Prepared By:-Manoj Kumar Gautam

Production:- It refers to the

transformation of input into output

For Example:-The input of raw
cotton,labor,& capital results in the
output of cloth.

You may find 10 units of capital & 5 units of
labor are required to produce 100 units of
commodity. It is this relationship b/w
physical inputs(i.e 10 units of capital & 5
units of labor) & Physical output(100 units of
commodity produced) which in economics is
termed as production function.

Production Function:- it simply means the
functional relationship between physical inputs
& physical output of a commodity.
The production function is purely a technical
relation which connects factor inputs & factor
outputs. It can be expressed by the formula:
Y=f(L,K,S)
Y-Yield / Output
L,K,S- Labour, capital, Land
Respectively


Production function explains in what proportion
factor input should be combined to increase the
production.
Factor inputs are-
1. Fixed factors:- are not related with the
volume of output.
2. Variable factors:- directly related with volum
of output.
The distinction between these factors are restricted
to short run.
In long run all factors are supposed to be variable.


So on the basis of above discussed , we can
conclude that production function is the
technical relationship between quantity of
goods produced and factors of production
(inputs) necessary to produce it.
Perfect divisibility of both inputs and outputs

Limited substitution on one factor for the other

Technology is constant

Inelastic supply of fixed factor in short run
It indicates functional relationship b/w physical
inputs and outputs.
It is always in relation to a period of time.
It can specify either maximum output that can be
produced from a given sets of inputs or minimum
quantity of inputs required to produce a given
level of output.
It is purely a technical relationship.
Output in production function is the result of joint
use of factor of production.
It describe the law of production.
Short run production function:- input output
relation where some inputs are fixed and
quantities of other inputs are vary.

Long run production function:- input output
relation where all inputs are variable.
Fixed Proportion & Variable Proportion
Production Function:- When amount of
productive factor required to produce a unit of
product remains fixed irrespective of level of
production called fixed Proportion Where as
factors required to produce a unit of product
can be varied by substituting some other factor
in its place called variable proportion
Linear & Non Linear Production Function:-If
all factors are increased in some proportion
output also increase in the same proportion.
nq=f(K,L)=f(nK,nL)
& Vice versa in case of non linear production
function.
This was given by Cobb-Douglas .
This model is based on emperical study of
american mfg. industry (1899-1922)
It indicates production quantity as a function of
labour & Capital inputs.
Results for emperical study was published in
American Economic review in March 1948
Results were- Capital Contribution-1/4
th

Labor contribution-3/4
th

Q=AL

K

Here Q-Yield/Output
A- Efficiency Parameters
L,K- Labor & Capital
More efficient firm Have higher value of A
& are elasticity of output w.r.t labor &
Capital
These two exponent together measure total %
change in output for a given % change in input.



Q=1.01L
0.75
K
0.25
The above equation indicates that 1 percent
change in labor input Capital remaining
constant will result in 75% change in output
also 1% change in capital labor remain const.
will result 25% change in output.
Production is function of two variable
It is a linear function of one degree
It assumes const. return to scale
Perfect competition in the market
No change in technology
It shows multiplicative function i.e- the output
becomes zero if any inputs takes zero
Law of variable proportion states that as the quantity
of a variable input is increased by equal doses, the
other inputs constant, total output will increase but
after a point, at diminishing rate.
In simple words, the law of variable proportion
states that with the increase of a variable factor,
keeping other factors constant, the marginal product
after rising to some extent becomes smaller and
smaller.
It is called the law of variable proportion because if
one factor is varied keeping other factors constant,
the input output ratio also undergoes a change. The
ratio between the variable factor and output changes
so it is called the law of variable proportions.
It is possible to make change in the factor
of production.
All units of variable factors are
homogenous.
One is variable factor and others are
fixed factors.
No change in the technique of
production and organization.
FACTORS OF PRODUCTION ARE NOT
PERFECT SUBSTITUTE.
FACTORS OF PRODUCTION ARE
SCARCE
ALL FACTORS OF PRODUCTION
CANNOT BE CHANGED.
With the help of example we explain this law.
It is assumed that land is a fixed factor and labor is
variable factor.
Fixed
factor
Variable
factor
TP MP AP
1 0 0 0 0
1 1 4 4 4 Stage 1
1 2 12 8 6
1 3 24 12 8
1 4 32 8 8 Stage 2
1 5 36 4 72
1 6 36 0 6
1 7 28 -8 4 Stage 3
1 8 16 -12 2
0
50
100
150
200
250
1 2 3 4 5 6 7 8 9 10
T
o
t
a
l

