Theory of production

Production is the function of the factors inputs P = f(l,k) Production can be increased in short run and the long run. In the short run all factors can not be increased so to increase the production only one factor is increased keeping all other factors constant. Short run: it is the time period during all the factors can not be increased but to increase the production , only one factor can be increased like labour or capital.In short run the law of returns to a factor applies Long run: It is the time period during which all the factors can be increased simultaneously and the scale of the business is increased. During this time period the law of returns to scale applies. Law of returns to a factor: or law of variable proportions it has three stages: Law of increasing returns to a factor: It is the first stage during it, if only one factor is increased , the production increases at increasing rate.means the increment in the total production by adding one more unit of the factor input is higher than the previous one. When the TP increases at increasing rate the MP increases. Law of constant returns : this is the second stage of the theory of production according to this as the factor input is increased the total production increases at constant rate. Means the contribution of the additional factor to total production is equal to that of the previous unit. LAW of diminishing returns: according to this law the contribution of each additional unit of the factor of production goes on

decreasing. This is known as the third stage of the theory of production. At this stage the MP is diminishing. Factors of production In the long run, all of these factors of production can be adjusted by management. The short run, however, is defined as a period in which at least one of the factors of production is fixed. A fixed factor of production is one whose quantity cannot readily be changed. Examples include major pieces of equipment, suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate can be changed easily. Examples include electrical power consumption, transportation services, and most raw material inputs. In the short run, a firms scale of operations determines the maximum number of outputs that can be produced. In the long run, there are no scale limitations.

Total Product Curve The total product (or total physical product) of a variable factor of production identifies what outputs are possible using various levels of the variable input. The diagram shows a typical total product curve. In this example, output increases as more inputs are employed up until point A. The maximum output possible with this production process is Qm. (If there are other inputs used in the process, they are assumed to be fixed.)

TOTAL PRODUCT CURVE

80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 Series1

The average physical product is the total production divided by the number of units of variable input employed. It is the output of each unit of input. If there are 10 employees working on a production process that manufactures 50 units per day, then the average product of variable labour input is 5 units per day.
labour 0 1 2 3 4 5 6 7 8 9 10 11 12 TP 0 1 4 10 18 30 42 50 56 60 62 56 48 MP 0 1 3 6 8 12 12 8 6 4 2 -6 -8 AP 0 1 2 3 5 6 7 7 7 7 6 5 4

Relationships of TP and MP Initially as TP increases at increasing rate the MP increases. When TP increases at constant rate , the MP is maximum. When TP increases at decreasing rate the MP starts to fall but remains positive. When TP is maximum, the MP is zero.

 When TP starts to decline, the MP becomes negative. Relationships of AP and MP Initially as MP increases the AP also increases, but MP is higher then AP. MP becomes maximum but AP is still rising. MP cuts AP at the APs maximum point. After bcoming equal both starts to fall but MP is lower than AP MP may become zero but AP never becomes zero.

Relationship of AP and MP
15 10 5 0 -5 -10 Output

1 0

2 1 1

3 3 2

4 6 3

5 5

6 6

7 7

8 7

9 10 11 12 13 6 7 4 7 2 6 -6 -8 5 4

MP 0 AP

8 12 12 8

Cost function
What is cost? Cost is the sacrifices made to produce or to get something. These sacrifices may be fade in the form of money called monetary costs or in the form of sacrifices called opportunity costs. In economic decision making the producers are not concerned with only the monetary costs but also the real cost of production Costs can be classified in two categories. Accounting costs and economic costs accounting costs includes only the explicit costs wile the economic costs include the Explicit costs

as well as implicit costs. Explicit costs are the cost which are paid to the outsiders for hiring their services or for buying some products . These are visible to the producers as these are paid out in money form as amount paid for the rawmaterial , wages paid etc. Implicit costs are the cost of the self owned resources which are being used by the producers in the production process. These are not visible because for using the self owned resources nothing is paid out to anybody in monetary form. But the self owned resources also have income earning capacity but when they are used in our own business, we have to sacrifice the earnings that we could have earned otherwise. So the imputed cost of(the foregone income) is the implicit cost of the production like interest on self employed capital or rent of self owned building. Real costs are the cost of pains and risks taken by the producers to produce a good or services. While determining the prices of the product or his services, the real costs play an important role. Social cost some times due to the production process of a producer, the society who is directly related to the business in anyway , is get affected by the production process of the business and it has to incur extra costs due to harmful effects of the business, these cost incurred by the society are called social cost. These costs are not borne by the producers so generally these are ignored by him while taking the economic decision. These are called externalities also like the costs incurred by the surrounding people to remove the smell disseminating from the production activities of the business. In economics the costs are divided in two parts in short run

