FAIPS-DPS, KUWAIT

Introductory Microeconomics: 030

CLASS XI:G CBSE

UNIT 6: PRODUCER BEHAVIOUR AND SUPPLY

CHAPTER 3: PRODUCTION & COST (13 MARKS)

Production: Production is the process by which inputs are transformed into ‘output’.
Production is carried out by producers or firms. It is the transformation of resources into
commodities

Meaning of Production Function: Production function refers to a functional relationship

between physical inputs used and physical output of a commodity produced by a firm..
Y = F (LK)
Here, Y – Production, L = Labour, K = Capital
Short Run
Short run refers to a period in which output can be changed by changing only variable
factors. In the short run, fixed inputs like plant, machinery, building, etc. cannot be
changed. It means, production can be raised by increasing variable factors, but till the
extent of capacity of fixed factors.
Long Run
Long run refers to a period in which output can be changed by changing all factors of
production. Long run is a period, that is long enough for the firm to adjust all its inputs
according to change in the conditions. In the long run, firm can change its factory size,
switch to new techniques of production, purchase new machinery, etc.

VARIABLE FACTORS AND FIXED FACTORS

There are two types of factors of production namely:

(i) Variable Factors; (ii) Fixed Factors.

Variable Factors

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

1. Variable factors refer to those factors, which can be changed in the short run.
For example, raw material, casual labour, power, fuel, etc.
2. Variable factors vary directly with the level of output. As output increases, requirement
for variable factors also rises and vice-versa.
3. Variable factors are not required in case of zero output.
Fixed Factors
1. Fixed factors refer to those factors, which cannot be changed in the short run.
For example, plant and machinery, building, land, etc.
2. The quantity of fixed factors remain same in the short run irrespective of level of output,
i.e. they do not change, whether the level of output rises, falls or becomes zero.
Types of Production Function
The distinction between fixed and variable factors helps us to study the two types of
production function:

Short Run Production Function:

 Short run production function refers to the effect on output when only one input is
changed while keeping other inputs used in production fixed.
 As there is change in one variable input only, the ratio between different inputs tends
to change at different levels of output.
 This relationship is explained by 'Law of Variable Proportions' or ‘Returns to a
factor’.

Long Run Production Function:

 Long run production function refers to the effect on output when all the inputs used
in production are changed simultaneously and in the same proportion.
 As all inputs are variable in the long run, the ratio between different inputs tends to
remain the same at different levels of output.
 This relationship is explained by the ‘Law of Returns to Scale’.

Total Product (TP) or Total Physical Product (TPP): Total product refers to the total
quantity of output produced by a firm in relation to the variable input employed. It is the
sum total of output produced by all the units of a variable factors along with some constant
amount of the fixed factor used in the process of production.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

The total product (TP) curve represents the total amount of output that a firm can produce
with a given amount of labor. As the amount of labor changes, total output changes. The
total product curve is a short-run curve, meaning that technology and all inputs except
labour are held constant. In the example on the left, you plot output/labor combinations
from the total product schedule. The vertical axis is output and the horizontal axis is
labour.

Marginal Product (MP) or Marginal Physical Product (MPP)

Marginal product refers to addition to total product, when one more unit of variable input
is employed.
MPn = TPn – TPn-1
TP = ΣMP (Area under the MP curve is TP)
Where MP = Marginal product of nth unit of variable input
TPn = Total product of n units of variable input
TPn-1= Total product of (n -1) units of variable input
MP = ΔTP/ ΔVI
Where TP is Total Product and VI is units of variable input
MP is the rate of change of TP for a given change in variable input

Average Product (AP) or Average Physical Product (APP): Average product refers to
output per unit of variable input.

