Consumer Behaviour :

Ordinal Approach

BLOCK 3 PRODUCTION AND COSTS

141
Theory of
Consumer
BLOCK 3 PRODUCTION AND COSTS
Behaviour
Block 3 develops the theory of the firm and explains the laws that are observed
in course of production. This will enable you to know how firms combined
inputs such as capital, labour and raw materials to produce goods and services
in a way that minimises costs of production. In this process various concepts
like production function, Iso product curves, Iso-cost lines etc have been
explained.
The block comprises four units. Unit 7 throws light on production function
with one variable input, and discusses the law of variable proportions. Unit 8
deals with the Properties of isoquants and optimal combination of factors and
producer’s equilibrium. The economic region of production and ridge lines and
the expansion path have also been discussed. Unit 9 covers the production
function in the event all the inputs vary and hence application of returns to
scale. Unit 10 discusses the cost side of production considering different types
of costs.

142
UNIT 7 PRODUCTION WITH ONE
VARIABLE INPUT
Structure
7.0 Objectives
7.1 Introduction
7.2 Total, Average and Marginal Products
7.3 Total, Average and Marginal Product Curves
7.4 The Law of Variable Proportions: Returns to a Factor
7.4.1 The Three Stages of Production
7.4.2 Explanation of Increasing Returns
7.4.3 Explanation of Constant Returns
7.4.4 Explanation of Diminishing Returns

7.5 Let Us Sum Up

7.6 References
7.7 Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you will be able to :
state the concept of total product, average product and marginal product;

explain the nature and relationship of total, average and marginal product
curves;
analyse the operation of the law of variable proportions; and
identify the three stages of production.

7.1 INTRODUCTION
For the purpose of production, we require a combination of various inputs or
factors of productions. It is only with the joint efforts of these inputs (like
labour, machines, land, raw materials etc.) that output is produced. Normally,
production is carried out under conditions of variable proportions which
implies that the rate of input quantities may vary. Fixed proportions production
means that there is only one ratio of inputs that can be used to produce a good.
For example, only one driver can work one truck. In this case, the ratio of
driver and truck is technologically determined and is fixed. It is beyond the
capabilities of the producer to change it. However, the ratio of land and labour
in agriculture can be changed and is thus regarded as variable. In the short run,
not all inputs are variable. In the long run, however, all inputs are variable and
the ratio of inputs may also vary. This is the case of technological Progress. In
this unit, we shall focus only on short run production. In the short run, for the

*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi. 143
Production purpose of analysis, it is often assumed that only one input is variable and all
and Costs other inputs are fixed. We shall follow this convention.

7.2 TOTAL, AVERAGE AND MARGINAL

PRODUCTS
At the outset we shall explain the concept of total, average and marginal
products. The short run production function, whether it is shown as a table, a
graph or as a mathematical equation, gives the total output obtainable from
different quantities of the variable inputs given a specified amount of the fixed
input. Let us now consider the case in which capital is fixed, but labour is
variable, so that the firm can produce more output by increasing the labour
input. For example, consider a firm manufacturing garments. It has a fixed
amount of equipment, but it can hire more or less labour to operate the
machines. For decision making, the firm’s manager (or owner) must know how
the amount of total output or product (Q) increases (if at all) as the labour input
(L) increases. Table 7.1 provides this information about the production
function.
Table 7.1 shows the output that can be produced with different amounts of
labour and with capital fixed at 5 units. The first column shows the fixed
amount of capital, the second shows the amounts of labour from zero to 10
units and the third shows total product or output. From the table, it is clear that
when labour input is zero, output is zero because capital alone cannot produce
anything. Then, upto a labour input of seven units output increases first at an
increasing rate and then at a decreasing rate in response to increased use of
labour. The eighth unit of labour input does not raise output. Whether firm
applies 7 or 8 units of labour input to a fixed amount of capital input, total
output remains 224 units. Beyond this point using more units of labour input is
counter productive because output declines as use of labour is increased.
Table 7.1: Production with One Variable Input

Amount Amount of Total Average Marginal

of Capital Labour Product or Product Product
(K) (L) Output (Q) (Q/L) (
5 0 0 -- --
5 1 20 20 20
5 2 60 30 40
5 3 120 40 60
5 4 160 40 40
5 5 190 38 30
5 6 216 36 26
5 7 224 32 8
5 8 224 28 0
5 9 216 24 -8
5 10 200 20 -16
Although the figures provided in Table 7.1 are hypothetical, the general
relationship they indicate is common. To examine the relationship further, we
144 introduce the concepts of average product and marginal product of an input.
The average product (or average physical product) of an input can be Production with One
defined as total output (or total product) divided by the amount of input Variable Input
used to produce that output. For example, 4 units of labour input produce
160 units of output, so the average product of labour is 40 units of output per
worker at that level of employment. In a more general way, we may express

APL =

where, APL = average product of labour

Q = total output or total product
L = amount of labour
The fourth column in Table 7.1 shows the average product of labour (APL).
The average product for each quantity of labour is derived by dividing total
output shown in column 3 by corresponding amount of labour in column 2 that
produces each output level. In our illustration, the average product of labour
increases initially but when labour input exceeds 4 units, it tends to fall.
The marginal product (or marginal physical product) of an input is
defined as the change in total output due to a unit change in the use of an
input while quantities of other inputs are held constant. For example, with
capital fixed at 5 units when the amount of labour increase from 3 to 4 units,
total output rises from 120 to 160 units or by 40 units. So the marginal product
of labour, when fourth unit of labour input is employed, is 40 units of output.
We may thus generalise,

MPL=

where, MPL = Marginal product of labour

Q = Change in output
L = Change in labour input
In Table 7.1, the fifth column shows the marginal product of labour. It may be
noted that like the average product, the marginal product increases initially and
then falls and finally becomes negative. In the present example, the marginal
product of labour becomes negative when labour input exceeds 8 units. This
happens when the variable input is used too intensively with the fixed input.
The marginal product is greater than average product when average
product is rising, equals average product when average product is at
maximum, and is less than average product when average product is
falling.

This proposition is, in fact, true of all marginal and average relationships.

7.3 TOTAL, AVERAGE AND MARGINAL

PRODUCT CURVES
Fig. 7.1 plots the information provided in Table 7.1 (it has been assumed in
drawing the graphs that both labour input and the product are divisible into
smaller units and thus the relationships are smooth curves rather than discrete
points). The total product curve shown in Fig. 7.1 indicates how the total
145
Production product varies with the quantity of labour input used. As indicated in Table 7.1,
and Costs Fig. 7.1 a also shows that first the total output increases at an increasing rate
upto point E as more labour is used. The point E where total product stops
increasing at an increasing rate and begins increasing at a decreasing rate is
called the point of inflexion. Total product reaches a maximum at 224 units
when 7 units of labour input are used. The use of an additional unit of labour
input at this stage does not lead to any increase in total product. Beyond this
point, further use of labour input results in a fall in total product.
That portion of total product curve (TP) is shown by dashed segment which
indicates a decline in output as a result of increased employment of labour. In
Fig. 7.1 a when labour input is expanded beyond eighth unit, output falls which
means that production is not technically efficient and is thus not a part of the
production function.
Fig. 7.1 b shows the average and marginal product curves for labour. (The
units of the vertical axis have been changed from output per period of time to
output per unit of labour). Hence, average product and marginal product curves
measure the output per unit of labour. It may be noted that as the use of labour
input increases, initially the marginal product of labour increases, reaches a
maximum at 3 units of labour, and then declines. The marginal product of
labour in our example becomes zero at 8 units of labour and thereafter turns
negative. However, technical efficiency rules out the possibility of negative
marginal products and is, therefore, not a part of the production function. The
average product of labour also increases initially, reaches a maximum at 4 units
of labour input, and then declines.
Relationship between MP and AP Curves:
Let us now consider the relationship between the marginal and average product
curves. As is true of all marginal and average curves, there are definite
relationships between the marginal and average product curves.
i) When marginal product increases, average product also increases though
at a rate lower than that of the marginal product. It is important to note in
this context that even when marginal product starts declining but remains
greater than the average product, the latter shows a tendency to increase.
ii) When the average product is maximum, the marginal product is equal to
it. This is the reason why the marginal product curve intersects the
average product curve at its highest point.
iii) Beyond this point, when the marginal product declines, it also pulls down
the average product. However, the rate of decline in the average product
is less than that of the marginal product.
Relationship between TP and MP Curves
The relationship between the total product curve and the marginal product
curve can be stated as under:
i) As long as marginal product is positive, total product curve will continue
to rise.

146
 Production with One
Variable Input

Fig 7.1: Production with one variable input (labour). In the upper part of the figure, the
total product curve (TP) of labour is shown. The lower part of the figure shows how
average product curve (AP) of labour and marginal product curve (MP) of labour are
obtained with the help of information contained in the upper part

ii) When marginal product is zero, total product curve reaches its highest
point. It may be noted that when eighth unit of labour input is employed,
marginal product of labour becomes zero and total product is at the
maximum.
iii) Thereafter, marginal product of labour is negative and total product curve
has a downward slope which means that total product falls.
Check Your Progress 1
1) Indicate the following statement as true (T) or false (F):
i) The marginal product is greater than average product when average
product is falling.
ii) As long as marginal product is rising, total product curve will
continue to rise.
2) Discuss the relationship between the marginal and average product
curves.
....................................................................................................................
....................................................................................................................
....................................................................................................................
147
Production
and Costs
7.4 THE LAW OF VARIABLE PROPORTIONS:
RETURNS TO A FACTOR
Knowledge regarding the conditions of production reveals that as more and
more of some input is employed, all other input quantities being held constant,
normally marginal and average product (of the variable input) increase upto a
point. Thereafter, marginal product starts declining and this pulls down the
average product also. In the production process generally land, capital
equipment and buildings remain fixed in the short run while quantities of
labour and raw materials can be conveniently varied. However, we may
consider a case where amount of capital is fixed and the quantity of labour is
increased.
i) In this case, initially the marginal product of labour will increase as its
amount is increased and the marginal product will also pull up average
product with it. In this situation, total product increases at an increasing
rate.
ii) If the variable input, say, labour is further increased, marginal product
stops increasing after a point. Therefore, the rate of increase of total
product also shows a tendency to fall.
iii) Ultimately marginal product turns negative and this causes a fall in total
product itself.
Since in the short run, changes in technology are ruled out, the tendency of
marginal product to decline after a point is inevitable. This statement of trends
in marginal product in response to changes in the quantities of a variable factor
applied to a given quantity of a fixed factor is called the law of diminishing
returns. It is also called the law of variable proportions because it predicts the
consequences of varying the proportions in which factors of production are
used. we can sum up the law of variable proportions as follows:
“As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point the
resulting increments of product will decrease, i.e, the marginal product
will diminish.”
The law of variable proportions can be easily followed with the help of Table
7.1 and Fig. 7.1 which has been drawn on the basis of illustration given in
Table 7.1. In Table 7.1, it has been assumed that capital is a fixed factor and its
quantity remains unchanged at 5 units. Labour is the variable factor and its
quantity increases from 1 to 10. It can be seen from Table 7.1.
i) As the amount of labour employed increases, the total output also
increases until the seventh unit of labour is employed. Initially the
increase in output takes place at an increasing rate because marginal
product rises. This tendency is observed upto the point E where marginal
product reaches a maximum. At point E, which is the point of inflexion,
the rate of increase in total product switches from increasing to
decreasing because marginal product begins to diminish. However,
average product continues to increase until it reaches a maximum at point
F on total product curve (point J on average product curve).
ii) When the amount of labour is further expanded, total product continues
to increase though at a diminishing rate. Both marginal product and
148
 average product remain positive, but both continue to diminish. Production with One
Eventually, total product reaches a maximum at point G and the marginal Variable Input
product becomes zero (note point K in Fig. 7.1 b). The average product,
however, remains positive but continues to diminish.
iii) Any attempt to increase output beyond this point by employing more
units of labour will not be fruitful. In fact, it will be counter-productive
because marginal product is negative which implies that total product
diminishes.
Product curves such as the one shown in Fig. 7.1 are general representations of
production function with fixed and variable inputs. To illustrate particular
instances, similar product curves could be drawn, though each different from
others in some way. The stage of increasing marginal product may be long or
brief or can be totally absent. Moreover, when marginal product diminishes,
the rate at which it happens may be different in each case. Table 7.2 sums up
the law of variable proportions.
Table 7.2: Properties of Product Curves

Marginal Average
Total Product Figure 7.1
Product Product
Stage I
first increases at Increases Increases to point E
increasing rate

then rate of reaches a continues at points E and H

increase changes maximum, and increasing
from increasing then starts
to diminishing diminishing
Stage II
continues to continues reaches a at points F and J
increase at diminishing maximum where
diminishing rate it equals MP and
then starts
diminishing

reaches a
maximum and continues
diminishing at points G and
then starts
becomes zero K
diminishing
Stage III
diminishes is negative continues to right of points
diminishing J and K

7.4.1 The Three Stages of Production

Normally when the amount of a variable input is expanded, the marginal
product first rises and then falls and the product curves have the shapes shown
in Fig. 7.1. Conventionally, these product curves are partitioned into three
regions, shown as Stages I, II and III in Fig. 7.1.

