Chapter No. 1.. Introduction to Microeconomics

8/2/2019 Chapter No. 1.. Introduction to Microeconomics

1/50

INTRODUCTION

Human beings need various goods and services to satisfy their wants. Act of production is essential for the

satisfaction of wants. But what is production and what factors make production possible are certain

questions that we would like to discuss in the following section.

1.1 What is Production?

Production is an important economic activity. It is an activity directed to satisfy other peoples wants

through exchange. During the process of production material goods and services are produced or utility is

created in the materials to satisfy human wants. Production is not merely transformation of material

things or creation of utility but it also involves the process of exchange through which goods and services

reach the ultimate consumers to satisfy their wants.

Paul Studenski has given a comprehensive definaition of production. According to him economic

production covers the complex of human activities devoted to the creation, with limited resources of goods

and services capable of satisfying human wants and because of their limited supply. Having definite

economic value.

In brief, those economic activities which help in the creation of goods and services for the satisfaction of

human wants through exchange are called production.

Utility may be created (or production may take place) in the following ways:

(i)From Utility. From utility is created when the existing matter is transformed or rearranged, so that it

becomes more useful. Through increase in its utility a material becomes more adapted to satisfy some

particular human wants. A farmer sows seeds and reaps crop, similarly, a carpenter transforms wooden

planks into beautiful furniture; a flour mill converts wheat into flour; a bakery converts flour into bread; a

diamond is taken out of a mine, is properly cut and polished, and it becomes aprecious possession. All

these are the instances, like millions of others, in which the utility is created by transforming the shape of

the matter. This type of transformation of matter is called form utility.

(ii)Place utility. Another way in which utility is created is by transporting an object or material from one

place to another where it may be more useful. For example, sand at the river bed is not useful. Once it is

brought to the town for construction work it becomes more useful. Similarly, wheat to the markets where

consumers may buy it for the satisfaction of ttheir hunger, utility is added to it. On a wasteland, green

grass grows in plenty, but it is simply useless there. But when the same grass is brought to the town, it

can be used to feed cattle and hence it becomes useful as fodder. Thus through transport service, place

utility is created.

(iii)Time Utility. There is always a time-lag between the production of goods and their consumption. Goods

produced int-1 time are available for consumption inttime. For example, rice is harvested in winter, but

its demand continues throughout the year. It is through stocking of rice that its supply line can be

maintained all the year round. Similarly, mangoes are available in summers, peas are available in winter

and these become scarce in the other seasons. By storing and stocking these commodities during the

period when they are available in plenty and releasing them for the market when their supply is scarce,

utility is added to these commodities. All forms of storage, insurance and speculation create time utility.

(iv)Knowledge Utility. Utility can be created through spread of knowledge. A number of machines, tools,

equipment, apparatus, etc., are useful only when people possess necessary knowledge to operate them.

For example, a personal computer and an electronic typewriter is useless for a household if he does not

know how to operate them.

(v)Possession Utility. Utility is also created when a commodity is possessed by a person who can derive

satisfaction out of it. Books in the collage library are not useful Once these reach in the possession of

students they can derive utility out of them.

In brief, creation of utility is a necessary condition of production activity. Only those goods and

services will be classified in production which possess the following characteristics:

(a)These are created by human labour and ccapital;(b)These are capable of satisfying human wants directly or as producers goods indirectly;(c)These are comparatively scarce and therefore, need to be economized and have economic

value; and

(d)These either have a definite monetary price or cost or can be given one by imputation.1.2 What should be Excluded form Production?All kinds of activities directed for the production of goods and services for satisfaction of other peoples

wants are not included in production. Production should exclude the following types of activities :


2/50


3/50

textile mill should have enough stock of raw cotton, and so on. Non-factor inputs are also known as

secondary inputs. The supply of non-factor inputs comes from the nature and other producing units.

Some economists prefer to classify factors of production or inputs in two broad categories i.e., (a) Labour,

and (b) Capital While labour includes the services of workers and entrepreneurs

Unit 1 : Factors of Production

PI.91

capital comprises land and building, plant, machinery and equipment and other natural resources. An

alternative classification of the factors of production is shown in Fig. 3.3.

2.1. Land

Land includes all those natural resources, whose total supply in the economy is fixed or inelastic. It does

not mean only the surface of soil or physical territory but all other scarce natural resources which are the

free gift of nature such as forests, mines, rivers and sea water, temperature, rainfall, etc. The moment

these natural resources come under the ownership of an individual or the society, these start earning

income in the form of rent, royalty, etc.

(An Alternative Classification of Inputs)

INPUT

S

i

Labou

r

Capital

i i

Workers Entre-

preneur

s

Land and

Structure

s

Machiner

y, Plant

and

Equipmen

t

Natural

Resourc

es

Fig. 3.3.

Characteristics of Land

Land is the source of all commodities. As a factor of production, it possesses the following characteristics:

1. It is a free gift of nature. Man can neither create land nor can he destroy it. Land comes to man as a

free gift of nature, he has not to pay any price for it so long as it is not owned and controlled by some one.

2. Inelastic Supply. The supply of land is fixed. Man can simply change the uses of land, he can neither

expand nor contract the land area.

3. Immobility of Land. Land is a static factor of production. It cannot be shifted from one place to another

like labour and capital.

4. Passivity. Land is a passive factor of production. Land itself cannot produce anything. Active assistance

of labour and capital is needed to make land productive.

5. Heterogeneity. Lands differ in fertility. No two pieces of land possess the same fertility. Mineral

resources, river system, forest resources, mountain formation, fertility of soil, etc., differ from one region to

another.

Heterogeneity also signifies that land can have a variety of uses. It can be used for cultivation,

construction of structures, development of road transport system, etc.

2.2. Labour

Labour may be defined as any human exertion of the body or the mind undertaken with a view to produce

material things and services. It is the 'human' element which distinguishes it from

PI.92

General Economics


4/50

other factors, for it gives rise to special problems regarding mobility, efficiency, unemployment and

psychological attitudes.

Characteristics of Labour

As a factor of production, labour possesses certain peculiar characteristics which are as follows;

(i) Labour is an active factor of production. Without the active participation of labour land and capital

cannot produce anything.

(ii) Labour is perishable. It cannot be stored. If the labourer does not work on a particular day, that day's

labour goes for good.

(iii) Labour is inseparable from the labourer. The labourer has to present himself physically at a place

where production activities take place.

(iv) Productivity of labour can improve. Through education,, training, use of better machinery and

equipment the productivity of labour can be improved.

(v) Supply of labour is inelastic during the short run. The supply of labour is related to population. It takes

a child more than 15 years to develop into a labourer.

(vi) Labour differs in productivity. Efficiency and productivity of one iabourer differ from another.

(vii) Labour is mobile. As compared to other factors, labour is more mobile. It can easily move from one

place of work to another.

Mental and Physical Labour

The labour that applies more of mind and less of muscle power is called mental labour. The work of a

teacher, an advocate, doctor, engineer, research scholar, etc., falls under the category of mental labour.

Conversely, the labour that uses more of muscle power and less of mental power is called physical labour.

For example, the work of a coolie, rickshaw-puller, mason, blacksmith, etc., is put under the category of

physical labour.

2.2.1. Division of Labour

Division of labour implies two things: (a) specialisation of functions, and (b) co-operation between different

labourers. Division of labour occurs when a labourer confines himself to the production of a single

commodity or single sub-process and leaves the production of other commodities or processes to others.

Types of Division of Labour

We can distinguish between the following forms of division of labour:

(a) Product-based division of labour. It is also known as simple division of labour. In the primitive or

traditional economies, a worker specialised in the production of a single good such as cloth, furniture,

shoes, ornaments, etc.

(b) Process-based division of labour. It is also known as complex division of labour. In a modern economy,

large business enterprises (joint stock companies, corporations, etc.) divide and sub-divide the process of

production of a single commodity and each worker performs one or two of the several processes involved in

the production of the commodity.

(c) Territorial specialisation. This type of specialisation occurs when a particular area gets specialised in

the production of a specific commodity. Labour at Lucknow has specialised in chikken-work, at

Moradabad in brass-ware, at Srinagar in shawl-embroidery, etc.

Unit 1 : Factors of Production

PI.93

2.2.2.Efficiency of Labour

The efficiency of labour refers to the productivity of labour, both quantitative and qualitative during a

given time. If a worker produces more than other workers, other things remaining the same, he is called

more efficient. Thus, the efficiency of labour has two aspects, viz., (i) the qualitative aspect, and (ii) the

quantitative aspect.

