Cost concepts & interrelations - Optimum level of input use and optimum production

A. COSTS

Costs are expenses of the firm incurred in the production of a given unit of output. These costs are
rewards to factors of production employed by the firm.

Production costs play an important role in the decisions of the farmers. Explicitly or implicitly, most of
the producers keep in mind the cost of producing additional units of output. In general, at given level of
prices, a farmer can increase his farm income in two ways, i.e., i) by increasing production and / or ii) by
reducing the cost of production. Since cost minimization is an individual skill, degree of success in this
direction directly adds to the profits of the farm.

Costs can also be referred to as the money value of effort extended or sacrifice made in producing an
article or rendering a service or achieving a specific purpose. Costs, thus, are the expenses incurred in
organizing and carrying out the production process. They include outlays of funds for inputs and services
used in production. The costs of a firm are divided into two major categories;

 Implicit costs: these are costs incurred in the production but are not included when calculating
profit and loss of a firm. For example salary of the firm’s owner, own transport, personal
premises. They are basically social costs such as real costs which are being used in production of
a given unit of output. They also include noise.
 Explicit costs: these are the expenses incurred by the firm and are included in the calculation of
the firm’s profit and losses. For example wages and salaries of workers, costs of raw materials,
and transport costs.it is assumed that in case the firm employs labour and capital, the cost
function would be expressed as C=a +L P L + K P K .
Where, a = fixed costs

L = Amount of labour employed

K = amount of capital employed

P L = Price of labour/ wage

P K = Price of capital/interest

Explicit costs can further be divided into fixed costs, variable costs, total costs, average fixed costs,
average variable costs, average total costs and marginal costs.

 Total fixed/ supplementary/overhead/indirect costs (TFC): these are expenses of a firm which do
not change with the level of output. Fixed costs do not change in magnitude as the amount of
output of the production process changes and are incurred even when production is not
undertaken, i.e., fixed costs are independent of output. Land revenue, salaries of top
management, taxes, contractual payments such as rent and interest on capital for the use of
fixed resources, and the value of services from fixed resources all represent fixed costs. In
farming, cash fixed costs include land taxes, rent, insurance premium, etc. Non-cash fixed costs
include depreciation of building, machineries and equipments caused by the passing of time,
interest on capital investment, charges for family labour and charges for management
TFC = TC –TVC.
 Graphical illustration of TFC

 Total variable/prime/direct/running/operating costs (TVC): These are expenses of a firm which

change with the level of output. Variable costs constitute the outlay of funds that are a function
of output in a given production period, i.e they vary with the level of output. The outlays of
funds on seed, fertilizer ,insecticide, casual labour, fuel and oil, feeds, etc, are a few examples of
variable costs. They also include transport costs, wages/salaries and costs of raw materials.
TVC = TC –TFC

Graphical illustration of TVC

 Total costs (TC): These are the total expenses of a firm incurred in the production of a given level
of output. Money value of all inputs used in the production process is termed as the total cost. If
the inputs used are represented by X1, X2,..., Xn and the respective prices by Px1, Px2, ..., Pxn,
then the total cost (TC) can be expressed as:
TC = Px1.X1 + Px2.X2 + ... + Pxn Xn.
The total cost comprises of two components, i.e., fixed and variable costs. TVC and TC increase
as output increases. Total fixed costs and total variable costs are denoted by TFC and TVC
respectively. In short run, total costs include fixed and variable costs. When no variable input is
used, TC=TFC. The TC curve at any point is equal to the vertical addition of TFC and TVC. In the
long run, all costs are considered variable costs because all inputs are variable. Conventionally,
total cost (TC) is thought of as a function of output (Y), rather than that of inputs, i.e., TC = f
 (Y).Such a cost curve is illustrated with TC on the vertical axis and Y (output) on the horizontal
axis. The total cost curve is similar to the production curve, when the physical units of X (input)
have been replaced with the corresponding cost (PxX). Hence, the shape of the TC curve, like
that of the TVC curve, depends upon the production function. In symbolic notation, TC can be
written as
TC = TFC + TVC = TFC + Px X, where TVC = PxX.

