B.Economics –I Ghanshyamdas Saraf College of Arts &Commerce FY.

BCOM-SEM-I
Prof.Goldi.P.
F.Y.BCOM SEMESTER-I
MODULE-III & IV
5- DEMAND ESTIMATION AND FORECASTING
Demand Forecasting
Meaning
Demand forecast is an estimation of demand for the product for a future period.
No one can predict the future with absolute certainty. However every firm tries to obtain a forecast as
precise as possible.
For example Samsung will be interested to know the demand for its various products like T.V., phone,
Fridge etc. for the future period in order to plan its strategy.
Significance of Demand Forecasting
Demand forecast are significant for the following reasons.
1. Product Planning : Demand forecasts are essential to plan future production of goods and services
which involves a gestation period.
2. Resource Planning : Arrangements have to be made to procure finance from institutional and
other sources.
3. Sales Policy : Demand forecasting can help to formulate an effective sales policy and therefore to
increase sales revenue.
4. Price Policy : Demand forecast can help business to formulate appropriate price policy.
Types of Demand Forecasts
1. Passive Demand Forecast : Passive demand forecast try to predict the future situation with the
existing actions or policies of the firm.
2. Active Demand Forecast : If your business is in a growth phase or if you're just starting out active
demand forecasting is a good choice.
An active forecasting models takes into consideration your market research, marketing campaigns
and expansion plans.
3. Forecasts for Total Market and for Market Segments : Demand forecasts may be made for total
markets as well as market segments like domestic market, foreign market etc.
4. Short Term and Long Term Demand Forecasting : Short term forecast helps the firm to take
decisions within the3 limited resources currently available as well as within the existing capacity. It
may be undertaken monthly, quarterly , half yearly or yearly to avoid over production or under
production.
On the other hand, long term demand forecasts are undertaken in order to find out the viability of
establishing a new company or expanding the existing the existing business.
Steps in Demand Forecasting
Demand forecasting being a scientific exercise , has to go through the following steps.
1. Nature of Forecast : For what purpose demand forecast will be used. It depends upon its use one
has to choose the type of forecasts micro or macro, active or passive etc.\
2. Nature of Product : The next step is to understand the nature of product. It is necessary to see
whether the product is consumer good or producer good, perishable or durable good etc.
3. Determinants of Demand : We have to find out clearly the determinants of demand for the product.
4. Identifying Relevant Data :The forecaster has to decide whether he is going to use primary or
secondary sources of data. Then he has to collect the relevant data on the various determinants of
demand.
5. Choice of Method : The choice of method has to be logical and appropriate.
6. Testing Accuracy : There are various methods for testing stastical accuracy of a forecast. This
testing helps to reduce the margin of error.
7. Evaluating the Forecast : The forecaster will have to evaluate the forecast and draw conclusions from it.
B.Economics –I Ghanshyamdas Saraf College of Arts &Commerce FY.BCOM-SEM-I
Prof.Goldi.P.
Methods of Demand Forecasting
There are two approaches to demand forecasting
1. Survey Method : Survey method is one of the most common and direct methods of forecasting
demand in the short term.
The survey method undertakes three exercises, which are shown in Figure
Survey methods
(1) Experts opinion poll
(2) Market experiment method
(3) Delphi method
(i) Expert's Opinion Poll : Refers to a method in which experts are requested to provide their
opinion about the product.
Advantages
1. This method is quite simple and less expensive.
2. This method requires minimum statistical work.
Limitations
1. It is likely to be biased.
2. The experts may not be aware of the broader economic changes that may have an impact on future
demand.
(ii) Market Experiment Method : This method involves collecting information regarding the
current and future demand for a product. This method carries out the studies and experiment on
consumer behavior under actual market conditions.
Advantages
1. The forecaster does not introduce any bias or value judgement of his own.
2. The demand forecast is likely to be more accurate than many other method.
Limitations
1. Refers to an expensive method
2. Affects the results of experiments due to various social-economic conditions such as strikes, political
instability, natural calamities.
(iii) Delphi Method : This method refers to a group decision – making technique of forecasting
demand. In this method, questions are individually asked from a group of experts to obtain their
opinions on demand for products in future.
Advantages
1. It enables the respondents to be forthright in their views.
2. It is time and cost effective .
Limitations
1. It could be tedious and costly
2. It is still a poor proxy for market behaviours of economic variables.
Statistical Method
Statistical methods are complex set of methods of demand forecasting. These methods are used toforecast
demand in the long term.
In this method, demand is forecast on the basis of historical data and cross- selection data.These
different statistical methods are shown below-
1. Trend analysis
2. Regression analysis
(1) Trend Analysis : Under this method, the time series data of the variable under forecast are used
to fit a trend line, either graphically or through the statistical method of least squares.
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Prof.Goldi.P.
For example, we have the data of coffee sales in India for the period 1990-91 to 2015-16.
This data plotted on the graph.
C2 C1
400
300 C3
B
Sale of
200
Coffee
(Tonnes) 100

90-11 95-96 2000-01 2006-07 2015-16 2016-17

Years
The reading of the extrapolated graph or line will give the forecast.
This is a crude version of trend method and it is called the 'graphical method'. This is illustrated by
the figure.
In the figure the line AB shows the behavior of coffee sales during 1990-91 to 2015-16.
Then the line is extrapolated to C1, C2 and C3.
If the extrapolated line is taken as BC1, then the forecast for coffee sales for the year 2016-17 can be
worked out.
2. Regression Method
This is the most commonly used method of forecasting among economist.
It requires historical data on the variable under forecast as well as on the determinants of this
variable.
To obtain forecasts through this method the forecaster will have to follow the following steps.
(1) Identification of Variables : The first step is to identify the variables which influence the
demand for the product under study.
(2) Collection of Historical Data : It is essential to collect data on the variable under forecast and
its determinants.
i. Time series
ii. Cross section data
Time series data are observation on a variable of a given population over time e.g. data on
income, prices, consumption etc.
Cross section data refers to observation on a variable at a point of time across different
populations.
(3) Choice of Demand Function :The third step is choice of an appropriate form of demand
function for estimation.
The function could take any one of several log etc. depending on the problem.
(4) Estimation of the Function : The fourth step is the estimation of the function by using the
collected data of the variable and its determinants.
(5) Derivation of Forecast : The last step is the derivation of the forecast for the variable under
forecasting.
Advantages of Regression Method
The important advantages of this method is that it is prescriptive as well as descriptive.
Limitations of Regression Method : If some of the explanatory variables are not correctly chosen they
tend to be misleading.
Conclusion :
There is no unique method for demand forecasting or for forecasting other variables. Since no method is
perfect, more than one method can be used in practice.This can help for cross-checking and then to improve
the reliability of forecasts.
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Prof.Goldi.P.
EXERCISE
Q.1. Examine the survey method of demand forecasting.
Q.2. Why should demand forecasting be done?
Q.3. What are the types of demand forecasting?
Q.4. Discuss the steps to be taken in forecasting demand.
Q.5. Write short notes on:
(1) Consumer survey method
(2) Statistical method
Q.6. Explain the following concepts :
(1) Passive and Active forecast
(2) Micro and Macro level forecast
(3) Expert's opinion Survey
(4) Delphi Method
(5) Consumer survey
(6) Market Experiment
(7) TrendAnalysis
(8) Regression Method
(9) Complete Enumeration
(10) Sample Survey
(11) End-use Method
Q.7. Choose the correct answer and rewrite the statement.
(1) which of the following method are often used to make short-term forecasts when quantitative
data are not available?
a. Consumer Survey b. Regression Analysis
c. Trend Method d. MovingAverages
(2) Under which of the following methods all potential consumers are asked about the amount of
the commodity they would like to buy?
a. Delphi b. End-use
c. complete enumeration d. Consumer clinic
(3) Which of the following is not a feature of the sample survey method?
a. Errors may occur in large size sample
b. All potential consumers are included in the survey
c. Possibility of consumer bias
d. Useful to detect changes in consumer tastes and preferences.
(4) Which of the following methods makes use of historical data and demand determinants to
forecast demand?
a. Market experiment b. consumer Survey
c. End-use d. Statistical
(5) Which of the following methods use to bridge the opinions given by different experts?
a. Expert's opinion b. Trend Analysis
c. Delphi d. Sample Survey
(6) The …… method uses time series data
a. Trend b. End-use
c. Sample survey d. Delphi
(7) Which is not a feature of market experiment method of demand forecast?
a. Use of consumer clinics b. Actual market situations are created
c. Forecast is based on past statistical data d. Based on observed consumer behavior
Ans: 1. a 2. c 3. b 4. d 5. c 6. a 7. c
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Q.8. State whether the following statement are true or false.
(1) Demand forecasts are essential to plan future production. (Ans : True)
(2) Very small firms do not need to forecast demand. (Ans : False)
(3) Demand forecasting is not necessary for inventory planning. (Ans : False)
(4) Passive forecasts take into account future changes. (Ans : False)
(5) Long term forecasts are required for capital investments. (Ans : True)
(6) Choice of method is an important factor in demand forecasting. (Ans : True)
(7) The expert opinion method generates accurate demand forecast. (Ans : False)
(8) The Delphi method is a variant of the expert opinion method. (Ans : True)
(9) Sample survey method undertakes survey of all consumers. (Ans : False)
(10) There can be limitations of the sample survey method. (Ans : True)
(11) Results of stimulated market experiments are better than actual market experiment. (Ans : False)
(12)The Graphical method is a crude version of the trend method. (Ans : True)
(13) Knowledge of economic theory is not necessary to forecast demand through the regression
method. (Ans : False)