Efficiency of labour is a relative concept. It is futile to say that a Japanese worker looks after 16 looms at a

time. But, if we say that an Indian worker looks after 8 looms at a time, it gives a clear indication that the

Japanese worker is more efficient. The efficiency of labour differs from one labourer to another and

changes over time.

2.2.3.Mobility of Labour

Mobility of labour refers to the shifting of labour from one place to another, from one job to another and

from one particular work to another. Labour is an active factor of production, and therefore, has lot of

mobility.

Kinds of the Mobility of Labour

Mobility of labour can take any of the following forms :


5/50

1. Territorial Mobility. It is also known as geographical mobility of labour. It relates to the movement of

labour from one place to another.

2. Occupational Mobility. When a labourer leaves one occupation to join the other, it is called occupational

mobility. For example, if a worker leaves a cotton textile mill to join a jute mill, it is called occupational

mobility.

3. Grade Mobility. When a worker moves from one position to another in the same or other occupation, it

is called grade mobility. Grades are formed according to different wage-groups.

Grade mobility can assume two forms: (i) horizontal mobility, and (ii) vertical mobility When a labourer

moves from one occupation to another on the same grade, it is called horizontal mobility. For example, if a

doctor moves from hospital A to hospital B on the same grade, it is called horizontal mobility. But, if a

doctor shifts from hospital A to hospital B in a higher position, it is called vertical mobility. Vertical

mobility can take place within the same occupation as well.

2.3. Capital

While land is a free gift of nature, capital comprises man-made materials which are used for further

production. Goods produced with the help of different factors of production are broadly classified in two

categories, viz., (i) consumer's goods, i.e., those goods which directly satisfy human wants, and (ii)

producer's goods, i.e., those goods which are not wanted directly for their own sake, but for the

contribution that they make in the production of consumer goods. Capital consists of producer's goods

and stocks of consumer goods not yet in the hands of consumers. Capital consists of the following:

1. Structures, such as private residential houses, factory buildings, government buildings, etc.,

2. Equipment, that includes three types of goods, viz.,

(i) Durable consumer goods, like furniture, TV sets, air-conditioners, cars, etc., which are yet to reach

consumers,

FI.94 General Economics

(ii) Durable capital goods, like machinery, plants, tools, roads, bridges, dams, buses trucks, etc.,

(iii) Inventories, such as stocks of raw materials, intermediate goods and finished (final) goods lying unsold

with the wholesalers and retailers. 3. Money, used for production purposes.

2.3.1.Some Distinctions

Sometimes confusion arises in the use of certain terms akin to capital. It is, therefore, necessary to make

such distinctions clear.

1. Capital and Money. Money is anything that is generally accepted by the people as a medium of

exchange and a measure of value, and is also used to meet other kinds of business obligations. But, all

money is not capital, that part of money which is used for further production is called capital.

2. Capital and Income. Earnings regularly drawn either from the ownership of assets, or by doing some

economic activity are called income. That part of income which is saved and used for further production is

called capital. Capital is a stock, whereas income is a flow

3. Capital and Wealth. Wealth comprises the stock of all reproducible and irreproducible goods. All wealth

is not capital. That part of wealth which is used for further production of wealth is called capital; on the

other hand, all capital is wealth.

2.3.2.Classification of Capital

Capital assists in production in different ways. Capital, on the basis of its use, can be conveniently

classified in the following forms:

1. Fixed and Circulating Capital. Fixed capital is one which is durable and which is used in production for

a considerable long time. The examples of fixed capital are machines plants, equipment, factory buildings,

dams, irrigation canals, etc.

Circulating capital refers to the capital which is used only once in production. It loses its utility after single

use. The examples of the circulating capital are raw materials, seeds, coal, petrol, gas, etc. It regularly

needs replacement.

2. Material and Personal Capital. Material capital consists of objects which exist in concrete and tangible

form and are capable of being transferred from one person to another Examples of the material capital are

machines, tools, transformers, etc.

Personal capital comprises all those energies, faculties and habits which contribute to make labour

efficient. It includes all the personal qualities of an individual which are non-transferable. Examples of

personal capital are art of dancing and singing, art of painting, art of oratory, etc.


6/50

3. Sunk and Floating Capital Sunk or specialised capital is one which can be used in a specific

occupation. Once invested in a particular business, it cannot be withdrawn. Examples of sunk capital are

railway bridges, factory buildings, roads, dams, etc.

Capital is said to be floating or free when it can be changed at will for employment in any branch of

industry and can at any time assume a different form. Examples of floating capital are wood, raw

materials, electricity, etc.

4. Remuneratory and Auxiliary Capital. Remuneratory or wage capital is one which is applied to the

payment of labour engaged in production.

Unit 1 : Factors of Production i _*j[*_Z>5_

Auxiliary capital is that which assists the labour to carry out their duties smoothly. Machines, tools,

equipment, etc., are the examples of the auxiliary capital.

5. Production and Consumption Capital. Production capital comprises all those articles which help the

labour directly in production. Examples of production capital are raw materials, machines, tools,

equipment, etc. Production capital may be material as well as personal.

Consumption capital consists of those materials which indirectly assist in the process of production.

Examples of production capital are food, clothes, residential accommodation, vehicles, etc.

6. Internal and External Capital. This classification of capital is based upon the criterion of place. The

capital which is the result of domestic savings in the country is called internal capital.

Capital which is imported or invited from abroad and used in recipient country, is called external capital.

The capital received in India from the World Bank, International Finance Corporation, etc., is an example

of external capital.

2.3.3. Capital Formation

Production is a continuous process. Whatever goods and services are produced in an accounting year are

not consumed instantaneously. A part of current production is consumed, while the remaining part is

retained for further production. We may define capital formation as "the surplus of production over

consumption in an accounting year which is used for further production."

Capital formation is regarded as a social process whereby a society's capital stock increases during a given

period. According to Prof. Nurkse, "Themeaning of capital formation is that society does not apply the

whole of its current productive activity to the needs and desires of immediate consumption, but directs a

part of it to the making of capital goods, tools and instruments, machines and transport facilities, plant

and equipmentall the various forms of real capital that can so greatly increase efficacy of productive

effort."

Capital formation plays a vital role in the development of an economy. Generally speaking, higher the rate

of capital formation more economically developed an economy would be. It determines the production

potential of an economy.

Stages of Capital Formation

There are mainly three stages of capital formation, which are as under:

1. Real Savings. Saving is the foundation stone upon which the edifice of capital formation is erected. A

part of the resources is withdrawn from current consumption so as to increase the real savings of a

community. The magnitude of the real saving depends upon the will to save, power to save and the

facilities to save.

(a) Will to save. How much t. person would be willing to save depends upon the individual's nature. If an

individual is foresighted and wants to make his old age secure, he will save more. Some persons are

miserly by nature, and whatever the hardships, they will save a certain proportion of their money income.

Out of family affection people may like to save more with a view to have comfortable future for their

dependents. Sometimes people save more in order to command greater respect in the society. Allurement

to earn a high rate of interest may also induce people to save more.

(b) Power to save. It is the capacity, or the ability to save, that depends upon the income of


7/50

PI.96

General Economics

an individual. Higher incomes are generally followed by higher savings. The availability of abundant

natural resources and high level of economic development will create and lead to greater wealth in a

country, and therefore, the capacity to save will increase. If the distribution of wealth is equitable, every

one will have more money income, and therefore, the power to save will increase.

(c) Facilities to save. If the country is free from internal disturbances and threat of foreign aggression,

people will have opportunities to save. Stability of money value also facilitates savings. Frequent

fluctuations in the money value, and particularly inflation reduce the purchasing power of the people, as a

result, savings get discouraged Facilities of investment in productive activities encourage saving.

2. Mobilisation of Saving. In case people save money but it is hoarded or does not enter into circulation, it

will not facilitate the process of capital formation. There should be a widespread network of banking and

other financial institutions to collect public saving and take them to the prospective investors.

3. Investment. Process of capital formation gets completed only when real savings get converted into real

capital assests. A country should have an entrepreneurial class which is prepared to bear the risk of

business and invest the saving in productive occupations so as to create new capital assets.

If the process of capital formation is to succeed, all these stages should be interlinked. In the absence or

slackness of any of these stages the process of capital formation will remain incomplete.

2.4. Enterprise

Business is full of risks and uncertainties. The task of bearing risks is called enterprise. The man who

bears the risk of business is called an entrepreneur.