Average Product (AP) =

TP = AP x Units of Variable Input

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

PRACTICE

Calculate AP, MP:

Unit of labour 1 2 3 4 5 6 7
TP 20 36 48 56 60 60 56
Complete the table:

Unit of labour TP AP MP
1 18
2 16

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

3 14
4 12
5 -5

RETURNS TO A FACTOR
Returns to a factor refers to the increase in the total product (return) when only one input is
increased, keeping all other factors fixed.
LAW OF VARIABLE PROPORTIONS
Law of Variable Proportions states that as we increase quantity of only one input keeping
all other inputs fixed, total product (TP) initially increases at an increasing rate, then at a
decreasing rate and finally falls.

Assumptions of Law of Variable Proportions

1. It operates in short run, and factors are classified as variable and fixed factors.
2. It is assumed that the factors of production become imperfect substitutes of each other
beyond a certain limit.
3. The state of technology is assumed to be constant.
4. It is assumed that all units of variable factor are equally efficient

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

According to the Law of Variable Proportions, the changes in TP and MP can be classified
into following three Phases:
Phase I: TP rises at increasing rate. MP increases (Increasing Returns to a Factor)
Reasons for Phase I: In the first phase,(till 2nd unit of variable input) every additional
variable factor adds more and more to the total output.
[In phase I, TP increases at increasing rate (till point ‘Q’) and MP rises till it reaches its
maximum point ‘P’, which marks the end of first phase.]

1. Better Utilization of the fixed factor: In the first phase, the supply of the fixed factor
(say, land) is too large, whereas variable factors are too few. So, the fixed factor is not fully
utilised. When variable factors are increased and combined with fixed factor, then fixed
factor is better utilised and output increases at an increasing rate.

2. Specialisation of variable factor: When variable factors are increased and combined
with the fixed factor, there is greater cooperation and high degree of specialization between
different units of the variable factor, as a result efficiency of variable factor increases.

NOTE: Phase II and III together constitute Diminishing Returns to a Factor

Phase II: TP rises at decreasing rate. MP decreases but is positive. (DRF)
Reasons for Phase II : In the second phase (from 2 units to 5 units of variable input),
every additional variable factor adds lesser and lesser to the total output.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

[In phase II, TP increases at a decreasing rate from Q to M and ends where TP is maximum
(point ‘M’) at 52 units and at point ‘S’, when MP is zero.]

1. Use beyond optimum combination of factors: Among the different combinations

between variable and fixed factor, there is one optimum combination, at which marginal
product is maximum. Beyond this combination, the marginal product begins to diminish.

2. Over-utilization of fixed factor: As we keep on increasing the variable factor with the
other factors fixed, eventually a point comes when over-utilisation of fixed factor starts
giving diminishing returns.

3. Imperfect Substitutes: Diminishing returns to a factor occurs because fixed and variable
factors are imperfect substitutes of one another. There is a limit to the extent of which one
factor of production can be substituted for another. But, beyond the optimum limit, they
become imperfect substitutes of one another, which leads to diminishing returns.

Phase III: TP falls. MP falls and turns negative. (DRF – Negative returns to factor)
Reasons for Phase III: In the third phase (after the 5th unit of variable input), the
employment of additional variable factor causes TP to decline.
[The phase III starts after point ‘S’ on MP curve and after point ‘M’ on TP curve.]

1. Excessive pressure on fixed factors: The negative returns to a factor apply because
some factors of production are of fixed nature, which cannot be increased with increase in
variable factor in the short run. Hence the per unit availability of fixed input for each
variable factor keeps on declining leading to negative MP.

