Unit 3

Production & Cost Analysis

Notes

BBA Semester 3
Subject – Micro-Economic Fundamentals

Topics Covered
1. Production & Production Function: Concept, Forms of Production function
2. Law of Variable Proportions, Returns to scale.
3. Cost Concepts, Short term and long-term cost output relationship
4. The Isocost and Isoquant Approach
5. Economic Region and Economies & Diseconomies of scale.
 Unit – 3
Production & Cost Analysis

Production Analysis
INTRODUCTION

Production analysis basically studies the input–output relationship. This relationship

can be expressed both in physical (quantitative) terms as well as in money (monetary)
terms.
In production analysis, the input–output relationship is expressed in physical terms. It
means that the cost of production is expressed in terms of physical quantities of inputs.
This expression of input–output relationship in physical terms is called production
function.
In production analysis, the input–output relationship is also expressed in money terms.
It means that cost of production is expressed in terms of monetary values of inputs.
This expression is called cost function.

MEANING OF PRODUCTION

In an ordinary sense, production means the creation of products. But in economics,

production means the creation of utilities. Utility refers to the ability of a product to
satisfy human wants. In other words, utility means want satisfying power of a product.
Usually, producers create utilities by means of transforming physical inputs (factors of
production) into outputs (finished products) by transporting products from the
producing centre to the marketing centre; and by stocking, storing and releasing of
products for consumption whenever required.

James Bates and J.R. Parkinson define production as “an organized activity of
transforming physical inputs (resources) into outputs (finished products) which will
satisfy the products’ needs of the society.”

J.R. Hicks defines production as “any activity whether physical or mental which is
directed to the satisfaction of other people’s wants through exchange.” Hence in
production analysis, we study how the entrepreneur of a firm combines various inputs
efficiently to produce a particular level of output, with a given state of technology.
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 Factors AffectingProduction

(1) Technology.

A firm's production behaviour is fundamentally determined by the state of technology.

Existing technology sets upper limit for the production of the firm, irrespective of the
nature of output, size of the firm or the kind of management.

(2) Inputs.

There are wide variety of inputs used by the firms, like various raw materials, labour
services of different kinds, machine tools, buildings, etc. All inputs used in production
are broadly classified into four categories: land, labour, capital and entrepreneurship.
Land is all that is gifted by nature, while the physical and mental human effort spent in
producing goods and services is labour.
Capital is the man-made means of production like machinery, factory building, etc.,
and the entrepreneur coordinates the inputs and takes risk of business. Each of these
categories can be further subdivided. For example, we have skilled, unskilled and
semi-skilled labour. Broadly, the inputs are divided into two main groups-fixed and
variable inputs. A fixed input is the one whose quantity cannot be varied during the
period under consideration. Plant and equipment are examples of fixed inputs.
An input whose quantity can be changed during the period under consideration is
known as a variable input Raw material, labour, power, transportation, etc., whose
quantity can often be increased or decreased short notice are examples of variable
inputs.

(3) Time Period of Production.

The fixity or variability of an input depends on the length of time period under
consideration. Shorter the time period, more difficult it becomes to vary the inputs.
Economists classify time period into two categories: the short-run and the long-run.
The short-run is that period of time in which some of the firm's inputs are fixed these
fixed inputs act as a limiting factor on change in output. In practice, the short-term is
generally understood to mean the length of time during which firm's plant and
equipment are fixed. On the other hand, the long-term is that period of time in which
there are no limiting factors on output change. In other words, in the long run all inputs
can be changed.

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 PRODUCTION FUNCTION
Meaning of Production Function
Production function is generally referred to as ‘the technological relationship between
the physical inputs and physical output of a firm.’ In the words of George J. Stigler,
‘Production function is the name given to the relationship between the rates of input of
productive services and the rate of output…’. Physical inputs mean productive services
or factors of production like land, labour, capital, etc. whereas physical outputs mean
the quantity of finished products or the quantity of products produced.
The mathematical form of production function is thus:
Q = f(L, K, N, R, V, e)
Where,
Q = Output
L = Labour input
K = Capital input
N = Land input
R = Raw materials
V = Returns to scale
e = Efficiency parameter

Thus the production function expresses the relationship between the physical quantity
of output and the physical quantities of various inputs used in the process of
production. This relationship depends on a given state of technology and managerial
ability of the firm concerned.