Several types of risks are involved in business. Sometimes, the demand falls short of supply; at another

time, the supply falls short of demand. The market fluctuations may cause heavy losses, therefore, the

services of entrepreneurs are required to bear all such risks of business.

2.4.1. Functions of Entrepreneur

Besides risk-bearing, the entrepreneur has to perform several other important functions which are as

follows;

1. Risk-bearing function. The most important function of an entrepreneur is to bear the risk of business.

There is always a time-lag between production and consumption of goods. The goods produced int-1 time

are consumed in 't time. Therefore, heavy risk is involved in equating the current production to future

demand. No other factor of production, except the entrepreneur, bears the risk of the business.

2. Decision-taking function. Decision-taking is an important function of an entrepreneur. An entrepreneur

has to take decisions as regards the following matters:

(i) Selection of the product. An entrepreneur would choose a trade which seems to be more profitable,

subject to such qualifications as his personal interest, the degree of risk involved, his temperament, his

technical knowledge, the amount of capital required, and estimate of his own ability.

(ii) Selection of the type of the firm. The entrepreneur has to decide whether he would prefer sole

proprietorship, partnership, or a joint stock company. Further, he has to decide whether it should be a

private limited company or a public limited company.

(iii) Selection of the location of plant. The entrepreneur has to decide where to install the plant, so that

advantages of location can be obtained. Economic and non-economic factors, both are essential while

making choice about the location of a plant.

(iv) Selecting techniques of production. An entrepereneur aims at maximising his output and minimise the

cost of production. He has to decide about the most suitable combination of land, labour and capital so as

to obtain maximum production.

(v) Selection of the size of the firm. The entrepreneur has also to decide whether to produce on a large

scale, or on a small-scale. He will have to take into account the cost of production, returns to scale,

economies of scale, and profitability, while taking any decision as regards the size of the firm.

3.Distributive function. Peaceful and congenial atmosphere inside the factory premises is essential for

smooth production activity. The entrepreneur has to keep all factors of production contended. He has to

decide about the share that each factor of production should receive from the total produce.

4.Innovative function. Innovation is considered as an important function of an entrepreneur. Innovation

is defined as the commercial use of invention. Individuals and experts working for corporation, conduct

basic research and invent new products, new technology, new sources of energy, and soon the

entrepreneur makes use of these inventions for commercial purposes, i.e., for earning profits for ABC firm.

Innovation is never static. A progressive and talented entrepreneur should always take a lead to introduce

a new product or a new technique of production. It does involve risk, but risk-bearing is the prime


8/50

function of an entrepreneur. Innovations help a firm to earn large profits. Prof. Schumpeter has developed

a full-fledged theory of profit based on innovation.

In modern economies, the role of organising the factors of production is regarded as a managerial

function, which can be performed by a paid manager, i.e., by a highly skilled form of labour. What really

distinguishes enterprise from other factors of production is that it has to carry all the risks and

uncertainties, and is rewarded for bearing these, in the form of profits.


9/50

Unit 2: Concept of Product and Laws of Returns

1. INTRODUCTION

The theory of production seeks to explain the relationship between inputs and output. For clear

understanding of the theory of production and laws of returns it is essential to get acquainted with a few

concepts which are discussed below.

1.1. Fixed Factors and Variable Factors of Production

In production, certain factors (inputs) are fixed, while others are variable.

(i) Fixed factors of production are those factor inputs whose quantity remains the same irrespective of the

level of output. Among these inputs are included land, factory building, machines, plant, equipment, top-

management, etc.

Unit 2 : Concept of Product and Laws of Returns IPM01

(ii) Variable factors of production are those inputs the supply of which has to be changed to obtain

different units of output. Among these inputs are included, raw materials, fuel, transport, etc.

The distinction between fixed and variable factors of production is relevant only in the short run; in the

long run all factors are variable, i.e., their supply can be raised in the long-run.

1.2.Short-run and Long-run

Production has a time dimension. Production can be planned for short-run or for long-run. Whether a firm

will plan for short-run or long-run production depends upon the nature of demand for its product,

availability of inputs, state of technology, etc.

(i) Short-run. In the short-run, some factor inputs are fixed, while the others are variable. The production

can be increased only by raising the supply of the variable inputs. The time is so short that the firm

cannot contract to hire additional units of the fixed factors. This sets limit to the maximum quantity of

output that a firm can turn out.

(ii) Long-run. In the long-run all factor inputs are variable. A firm has enough time to install a new plant

or raise a new building in response to increased demand. The distinction between the fixed and the

variable inputs becomes irrelevant in the long-run. The quantity of output to be produced by a firm will

range from zero to an indefinite quantity.

1.3.Level of Production and Scale of Production

Distinction can be made between the level of production and scale of production.

(i) The level of production can be changed by changing the proportion of factor inputs. As discussed

earlier, during short-run some factor inputs are fixed, while the others are variable. Output can be

increased only by increasing the units of variable inputs. Suppose, 10,000 units of a commodity can be

produced with the help of the X quantity of the fixed inputs and the Y quantity of the variable inputs. If

20,000 units of this commodity are to be produced, then we shall require the X quantity of the fixed inputs

and Y + a quantity of the variable inputs.

(ii) The scale of production can be changed only in the long-run. In the long-run, it is possible to raise the

supply of all the inputs, i.e., fixed and variable inputs. The scale of production can be changed by

changing the supply of all the inputs.

2. CONCEPT OF PRODUCT

'Product' or 'output' refers to the volume of goods produced by a firm during a specified period of time. The

volume of goods produced can be looked at from three different angles, viz., (i) Total Product, (ii) Marginal

product, and (iii) Average product.

2.1. Total Product

Total product refers to the total volume of goods produced during a specified period of time. Total product

of a firm can be raised only by increasing the quantity of the variable factors employed in production. For

instance, more shirts will be produced when more labour and capital are used. Suppose, a firm has the

capacity to keep 100 machines on which 100 labourers can work.

Table 31: Prod uct Schedule

. Men Total Product

(Units)1 30

2 80

3 120

4 150


10/50

5 170

6 170

7 150

8 120

Suppose, it were to keep 150 labourers. What will happen? There will be overcrowding. Labour will not be

in a position to work most efficiently. The entrepreneur may find to his dismay that the total product

obtained from the employment of 150 labourers is less than the total product obtained from the

employment of 100 labourers. This situation is illustrated in Table 3.1 which represents the total productwhen changing units of labour are employed and all the other factors are kept as constant.

It would be seen that the total product is maximum when 6 men are employed. It would also be observed

that the rate at which total output increases is different at different stages. The second man employed

helps to produce 50 units of output, whereas the third man helps to produce only 40 units, and so on.

2.2. Marginal Product

The rate at which total product increases is known as marginal product. We can also define marginal

product as the addition to the total product resulting from a unit increase in the quantity of the variable

factor. Marginal product can be calculated from the total product as shown in Table 3.2.

It would be seen from Table 3.2 that initially marginal product rises, but ultimately it begins to fall down,

it becomes zero and at last becomes negative. It would be seen that the total product is maximum when

the marginal product is zero.2.3. Average Product

Average product can be known by dividing total product by the total number of units of the variable factor.

It is also known as the per unit product of a variable factor. We can calculate the average product from the

total product as in Table 3.3.

It would be seen that the average product also shows almost the same tendency as does the marginal

product.

Initially, both the marginal product and the average product rise but ultimately both of these fall.

However, marginal product may be zero and negative, but average product can never be zero.

Why do marginal product and average product behave like this as explained by the laws of returns? This is

to the study of these laws that we turn our attention.

Practical ExerciseThe following schedule represents the total output when changing units of labour are employed and all

other factors are kept constant:

Table 3.2: Product

Schedule

No. of Men Total Margin

al

Employed Prod

uct

Produc

t

1 30 3C -0 = 30

2 80 80 -30 = 50

3 120 120 - 80 = 404 150 150- 120 = 30

5 170 170- 150 = 20

6 170 170- 170 = 0

7 150 150- 170 =

-

20

8 120 120- 150 =

-

30

Table 3.3: Produc

t

Schedule

No. of Men Total Average

Employed Product

Product

1 30 30.0

2 SO 40.0

3 120 40.0


11/50

4 150 37.5

5 170 34.0

6 170 28.3

7 150 21.4

8 120 15.0

Unit 2 : Concept of Product and Laws of Returns LPI'103

Number of Men 1 2 3 4 5 6 7 8

Total Output (units) 30 80 120 150 170 170 140 100

(a) Find the marginal and average product of labour.

(b) Draw diagram showing the marginal and average product of labour.