P
r
o
d
u
c
t
i
o
n

(
I
n

U
n
i
t
s
)
Variable Input (Number of Workers)
Production Function Using Variable Amounts of Labor
S
Stage of increasing returns
Stage of diminishing returns
Stage of negative returns
INCREASE IN EFFICIENCY
OPTIMUM COMBINATION
FIXED FACTORS
INDIVISIBILITY OF FACTORS
DIVISION OF LABOUR
Total production continues to increase but at
diminishing rates.
TP is maximum and MP is zero
AP goes on diminishing because decline in
efficiency of labor.
Second stages runs between 5 th and 6
th
unit.
MP and AP decline but remain positive.
This stage is known as the stage of diminishing
returns.

The relation b/w quantities of output & scales
of production in long run. When all inputs are
increased in some proportion is called returns
to scale
In order to meet long run change in the
demand the firm increases its scale of
production by increasing the quantities of all
inputs of production.
In case all inputs increased in same proportion
the effect on output may take in three forms.
Increasing return to scale
Const. return to scale
Decreasing return to scale
All factors ( Inputs) are variable
A worker work with tool & equipment
Technology is const.
There is perfect competition
Pdt. Is measured in quantities
Internal & External Economies & diseconomies
of scale
When Internal & External Economies >Internal
& External DiseconomiesStage of Increasing
return to scale
Vice Versa of Ist Stage of Diminishing return
to scale
When Const.Constant return to scale
Internal Economies--Benefits obtained by
producers due to their individual efforts are
known as Internal Economies.
Technical Economies
Managerial Economies
Labor Economies
Marketing Economies
Financial Economies
Benefits for which producers have not to make
any individual efforts are known as external
economies.
Economies of welfare
Economies of Decentralisation
Economies of Information
Economies of Concentration
Managerial Diseconomies
Financial Diseconomies
Technical Diseconomies
Marketing Diseconomies
Entrepreneurial Diseconomies
Study of cost is essential for making a choice.
Production decision are not possible with out
their respective cost consideration since
productive resource are scarce with alternative
uses which involves sacrifies i.e. cost. Cost and
Revenue are two major factor with which the
profit maximising firms need to deal carefully.
Concept Of Cost:
The cost concept which are relevant to
business operations and decision can be
grouped under two overlapping categories.

Two types of Cost Concept:
Accounting cost concept
Anatytical cost concept

cost
Accounting
cost
Analytical cost
Business
cost
&
Full Cost
Explicit cost
Implicit cost
&
Imputed
Cost
Out of Packet
&
Book Cost
Total cost
& AC
MC
Short Run
& Long
Run
Incremental
& Sunk Cost
Private &
Social Cost
Historical &
Replacement Cost
Opportunity
cost
&
Actual Cost
Fixed &
variable cost
Actual Cost and oppprtunity cost:
Actual cost one the cost which the firm incurs
while producing goods and services like cost on
raw material , labour , rent interest. These cost are
called out lay costs or absolute cost or acquistion
cost.
Opportunity cost:
Resource are scarce with alternative uses with
different returns. The firm or owner of the input
put these resource to most productive use and
they expest income from the second best use of the
resource. So opportunity cost may be defined as
the expected returns from the second best use of
the resource. It is also called alternative cost.

Business Cost:
Business cost includes the expenses which are incurred to
carry out a business. The concept of Business cost is similar
to the actual or real cost. It includes all the payment made
by the firm with the book cost of depreciation on plant and
equipment. These cost are used for calculating business
profit and losses and for filling returns for income tax and
legal purpose.
Full Cost:
The full cost includes business cost, opportunity cost and
normal profit, Opportunity cost is the expected earning
from the next best use of Firms resoure like Capital , land
building and enterprenueues effort and time. The Firm
must earn a necessary minimum return called Normal
Profit.