Assumptions of Production Function

Production function is based on the following assumptions:
1. Production function is related to a specified period of time (i.e., over a period of
time).
2. The state of technology remains constant during that period of time.
3. The factors of production (or productive services) are divisible into most viable
units.
4. The substitution of one factor input for the other is limited.
5. The firm is using the most efferent technique available in production.

Usefulness of Production Function

Production function analysis is of practical importance in managerial decision making
in business. Some of its managerial uses are given below:
1. Production function analysis is of great help in making short period decisions by
business executives in two ways:
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(a) how to get optimum level of output from a given set of inputs.
(b) how to get the given level of output from the minimum set of inputs.

2. Production function analysis is of highly useful in making long period decisions by

business executives. If returns to scale are increasing, it will be worthwhile to increase
production, if returns to scale are diminishing, it will be worthwhile to decrease
production, and if returns to scale remain constant, it would be indifferent to the
producer whether to increase or decrease production if demand is no constraint.

3. Production function analysis is of great use to calculate the least-cost combination

of various factor inputs for a given level of output or the maximum output–input
combination for a given cost.

4. Production function analysis is logical and close to common sense. If the price of
one factor input falls while that of another rises, one would expect the substitution of
the first one for the second.

5. Production function analysis is of great importance in making decision on the utility

of employing a variable factor input in the production process.

Limitations of Production Function

Production function analysis has the following limitations:
1. Production function analysis has restricted itself to the case of two inputs and one
output. Mathematically, there is no great difficulty in extending this analysis to
multiple inputs and outputs.

2. Production function analysis has assumed smooth and continuous curves, while in
the real world, discontinuities in the production function may appear.

3. Production function analysis assumes that technology remains constant. But in

reality, it does not remain the same.

4. Production function analysis is also applied under perfectly competitive market

situations which are rare in the real world.

5. Production function analysis assumes that units of labour are homogeneous. In

reality, labour units are not identical but heterogeneous in characters.

PRODUCTION THEORY
Production theory plays an important role in making business decisions pertaining to
the organisation and management of production process of a business firm.
The relevance of production theory in the price theory or the theory of firm is highly
justified on the following ground:
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Production theory is relevant to the theory of firm which is concerned with what level
of output it will produce so as to maximize its profits. This profit maximizing output of
a firm depends upon the average and marginal cost of production, besides average and
marginal revenue.

Production theory thus plays an important role in the price theory as

(a) it provides a basis for the analysis of relation between costs and output; and
(b) it provides a basis for the analysis of firm’s demand factor inputs.

Production with One Variable Input or Law of Variable Proportions

The analysis of production with one variable input is a short run phenomenon. In the
short run, labour input is variable while the other factor inputs are assumed to be fixed.
This analysis in otherwise known as the law of variable proportions or the law of
diminishing returns.
The law of variable proportions examines production function with one variable input
(labour), keeping other factor inputs constant. This law also implies that the scale of
production can be changed by altering the variable inputs only and the quantity of
fixed inputs cannot be altered.

Suppose we cultivate a piece of one acre of land with 20 labourers. The ratio of land is
1:20. Now in order to increase the scale of production, 25 labourers are employed on
the same piece of land. This will alter the ratio of land to labour to 1:25. This variation
in the ratio of the factor inputs causes a change in the scale of production at various
rates. This tendency of change in the scale of production is termed as the law of
variable proportions.
As the particular firm keeps on changing this proportion by changing the variable input
(labour), it experiences the law of diminishing returns. This law states that beyond a
certain point of production, further increases in the employment of a variable factor
input will lead to a successively smaller increment in total output. In other words, after
a certain point of production the marginal physical product (MPP) starts declining. No
doubt, the total output increases but at a diminishing rate.

The law of variable proportions is based on the following assumptions:

1. The techniques of production remain constant.
2. It operates only in the short period.
3. The units of variable input employed are identical in character.
4. There is possibility of using various units of a variable input with fixed inputs.
Let us illustrate the law of variable proportions with the help of an example. Suppose a
farmer has one acre of land for cultivation. The amounts of capital and land are called
fixed factor inputs. He can vary the number of labourers employed in cultivation. Any
change in the number of labourers employed will definitely alter the total output. An
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important decision has to be taken by the farmer is that how many labourers are to be
employed by taking into account the physical productivity of labour.

