Introductory Microeconomics Chapter 3 Production And Costs

False; because ATC is sum of AFC and AVC; also AFC decreases as level of output increases.

The functional relationship between physical inputs and physical output of a firm is called production function. How? Production is also defined as 'transformation of physical inputs into physical output.' Output depends on inputs i.e., output is a function of inputs. There is direct relationship between the amount of inputs (such as land, labour, machinery etc.) used and the amount of output produced. Thus production function shows relationship between physical inputs and physical output. Algebraically, it can be expressed as below presuming there are three factor inputs : labour (L), capital (K) and Land (D). Q = f(L, K, D ...) where Q is quantity of physical output and L, K, D stand for quantities of labour, capital and land. The equation tells that output is a function of labour, capital and land. Mind, with given technology different levels of output can be produced using given resources. Thus production function gives information regarding maximum amount of output that can be produced from different quantities of factor inputs with given technology per period of time. In short 'a production function is an expression of relationship between change in inputs and the resultant change in output'. Again note that production function does not tell about price and cost of output but describes a purely technical relationship between physical inputs and output.

Mind, product or output or production means the volume of goods and services produced by a firm with given inputs. The production function showing relationship between inputs and output can be explained in terms of total product i.e., total physical product (TPP), marginal physical product (MPP) and average physical product (APP), as given in the next question.

(a) Relationship between MPP and TPP

Note. Since MPP is addition to TPP, it also implies that if MPP is positive, TPP must be increasing and if MPP is negative (-), TPP must be decreasing.

(i) When MPP rises, TPP rises at an increasing rate. (It is up to 4th unit of labour in the above schedule).

(ii)    When MPP falls but is positive, TPP rises at a diminishing rate. (It is from 5th to 7th unit of labour in the schedule).

(iii)    When MPP is zero, TPP is maximum. (It is indicated by 8th unit.)

(iv)    When MPP falls but is negative (-), TPP declines. (It is shown by 9th unit of labour in the above schedule).

Laws of Returns. Production broadly means, "transformation of inputs into output." Further output is function of inputs. More the inputs, more will be the quantity of output produced if technology remains the same. Change in quantity of output may be referred to as 'return'. Law of Returns explains the change in physical output as a result of change in inputs. It is studied under two situations, namely (i) short period (in which some factors are fixed and some are variable) and (ii) long period (in which all factors are variable).

(a) Short Period and Long Period.

Short period. A short period is the period of time in which a firm can change only variable factor (like labour, raw material) but not its fixed factors of production (like plant, machinery, building etc.) Therefore, in short period output can be increased only by increasing the quantity of variable factors like raw material, labour, power etc.

Long period. "A long period is a time period during which a firm can change all factors of production including machinery, building, organisation etc." It is period of time when all factors are variable i.e. supply can fully adjust itself to change in demand.

(b) Fixed Factors and Variable Factors

Fixed factors generally mean those factors of production which cannot be changed easily during short period, e.g., factory building, machines, plant, and services of management.

Variable factors, on the other hand, generally refer to those factors of production which can be varied or changed during short period, e.g., raw material, ordinary labour, power, fuel etc. Thus distinction between fixed and variable factors is valid only in short period as in the long period all factors become variable.

Two types of production function are generally discussed namely: (t) Short period production function, and (ii) Long period production function. Short term production function is explained in the form of law of variable proportion (also called Returns to a factor) whereas long run production function is discussed in the form of Returns to scale as shown below.

Beware that fixed cost (i.e., total fixed cost) remains fixed or same at different levels of production. As a result when units of production increase, AFC falls as depicted in Fig.

3.7. Thus AFC decreases as level of output is increased.

(ii) Average Variable Cost. It is per unit variable cost of producing a commodity. It is worked out by dividing the total variable cost by the number of units produced. For instance if total variable cost of manufacturing 100 fans is र 12,500, then:

It should be kept in mind that in the beginning AVC decreases but after reaching the stage of minimum cost, it starts increasing as shown in Fig. 3.7. AVC curve is a dish shaped (U-shaped) curve.