(14) Regression co-efficient are components of the relevant elasticity of demand. (Ans : True)
(15)Regression method forecasts demand accurately. (Ans : False)

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SEMESTER-I
6 - THEORY OF PRODUCTION
Introduction of Production
1. Production is a process of combining various material inputs and immaterial inputs in order to make
something for consumption.
2. The essence of production is the creation of utilities.
3. Aproductive activity may involve the forms as increase in the quantity of a good and service, change
in the form of a good and service, change in the spatial or temporal distribution of a good and
service.
4. The act of production involves the transformation of inputs or resources into output.
5. The inputs are labour, capital, land or natural resources, entrepreneur etc.
Production Function
1. The relation between inputs and output of a firm has been called the ‘Production Function’.
2. Aproduction can be an equation, table or graph showing the maximum amount of a commodity that
a firm can produce from a given set of inputs during a period of time.
3. It shows the maximum volume of physical output available from a given set of inputs or the
minimum set of inputs necessary to produce any given level of output.
4. Amethod of production is technically efficient to any other method if it uses less of at least one factor
and no more of the other factors as compared with another method.
Technically Efficient Method of Production
1. Technical efficient method of production refers to how productive a business can be given the fewest
inputs, or resources, necessary to do the output.
2. For example that commodity X is produced by two methods by using labour and capital :
Method A Method B
Labour 4 5
Capital 5 5
According to table method B is inefficient to method A because method B uses more of labour and
same amount of capital as compared to method A.
3. The profit maximizing firm will not be interested in wasteful or inefficient method of production.
Method A Method B
Labour 4 3
Capital 5 6

According to this table both methods A and C are technically efficient and are included in the
production function, which one of them would be chosen depends on the prices of factors.
4. The choice of any particular technique from a set of technically efficient techniques is an economic
one, based on input prices and not a technical one.
5. The act of production involves the transformation of inputs into output.
6. The dependent variable is the output and the independent variable are the inputs.
7. Production function can be expressed as
Q = f (N,L,K,E,T)
Q = Quantityproduced, N = Natural resources, L= Labour, K = Capital, E = Entrepreneur,
T = Technology
8. Only the inputs of labour and capital are considered as independent variable.
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9. The state of technology is given and remains constant.
Isoquants
1. Isoquants are called as equal product curve or Iso-product curve.
2. An Isoquant shows all those combinations of factors which produce the same level of output.
Types of Isoquants
1. Linear Isoquant :
(1) It is the Isoquant would be straight line.
(2) There is perfect substitutatility of factors of productions.
(3) Labour and capital are perfect substitutes, that is, the rate at which labour can be substituted for
capital in production is constant.
Y
A

Q
O X
Labour B

(4) According to diagram if an isoquant intercepts Y or X axis it would mean that a given commodity
may be produced by using only capital or only labour or by an infinite combination of lobour and
capital
2. Right Angled Isoquant :
(1) It is the isoquant takes the form of a right angle.
(2) It means Zero substitutability of the factors of production.
(3) In this case, labour and capital are perfect complements, that is labour and capital must be used in
fixed proportion.
Y

Q
C

O X
Labour
(4) The output can be increased only by increasing both the quantity of labour and capital in the same
proportion depicted at the point C.
(5) It is also called as input-output isoquant or Leontief isoquant.
3. Kinked Isoquant :
(1) There are onlya few process for producing any one commodity.
(2)This isoquant only limited substitutability of capital and labour.
Y A1

A2

A3

A
Q A4
B
C

D
X
O
Labour
42
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Prof.Goldi.P.
(3) According to diagram where A1,A2,A3 and A4 show the production process and Q is the kinked
isoquant.
(4) The substitutability of factors is possible only at the kinks, that is at points A,B,C and D.
4. Smooth Convex Isoquant :
(1) It is an isoquant includes all the technically efficient methods of producing a given level of output.
(2)This type of isoquant assumes continuous substitutability of capital and labour over a certain
range, beyond which the factors cannot substitute each other.
Y

Q
O X
Labour
(3)According to diagram an approximation to the more realistic form of a kinked isoquant because
as the number of process become infinite, the isoquant becomes a smooth curve.
Isoquant Map :
(1) Each isoquant represents a specific level of output it is possible to say by how much the output is
greater or lesser on one isoquant than on another it is called as isoquant map.
Y
Capital

Q3 [60 units]
Q4 [40 units]
Q1 [20 units]
X
Labour
(2) According to diagram the isoquant closer to the origin denotes a lower level of output.
K MP L
(3) The slope of an isoquant is = MRTS =
LK
L MPK
Properties of Isoquants
(1) Isoquants Slope Downwards to the Right, because when the quantity of a factor, say labour, is
increased, the quantity of other capital that capital must be reduced so as to keep output constant
on a given isoquant.

According to diagram the same output could be obtained at less cost by reducing the amount of
one of the factors, thus isoquants slope downwards to the right.
(2) Isoquants are Convex to the Origin :
i. The convexity of isoquants curves means that as we move down the curve successively smaller
units of capital are required to be substituted by a given increment of labour so as to keep the
level of output unchanged.
ii. It equals the ratio of the marginal product of labour to the marginal product of capital.

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Prof.Goldi.P.
K MPL
iii. The slope of an isoquant is = MRTS =
L LK
MPK
Y
(A)

{ K1

Capital
{  K2

X
O

{
{
L L Labour
iv. According to diagram if we increase labour at a constant rate the amount of capital given up ()
for an additional unit of labour goes on falling.
v. The convexity of the isoquant shows that the marginal rate of technical substitution of labour for
capital is diminishing. K1 >K2
Y
(B)

{ K 1

{ K 2

{ K 3

L L L Q
O X
Labour

vi. If the isoquant is concave to the origin it would mean that the marginal rate of technical
substitution is increasing.
vii. According to diagram A the labour is increased at a constant rate the amount of capital given up( K)
goes on increasing.
viii. Such behaviour is irrational and therefore, isoquants are not concave to the origin,
∆K1< ∆ K2 < ∆K3
(3) Isoquants do not Intersect :
i. Isoquants can never cut each other.
Y

b
c
1S2 (200)

a 1S1 (200)
O X
Labour

ii. According to diagram have two isoquants IS1 and IS2 isoquant IS1 measures 100 units of
output and isoquant IS2 is equal to 200.
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iii. Which means output on IS1 (100) is equal on IS2(200)
iv. To avoid such an anomaly, the two isoquants should not intersect.
(3) Isoquant can not Touches any Axis :
Y