Explicit Cost:
These are the costs which fall under actual cost entered in
the account book as wages and salaries materials, license
fee, insurance premium depreciation chnges etc. These cost
is important for loss and profit calculation.

Implicit Cost or Imputed Cost:
Opportunity cost is the example of implicit cost. These
cost do not take the form of cash outlays.They are not in
accounting books.
For Eg: The interest payment on horrowed funds in an
explicit cost and enters the accounting record when same
fund is used by a person in his firm .
But for economics decision making the firm takes into
account both explicit and implicit cost.

Out Of Pocket Cost:
The items of expenditure ehich involves cash
payment or cash transfers both recurring and Non
recurring are known as Out of Pocket Costs.
Ex: Explicit cost W,R,r cost of material , Transfer Cost
etc.

Book Cost:
There are certain actual business costs which do not
involves cash payment but a provision is made in
books of account and they are taken into account while
finalising the profit and loss account. Depreciation
allowabces and unpaid interest.

Fixed Cost:
Fixed costs are those cost which are fixed in
volume for a certain given output it include ost of
Managerial and adminstrative staff depreciation of
Machinary. Maintenance of Law.
Variable Cost:
Variable cost is dependent on volume of output
i.e. Expenditure on Labour , raw material
TC=FC+VC
Total Cost:
Total cost is the total expenditure incured on the
production of goods and services. It include both
fixed and vaariable costs.

Average Cost:
AC is obtained by dividing the total cost by the
Total output
AC=TC/Q
Marginal Cost:
Mc is the addition to the total cost on account of
producing one additional unit of the product

MC=TCn- TCn-1
Short Run Cost:
Short run cost are the same as variable costs.
They are the costs which varry with variation in
output. The size of the firm is remaining the same

Long Run Cost:
Long run costs are the cost which are incurred on fiwed
capital assests like plant,building , machinery etc. Long run
costs are by implication the same as fixed costs in long run
fixed cost becomes variable cost as the size of the firm or
sale of production.
Incremental Cost:
Incremental costs are related with marginal cost. MC
refres to the cost of marginal unit of output incremental cost
refers to the total additional cost associated with the
decisions to expe3nd the output. In long run when firm
expend their production they hire more of men,machinary,
material etc. This type of expenditure is incremental cost
arises due to change in product lines ,introduction of a new
product replacement of old Techniques of Production etc.

Sunk Cost:
The sunk cost are those cost which can not be
altered increase or decrease by varying the rate of
output once. It is decided to make incremental
investment expenditure and funds are allotted and
spent all the preceding costs are considered to be
the sunk cost.
Historical cost:
It refers to the cost of an asset acquired in the
past. It is used for accounting purpose in the
assessment of net worth of the firm.


Replacement cost:
Replacement cost refers to the outlay which has
to be made for replacing an old asset.

Private Cost:
Private cost are those costs which are actually
incurred by an individual or a firm on the
purchase of goods and services from the market
for the firm all the actual cost ( Explicit & Implicit
cost ) are private cost.



Social Cost:
Social cost refer to the total cost borne by the
society due to production of the commodity
social cost includes both private and external
cost.
It includes the cost of resources for which the
firm is not compelled to pay a price i.e. river ,
lakes , atmosphere etc.


The theory of cost deals with the behaviour of
cost in relation to a change in output . Cost
theory deals with cost output relations. The
basic principle of the cost behaviour is that TC
increase in ouput.

TC=f(Q), TC/ Q>0


Main determinants of Cost

1. Size of Plant
2. Output Level
3. Price of Input
4. Technology
5. Marginal Efficiency
Cost function is the output function expressed
in memory units. Cost function is depends on
whether the time framework choosen for cost
Analysis is short period or long period.
There are two types of cost function
1. Short run cost function
2. Long run cost function

Short Run Cost:
Short run cost are those associated with
variation in utilisation of fixed plant and other
facilities. The short is a period which does not
permit alternation in the fixed equipment and in
the size of the organisation.

Long Run Cost:
Long run cost is a period in which there is
sufficent time to alter the equipment and size of
organisation.