Solution. Marginal product of labour is the addition to the total product resulting from a unit increase in

the employment of labour.

Similarly, the average product of labour can be calculated by dividing total product by the total number of

men employed.

These can be calculated and shown through a schedule and a graph as shown in Table 3.4 and Fig. 3.4

respectively:Table 3.4: Product

Schedule

Number Total Marginal Average

of Men Output Product Product

0 0 0 0

1 30 30 30

2 80 50 40

3 120 40 40

4 150 30 37.5

5 170 20 34.0

6 170 0 28.3

140 -30 20.0

8 100 -40 12.5

y

50

40

30

_ 20 o

o 10

o

0

10

i i i i i \ i

i y

1 2 3 4 5 6\ 7 8 \

20 Number of Men \

30 t \

40

Fig. 3.4.

3. PRODUCTION FUNCTION

In an earlier chapter we had illustrated the functional relationship between price of a commodity and its

quantity demanded with the help of what we call demand function. Similarly, a production function

explains the relationship between factor inputs and output which means factors of production, their

productivity and the final outcome of their efforts (produce).

The production function illustrates the technological relationship between inputs and output. In otherwords, it shows that with a given state of technological knowledge and during a particular period of time

how much can be produced with given amount of inputs. It can also be written as follows:

Q =/(/"/2...../)


12/50

where Q is the physical quantity produced per period of time andfvf2, .. .,fn are the physical quantities of m

different factors used.

Economic theory looks to two kinds of input-output relations in production function. One is the relation

where quantities of some inputs are fixed while quantities of other inputs vary (as in short-run for a firm).

In the other relation, all the inputs are variable (as in the long run for a firm). The former relationship is

explained by the law of variable proportions, whereas the latter is explained by the returns to scale.

F1.104 General Economics

4. LAW OF VARIABLE PROPORTIONS OR

PRODUCTION FUNCTION IN THE SHORT-RUN

We have seen above that the various factors of production can be classified as fixed factors and variable

factors. If we want to produce more of a commodity, more quantity of the factors of production would have

to be employed. In the short run, the quantity of the fixed factors cannot be changed; the quantity of the

variable factors can be changed. If we increase the quantity of the variable factors only the proportion

between the fixed factors and variable factors will change. Suppose, we were employing one unit of land

and 10 units of labour. The proportion between the land and labour was 1 : 10. Now, if we increase the

quantity of labour, and land being the fixed factor remains constant, the new proportion will be 1 : 15.

How will this change in factor proportions affect the level of production? This is explained with the help of

the law of variable proportions.

The law of variable proportions explains the relation between proportions of fixed and variable inputs, on

the one hand, and output on the other. When a firm expands output by employing more units of a variable

factor, it alters the proportions between the fixed and the variable factors. There is always an optimum

combination of factors of production at which cost per unit is minimum. Too less or too much of the

variable factors leads to cost increases. For example, operation of a double-decker bus with carrying

capacity of 150 passengers it may be either uneconomical if there are 10 passengers only, or it may be

unfeasible if there are 250 passengers. The law speaks about three stages of production.

Table 3.5: Output

Schedule

Fixed Input No. of

Labour

Total Output Average

Output

Marginal Output

X

X X X

I 0 1 2 3 0 3 8 12 0 3 4

4

3

5 4

I

X + 4 15 4 3

X + 5 17 L5 2 II

X + 6 172l 6

0

X X 7 8 16 13 2^

7

8^

-1

-3III

From the output schedule as shown in Table 3.5, and graphically represented in Fig. 3.5, the following

three stages can be observed:

First Stage. The first stage goes from the origin to the point where the average output is the maximum.

When a firm expands output by increasing the quantity of variable factors in proportion to fixed factors, it

moves towards optimum combination of the factors of production. In this stage, the marginal output

increases, i.e., the total output increases at an increasing rate. In this

Unit 2 : Concept of Product and Laws of Returns FI-105

Quantity of Variable Input Fig. 3.5. Three Stages of Production

situation, the law of increasing returns may be said to operate. In this stage itself, marginal output begins

to fall, and the law of diminishing returns sets in.

It would be seen from the Table 3.5 that the average output is maximum when 2 units of the variable

factor are employed; it remains constant at the maximum when even 3 units are employed. The first stage

of production operates till this point. The marginal output, as would be seen, begins to fall after the


13/50

employment of 2 units of labour itself. Similarly, in Fig. 3.5, we see that the average output curve, AQ,

goes upwards till it reaches T; the MQ curve, on the other hand, begins to fall from the point / onwards.

Thus, the first stage is characterised by the operation, initially, of the law of increasing returns to be

followed by the law of diminishing returns. In between there may be the intermediate stage of the

operation of the law of constant returns.

Second Stage. The second stage goes from the point where the total output is maximum to the point where

the marginal output is zero. After having attained the optimum combination of the fixed inputs and the

variable input, if the firm increases still further the quantity of the variable input, the per unit output of

the variable input falls. In this stage, the total output rises, but only at a diminishing stage. This is the

crucial stage for the firm, because it is within this stage that the firm determines its level of the actual

operation.

In Table 3.5, the second stage of the law of variable proportions operates between the stage when 4 units

and 6 units of labour are employed. In Fig. 3.5, the second stage lasts till the point S is reached.

Third Stage. The third stage covers the range over which the marginal output in negative. This is also

known as the stage of negative returns. In Table 3.5, this stage occurs when 7 or more units of labour are

employed along with the given quantity of the fixed factors. In Fig. 3.5, the third stage operates beyond the

point S. In this stage, the total output, after having reached the maximum of W at the beginning of this

stage, begins to fall. Thus, in this stage, the total output, average output and marginal output all fall. No

producer will operate at this stage, even if he can procure the variable input at zero price.

The Stage of Operation. During the first stage, the marginal output rises in part and ultimately begins to

fall; the average output, on the other hand, rises. During this stage, the quantity of the fixed factors is too

much relative to the quantity of the variable factor, so that if some of the fixed factors are withdrawn, the

total product would rise, i.e., the marginal product of the fixed factors is negative. No producer would like

to operate in this stage, even if the fixed factors are supplied free of cost to him because the fixed factors

only bring in negative marginal returns.

Similarly, during the third stage the marginal product of the variable factor becomes negative, implying

that a producer will not like to operate in this stage also.

The first and the third stages are known as stages of economic absurdity or economic nonsense.

PI. 106 - : ~:.;

A producer will always seek to operate in the second stage. At which point the producer will operate in this

stage will depend upon the prices of-the factor inputs.

In brief, the law of variable proportions tells us about the possibility of the operation, initially of both of

the law of increasing returns and the law of diminishing returns with an intermediate situation of the law

of constant returns.. Ultimately, the law of diminishing returns operates.

Practical Exercise

Below are given output data for different units of variable inputs. Determine the production regions:

Variable

Input 0 1 2 3 4 5 6 7 8

Output 0 3 7 10 12 13 13 12 10

Solution:

Unitof Variable Total Marginal Average Production

Inputs Product Product Product Regions

0 0 0

1 3 3 3 I

2 7 4 3.50 II

3 10 3 3.30 II

4 12 2 3.00 II

5 13 1 2.60 II

6 13 0 2.16 II

7 12 -1 1.71 III

8 10 -2 1.25 III

5. RETURNS TO SCALE OR PRODUCTION FUNCTION IN THE LONG RUNLevel of Production

5.1. Operation of Returns to Scale

In the short-run a firm can change its level of production by changing the quantity of the variable factors.

The quantity of fixed factors, by their definition, remains unchanged. Change in the quantity of variable


14/50

factors leads to change in factor proportions. Hence, the behaviour of production is explained by the law of

variable proportions. In the long-run, all the factors become variable. Distinction between fixed and

variable factors disappears. A firm can manage to get additional plant, equipment or building or any other

resources that it could not manage in the short run. When a firm changes the quantity of both fixed and

variable factors in the long-run, it changes its scale of production. In Fig. 3.6, three different scales of

production are" shown. A firm, if it operates on scale-1, can vary its level

Fig. 3.6. Scale of Production and Level of Production

Increase in the Increase in Type of Returns Quantity of Factors Output to Scale

10% 20% Increasing

10% 10% Constant

10% 5% Decreasing

Unit 2 : Concept of Product and Laws of Returns PI-107

of output between 0 and 2000 units without changing the quantity of fixed factors. If it decides to produce

more than 2000 units it will have to change its scale of production and operate on scale-2 which can be

attained if the firm changes the quantity of both fixed and variable factors. Similarly, scale-3 can be

attained if the firm increases the quantity of both fixed and variable factors.