(iii) Average total cost. It is per unit cost of production of a commodity. It is worked out by dividing the total cost (fixed cost + variable cost) by the number of units produced. Continuing the above example if total cost of manufacturing 100 fans is र 20,000 (fixed cost 7,500 + variable cost 12,500), then:

Like total cost which is the sum of total fixed cost and total variable cost, ATC is also the sum of AFC and AVC. Symbolically:

ATC = AFC + AVC

Return to a factor means, 'Change' in total physical product when an additional unit of a variable factor is employed with fixed factors'. Alternatively 'when only one factor is increased keeping all other factors fixed, the resultant increase in output is called returns to a factor'. It is also known as 'law of return to a factor' although modern economists call it as 'law of variable proportion' because with increase in variable input, the proportion between variable factors and fixed factors gets changed.

Table and diagram. The following table and diagram further clarify the law. when more and more units of labour are applied in a given plot of land, marginal product goes on falling as shown below:

It would be observed from the above table and diagram that when more units of labour are employed with a given quantity of fixed factor (land), TPP increases at a diminishing rate or MPP goes on falling. That is why shape of MPP curve is downward sloping. Mind, the law operates if technology does not change, i.e., there is no improvement in state of technology.

Importance. This law is called a universal law because tendency to diminishing return is all pervading. The law applies without fail sooner or later in every field of production. Nothing can stop the operation of this law. Its application is all pervading. If tendency to diminishing returns could be removed somehow, all economic problems would be solved.

(c)    Reasons for operation of law. The reasons why diminishing returns appear are:

(i)    Use beyond optimum capacity. After achieving optimum combination of variable and fixed factors, efficiency starts declining when more units of a variable factor are employed. As a result marginal product starts falling.

(ii)    Lack of perfect substitution between factors. Up to a certain limit, factors of production can be substituted for one another, e.g. more labour can be employed instead of machinery but beyond a certain stage, this is not possible. The factors become imperfect substitutes leading to diminishing returns.

(iii)    Fixity of the factor. When more units of a factor are combined with fixed factor, quantity of fixed factor inputs per unit of variable factor falls. This adds decreasing return to total product. In other words, fixed factor becomes too small.

(iv)    Scarcity of factors.

Note. Although 'Returns to scale' is now out of syllabus yet for better understanding of 'Law of Returns', it is briefly given here.

Three tendencies of Returns to Scale. When all the inputs are increased in the same proportion, the following three types of situations in output are observed.

(i)    Increasing Returns to Scale (IRS). It occurs when output (TPP) increases by a greater proportion (say, by 120%) than the proportion of increase (say, by 100%) in all the inputs. For detail, see part (b) of this question.

(ii)    Constant Returns to Scale (CRS). It happens when output (TPP) increases by the same proportion (say, by 100%) as that of increase (say, by 100%) in inputs. For detail, see part (d).

(iii)    Diminishing Returns to Scale (DRS). It occurs when output (TPP) increases by a lesser proportion (say, by 80%) than the proportion of increase (say, by 100%) in inputs. For detail, see part (c).

(Mind : The above cited three tendencies are not three different laws of return to scale but three aspects of one and the same law.)

Tabular presentation. The above mentioned three stages of returns to scale are further clarified with the help of an imaginary following table, presuming that the firm is employing only two factors, namely, labour and capital (machines), capital in machine-hours and the commodity in metres. It is presumed that according to the following table, combination of 2 units of labour and 1 unit of machine produce 200 metres of cloth in the beginning.

The above table indicates increasing returns from Ist to 3rd combination of inputs; constant returns from 4th to 6th combination of inputs and diminishing returns from 7th to 10th combination of inputs.

Note. Remember, law of increasing returns is also called law of diminishing costs and the law of diminishing returns is labelled as law of increasing costs.

Returns to a variable factor and returns to scale

Returns to a variable factor refer to the behaviour of output when quantities of one variable factor are increased keeping other factors fixed. Since the proportion between variable factor and the fixed factors change, this law is also called the law of variable proportion. The law usually operates in short period.

Returns to scale refer to the behaviour of output when all the factors are changed simultaneously and in the same proportion. This changes the scale of production and the capacity to produce. That is why this law is called the law of returns to scale. Here the factor proportion remains constant. The law operates in the long period when all the factor inputs are changeable.

Difference. The difference between returns to a variable factor and returns to scale are summed up as below:

(i)    In the former (returns to a variable factor) only one factor is changed keeping other factors fixed whereas in the latter (returns to scale), all the factors are changed in the same proportion.

(ii)    The former usually happens in short period wherein level of production can be changed whereas the latter operates in long period wherein scale of production can be changed.

(iii)    In the former, the ratio between the variable factors and fixed factors changes whereas in the latter, the factor ratio remains constant.