In short run cost are divided into overhead into
two component.
1. Fixed Cost( supplementry or overhead cost)
2. Variable cost ( Prime Cost)

In short Run
TC=TEC+TVC

Fixed Cost:
Fixed cost are the sum of total of expenditure
incurred by the produes on the purchase of
fixed factor of production. These cost do not
change with the volume of output. They are
known as induced cost. It includes expenses
like Rent, Wages of permanent employ, licence
fee etc.

0
2
4
6
8
10
12
0 1 2 3 4 5 6 7
Unit of output fixedcost
0 10
1 10
2 10
3 10
4 10
5 10
6 10
The Curve Fc is parallel to X axis. It means what ever be the
volume of output, The cost will remain fixed.
Variable Cost:
Variable cost are th expenditure incurred by the producer on
the use of variable factor of production. When the output changes
these cost also change, As the output increase these cost also
increase and or the output decrease, these cost are also decrease
when the output is zero. There cost are also zero. They are called
direct cost in includes expenses like purchase of raw material ,
wages os causial labour, electricity charges, wear and tear
expenses.
Unit of output variable cost
0 0
1 10
2 18
3 24
4 28
5 32
6 38
0
5
10
15
20
25
30
35
40
0 1 2 3 4 5 6 7
Table shows that as the output goes on increasing the variable
cost also go on increasing.when ouput is zero variable cost are
zero when ouput reaches six unit the variable cost are 38. VC
curve in the diagram is an upward sloping curve. It means that
cost are increasing with increased ouput.
Output FC VC TC(FC+VC)
0 10 0 10
1 10 10 20
2 10 18 28
3 10 24 34
4 10 28 38
5 10 32 42
6 10 38 48
0
10
20
30
40
50
60
0 1 2 3 4 5 6 7

In a table
Total cost is the aggregate of FC & VC with the
increase in output total cost is also increasing.

In diagram ox shows output and oy shows cost
curves.
FC line represents Fixed cost curve and VC is
Variable cost and TC is Total cost. TC & VC curves
are parallel to each other.


Average cost is the cost per unit of ouput
produced. It is also called unit cost of
production.
AC=TC/Q

AC=AFC+AVC

AFC
AFC=TFC/Q


Output Fixed cost AC
1 10 10
2 10 5
3 10 3.3
4 10 2.5
5 10 2
6 10 1.67
7 10 1.42
8 10 1.25
0
2
4
6
8
10
12
0 2 4 6 8 10
The curve slopes down wards to the right AFC curve
represents AFC. It includes that AFC can never be zero so
it is not possible that AFC touches ox axis.
A curve with this property that if we take any point on
AFC curve and multiply the AFC with output the
products is always same as product taken on any other on
the same curve is called rectangular Hyperbola.
Output VC AVC
1 10 10
2 18 9
3 24 8
4 28 7
5 32 6.4
6 38 6.3
7 46 6.6
8 62 7.7
0
2
4
6
8
10
12
0 2 4 6 8 10
AVC resembles english alphabat U upto 6
th
unit curv
is falling because as the output increase AVC falls. The
curve starts moving upward from 7
th
unit.
The space of AVC is U shaped because law of variable
proportion is implemented first. AVC falls then it
becomes constant and finally it raises.

AC is the summation as ( AFC+AVC )
AC=AFC+AVC
It is vertical summation when AC,AFC, are measured on Y axis, It
is vertically adding up the values of AFC & AVC.
Output 01
AVC LT
AFC LK
AC=AVC+AFC=LT+LK=LS
OL1 =AVC=L1T1,AFC
AC=L1T1+L2T2=L1S1
Output L2
AVC=L2T2
AC=L2K1+L2T2=L2T2
s
T
T1
T2
s1
s2
AVC
AC
AFC
L
L1
L2
X
o
K1
k
outpu
t
A
C
,
A
F
C
,
A
V
C

c
o
s
t

Marginal Cost is the addition to total cost due
to addition of one unit of output.
MC =Tcn-Tcn-1
or
MC=TC/ Q
MC curve is short period.