The abovesaid idea of the law of variable proportions (or law of diminishing returns) is
clearly illustrated in Table below.

It is evident from Table below, that both the average physical product (APP) and the
marginal physical product (MPP) increase at the first instance. At one stage, both are
equal and then, start declining. The MPP rises and falls more rapidly than the APP.
When 7 labourers are employed, the total physical product (TPP) is the maximum.
When 8 labourers are employed, the total output remains constant at 112. The marginal
physical product of 8 labourers is zero. When 9 labourers are employed, the total
physical product declines to 108 and the marginal physical product is – 4.

The reason is the excessive number of labourers employed in relation to the size of
fixed factor input of land. Thus, the law of variable proportions comes into operation
only after a certain point of production.
The law of variable proportions (or law of diminishing returns) can also be explained
with the help of Figure.
The upper part of Figure shows that as labour is increased, output also increases until it
reaches the maximum output of 112; thereafter it falls. The dashed portion of the TPP
curve denotes that producing with more than 8 workers is not economically desirable;
it can never be profitable to employee additional units of labour to produce less output.

The lower part of Figure shows that the marginal physical product (MPP) is positive as
long as long as total output is increasing; but becomes negative when total output is
declining. The APP and MPP curves are closely related. When marginal physical
product is greater than, the average physical product, the APP is increasing. This is the

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case for labour inputs upto 4 in the lower part of Figure. In Table above, two labourers
produce 30 units of total output, so that the average physical product is 15. Adding a
third labourer increases total output by 30 units (to 60), which increases the average
physical product to 20.

Similarly, when the marginal physical product is less than the average physical
product, the average physical product is decreasing. In Table, six labourers produce
108 units of total output, so that the average physical product is 18. Adding a seventh
labourer increases total output by 4 units (to 112), which decreases the average
physical product to 16.

It is also seen from Figure that the MPP is above the APP when APP is increasing; and
below the APP when APP is decreasing. Therefore, the MPP must equal the APP
when APP reaches its maximum. The point E in the lower part of Figure represents the
point at which the average physical product (APP) and the marginal physical product
(MPP) are equal, when the average physical product reaches it maximum.

Production with Two Variable Inputs or Isoquants

The analysis of production with two variable inputs is a long-run phenomenon. In the
long run, both the inputs, i.e., labour and capital are potentially variable. Production
with two variable inputs can be examined by means of a family of isoquants or
isoproduct curves or equal product curves or production indifference curves.

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An isoquant is defined as the locus of various combinations of two inputs (labour and
capital) in the existing state of technology to produce a given level of output. In other
words, an isoquant is a curve that shows all possible combinations of inputs that yield
the same level of output. Isoquants are used by a firm to analyse and compare the
different ways to produce a given level of output.

The analysis of production with two variable inputs (or isoquants) is based on the
following assumptions:
1. There are only two factor inputs (labour and capital) to produce a particular product
for a firm.
2. These two factor inputs can substitute each other up to a certain limit.
3. The state of technology adopted in production is given over a period of time.

Table clearly shows the various combinations of the two factor inputs (labour and
capital) and the resulting outputs.

It is clear from Table that the number of the units of labour input used varies vertically
from 1 to 5 and the number of units of capital input used varies horizontally from 1 to
5. Figures presented in different combinations of labour and capital inputs represent
output.
For example, 3 units of labour and 1 unit of capital yield 50 units of output. The same
level of output is produced by 1 unit of labour and 3 units of capital. Similarly, 5 units
of labour and 1 unit of capital yield 70 units of output. The same level of output is
produced by 3 units of labour and 2 units of capital; 2 units of labour and 3 units of
capital; 1 unit of labour and 5 units of capital. Likewise, 5 units of labour and 2 units
of capital yield 90 units of output. The same level of output is produced by 3 units of
labour and 3 units of capital; and 2 units of labour and 5 units of capital.
Figure shows three isoquants. These isoquants are based on the data shown in Table.
It is obvious from Figure that production isoquants show the various combinations of
labour and capital inputs required for the firm to produce a given level of output. A set
of isoquants describes the firm’s production function. The output increases as we move
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from isoquant Q1 (at which 50 units are produced at points A and D) to isoquant Q2
(at which 75 units are produced at the point B) and to isoquant Q3 (at which 90 units
are produced at points C and E).