(iv)    The former indicates three stages, i.e., increasing, diminishing and negative returns but in the latter, returns can be increasing, constant and decreasing.

(v)    In the former increasing returns are due to (a) Optimum use of fixed factor, (b) Specialisation, and (c) Volume discount. In the latter increasing returns are due to internal and external economies of scale.

(vi)    In the former, increasing and constant returns may or may not appear but diminishing returns are certain. As against it, all the three phases of returns appear in the latter (returns to scale).

(vii)    In the former, scale of production remains unchanged whereas in the latter, scale of production changes.

Conclusion. Returns to a variable factor examine the effects on output when only one factor is increased while assuming other factors to be constant. Returns to scale examine the effects on output when all the factors are increased simultaneously in the same proportion.

It refers to allocation of tasks (work) among workers according to their specialisation.

TPP falls when MPP is negative.

Meaning of Cost. Cost of producing a good is the sum of actual expenditure on purchase of inputs and imputed expenditure on inputs supplied by the firm itself Thus sum of explicit costs and implicit costs constitutes total cost of production of a commodity.

Explicit Cost. The actual money spent by a firm on buying or hiring of factor inputs and nonfactor inputs is called money cost or explicit costs. These include wage bills, raw material expenses, electricity bills etc. Thus all money costs paid are known as explicit cost of production.

Implicit cost. Implicit cost is the estimated (imputed) value of inputs supplied by the owner of the firm himself. For example the owner may utilise his own building, his own capital or may act as a manager of his firm himself. He does not pay rent or interest or salary to himself although such payments accrue to him. Imputed or estimated value of these productive services supplied by the owner himself is called implicit cost.

Thus in economies sum of explicit cost and implicit cost constitute total cost of production. It needs to be noted that cost also includes normal profit (i.e., the minimum profit) which a producer must get to remain in business. Costs are discussed in the context of short run and long run.

Cost Function — The functional relationship between output and cost is called cost function. Symbolically C = f(Q) i.e., Cost (C) is function (f) of units of output (Q).

(i)    Short run costs — Since in the short run (or period), some factors are fixed (like machinery, building, technical labour which cannot be changed due to insufficiency of time) and some are variable (like raw material, ordinary labour, power etc. which can be changed), therefore, the associated costs are either fixed costs or variable costs. Thus short run costs refer to the costs incurred by a firm during short period. Although main short run costs consist of Fixed Cost (FC) and Variable Cost (VC) but with their offshoots, different types of short run costs are : TVC, TFC, TC, SAC (Short run average cost), AFC, AVC and SMC (short run marginal cost). Here S stands for short run.

(ii)    Long run costs — Since in the long run all the factors are variable and there is no distinction between variable factors and fixed factors, so there is no distinction between fixed costs and variable costs. All costs are variable. Therefore there is no distinction between total cost and total variable cost; between ATC and AVC. We simply use the term long run average cost denoted by LAC. Similarly we use the term LMC for marginal cost. Therefore generally two kinds of costs namely LAC (long run average costs) and LMC (long run marginal costs) are discussed. Following implications of long run costs are noteworthy.

(i)    Distinction between total cost and total variable cost disappears. Simply the term total cost is used.

(ii)    There are no TFC and AFC curves because fixed costs do not exist.

(iii)    There is no distinction between average total costs and average variable costs because of absence of fixed costs. Instead only the term 'Long run Average Cost' (LAC) is used.

(iv)    Marginal cost is denoted by 'Long run Marginal Cost' (LMC).

At a given point of time a firm faces two types of cost : fixed cost and variable cost as explained below.

(a) Fixed costs. Fixed costs are the costs which do not change with change in the level of output. These are primarily incurred on fixed factors like machines, building, etc. Fixed costs do not change when level of output is increased or decreased. Fixed costs remain (because fixed factors remain) even if output is zero. In fact fixed costs are incurred even before output actually starts. These have to be borne even if no output is produced. For instance, a sugar mill usually remains closed for about 3 months during a year for want of raw material (sugarcane) but still the mill owner has to incur certain costs like rent of factory building, interest on past borrowings, salaries of permanent employees, municipal taxes, insurance premium etc. These costs are called fixed costs or supplementary costs or overhead costs. Fixed cost and variable cost are formally called total fixed cost (TFC) and total variable costs (TVC). These are shown in the following table and depicted in Fig. 3.4. The point to be noted that Total Fixed Cost (TFC) is constant, i.e., र 150 whether output is zero or 4 units. Since TFC remains the same (fixed) at all levels of output, TFC curve is equidistant from horizontal axis (i.e., X-axis). As a result TFC curve is a straight line parallel to X-axis as shown in fig.