What happens when a producer changes his scale of production? This is explained by returns to scale'.

There are three types of returns to scale, viz., (a) Increasing returns to scale, (b) Constant returns to scale,

and (c) Diminishing returns to scale.

If all inputs are increased by some proportion, the output also increases in the same proportion, there is

said to be constant returns to scale. In this case, when output increases more than proportionately to the

increase in inputs, increasing returns to scale is said to exist. If however, all inputs are in-creased by some

proportion and the output increases less than proportionately, we have decreasing returns to scale. We

can sum up these situations as follows:

Increasing returns to scale occur when the economies of scale operate. Diminishing returns to scale occur

when the diseconomies of scale operate. Constant returns to scale is an intermediary situation, when

certain advantages of large scale production are counterbalanced by certain disadvantages.

(I) Increasing Returns to Scale. Increasing returns to scale occur when the total output increases in a

larger proportion than the proportionate increase in the factor input along a given scale.

In other words, for a given increase in output from say 1,000 units to 2,000 units or from 2,000 units to

3,000 units, the cost on labour and capital increases but it is less than the proportionate increase in

output.

(ii) Constant Returns to Scale. Constant returns to scale occur when the increase in the total output is

proportionate to the increase in the quantities of inputs. In other words, in order to get an equal increase

in output, the factor proportion required to raise the output rises in an equal proportion.

In other words, constant returns to scale operate when the total output increases exactly in the same

proportion as an increase in the quantity of factor inputs.

(iii) Diminishing Returns to Scale. Diminishing returns to scale implies that for a given increase in output,

a more than proportionate increase in the quantities of factor inputs is required.

In other words, the proportionate increase in factor inputs would cause a less than proportionate increase

in the total output.

Thus, the diminishing returns to scale operate when progressively increasing factor inputs are required to

yield the same additional increase in output.

5.2. Returns to Scale and Returns to a Factor

Returns to a variable factor refer to the effects on output of changes in one input with other inputs being

held fixed. Returns to scale, on the other hand, refer to the effect on total output of

PI.108

General Economics

\ K 1 2 3 4

1 100 128 144 158

2 164 200 232 256

3 207 266 300 330

4 249 328 365 400


15/50

changes in all the inputs simultaneously.

The distinction between returns to a scale and returns to a variable factor can be illustrated in terms of

production in the table below:

The entries are the outputs associated with various combinations of inputs. Thus, with one unit of labour

services (L) and one unit of capital (K), the maximum output attainable is X - 100 units; with L = 2, and K

= 2, X - 200 units with I = 3 and K = 3, X - 300 units, and so on. The production function here exhibits

constant returns to scale; equal proportionate increases of both capital and labour lead to the same

proportionate increase in output.

On the other hand, assume that capital is fixed at one unit. Then the first column of the table gives the

returns to the variable factor, labour, as L varies from one unit to four units. The marginal product of the

first unit of labour is 100, of the second unit 64, of the third unit 43, and of the fourth unit 42. If labour is

fixed at three units, then the third row gives the returns to the various inputs, capital K varies from one to

four units. The marginal product of the first unit of capital is 207, of the second unit 59, of the third unit

34, and of the fourth unit 30. One feature of the schedule is that for any given amount of the fixed input,

each additional unit of a variable input increases output, but the rate of increase falls as more and more

units of the variable input are added. This is the special case of the law of diminishing marginal

productivity.

6. ECONOMIES OF SCALE

Economies of scale imply the benefits derived by a producer by expanding its scale of production. When a

firm expands its scale of production, it finds itself using in a better way some of the resources that were

underutilised hitherto. These benefits can accrue to a firm in two ways: one is known as internal

economies, and the other is known as external economies. Internal economies accrue to a firm largely

because of its own efforts. It begins to make better use of such resources by expanding the scale of

production which were not being utilised properly in the earlier stages.

External economics, on the other hand, will accrue to a firm largely because of the reasons with which an

individual firm has got nothing to do. For example, suppose in a region a number of firms producing the

same commodity are set up. A number of other such firms will also be set up in this region, which will

supply raw materials to the earlier group of firms. The result will be that each individual firm will have to

spend little towards the transportation of raw materials. The raw material supplying firms would not have

been set up unless the number of consuming firms is very large. Benefits for which the producers have not

to make any individual efforts are known as external economies.

Causes of Internal Economies. There are mainly two factors that give rise to internal economies. These are

as follows: (i) indivisibilities, and (ii) specialisation.

(i) Indivisibilities. There are certain factors of production that cannot be used in parts. For example,

operating cost of 767 Jumbo jet will be the same irrespective of the number of passengers on board that

may vary from zero to 350. Likewise, as Stonier and Hague put it, a manager cannot be chopped in half

and asked to produce 500 units of the commodity instead of 1,000 units. Apparently, cost of manager per

unit of output shall

Unit 2 : Concept of Product and Laws of Returns 1 1^

ECONOMIES OF SCALE

Internal Economies

bxternai Economies

Technical Economies

1. Economies of

superior technique

2. Economies of increased dimensions

3. Economies of linked processes

Managerial Economies

1. Delegation of detail

2. Functional specialization

Marketing Economies

financial Economies

Economies in the purchase of raw materials Economies in the sales of manufactured goods

Risk-bearing

Economies


16/50

1. Diversification of output

2. Diversification of markets

3. Diversification of

sources of supply

4. Diversification of

processes of manufacture

Economies of Concentration

Economies of Information

Economies of Disintegration

be less if 1,000 units are produced instead of 500 units. Similarly, a plant equipped to produce 1,000

scooters per month shall work at its maximum efficiency if it produces at its full capacity. Otherwise, the

plant would turn out scooters at higher per unit cost, since its expenses on depreciation, cost towards

maintenance of plant, rent of the buildings and the other factors contracted for employment shall remain

the same whatever the level of production. Large-scale of production makes it possible to make better use

of the invisible factors of production. At a smaller scale of production, factors remain underutilised

without any corresponding advantages to the producer in terms of the expenses or the costs to be incurred

on those factors. Thus, large-scale of production brings in economies of scale..

(ii) Specialisation. Larger scale of production makes it possible to introduce better division of labour.

Through division of labour it is possible for a firm to have more units of output at a lesser average cost,

that is, to reap economies of scale. Division of labour makes it possible (a) to save on time involved in

shifting from one process to another, and (b) to take advantage of the specialisation and perfection reached

by the individual at a particular process.

Causes of External Economies. External economies mainly arise because of the following two reasons: (i)

Localisation of industries, and (ii) Specialisation.

(i) Localisation. By localisation of industry we mean concentration of a number of firms belonging to a

particular industry at a particular place. The concentration of firms, producing the similar products at a

particular place, may be due to some natural

IJLjllO General Economics

advantage or acquired advantages that the place has for the production of particular commodity. Thus, we

find heavy concentration of jute industry in Bengal, tea industry in Assam, cotton textile industry at

Ahmedabad, sports goods industry at Delhi and wood-work industry at Saharanpur. The concentration of

industry results in endowing certain advantages to the individual firms which are in the nature of external

economies to an individual firm.

(ii) Specialisation. A second source of external economies is specialisation among centralised firms.

Specialisation takes the form of division of labour among the different firms belonging to the same area

and the same industry.

For example, it may be observed that when an industrial area develops it makes possible the growth of a

number of firms that act as complements to each other, serving as consumers of waste products and

suppliers of ancillaries for each other. Growth of a bicycle manufacturing firm in a particular area may

induce the growth of a number of firms that may supply the various components to the bicycle

manufacturing firm at a lower cost. Similarly, growth of an area induces the emergence of firms supplying

specialised services such as advertisement, legal consultation, accountancy, distributorship, etc. These

specialised agencies are in a position to provide these services to a firm at a cost lower than what that firm

would have to incur if it decides to take up these services itself. Similarly, provision of common services

and distribution of their costs among the number of firms will work to reduce the cost of the different

firms. To sum up, provision of the specialised services brings in reduction in the costs of those firms which

decide to take advantage of these services.

Internal and external economies of scale also operate up to the point of optimum capacity Beyond this

point, economies yield place to diseconomies, i.e., beyond this point of optimum capacity, it may not be

advisable for the firm to employ more of the fixed and the variable factors. If the firm expands its scale

beyond this point it may find to its dismay that the same forces which, hitherto, were working to its

advantage, are now working against it. Expanding the scale of production no longer brings economies of

scale; rather, it causes diseconomies of scale. If the diseconomies of scale are more than the economies of

scale, diminishing returns to scale set in. Therefore, a firm cannot go on increasing its scale of production

indefinitely; it has to content itself with a smaller scale of production.