2. Decrease in efficiency of variable factor: With continuous increase in variable factor,

the advantages of specialization and division of labour start diminishing. It results in
inefficiencies of variable factor, which is another reason for the negative returns to
eventually set in.
RELATIONSHIP BETWEEN TP & MP
1. MP is increasing ,TP is increasing at increasing rate
2. When MP starts diminishing, TP increases only at a diminishing rate.
3. When TP is maximum MP is zero
4. When MP is negative ,TP starts declining.
RELATIONSHIP BETWEEN AP & MP
1. AP increases as MP > AP ,it happens where AP is at its top.
2. AP decreases when MP<AP , it happens where AP is at its top.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

3. AP is maximum when AP= MP, it happens when MP curve cuts AP from its top.MP
may be zero or negative, but AP continues to be positive.
Phase of operation by a rational producer:

A rational producer will always seek to operate in Phase II of Law of Variable

Proportions.
 In Phase I, employment of every additional unit of variable factor gives more
and more output i.e. marginal product increases. It means, there is scope for
more profits, if production is increased with more units of variable factor.
 In Phase III, marginal product of each variable factor is negative. So, this
phase is ruled out on the ground of technical inefficiency and a rational
producer will never produce in the third phase.
LAW OF DIMINISHING RETURNS
Law of diminishing returns states that when more and more units of a variable input are
employed along with fixed inputs, then marginal product of the variable factor must fall.
It includes Phase II and Phase III of Law of Variable Proportions
The difference between Law of Variable Proportion and Law of Diminishing Returns is
that the Law of Variable Proportions includes Phase I of increasing returns to factor which
is not included in the latter.
Relationship between AP and MP
1. When MP is greater than AP, AP rises.
2. When MP is equal to AP, AP is constant and maximum.
3. When MP is less than AP, AP falls.

At what point does the MP curve cut AP curve?

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

The MP curve cuts AP curve from above at its maximum point. This is because as long as
MP is greater than AP, AP increases.
Similarly, when MP is less than AP, AP falls. It, therefore, follows that MP curve cuts AP
curve from above at its maximum point where MP is equal to AP and AP is constant and
maximum.
Relationship between TP and MP
Marginal products (MP) are additions to total product (TP), therefore, at any level of
employment of an input, TP is the sum of MPs of all units of that input, i.e., TP = ΣMP.
• When MP increases, TP increases at an increasing rate.
• When MP decreases but remains positive , TP increases at a decreasing rate.
• When MP becomes zero, TP is maximum.
• When MP falls and becomes negative, TP also falls.
Postponement of law
2:COST
MEANING OF COST IN ECONOMICS
Cost is the total expenditure incurred in producing a commodity.
Economic Cost is the sum of actual or direct expenditures on hired inputs (i.e. explicit
cost) and the imputed value of the inputs supplied by the owners (i.e. implicit cost)
including normal profits.
1. Explicit Cost: It is the actual or direct expenditures on hired inputs. For example, wages
paid to the employees, rent paid for hired premises, payment for raw materials,
depreciation, taxes on production etc.

2. Implicit Cost: It is the imputed value of the inputs supplied by the owners including
normal profit. For example, imputed interest on owner’s capital, imputed rent of owner’s
land, imputed salary of owner’s managerial services, etc. Such costs are the costs of owner
supplied factors.

Normal Profits is the minimum level of profits that the producer must get in order to stay
in the line of business.
NOTE: 'Normal Profit' is also treated as part of the Implicit Cost.
Cost Function
Cost function refers to the functional relationship between cost and output produced of a
commodity.
C = f (Q) (Where: C = Cost of production, Q = Units of output)
Opportunity Cost
Opportunity cost is cost of the next best alternative foregone.
SHORT RUN COSTS

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

Short run cost is defined as the cost of producing a given level of output of a good keeping
some inputs fixed and others variable. Short run costs are of two types:
(i) Fixed Costs (ii) Variable Costs
The sum total of fixed cost and variable cost is equal to total cost.
TOTAL FIXED COST (TFC)

Fixed Costs refer to those costs which do not vary with the level of output.
Fixed Cost is also known as: (i) Supplementary Cost; or (ii) Overhead Cost
Fixed cost is incurred on fixed factors like machinery, land, building, etc., which cannot be
changed in the short run. For example, rent of premises, interest on loan, salary of
permanent staff, license fees etc.