Total fixed costs and total variable costs

TVC 0 1 2 3 4 5 6 7 8 9 10 11 0 100 175 230 270 300 350 420 530 700 900 1120 AVC 0 100 87.5 76.67 67.5 60 58.33 60 66.25 77.78 90 101.82 MC 0 100 75 55 40 30 50 70 110 170 200 220 FC 150 150 150 150 150 150 150 150 150 150 150 150 AFC 150 75 50 37.5 30 25 21.43 18.75 16.67 15 13.64 ATC 250 162.5 126.67 105 90 83.33 81.43 85 94.45 105 115.46 AVC 100 87.5 76.67 67.5 60 58.33 60 66.25 77.78 90 101.82 TC 150 250 325 380 420 450 500 570 680 850 1050 1270

All the figures in the present chapter are based on the above table Total fixed costs (TFC) Total fixed costs are the costs which donot changes with the change in the level of production. These costs remain constant upto a certain level of production. At zero level of production also they are same as at higher level of production. The curve drawn is parallel to the x axis
Total fixed cost
6000 5000 4000 3000 2000 1000
0

fixed costs

Average fixed costs : average fixed costs are the per unit fixed cost of the units produced. It goes on decreasing as the volume of the production increases as the AFC = TFC/Q . the curve drawn is downward sloping continuously but never touches the x-axis, because it never becomes o.

average fixed cost

6000

5000 4000 3000 2000 1000 0 1 2 3 4 5 6 7

Total variable costs ( TVC ) total variable costs are the cost which are dircectly related with the volume of production. These costs remain zero at the production volume of zero units and as the level of production is increased, it also increase with it. It includes the cost of raw material, piece rate wages, power consumption, etc. the increment in the TVC passes through three stages, which are associated with the law of returns to a factor. 1st phase : In the fist phase when the increasing returns to a factor applies at that time the TVC increases with decreasing rate means as each one more unit is added to the production the TVC will increases at decreasing rate. The reason is that the cost of each variable factor remains same while his contribution to the production is increasing so per unit cost decreases and the total variable cost increases at decreasing rate. 2nd phase: In the second phase when the constant returns to factor applies, the TVC start to increase at constant rate. 3rd phase : when the diminishing returns to a factor applies, the TVC start to increase at increasing rate because each additional factor is paid at the same rate,while his productivity start to decrease , so the per unit cost produced start to increase so the TVC increases at increasing rate.

700 600 500

400

300 200 100 0 1 2 3 4 5 6 7 8 9

TVC

units

Average variable cost: it is the per unit variable cost which is calculated as AVC = TVC/Q Its curve is U shaped means initially as the production level is increased, it decreases because initially as the increasing returns to a factor applies so contribution by the variable factor increases at increasing rate while he is being paid at constant rate so AVC dereases , after reaching to its lowest point, it starts to rise.

Marginal cost : Marginal cost is the addition to the total cost by each additional unit of out put produced. It can be derived from either the Total cost or the total variable cost .

m arginal cost curve

marginal cost

output

Why the MC curve is U shaped It is also U shaped, and the reason are again, the returns to a factor means when increasing returns to factor applies , the productivity of each factor increases at increasing rate while the cost of each factor is constant so the cost of each additional unit decreases initially, but when the decreasing return to a factor applies, the productivity of each factor decreases ,while it is paid at the same rate,so the marginal cost for each additional unit start to increase.

Relationship of TC and MC or Relationship of TVC and MC When TC(TVC) increases at decreasing rate the MC increases. When TC(TVC) increases at constant rate the MC is minimum and constant. When TC(TVC) increases at increasing rate the MC start to increase. Relationship of MC and AVC or relationship of MC and AC

 when AVC (AC) falls the MC also falls but MC is less then AVC(AC) when AVC (AC) rises the MC also rises but MC is more then AVC(AC) MC reaches to its minimum point before AC means it is possible that AVC(AC) is still falling but MC has started to rise. MC is equal to AVC(AC) at the lowest point of AVC(AC). After becoming equal both start to rise but MC becomes faster then AVC(AC)
250