Properties of isoquants:
Isoquants have the following important properties:
1. Isoquants are convex to the origin. It implies not only the substitution of one factor
input with the other but also a diminishing marginal rate of technical substitution.
2. Isoquants have a negative slope, i.e., they slope downwards to the right. It implies
that if one of the factor inputs is decreased, the other has to be increased so that the
total output remains the same.
3. Isoquants never cut each other. It implies that a certain quantity of a product can be
produced with smaller factor input combination as well as with a larger factor input
combination.
Production with All Variable Inputs or Returns to Scale
The analysis of production with all variable inputs is a long-run phenomenon. In the
long run, all the productive inputs are variables. The firm should, therefore, consider
the best way to increase the output. Output can be increased, in this case, by changing
the scale of operation by increasing all the productive inputs proportionately. This is
generally referred to as returns to scale.
The concept of returns to scale is defined as the rate at which output increases as all
the productive inputs are increased proportionately. In other words, returns to scale
means the behaviour of returns or output when all the productive inputs are increased
or decreased simultaneously in the same ratio. Returns to scale is of three important
stages:
1. Constant returns to scale

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2. Increasing returns to scale
3. Decreasing returns of scale

Constant returns to scale

This scale means that a given increase in all the productive inputs leads to a
proportionate increase in the level of output. This can be illustrated in Figure.

It is clear that when the units of productive inputs, i.e., labour and capital are doubled
(from 2 to 4), the output is also doubled (from 50 to 100 units); and also, the inputs are
trebled (from 2 to 6), the output is also trebled (from 50 to 150 units). Hence, a
doubling or trebling of inputs doubles or trebles the level of output respectively.

Increasing returns to scale

This scale means that a given increase in all the productive inputs leaves to a more
than proportionate increase in the level of output. This can be illustrated in Figure.
It is clear that when the units of productive inputs (labour and capital) are doubled, the
output is more than doubled (from 50 to 120 units). Hence, a doubling of productive
inputs makes the level of output more than doubled. Increasing returns to scale are due
to technical and managerial economies of scale.

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Decreasing returns to scale
This scale means that a given increase in all the productive inputs leads to a less than
proportionate increase in the level of output. This can be illustrated in Figure.
It is clear that when the units of productive inputs labour and capital are doubled, the
output is less than doubled (from 50 to 90 units). Here, the firm is not able to double
the level of output. Hence, a doubling of productive inputs makes the level of output
less than doubled. Decreasing returns to scale are mainly due to non-availability of
skilled labour and employment of less efficient labour for higher wages.

The term expansion path (indicated in Figures) indicates all possible points of
equilibrium input combinations. It is defined as the set of combinations of labour and
capital and capital inputs that meet the efficiency condition:

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It is obvious that with the scale of production of 1 unit of labour and 2 units of capital,
the total output is 4 units. When the scale of production is doubled (i.e., 2 units of
labour with 4 units of capital), the total output is more than doubled (i.e., 10 units),
when the scale of production is trebled (3 units of labour with 6 units of capital), the
total output is more than trebled (i.e., 19 units). Likewise, the total output reaches 29
units. Up to this stage, the firm enjoys increasing returns to scale.
When the scale of production is further increased, total output increases in such a way
that the marginal returns become constant. In the case of 5 units of labour with 10 units
of capital and 6 units of labour with 12 units of capital, the marginal returns are the
same, i.e., 10 units only. In this stage, the firm has constant returns to scale.
When the scale of production is still further increased, total output increases in such a
way that the marginal returns are diminishing. In the case of 7 units of labour with 14
units of capital and 8 units of labour with 16 units of capital, the marginal returns start
diminishing, i.e., 8 units and 6 units respectively. In this stage, the firm experiences
decreasing returns to scale.

ECONOMIES OF SCALE
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Economies of scale simply means the advantages of large-scale production of a firm.
The economies of scale are of two types, namely, internal economies and external
economies.
Internal Economies
Internal economies are those which arise from a particular firm as it expands the size
of the firm. The internal economies include technical economies, managerial
economies, financial economies, commercial economies and risk-bearing economies.

