beginning with the scale of production of (1 worker
+ 2 acres of land), total output is 8. To increase output when the scale of
production is doubled (2 workers + 4 acres of land), total returns are more than
doubled. They become 17. Now if the scale is trebled (3 workers + о acres of
land), returns become more than three-fold, i.e., 27. It shows increasing returns
to scale. In the figure RS is the returns to scale curve where R to С portion
indicates increasing returns.

Causes of Increasing Returns to Scale:

Returns to scale increase due to the following reasons:
(i) Indivisibility of Factors:
Returns to scale increase because of the indivisibility of the factors of
production. Indivisibility means that machines, management, labour, finance,
etc. cannot be available in very small sizes. They are available only in certain
minimum sizes.

(ii) Specialisation and Division of Labour:

Increasing returns to scale also result from specialisation and division of labour.
When the scale of the firm is expanded there is wide scope of specialization and
division of labour. Work can be divided into small tasks and workers can be
concentrated to narrower range of processes. For this, specialised equipment can
be installed. Thus with specialisation, efficiency increases and increasing
returns to scale follow.
(iii) Internal Economies:
As the firm expands, it enjoys internal economies of production. It may be able
to install better machines, sell its products more easily, borrow money cheaply,
procure the services of more efficient manager and workers, etc. All these
economies help in increasing the returns to scale more than proportionately.

(iv) External Economies:
A firm also enjoys increasing returns to scale due to external economies. When
the industry itself expands to meet the increased long-run demand for its
product, external economies appear which are shared by all the firms in the
industry.

When a large number of firms are concentrated at one place, skilled labour,
credit and transport facilities are easily available. Subsidiary industries crop up
to help the main industry. Trade journals, research and training centres appear
which help in increasing the productive efficiency of the firms. Thus these
external economies are also the cause of increasing returns to scale.

2. Constant Returns to Scale:

Returns to scale become constant as the increase in total output is in exact
proportion to the increase in inputs. If the scale of production in increased
further, total returns will increase in such a way that the marginal returns
become constant. In the table, for the 4th and 5th units of the scale of
production, marginal returns are 11, i.e., returns to scale are constant. In the
figure, the portion from С to D of the RS curve is horizontal which depicts
constant returns to scale. It means that increments of each input are constant at
all levels of output.

Causes of Constant Returns to Scale:

Returns to scale are constant due to:
(i) Internal Economies and Diseconomies:
But increasing returns to scale do not continue indefinitely. As the firm expands
further, internal economies are counterbalanced by internal diseconomies.
Returns increase in the same proportion so that there are constant returns to
scale over a large range of output.

(ii) External Economies and Diseconomies:

The returns to scale are constant when external diseconomies and economies are
neutralised and output increases in the same proportion.

(iii) Divisible Factors. When factors of production are perfectly divisible,

substitutable, and homogeneous with perfectly elastic supplies at given prices,
returns to scale are constant.

3. Diminishing Returns to Scale:

Returns to scale diminish because the increase in output is less than proportional
to the increase in inputs. The table shows that when output is increased from the
6th, 7th and 8th units, the total returns increase at a lower rate than before so
that the marginal returns start diminishing successively to 10, 9 and 8. In the
figure, the portion from D to S of the RS curve shows diminishing returns.
Causes of Diminishing Returns to Scale:
Constant returns to scale is only a passing phase, for ultimately returns to scale
start diminishing. Indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of
supervision and coordination. Large management creates difficulties of control
and rigidities. To these internal diseconomies are added external diseconomies
of scale.

These arise from higher factor prices or from diminishing productivities of the
factors. As the industry continues to expand, the demand for skilled labour,
land, capital, etc. rises. There being perfect competition, intensive bidding raises
wages, rent and interest. Prices of raw materials also go up. Transport and
marketing difficulties emerge. All these factors tend to raise costs and the
expansion of the firms leads to diminishing returns to scale so that doubling the
scale would not lead to doubling the output.

ECONOMIES OF SCALE: INTERNAL AND EXTERNAL ECONOMIES

An economy of scale exists when larger output is associated with lower per unit
cost. Economies of scale have been classified by Marshall into Internal
Economies and External Economies. Internal Economies are internal to a firm
when it expands its size or increases its output.