(b) Variable costs. These are the costs which vary directly with the change in the level of output. These are costs which are incurred on variable inputs. Such costs increase when output increases and decrease when output falls. That is why they are called direct costs since they vary (change) directly with the change in the level of output. In other words, variable costs are incurred so long as production continues but the moment production stops, variable costs also cease. The costs incurred on raw material, power, fuel, wages of temporary labour, wear and tear of machines etc. are examples of variable costs. Continuing the above example, when sugar mill is working, the mill owner has to incur costs, on sugarcane, power, wages of temporary labour etc. If production of sugar has to be increased, these costs will also increase and if production has to be decreased, these costs will also decrease. And if sugar mill closes, variable costs will also fall to zero. These have been shown in the following table and depicted in Fig. 3.5. Total cost incurred on variable factors is called Total Variable Cost (TVC). It is clear from the table that TVC is zero at zero output but increases as output increases. TVC curve in Fig. 3.5 also represents the same. The curve is upward sloping which indicates that total variable costs go on increasing with increase in output. Variable costs are called prime costs or direct costs because these are costs of direct labour and direct material incorporated into product.

Fig. 3.5

Importance. The significance of distinction in costs lies in the fact that when a firm is incurring losses, it still continues its production if the market price covers at least its variable costs during short period. In other words, the firm will be ready to incur losses equal to fixed costs rather than stop production in the short period. However, in the long period, market price must cover firm's fixed and variable costs otherwise firm will stop production.

Distinction between fixed costs and variable costs:

Fixed costs and variable costs constitute total cost of production. These are formally called total fixed costs, total variable costs and total costs respectively.

Area under MC curve = TVC.

We have seen that MC is addition to the total variable cost when an additional unit is produced. This means that total variable cost (TVC) is the sum of marginal costs because total fixed costs remain the same in short period. This is proved in Fig. 3.9. Assuming output perfectly divisible, a hypothetical smooth MC curve is drawn in the adjoining figure. We know that TVC is simply the sum of marginal costs of number of units produced. Thus under the assumption of smooth marginal cost curve, total variable cost (TVC) is equal to the area under marginal cost curve. For instance at OQ units of output, TVC is equal to the shaded area OABQ in the diagram.

(a) Average Cost (AC)

It is per unit cost of production of a commodity. According to Ferguson, "Average cost is total cost divided by output". AC is calculated by dividing the total cost by the number of units produced. Suppose the total cost of production of 25 chairs is र 2,500. In this case, cost per chair or

AC can also be measured by adding AFC and AVC, i.e.,

AC = AFC + AVC

(Remember AC is formally called ATC)

Why is AC curve U-shaped? It means that initially it falls, after reaching its minimum, it starts rising. AC curve is depicted in Fig.  AC curve in short period is a U-shaped curve due to operation of law of variable proportion. Remember, increasing returns imply diminishing costs, constant returns mean constant costs and diminishing returns imply increasing costs. As output is increased, initially AC falls due to operation of law of increasing returns, reaches its minimum and then rises due to diminishing returns. Hence, AC curve becomes U-shaped. Minimum point of AC curve indicates lowest per unit cost or production.

Simply put, the U-shape of the LAC curve is the result of operation of returns to scale, i.e., a firm experiences increasing returns to scale (i.e. diminishing cost) in the beginning followed by constant returns to scale and then by diminishing returns to scale (i.e. increasing cost) (see Q. 3.7). It is explained below. Remember that increasing returns means decreasing costs and diminishing returns imply increasing costs. That is why law of diminishing returns is called as law of increasing costs and law of diminishing returns is called as law of increasing costs.

(i) It is because of increasing returns to scale (i.e., decreasing costs) that LAC curve declines initially when a firm expands production from small scale to large scale. (ii) When AC becomes lowest as a result of increasing returns, a firm experiences constant returns for a while. (iii) A further increase in the scale of output beyond a certain point results in diseconomies of scale. This leads to decreasing returns (i.e., increasing costs). It is because of decreasing returns to scale that LAC curve starts rising.

In short, LAC curve first declines due to economies of scale and then rises due to diseconomies of scale. This briefly explains the U-shape of LAC curve. U-shape of LAC curve, in turn, implies U-shape of LMC curve.

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