200

150

100

50

0 1 2 3 4 5 6 7 8 9 10 11

The relationships of AC and AVC The AC and AVC both has same type of behavior means both falls initially becomes maximum and then start to rise but they never becomes equal to each other but the distance between them goes narrowing with each successive unit of production. The reason is continuously falling AFC because AC = AFC + AVC .The AC is the sum of AFC and AVC and we know that for each successive unit of the production the AFC goes down continuously. So the difference between the AC and AVC becomes narrower continuously but they never touch each other

300 250 200 AFC 150 100 50 0 ATC AVC

Some important points to solve the numericals 1. At 0 units of the production the TFC and TC are equal because at this level the TVC is 0. 2. at 1 unit of production the TVC = MC 3. TC = TVC + TVC 4. TVC = TC- TFC 5. MC = TCn -TCn-1 6. MC = TVCn TVCn-1 7. TVCn = MCn + TVCn-1 Total revenue function Total revenue is the total receipts by a firm by selling its output. It is calculated as TR = Price * Q AR = TR / Q MR = TRn - TRn-1 The behaviour of the TR is different for different types of markets.

Total revenue function in a perfect competitive firm

The Tr curve is constantly upward sloping means with every additional unit of the output sold the TR inceases continuously at increasing rate. The reason for this behaviour of TR is that in the perfect competition market each firm is a price taker and it can sell any level of output without decreasing the price. It sells the product only at the price set by the industry and it has no control over the prices of the product so with every additional sale of units the TR increases constantly

output 1 2 3 4 5 6 7 8 9 10 11 12 13 14

price 60 60 60 60 60 60 60 60 60 60 60 60 60 60

TR 60 120 180 240 300 360 420 480 540 600 660 720 780 840

MR 60 60 60 60 60 60 60 60 60 60 60 60 60 60

AR 60 60 60 60 60 60 60 60 60 60 60 60 60 60

Total revenue curve in a perfect competitive firm

1000 total revenue 800 600 400 TR

200
0 output

The MR curve and the AR curve in such a market are equal to each other because the maginal revenue i.e. the addition to total revenue is equal for each additional unit sold in this market so the MR and AR curves are horizontal to X axis.

marginal and average revenue

80 60 40 20

AR and MR in a perfect compettion fim

MR AR output

Total revenue in a monopoly

The monopoly firm is that firm which is the only supplier of that product. There is no close substitute of that product so there the firm is in itself becomes an industry and has full control over the market price of the product. In this market the demand curve of the industry and firm both is downward falling means a firm has to decrease the price of the product to raise the demand of its product so when it increases the prices , the demand increases and on decreasing the prices, demand rises. The product of this firm becomes a necessity so it has relatively lower elasticity of demand so the slope of TR is steeper relatively. if the prices are reduced continuously, the TR curve of the firm will : First increase at increasing rate; Then increase at constant rate; And after a certain level it will start to increase at decreasing rate and then if the prices are continuously brought down the TR will start to fall instead of rising.

Units sold 1 2 3 4 5 6 7 8 9 10 11 12

prices 60 55 50 45 40 35 30 25 20 15 10 5

TR 60 110 150 180 200 210 210 200 180 150 110 60

MR 60 50 40 30 20 10 0 -10 -20 -30 -40 -50

A R 60 55 50 45 40 35 30 25 20 15 10 5

Total revenue curve in a monoploy firm

250 total revenue 200 150 100 50 0 1 2 3 4 5

output

TR

The AR and MR curve in a monopoly firm

The Average revenue and the marginal revenue of this firm is downward falling because addition to total revenue by each additional unit sold, falls continuously because the firm has to devrease the prices for selling its additional units. The MR and AR both falls downward but the AR remains greater than MR . The MR may become 0 or negative but AR always remains positive never becomes 0. The fall in AR is always half of fall in MR.

AR and MR in a monopoly firm

marginal and average revenue 70 60 50 40 30 20 10 0 1 2 3 4 output 5 6 7 8 9 MR AR

Behaviour of TR , AR ,MR in a monopolistic competitive firm . A monopolistic competitive firm is one where there are many sellers of very close substitute products but their products are slightly different from each othe. The price of its products are determined by each firm itself. Like a monopolist, these firms has to bring the prices down to attract more customers or increase the demand , So the TR, AR and MR curve for these firm are also like a monopoly firm but as the price elasticity of demand for these products is high so these curve are flatter than the monopoly firm.