149
Production Stage I is characterised particularly by the rising average product. In our
and Costs example, Stage I occurs when labour is employed from 1 to 4 units. In Stage 1,
total product first increases at an increasing rate and thus marginal product
rises. It reaches a maximum at labour input of 3 units. When fourth unit of
labour input is employed, diminishing returns set in implying that total product
increases at a diminishing rate and the marginal product falls.
In Stage II, total product increases at a diminishing rate and thus both marginal
product and average product decline. Marginal product being below the
average product, pulls the latter down. The right-hand boundary of Stage II is
at maximum total product where marginal product reaches zero. In our
example, Stage II ranges from 4 to 8 units of labour.
In Stage III, total product falls and marginal product is negative. In our
example, stage III occurs when labour is employed in excess of 8 units.
Actual Stage of Operation
The rational producer will operate in Stage II. It is not difficult to follow why
production will not be done in Stage III. In Stage III, less output is produced by
using more of the variable input which means that production costs would be
higher in Stage III than they were in Stage II. Obviously, any rational producer
will always avoid such inefficiencies in the use of production inputs.
In Stage I, average product of the variable input is increasing. Therefore, if the
amount of variable input is doubled, the output more than doubles and the unit
cost of producing output decreases. If a firm is operating in a competitive
market, it would avoid producing in this stage because by expanding output it
reduces the unit costs while the price it receives remains same for each
additional unit sold. This means that total profits increase if production is
expanded beyond the region of rising average product.
To sum up we can say: Initially, the variable factor-labour is not able to use all
the capacities of the fixed factor, hence MP and AP remain low. For instance,
one worker may not be able to make full use of the potential of a one hectare
plot of land. But two workers, together are is a better position to work on that
field. Hence rise in MP as Labour increases from 1 to 2.
Thus, any rational producer will operate in the second stage only when the law
of diminishing marginal return operates. This is why the law of variable
proportions is also called the Law of Diminishing Marginal Returns to a factor.

7.4.2 Explanation of Increasing Returns

According to modern economists, when in the initial stage of production
quantity of the variable factor is increased, the tendency of increasing returns
in production operates. The classical economists had also observed this
tendency and had termed it as the Law of Increasing Returns. However, they
felt that this law operated only in manufacturing industries. As against this, the
modern economists believe that this law can operate in any area of economic
activity. Below we give the views of Marshall (representing the former
position) and Joan Robinson (representing the latter position) in this regard.
Marshall opined that the tendency of increasing returns operates only in the
manufacturing industries. He believed that when the quantity of labour and
capital employed in the manufacturing industries is increased, the scale of
150
production expands and this leads to a better organisation of production. In Production with One
Marshall’s own words: Variable Input

“An increase in labour and capital leads generally to improved

organisation, which increases the efficiency of the work of labour and
capital... Therefore, in those industries which are not engaged in raising
raw produce, an increase in labour and capital generally gives a return
increased more than in proportion.”

Joan Robinson’s explanation of the tendency of increasing returns is more

scientific. She states:

“When an increased amount of any factor of production is devoted to a

certain use, it is often the case that improvements in organisation can be
introduced which will make natural units of the factor (men, acres or
money capital) more efficient, so that an increase in output does not
require a proportionate increase in the physical amount of the factors.”
From the above statement of Joan Robinson, it is clear that:
1) The tendency of increasing returns operates not only in manufacturing
industries but in all productive activities. Limiting the application of this
tendency to manufacturing industries alone is wrong.
2) The tendency of increasing returns comes into operation because the
efficiency of the factors of production is improved.
Let us now examine in detail why the tendency of increasing returns operates.
1) Optimum combination of factors of production: According to Joan
Robinson, full exploitation of some indivisible factors of production is
not possible until increased quantities of some other factors of production
are employed. Therefore, when the producer engages a small quantity of
different factors of production, an optimum proportion among them is not
established and the level of production remains low. When he increases
the quantities of those factors of production, which were employed less
(in relation to the requirements of optimum production), marginal product
increases till the point is reached where the factors are combined in
optimum proportion. Naturally, at this point, output level is the
maximum.
2) Large size of fixed factors: When the size of the fixed factors used for
producing a given good is very large while the quantity of the variable
factor used is very small, the level of efficiency remains very low. As
more and more quantities of the variable factors are employed, marginal
productivity increases (since the level of efficiency increases). For
example, if only one person is working on a ten hectare plot of land, his
productivity will be very low. As the number of workers increases,
division of labour and specialisation will lead to increasing returns as
marginal product will rise rapidly.

7.4.3 Explanation of Constant Returns

If even on continuously increasing the quantity of variable factors of
production in a firm, the marginal product neither increases nor decreases but
151
Production remains constant, the tendency of constant returns is in operation. In fact, there
and Costs is no industry in which increase in the quantity of variable factors of
production yields constant returns permanently. According to Marshall, “if the
actions of the law of increasing and diminishing returns are balanced, we have
the law of constant returns.”
Marshall feels that the operation of the law of constant returns is very limited.
According to him, this law can operate only when there is a balance between
the tendencies of increasing returns and diminishing returns. However, modern
economists regard the area of operation of constant returns as fairly large.
According to them, tendency of constant returns is generally found to operate
before the tendency of diminishing returns sets in. In no field of productive
activity increasing returns are obtained forever. Whether it is agriculture,
manufacturing, industry or any other productive activity, the tendency of
increasing returns can operate only up to a certain limit. After this limit is
reached, constant returns operate for some time. From the point of view of the
producer, this is an important stage because it exhibits an optimum
combination of the factors of production. In this stage, marginal cost is the
minimum. This is due to two reasons. First, the stage of constant returns is
reached only when the tendency of increasing returns comes to an end so that
there is no possibility of a further decline in marginal cost. Second, after the
stage of constant returns, the stage of diminishing returns sets in. Therefore, the
stage of constant returns is very significant from the point of view of the
producers.

7.4.4 Explanation of Diminishing Returns

The diminishing returns stage is the most important of the three stages of the
law of variable proportions. In Economics, the explanation of the law of
diminishing returns is presented in two ways. The classical economists
believed that this law applies only to agriculture. Basically accepting this
position of the classical economists, the neo-classical economist Marshall had
stated, “We say broadly that while the part which nature plays in production
shows a tendency of diminishing returns, that part which man plays shows a
tendency of increasing returns.”
Modern economists like Joan Robinson, Stigler, etc. constitute the second
category of economists. These economists regard the law of diminishing
returns of far greater applicability than the classical economists. According to
them, this law operates in all areas of productive activity.
Marshall had argued that this law operated only in agriculture. Therefore, he
discussed it only in reference to agriculture. According to him,
“An increase in the capital and labour applied in the cultivation of land
causes in general a less than proportionate increase in the amount of
produce raised unless it happens to coincide with an improvement in
the arts of agriculture.”
The implication is that when land is kept fixed in agriculture while the quantity
of labour and capital applied on that land is increased, total production
increases but not in the same proportion as the factors of production are
increased. It increases by a lesser proportion. For example, if an agriculturist
doubles the amount of labour and capital employed on a fixed plot of land, the
total production will undoubtedly increase but it will not double itself. Due to
152
this reason agriculturists do not consider it profitable to continuously increase Production with One
the application of other factors of production on their fixed plots of land. They Variable Input
know from their experience that unless there is some improvement in
agricultural techniques, increased application of labour and capital on a fixed
quantity of land leads to a situation of continuously declining marginal
product.
Marshall has accepted two limitations of the law of diminishing returns as
applied to agriculture:
1) The law generally operates in agriculture: Marshall was aware of the
fact that the law of diminishing returns does not always operate in
agriculture (hence the qualification that it generally operates in
agriculture). In some cases when the agriculturist applies the first unit of
labour and capital on his fixed plot of land, the fertility of the soil is not
properly exploited. Accordingly, the level of production remains low.
When the second unit of labour and capital is applied, output increases in
a greater proportion. However, this tendency does not remain for long
because the agriculturist soon finds that additional units of labour and
capital start yielding a lower and lower marginal product. On account of
the above reasons, Marshall was careful in pointing out that the law of
diminishing returns operates generally in agriculture. However, in certain
exceptional cases, it may not operate.
2) There should be no improvement in agricultural techniques: The
law of diminishing returns operates only if there is no improvement in
agricultural techniques. It is a law of static agriculture. If the agriculturist
is able to expand irrigation facilities on his land, or make use of better
seeds, better agricultural implements, more fertilisers, etc. or use new
scientific methods in production, he can stall the operation of this law.
Generally, an improvement in agricultural techniques leads to a more
than proportionate increase in output corresponding to an increase in
labour and capital.
As against the view of Marshall, modern economists like Joan Robinson,
Stigler and Boulding regard the law of diminishing returns as more pervasive
and universal. According to these economists, this law operates in all branches
of productive activity. Accordingly, they have presented this law in a general
fashion as would be clear from the definition of this law presented by Joan
Robinson:

“The Law of Diminishing Returns, as it is usually formulated, states

that, with fixed amount of any one factor of production, successive
increases in the amount of other factors will after a point yield a
diminishing increment of the product.”
From the above definition of the law by Joan Robinson, it is clear that she
regards this law as of universal value and does not restrict its application to
agriculture alone. According to her, this law operates in all branches of
productive activity and the principal reason behind the operation of this law is
that the optimum proportion between different factors of production breaks
down sooner or later.
The law of diminishing returns is a logical necessity. When in any productive
activity, the quantity of the variable factors of production employed with given
153
Production quantity of fixed factor of production is increased, the law of diminishing
and Costs returns sets in after the point of optimum proportion has been reached.
Initially, application of variable factors was sub-optional, given the size of
fixed factor. Later, the expansion in use of variable factors leads to sub-
optimality of a different kind: each doze or unit of variable factors have sub-
optional quantity of fixed factor to work on.
Another important reason for the operation of the law of diminishing returns is
that one factor of production (out of the various factors of production) is used
in a fixed quantity. Had all the factors of production been available in
abundance and had it been possible to increase their use in production to all
conceivable limits, the law of diminishing returns would not operate. However,
all factors of production land, labour, capital, enterprise, organisation, etc. are
scarce and often the supply of one of these is taken to be fixed. It is this factor
that results in diminishing returns.
Check Your Progress 2
1) Indicate the following statement as true (T) or false (F):
i) In statge II of production, both marginal product and average
product decline.
ii) In stage III of production, marginal product is negative.
iii) The law of diminishing returns operates only in agriculture.
2) State the law of diminishing marginal returns. There is a provision to the
law that other things be held constant. What are these things?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Explain the three stages of production. Why should a rational producer
under competitive conditions produce in stage II?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the (i) law of increasing returns, (ii) law of constant returns.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

7.5 LET US SUM UP

In this unit we have focused on short run production assuming that only one
input is variable and all other inputs are fixed. We then define total product,
154 average product of an input and the marginal product of an input. We note that
total product in the case of production with one variable input first increases at Production with One
an increasing rate as the amount of variable input expands and then switches to Variable Input
increasing with decreasing rate. Having reached a maximum, it eventually
declines. We then explain the law of variable proportions. Conventionally the
product curves drawn to depict the law of variable proportion are partitioned
into three stages. In stage I, average product increase throughout, in stage II
marginal product from the point where it equals average product falls
throughout but remains positive; and in stage III total product fall and marginal
product is negative. The diminishing returns stage is the most important of the
three stages of the law of variable proportions.