They “are open to a single factory or a single firm independently of the action
of other firms. They result from an increase in the scale of output of the firm,
and cannot be achieved unless output increases. They are not the result of
inventions of any kind, but are due to the use of known methods of production
which a small firm does not find worthwhile.” (A.K. Caimcross).

External Economies are external to a firm which is available to it when the

output of the whole industry expands. They are “shared by a number of firms or
industries when the scale of production in any industry or group of industries
increases. They are not mono-polised by a single firm when it grows in size, but
are conferred on it when some other firms grow larger”. (A.K. Cairncross).

Modem economists distinguish economies of scale in terms of real and

pecuniary internal and external economies.
(A) Real Internal Economies:
Real internal economies are “associated with a reduction in the physical
quantity of inputs, raw materials, various types of labour and various types of
capital (fixed or circulating) used by a large firm.”

Real internal economies which arise from the expansion of a firm are the
following:
1. Labour Economies:
As the firm expands, it achieves labour economies with increased division of
labour and specialisation. When a firm expands in size, this necessitates
division of labour whereby each worker is assigned one particular job, and the
splitting of processes into sub-processes for greater efficiency and productivity.

This, in turn, leads to the increase in the skill of every worker, the saving in
time to produce goods.

2. Technical Economies:
Technical economies are associated with all types of machines and equipment’s
used by a large firm. They arise from the use of better machines and techniques
of production which increase output and reduce per unit cost of production.

Technical economies are classified as follows:

(i) Economies of Indivisibility:
(ii) Economies of Superior Technique:
(iii)Economies of Increased Dimensions:
(iv) Economies of Linked Processes:
(v) Economies of the Use of By-products:
(vi) Economies in Power Consumption:
3. Marketing Economies:
A large firm also reaps the economies of buying and selling. It buys its
requirements of various inputs in bulk and is, therefore, able to secure them at
favourable terms in the form of better quality inputs, prompt delivery, transport
concessions, etc.

Because of its larger organisation, it produces quality products which are

offered for sale in attractive packing by its packing department. It may also have
a sales department manned by experts who carry on salesmanship, propaganda
and advertisement through the various media efficiently. Thus a large firm is
able to reap the economies of marketing through its superior bargaining power
and efficient packing and sales organisation.

4. Managerial Economies:
A large firm can afford to put specialists to supervise and manage the various
departments. There may be a separate head for manufacturing, assembling,
packing, marketing, general administration, etc. This decentralisation leads to
functional specialisation which increases the productive efficiency of the firm. “

5. Risk-Bearing Economies:
A large firm is in a better position than a small firm in spreading its risks. It can
produce a variety of products, and sell them in different areas. By the
diversification of its products the large firm is able to reduce risks by counter-
balancing the loss of one product by the gain from other products.

External economies are discussed below:

1. Technical Economies:
Technical external economies arise from specialisation. When an industry
expands in size, firms start specialising in different processes and the industry
benefits on the whole. For example, in the cotton textile industry some firms
may specialise in manufacturing thread, others in printing, still others in dyeing,
some in long cloth, some in dhotis, some in shirting, etc. As a result, the
productive efficiency of the firms specialising in different fields increases and
the unit cost of production falls.

2. Economies of Information:
As an industry expands, it specialises in collecting and disseminating market
information, in marketing the industry’s product and in supplying the firms with
consultant services. An industry is in a better position to set up research
laboratories than a large firm because it is able to pool larger resources.

3. Economies of By-products:
When an industry is localised, it turns out large quantities of waste materials,
such as molasses in sugar industry and iron scrap in steel industry. New firms
enter the industry which purchase these waste materials at reasonable prices and
use them for manufacturing by products.

The firms in the industry are able to reduce per unit cost in two ways: first, they
do not incur expenses in disposing of the waste materials, and second, they earn
some amount by selling them to manufacturers of by-products.

Diseconomies of Scale:
A diseconomy of scale exists when larger output leads to higher per unit cost.
The economies of scale cannot continue indefinitely. A time comes in the life of
a firm or an industry when further expansion leads to diseconomies in place of
economies. Internal and external diseconomies are, in fact, the limits to large
scale production. We discuss below real and pecuniary internal and external
diseconomies.
(A) Real Internal Diseconomies:
When a firm expands beyond an optimum level, a number of problems arise
such as factor shortages, lack of coordination and management, marketing and
technological difficulties, etc. They tend to raise per unit cost of production.