(1) Technical economies

These are the advantages enjoyed by a firm due to its technical efficiency, which is
resulted from the use of machine which can save labour and produce on a large scale.
Insurance companies and banks make use of machines for calculation and enjoy this
advantage.
These are associated with fixed capital, which includes machinery and equipment.
Such economies arise because of the following:
(i) Specialised equipment. The production methods become more mechanized
as the output scale increases. This would imply more specialised capital
equipment and lower variable costs.
(ii) Indivisibility. The machinery and equipment generally have the property of
indivisibility, which means that equipment is available only in minimum
sizes or in definite ranges of size. When output is increased from zero to the
maximum capacity level of the machine, the same machine and equipment
are used. As a result the cost of machine is shared between more and more
units of output. In short, as the output is increased the machinery and
equipment comes to be utilised more intensively and consequently the cost of
production per unit declines.
(iii) Integration of processes. The large size firms enjoy economies of large
machines, Integration of processes occurs where one large automatic transfer
or numerically controlled machine can carry out a series of consecutive
processes, saving labour cost and time required to set up the work on each of
a series of successive specialised machines.
(iv) Economies of increased dimensions, for many types of equipment both initial
and running costs increase less rapidly than capacity (e.g., tanks, blast
furnaces and other static and mobile containers). These result in economies
of increased dimensions. Any container whose external dimensions are
doubled has its volume increased eight times, but the area of its surface walls
would have increased only four times. This reduces material costs and, where
appropriate, heat loss and surface, air and water resistance per unit.

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 (v) Economies in set-up costs. The larger the scale of output, the more a multi
purpose machinery is left to one set-up and, therefore, set-up costs of general
purpose machines reduce
(vi) Economies of overhead costs. Obviously, the larger the scale of output, the
lower the unit costs of initial fixed expenses which are need for a new
business or a new product

(2) Inventory economies.

Role of inventories is to meet the random changes in the input and output sides of the
operations of the firm. It has been found that the input as well as output inventories
increase at a rate lower than that of increase in output. These economies arise due to
the phenomenon of massed resources.
(3) Managerial economies
These kinds of economies are the advantages enjoyed by the management of a firm.
These advantages arise from the creation of special departments or from specialization.
A large firm can improve its efficiency by introducing division of labour and
specialization. Accounts department and research department are created and managed
by experienced personnel.
(4) Financial economies
These are the advantages enjoyed by a firm in raising adequate finance or capital. A
large firm is considered as trust worthier and as a stable one so that banks prefer to
advance loans at cheaper rate. Stock exchanges raise capital by selling shares of large
firms.
(5) Commercial economies
These are the advantages enjoyed by a firm in buying raw materials and other means
of production and also in selling the finished products. Large business firms buy these
input requirements on a large scale. Hence, they enjoy concessions from railway and
road transport, cheap credit from banks, prompt delivery, careful attention and also,
they enjoy concessions at the hands of their dealers.
(6) Risk-bearing economies
Large business firms are normally able to bear the risks of loss in their business better
than smaller firms. Suppose that electricity is supplied on a large scale by a large firm
to different consumers. A loss in one section will be compensated by the excess profits
enjoyed in another section.
(7) Production economies.
Production economies arise from (a) labour, (b) fixed capital, and (c) inventory
requirements of the firm. These are :Labour economies. Labour economies arise
because of the following factors:
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 (i) Division of Labour Economies. Larger output allows division of labour
which reduces cost by increasing specialisation, by saving time (otherwise
lost in passing from one operation to another), and providing good conditions
for inventions of a great number of machines.
(ii) Cumulative volume economies. The technical personnel engaged in
production tend to acquire significant experience from large-scale
production. This 'cumulative volume' experience helps in higher productivity
and, therefore, reduced costs.

(8) Marketing Economies.