Capital
Q
Q1

O X
Labour
i. If an isoquant touches any axis it would mean that the output can be produced with the help of
one factor.
ii. It is unrealistic because output cannot be produced only by labour or capital alone.
Ridge Lines
1. The ridge lines are the locus of points of points of isoquants where the marginal products of factors
are zero.
2. The firms will produce only in those segments of isoquants which are convex to the origin and lie
between the ridge lines.
3. Regions outside the ridge lines are called regions of reconomic nonsense.
Y Ridge Line

Q3 (300)
Q2 (200)
S E A Q1 (100)
D
B
C
H
G
F
X
O T Labour
4. According to diagram OAand OB are the ridge lines on the oval shaped isoquant.
5. The curves Q1,Q2 and Q3 are the isoquants.
6. The points C,D,E and F,G,H between the ridge lines are economically feasible units of capital and
labour which can be empolyed to produce 100, 200 and 300 units of the output.
7. The points outside the ridge line are uneconomic region of production while the points inside the
ridge lines are economic region of production.
8. The isoquants are convex to the origin inside the ridge lines.
9. The lines OA and OB are called the ridge lines which bound a region in which marginal products of
the two factors are positive.
10. In the uneconomic region the marginal product of an input becomes either zero or negative and the
input substition does not arise.
11. Production in such region is not profitable or not feasible.
Least-Cost Combination of Inputs
1. Least cost combination of inputs is also known as optimal combination of inputs or producer’s
equilibrium, or equal product map.
2. An equal product map represents the various factor combination which can yield various levels of
output, every equal product curve or isoquant showing those factor combination each of which can
produce a specified level of output.
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3. An equal product map represents the production function of a product with two variable factors.
4. The firm will have to choose that combination of factors which will cost it the least, in this way the
firm can maximize its profits .
5. The firm can maximize its profits either by maximizing the level of output for a given cost or by
minimizing the cost of producing a given output.
6. In either case the factors will have to be employed in optimal combination at which the cost of
production will be minimum.
7. There are two ways to determine the least cost combination of factors to produce a given output. That
is
i. Finding the total cost of factor combinations.
ii. Geometrical Method.
1. Finding the total Cost of Factor Combination :
(1) To find the total cost of each factor combination and choose the one which has the least cost.
(2)The cost of each factor combination is found by multiplying the price of each factor by its quantity
and then summing it for all inputs.
Technique capital (Units) Labour (Units) Capital Cost ₹ Labour Cost ₹ Total Cost ₹
A 8 20 600  8 = 4800 400  20 = 8000 12800
B 4 24 600  4 = 2400 400  24 = 9600 12000
(3) According to table 100 pairs of shoes are produced per week and the price of capital and the wage
of labour are ₹ 600 and ₹ 400 per week respectively.
(4) There are only two technically efficient methods of producing shoes and they are labelled as A
and B.
(5) The total cost of producing 100 pairs of shoes is 12800 ₹ per week using technique Aand ₹ 12000
₹ per week using technique B.
(6) The firm will choose technique B which is economically efficient because of lower cost
(7) If either of the factor prices change the equilibrium proportion of the factors will also change so as
to use less of the factors whose price has gone up the most.
2. Geometrical Method : Geometrical method we can explain with isoquant map and iso-cost line.
(1)Isoquant Map : An isoquant map shows all the possible combinations of labour and capital that
K MP1
can produce different levels of output. The slope of isoquant is = MRTSLK = MP
L K

(2) Iso-Cost Line :

i. The iso-cost line shows various combinations of labour and capital that the firm could buy for a
given amout of money at the given factor prices.
Y
A2
A1
Capital

O B B1 B2
Labour
ii. According to diagram the line AB is the iso-cost line.
iii. The firm can hire OAamount of capital and OB amount of labour and capital along the AB line.
iv.Iso-cost line is the locus of all those combinations of labour and capital which, given the prices
of labour and capital, could be bought for a given amount of money.
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Slope of Isocost Line

1. If the factor prices change then the slope of iso-cost line will change.
2. With a given amount of money and the prices of labour and capital, the iso-cost line is AC.
Y
A

Capital
X
O C2 C C1
Labour
3. If the price of labour falls the firm could hire more than OC amount of labour for the same amount of
money.
4. The firm could hire only OC1 amount of labour then the slope of iso-cost line changes to Ac1.
5. If the price of labour rises, the firm could hire less than OC anount of labour.
6. The iso-cost line depends upon 2 factors as prices of factors of production and the amount of money
which the firm can spend on the factors.
7. AChange in factor price it will change the slope of iso-cost lines.
Optimal Input Combination for Minimizing Cost :
1. The firm has to produce the given output with the minimum cost.
Y
A2
A1
A
Capital

K e

O X
L B B1 B2
Labour
2. According to diagram isoquant Q is tangent to the iso-cost line A1B1.
3. The optimal combination of factors is OK and OL and at point ‘e’ where the given output can be
produced at the least cost.
4. Points below ‘e’are desirable in terms of cost but are not attainable for output Q.
5. Points above ‘e’are on higher iso-cost lines and they show higher costs.
6. The point ‘e’ is the least cost point and it is the lowest cost combination of factors for producing the
maximum output Q.
7. At point ‘e’the slope of iso-cost line is equal to the slope of the isoquant.
8. This is the first condition for the equilibrium, the second condition is that the isoquant should be
convex to the origin at the point of equilibrium, it means.
Marginal Product of Labour Price of Labour
= Price of Capital
Marginal Product of Capital
Optional Input Combination for Maximization of Output
1. In this case the firm has to maximize its output for a given cost.

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Y

A S

Capital
K1 C
Q3
Q2
T Q1
O X
L1 B
Labour
2. According to the diagram the maximum level of output that the firm can produce is Q2 because the
point ‘e’lies on the isoquant Q2.
3. The point ‘e’ is the equilibrium point because at this point the iso- cost line AB is tangent to the
isoquant Q2
4. Sand T lie on a lower isoquant Q1.
5. Points above ‘e’that is on isoquant Q3 indicate higher levels of output which are desirable, but are not
attainable due to the cost constraint.
6. Q2 is the maximum output possible for the given cost, the optimal combination of factors is OK1 and
OL1.
7. If the factor prices change the firm will choose another factor combination which will minimize the
cost of production for the given output or maximize the level of output for a given cost.
Expansion Path (Scale Line)
1. The expansions path may be defined as the locus of the points of tangency between the isoquants and
the iso-cost line.
2. Expansion path represents the minimum-cost combination for various levels of output.
3. Expansion path is also known as scale line.
4. The scale line have different shapes and slopes depending upon the relative prices of the factors used
and the shape of the isoquants. Y
A3
E
A2
Capital

A1
e3
e2 Q3
e1
Q2
Q1
O B1 B2 B3 X
Labour

5. According to diagram the firm, given the factor prices, will change its factor combinations as it
expand its output in the long run.
6. The iso-cost lines A1B1, A2B2 are parallel to each other because the relative factor prices are assumed
constant.
7. If the firm wishes to produce the level of output denoted by isoquant Q1 it will choose the least cost
factor combination e1 at which isoquant Q1is tangent to iso-cost line A1B1.
8. If the firm wants to produce higher levels of output denoted by isoquants Q2 and Q3 it will choose the
factor combinations e2 and e3 which are the least cost factor combinations for the output Q2 and Q3.
9. Points e1,c2 and e3 the marginal rate of technical substitution of labour for capital is equal to the ratio
of factor prices, each isoquant is tangent to the relevant iso-cost line.
10. Join the minimum cost factor combinations e1,e2 and e3, we get line OE it is called as expansion path.