Thus real internal diseconomies arise from the following:

(1) Managerial Diseconomies:
The check to the further expansion of a firm is put due to the failure on the part
of the management to supervise and control the business properly. There is a
limit beyond which a firm becomes unwieldy and hence unmanageable.
Supervision becomes lax. Workers do not work efficiently, wastages arise,
decision-making becomes difficult, coordination between workers and
management disappears and per unit cost increases.

(2) Marketing Diseconomies:
The expansion of a firm beyond a certain limit may also involve marketing
problems. Raw materials may not be available in sufficient quantities due to
their scarcities. The demand for the products of the firm may fall as a result of
changes in tastes of the people and the firm may not be in a position to change
accordingly in the short period. The market organisation may fail to foresee
changes in market conditions whereby the sales might fall.

(3) Technical Diseconomies:
A large scale firm often operates heavy capital equipment which is indivisible.
As the firm expands its size beyond the optimum level, there are repeated
breakdowns in plants and equipment’s and the firm may fail to operate its plant
to its maximum capacity. It may have excess capacity or idle capacity. As a
result, per unit cost increases.

(4) Diseconomies of Risk Taking:

As the scale of production of a firm expands, risks also increase with it. An
error of judgment on the part of the sales manager or the production manager
may adversely affect sales or production which may lead to a great loss.

(B) Pecuniary Internal Diseconomies:

Pecuniary internal diseconomies arise when the prices of factors used in the
production and distribution of the commodity increase. As a firm expands, it
may need more labour, raw materials, finance, etc. But trained and skilled
labour may be available at higher wages.

There may arise shortages of raw materials which it may have to buy at higher
prices. More finance may be available at a high interest rate. Marketing, sales
and transport expenses may increase with the expansion of the firm. All these
physical factors tend to raise per unit cost.

(C) Pecuniary External Diseconomies:

Pecuniary external diseconomies arise solely through increases in the market
prices of inputs of an industry’. As an industry expands, pecuniary external
diseconomies arise when the prices of factors increase. When an industry
expands, the demand for factors like labour, capital equipment, raw materials,
etc. increases on the part of firms which may eventually raise their prices.

But the localisation of an industry and its overgrowth may lead to shortages of
labour, capital, equipment’s, raw materials, power, transport, etc. which tend to
raise the prices of these inputs and lead to the rise in per unit costs of firms.
These diseconomies are external to each firm in the industry because the
increases in the prices of factors are not caused by the expansion of any single
firm but are the consequence of the expansion of the whole industry.

COST:
Definition of cost:

Production or product costs refer to the costs incurred by a business

from manufacturing a product or providing a service. Production costs can
include a variety of expenses, such as labor, raw materials,
consumable manufacturing supplies, and general overhead.

Concept of Cost:
Cost, a key concept in economics, is the monetary expense incurred ‘by
organizations for various purposes, such as acquiring resources, producing
goods and services, advertising, and hiring workers. In other words, cost can be
defined as monetary expenses that are incurred by an organization for a
specified tiling or activity.

A cost comprises a number of elements, which are shown in Figure-1:

SHORT RUN COST :

Definition:The Short-run Cost is the cost which has short-term implications

in the production process, i.e. these are used over a short range of output. These
are the cost incurred once and cannot be used again and again, such as payment
of wages, cost of raw materials, etc.

LONG RUN COST:

Definition: The Long-run Cost is the cost having the long-term implications in
the production process, i.e. these are spread over the long range of output. These
costs are incurred on the fixed factors, Viz. Plant, building, machinery, etc. but
however, the running cost and the depreciation on plant and machinery is a
variable cost and hence is included in the short-run costs.

COST FUNCTIONS:

Short Run Cost Function

The cost function is a functional relationship between cost and output. It explains
that the cost of production varies with the level of output, given other things
remain the same (ceteris paribus). This can be mathematically written as:

C = f(X)

where C is the cost of production and X represents the level of output.

Total Fixed Cost

Fixed cost refers to the cost of fixed inputs. It does not change with the level of
output (thus, fixed). Fixed inputs include building, machinery etc. Hence the cost
of such inputs such as rent or cost of machinery constitutes fixed costs. Also
referred to as overhead costs, supplementary costs or indirect costs, these costs
remain the same irrespective of the level of output.