7.6 REFERENCES
1) Robert S.P rindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh edition, 2009), Chapter 5,
Section 5.1.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth edition, 2010), Chapter 7, Section 7.2.
3) A.Kontsoyianmis, Modern Microeconomics (The Macmillan Press Ltd.,
Second Edition, 1982/, Chapter 3.
4) John P Gould and Edward P Lazar, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 6.

7.7 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (i) (F); (ii) (T)
2) See Section 7.3
Check Your Progress 2
1) (i) F; (ii) (T); (iii) (F)
2) See Sub-section 7.4.4
3) See Sub-section 7.4.1
4) See Sub-section 7.4.2. for law of increasing returns and Sub-section 7.4.3
for law of constant returns.

155
 UNIT 8 PRODUCTION WITH TWO
VARIABLE INPUTS
Structure
8.0 Objectives
8.1 Introduction
8.2 Production Function
8.3 What are Isoquants?
8.3.1 Definition
8.3.2 Types of Isoquants
8.3.3 Isoquants Map
8.3.4 Assumptions of Isoquants

8.4 Characteristics or Properties of Isoquants

8.5 Economic Region of Production and Ridge Lines
8.6 The Optimum Combination of Factors and Producer’s Equilibrium
8.6.1 Input Prices and Isocost Lines
8.6.2 Maximisation of Output for a Given Cost
8.6.3 Minimisation of Cost for a Given Level of Output

8.7 The Expansion Path

8.7.1 Optimal Expansion Path in the Long Run
8.7.2 Optimal Expansion Path in the Short Run

8.8 Let Us Sum Up

8.9 References
8.10 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you should be able to:
know the meaning and nature of isoquants;

identify the economic region in which production is bound to take place;

find out the level at which output will be maximised subject to a given
cost;

find the point on the isoquant where cost will be minimised; and

describe the nature of optimal expansion path both in long run and short
run.

*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi.
156
 Production with Two
8.1 INTRODUCTION Variable Inputs
As stated in Unit 7, production requires the use of certain resources often
called factors of productions or inputs. When resources are broadly defined,
they are known as factors of production and classified as labour, land and
capital. The relationship between the inputs to the production process and the
resulting output is described by a production function. In this unit we shall start
with a definition of production function and then proceed to discuss the
concept of isoquants. This will be followed by a discussion on the economic
region of production and then, finally, on how the optimum combination of
factors and producer’s equilibrium is obtained.

8.2 PRODUCTION FUNCTION

The theory of production begins with some prior knowledge of the technical
and/or engineering information. For instance, if a firm has a given quantity of
labour, land and machinery, the level of production will be determined by the
technical and engineering conditions and cannot be predicted by the economist.
The level of production depends on technical conditions. If there is an
improvement in the technique of production, increased output can be obtained
even with the same (fixed) quantity of factors. However, at a given point of
time, there is only one maximum level of output that can be obtained with a
given combination of factors of production. This technical law which expresses
the relationship between factor inputs is termed as production function.

The production function describes the laws of production, that is, the
transformation of factor inputs into products (outputs) at any particular
period of time. Further, the production function includes only the technically
efficient methods of production. This is because no rational entrepreneur
will use inefficient methods.

For the sake of simplicity, we may assume that there are two inputs, labour (L)
and capital (K). We can, then, write the production function as
Q = F (L,K)
This equation relates the quantity of output Q to the quantities of the two
inputs, labour and capital.
A popular production function in economics is Cobb Douglas production
function which is given as
Q=
A special class of production functions is linear homogenous production
function. In this case, when all inputs are expanded in the same proportion,
output expands in that proportion. In this case, Cobb Douglas production
function becomes
Q=
i.e. = 1–
Here we can see that when labour and capital

=A[
157
Production
and Costs
8.3 WHAT ARE ISOQUANTS?
8.3.1 Definition
An isoquant is the locus of all the combinations of two factors of
production that yield the same level of output.

It is easy to understand the concept of an isoquant with the help of an example.

Let us suppose that a firm wants to produce 100 units of commodity X and for
that purpose can use any one of the six processes indicated in Table 8.1.
Table 8.1: Isoquant table showing combinations of Labour and Capital
Producing 100 Units of X

Process Units of Labour Units of Capital

1 2 7
2 4 4
3 6 3

From Table 8.1, it is clear that all the three processes yield the same level of
output, that is, 100 units of X. The first process is clearly capital-intensive.
Since we assume possibilities of factor substitution, we find that there are two
more processes available to the firm and in each of them factor intensities
differ. The third process is the most labour-intensive or the least capital-
intensive. Graphically, we can construct an isoquant conveniently for two
factors of production, say labour and capital. One such isoquant is shown in
Fig. 8.1. It has been constructed on the basis of information provided in
Table 8.1.

Fig. 8.1: This figure shows that at point A, B and C same level of output (=100 units) is
obtained by using different combinations of labour and capital. Curve p
158 is known as isoquant
8.3.2 Types of Isoquants Production with Two
Variable Inputs
1) Convex isoquant
2) Linear isoquant
3) Input-output isoquant
The traditional economic theory has mostly used the convex isoquant as shown
in Fig. 8.1. However, the isoquant can assume some other shapes depending on
the degree of the substitutability of factors. The two other possible production
isoquants are linear isoquant and input-output isoquant.
Linear Isoquant: In case of perfect substitutability of the factors of
production, the isoquant will assume the shape of a straight line sloping
downwards from left to right as in Fig. 8.2. In Fig. 8.2 it is shown that when
quantity of labour is increased by RS, the quantity of capital can be reduced by
JK to produce a constant output level, i.e., 50 units of X. Likewise, on
increasing the quantity of labour by ST, it is possible to reduce the quantity of
capital by KL, and on increasing the quantity of labour by TU, quantity of
capital can be reduced by LM for producing 50 units of X. Since in respect of
labour RS = ST = TU and in respect of capital JK = KL = LM, it is clear that a
constant quantity of labour substitutes a constant quantity of capital. It implies
that a given commodity can be produced by using only labour or only capital
or by infinite combinations of labour and capital. In the real world of
production, this seldom happens. Therefore, a linear downward sloping
isoquant can be taken only as an exception.

Fig. 8.2: In the case of perfect substitutability of factors of production, the isoquant
becomes a straight line and is, therefore, known as linear isoquant

Input-Output Isoquant: When factors of production are not substitutes but

complementary, technical coefficients are fixed. The meaning of this statement
is that optimum output is obtained only when the factors of production are used
in a fixed proportion. In this situation, if a producer uses one factor of
159
Production production in excess of what is required by fixed proportion, there will be no
and Costs increase in output. In the case of complementarily of factors of production, the
shape of the isoquant is right angled or like the letter ‘L’ as shown in Fig. 8 .3.
As would be clear from the figure, the isoquant is formed by two straight lines,
one vertical and the other horizontal, and these two lines are perpendicular to
each other. The common point of these lines is convex to the origin.
This type of isoquant is also called Leontief isoquant after Wassily Leontief
who did pioneer work in the field of input-output analysis. Input-output
isoquant does not imply that by increasing the quantities of the two factors of
production, viz., labour and capital the output will increase proportionately; it
implies only that for producing any quantity of a commodity, capital and
labour must be used in a fixed proportion. Fig. 8.3, slope of Isoquant P1 and P2
indicates the capital-labour ratio has to be maintained for ensuring efficiency in
production.

Fig. 8.3: If factors of production can be used only in a fixed proportion, the isoquant is
‘L’ shaped and is known as an input-output isoquant

8.3.3 lsoquants Map

The production function shows how output varies as the factor inputs change.
Therefore, there are always a number of isoquants for a producer depicting
levels of production (one isoquant depicting one particular level of production).
Isoquants nearer the point of origin represent relatively lower level of
production. The level of production increases as one moves away from the
origin and goes to higher isoquants. A complete set of isoquants for the
producer is called an isoquant map. One such isoquant map showing four
isoquants is shown in Fig. 8.4.
In Fig. 8.4, is the highest isoquant and it represents the highest level of
output, i.e., 400 units. , and represent lower output levels in that order.
160
It may, however, be noted that the distance between two isoquants on an Production with Two
isoquant map does not measure the absolute difference between output levels. Variable Inputs

Fig. 8.4: When a number of isoquants are depicted together, we get an isoquant map

8.3.4 Assumptions of lsoquants

Isoquant analysis is normally based on the following assumptions:
1) It is generally assumed that there are only two factors or inputs of
production. This makes the geometric exhibition of the concept easy
since we can easily draw a diagram. If we abandon this assumption and
consider four or five factors of production (in keeping with the reality)
we would not be able to make use of the diagrammatic representation and
would have to resort to the algebraic method.
2) The second assumption of the isoquant analysis is that the factors of
production are divisible into small units and can be used in various
proportions.
3) Technical conditions of production are given and it is not possible to
change them at any point of time.
4) Given the technical conditions of production, different factors of
production are used in the most efficient way. If this assumption is
abandoned, then any one combination of the factors of production will
yield a number of different levels of production of which the highest level
obtained would be efficient (and all lower levels of production
inefficient).

8.4 CHARACTERISTICS OR PROPERTIES OF

ISOQUANTS
A smooth continuous isoquant that has been adopted in the traditional
economic theory possesses the following characteristics:
1) lsoquants are negatively sloped
161
Production 2) A higher isoquant represents a larger output
and Costs
3) No two isoquants intersect or touch each other
4) lsoquants are convex to the origin.
1) lsoquants are negatively sloped
Normally, isoquants slope downwards from left to right implying that they are
negatively sloped. The reason for this characteristic of the isoquant is that
when the quantity of one factor is reduced, the same level of output can be
achieved only when the quantity of the other is increased. This characteristic of
the isoquant, however, assumes that in no case marginal productivity of a
factor will be negative. In a more realistic case when this assumption is
dropped, one may find an isoquant which bends back upon itself or has a
positively sloped segment. in Fig. 8.5, such an isoquant is shown. AB and CD
segments of this isoquant are positively sloped.

Fig. 8.5: Isoquant having positively sloped segments

2) A higher isoquant represents a larger output

A higher isoquant is one that is farther from the point of origin. It represents a
larger output that is obtained by using either the same amount of one factor and
the greater amount of the other factor or the greater amounts of both the
factors. Two isoquants and have been shown in Fig. 8.6. They depict
output levels of 100 units and 200 units. Obviously, the output level
represented by isoquant can be reached only by using more of factor inputs
as compared to the amount of factor inputs required to reach output level
represented by isoquant .
162
 Production with Two
Variable Inputs

Fig. 8.6: Two Isoquants representing different output levels. A higher isoquant depicts a
higher amount of output

3) No two isoquants intersect or touch each other

Isoquants do not intersect or touch each other because they represent different
levels of output. If, for example, isoquants and (Fig. 8.7) represent output
levels of 100 and 200 units respectively, their intersection at some point, say A
would mean that two output levels (i.e, 100 and 200 units) will be reached by
using the same amount of capital and labour which is not likely to happen. For
the same reason, no two isoquants will touch each other.