These economies arise because:
(i) The advertising expenditure is generally found to have increased less than
proportionately with scale. Consequently, larger the output, smaller the advertising
cost per unit. Similar situation prevails in case of other types of selling activities.
(ii) The development and adoption of new models and designs involve considerable
expenses in R&D. The larger the output, more thinly this R&D expenditure spreads
over output.
(9) Transport and Storage Economies.
Storage costs obviously fall with the increase in the size of output, as it provides the
economies of increased dimensions (discussed already). The transportation costs, on
the other hand, involve an L-shaped average cost curve-transport unit costs falling up
to the point of the full capacity and remaining constant thereafter.
(10) Pecuniary Economies of Scale
These economies include the discounts that a firm can obtain due to its large size.
These discounts may be in the nature of:
(1) Lower raw material price due to bulk buying.

(2) Lower cost of capital, as banks usually place greater faith in the large firms
and, therefore, charge lower rate of interest.

(3) Offers of lower rates for advertising to large firms because of their large-
scale advertising.
(4) Lower transportation rates due to bulk transportation.

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 (5) In case the large firm is able to attain a size to gain monopsolistic power or is
able to create an image of prestige to be associated with the firm it may be in a
position to save on labour costs by paying lower wages and salaries.

External Economies
Like internal economies, external economies also help in cutting down production
costs. With the expansion of an industry, certain specialised firms also come up for
working up the by-products and waste materials. External economies are the
advantages enjoyed by all the firms in an industry which is localized at a particular
place. Similarly, with the expansion of the industry, certain specialised units may come
up for supplying raw material, tools, etc., to the firms in the industry.
Moreover, they can combine together to undertake research, etc., whose benefit will
accrue to all the firms in the industry. Thus, a firm benefit from expansion of the
industry as a whole. These benefits are external to the firm, in the sense that these arise
not because of any effort on the part of the firm but accrue to it due to expansion of
industry as a whole. In this sense these economies are external to the firm.
All these external economies help in reducing production costs. The external
economies include economies of concentration, economies of information and
economies of disintegration.
1) Economies of concentration
This refers to the advantages arise from the availability of skilled labourers, better
transport and credit facilities, etc.
2) Economies of information
This refers to the advantages derived from the publication of trade and technical
journals and from central research institutions.
3) Economies of disintegration
When an industry grows, it is possible to split up some of the whole processes which
are taken over by specialized firms.

DISECONOMIES OF SCALE
Diseconomies of scale simply means the disadvantages of large-scale production
facing a business firm. The diseconomies of scale are of two types, namely, internal
diseconomies and external diseconomies.
Internal Diseconomies
Internal diseconomies are those factors which raise the cost of production of a business
firm as its scale of production is increased beyond a point. The factors that influence
the cost of production of a firm include: 1. Lack of operational efficiency, i.e., there is
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a limit to decision and supervision. 2. Technical difficulties in its duration, i.e., there is
a limit to division of labour.

External Diseconomies
External diseconomies are those factors which ultimately limit the expansion of the
industry. The factors that limit the expansion of the industry include: 1. Increase in the
cost of transportation 2. Scarcity of raw materials and other means of production 3.
Difficulties in getting skilled labourers and finance or credit facilities.

Cost Output Relationship in Short Run

Time element plays an important role in price determination of a firm.

During short period two types of factors are employed. One is fixed
factor while others are variablefactors of production. Fixed factor of
production remains constant while with the increase in production, we
can change variable inputs only because time is short in which all the
factors cannot be varied.

Raw material, semi-finished material, unskilled labour, energy, etc., are

variable inputswhich can be changed during short run. Machines, capital,
infrastructure, salaries of managers and technical experts are included in
fixed inputs. During short period an individual firm can change variable
factors of production according to requirements ofproduction while fixed
factors of production cannot be changed.

Cost-Output Relationship in the Short Run:

Marginal Costs, Average Costs and Total Cost.

Total cost represents the money value of the total resources required for
production of goods and services by the firm. Average cost is the cost per unit of
output, assuming that production of each unit of output incurs the same cost. That
is,

AC= TC ÷Number of units

Marginal costs are the incremental or additional costs incurred when there is
addition to the existing output of goods and services. For example, if the total cost
increases from Rs. 2,000 to Rs. 2,100 when production increases from 10 units to
11 units, the marginal cost of 11th unit is:

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Rs. 2,100 - Rs. 2,000 = Rs. 100.

Thus, marginal cost of nth unit (MC) is the difference between the total costs of nth
unit (TC) and total cost of (n-1)th unit (TCn-1), i.e.,

MCn (TCn-TCn-1)

The relationship between MC, AC and TC is shown in Table

Fixed Costs and Variable Costs.