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EXERCISE
Q.1. Explain the least cost combination of factors.
Q.2. Explain the concept of isoquant with properties.
Q.3. Explain types of isoquant.
Q.4. Short notes
(1)Production function.
(2) Smooth convex isoquant.
(3) Isoquant map.
(4) Ridge lines.
(5) Iso cost line.
(6) Optimal input combination for minimizing cost.
(7) Optimal input combination for maximizing of output.
(8) Expansion path.
Q.5. Choose the correct answer and rewrite the statements.
(1) Which of the following properties of an iso-quant is due to diminishing marginal rate fo technical
substitution?
a.Nagative slope b. Right angle
c. Does not intercept axes d. Convexity
(2) If a firm has to choose between two equally technically efficient methods of production, then its
choice of a method will depend on.......... .
a.Prices of the factors b. availability of the factors
c. Monetary resources available with the firm d.All the above
(3)If an iso-quant is linear and touches both axis, it indicates ......... .
a.Zero substitutability of factors b. Perfect substitutability of factors
c. Continuous substitutability of factors d. Limited substitutability of factors
(4)A kinked iso-quant indicates.......... .
a.Limited substitutability of factors b. Continuous substitutability of factors
c. Perfect substitutability of factors d. Zero substitutability of factors
(5)The slope of the iso-cost line is.......... .
a. MRTSKL b. MRSXY
c.PKIPL d. PLIPL
( Ans : i. d ii. d iii. b iv. a v. d )
Q.6. State weather the following statements are true or false.
(1) Production refers to creation utilities. (Ans : True)
(2) Akinked iso-quant represents perfect substitutability of factors. (Ans : False)
(3) The slope of the iso-cost line will change if the monetary resources of the producer changes, with
no change in the price of input. (Ans : False)
(4) The scale line shows least cost combination of factors for different levels of output. (Ans : True)
(5)A technically efficient production function is also the most economic one. (Ans : false)
(6)Zero substitutability of factors is indicated by a kinked iso-quant. (Ans : False)
(7)Two iso-quants never intersect each other. (Ans : True)

******

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SEMESTER-I
7 - SHORT-RUNAND LONG-RUN ANALYSIS OF PRODUCTION
Types of Production Function
Fixed Proportion Production Function :
1. It is one in which the technology requires a fixed combination of inputs, say capital and labour, to
produce a given level of output.
2. There is no possibility of substitution between the factors of production.
3. fixed proportion function is explain by isoquants which are ‘L’shaped or ‘right angle’shaped.
9
8
7 A
6
Capital

5
4 Q2
A2
3
2 Q1
A1
1
0 1 2 3 4 5 6 7 8 9
Labour
4. At point A 1 output is one unit.
5. The isoquant Q1 passing through the point A1 that one unit of output is produced by using 2 units of
capital and 3 units of labour.
6. With 2 units of capital, any increase in labour beyond 3 units will not increase output, therefore,
labour beyond 3 unit is redundant.
7. Similarlywith 3 units of labour, any increase in capital beyond 2 units is redundant.
8. The kink (angle) point shows the most efficient combination of factors.
9. The output can be doubled by doubling the quantity of inputs, that is, two units of output can be
produced by 4 units of capital and 6 units of labour.
10. Isoquant Q2 passes through the point A2, the ray OA describe a production process, that is, a way of
combining inputs to obtain certain output.
11. The slope of the ray shows the capital labour ratio.
12. Fixed proportion production function is characterized by constant returns to scale, that is, a
proportionate increase in inputs leads to a proportionate increase in output.
13. This type of isoquant is also called input output isoquant or “Leontiff” isoquant.
Variable Proportion Production Function
1. In variable proportion production function a given level of output can be produced by several
alternative combinations of factors of production, say capital and labour.
2. The common level of output obtained from alternative combinations of capital and labour is given
by an isoquant Q.

Y
Capital

O Q
X

3. The isoquant Q is the locus of efficient points of factor combinations to produce a given level of
output.
4. The isoquant is continuous, smooth and convex to the origin.

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Short-Run Production Function Long-Run Production Function
1. The short run is a period in which the firm can 1. The long run is a period sufficiently long so
adjust production by changing variable factors that all factors including capital can be
such as materials and labour but cannot change adjusted.
fixed factors such as capital.

2. Short-run production function are called 2. Long-run production function are called fixed
variable factors. factors.
3. The short run the output can be increased by 3. In the long-run all inputs can be adjusted
changing the variable factors, keeping the according to the requirement.
fixed factors constant.
Law of Variable Proportions
1. The law of variable proportions was developed by classical economists to explain the behaviour of
agricultural output.
2. This law is also known as the law of diminishing marginal returns.
3. The law explain the behaviour of the production in the short-run where the output is increased by
increasing units of variable factors, keeping other factor fixed.
4. According Paul A. Samuelson states, “An increases in some inputs relative to other fixed inputs will,
in a given state of technology, cause output to increase , but after a point extra output resulting from
the same additions of extra inputs will become less and less”
Assumptions of the Law
1. State of technology is assumed to be given and unchanged.
2. Fixed Factors means factors of production or inputs remain constant. For example land.
3. Variable factors are inputs whose supply can be increased in the short run. For example labour.
4. Homogenity of variable factors : All units of variable factors are of the same efficiency, so that the
rate of returns would not change due to differences in efficiency.
Changes in Output due to Increase in Variable Factor
Units of Variable Factor Total Product (TP) Average Product (AP) Marginal Product (MP)
(LABOUR)

1 10 10 10

2 16 8 6

3 33 11 17

4 56 14 23
5 80 16 24

6 96 16 16
7 104 14.85 8 TP
8 110 13.75 6 TVF

9 110 12.22 0
10 98 9.8 -12

5. According to the table labour is the variable factor, and all other factors are assumed to be constant.
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6. Total product is the total amount of output produced by all the variable inputs applied in combination
with the fixed input. The total product increases at an increasing rate upto the 4th unit of labour and
increases at a decreasing rate upto the 8th unit and remains constant between 8th and 9th units. There
after the total product declines.
7. Average product is obtained by dividing the total product by the units of total variable factor AP = .
After some times units of labour declines.
8. Marginal Product is the additional output produced by an additional unit of variable factor. It is equal
to a change in total output divided by a change in variable factor employed. For the last unit of labour
marginal product in negative.
Y
C
B
Output

A TP
I II III

AP X
O N M
MP
Variable Factor
9. According to diagram we can see the behaviour of total product, average product and marginal
product, the changes in output we can explain in three phases.
10. Phase I : In the phase 1 the total product increases up to point A, which means marginal product of
the variable factor is rising, from the point A onwards the total product increases at a diminishing
rate marginal product falls but is positive. The first stage ends where the average product curve
reaches its highest point, at the end of phase I the average and marginal products become equal.
11. Phase II : In this phase, the total product continues to increase at a diminishing rate until it reaches
the maximum point C. While the total product increases at a diminishing rate, the marginal product
decline. In this phase of diminishing marginal returns as both the marginal and average products
continuously decrease.
12. Phase III : In this phase experiences a decline in the total product, it makes the marginal product
negative. The average product though positive continues to diminish in the third stage.
13. The Stage of Operation :
(1) Producer has to decide about how far he can carry out production, and in which of the three phases
of production producer should function.
(2) A rational producer will never choose to produce in stage 3 where marginal product of the
variable factor is negative.
(3) Producer would not stop his operation in the first phase of increasing return.
(4)Producer leaves only phase II where the producer carries out his production.
(5)The rational producer would operate in that part of the second phase where marginal product is
positive.
Reasons for the Increasing, Diminishing and Negative Marginal Returns
1. Increasing Returns :
(1) In the initial stage of production the returns to variable factors increase due to the abundance of
fixed factor relating to variable factor.