Fig. 8.7: No two isoquants intersect one another because each isoquant depicts a different
level of output

4) lsoquants are convex to the origin

In most production processes, the factors of production have
substitutability. Often, labour can be substituted for capital and vice versa.
However, the rate at which one factor of production is substituted for the other
in a production process, that is, the marginal rate of technical
substitution (MRTS) often tends to fall.
163
Production Marginal rate of technical substitution of factor L for factor K
and Costs (MRTSL,K) is the quantity of K that is to be reduced on increasing the
quantity of L by one unit for keeping the output level unchanged.
The isoquants are convex to the origin precisely because the marginal rate of
technical substitution tends to fall. Let us explain why this happens with the
help of Fig. 8 8. Here, the isoquant is curve P. Let us suppose that the producer
is at point ‘a’ of the curve. The meaning of this is that he uses OJ units of
capital and OR units of labour to produce 100 units of output. We shall assume
that one unit of labour is OR = RS = ST = TU = UV. Now, if he wants to
increase the amount of labour by RS, and keep the output at 100 units, he must
reduce the use of capital by JK. Similarly, when he increases the amount of
labour by ST, TU and UV, he must reduce the application of capital by KL,
LM and MN respectively if output has to be kept at the same level (i.e., 100
units). It is clear from the figure that JK > KL > LM > MV. In other words, as
additional units of labour are employed it becomes progressively more and
more difficult to substitute labour in place of capital so that lesser and lesser
units of capital can be replaced by additional units of labour. This means that
the marginal rate of technical substitution tends to fall. This is due to the reason
that factors of production are not perfect substitutes for one another. When the
quantity of one factor is reduced, it becomes necessary to increase the quantity
of the other at an increasing rate. For example, let us suppose that in a
particular productive activity two factors of production – labour and capital–
are employed. When the quantity of labour employed is reduced by one unit, it
is possible to undertake the activity by employing one more unit of capital
initially. However, when one more unit of labour is reduced, it might become
necessary to compensate this by employing, say, two units of capital. As the
quantity of labour employed is reduced successively at each stage, we would
require more and more units of capital to compensate for the loss of each
additional unit of labour.

Fig. 8.8: An isoquant is covex from below because the marginal rates of technical
164 substitution tends to fall
If the factors of production are perfect substitutes, the marginal rate of Production with Two
technical substitution between them would be constant and the isoquant will be Variable Inputs
linear and sloping downwards from left, to right as in Fig. 8.2. In the case of
strict complementarity, that is, zero substitutability of the factors of production
the isoquant will be right angled or we may say that it will assume the shape of
‘L’ as in Fig. 8.3. However, the linear and right angled isoquants are the
limiting cases in the production processes.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) In case of perfect substitability of the factors of production, the
isoquant is convex from below.
ii) Isoquants are positively sloped.
iii) A higher isoquant represents a larger output.
iv) No two isoquants intersect each other.
2) Define isoquant. Discuss its properties.
......................................................................................................................
......................................................................................................................
......................................................................................................................
3) Discuss the possible shapes which the isoquants may assume depending
on the degree of substitutability.
......................................................................................................................
......................................................................................................................
......................................................................................................................

8.5 ECONOMIC REGION OF PRODUCTION AND

RIDGE LINES
Generally, production functions generate isoquants which are convex to the
origin, negatively sloped throughout, do not intersect each other and the higher
the isoquants, greater the level of output. However, there are some production
functions which yield isoquants having all the properties of a normal isoquant
except that they are not negatively sloped throughout. In other words, they
have positively sloped segments. In Fig. 8.9, the production function is
depicted in the form of a set of isoquants which have positively sloped
segments.
Let us consider isoquant . AB segment of this isoquant has a negative slope.
Beyond points A and B, this isoquant is positively sloped. Similarly, other
isoquants have the points where they bend back upon themselves implying that
they become positively sloped. The lines OK and OL joining these points are
called ridge lines. They form the boundaries for the economic region of
production. A careful interpretation of any of the isquants in Fig. 8 .9 will
make this point clear.

165
Production Suppose the output represented by isoquant is to be produced. For producing
and Costs this quantity, a minimum of amount of capital is required because any
smaller amount will not allow the producer to attain the level of output.
With amount of capital, amount of labour must be employed. In case
the producer uses an amount of labour less than together with amount
of capital, his output level would be lower than the one represented by isoquant
. This is quite normal, because use of inputs in smaller amounts would yield
a smaller output. But combining labour input in an amount larger than
with amount of capital would also result in output smaller than that is
represented by the isoquant . In order to maintain the level of output with
a larger labour input, capital input also in a larger amount has to be used.
Obviously, this is something which no rational producer would attempt
because it involves uneconomic use of resources.

Fig. 8.9: Area enclosed within the upper side line OK and the lower side lint OL indicates
the economic region of production

Point B on isoquant represents the intensive margin for labour because an

increase in the amount of labour input beyond with a fixed amount of
capital input does not increase the output level. At this point, marginal
product of labour is zero and thus the marginal rate of technical substitution of
labour for capital ( ) is zero. This implies that at point B labour has
been substituted for capital to the maximum extent. Thus, to the right of ridge
line OL in Fig. 8.9, we have Stage III for labour.
Similarly, for producing level of output, a minimum of amount of
labour input is required. A smaller amount of labour input will not allow the
producer to attain level of output. With amount of labour, amount
of capital must be used and any additions to capital input beyond would
not increase output. This point represents intensive margin for capital because
an increase in the amount of capital input beyond with a fixed labour input
of does not augment output. At point A on , capital has been substituted
for labour to the maximum extent. Thus, above ridge line OK in Fig. 8.9, we
have Stage III for capital. The marginal rate of technical substitution of capital
for labour (MRTSKL) is zero, which means that the marginal rate of technical
substitution of labour for capital (MRTSKL) is infinite or undefined.
166
The line OK in Fig. 8.9 connects the point of zero marginal product of capital. Production with Two
We have designated it as the upper ridge line. Similarly, the line OL Variable Inputs
designated as the lower ridge line joins the points of zero marginal product of
labour.

The combinations of labour and capital inputs comprising the area

between ridge lines OK and OL constitute the generalised Stage II of
production for both resources. These are the combinations that are
relevant for production decisions.

8.6 THE OPTIMUM COMBINATION OF

FACTORS AND PRODUCER’S EQUILIBRIUM
So far, we have explained as to how different combinations of inputs allow a
producer to attain a certain level of output. The producer is free to choose any
of these input combinations. However, his choice cannot be arbitrary if he
wishes to minimise cost of producing a stipulated output. Our task now is to
explain how the producer selects a particular input combination.

8.6.1 Input Prices and Isocost Lines

A producer may attempt maximisation of output subject to a given cost or
alternatively, he may seek to minimise cost subject to a given level of output.
In both cases, for choosing optimum quantities of two inputs, viz., labour and
capital, he must consider their physical productivities as well as their prices.
While isoquants represent the productivities of the inputs, their prices are
shown by isocost lines.

An isocost line represents various combinations of inputs that may be

purchased for a given amount of expenditure; that is, the producer’s
budget.

The firm or the producer has to purchase factors or inputs from the market.
How the prices of labour and capital are determined in the market is not our
present concern. Moreover, the firm is in no position to influesence the input
prices unless it is a monopsonist or oligopsonist. In other words, prices of
labour and capital have to be taken as given by the firm operating in a
competitive factor market. Let us now suppose that the firm’s total cost outlay
on labour and capital is Rs. 1000. The firm is free to spend this entire amount
on labour or capital or it may spend it on a combination of both labour and
capital. In Fig. 8.10, we have shown that if the firm chooses to spent the entire
amount of Rs. 1,000 on labour input, it can employ amount of labour, and
if the entire amount is to be spent on capital, it can get amount of capital.
The straight line is an isocost line representing all the combinations of
capital and labour which the firm can obtain for Rs. 1,000. In the figure, the
length of is twice the length of which means that the price of a unit of
labour is half that of a unit of capital. The slope of the line shows the
ratio of input prices. Hence, the slope of an isocost line is (w/r), which is the
ratio of the price of labour (w) to the price of capital (r) when X-axis denotes
labour input and Y-axis denotes capital input. We can thus generalise that for
any isocost line which is always linear because the firm has no control over the
167
Production prices of inputs and the prices remain the same, no matter how much quantity
and Costs of these inputs, the firm buys,

Slope = = = / =

Fig. 8.10: Isocost Lines - A higher cost line indicates a higher cost

This property of an isocost line is similar to that of the budget line of the
consumer. However, there is an important difference between the two lines.
Since the consumer’s budget is invariably fixed, he has a single budget line.
The firm generally has no such constraint and thus has more than one isocost
lines. In Fig. 8.10, we have shown three isocost lines. There can be many more
of them corresponding to firm’s cost outlay plans to attain various output
levels.

An isocost line farther to the right reflects higher costs; the one closer
to the origin reflects lower costs.

8.6.2 Maximisation of Output for a Given Cost

A rational producer is expected to maximise output for a given cost.

Alternatively, he may attempt to minimise cost subject to a given level
of output.

In this section, we shall explain how a producer maximises his output for a
given cost. Suppose the producer’s cost outlay is C and the prices of capital
and labour are r and w respectively. Subject to these cost conditions, the
producer would attempt to attain the maximum output level.
Let KL isocost line in Fig. 8.11 represent the given cost outlay at input prices r
and w. , and , are isoquants representing three different levels of output.
It may be noted that P3 level of output is not attainable because the available
factor resources (various labour-capital combinations represented by isocost
line KL) are insufficient to reach that output level. In fact, any output level
beyond isocost line KL is not attainable. The producer, however, can attain any
output level in the region OKL, but that would not require all the resources
168
(labour and capital inputs) that are available to the producer for his cost outlay.
Therefore, in the case of a given cost, the producer’s attempt would be to reach Production with Two
the isoquant which represents the maximum output level. The producer can Variable Inputs
operate at points such as R and T. At these two points, the combinations of
labour and capital to produce level of output are available for a given cost
represented by isocost line KL. In contrast, at point S, the combination of
labour and capital available for the same cost (as it is also on isocost line KL)
enables the producer to reach isoquant which represents an output level
higher than that represented by . Since at point S on isoquant is jus tangent
to isocost line, a greater output than is not obtainable for the given level of
cost. A lesser output is not efficient because production can be raised without
incurring additional cost. Hence, the optimal combination of factors of
production, viz., capital and labour is of capital plus of labour as it
enables the producer to reach the highest level of production possible given the
cost conditions.

Fig. 8.11: With the given cost line KL, the highest isoquant that a producer can reach is
P2. Point S on this isoquant, therefore, indicates producer’s equilibrium

The above proposition should be obvious to those who have studied the theory
of consumer behaviour. At the same time, the reason that lies behind it must be
followed carefully. Let us suppose that the producer wishes to produce at point
T. The marginal rate of technical substitution of labour for capital indicated by
the slope of tangent AB at point T is relatively high. Suppose K is equal to 3
and L is equal to 1. Thus, the slope of tangent AB is 3:1 which implies that at
point T one unit of labour can replace 3 units of capital. However, the relative
factor price indicated by the slope of KL is less, say, 0.7:1 which means that
the cost of 1 unit of labour is the same as the cost of 0.7 unit of capital.
Therefore, it would be rational on the part of the producer that he substitutes
labour for capital so long as the marginal rate of substitution of labour for
capital is not equal to the factor price ratio, that is, the ratio of the price of
labour to the price of capital. At point R, the opposite situation prevails
because the marginal rate of technical substitution is less than the factor price
ratio.
169
Production
and Costs
The producer maximises output for a given cost (reaches equilibrium)
only when the marginal rate of technical substitution of labour for
capital is equal to the ratio of the price of labour to the price of capital.

Thus,

= =

8.6.3 Minimisation of Cost for a Given Level of Output

If a producer seeks to minimise the cost of producing a given amount

of output rather than maximising output for a stipulated cost, the
condition of his equilibrium remains formally the same. That is, the
marginal rate of technical substitution must be equal to the factor
price ratio.

This can be easily followed graphically. In Fig. 8.12, we have a single isoquant
P which denotes the desired level of output, but there is a set of isocost lines
representing various levels of total cost outlay. An isocost line closer to origin
indicates a lower total cost outlay. The isocost lines are parallel and thus have
the same slope w/r because they have been drawn on the assumption of
constant prices of factors.