Output FC VC TC MC
0 10 0 10 -
1 10 10 20 10
2 10 18 28 8
3 10 24 34 6
4 10 28 38 4
5 10 32 42 4
6 10 38 48 6
7 10 46 56 8
8 10 62 72 16
0
2
4
6
8
10
12
14
16
18
0 2 4 6 8 10
It is clear from the table is that in the beginning the Mc of every additional
unit goes on diminishing but after a given level of output the MC cost of
every additional unit goes on increasing.
In diagram OX shows output and OY shows MC. MC curve is U shaped in
the initial stages of production Mc is falling but later in it rising because of
Law of variable proportion.
Output TC AC MC
0 10 Infinity -
1 20 20 10
2 28 14 8
3 34 11.3 6
4 38 9.5 4
5 42 8.4 4
6 48 8 6
7 56 8 8
8 72 9 16
0
5
10
15
20
25
0 2 4 6 8 10
AC & MC re caculated from TC
AC=TC/Q
MC=Tcn-Tcn-1
When AC falls, Mc is lower than AC
When AC rises MC is greater than AC
MC cuts AC at its lowest point
Relation between TC & MC
MC is estimated by the differences between TC of two
succassive units of output
MC=Tcn-Tcn-1
When the rate of increase in TC stops diminshing , the
MC is at its minimum.
When the rate of increase in TC start rising , the MC is
increasing.


MC curve should be shown
cutting both AC and AVC at
their lower point.

When AC deblines MC
deblines faster than AC so
MC curve remains below AC
curve.

When AC increases MC
increases faster than AC so
MC curve is above AC curve.

MC must cut AC from its
lowest point.

AC may continue to deblines
even when MC is rising.
MC
AC
AVC
AFC A
Q
Q output
B
c
o
s
t

Long run is a period in which all the inputs
become variable. The long run cost output
relation imply the relationship between the
changing scale of the firm and total output.
Long run total cost curve ( LTC)
All the costs are variable costs in the long
run shape of LTCC remains the same as of
STCC. It first increases at a diminshing rate,
then it tends to increases at a constant rate and
finally it rises at an increasing rate.

Long period TCC starts from the origion
suppose the firm has only one plant and its
short run total cost is STC if there is rise in
demand and firm wants to incrases the output
from Q the firm can increases variable inputs
like labour and raw material. In such case the
short run cost average cost will be high, if
demand lasis for a long period then the firm
will set a new plant i.e. ST2 and ST3 etc. Now
LTC can drawn through the minimum points
of STC1, STC2 and STC3.
The long run AC curve is
decreased by combining the short
run average cost curve. The firm
has a service of SAC curves, each
having a bottom point showing
the minimum Sac. When AC has
one plant C,C1 is maximum if
seconed plant has been set , AC
will decreases from C1Q1 to
C2Q2, When the secones plant is
added rises to C3Q3 after the
addition of the third plant. LAC
curve can be drawn through the
SAC1, SAC2 and SAC3. It is
known as envelop curve or
planning curve.
Q1
Q2

Q3
output
C1
C2
C3
SAC1
SAC2
SAC3
LAC
AC
The long run LMCC is defined from the short run
marginal cost curve.
The deviation of LMC is illustrated in the diagram.
In the long run point ABC determine the output
levels at different level of production i.e. Q1,Q2,Q3.
AQ, cuts SMC1 at M point. It means that at output
OQ1 LMC is MQ1 if output increases from Q1 to Q2
LMC rises to BQ2 and increases in ouput from Q2
to Q3, CQ3 measured the LMC.
LMC must equal to SMC
LAC=SAA is the point of tengency at
point
B=SAC2=SMC2=LAC=LMC

It refers to various quantities of commodity
which a producer will actually offer for sale at
a particular time at various corresponding
prices.
Accoeding to K.E.Boulding- The relation b/w
a price & the quantity supplied is rather like a
relation b/w whistle & dog.Louder the whistle
the faster comes the dog. Raise the price and
quantity supplied increases.
Individual supply refers to supply of a
commodity by an individual firm in the
market. Market supply refers to supply of a
commodity by all the firms in the market
producing/selling that particular commodity.



Supply schedule is a tabular presentation of
various quantities of a commodity offered for
sale corresponding to different possible prices.
It has two aspects (1) Individual Supply
Schedule, (2) Market Supply Schedule.



Individual supply schedule refers to supply schedule of
an individual firm in the market. It shows supply
response of a particular firm in the market.