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(2) Producer increasing returns to the variable factor in the initial stage is that as more units of the
variable factor are employed the efficiency of the variable factor itself increases.
2. Diminishing Returns :
(1) Increasing returns come to an end when we reach the point of full and efficient use of fixed
factor.
(2) The phenomenon of diminishing returns, like that of increasing returns, rest upon the
indivisibility of the fixed factor.
(3) Increasing as well as diminishing returns are the result of disproportion in the combination of
fixed and variable factors.
3. Negative Return :
(1) In the third phase too many units of variable factor working on fixed factor.
(2) Abundance of variable factor in comparison to fixed factor is the main reason for diminishing
returns.
Laws of Returns to Scale
1. Change in output as a consequence of changes in the scale froms the subject matter of “returns to
scale.”
2. Laws of returns to scale refers to the long-run analysis of the laws of production.
3. Scale refers to quantity of all factors which are employed in optimal combination for specified
outputs.
4. The term ‘returns to scale’refers to the degree by which output changes as a result of a given change
in the quantity of all inputs used in production.
Types of Returns to Scale
1. Constant Returns to Scale :
(1) If we increase all factors in a given proportion and the output increases in the same proportion,
returns to scale said to be constant.
(2) If a doubling or trebling of all factors causes a doubling or trebling of output, returns to scale are
constant.
(3) The case of constant returns to scale is sometimes called linear homogenous production
function.
Y

E
Capital

C
b Q3 (300)
a Q2 (200)
Q1 (100) X
O Labour

(4) According to diagram the constant returns to scale explain with the help of isoquants.
(5) There are two factors of production labour and capital.
(6) Line OE is scale line, it indictes the increases in scale.
(7) The distance between successive isoquants is equal, that is Oa =ab=bc.
(8) It means that if both labour and capital are increased in a given proportion the output expand in
the same proportion as the numbers 100, 200 and 300 against the isoquants indicates,

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2. Increasing Returns to Scale :
(1) It means that output increases in a greater proportion than the increase in inputs.
(2)Increasing returns to scale arise on account of indivisibilities of some factors.
Y

Capital
C
b Q3 (300)
a Q2 (200)
Q1 (100)
X
O Labour

(3) When increasing returns to scale occur the successive isoquants will lie at decreasingly smaller
distances along a straight line ray OE through the origin
(4) The various isoquants Q1, Q2, and Q3 are drawn which successively represent 100, 200 and 300
units of output.
(5) The increasing returns to scale occur since oa>ab>bc, which means that equal increases in output
are obtained by smaller and smaller increments in inputs.
3. Decreasing Returns to Scale :
(1) When a firm goes on expanding by increasing all his inputs, eventually diminishing returns to
scale will occur.
(2) When the output increases in a smaller proportion than the increase in all inputs returns to scale
are said to be decreasing.
Y

E
Capital

C Q3 (300)
b
Q2 (200)
a
Q1 (100) X
O Labour

(3) The distance between successive isoquants are increasing, that is Oa<ab<bc.
(4) It means that successively more and more of inputs are required to obtain equal increments in
output.
(5) The decreasing returns to scale are caused by diseconomies of large scale production.
(6)The returns to scale can be measured in terms of the coefficient of output elasticity (QE).
Percentage Change in Output
QE =
Percentage Change In All Inputs
If QE = we have constant returns to scale.
If QE > 1 we have increasing returns to scale.
If QE < 1 we have decreasing returns to scale.
Factors Responsible for Returns to Scale
1. Size of a firm
2. Division of labour
3. Large quantity of inputs.
4. Multiplicity of complex activities of the firm.
5. Perfectly divisible of inputs
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EXERCISE
Q.1. What is production function, explain with fixed proportions and variable proportions production
function.
Q.2. Explain laws of returns to scale.
Q.3. Explain law of variable proportions.
Q.4. Short notes
(1)Production function
(2) Short run production function
(3) Long run production function
(4)Total product
(5)Average product
(6)Marginal product
(7)Reasons for the increasing, diminishing and negative marginal returns.
(8)Constant returns to scale
(9) Increasing returns to scale
(10) Decreasing returns to scale
(11) Factors responsible for returns to scale.
Q.5. Choose the correct answer and rewrite the statements.
(1)When TP is maximum MPis.......... .
a. Zero b. Negative c. Maximum d. constant
(2)Returns to scale determine the behaviour of.......... .
a. Short run average cost b. Marginal cost
c.Average fixed cost d. Long run average cost
(3) If a simultaneous and equal percentage increase in the use of all inputs leads to a smaller
percentage increase in output, a firm’s production function is said to indicate.......... .
a. Decreasing returns to scale b. Constant returns to scale
c. Increasing returns to scale d. Diseconomies of Scale
(4)In case of decreasing return to scale, the distance between subsequent iso-quants.......... .
a. Remain constant b. Increase
c. Decrease d. None of the above
(5) In the short run, which of the following statements describes the presence of diminishing returns?
a. The marginal product of a factor is positive and rising.
b. The marginal product of a factor is positive and falling.
c. The marginal product of a factor is falling and negative.
d. The marginal product of a factor is constant.
(6) In the short run, increasing marginal returns take place due to.
a. Variabilityof all factors b. Abundance of fixed factors
c. Abundance of variable factors d. Economies of scale
Ans : 1. a 2. d 3. a 4. b 5. b 6. b
Q.6. State whether the following statements are true or false.
(1) In creasing returns to scale occur when variable factors are added while keeping some factors
fixed. (Ans : False)
(2) In the short run, the decision by a producer to operate in the third phase is irrational. (Ans : True)
(3)According to the law of variable proportions, the first phase of production is characterized by
rising total product. (Ans : True)
(4)Fixed proportion production function is characterized by constant returns to scale. (Ans : True)
(5)Fixed proportion production function is represented by a smooth convex iso-quant. (Ans : False)
(6)The laws of returns to scale explain production in the long run. (Ans : False)
(7)Returns to scale occurs due to indivisibility of some factors. (Ans : True)
(8) The increasing and decreasing returns to scale describe the behaviour of short run average cost.(Ans : False)
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SEMESTER-I
8- ECONOMICS AND DISECONOMIES OF SCALE

Introduction
Economies of scale are when the cost per unit of production or average cost decreases because the output
or sales increases. Diseconomies of scale are when the cost per unit of production or average cost
increases because the output increases.
Types of Economies and Diseconomies of Scale
1. Internal Economies and Diseconomies of Scale :
(1) It means those which a firm reaps as a result of its own expansion.
(2) The internal economies and diseconomies of scale affect the shape of the long run average cost
curve
(3) Internal economies of scale cause the long run average cost to fall, while internal diseconimies
of scale cause the long run average cost to rise as output increases.
2. External Economies and Diseconomies of Scale :
(1) are those which a firm reaps as a result of the growth of industry as a whole.
(2) Exteranal economies and diseconomies of scale affect the position of both the short run and long
run average cost curves.
(3) External economies shift down the cost curve, while external diseconomies shift up the cost
curve.
Internal Economies of Scale
(1) Internal economies of scale are the advantages of large scale production.
(2) Internal economies of scale can be because of technical improvements, managerial efficiency,
financial ability, monopsonypower, or access to large networks.
(3) According to many economists, internal economies arise due to indivisibility of some factors.
(4)As the output increases the large indivisible factors can be used more efficiently and therefore,
the firm experiences increasing returns to scale.
(5)The internal economies of scale are divided into two part.
A. Real Economies of Scale :
(1) Real economies are those which are associated with a reduction in the physical quantity of input
such as raw materials, varying types of labour and various types of capital.
(2) Real economies of scale is divided into four part
1. Production Economies : It arise from the use of factors of production in the form of labour,
technical and inventoryeconomies. It is also divided into three par.
(1) Labour Economies :
(i) As the size output increases the firm enjoys labour economies due to specialization, time
saving, automation of the production process and cumulative volume economies.
(ii) Labour economies refer to the benefit which arise due to division of labour.
(iii) Division of labour saves time and improves the innovative skill of the workers.
(iv) This increases efficiency, skills, productivity, saves time and reduces the cost of production
of a firm.
(2) Technical Economics :
(i) Technical economies arise from the indivisibilities which are the characteristics of the
modern techniques of production.
(ii) This will reduce the unit cost of production.
(3) Inventory Economies : The role of inventories is to help the firm to meet the random changes in
the input and the output sides of the operations of the firm.
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2. Marketing Economics :
(1) It refers to the benefits while buying inputs and selling the finished good.
(2) A large firm enjoys economies in purchasing its raw material on a large-scale at a low cost.
(3)The selling costs will be low and it can manage to sell his product to large number of people.
3. Managerial Economies :
(1) It refer to the benefits enjoyed by the firm due to specialization in managerial functions when the
firm expands, the various functions of the management can be divided into marketing finance,
administration etc and can be delegated to juniors and the manger can concentrate on the main
issues
(2) Hence, as output increases the managerial cost per unit of output continue to decline
4. Transport and Storage Economies :
(1) As the output increases, the unit cost of transportation of raw material, intermediate products and
finished products fall.
(2) As the size of the firm increases the storage costs will also fall.
B. Pecuniary Economies :
(1) Pecuniary economies is also known as monetary economies.
(2) These are those economies realized by the firm from paying lower prices for the factors used in
production and distribution of the product due to bulk buying by the firm.
(3) Alarge firm can get funds at lower cost, that is , at a lower rate of interest due to its reputation in the
money market.
(4) Transport rates may be also low if the amount of commodities transported are large.