Economists often divide costs into the two main groups: fixed cost and variable
costs. Fixed (or. constant) costs are that part of the total cost of the firm which does
not vary with output, e.g. expenditures on depreciation, rent of land and buildings,
property taxes, etc. If the period under consideration is long enough to allow the
necessary adjustments in the capacity of the firm, the fixed costs no longer remain
fixed. These can then be varied. To an economist the fixed costs are overhead costs
and to an accountant these are indirect costs. When the output goes up the fixed
cost per unit of output comes down as the total fixed cost is then divided between
larger number of units of output.

Variable costs, on the other hand, are directly dependent on the volume of output
or service. Variable costs (for example, expenditure on labour, raw material, etc.)
increase but not necessarily in the same proportion as the increase in output. The
degree of proportionality between the variable cost and output depends upon the
utilisation of fixed facilities and resources during the process of production.

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It is usually assumed by theorists that the variable costs continuously vary with
output. But there are cases where costs remain fixed for each of range of output but
the movement of cost from one range of output to another is discontinuous, i.e., the
cost curve would show a jump as we move from one range to another. The
telephone bill, wages paid to a supervisor, etc. are some examples of such costs.
These costs consist of a fixed portion and a variable portion and is, therefore,
known as semi-variable costs. For simplicity we assume that there are only two
categories of costs: fixed and variable.

Let us understand the nature of relationship between the various cost components
with the help of Table
The table reveals that; (i) The fixed cost remains the same for all levels of outputs
upto capacity limit of the equipment. The average fixed cost, therefore, declines
proportionately with additions to output.
(ii) Variable cost increases as output increases but this increase need not be equally
proportionate. Its
proportion first declines, becomes constant and then starts rising. Average variable
cost also behaves in a similar way.
(iii) Total cost is the sum of fixed and variable costs. The average total cost is,
therefore, the sum of average fixed and average variable cost. Average variable cost
and average total cost curves are U-shaped

Short-run Costs and Long-run Costs.

The short-run is defined as a period in which the supply of at least one of the inputs
cannot be changed by the firm. To illustrate, certain inputs like machinery,
buildings, etc., cannot be changed by the firm whenever it so desires. It takes time
to replace, add or dismantle them. Long-run, on the other hand, is defined as a
period in which all inputs can be varied as desired. In other words, it is that time-
span in which all adjustments and changes are possible to realise. Thus, in the
short-run, some inputs are fixed (like installed capacity) while others are variable
(like the level of capacity utilization). While in the long-run all inputs, including the
size of the plant, are variable.

In the short-run, by definition, some inputs are fixed while the others are variable.
The latter kind of inputs give those costs that vary with the degree of utilisation of
variable input. The short-run costs are, therefore, of two types: fixed costs and
variable costs. The fixed costs remain unchanged, while variable costs fluctuate
with output. Long-run costs, in contrast, are costs that can vary with the size of
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plant and with other facilities normally regarded as fixed in the short-run. In fact,
in the long-run there are no fixed inputs and, therefore, no fixed costs, i.e., all costs
are variable.

SHORT-RUN COST FUNCTION

Short-run total cost. Once money resources of the firm have been invested into
buildings, machinery and other fixed assets, their amounts cannot be readily
changed. If the firm wants to expand its output, it is possible in the short run only
by a change in the rate of utilisation of these assets. This results in two kinds of
inputs: fixed and variable inputs. Since the fixed inputs do not change with the rate
of output, the cost to the firm of these fixed resources is also fixed. On the other
hand, cost of those inputs whose quantity can be changed to match the production
needs is known as variable cost. Thus: TC=TFC+TVC

where TC = total cost, TFC = total fixed cost and TVC = total variable cost. The total
fixed cost includes (1) salaries of the administrative staff, (ii) depreciation of
machinery and buildings, and (iii) expenses on repairs and maintenance of
buildings and machinery. On the other hand, total variable cost includes (i)
expenses on raw material, (ii) cost of direct labour, and (iii) the running expenses
of fixed capital such as fuel, ordinary repairs and routine maintenance.