Unif 3 : Theory of Cosf and Revenue1. INTRODUCTION


17/50

Production is the result of the services rendered by various factors of production. The producer Dr firm

has to make payment for the factor services. From the point of view of the factor-inputs .it is called 'factor

income', while for the firm, it is 'factor payment' or cost of inputs. A clear understanding of the different

concepts of cost, nature of costs and components of costs is very helpful to the firm in taking vital decision

as regards the level of output, pricing of products, sales strategy, etc.

jjL?:. I General Economics1.1. Concept of CostOrdinarily, the term cost of production refers to the 'money expenses' incurred in the production of a

commodity. But money expenses are not the only expenses incurred on the production of a commodity.There are a number of services and inputs such as entrepreneurship, land, capital etc., which are offeredby an entrepreneur without charging any price or receiving any payment for them. While computing thetotal cost of production, allowance should be made for such expenses. It is, therefore, essential to have

clear understanding of the different concepts of cost which are discussed below.(i) Explicit and Implicit Costs. Money expenses incurred on and resources used in the production of acommodity are known as explicit costs of production of a commodity These include wages paid to thelabourers, rent paid for the premises, payments made for the raw materials, payments into depreciationaccount, premium paid towards insurance against fire, theft, etc.Implicit costs of production, on the other hand, are the costs of self-owned, self-employed resources. Theseare frequently overlooked while computing the expenses of a producer. These include the rewards for theentrepreneur's self-owned land, labour and capital The sum of explicit costs and implicit costs constitutesthe total cost of production of a commodity.

(ii) Opportunity Cost. The concept of opportunity cost is the most important concept in economic theory.The concept is highly useful to each and every economic unit, be it a household, or a firm, or thegovernment. Every action that we take involves an opportunity cost. For example, if you decide to buy thisbook of economics by paying Rs. 100, then you may have to forego the purchase of a fountain pen, or aticket of a cricket match, or snacks in a restaurant. The opportunity cost of the economics book is the nextbest alternative (say, a ticket of cricket match) that you had to sacrifice. If there is no sacrifice involved,then the opportunity cost is zero.In the most simple terms, opportunity cost of a decision may be defined as the cost of next alternativesacrificed in order to take this decision.Two points need special attention while considering the concept of opportunity cost. First, the opportunity

cost of a thing is only the next best alternative foregone. In other words, it is not the cost of any other goodthat can be produced with the help of same inputs, but the 'most valuable other good'. Secondly, the nextbest alternative good should be produced with the help of more or less the same factors having the samevalue. For example, a farmer can grow the wheat crop instead of cotton crop on the same piece of land.Whereas all other inputs used in the cultivation of wheat will remain the same, the farmer will have to usedifferent seeds.In short, the opportunity cost of using resources to produce a good called A is the value of the bestalternative or opportunity foregone. Whenever an assessment of cost is required for decision-making, therelevant cost is the opportunity cost. For instance, a fixed input has no alternative use in the short-run,thus, the opportunity cost of using the fixed input in the short-run is zero even though the so-called

'historical cost' (i.e., the cost at which this input was originally procured by the firm) was substantial.Similarly, every variable

factor must be paid what it receives in its next best alternative, that is, the opportunity cost. Otherwise,the factor-input cannot be retained in its current employment. Thus, the money outlay for a factor-input

represents the opportunity cost of the resources.Opportunity costs include both explicit and implicit costs.(iii) Real Cost. Real costs refer to those payments which are made to factors of production to compensatefor the toil and effort in rendering their services. According to Marshall, "The exertions of all the differentkinds of labour that are directly or indirectly involved in making it, together with the abstinences or ratherthe waiting required, for saving the capital used in making it; all these sacrifices together will be called thereal cost of production of the commodity". Real cost is computed in terms of the pain and the discomfortinvolved for labour when it is engaged in production, and also the abstinence and sacrifice involved insaving and capital accumulation. The concept of real cost, however, does not carry any significance in thecost of production because it is a subjective concept and lacks precision.(iv) Private, External, and Social Costs. Sometimes, there is a discrepancy between the cost incurred by afirm and the cost that must be incurred by the society as a whole. For example, a factory may dispose ofits untreated waste into a river of a lake. Such a method of waste disposal may minimise the private cost,

but it does impose a cost to the society in the form of polluted waterways. A cost that is not borne by thefirm, but is incurred by others in society is called an external cost. The true cost to the society mustinclude all costs regardless of who bears them. Thus, the social cost is the sum of private and externalcost. That is,Social Cost - Private Cost + External Cost


18/50

OrExternal Cost = Social Cost - Private CostA firm may also create, in the process of production, some benefits to society for which it is not directlypaid. For example, there is the celebrated example of apple blossoms and honey bees. The apple blossoms

increase the output of nearby honey producers. Thus, the apple growers create external benefits to thehoney producers. Opening of a big general store in the neighbourhood brings more customers to the smallretailers who may be operating in the area. These are known as externalities. In brief,If social cost is more than private cost, there is an external cost or negative externality; if social cost is lessthan private cost, there is an external benefit or positive externality.

(v) Traceable Costs and Non-traceable Costs. Traceable costs are those which can easily be identified by aproducing unit. These are directly related to a unit of operation like a product, a process or a departmentof the firm. These are also known as direct costs or assignable costs.

Non-traceable costs or indirect costs are not traceable to plant, department or unit of operation or

individual final product. For example, for operating air-services, the cost of

PI.116General Economicsrunway, air-port, equipment, staff, etc., cannot be assigned to one passenger. These are common costswhich are non-assignable.It is not always possible to distinguish between traceable and non-traceable costs. Changes in the totaloutput and product-mix affect the total costs in complex ways. Even a traceable cost gets lost in theprocess and has to be identified as overhead cost only.

(vi) Incremental Costs and Sunk Costs. Incremental cost or differential cost is the addition to a change inthe level or nature of business activity. It may be defined as a change in the total cost resulting from adecision. Symbolically,IC =TC2TC1 = ATCwhere IC is the incremental cost, TCl is the total cost before a change in the business activity, and TC2 isthe total cost after a change in the business activity.The incremental cost differs from the marginal cost in the sense that whereas the marginal cost measureschange in total cost per unit of output, incremental cost measures change in total cost as a result ofchange in total output.Sunk Cost is one which is not affected or altered by a change in the level or nature of business activity. It

will remain the same irrespective of the nature and level of business activity. The most important exampleof sunk cost is the amortization of past expenses, i.e., depreciation.(vii) Controllable Costs and Non-controllable Costs. Controllable costs are those that can be controlled by

some executive action on the part of the management. These improve the efficiency of the factor inputs.Non-controllable Costs are those that cannot be controlled through any administrative or supervisoryaction. These lead to wastage of resources and encourage inefficiency.2. COST FUNCTIONA cost function expresses the relationship between cost and its determinants. Several factors influencecost. When their relationship to cost is expressed in a functional or mathematical form, it is called costfunction. Symbolically,c=/(s,o,p,r,.......)where C is cost, S is size of plant, 0 Is level of output, P is prices of inputs, and T is technology.Cost function, can be formulated for the short-run and the long-run depending upon the requirements ofthe firm. However, the short-run and long-run functions are interrelated. Cost function can be linear ornon-linear depending upon the nature and behaviour of cost.Determinants of Cost Function. The following are the main determinants of a cost function:

(1) Size of Plant. Size of plant or the scale of operation is inversely related to cost. As the size of plantincreases costs decline/and vice versa. How much the costs will decline as a result of increase in the scaleof operation depends upon the different sizes of plants.

(2) Output Level. Total output and total cost are positively related to each other. As the level of total

output increases total cost also rises. This, however, does not apply to average cost and marginal cost. As

the level of output increases marginal cost and average cost decline initially, and rise thereafter.

Unit 3 : Theory of Cost and RevenuePI.117(3) Prices of Inputs. Input prices are again positively related to cost. Increase in the input prices brings asimultaneous rise in the cost. Change in cost depends upon the relative usage of the inputs and relativechanges in their prices. For example, prices of wage-goods in India have a large bearing on the cost of finalproducts.

(4) State of Technology. State and the nature of technology also influence cost. Modern technology is cost-efficient and cost-saving. The impact of technology on cost is generally expressed in terms of capital-output ratio.