Internal Diseconoimes of Scale

1. Division of labour results in increase in number of labourers, when workers are increased it becomes
difficult to have personal contact with them. This results in disputes and inefficiency.
2. As production increases, it becomes difficult to run the plant co-ordinating various factors like
labour, advertisement marketing etc.
3. As the scale of production increases, the extent of risk also increases. Capital invested is large. Any
problem which stop production of scale will result in excessive loss.
External Economies of Scale : External economies of scale refers to the benefit enjoyed by all the firm
due to the expansion of an industry as a whole.
Types of External Economies of Scale
1. Economies of Localization : When a number of firms are located in one place, all of them derive
mutual advantages through the training of skilled labour, provision of better transport facilities,
stimulation of improvement etc.
2. Economies of Information : Each firm enjoys the benefits of research, statistical, technical and
markets information becomes more readily available to all firms in growing industry. As such when
the industry progresses, the cost of production falls.
3. Economies of Vertical Disintegration : The growth of industry will make it possible to split up
production and some subsidiary jobs can be left to do more efficiently by specialized firms. For
example automobile industry, there are separate firms which manufactures radiators, carburetors,
electrical equipments etc.
4. Economies of By-Product : A big industry can make use of waste materials for manufacturing by
products. The firm will get some extra income and this will tend to reduce the costs of production in
general.
5. Development of Transportation and Marketing Facilities : Expansion of an industry may make
possible the development of transportation and marketing facilities which will reduce the cost of
transportation.
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External Diseconomies of Scale :
1. Impossibility to Suit Individual Tastes : When goods are produced on large scale, there cannot be
any variations to suit individual tasts.
2. Competition : The overall cost of various firms of an industry increases due to competition.
Increases in cost of labour, advertising, marketing etc. will reduce the profit margin.
3. Fall in Profits : With increase in production supply increases. With increase in supply prices fall and
this reduces the profit.
4. Over Crowding : Increase in production will require more machines, more labourers, more storage
and more space. Lack of such space will result in overcrowding. Work will become inefficient.
EXERCISE
Q.1. Explain the internal economies and diseconomies of scale.
Q.2. Explain the external economies and diseconomies of scale.
Q.3. Short notes
(1) Internal economies of scale
(2)Internal diseconomies of scale
(3)External economies of scale
(4)Pecuniary economies
(5)Types of real economies of scale
(6)Producation economies
Q.4. Choose the correct answer and rewrite the statements.
(1)An important cause of internal diseconomies of scale is
a. Rising factor costs b. Diminishing returns to management
c. Transport congestions c. Pollution and health hazards
(2)Labour economy is caused by.......... .
a. Division of labour b. Time management
c. Managerial efficiency d. Better organization
(3)Interanal economies are realized by the firm.......... .
a. When size is big b. Scale of operation is large
c. Within itself d. All of the above
(4) External economics occur when.......... .
a. Size of firm expands b. Size of industry expand
c. Economy grows d. All of the above
(5)Which of the following is not due to external economies of scale?
a. Growth of technical know-how b. Managerial division of functions
c. Growth of subsidiary industries d. development of information services
(6)Transport bottlenecks due to excessive localization of industries is an example of.......... .
a. Internal economies of scale b. Division of labour and specialization
c. Smaller percentage of inventories to total output held
d. Use of specialized capital equipment
Ans : 1. b 2. a 3. b 4.b 5. b 6. c 7. a
Q.5. State whether the following statements are true or false.
(1) Pecuniary economies are associated with reduction in the physical quantity of inputs. (Ans : False)
(2)Division of labour leads to labour economy. (Ans : True)
(3)With the division of labour specialization leads to technological economics. (Ans : False)
(4)External economics are realized by the monopolist firms since there is no competition. (Ans : False)
(5)Internal economics enjoyed by an individual firm. (Ans : True)
(6) Division of labour leads to labour economy. (Ans : True)
(7) Using superior technology leads to external economy of scale. (Ans : False)

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SEMESTER-I
9- COST CONCEPTS
Meaning
1. Cost refers to all the expenses which the firm has to bear for producing the commodities.
2. The cost can be brought down either by producing the optimum level of output using the least cost
input combination or by increasing productivities of input, or by improving the organizational
efficiency.
3. Production and cost analysis are concerned with the supply side of the market.
4. Production analysis is done in physical terms while cost analysis is done in money terms.
Cost Concepts
1. Money Cost :
i. It is the total money spent by the firm on purchasing the different units of factors of production
needed for producing a commodity.
ii. Money cost include both explicit as well as implicit cost.
Money Cost = Explicit cost + Implicit cost
(1) Implicit Cost :
i. It refers to the opportunity cost of the use of factors which a firm does not buy or hire but
already owns
ii. Implicit Costs are the imputed value of the entrepreneurs own resources and services.
iii. It is also called as indirect cost.
iv. Implicit costs are the opportunity costs of the factors owned and used by the entrepreneur.
v.Implicit costs include wages of labour rendered by the entrepreneur himself, interest on capital
supplied by him, rent of premises sued in production normal profits of entrepreneurs.
(2) Explicit Costs :
i. It refers to the remuneration paid for the use of other factors of production.
ii. Explicit costs are the contractual cash payments made by the firm for purchasing or hiring
the various factors
iii. They include wages and salaries, payments for raw materials, power, light, fuel,
advertisements, transportation and taxes.
iv. Explicit cost also known as out of pocket cost or direct cost.
2. Accounting Cost :
(1) It refers only to the firm’s actual expenditures or explicit costs.
(2) It is also known as explicit costs.
(3) Accounting costs are important for financial reporting by the firm and for tax purposes.
3. Economic Cost :
(1) It include both implicit cost and explicit cost.
(2) It refers to the total money cost incurred by a firm for producing a commodity.
(3) Economic cost include costs of raw materials, rent of land and premises belonging to the
entrepreneur etc.
4. Fixed Cost :
(1) Fixed cost are those which are independent of output.
(2) Fixed cost refers to those cost which remain fixed whether the output increased or decreased.
(3) Fixed costs are also called as overhead cost or supplementary costs.
(4) It include such payments as rent, interest, insurance, depreciation charges, maintenance costs,etc

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5. Variable Cost :
(1) Variable cost are those which are incurred on the employment of variable factors of production.
(2) It is also known as prime costs.
(3) When the production increases these costs will also increase and when there is no production the
firm doesn’t incur any variable cost.
(4) Variable cost include as prices of raw materials, wages of labour, fuel and power charges,
transport expenditure, electricity charges, excise duties, sales tax etc.
6. Total Cost :
(1) The total cost of the f/irm is a function of output.
(2) It will increase with the increase in output that is it varies directly with the output.
(3) Total cost is combination of total fixed cost and total variable cost.
TC = TVC + TFC
Relationship between TC, TFC and TVC
Total Variable Cost Total Cost TC
Output Q Total Fixed Cost (TFC)
(TVC) TC = TFC + TVC
1 200 0 200