Fig. 8.12: To obtain a level of production indicated by isoquant P, the minimum cost that
must be incurred is given by point E on the isocost line K2L2. Therefore, point E indicates
the point of producer’s equilibrium

It may be noted that isocost line is just not relevant because the output
level represented by the isoquant P is not producible by any factor combination
available on this isocost line. However, the P level output can be produced by
the factor combinations represented by the points F and G which are on isocost
line . Alternatively, the producer can attain the P level output by the
170
factor combination represented by the point E which is on isocost line . Production with Two
Since the isocost line is closer to the origin as compared to the isocost Variable Inputs
line , it represents relatively lower cost. Therefore, by moving either from
F to E or from G to E, the producer attains the same output level at a lower
cost. The producer thus minimises his costs by employing OB amount of
capital plus OA amount of labour determined by the tangency of the isoquant P
with the isocost line L2. Points representing factor combinations below E
are certainly preferable because they represent lower costs but they cannot be
considered as they cannot help in producing the output level represented by the
isoquant P. Points above E represent higher costs. Hence, point E denotes the
least cost combination of the factors, viz., labour and capital for producing
output shown by isoquant P. This discussion thus leads us to the principle that
in the case of producer’s equilibrium, the marginal rate of technical
substitution of labour for capital must be equal to the ratio of the price of
labour to the price of capital. We can now sum up the whole discussion as
follows:

1) The optimal combination of factors, whether the producer seeks to

maximise output for a given cost or he wishes to minimise cost for
a stipulated output, is that where marginal rate of technical
substitution and the factor price ratio are equal.
2) The producer is in equilibrium when there is optimal combination
of factors.

8.7 THE EXPANSION PATH

Producers expand their outputs both in the long run and in the short run. In the
long run, output expands with all factors variable, while in the short run,
expansion of output is possible with some factor(s) constant and some others
variable. We shall consider both cases.

8.7.1 Optimal Expansion Path in the Long Run

In the long run, there is no limitation to the expansion of output as all the
factors of production are variable. The firm’s goal being maximisation of its
profits, it seeks to expand outputs in the optimal way. With given factor prices,
the optimal expansion path is the locus of the points of tangency of successive
isocost lines and successive isoquants.
Consider now Fig. 8.13. Given the factor prices, the output corresponding to
isoquant is producible at the lowest cost at point A where isocost line
is tangent to the isoquant . This is the initial position of producer
equilibrium. Assuming that factor prices remain constant, suppose the producer
desires to expand output to the level indicated by the isoquant . This will
cause a shift in the isocost line from to . The new equilibrium is
found at point B where isocost line is tangent to the isoquant . Further
expansion in output to the level corresponding to the isoquant will shift
equilibrium to point C where isocost line is tangent to the isoquant .
On connecting all points of producer equilibrium, such as A B and C, we get
the curve OE which is called the expansion path. Since every point of the
expansion path denotes an equilibrium point of the producer, it indicates
the optimum combination of factors of production of some particular level
171
Production of output. It may be recalled that each point of producer equilibrium is defined
and Costs by equality between the marginal rate of technical substitution and the factor
price ratio. Since the latter has been assumed to remain constant, the former
also remains constant. Hence, OE is an isocline along which output expands
when factor prices remain constant.

Fig. 8.13: Expansion path in the case of non-linear production function

In the case of linear homogeneous production function, the isoclines are

straight lines through the origin. Therefore, the expansion path will also be a
straight line as shown in Fig. 8.14. This means that given the prices of the
factors of production, the optimal proportion of the inputs of the firm will not
change with the size of the firm’s output or input budget.

Fig. 8.14: Expansion path in the case of linear homogeneous production function is a
straight line

The line formed by connecting the points determined by the tangency

between the successive isoquants and the successive isocost lines is the
firm’s expansion path. It identifies the least costly input combination for
each level of output and will slope upward in the long-run setting. This
172 means that the firm will expand use of both inputs as it expands its
output.
 Production with Two
Variable Inputs
8.7.2 Optimal Expansion Path in the Short Run
In the short run, capital is a fixed factor and thus its amount remains constant.
Labour is, however, variable and the producer can expand his output by
increasing the amount of labour along a straight line parallel to the axis on
which this factor is measured. In Fig. 8.15, the straight line AB indicates the
expansion path as the total amount of capital is fixed at OA in the short run.
With the prices of the factors of production remaining constant, the firm
cannot maximise its profits while it expands its output in the short run, on
account of the constraint of the fixed amount of capital. This can be
followed from Fig. 8.15. The firm’s initial equilibrium is at point E where
isocost line is tangent to the isoquant . If the firm wishes to raise its
output level corresponding to the isoquant , it reaches the point F which,
given the factor prices, is not the least cost situation. Further expansion of
output to the level corresponding to the isoquant leads the firm to reach the
point G which again does not represent the least cost situation. The optimal
expansion path would be OR, were it possible for the firm to increase the
quantity of capital. However, given the amount of capital, the firm has no
choice but to expand along the straight line AB in the short run.

Fig. 8.15: Expansion path in the short run in the case of linear
homogeneous production function

Check Your Progress 2

1) Indicate the following statements as True (T) or False (F):
i) The condition for optimal combination is that marginal rate of
technical substitution is greater than factor price ratio.

173
Production ii) The area between ridge lines constitutes the Stage II of production
and Costs for both resources.
iii) An isocost line represents various combinations of input that may
be purchased for a given amount of expenditure.
iv) An isocost line farther to the right reflects higher cost.
v) Every point on the expansion path denotes an equilibrium point of
the producer.
vi) The line formed by connecting the points determined by the
tangancy between the successive isoquants and the successive
iocost lines is the firm’s expansion path.
2) Explain the condition of a producer’s equilibrium.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Suppose that = Rs. 10, = Rs. 20 and TO (total outlay) = Rs. 160.
i) What is the slope of the isocost ?
ii) Write the equation of the isocost?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Explain the significance of tangency between an isoquant and an isocost
line.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Explain why, for a least cost combination of inputs, a firm requires that
the marginal rate of technical substitution be equal to the input ratio.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
6) What is meant by a firm’s expansion path? Distinguish between the
expansion path in respect of a linear homogeneous production function
from the expansion path in respect of a non-linear production function.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
174
 Production with Two
8.8 LET US SUM UP Variable Inputs
The unit begins with the concept of Production function which refers to
functional relationship between inputs and output. This is followed by the
definition of an isoquant and the explanation of three types of isoquant- (i)
convex isoquant, (ii) linear isoquant, and (iii) input-output isoquant. The
properties of isoquants are: (i) isoquant are negatively sloped (ii) a higher
isoquant represents a larger output, (iii) no two isoquants intersect or touch
each other, and (iv) isoquants are convex to the origin. From here we proceed
to a discussion of the concept of the economic region of production and ridge
lines. The next section is devoted to a discussion of the optimum combination
of factors and producer’s equilibrium. In this section, we first consider the
concept of isocost lines and then consider (i) maxmisation of output for a given
cost, and (ii) minimisaton of cost for a given level of output. The last section of
the chapter discusses the optimal expansion path for a firm both under long run
and short run.

8.9 REFERENCES
1) Robert S Pindyck, Daniel L. Rubinfld and Prem L Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2009), Chapter 5,
Section 5.1 and Section 5.3.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Press, Fifth Edition, 2010), Chapter 7, Section 7.1, Section 7.3 and
Section 7.4.
3) A.Koutsoyiannis, Modern Microeconomics (The Macmillan Ltd., Second
edition, 1982). Chapter 3.
4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 7.

8.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) i) F) ii) F iii) T iv) T
2) See Sub-section 8.3.1 of Section 8.3 and Section 8.4
3) See Sub-section 8.3.2 of Section 8.3
Check Your Progress 2
1) i) F ii) T iii) T iv) T v) T vi) T
2) See Section 8.6
3) (i) Slope of isocost is – / = –2 and the eqution is 160 = 10K + 20L or
16 = K + 2L or K = 16 – 2L
4) See Section 8.6
5) See Sub-section 8.6.3 of Section 8.6
6) See Section 8.7

175
 UNIT 9 RETURNS TO SCALE
Structure
9.0 Objectives
9.1 Introduction
9.2 Concept of Returns to Scale
9.2.1 Increasing Returns to Scale
9.2.2 Constant Returns to Scale
9.2.3 Diminishing Returns to Scale

9.3 Economies and Diseconomies of Scale

9.3.1 Internal Economies of Scale
9.3.1.1 Real Internal Economies of Scale
9.3.1.2 Pecuniary Internal Economies if Scale
9.3.2 Internal Diseconomies of Scale
9.3.3 External Economies
9.3.4 External Diseconomies

9.4 Let Us Sum Up

9.5 References
9.6 Answers or Hints to Check Your Progress Exercises

9.0 OBJECTIVES
After going through this unit, you should be able to :
state the concept of returns to scale;
distinguish between the stage of increasing, constant and diminishing
returns to scale; and
explain the concepts of economies and diseconomies of scale (both
internal and external).

9.1 INTRODUCTION
Sometimes to increase the level of output, all factors are increased
simultaneously and factor proportions are held constant. This is known as
expansion in scale. In this context, three phases of production are discussed:
increasing returns to scale, constant returns to scale, and diminishing returns to
scale. Expansion of scale confers a number of economies i.e. advantages on the
firm – both internal and external. Internal economies, in turn, can be divided
into real internal economies of scale and pecuniary internal economies. If the
scale of production is continuously expanded, a stage of internal diseconomies
of scale sets in i.e. after a certain point, increase in production is less than
proportionate increase in the factors of production. In this unit, we propose to
discuss all these issues. We shall also explain the concept of external
economies and external diseconomies.

*Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi.
176
 Returns to Scale
9.2 CONCEPT OF RETURNS TO SCALE

The concept of returns to scale is associated with the tendency of

production that is observed when the ratio between the factors is kept
constant but the scale is expanded, that is use of all the factors is
changed in same proportion.

When all the factors of production (labour, capital, etc.) are increased in the
conditions of constant techniques, three possibilities arise:
1) Output increases in a greater proportion as compared to the increase in
the factors of production. This is the case of increasing returns to scale.
2) Output increases in the same proportion as the increase in the amount of
the factors of production. This is the case of constant returns to scale.
3) Output increases in a smaller proportion as compared to the increase in
the amounts of the factors of production. This is the case of diminishing
returns to scale.
We can illustrate these three situations with the help of numerical examples as
follows:

OUTPUT SCHEDULE-1
Input-X Input -Y % Change in Output % Change in
Inputs Output
2 4 100 1000 -
4 8 100 3000 200
8 16 100 10000 233
16 32 100 35000 250

It can be observed from the given output schedule that:

1) At all the stages, we are increasing the quantity of inputs by 100%.
2) With increase in the quantity of inputs, the quantity of output is
increasing by more than 100% at all stages. In other words output is
increasing proportionately more than the increase in input.
Compare this situation with the illustrations given below:
OUTPUT SCHEDULE-2
Input-X Input -Y % Change Output % Change in
in Inputs Output
2 4 100 1000 -
4 8 100 2000 100
8 16 100 4000 100
16 32 100 8000 100
Output shedule-2 indicates that:
1) Inputs increase by 100% at each stage.
2) Output also increased by 100% at each stage. 177
Production In this illustration, output increased by the same proportion in which inputs
and Costs have been increased.
Compare this situation with the one given below:

OUTPUT SCHEDULE-3
Input-X Input -Y % Change Output % Change in
in Inputs Output
2 4 100 1000 -
4 8 100 1800 80
8 16 100 2500 39
16 32 100 3000 20

It would be observed that the total output at all stages increases less
proportionately than the increase in inputs.

9.2.1 Increasing Returns to Scale

When the ratio between the factors of production is kept fixed and the
scale is expanded, initially output increases in a greater proportion
than the increase in the factors of production.