Shape of TFC curve: TFC curve is parallel to the x-axis as fixed cost remains same for all
levels of output even at zero level of output.

TOTAL VARIABLE COST (TVC)

Variable costs refer to those costs which vary directly with the level of output.
• Variable costs are incurred on variable factors like raw material, labour, power, etc, which
changes with change in level of output.
• Variable costs rise with increase in the output and fall with decrease in the output.
For example, payment for raw material, power, fuel, wages of casual labour, etc.
TVC is zero at zero level of output as no variable input is employed. So, TVC curve starts
from origin.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

Shape of TVC curve: The TVC curve is inverse S-shaped due to the Law of Variable
Proportions. TVC initially increases at a decreasing rate and then at an increasing rate.
 In the first phase of Law of Variable Proportions, when there are increasing returns
to factor, due to increase in efficiency of variable input and better utilisation of fixed
inputs, each additional unit of output is produced at a lower cost as compared to the
previous unit. Hence variable cost increases at a decreasing rate.
 In the second and third phase of Law of Variable Proportions, when there are
decreasing returns to factor resulting in a fall in efficiency of variable input due to
over-utilisation of fixed inputs, each additional unit of output is produced at a higher
cost as compared to the previous unit. Hence variable cost increases at an increasing
rate

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

TOTAL COST (TC)

Total Cost (TC) is the total expenditure incurred by a firm on the factors of
production required for the production of a commodity.
TC is the sum of total fixed cost (TFC) and total variable cost (TVC) at all levels of output.
TC = TFC + TVC
Since TFC remains same at all levels of output, the change in TC is entirely due to TVC

 In the given schedule, TC = TFC = 12 at zero level of output because TVC is zero.
 At first unit of output, TFC remains same at 12, but TVC increases to 6. As a result,
TC becomes 12 + 6 = 18. Similarly, other values of TC have been calculated.

Any change in TC curve is due to a change in TVC as TFC is constant for all levels of
output, hence the TC curve is also inverse S-shaped, due to the Law of Variable
Proportions.
Relationship between TC, TFC and TVC

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

1. TC curve lies above TVC and TFC curves as TC is a vertical summation of TVC and
TFC curves.

2. At zero level of output, TC is equal to TFC because there is no variable cost (TVC is
zero at zero level of output). So, TC and TFC curves start from the same point, which is
above the origin while TVC starts from the origin.

3. TC and TVC curves are parallel to each other and the vertical distance between them
remains the same at all levels of output because the gap between them represents TFC,
which remains constant at all levels of output.

4. The vertical distance between TC curve and TFC curve is equal to TVC. As TVC rises
with increase in the output, the distance between TC and TFC curves also goes on
increasing.

AVERAGE COSTS
There are three types of average costs namely:

1. Average Fixed Cost (AFC)

2. Average Variable Cost (AVC)
3. Average Total Cost (ATC) or Average Cost (AC)

AVERAGE FIXED COST (AFC)

Average fixed cost refers to the per unit fixed cost of production.

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Introductory Microeconomics: 030
CLASS XI:G CBSE

Shape of AFC Curve: AFC is a rectangular hyperbola (areas of rectangles formed under
the curve are equal. AFC x Q = TFC which is constant for all levels of output), it
approaches both the axes. It gets nearer and nearer to the axes, but never touches them.
 AFC can never touch the X-axis i.e. AFC can never be zero as AFC = TFC/Q and
TFC can never be zero in the short run.
 AFC curve can never touch the Y-axis because at zero level of output, TFC is a
positive value and any positive value divided by zero will be an infinite value.
 AFC falls with increase in output as AFC= TFC/Q and TFC remains same for all
levels of output.

AVERAGE VARIABLE COST (AVC)

Average variable cost refers to the per unit variable cost of production

Shape of AVC Curve: AVC curve is U-shaped due to the Law of Variable Proportions.
AVC initially falls with increase in output, reaches a minimum and then starts rising.