GRAPHICAL ILLUSTRATION OF TC, TFC AND TVC

The total cost doesn’t begin from zero because when output is zero there are still the fixed costs to be
incurred by the firm. Therefore at output zero the total costs equal to total fixed costs i.e. TC = TFC

In the short run some factors are fixed and expenses on such factors are fixed costs while other factors
are variable so expenses on them are variable costs where as in the long run all costs are variable
because time is long enough to enable firms vary all their factor inputs.

 Marginal costs (MC): It is the additional costs arising from production of one more unit of output
∆ TC
i.e. MC = . The MC at any output level equal to the change in the slope of the total cost
∆Q
curve at that level of output. The MC is entirely determined by the variable costs. The marginal
cost curve is U-shaped due to the law of diminishing marginal returns.
 Average Fixed Costs (AFC): It is the fixed cost per unit of output produced. Average fixed
costs(AFC) are computed by dividing total fixed costs by amount of output. AFC varies
depending on the amount of production.
TFC
AFC =
Q
 Average variable cost(AVC): It is the total variable cost per unit of output produced. It is
computed by dividing total variable cost by the amount of output. AVC varies depending on the
amount of production. The shape of the AVC curve depends upon the shape of the production
function while AFC always has the same shape regardless of the production function.
TVC
AVC =
Q
 TC
 Average Total Costs( ATC): It is the total cost per unit of output produced i.e AC = . It is also
Q
equal to the sum of average fixed costs and average variable costs i.e AC = AFC + AVC.

Nature and Relationship between Cost Curves: The shape of the ATC curve depends upon the shape of
the production function. ATC decreases as output increases from zero, attains a minimum, and increases
thereafter. ATC is referred to as unit cost of production, i.e., the cost of producing one unit of output.
The initial decrease in ATC is caused by the spreading of fixed costs

Among an increasing number of units of output and the increasing efficiency with which the variable
units is used (as indicated by the decreasing AVC curve). As output increases further, AVC attains a
minimum and begins to increase; when these increases in AVC can no longer be offset by decreases in
AFC, ATC begins to rise. AVC reaches its lowest point earlier than ATC.

a) Law of Diminishing Marginal Returns (LDMR)

Alfred Marshall stated the law thus: “An increase in labour and capital applied in the cultivation of a
land causes, in general, a less than proportionate increase in the amount of produce raised, unless it
happens to coincide with an improvement in the arts of agriculture”.

The law of diminishing marginal returns is a universal economic law that states that, in any production
process, if you progressively increase one input, while holding all other factors/inputs constant, you will
eventually get to a point where any additional input will have a progressive decrease in output.
In other words, you will get to a point where the benefits gained from increasing each extra unit of the
input will start decreasing. (luenendonk, 2018).

The advancement in agricultural technology may bring about changes where the operation of this law
is delayed, for example, by evolving, varieties of crops, which give higher yields at higher levels of
fertilizer application. But so far, science has not succeeded in stopping the operation of this law in
agriculture. The law of diminishing returns is also called the law of variable proportions. E.O. Heady
has stated that if the quantity of one productive service is increased by equal increments, with the
quantity of other resource services held constant, the increment to total product may increase at first
but will decrease, after a certain point. In other words, as the amount of a variable resource used in
the production of an output is increased, the level of output will at first increase at an increasing rate,
then increase at a decreasing rate and finally a point will be
reached, where further applications of the variable resource will result in a decline in the total output
of the production.

GRAPHICAL REPRESENTATION
The law of diminishing marginal returns is usually represented in graphical form using three curves: the
marginal product curve, the total product curve and the average product curve.
The marginal product curve shows the change in amount of production per input. The total product curve
shows the change in production with progressive increase in one production input. The average product
curve shows the change in average production.

.
ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL RETURNS
For the law to be applicable in any situation, it makes the following assumptions:

No Change in Technology
The law assumes that the progressive increase in the input is not accompanied by any change in the
techniques of production.
A change in the production technique will result in increased efficiency of production, thus negating the
effects of the law.
Therefore, for this law to apply, the method of production has to remain unchanged.