Hence, if we plot the Total Fixed Cost (TFC) curve against the level of output on
the horizontal axis, we get a straight line parallel to the horizontal axis. This
indicates that these costs remain the same and that they have to be incurred even if
the level of output is zero.

Total Variable Cost

The cost incurred on variable factors of production is called Total Variable Cost
(TVC). These costs vary with the level of output or production. Thus, when
production level is zero, TVC is also zero. Thus, the TVC curve begins from the
origin.

The shape of the TVC is peculiar. It is said to have an inverted-S shape. This is
because, in the initial stages of production, there is scope for efficient utilization
of fixed factor by using more of the variable factor (eg. Workers employing
machinery).

Hence, as the variable input employed increases, the productive efficiency of

variable inputs ensures that the TVC increases but at a diminishing rate. This
makes the first part of the TVC curve that is concave.

As the production continues to increase, more and more variable factor is

employed for a given amount of fixed input. The productive efficiency of each
variable factor falls and it adds more to the cost of production. So the TVC
increases but now at an increasing rate. This is where the TVC curve is convex in
shape. And so the TVC curve gets an inverted-S shape.

Total Cost

Total cost (TC) refers to the sum of fixed and variable costs incurred in the short-
run. Thus, the short-run cost can be expressed as
TC = TFC + TVC

Note that in the long run, since TFC = 0, TC =TVC. Thus, we can get the shape of
the TC curve by summing over TFC and TVC curves.

The following can be noted about the TC curve:

 The TC curve is inverted-S shaped. This is because of the TVC curve.

Since the TFC curve is horizontal, the difference between the TC and
TVC curve is the same at each level of output and equals TFC. This is
explained as follows: TC – TVC = TFC

 The TFC curve is parallel to the horizontal axis while the TVC curve
is inverted-S shaped.

 Thus, the TC curve is the same shape as TVC but begins from the
point of TFC rather than the origin.

 The law that explains the shape of TVC and subsequently TC is called
the law of variable proportions.

LONG RUN COST FUNCTION:

In the long run, the firm can vary all its inputs. 

Long run cost = Long run variable cost

In the long run, firms don’t have the liberty to reach equilibrium between supply
and demand by altering the levels of production. They can only expand or
reduce the production capacity as per the profits. In the long run, a firm can
choose any amount of fixed costs it wants to make short run decisions.

SHORT RUN AND LONG RUN COST CURVE:

SHORT RUN COST CURVE:

• Short run costs are accumulated in real time throughout the production
process.

• Fixed costs have no impact of short run costs, only variable costs and
revenues affect the short run production.

• Variable costs change with the output. Examples of variable costs include
employee wages and costs of raw materials.

• The short run costs increase or decrease based on variable cost as well as
the rate of production.
 • If a firm manages its short run costs well over time, it will be more
likely to succeed in reaching the desired long run costs and goals.

LONG RUN COST CURVE:

While in the short run firms are limited to operating on a single average cost
curve (corresponding to the level of fixed costs they have chosen), in the long
run when all costs are variable, they can choose to operate on any average cost
curve. Thus, the long-run average cost (LRAC) curve is actually based on a
group of short-run average cost (SRAC) curves, each of which represents one
specific level of fixed costs. More precisely, the long-run average cost curve
will be the least expensive average cost curve for any level of output. Figure
2 shows how the long-run average cost curve is built from a group of short-run
average cost curves. Five short-run-average cost curves appear on the diagram.
Each SRAC curve represents a different level of fixed costs. For example, you
can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as
a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although
this diagram shows only five SRAC curves, presumably there are an infinite
number of other SRAC curves between the ones that are shown. This family of
short-run average cost curves can be thought of as representing different choices
for a firm that is planning its level of investment in fixed cost physical capital—
knowing that different choices about capital investment in the present will cause
it to end up with different short-run average cost curves in the future.
From Short-Run Average Cost Curves to Long-Run Average Cost Curves. The
five different short-run average cost (SRAC) curves each represents a different
level of fixed costs, from the low level of fixed costs at SRAC 1 to the high level
of fixed costs at SRAC5. Other SRAC curves, not shown in the diagram, lie
between the ones that are shown here. The long-run average cost (LRAC) curve
shows the lowest cost for producing each quantity of output when fixed costs
can vary, and so it is formed by the bottom edge of the family of SRAC curves.
If a firm wished to produce quantity Q3, it would choose the fixed costs
associated with SRAC3.