Based on the information in Table, we may draw different short-run cost curves
(Fig.). The shape of the total variable cost (TVC) curve is principally determined by

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the productivity of the variable input. TVC increases at a decreasing rate upto Q₁
output, beyond which TVC increases at an increasing rate. This is because below
Q₁ output, the variable input is insufficient for the given fixed inputs. So, an
increase in the of variable input results in better utilisation of the fixed inputs,
leading to more than proportionate increase in output. For output levels greater
than Q₁, the fixed inputs fall short of the variable input. As a result the increase in
variable input can add proportionately less to output.

Since fixed costs do not change with output, the TFC curve is a horizontal straight
line. TC curve is the lateral summation of the TFC and TVC curves as shown in Fig.

Average and Marginal Cost Curves.

In order to arrive at various kinds of decision problems in the short run, we need
to understand the behaviour of several cost curves, viz., average fixed cost (AFC),
average variable cost (AVC), average total cost (ATC) and marginal cost (MC). We
may derive all these costs from the total cost data. If Q represents the level of
output, then, AFC = TFC/Q, ATC = TC/Q and MC = ∆TC/∆Q Or ∆TVC/∆Q
(for discrete functions) and MC=d(TC)/dQ or d(TVC)/dQ (for continuous
functions). We may understand these average cost relationships with the help of
Table and Fig. Since the TFC remains constant, AFC (which is TFC/Q), therefore,
continuously declines with increase in Q. This is because as output increases, the
total fixed cost gets spread more and more thinly over an increased volume of
output. Graphically, the AFC is a rectangular hyperbola, showing the same
magnitude (equal to TFC) at all its points (Fig).
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As can be seen from Table, average variable cost (AVC) declines, reaches a
minimum at 40 units of output, and then starts to increase. Average total cost (ATC)
behaves in a similar manner but reaches its minimum at 50 units of output.
Marginal cost (MC), which is the rate at which total cost changes with the change
in output, declines and then starts to increase once 40 units of output are produced.
The particular relationship between the average cost concepts and the marginal
cost are depicted in Table. Note that when ATC and AVC reach their respective
minimum points, they equal marginal cost. In the
figure AVC=MC at 47 units of output and ATC-MC at 56 units of output. Further,
notice that for the output Levels for which:

(1) MC<AVC, the AVC declines;

(2) MC =AVC, the AVC is at its minimum
(3) MC> AVC, the AVC is rising

Exactly, the same relationship holds between MC and ATC. In fact, MC concept is
highly useful in decision-making. In deciding whether to produce additional units
of output, the relevant cost is marginal cost

(i.e, the resultant change in total cost).

Cost Output Relationship in Long Run

The long run is a period long enough to make all costs variable including
such costs as are fixed in the short run. In the short run, variations in output
are possible only within the range permitted by the existing fixed plant and
equipment. But in the long run, the entrepreneur has before him a number
of alternatives which includes the construction of various kinds and sizes
of plants.
Thus, there are no fixed costs since the firm has sufficient time to fully adapt
its plant. And all costs become variable. In view of this, the long-run costs
will refer to the costs of producing different levels of output by changes in
the size of plant or scale of production. The long-run cost-output
relationship is shown graphically by the long- run cost curve—a curve
showing how costs will change when the scale of production is changed.
The concept of long-run costs can be further explained with the help of
an illustration. Suppose that at a particular time, a firm operates under
average total cost curve U2 and produces OM. Now it is desired to
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 produce ON. If the firm continues under the old scale, its average cost
curve will be NT. If the scale of firm is altered, the new cost curve will be
U3. The average cost of producing ON will then be NA.
NA is less than NT. So the new scale is preferable to the old one and should
be adopted. In the long run, the average cost of producing ON output is NA.
This may be called as the long-run cost of producing ON output. It may be
noted here that we shall call NA as the long-run cost only so long as the U3
scale is in the planning stage and has not actually been adopted. The
moment the scale is installed, the NA cost will be the short-run cost of
producing ON output.

To draw a long-run cost curve, we have to start with a number of short-

run average cost curves (SAC curves), each such curve representing a
particular scale or size of the plant, including the optimum scale. One can
now draw the long-run cost curve which tangential to the entire family of
SAC curves, that is, it touches each SAC curve at one point.

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Compiled by: Abdul Karim (MEF Unit 3 Notes)