AVERAGE TOTAL COST (ATC) OR AVERAGE COST (AC)

Average Cost Refers To the Per Unit Total Cost Of Production.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

• In the
above given table, AC is calculated by adding AFC and AVC.

• AC curve is obtained by a vertical summation of AFC and AVC curves.

Shape of AC Curve: AC curve is also U-shaped due to the Law of Variable Proportions.
AC initially falls with increase in output, reaches a minimum and then starts rising.
Relationship between AC, AVC and AFC

1. AC curve will always lie above the AVC and AFC curve because AC, at all levels of
output, is a vertical summation of AVC and AFC curves.

2. The minimum point of AC curve (point A) lies to the right of the minimum point of
AVC curve (point B) since even when AVC starts rising, AFC is still falling. AC rises only
when the rise in AVC is more than the fall in AFC.

3. As the output increases, the gap between AC and AVC curves decreases because the
vertical distance between them is AFC, which decreases with increase in output.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

4. As the output increases, AC and AVC curves never intersect each other because the
vertical distance between them is AFC, which can never be zero in the short run.

MARGINAL COST
Marginal cost refers to the addition to total cost when one more unit of output is
produced.
MCn = TCn - TCn-1
Also, MCn = TVCn - TVCn-1
Where: n = Number of units produced MCn = Marginal cost of the nth unit
TCn = Total cost of n units TCn-1 = Total cost of (n - 1) units.
TVCn = Total variable cost of n units TVCn-1 = Total variable cost of (n - 1) units.

MC is not affected by Fixed Costs

We know, MC is the addition to TC when one more unit of output is produced. We also
know, TC = TFC + TVC. As TFC does not change with change in output, MC is
independent of TFC and is affected only by change in TVC.
• Area under the MC curve is TVC: MC = ΣTVC

Shape of MC curve: The MC curve is U- shaped due to the Law of Variable

Proportions
The MC curve first falls, reaches a minimum and then starts rising.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

In the first phase of LVP, when there are increasing returns to factor, due to increase in
efficiency of variable input and better utilisation of fixed inputs, each additional unit of
output is produced at a lower cost as compared to the previous unit. Hence an addition to
cost falls or MC falls.
• In the second and third phase of LVP, when there are decreasing returns to factor
resulting in a fall in efficiency of variable input due to over-utilisation of fixed inputs, each
additional unit of output is produced at a higher cost as compared to the previous unit.
Thus, additions to cost increases or MC rises.

RELATIONSHIP BETWEEN SHORT RUN COST CURVES

RELATION BETWEEN MC & AC

1. When MC is less than AC, AC falls with increase in the output.

2. When MC is equal to AC (when MC and AC curves intersect each other), AC is
constant and at its minimum point.
3. When MC is greater than AC, AC rises with increase in output

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

Relation between TC & MC

1. MC is estimated as difference b/w TC of two successive units of output i.e MCn = TCn
– TC n-1.
2. When MC is diminishing, TC increases at a diminishing rate.
3. When MC is rising, TC increases at an increasing rate.
4. When MC reaches its lowest point (Q) TC stops increasing at a decreasing rate.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

• Between AC and AVC

1. AC is greater than AVC by the amount of AFC.
2. AC and AVC curves approach each other with increase in output because the vertical
gap between them is AFC, which continues to decline with rise in output.
3. AC and AVC curves never intersect each other as the gap between them is AFC and
AFC can never be zero in short run.
4. The minimum point of AC curve (point A) lies to the right of the minimum point of
AVC curve (point B) since even when AVC starts rising, AFC is still falling. AC rises only
when the rise in AVC is more than the fall in AFC.
5. Both AC and AVC curves are U-shaped due to the Law of Variable Proportions.

