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Production Theory:
A) Production function:
A production function represents input – output relationship.
Q = f (X, Y, Z)
Q = Dependent variables
XYZ = Independent variables
The Law of Diminishing Returns states that the additional or marginal product of a
variable input factor X (say labour) successively decreases as we go on increasing that
input factor at a particular point of time, other input factors Y (say land) and Z (say
capital) remaining fixed.
TPx = ∑ MPxi (i = 1 + n)
MPx is the additional product produced by one additional unit of input factor X.
100
80
60
MPx
40 TPx
Apx
20
0
1st 2nd 3rd 4th
-20 Qtr Qtr Qtr Qtr
Ans. In every production function there exists an optimal input factor ratio to get the
optimal output.
Return to scale:
a. Increasing returns to scale
b. Constant returns to scale
c. Decreasing returns to scale
MPx/MPy = Px/Py
MPx/Px = MPy/ Py
Higher levels of combination show higher levels of output. Hence Q3 > Q2 > Q1
Chapter- 5: Cost Concepts, Relationships & Practical Applications
A. Fixed & variable cost concepts:
Fixed costs are those costs that do not change with changes in output levels.
Example: Rent, Insurance premium, Depreciation of building etc.
Variable costs are those costs that do change (vary) with changes in output levels.
Example: Raw materials cost, Direct wages.
Indirect costs are those costs that can not per calculated per product or process unit
Example: Rent, Utility bills, Depreciation etc.
D. Sunk cost:
Sunk costs are irrecoverable expenses that is, these are expenses incurred that can’t be
recovered in future.
Example: Lottery ticket money when the lottery is lost, non-refundable tender bid money
when the tender is lost.
Incremental cost is the additional cost associated with implementation of one additional
management decision.
Example: If IIUC management decides to open a new department then the additional cost
associated with the opening of a new department will be called incremental cost.
F. Opportunity costs:
Opportunity cost is the potential benefit foregone (lost) from the next best decision
alternative.
The basic principal of opportunity cost is ‘if we do one things then we have to give
something else up’.
Opportunity cost is the potential benefit foregone from the alternative given up. The life
involves trade offs.
A rational investment will go for the best alternatives. In our example case the meat
processing investment decision is right.
Fixed and variable cost concepts, direct and indirect cost concepts are accounting cost
concept.
Explicit and implicit, marginal and incremental, and opportunity cost concepts are
economic cost concepts.
Figure: LRTC Curve showing increasing Figure: LRTC Curve showing decreasing
returns to scale returns to scale
In this case Q > C. In this case Q < C
Rate of change output is greater than the rate of
Here, rate of change output is smaller than
change input.
the rate of change input.
C. D.
Figure: LRTC Curve showing constant Figure: LRTC exhibiting variable returns to
returns to scale. scale
The rate (or percentage) increase or This figure initially exhibits increasing
decrease in output is equal to the rate (or returns to scale and after certain output
percentage) increase or decrease in cost. level (Q*) level, it exhibits decreasing
returns to scale.
E.
MC curve is U-shaped. And again MC curve determines the shapes of AVC and AC
curves. Hence both AVC and AC curves are also U-shaped
AC = AFC + AVC
AC > AVC
MC must cut both AC and AVC curve at the bottoms (or lowest points) from below.
AFC curve is hyperbola. That means, it goes on decreasing as output is increased. AFC
continuously decreased. It never cut the both X and Y axis. Its value never be zero.