19/50

(5) Managerial and Administrative Efficiency. Managers are the controllers and monitors of the firms.Through efficient supervision, control and administration they can improve the efficiency and productivityof factor-inputs, and thus economise the cost.2.1.Short-run Cost Function

We have defined 'cost' to include expenses (explicit and implicit) incurred on the factors of production usedin the production of a commodity. These various factors of production can be classified in two groups, viz.,(a) fixed factors, and (b) variable factors. The expenses incurred on fixed factors may be called fixed costs,whereas those incurred on variable factors may be called variable costs. The fixed costs include the costsfor:

(a) the salaries and other expenses of administrative staff;(b) the salaries of staff involved directly in the production, but on a fixed term basis;(c) the wear and tear of machinery' (standard depreciation allowances);(d) the expenses for maintenance of buildings;(e) the expenses for the maintenance of the land on which the plant is installed and operates; and(f) normal profit, which is a lump sum including a percentage return on fixed capital and allowance of risk.

The variable costs include the cost of:(a) direct labour which varies with output;(b) raw materials; and(c) running expenses of machinery.The sum of fixed and variable costs constitutes the total cost of production. We may also be interested tokow the cost of production incurred on average on one unit (i.e., the average cost), or the cost incurred onevery additional unit (i.e., the marginal cost). Average cost of producing a commodity is the sum of average

fixed cost and average variable cost. The cost of producing an additional unit of a commodity is calledmarginal cost.2.2.Total Fixed Cost (TFC)Suppose Ram has hired a shop at a rent of Rs. 500 per month to run an engineering works. During thefirst month he keeps the shop closed as he is busy making preparations. Does he incur any expenses onthe shop? Yes, he does; once he has contracted to pay rent for the shop, he will pay it whether hisengineering works produces anything or not. Next month, Ram produces 1,000 units of metal rings. Howmuch does he spend towards rent on the shop? Obviously, he pays Rs. 500

Table 3.6: Cost Schedule

Wo. of Units Total Fixed

Produced Costs (Rs.)

0 1,0001,000 1,0002,000 1,0003,000 1,0004,000 1,000

PI.118Genera! EconomicsO0

Total Fixed CostTFC

12 3 4Output ('000)Fig. 3.7. Total Fixed Costno matter what is the level of output. In the next month, he produces 2,000 units of metal rings. Howmuch does he spend towards the rent of shop? Again the same: Rs. 500. It gives us a lessonTheexpenses incurred on the fixed factors remain unchanged whatever the level of output, i.e., the total fixedcost always remains constant, as would be seen from the following cost schedule:Graphically, total fixed costs will be represented as a straight line curve parallel to the X-axis as shown inFig. 3.6. This curve will show that the total costs will remain constant at different levels of output.2.3. Total Variable Cost (TVC)In the first month, Ram does not use his shop; he does not consume any power or water, he has notemployed any labour; he has not used his machinery. It means he is not required to spend any moneytowards payment for power or water for labour or payments for raw materials which are fed in the

machines. Once he begins to produce/ he has to incur expenses of different types. More he produces,more expenses he has to incur. In other words, with an increase in the level of output, total variable costs(i.e., expenses on the variable factors) go on increasing.Average Cost of Production (AC)Total Cost of Production (TC)


20/50

Average Variable Cost (AVC)Salaries of(a) Administrative Staff(b) Production Staff Paid on Fixed BasisLabour Costs which Vary with OutputDepreciation of Fixed Capital

Running Expenses of Machinery

Unit 3 : Theory of Cost and Revenue

PI.119Table 3.7: Cost Schedule

Total Output Total Variable Costs(Rs.)

0 0

1,000 1,000

2,000 1,8003,000 2,6004,000 3,5005,000 5,000

The rate of increase of the total variable costs is determined by the laws of returns. We have seen in the

earlier chapter, there are three stages of returns, viz., increasing returns, constant returns and decreasingreturns. In a production unit, in the initial stages, as the level of output increases, every additional unit ofthe variable factor brings in more than proportionate returns; at the point of optimum capacity, theseadditional returns remain constant; ultimately, every additional unit of the variable factor yields only lessthan proportionate returns. Corresponding to these stages of returns we can also read three stages ofvariable costs. Initially, total variable costs increase at a falling rate, in the intermediate stage, theseincrease at constant rate, and finally, these increase at a rising rate, as could be seen from the adjoiningTable 3.7.It would be seen from Table 3.7 that total variable costs increase with an increase in the level of output.

But the rate of increase in the total variable costs is different at different levels of output. Initially, first1,000 units are produced at Rs. 1,000. The next 1,000 units are produced only at Rs. 800. In this stage,

the law of decreasing costs operates. In the intermediate stage, when the law of constant returns (or the

law of constant costs) sets in the next 1,000 units are produced at the same additional cost, i.e., Rs. 800.In the ultimate stage, the law of diminishing returns (or the law of increasing costs) sets in. The next 1,000units of output are produced only at a higher cost of Rs. 900 and the next at Rs. 1,500. In other words,total variable costs increase at a decreasing, constant and increasing rates corresponding to the threestages of the laws of returns.


21/50

Diagrammatically, total variable cost curve moves upwards as shown in Fig. 3.8.a:Total Variable CostTVCj

2 3 4Output {'000)Fig. 3.8.2.4. Total Cost (TC)Total cost to a producer for the various levels of output is the sum of total fixed costs and total variable

costs, i.e., TC - TFC + TVC. This can be seen as follows in the Table 3.8:Table 3.8 : Cost Schedule

Total Output Total Fixed Costs Total Variable Costs Total Costs (2) + (3)

(Units) (Rs.) (Rs.) (Rs.)(V (2) (3) (4)

0 1,000 0 1,000

1,000 1,000 1,000 2,0002,000 1,000 1,800 2,8003,000 1,000 2,600 3,6004,000 1,000 3,500 4,5005,000 1,000 5,000 6,000

PI.120General Economicso

12 3 4 5 Output ('000)

Fig. 3.9.xIt would be seen from Table 3.8 that the cost of production increases with an increase in the level ofoutput. At different levels of output total costs follow total variable costs, because total fixed costs alwaysremain constant. Total cost curve can also be obtained by adding the total fixed cost curve and total

variable cost curve as shown in Fig. 3.8.In Fig 3.9, we have added a distance equal to the total fixed cost at different levels of output to the totalvariable costs, and have obtained the total cost curve.2.5. Average Fixed Cost (AFC)Ram spends Rs. 500 towards the rent of his shop and produces during the second month 1,000 units ofoutput. How much does he spend towards rent per unit of output? He spends Rs. 500 + 2,000 - 25p.The more he produces, per unit cost on fixed factors falls. Per unit cost on fixed factors is called average

fixed cost, and is defined as follows:AFC =TFC TQwhere, TQ is the total output.As the level of output increases, the average fixed cost falls (since the total fixed costs remain unchangedat different levels of output), as will be seen from Table 3.9 below:

Table 3.9 : Cost Schedule

Total Output Total FixedCosts

Average FixedCost

(Rs.) (2) - (1)(V (2) = (3) (Rs.)

0 1,0001,000 1,000 1.002.000 1,000 0.503,000 1,000 0.334,000 1,000 0.25


22/50

5,000 1,000 0.20

y

1.00

\ AverageFixed

Cost

Cost(Rs.

)

0.800.60

0.400.20

\ AFC--*,

0

12 3 4Output {'000)

5

Fig. 3.10.

It is clear from Table 3.9 that as output increases, average fixed costs fall because more units are being

produced now at the same fixed expenses. Graphically, the average fixed cost curve will be a downward

sloping curve. This curve will never touch the X-axis, because average fixed cost cannot be zero, however

large the level of output may be. Similarly, AFC curve neverUnit 3 : Theory of Cost and RevenuePI.121touches the Y-axis. It is so, because TFC is a positive value at zero output and any positive value dividedby zero will provide infinite value.Average Fixed Cost Curve is a rectangular hyperbola; the total area under the curve at different points willbe the same. The total area at a given point will show the total fixed cost of production for the specifiedoutput. In Fig. 3.11, we have marked four different levels of output, viz., 1, 2, 3 and 6. For each of these,total fixed costs equal six squares (Rs. 60).2.6. Average Variable Cost (AVC)

The average variable cost is found by dividing the total variable costs by the total units of output,TVC

i.e., AVC =TQ

Total variable costs, as we already know, are determined by the law of returns. Consequently, averagevariable cost also shows the same tendency, Average variable cost falls initially, and rises after the point ofnormal capacity has been reached. This can be illustrated with the help of Table 3.10.