2 200 30 230

3 200 50 250

4 200 60 260

5 200 80 280

6 200 100 300

7 200 110 310

8 200 150 350

9 200 180 380

10 200 200 400

(1) According to table total fixed cost remains fixed at all level of output
(2) Total variable cost change with change in the level of output.
(3) Total variable cost does not change in the same proportion
(4) In the beginning as the output increases, TVC increases at a decreases at a decreasing rate, but
after a point it increases at an increasing rate.
(5) TC varies with the change in output in the same proportion as the TVC.
Y
TC
Total Cost

TVC

TFC
O Output X
(6) According to diagram total fixed cost curve remain constant which is parallel to the x-axis
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(7) The TVC curve begin at zero and then rises gradually in the beginning and eventually becomes
steeper as the output rises.
(8) The TC curve is obtained by adding up vertically TFC and TVC curves.
7. Average Total Cost :
(1) It when compared with price or average revenue will allow a business to determine whether or
not it is making a profit.
(2) Average total cost is total cost divided by the number of units produced that is
Total cost
Average Total Cost =
Output
OR
Average total cost =Average fixed cost +Average variable cost
8. Average Fixed Cost :
(1) By dividing total fixed cost by output we get average fixed cost by output we get average fixed
cost.
TFC
AFC = q
(2) The same amount of fixed cost is shaved equally between the various units of output, AFC falls
continuously as output rises.
9. Average Variable Cost :
(1) It is total variable cost divided by output
TVC
AVC = q
(2) The average variable cost will generally fall as the output rises from zero to the normal capacity
level of due to the operation of increasing returns.
10. Marginal Cost :
(1) It is the extra or additional cost of producing one extra unit of output.
(2) In economics the term ‘marginal’ whether applied to utility, cost, production, consumption or
whatever, means ‘incremental’or ‘extra’.
Mcn =Tcn - TCn - 1
NUMERICAL PROBLEM
Q.1. Q TFC TVC
1 100 50
2 100 60
3 100 70
4 100 80
5 100 90
6 100 100
7 100 110
8 100 120
9 100 130
10 100 140
With the help of table data find out TC, AFC, AVC, AC and MC.
Q.2. The cost of attending a private college for one year is ₹70,000 for tuition, ₹ 40,000 for the room,
₹8,000 for meals, and ₹ 6000 for book and supplies. The student could also have earned ₹52,000 a year by
getting a job instead of going to college and 10% interest on expenses he or she incurs at the beginning of the
year. Calculate the explicit, implicit and the total economic costs of attending college.

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Prof.Goldi.P.
EXERCISE
Q.1. Explain different types of cost. (Nov. 17)
Q.2. Short notes
(1)Money Cost
(2) Implicit Cost (Mar. 17)
(3) Explicit Cost (Mar. 17)
(4) Marginal Cost (Mar. 17)
(5) Accounting Cost (Nov. 18)
(6) Economic Cost (Nov. 18)
(7) Fixed Cost
(8)Variable Cost
(9)Total Cost
Q.3. Choose the correct answer and rewrite the statement.
(1) Accounting cost does not include.......... .
a. Payment made to the accountants
b. Rent paid to the landlord
c. Interest of own money invested by the entrepreneur
d. Bank rate
(2) Which of the following would be an implicit cost for a firm?
a. Payment of wages and salaries of workers
b. Payment to the supplier of raw materials
c. Salary that the business owner would have earned by working elsewhere
d. Interest to the bank for borrowed found.
(3) is the cost that has already been incurred and which cannot be recovered.
a. Fixed cost b. Sunk cost c. Private cost d. Social cost
(4) Fixed cost is regarded as.......... cost.
a. Unavoidable b. Variable c. Avoidable d. None of the above
(5) Electricity charges, sales tax etc. are examples of............ cost.
a. Fixed b. Variable c. Private d. Social
(6)is not related to the level of output
a. Total cost b. Total variable cost c. Total fixed cost d. Average cost
(7)is obtained by dividing TC by the level of output produced.
a. Average fixed cost b. Average variable
c. Total fixed cost d. Average total cost
Ans : 1. c 2. c 3. b 4. a 5. b 6. c 7. a
Q.4. State whether the following statement are true or false.
(1) Fixed cost refers to labour cost. (Ans : False)
(2) Economic cost is equal to explicit cost minus implicit cost. (Ans : False)
(3) Social cost is included in price. (Ans : False)
(4) Money cost is the payment made for the factors in terms of money. (Ans : True)
(5) Variable cost remain fixed at any level of output in the short run. (Ans : False)
(6) Fixed cost are overhead cost. (Ans : True)
(7) Implicit costs are called as indirect cost. (Ans : True)
(8) Explicit costs are called as the accounting costs. (Ans : True)
(9) Fixed cost include cost of raw materials. (Ans : False)
(10) Fixed costs are independent of output. (Ans : True)

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Prof.Goldi.P.
SEMESTER-I
10- COST OUTPUT RELATIONSHIP
Meaning of Cost
Function
1. Cost function is a derived function.
2. It is obtained from the production function and the market supply of inputs.
3. The production function specifies the technical relationship between inputs and the level of output.
4. Cost functions are of two kinds as short run cost function and long-run cost function.
Short-Run Cost Function
In the short run, there are two major categories of costs as fixed cost.
C = f (Q,T,P)
C = Total cost, Q = Output, T = Constant technology, P= Constant prices of factors.
Long - Run Cost Function
however, all costs are variables
C = f (Q, T, P)
C =Total cost, Q = Output, T= Technology,
P= Prices of factors
Relationship betweenAC, AFC, AVC and MC
MC AC
AVC
Cost

AFC
Output
Marginal and Average Cost Cirves
1. The relationship between AC, AFC, AVC and MC is explained by diagram with cost curve.
2. As the output increases, the total fixed costs get spread over a larger and larger output and therefore,
the average fixed cost goes on progressively declining.
3. The average fixed cost curve slope downwards from the left to right throughout its entire stretch.
4. AFC curve is a rectangular hyperbola.
5. The average variable cost (AVC) declines in the initial stages as the firm expands and approaches
the optimum level of output.
6. The AVC curve is thus slightly U - shaped, indicating that as the output increases.
7. The lowest point of U shape average cost is decreasing, then it remains constant for a while and
again starts increasing.
8. The lowest point of U shape average cost occurs at which the quantity of output has a minimum
average cost. This output level is called the efficient scale of the firm.
9. The marginal cost curve also assumes U - Shape indicating that in the beginning the marginal cost
declines as output expands, there after, it remains constant for a while and then starts rising upward.
10. Marginal cost is the rate of change in total costs when output is increased by one unit.
11. the slope of the MC curve also reflects the law of diminishing returns.
Relationship between AC And MC
1. When AC is minimum, the MC is equal to AC.
2. MC curve must intersect at the minimum point of AC curve
3. When AC is falling, MC is also falling initially, after a point MC may start rising but AC continues
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Prof.Goldi.P.
Y MC
AC

O X
Output
4. According to diagram when MC and AC are falling, MC curve lies below the AC curve.
5. Both MC and AC curves are sloping downward. When AC curve is falling MC curve lies below it.
Short-Run Average Cost and Output
Y
SAC

E1 E2
Cost in ₹

O Q1 Q Q2
Output
1. The short-run cost curve is U shaped.
2. When production increases, average cost declines, reaches the lowest point, indicating the maximum
output at minimum cost.
3. At OQ1 output, average cost is Q1E1.
4. Cost declines as production increases.
5. At Q output, average cost at E is the lowest, indicating maximum output at minimum cost.
6. The output at minimum average cost is called capacity.
7. Production less than or more than capacity .
8. Output Q1 and Q2 are at a cost higher than minimum cost, that is QE.
Long-Run Average Cost Curve
1. The long-run period is long enough te enable a firm to vary all its factor inputs.
2. In the long run, a firm is not tied to a particular plant capacity.
3. In the long run, there are only the variable costs or direct costs as total cost.
Y SAC1 SAC
F SAC1 C
3

B
C D F
A E

X
O LN M QP
Output
4. A long run average cost curve is derived with the help of various short run average cost curves.
5. There are three plants and they are depicted by the shortrun average cost curves SAC1, SAC2, and
SAC3.
6. Output OLcan be produced at a lower cost with the plant SAC1, than with the plant SAC2.
7. The cost of producing OL output on plant SAC1, is AL and it is less than the cost of producing the
same output with plant SAC2.
8. The difference in cost is equal to AB.