• With MC
1. When MC is less than AVC (or AC), AVC (or AC), falls with increase in the output.
2. When MC is equal to AVC (or AC), AVC (or AC), is constant and at its minimum point.
[MC curve cuts AVC and AC curves at their minimum points.]
3. When MC is greater than AVC (or AC), AVC (or AC) rises with increase in output.
REVENUE
Revenue:

What is revenue?
Revenue is the earning that an enterprise has from its normal business pursuits, usually
from the sale of commodities, and services to consumers. Revenue is also mentioned and
referred to as turnover or sales. A few companies get revenue from royalties, other fees, or
interests.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

An enterprise believes that it can sell as many quantities of the commodity as it requires by
setting a cost price less than or equivalent to the market cost price. In such a case, there is
no logic to set a cost price lower than the market cost price. In other words, the enterprise
should sell some amount of the commodity so that the cost price it sets is exactly
equivalent to the market cost price.

• Total Revenue (TR)

Total Revenue refers to total receipts from the sale of a given quantity of a
commodity.
Total revenue is the total receipts a vendor can procure from selling commodities or
services to the customers. It can be mentioned as P × Q, which is the cost price of the
commodities multiplied by the amount of the commodities sold. So, the total revenue (TR)
of an enterprise is defined as the market cost price of the commodity (p) multiplied by the
enterprise’s output (q).
Total Revenue = Quantity of Output x Price
• Average Revenue (AR)

Average revenue refers to revenue per unit of output sold.

AR and Price are the same

• Marginal Revenue (MR)

Marginal revenue is the addition to total revenue when one more unit of output is sold.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

It is the change in TR from sale of one more unit of a commodity.

MRn = TRn-TRn-1

The relationship between different revenue concepts can be discussed under two situations:
(i) When price remains constant (Perfect Competition).

It means that the producer can sell any quantity of a commodity at the same per unit price.
(ii) When price falls with rise in output (Imperfect Competition).

The producer can sell higher units of output of a commodity only by reducing the price.

• Relationship between TR and MR

When price remains constant, firms can sell any quantity of output at the price fixed by the
market. As a result, MR curve (and AR curve) is a horizontal straight line parallel to the X-
axis. Since MR remains constant, TR also increases at a constant rate.
• Relationship between TR and Price line

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

When price remains constant at all the levels of output, then Price = AR = MR. Therefore,
price line is the same as MR curve.
Also, TR = MR. So, the area under MR curve or price line will be equal to TR.
• Relationship between AR and MR
When price remains same at all output levels, the revenue from every additional unit (MR)
is equal to AR. As a result, both AR and MR curves coincide in a horizontal straight line
parallel to the X-axis.
Price line
The horizontal straight line where AR = MR is called the price line. It is also the firm’s AR
curve under perfect competition.
The price line also depicts the demand curve facing a firm. This means that a firm can sell
as many units of the good as it wants to sell at the same price p.
Case 2: When price falls with increase in output
• Relationship between TR and MR

When more of output can be sold only by lowering the price, then revenue from every
additional unit (i.e. MR) will also fall.
MR is the addition to TR when one more unit of output is sold.

The relationship can be summed up as under:

1. When MR falls but is positive, TR increases at a diminishing rate.

2. When MR is zero, TR is at its maximum point.
3. When MR falls and becomes negative, TR starts falling.

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 FAIPS-DPS, KUWAIT
Introductory Microeconomics: 030
CLASS XI:G CBSE

• Relationship between AR and MR

When firms can sell higher units of output only by reducing the price, AR falls with
increase in output sold.
It means, revenue from every additional unit sold (i.e. MR) will be less than AR. (MR <
AR)
As a result, both AR and MR curves slope downwards from left to right

The rate of fall in MR is twice that of AR. (Marginal rise and fall faster than Averages)
hence MR is steeper than AR and MR always lies below AR.
MR can be negative or zero, but AR is the price and hence is always positive.
• General Relationship between AR and MR
1. When MR is greater than AR, AR increases.
2. When MR is equal to AR, AR is maximum and constant.
3. When MR is less than AR, AR falls.

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