Table 3.10: Cost Schedule

TotalOutput

TotalVariable

AverageVariable

Costs Costs (2) + (I)(V (2) (3)

(Rs.) (Rs.)

0 0

1,000 1,000 1.00

2,000 1,800 0.903,000 2,600 0.874,000 3,500 0.885,000 5,000 1.00

y


23/50

1.00-0.95-0.90-0.85-0AVC

X12 3 4 5 Output f'000)Fig. 3.12. Average Variable Cost CurveIt can be seen from Table 3.10 that the average variable cost goes on falling as output rises from 1,000 to3,000 units. However, beyond this stage, average variable cost begins to rise.Graphically, the average variable cost curve will be a dish-shaped (U-shaped) curve as shown in Fig. 3.12.The curve moves from downwards to upwards, indicating that average variable cost falls initially and

finally rises. At the output level of 3,000 units, it is the minimum.2.7. Average Cost (AC)Average cost of production can be obtained by dividing total cost by the units of output, i.e.,AC =TCTQ

as is illustrated in Table 3.12 below:

PI.122

General EconomicsTable 3.11: Cost < Schedule

TotalOutput

Total Cost Average Cost

(V (2) (2)*(1)(Rs.) (Rs.)

0 1,000

1,000 2,000 2.002,000 2,800 1.40

3,000 3,600 1.204,000 4,500 1.13

5,000 6,000 1.20Average cost can also be measured as the sum of average fixed cost and average variable cost, i.e., AC =AFC + AVC. We can sum up the average fixed cost schedule given in Table 3.9 and the average variablecost schedule given in Table 3.10, and get the average cost schedule of Table 3.11. Geometrically, ACcurve is obtained by adding AFC and AVC curves.* AC curve is a LJ-shaped curve, as illustrated in Fig.

3.13.In Fig 3.13, if the producer was to expand his output level beyond 4,000 units the average costcurve would have moved upwards. The point of output at which the average cost is the minimum is thepoint of optimum capacity for the producer.By optimum capacity we mean the level of output at which a firm can produce at the lowest per unit costof production.

Y

20 \

Ift \

1.5

\

Cost 1.

0AC J

0 r i

1 2 34

5 X

Output

('000)Fig. 3.13.

AverageCost

Curve

It is also known as Plant Capacity. A firm producing with excess capacity is producing at the rate ofoutput below the point of minimum average total cost. A firm producing above capacity is producing abovethis point, and is thus incurring costs higher than the minimum achievable.


24/50

2.8. Marginal Cost (MC)Marginal cost is the addition to the total cost as a result of a unit(one unit) increase in the output. It isexpressed symbolically as:MC^ = TCW - TC,, , where N is the number of units of output.

^Symbolically,AC*TQAC =; since TC = TVC + TFC,

. We can divide the equation in two partsTCTVC TFCand set AC = ------+------. We already knoxoTQ TQTVC TFC

------ equals AVC, and ------ equals AFC,TQ TQ '

therefore, AC equals AVC + AFC.

Unit 3 : Theory of Cost and Revenue FI.123Alternatively, marginal cost can also be expressed as follows:MC =ATC &TQwhere, A stands for the change in total cost or total output.Marginal cost is calculated by measuring the change in total cost resulting from a unit increase in output.It can be illustrated as follows in Table 3.12.It will be seen that the marginal cost is obtained by measuring the change in total cost resulting from aunit increase in output. The behaviour of marginal cost is also influenced by the laws of returns. Initially,marginal cost falls, in the intermediate stage marginal cost remains constant and ultimately it rises. The

behaviour of marginal cost can also be illustrated graphically as in Fig. 3.14.

Table3.12:

Cost Schedule

Total Total Average Marginal

Output Cost Cost Cost(Rs.) (Rs.) (Rs.)

1 10 10.00 10

2 19 9.50 93 27 9.00 84 35 8.75 85 44 8.80 96 54 9.00 107 65 9.30 118 77 9.60 12

Y

12-

Marginal Cost /we

11-

\ /

10-

\ /

Cos

t

9- V y

8-A

0 12 3 4 56

7 8

Output

Fig. 3.14. MarginalCost

Curve

In Fig. 3.14, MC is the marginal cost curve. It is also a (i-shaped curve which shows that initially themarginal cost falls, and ultimately it rises.Relationship between Average Cost and Marginal Cost


25/50

Both average cost and marginal cost are derived from the total costs. Average cost is obtained by dividingtotal costs by the units of output. Marginal cost is the change in total costs resulting from a unit increasein output.The relationship between marginal cost and average cost is exactly of the similar nature, and could be

illustrated with the help of Fig. 3.15 based on cost schedule shown in Fig. 3.15. The various points ofrelationship between average cost and marginal cost can be summed up as follows:(i) When average cost falls with an increase in output, marginal cost is less than the average cost.(ii) Marginal cost begins to rise earlier than the average cost. Marginal cost carve cuts the

PI.124

General Economicsaverage cost curve at its minimum point, (remember minimum point on the average a curve is also thepoint of optimum capacity), i.e., at the point of optimum capacityMC = AC.(iii) With increase in average cost, marginal cost rises at a faster rate. This relationship between marginalcost and average cost will be found useful in the study of price output trends.2.9. Long-run Cost FunctionIn the long-run all factors are variable; hence there is no distinction between fixed and variable costs. Allcosts are variable costs. Therefore, we are interested only in long-run average cost curve (LAC) and long-run marginal cost curve (LMC).(1) Long-run Average Cost Curve. Long-run average cost curve can be depicted as the sum of variousshort-run cost curves reflecting different plant sizesConsider a situation in which a firm has three alternative scales of plant. These are represented by SAC1

SAC2, and SAC3 in Fig. 3.16. The three L1 L2 and L3 represent the minimum average cost points at threedifferent scales. It may be observed that the firm can have OQ3 output either (i) by producing morequantity on the earlier scale itself or by changing the scale. Obviously, it is advantageous for the firm toproduce at the new scale and have the output at average cost being shown by point L3 In the earlier scalebeing shown by SAC2 the firm can produce OQ3 output at a cost higher than L3

The long-run average cost curve can be plotted by joining all the short-run cost curves. In Fig. 3.16, LACcurve is the long-run average cost curve.The LT-shape of the long-run average cost curve can be explained by the economies and diseconomies ofscale. Initially, when the firm increases its scale of production it reaps economies of scale. However,beyond a point in the short-run period, further expansion in the scale of production results in

diseconomies of scale and the long-run average cost curve begins to rise.

Modern economists, however, do not agree with the U-shape of the LAC curve. They attach greatimportance to technological progress. Technological progress leads to maximisation of output andminimisatior of cost. In such a situation, LAC will be L-shaped as shown in Fig. 3.17.The implication of the L-shaped LAC curve is that it does not show rising trend at any level of output. Thesupporters of L-shaped LAC curve argue that no firm would like to operate beyond a level of output thatyields diminishing returns to scale. Therefore, the rising portion of the LAC is not relevant for a profitmaximising firm.

(2) Long-run Marginal Cost Curve. Long-run marginal cost curve (LMC) bears the same relationship tolong-run average cost curve (LAC) that any given short-run marginal cost bears-

y

SAC,

\\ /"V*c,

_, \\\ / Y

oo Li -~

*


26/50

o * *

Q, Q2 C A

Output

Fig. 3.16.

Y

Cost

0

Output

Fig. 3.17.

Unit 3 : Theory of Cost and RevenuePI.125

TO short-run average cost. LMC curve cuts LAC at its lowest point as shown in Fig. 3.18. LMC curve cutsLAC at its lowest point R. LAC curve is flatter than the short-run marginal cost curve. It is because ofthe fact that the U-shape of the long-run average cost is less pronounced than that of the short-runaverage cost curve.It will be seen that the most efficient scale ofproduction for the firm is at the point where the short-run average cost is equal to the long-run average

cost. The firm can produce OQ output. This is the point of optimum capacity for the firm. Beyond thispoint, the firm undergoes diseconomies on the long-run cost curve; similarly before the point of optimum

capacity has been reached a firm will gain economies by expanding the scale of production.y LMC SMC3

Cost

SAC,i V,,'SAC

! ,S/\C3

i R //

10 Q X

Output

Fig. 3.18. Long-runCost Curve Marginal

3. COMPONENTS OF COSTSClassification of total cost on the basis of the cost of fixed and variable inputs is not enough for takingmanagerial decisions. A firm has to work out in deta

Documents

Chapter No. 1.. Introduction to Microeconomics