Fig. 9.1: Increasing returns to scale output increases in a greater proportion than the
increase in the factors of production

For example, if factors are doubled the output is more than doubled. In other
words, to double the quantity of the output, it is not necessary to double the
quantity of the factors of production. This can be understood with the help of
Fig. 9.1. In this figure P1, P2, P3, P4 are isoquants. They show 10, 20, 30, 40
units of output respectively. OS is the scale line which is cut by the isoquants
at unequal distances. In the figure, it can be seen that cd < bc < ab < oa. This
means that to enable the firm to rise from isoquant P1 to P2 (so that production
increases from 10 to 20 units), the amount of factors of production required is
178 less than the amount required to produce the initial l0 units of output.
Similarly, to increase the output further by 10 units so as to reach isoquant P3, Returns to Scale
the amount of factors of production required is less than the amount required to
produce the earlier 10 units of output as bc < ab. This position seems to hold
true till isoquant P4. There are three main factors which account for increasing
returns to scale:
1) Indivisibility: The most important reason of increasing returns to scale is
the ‘technical and managerial indivisibilities’. The meaning of an
indivisible factor of production is that there is a certain minimum size of
the factor and even if it is large in relation to the size of the output, it has
to be used (i.e., it cannot be divided). For example, even if only 10-15
letters are to be despatched from an office, it would be necessary to keep
a typewriter. It is not possible to purchase only half the typewriter since
only a small number of letters have to be typed daily. We would,
therefore, say that typewriter is not divisible. In a similar way, plants and
managerial services in modern factories are not divisible. Accordingly,
when the scale of production is enlarged initially, there is no equi-
proportionate increase in the demand for the factors of the production.
2) Specialisation: Chamberlin does not regard indivisibility as an important
cause of ‘increasing returns to scale’. According to him, the main reason
of increasing returns to scale is specialisation. When due to division of
labour, workers are given jobs according to their ability, their
productivity increases while cost declines. According to Donald S.
Watson, acknowledgement of this fact contradicts the assumption that the
ratio of different factors of production remains constant. Accordingly, he
casts doubts whether specialisation can be regarded as leading to
increasing returns to scale. The importance of specialisation can be
accepted only if we assume that although an increase by an equal amount
in quantity of labour and capital employed is necessary for an expansion
in scale, this increase does not mean the doubling or trebling their units
employed but it does mean an increase in their fixed money cost. But this
can lead to technical changes and it is very much possible that increasing
returns emerge not due to an expansion in scale but due to technical
reasons.

9.2.2 Constant Returns to Scale

Increasing returns to scale can be obtained only upto a point. After

this point is reached, expansion of scale only leads to equal
proportionate change in output.

Empirical evidence suggests that the phase of constant returns is a fairly long
one and is observed in the case of a number of commodities. In a scientific
sense, constant returns to scale implies that when the quantity of the factors of
production is increased in such a way that the ratio of the factors remains
unchanged, output increases in the same proportion in which the factors are
increased. In other words, when the quantity of the factors is doubled, the
output also doubles. Such a production function is often called linear
homogeneous production function or homogeneous production function of the
first degree. The phase of constant returns to scale can be understood with the
help of Fig. 9.2. In this figure, when the firm goes from isoquant P3 to P4, or

179
Production from isoquant P4 to P5 or from isoquant P5 to P6, constant returns to scale are
and Costs obtained. The fact cd = de = ef on the scale line indicates this phenomenon.

Fig. 9.2: Constant returns to scale-output increases in the same proportion in

which inputs are increased

The question that now arises is what are the reasons which account for constant
returns to scale. Generally when inefficiencies of production on a small scale
are overcome and no problems regarding technical and managerial
indivisibilities remain, expansion in scale leads to a situation where returns
increase in the same proportion as the factors of production. Some economists
are of the view that when benefits of specialisation of a factor in the unit of
production are small or when such benefits have already been reaped at a small
level of production, then for a considerable period of time, production
increases according to the law of constant returns to scale.
Economists have argued that if the factors of production are perfectly divisible,
the production function must exhibit constant returns to scale. In their opinion,
if constant returns to scale does not prevail in some industries, it is because in
these industries either due to scarcity or indivisibility of some factors, it is not
possible to vary all them in the same proportion. Indivisibility of a factor often
results in its under-utilisation at lower levels of output. When a producer for
obtaining a larger output increases quantities of other factors, the amount of the
lumpy factor which had not been fully utilised at lower levels of output, will
not be increased. These economists do not think that economies of scale will be
available when the factors of production are perfectly divisible. They however,
stress the role of optimum factor proportionality in production. When factors of
production are perfectly divisible, they can be increased or decreased in such
amounts that an optimum proportion between factors is achieved. The output
can be increased or decreased by increasing, or decreasing the amounts of the
factors in the optimum proportion without any economies or diseconomies of
scale which means that constant returns to scale will necessarily prevail.

9.2.3 Diminishing Returns to Scale

Diminishing returns to scale ensure that the size of the productive firms cannot
be infinitely large. Generally after a limit when the quantity of the factors of
production is increased in such a way that the proportion of the factors remains
unchanged, output increases in a smaller proportion as compared to increases
180
in the amounts of the factors of production. For example, it may happen that an Returns to Scale
increase in amount of labour and capital by 100 per cent leads to an increase in
output by only 75 per cent. In other words, if output has to be doubled, the
factors of production will have to be more than doubled. We can understand
this phenomenon with the help of Fig. 9.3. In this figure, when the firm is at
isoquant P6, the tendency of constant returns to scale has come to an end. From
here, the increasing distance between two consecutive isoquants is an
indication that to obtain the same increase in output, factors of production will
have to be increased at a higher and higher rate. On the scale line OS, ij > hi >
gh >fg > ef indicate this phenomenon very explicitly.

Fig. 9.3: Diminishing returns to scale – output increases proportionally

less than inputs

Economists do not agree on the causes which leads to operation of diminishing

returns to scale. Nevertheless, the two causes that are often mentioned are as
follows:
1) Enterprise: Some economists emphasise that enterprise is a constant and
indivisible factor of production and its supply cannot be increased even in
the long run. Accordingly, when the quantity of other factors is increased
and the scale of production expanded in a bid to boost up production, the
proportion of other factors in relation to enterprise increases. Beyond a
certain point, this results in diminishing returns as enterprise becomes
scarce in relation to other factors.
2) Managerial difficulties: According to some other economists, the main
reason for the operation of diminishing returns to scale is managerial
difficulties. When the scale of production expands, the co-ordination and
control on different factors of production tend to become weak and
therefore output fails to increase in the same proportion as the factors of
production increase. This results in diminishing returns to scale.

181
Production
and Costs
9.3 ECONOMIES AND DISECONOMIES OF
SCALE
Expansion of the scale confers a number of economies on the firm. Some of
these are in ‘real terms’ while others are in ‘pecuniary terms’. Economies that
are obtained in production work, marketing, management, transport, etc. are in
real terms, while economies that are obtained in terms of, say, purchase of
inputs at wholesale rate, availability of finance at lower rate of interest, saving
on advertisement costs, etc. are in money terms. Then, there are certain
economies that do not accrue to the firm whose scale of operation is large but
accrue to certain other firms which benefit from the large scale of this firm.

In Economics, those economies which accrue to a firm on expansion of

its own size are known as internal economies. As against this, those
economies which accrue to a firm not due to its own operations but due
to the operations of other firms are termed external economies.

9.3.1 Internal Economies of Scale

Generally, when the scale of production is sought to be enlarged, the firm
replaces its small plant by a larger plant. This increases the efficiency of
production. However, it is not always necessary to change the plant for
expanding the scale of production. The firm can keep the old plant in a running
condition and either establish a new plant of the same type or a new plant of
some new type. In all these alternatives, the firm obtains many different kinds
of economies. The fact is that it is the economies of scale that determine the
nature of the long-run average cost curve.
9.3.1.1 Real Internal Economies of Scale
When expansion in the scale of production takes place, the firm obtains some
real internal economies. These economies accrue in the form of saving in the
physical quantities of raw materials, labour, fixed and variable capital, and
other inputs. Broadly speaking, real internal economies are of the following
four types: (i) production economies, (ii) selling or marketing economies, (iii)
managerial economies, and (iv) economies in transport and storage.
1) Production economies: When the scale of production expands, a number
of economies accrue to the firm in the production process itself. First,
opportunities for obtaining various types of economies emerge in the
workshop of the factory. Production on a large scale enables the firm to
carry out extensive division of labour and employ large automatic
machines. The capacity of the machines is also fully used on account of
the large volume of production. Instead of depending on others for
carrying out repairs of machines and machine tools, the firm can itself
employ technicians and workmen for the purpose. Techniques of
production are changing so rapidly in the modern world that every
producer has to remain ever alert. Large size of the firm and large-scale
of operations is distinctly better in this regard since a larger firm can
easily make use of its big financial resources to conduct research in its
laboratories and/or adapt technology discovered elsewhere to suit its own
requirements. The firm is, thus, able to discover better and less expensive
182 techniques of production.
 Whatever be the scale of operations, some waste material is invariably Returns to Scale
left out in each factory. If the scale of operations is small, a relatively
larger quantity of this material goes unutilised. However, if the scale of
operations is large, some useful goods can be prepared even from the
waste material. For example, from the syrup left out in the sugar factory,
liquor can be prepared. Similarly, in bangles factory, a number of small
glass goods can be prepared out of the broken bangles.
When the scale of production is small, the producer generally cannot
afford a packaging department. Therefore, he has to depend on others for
obtaining packaging material like boxes, labels, etc. This leads to a
substantial expenditure on packaging. However, if the scale of production
is large, the firm can setup its own packaging department which is
economical and also leads to lower per unit packaging costs.
2) Selling or marketing economies: Every producer produces with the
purpose of selling. Therefore, he has to incur some expenditure in making
his goods available to the consumer. When the scale of production is
large, the per unit expenditure of the producer on marketing of goods is
reduced substantially due to a number of reasons. All firms advertise their
products in a number of ways. Even very small firms have to spend a
certain minimum amount on advertising, though this expenditure of the
small firms is considerably less than the expenditure of the large firms,
yet the per unit cost of the large firms is smaller due to the fact that
advertising cost is not required to be increased proportionately as the
volume of production increases. Also, when the scale of production is
large, the firm can economise on the expenditure on salesmen, agents,
etc. The large firms can also enter into such contracts with the
wholesalers and distributors that they take more interest in selling the
products of the firm. Naturally, a small firm is deprived of this benefit.
3) Managerial economies: Managerial costs are partially production costs
and partially selling costs. However, they are generally considered
separately since it is convenient to do so. Managerial economies are
obtained on account of the following two basic reasons: First, benefits of
specialisation in the field of management can be obtained only when the
scale of operations is considerably large. When the scale of production is
small, all managerial responsibilities regarding production, marketing,
finance, etc. will have to be borne by one person only. However, as the
scale of operations expands, separate managers are appointed to look
after these tasks. This raises the level and quality of management. At the
same time, cost does not increase in proportion to the increase in the scale
of operations. Large firms are in a position to use a number of machines
for purposes of management. The use of computers, telephone, fax, etc.
can be made only by a sufficiently large firm. If small firms use these
machines, the total costs incurred on them would be very much higher in
relation to the level of production attained.
The economists are, however, not in complete agreement on the
managerial economies. Some economists argue that with the expansion of
scale, managerial economies are obtained only upto a limit. After this
limit, costs on management increase in a greater proportion. This is due
to two reasons. First, the managerial structure in large companies is
bureaucratic and when the scale of production expands, delays in
decision making creep in. This weakens managerial efficiency. Second, 183
Production the degree of uncertainty increases as the size of the firm increases. On
and Costs account of this reason, various difficulties have to be encountered in
decision making leading to an increase in managerial costs.
4) Economies in transport and storage: When the scale of production
expands, economies in transport and storage accrue to the firm. Small
firms have usually to depend on public transport and therefore their per
unit transport cost is higher. As the scale of operation expands, the firm
can purchase its own truck, lorry, etc. This will reduce the per unit
transport cost for the firm. If the scale of operation expands still further,
the firm can go in for larger trucks and lorries. The railways also give
siding facilities to large producers and this reduces their loading costs. In
reality, the transport cost is partly production cost and partly selling and
marketing cost. When the firm purchases raw material, the loading cost is
a part of its production cost. On the other hand, when finished goods are
transported to the market, it is a part of selling and marketing cost.
However, for convenience in analysis, the economists prefer to treat
transport costs separately.
Like transport costs, storage costs are also partly production costs and partly
selling and marketing costs. For example, expenditure on storing the raw
material is a production cost whereas expenditure on finished and semi-
finished goods is a part of marketing costs. From the point of view of the size
of the warehouse, an important thing to remember is that larger the size of
warehouse, larger will be the economies accruing to the firm. The reason is that
the cost of construction of the warehouse does not increase in the same
proportion as the increase in the storage capacity of the warehouse.
9.3.1.2 Pecuniary Internal Economies of Scale
Some pure pecuniary economies accrue to a firm as its scale of operation
expands. The more important ones are the following:
1) A large sized firm can ask the suppliers of raw materials to give specific
concessions and discounts. No raw material supplier usually ignores such
requests (or pressures) of the large firm.
2) Perfect competition generally does not prevail in the capital market.
Since the large companies have greater goodwill in the capital market,
they are in a position to obtain loans at lower rates of interest from the
banks and financial institutions.
3) Transport companies are also willing to provide discounts and
concessions if the cargo is substantially large. This enables the firm to
obtain monetary economies in transport costs by expanding its scale of
operations.
4) When production is large, the firm is required to spend a large amount on
advertising as well. However, advertising on a large scale attracts
discounts and concessions from the media in which the advertisements
appear.