The long-run average cost curve shows the cost of producing each quantity in
the long run, when the firm can choose its level of fixed costs and thus choose
which short-run average costs it desires. If the firm plans to produce in the long
run at an output of Q3, it should make the set of investments that will lead it to
locate on SRAC3, which allows producing q3 at the lowest cost. A firm that
intends to produce Q3 would be foolish to choose the level of fixed costs at
SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing
Q3 at lowest possible cost, and producing q3 would require adding a very high
level of variable costs and make the average cost very high. At SRAC4, the level
of fixed costs is too high for producing q 3 at lowest possible cost, and again
average costs would be very high as a result.

The shape of the long-run cost curve, is fairly common for many industries. The
left-hand portion of the long-run average cost curve, where it is downward-
sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of
scale. In this portion of the long-run average cost curve, larger scale leads to
lower average costs.

In the middle portion of the long-run average cost curve, the flat portion of the
curve around Q3, economies of scale have been exhausted. In this situation,
allowing all inputs to expand does not much change the average cost of
production, and it is called constant returns to scale. In this range of the
LRAC curve, the average cost of production does not change much as scale
rises or falls. The following Clear it Up feature explains where diminishing
marginal returns fit into this analysis.

BREAK EVEN POINT:

Definition:

The break-even point is a concept used in economics and business. It is derived

from cost accounting data. It is the number where total costs, fixed and variable,
and total revenue are equal. It is the number of units that need to be sold so there
is no net loss or gain.
What is a Break-Even Analysis?

At break-even, all the costs are covered. The profit at the breakeven point is 0.
This is the point after which additional sales will contribute to a profit.

The break-even point is the sales amount required to cover total costs. Total
costs are both fixed and variable costs. It can be measured either in units or
revenue. Break-even is only possible if the price charged per unit is higher the
variable cost per unit. The difference between price and variable cost contributes
toward covering fixed costs. We call this amount the Contribution Margin.

The goal of business is to make a profit. Break-even analysis determines the

sales that must be exceeded to make a profit. It is a measure of the sustainability
of a business. It also measures the impact of marketing campaigns.

The break-even point is clear and direct analytical tools for management. It
provides insight into the relationship between revenue, costs, and net income.
Components of Break Even Analysis
Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the
decision to start an economic activity is taken and these costs are directly
related to the level of production, but not the quantity of production. Fixed costs
include (but are not limited to) interest, taxes, salaries, rent, depreciation costs,
labour costs, energy costs etc. These costs are fixed rrespective of the
production. In case of no production also the costs must be incurred.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the
production volume. These costs include cost of raw material, packaging cost,
fuel and other costs that are directly related to the production.

Benefits of Break-even analysis

 Catch missing expenses: When you’re thinking about a new business, it’s
very much possible that you may forget about a few expenses. Therefore, a
break-even analysis can help you to review all financial commitments to figure
out your break-even point. This analysis certainly restricts the number of
surprises down the road or atleast prepares a company for them.
 Set revenue targets: Once the break-even analysis is complete, you will get
to know how much you need to sell to be profitable. This will help you and your
sales team to set more concrete sales goals.
 Make smarter decisions: Entrepreneurs often take decisions in relation to
their business based on emotion. Emotion is important i.e. how you feel, though
it’s not enough. In order to be a successful entrepreneur, decisions should be
based on facts.
 Fund your business: This analysis is a key component in any business
plan. It’s generally a requirement if you want outsiders to fund your business. In
order to fund your business, you have to prove that your plan is viable.
Furthermore, if the analysis looks good, you will be comfortable enough to take
the burden of various ways of financing.
 Better Pricing: Finding the break-even point will help in pricing the
products better. This tool is highly used for providing the best price of a product
that can fetch maximum profit without increasing the existing price.
 Cover fixed costs: Doing a break-even analysis helps in covering all fixed
cost.

Break even point formula:

Example:

Suppose the fixed cost of a factory in Rs. 10,000, the selling price is Rs. 4 and
the average variable cost is Rs. 2, so the break-even point would be

BEP = 10,000/(4 – 2) = 5,000 units

It means if the company makes the sales of 5,000 units, it would make neither
loss nor profit.