(2) Market Supply Schedule-Market supply schedule
refers to supply schedule of all the firms in the market
producing/supplying a particular commodity. Sum total
of the firms producing a particular commodity is called
Industry. Thus, market supply schedule refers to the
supply schedule of the industry as a whole. It shows
supply response of all the firms (producing a particular
commodity) in the market.



Supply Curve is a graphic presentation of
supply schedule, indicating positive
relationship between price of a commodity
and its quantity supplied.
(1) Individual Supply Curve
(2) Market Supply Curve

76
Supply function studies the functional
relationship between supply of a commodity
and its various determinants. The supply of a
commodity mainly depends on the goal of the
firm, price of the commodity, price of other
goods, prices of factors of production used in
the production of the commodity and state of
technology.

In other words, supply of a commodity is a
function of several factors as expressed in the
from of the following equation:

S
X
= f (P
X
, P
O
, N
F
, G, P
F
, T E
X
, G
P
)

Here, S
X
= Supply of commodity X;f =
Functional relation; P
X
= Price of commodity X;
P
O
= Price of other goods; N
F
= Number of
firms, G = Goal of the firm, P
F
= Price of factors
of production, T = Technology; E
X
= Expected
future price; G
P
= Government policy)

Price
Price of related goods
Cost of production
State of technology
Goal of producer
Natural factors
Means of transportation
Length of time
Other factors like govt. policy, taxation, fear of
war, strikes, lockouts,change in price.
It shows a direct relationship b/w price supply
of a commodity. The law states that price of a
commodity increase, the quantity of
commodity supplied per unitof time increases
& vice versa. Assuming all other factors
influencing supply remain const.
Change in price is cause & change in supply is
effect.

F
G
2.00
S
40,000 60,000
$4.00
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).
When the price is $2.00
per bottle, 40,000 bottles
are supplied (point F).
Number of Bottles
per Month
Price per
Bottle
There is no change in the prices of the factors of
production.
There is no change in the technique of
production.
There is no change in the goal of the firm.
There is no change in the prices of related
goods.
Producers do not expect change in the price of
the commodity in the near future.

The Law of supply does not apply strictly to
agricultural products whose supply is
governed by natural factors.
Supply of goods having social distinction will
remain limited even if their price may rise high.
Sellers may be willing to sell more units of
perishable goods although their price may be
falling.

Price(RS) Supply(Units)
1 5
2 10
3 15
4 20
A change in the price of a good causes a
movement along the supply curve
In Figure 4
A rise (fall) in price would cause a rightward (leftward)
movement along the supply curve
A drop in transportation costs will cause a shift
in the supply curve itself
In Figure 5
Supply curve has shifted to the right of the old curve (from
Figure 4) as transportation costs have dropped
A change in any variable that affects supplyexcept for the
goods pricecauses the supply curve to shift

S
2
G
J
S
1
60,000
$4.00
80,000
A decrease in transportation
costs shifts the supply curve for
maple syrup from S
1
to S
2
.
Number of Bottles
per Month
Price per
Bottle
At each price, more bottles
are supplied after the shift
Measures the degree to which the quantity
supplied responds to price changes.

% change in quantity supplied of a commodity
ES = -------------------------------------------------------------------
% change in price of the commodity
OR

Change in Qty supplied
----------------------------------------
Original supply
--------------------------------------------------------------------------- 100
Change in price
--------------------------------
Original price

Price elasticity of supply is the measure of change
in supply of a commodity de to change in its price.
Law of supply tells us the direction in which
supply will change as a result of change in price;
that is fall and rise in price will lead to contraction
and extension of supply. But, if we want to know
how much supply will extend due to 10 percent
rise in price, or, in what proportion the supply will
change, then we will have to study price elasticity
of supply. Thus, price elasticity of supply is the
proportionate change in supply consequent upon
proportionate change in price.

The following are the main factors which affect the elasticity of
supply of a commodity:
Nature of the Inputs used
Natural Constraints
Risk Taking
Nature of the Commodity: Perishable goods are relatively less
elastic in supply than durable goods
Cost of Production
Time Factor
Very Short Period
Short Period
Long Period
Technique of Production

Es=0
Es=
Es>1
Es<1
Es=1
Cross Elasticity of supply