9.3.2 Internal Diseconomies of Scale

If the scale of production is continuously expanded, is it possible that after a
certain point, increase in production is less than proportionate than increase in
the factors of production? Many economists believe that such a situation can
and does arise if production is pushed beyond the point of optimum scale. The
184 reasons that they advance are as follows:
1) Limitations on the availability of factors of production: The factors of Returns to Scale
production are always available in limited supply at the place of
production. When the scale of production is increased beyond a certain
point, it no longer remains possible to meet the requirements of some
factors from local sources and, accordingly, factors have to be transported
from other regions. This is generally possible only at higher prices. Let us
suppose that an engineering factory is to be set up at Rudrapur in the
Terai region. When the scale of production is small, it would be possible
to meet the demand for some materials from local sources. As the scale of
production expands, it will become more and more difficult to get even
the labour from local sources and after a certain point, workers will have
to be attracted from other regions by offering them higher wages.
2) Problems in management: When the scale of production is very large,
the task of management at the top level becomes increasingly more and
more burdensome and some inefficiency is bound to creep in. At times,
information vital for taking a decision does not reach the top managers of
the company in time. This delay, in turn, leads to a delay in decision
making and increases the per unit cost.
3) Technical factors: When the scale of production is expanded, per unit
cost increases due to a number of technical reasons. The establishment
cost of large and sophisticated plants and machinery is generally high.
The buildings of large factories should also have stronger foundations
and the factory itself must be equipped with coolers, air-conditioners, etc.
All these factors lead to an increase in per unit cost.
9.3.3 External Economies
External economies were discussed first of all by Alfred Marshall. According
to him, when a firm enters production, it obtains a number of economics for
which the firm’s own production strategy, managerial arrangements, etc. are
not responsible. In fact, these are economies external to the firm. For example,
let us suppose that a firm is established at a place where transport, advertising
facilities, etc. are not available. If the size of the firm remains small, it is
possible that these facilities are not locally available in the future as well.
However, if the size of the firm increases significantly, these facilities will
themselves start coming to the firm. These are, in fact, external economies.
When a firm expands its scale of production, other firms also earn many
economies. For example, when a large factory attracts various factors of
production fairly regularly, many other factories set up in the neighbourhood,
that could not have attracted these factors on their own, also stand to gain.
They obtain these factors at practically the same prices at which the large
factory obtained them.
Because of external economies of large-scale production, there is a gap
between private and social returns. When a firm expands its scale of
production, it becomes possible for the other firms to reduce their cost of
production. However, there is no method available in the prevalent price
mechanism to the firm expanding its scale of operations to charge for the
benefits it confers on the other firms.
9.3.4 External Diseconomies
When the scale of operations is expanded, many such diseconomies emerge
that have no particular ill-effect on the firm itself. In fact, their burden falls on
185
Production the other firms. On account of this reason, they are termed external
and Costs diseconomies. The smoke rising from the chimney of a factory pollutes the
atmosphere. When the firm is of a small size, the pollution is less and its ill-
effects on the people living in colony nearby is limited. However, if the scale
of the firm is large, the smoke will be very dense and can cause serious health
hazard to the people. Similarly, as the scale of production of the factories
increases, employment rises sharply. This creates problems of traffic
congestion and overcrowding in the city where these factories are located. In
agriculture, increase in the scale of production leads to problems of soil erosion
and this reduces the fertility of the adjoining fields as well. From the above
illustrations, it is clear that external economies and diseconomies can be both
pecuniary and technological.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) When output increases in a greater proportion as compared to the
increase in the amount of the factors of productions, we have the
stage of increasing returns to scale.
ii) Those economies which accrue to a firm an account of the other
firms are known as external economies.
iii) Production economies are a part of pecuniary internal economies.
iv) In the case of linear homogenous production function, we have
constant returns to scale.
2) Discuss the factors which account for increasing returns to scale.
......................................................................................................................
......................................................................................................................
3) Explains how decreasing returns to scale arise.
......................................................................................................................
......................................................................................................................
4) Discuss the internal economies of scale.
......................................................................................................................
......................................................................................................................
5) What do you mean by external economies and external diseconomies?
......................................................................................................................
......................................................................................................................

9.4 LET US SUM UP

In this unit, the concept of returns to scale has been explained. As noted in the
beginning itself, this concept is associated with the tendency of production that
is observed when the ratio between the factors is kept constant but the scale is
expanded. This, in turn, can give rise to three possibilities – increasing returns
186 to scale, constant returns to scale, and diminishing returns to scale. After
discussing all these possibilities, we shift our focus to a discussion of Returns to Scale
economies and diseconomies of scale. Economies of scale, in turn, are divided
into two parts – internal economies of scale and external economies of scale.
Economies which accrue to a firm on expansion of its own size are known as
internal economies while economies which accrue to a firm not due to its own
operations but due to operations of other firms are termed as external
economies. We have discussed in detail all the causes which can result in the
generation of such economies. In the end, we have focussed our attention on
diseconomies of scale – both internal and external.

9.5 REFERENCES
1) Robert S. Pindyck, Daniel L Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh edition, 2009), Chapter 5,
Secton 5.4.
2) Dominick Salvotore, Principles of Microeconomics (Oxford University
Press, Fifth edition, 2010) Chapter 7, Section 7.5.
3) A. Koutsoyianms, Modern Microeconomics (The Macmillan Press Ltd,
Second edition, 1982) Chapter 3.
4) John P. Gould and Edward P Lazear, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996), Chapter 8, Section 8.6.

9.6 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (i) (T), (ii) (T), (iii) (F), (iv) (T)
2) See Sub-section 9.2.1 of Section 9.2
3) See Sub-section 9.2.3 of Section 9.2
4) See Sub-section 9.3.1 of Section 9.3
5) See Sub-section 9.3.3 and 9.3.4 of Section 9.3.

187
 UNIT 10 THE COST OF PORDUCTION
Structure
10.0 Objectives
10.1 Introduction
10.2 The Concept of Costs
10.2.1 Private Costs and Social Costs
10.2.2 Money Cost: Explicit and Implicit Costs
10.2.3 Real Costs
10.2.4 Sunk Cost and Incremental Cost
10.2.5 Economic Cost and Accounting Cost
10.2.6 Historical Cost and Replacement Cost

10.3 Cost Functions: Short-Run and Long-Run

10.3.1 Cost Function and the Time Element
10.3.2 Long-Run Cost Function
10.3.3 Short-Run Cost Function

10.4 Theory of Cost in the Short-Run

10.4.1 Fixed Cost
10.4.2 Variable Cost
10.4.3 Total Fixed Cost
10.4.4 Total Variable Cost
10.4.5 Total Cost
10.5 Short-Run Cost Curves
10.5.1 Average Fixed Cost
10.5.2 Average Variable Cost
10.5.3 Average Total Cost
10.5.4 Marginal Cost
10.5.5 Relationship between Marginal Cost and Average Cost

10.6 Long-Run Cost Curves

10.6.1 Long Period Economic Efficiency
10.6.2 The Long-Run Average Cost Curve
10.6.3 Long-Run Marginal Cost Curve
10.6.4 Relationship between Long-Run Marginal Cost and Short-Run Marginal
Cost

10.7 Let Us Sum Up

10.8 References
10.9 Answers or Hints to Check Your Progress Exercises

10.0 OBJECTIVES
After going through this unit, you should be able to:

state the various concepts of costs like private cost, social cost, money
cost, sunk cost, economic cost, accounting cost etc.;
188 *Dr. V.K. Puri, Associate Professor of Economics, Shyam Lal College (University of Delhi) Delhi.
 differentiate between short-run and long-run cost functions; The Cost of
Production
know the difference between fixed cost and variable cost and the nature
of total cost curve;

explain the concept of average fixed cost, average variable cost, average
total cost and marginal cost and nature of these curves;

discuss the relationship between marginal cost curve and average cost
curve;
appreciate the difference between short-run and long-run cost curves; and

describe the relationship between long-run marginal cost and short

marginal cost.

10.1 INTRODUCTION
The decision of a firm regarding production of a good depends on two factors:
First, the demand for the good, and second, the cost of production of the good.
Accordingly, the concept of cost of production is basic to the understanding of
the price theory and requires a thorough discussion. A price taker firm wishes
to maximise its profits will be able to do so if it is able to minimise its costs.
Obviously a firm is interested in minimising what economists call the private
cost. The concept of social cost that is being often referred to in the context of
social welfare is not relevant for the theory of firm. However, it is necessary to
understand the distinction between the concepts of the private cost and the
social cost. In economic analysis, we often distinguish between money cost and
the opportunity cost. From analytical point of view both the concepts are
relevant and thus must be understood carefully. The concept of money cost
may be interpreted from the point of view of an accountant or an economist.
The two approaches differ on the treatment of implicit costs.
After settling these conceptual issues in the theory of costs, one has to analyse
the nature of costs in both the short-run and the long-run. In the short-run since
we have some fixed inputs and some other inputs are variable, one has to draw
the distinction between the fixed costs and the variable costs. However, in the
long-run because the amounts of all the inputs can be varied, all costs are
considered together. Finally, the theory of costs attempts to explain as to how
cost changes occur in response to changes in the size of production. In the last
two units we have discussed the theory of production at some length. This
discussion should help us to understand that the cost changes depend largely on
how changes in production take place as a result of changes in the amounts of
inputs.

10.2 THE CONCEPTS OF COSTS

10.2.1 Private Costs and Social Costs
In microeconomic theory, the concepts of both private cost and social cost are
used. The firm, in its attempt to attain the goal of profit maximisation, is
guided entirely by the private cost considerations. In its decision making, it
ignores all those costs which it may be imposing on others while carrying out
its production programme. However, in welfare studies, together with the

189
Production firm’s both explicit and implicit costs, all such costs are taken into account
and Costs which are external to the ‘narrow economy’ of the firm.
Private costs: Every firm requires various inputs to produce a good. In order
to secure a command over these inputs, the firm has to pay some price for each
of these inputs. In common parlance, the amount of money so paid is known as
cost. Economists, however, include in the private cost not only the expenditure
incurred by the producer on purchasing (or hiring) of factors of production (or
inputs) from the market, but also the imputed cost of all those services which
the producer himself provides. The private cost of production of any output
may thus be defined as either the purchase or the imputed value of all
productive services used in producing the output and is equivalent to the total
monetary sacrifice of the firm made to secure it.
Generally, economists include the following expenditures in the cost: (i) cost
of the raw materials, (ii) wages of the labourers, (iii) interest payments on
capital loans, (iv) rent of the land and the buildings, (v) repairing costs of
machines and depreciation, (vi) tax payments to the government and local
bodies, (vii) imputed wage payment to the producer for the work performed by
him, (viii) imputed interest payment for the capital invested by the producer
himself, (ix) rent of land and buildings owned by the producer himself and (x)
normal profits of the firm.