Short Term
Like I noted earlier, the law of diminishing marginal returns is only applicable in short term scenarios. It
is unlikely that all the other variables factors of production will remain unchanged over a long period of
time, making the law inapplicable in long term scenarios.
Homogenous Units
The law assumes that the units of all the variable factors of production are equal.
Measurement of Product
The law assumes that the output of the production process can be measured or quantified in physical
units, such as kilograms, liters or number of units.
THE RELATIONSHIP BETWEEN THE LAW OF DIMINISHING RETURNS AND THE 3
STAGES OF PRODUCTION

Stage One
The first stage of production is characterized by tremendous growth/ the stage of increasing returns to the
factor of production. In this stage, Marginal Product (MP) increases at first and then decreases. Average
Product (AP) increases throughout this stage i.e up to point A. that is why this stage is called the stage of
increasing returns. Average returns to the fixed factor increase during this stage because in the beginning,
the quantity of fixed factor is high relative to the quantity of variable factor. The efficiency can be
increased with an increase in variable factor. Total Product (TP) increases sharply during this stage
During this stage, any increase in a variable input will lead to a corresponding increase in the rate of
production, signifying increasing marginal return.
The increase in rate of production outweighs the investment on the variable input. At this stage, all the
three curves are positive.
Stage Two
The second stage is also known as stage of diminishing returns. In this stage of production, the marginal
returns start decreasing. Every extra variable unit added will still increase production, but at a decreasing
rate. In other words, the benefit gained from every additional unit of input will be less than the benefit
gained from the previous unit.
It is during this stage that the law of diminishing returns becomes applicable. During this stage, the total
product curve is still rising. However, the marginal curve and the average product curve start taking a dip.
According to Joan Robinson, “the law of diminishing returns as it is usually formulated states that with a
fixed amount of any factor of production, successive increases in other amounts of other factors will, after
a point, yield diminishing increments of output.”

Stage Three
This is the final stage of production. During this stage, the marginal returns become negative. In other
words, it becomes counterproductive to keep increasing the variable input. Any increase in the variable
input results in a decrease in the rate of production.
This happens as a result of limitations arising from inefficiency and the capacity of labor or capital.
At this stage, the total product curve starts taking a dip while the other two curves maintain their
downward trend.

EXAMPLES OF THE LAW OF DIMINISHING MARGINAL RETURNS

Example One: The Farmer
Let us imagine a farmer who plans to plant maize on a once acre piece of land. In addition to land, the
farmer will need other inputs such as seeds, fertilizer and labor.
The farmer has already bought the amount of seeds he needs and he has farmhands to help him out at his
farm.
However, the farmer is yet to decide on the amount of fertilizer he is going to use on the farm. If he
increases the amount of fertilizer, he will definitely increase the amount of grain he stands to harvest from
the farm.
However, if he keeps increasing the fertilizer, it will get to a point where the fertilizer will become
harmful to his crop, resulting in decreased yield from the farm.
According to the law of diminishing marginal returns, the farmer will get to a point where adding an extra
bag of fertilizer will result in less increase in yield compared to the previous bag.
To understand how this works, let us look at the table below.

Bags of Fertilizer Bags of Grain Marginal Bags of Grain

1 10 10
2 30 20

3 60 30

4 80 20

5 90 10

6 80 -10

If the farmer uses one bag of fertilizer, he will harvest 10 bags of grain from the farm. If he uses two bags
of fertilizer, he increases his total yield to 30 bags of grain.
In this case, the marginal (additional) yield gotten from the second bag of fertilizer is 20 bags. If he
increases the third bag of fertilizer, the total yield will be 60 bags, while the marginal yield from the third
bag of fertilizer will be 30 bags of grain.
However, after adding the fourth bag of fertilizer, the law of decreasing marginal returns kicks in.
While the fourth bag of fertilizer increases the total yield to 80 bags of grain, the marginal yield is only 20
bags which is a decrease from 30 for the previous bag of fertilizer.
After the sixth bag of fertilizer, the marginal yield of each bag will become negative, at which point the
total yield will also start decreasing. (Luenendonk, 2018)