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Prof.Goldi.P.
9. If the firm wants to produce ON output it can produce it either by plant SAC1, or plant SAC2.
10. The output larger than ON but less than OQ can be produced at a lower average cost with plant SAC2.
11. For output larger than OQ the firm will have to employ plant SAC3.
12. The output OPcan be produced at average cost of PE with plant SAC3.
Derivation of LAC
Y

LAC LAC

SAC1
SAC5

SAC2 SAC4
SAC3 V
S

T U
R
X
O M Output

1. The long-run cost of production is least possible cost of production of any given level of output, when
all inputs become variable, including the size of plant.
2. If an infinite number of SAC curves, every point on th LAC curve will be a tangency point with
some SAC curve.
3. The LAC curve is the locus of the points of the lowest average cost of producing various levels
of output.
4. At the output OM at which the lowest point of SAC3 coincides with the minimum point on the
LAC curve at point R.
5. LAC curve is tangent to falling portions of SAC1 and SAC2 at points S and T respectively, but
points of S and T are not the minimum points of SAC1 and SAC2.
6. The LAC curve is tangent to rising portions of SAC4 and SAC3 at points U and v respectively.
7. The long run average cost falls slowly, reaches a minimum and then rises gradually as the output
rises.
8. The LAC curve is U-shaped, but flatter than SAC curves, because all factors being variable in the
longrun, the size of th plant can be adjusted.
9. The behaviour of the LAC curve depends on the returns of scale.
10. The LAC curve falls with the increase in output due to the availability of economies of scale and
LAC curve rises due to diseconomies of scale.
11. The LAC curve is called an envelope curve because it envelopes a family of shortrun average
cost curves.
12. It is also called a ‘planning’ curve because the firm plans to expand its scale of production over
the longrun.
Long-Run Marginal Cost Curve
1. The long-run marginal cost curve is also derived from the slope of total cost curve at the various
points relating to the given output each time.
2. The shape of LMC curve has also a flatter U-shape, indicating that initially as output expands in
the long run with the increasing scale of production, LMC tends to decline.
3. At a certain stage LMC tends to decline

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Prof.Goldi.P.

Y
LMC LAC

Cost
O X
Output
4. According to the diagram when LAC curve decreases, LMC curve also decreases and LMC is less
than LAC(LMC<LAC)
5. When LMC tends to rise but the LAC continues to fall then LMC is still less than LAC.
6. When LAC curve is minimum, then LMC = LAC, thus LMC curve intersect LAC curve at the
lowest point.
7. When LAC curve rises, LMC curve also rises but LMC curve lies above the LAC curve that is
LMC>LAC.
Learning Curve :
1. The learning curve is referred to as the experience curve, the cost curve, the efficiency curve or
the productivity curve, because the learning curve provides measurement and insight into all of
these aspects of a business firm.
2. A learning curve is a concept that graphically depicts the relationship between cost and output
over a defined period of time.
3. The learning curve is used as a way to measure production efficiency and to forcast costs.
Y
70
60 A
50 B
40 C
30
20
10
X
O 100 200 300 400 500
Cumulative Total Output

4. According to diagram the learning curve is downward sloping in the beginning with a flat slope
toward the end, with the cost per unit on the Y-axis and total output on the X-axis.
5. The learning curve is convex to the origin
6. According to diagram the average cost declines from Rs. 60 for producing 100th unit of
production at the point A, to about 45 Rs. for producing 200 unit at the point B, and about 35
Rs.for producing 400 unit at point C.
7. It can be seen that the average cost is declining at a decreasing rate
Benefits of Learning curve :
1. Learning curve have been cited in many manufacturing and service sectors, ranging from the
manufacturing of airplanes, appliances, ship building etc for forcast the need for personnel,
machinery and raw-materials and for scheduling production, determining the price at which to sell
output and even for calculating suppliers price quotations.
2. The learning curve does a good job of depicting the cost per unit of output overtime.

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Prof.Goldi.P.
3. A Well-placed employee who is set up for success should decrease the company’s costs per unit
of output over time.
4. Businesses can use the learning curve to conduct production planning, cost forecasting and logistic
schedules.
5. The slope of the learning curve represents the rate in which learning translates into cost savings for a
business firm.
Long-Run Average Cost and Output :
1. In the long-run a firm operates under returns to scale, since, in this period all costs are variable and
capacity of a firm can be changed according to the demand.
Y LMC LAC

O X
Q Output
2. According to diagram output OQ is the lowest possible per unit cost of production for the given
technology and factor prices.
3. At point E, LMC cuts LAC indicating that it is lowest on LAC.
4. It is the point where the firm reaches the optimum size of output.
NUMERICAL PROBLEM
Q.1. Total fixed cost is ₹ 150. Find out TVC, TC, AFC and AVC using the following information
Units of output 1 2 3 4 5 6 7 8
MC 30 15 10 10 30 40 50 60
Q.2. Given TFC as ₹200, calculate TC, ATC,AVC, AFC and MC from the information given below.
Units 1 2 3 4 5 6
TVC 40 60 85 110 160 230
Q.3. Calculate TVC,ATC,AVCMC from the information given in the following table (Mar. 19)
Output (Units) 1 2 3 4 5 6 7 8
Total Cost (₹) 100 125 140 150 160 180 210 250
EXERCISE
Q.1. Explain TC, TFC, TVC,AFC,AVC,ATC and MC.
Q.2. Explain the relationship between AFC,AVC,ATC and MC.
Q.3. Explain the derivation of average cost curve in the long period.
Q.4. Explain the statement “LAC curve is an envelope curve”
Q.5. Explain the statements, “AFC curve is a rectangular hyperbola”.
Q.6. Short notes
(1) Learning curve
(2) Relationship beetween LAC and LMC
(3) Cost Function
(4) Short run cost function (5) Long-run cost function.

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Prof.Goldi.P.
Q.7. Choose the correct answer and rewrite the statements.
(1) The slope of the total cost curve equals.......... .
a. Average variable cost b. Marginal cost
c. Average cost d. Marginal physical product
(2) LAC is used to determine.......... .
a. The lowest possible AC for producing various levels of output.
b. The maximum output at lowest variable cost
c. The output at which fixed cost is minikmised
d. The optimum firm size
(3) Average fixed cost
a. Declines over a certain output range
b. Declines over the entire output range
c. Is a long-run concept only
d. Is influenced by decreasing returns to scale
(4) Which of the following statements about the relationship between marginal cost and average
cost is correct?
a. When MC is rising, AC always rises
b. Mc equals AC at Mc’s minimum point
c. When MC exceeds AC,AC will rise
d. When AC exceeds MC, MC will rise
(5) The reduction in cost due to increase in efficiency is referred as .......... .
a. Income effect b. Price effect
c. Learning curve effect d. All of the above
(6)causes LAC curve to rise
a. Internal economics b. Economies and diseconomies
c. External diseconomies d. All of the above
Ans : 1. b 2. d 3. b 4. c 5. c 6. c
Q.8. State whether the following statements are true or false.
(1) MC is independent of fixed cost. (Ans : True)
(2) In the long run, the firm faces no fixed costs. (Ans : True)
(3) Long run cost is used to determine the optimum firm size. (Ans : True)
(4) MC curve intersects the AC at AC’s lowest point. (Ans : True)
(5) When MC is greater than AC, AC will be falling. (Ans : False)
(6) TFC is parallel to X-axis. (Ans : True)
(7) Long-run is a period in which all the inputs become fixed. (Ans : False)

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