This shows that three types of expenditures are included in the private
cost: (i) the purchase price of the factors of production employed in the
production process, (ii) imputed price of the resources provided by the
producer himself, and (iii) normal profits.
Social costs: Social costs differ from private costs on account of two reasons:
First, externalities are not included in private costs. For example, a factory
located in the residential area by polluting the atmosphere will expose the
residents of the colony to various ailments and will thereby raise their medical
expenditures. Though these costs are quite relevant from the point of view of
the society, they will never be considered by the firm as part of its costs.
Secondly, market prices of goods may not reflect their social value and
thus there may be divergence between private and social costs. The
imposition of government taxes, subsidies, and controls of various kinds distort
free market prices. Further, prices of factors of production may overstate or
understate the opportunity cost of using those factors. In heavily populated
countries where widespread disguised unemployment is to be found in the
agricultural sector, the industrial wage often exceeds the opportunity cost of
the labour which is drawn from the agricultural sector. In computing the social
costs, adjusted market prices for goods and factors of production are used.
While the adjusted prices for factors of production are called shadow prices,
the adjusted prices for goods are termed as social prices.

10.2.2 Money Cost: Explicit and Implicit Costs

The concept of the money cost in contrast to the concept of opportunity cost is
simple.

The money cost of production of any output is considered to be

equivalent to the total monetary sacrifice made to obtain that output.
190
Thus, costs are not sacrificed alternatives but monetary payments. This The Cost of
conception of money cost is rather narrow and is used for accounting purposes. Production
From the point of view of the economists, this concept of cost is not very
relevant. Since economists wish to study as to how costs affect output choices,
employment decisions, and the like, costs should include imputed value of all
the inputs provided by the producer himself in addition to outright money
expenses. Hence, costs can be classified as explicit costs and implicit costs.
Explicit costs arise from transactions between the firm and other parties in
which the former purchases inputs or services of inputs for carrying out the
production. These costs are usually the costs shown in the accounting
statements and include wage payments, raw materials costs, interest on loans,
payments for insurance, electricity and so on. Implicit costs are the costs
associated with the use of the firm’s own resources. Since these resources will
bring return if employed elsewhere, their imputed values constitute the implicit
costs. Implicit costs are however difficult to measure. Economists nonetheless
assert that they must be taken into account in analysing the activities of a firm.

10.2.3 Real Costs

The concept of real cost was developed by Alfred Marshall. In his opinion, a
worker suffers discomfort while he renders his services for productive
purposes. Similarly, a person makes some sacrifice when he saves his income
and lends it to investors who use it for carrying out production. These
discomforts and sacrifices are in the nature of real costs of production. In
Marshall’s own words, “The exertions of all the different kinds of labour that
are directly or indirectly involved in making it; together with the abstinences or
rather the waitings required, for saving the capital used in making it; all these
efforts and sacrifices together will be called the real costs of the production of
the commodity.”
The concept of real cost is, however, based on subjectivity and cannot be used
for precise measurement of production cost. It is this reason why modern
economists do not consider it to be of much relevance in the price theory. They
admit that most of the labour involves hard work and is definitely unpleasant.
It, therefore, has a heavy real cost. In contrast, the real cost of simple and less
arduous work is generally low. But this fact is not at all relevant from the point
of view of price determination in a free enterprise economy. Moreover, to
modern economists, savings do not involve any sacrifice. Hence, these
economists regard the concept of real cost as inappropriate.

10.2.4 Sunk Cost and Incremental Cost

In economics and business decision-making, a sunk cost is a cost that has
already been incurred and cannot be recovered. Sunk costs (also known as
retrospective costs) are sometimes contrasted with prospective costs, which are
future costs that may be incurred or changed if an action is taken. In traditional
microeconomic theory, only prospective (future) costs are relevant for decision
making. Since sunk costs have already been incurred and cannot be recovered,
therefore they should not influence the rational decision-maker’s choices.
An incremental cost is the increase in total costs resulting from an increase in
production or other activity. For instance, if a company’s total costs increase
from Rs. 5.6 lakh to Rs. 6.0 lakh as a result of increasing its machine hours
from 7,000 to 8,000, the incremental cost of the 1,000 machine hours is Rs.
40,000.
191
Production 10.2.5 Economic Cost and Accounting Cost
and Costs
Economists and accountants view costs from different angles. Accountants are
concerned with the firm’s financial statement and tend to take a retrospective
look at the firm’s finances because they have to keep track of assets and
liabilities and evaluate past performance. Accounting cost includes
depreciation expenses for capital equipment at rates allowed by the tax
authorities.
Economists, on the other hand, are concerned with what cost is expected to be
in the future, and with how the firm might be able to rearrange its resources to
lower its cost and improve its profitability. Thus, they take a forward looking
view and must therefore be concerned with opportunity costs.
As stated earlier, there is a difference regarding the treatment of explicit and
implicit costs as well. Both, the economists and the accountants consider
explicit costs (like payment of wages and salaries, cost of raw material,
property rentals, etc.) because these involve direct payments by a company to
other firms and individuals that it does business with. However, while
economists also take into account the implicit costs, accountants ignore them.
For example, consider the owner of a retail store who manages his own retail
store but does not pay any salary to himself. Since no monetary transaction has
taken place, accountant will not include it in the accounting cost. However, the
economist will include this implicit cost in total cost as the retail store owner
could have earned a competitive salary by working elsewhere (that is, the
implicit cost of the owner will be his opportunity cost).
The treatment of depreciation is also different. When estimating the future
profitability of a business, an economist is concerned with the capital cost of
plant and machinery. This involves not only the explicit cost of buying and the
running of the machinery, but also the cost associated with wear and tear. On
the other hand, accountants use depreciation rates on different assets as
allowed under the tax laws in their cost and profit calculations. These
depreciation rates need not reflect the actual wear and tear of the equipment,
which is likely to vary asset by asset.
The above discussion shows that there are some important differences in the
methods of calculating costs as used by the economists and the accountants.
Accordingly, the calculation of profit will also differ. To illustrate, consider a
retail store owner who has invested Rs. 1,00,000 as equity in a store and
inventory. His monthly sales revenue is Rs. 2,60,000. After deduction of cost
of goods sold, salaries of hired labour, and depreciation of equipment and
buildings, the accounting profit to the store owner is Rs. 25,000 (see Table
10.1).
Table 10.1: Accounting income statement for the Retail-Store Owner
Sales Rs. 2,60,000
Cost of goods sold Rs. 1,80,000
Salaries 30,000
Depreciation expense 25,000 Rs. 2,35,000

Accounting profit Rs. 25,000

192
In Table 10.2 we consider the economic statement of profit of the same store. The Cost of
The cost of goods sold and salaries remain the same. Let us suppose that the Production
market values of the equipment and building in fact declined by Rs. 25,000
over the current year and that the depreciation charge, therefore, reflects the
opportunity costs of these resources. Thus, depreciation expense is taken to be
Rs. 25,000 as in Table 10.1. However, the economist will add two items
relating to the implicit cost in the cost of production. Suppose that the owner-
manager could earn Rs. 25,000 per month as a departmental manager in a large
store and that this is his best opportunity for salary. Then we would add
Rs. 25,000 as the imputed salary of the owner-manager to the cost of
production. Similarly, the owner-manager has Rs.1,00,000 equity in the store
and inventory – a sum he could have easily invested elsewhere. Let us suppose
that he could have earned 10 per cent interest on this amount had he invested it
elsewhere. Thus, imputed interest cost on equity will be Rs. 10,000. Thus, as
can be seen from Table 10.2, the total economic costs, or the opportunity costs
of all resources used in the production process will add up to Rs. 2,70,000.
This implies an economic loss of Rs.11,000 to the owner-manager of the store
against the accounting profit of Rs. 25,000 depicted in Table 10.1.
Table 10.2: Economic statement of profit to the Retail-Store Owner
Rs. Rs.
Sale 2,60,000
Cost of goods sold 1, 80,000
Salaries 30,000
Depreciation expense 25,000
Imputed salary to owner-manager 25,000
Imputed interest cost on equity 10,000 2,70,000

Economic Profit -10,0000

In addition to the above differences in the calculation of profits by the

economists and the accountants, it is also important to point out that while for
economists, profits and losses are the driving force, business accounting does
not stop here. Business accounts also include the balance sheet, which is a
picture of financial conditions on a particular date. This statement records what
a firm is worth at a given point of time. On one side of the balance sheet are
recorded the ‘assets’ and on the other side are recorded the ‘liabilities’ and ‘net
worth’. A balance sheet must always balance because net worth is a residual
defined as assets minus liabilities.
The business accounting concepts can be summarised as follows:

1) The income statement shows the flow of sales, cost, and revenue
over the year or accounting period. It measures the flow of money
into and out of the firm over a specified period of time.
2) The balance sheet indicates an instantaneous financial picture or
snapshot. It is like a measure of the stock of water in a lake. The
major items are assets, liabilities and net worth.

193
Production 10.2.6 Historical Cost and Replacement Cost
and Costs
The historical cost is the cost that was actually incurred at the time of
the purchase of an asset. As against this, replacement cost is the cost
that will have to be incurred now to replace that asset (i.e., replacement
cost is the current cost of the new asset of the same type).
These two costs differ because of changes in prices over a period of time.
Naturally, if prices remain unchanged over time, both the costs will be the
same. But this seldom happens. Accordingly, historical cost and replacement
cost of an asset always differ. If the price rises over a period of time,
replacement cost will be higher than the historical cost. On the other hand, if
the price of the asset declines over a period of time, replacement cost will be
lower than the historical cost.
Because of the requirements of tax laws and the laws governing financial
reporting to shareholders, accountants generally express many costs in terms of
the actual or historic costs paid for the resources used in the production process
in accordance with the convention of financial accounts. However, both
economists and accountants agree on the fact that for decision making
purposes, it is not the historical cost that is relevant but the replacement cost.
This is due to the reason that for all decision making purposes, it is the
‘current’ (or the replacement) cost that is important and not the cost that was
incurred some years earlier at the time of the purchase of the asset.
Check Your Progress 1
1) Indicate the following statements as true (T) or false (F):
i) Externalities are not a part of private cost ( )
ii) Implicit costs are the costs associated with the use of firm’s own
resource ( )
iii) Retrospective costs are relevant for decision making ( )
iv) Accountants tend to take a retrospective look at the firm’s finances
( )
v) Economists are concerned with opportunity costs ( )
vi) The historical cost is the current cost of the new asset of the same
type ( )
2) Explain the difference between explicit cost and implicit cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3) Distinguish between private cost and social cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
194
4) What is the difference between sunk cost and incremental cost? The Cost of
Production
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5) Explain the difference between economic cost and accounting cost.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

10.3 COST FUNCTIONS: SHORT-RUN AND

LONG-RUN
The relationship between product and costs is known as the cost function.
There are two elements in determining the cost function of a firm. First, the
production of the firm, and second, the prices paid by the firm for the factors
used.
In practice, production functions can be of various types. At times, one factor
of production is variable and other factors fixed. It is also possible for some
factors to be variable. On account of this reason, cost function can also be of
various types. In economics, generally two types of cost functions are
considered under the price theory:
i) The short-run cost function, and
ii) The long-run cost function.
Cost functions can be illustrated in diagrammatic forms as cost curves.

10.3.1 Cost Function and the Time Element

To understand the theory of cost, it is necessary to be clear about the meaning
of short-run and long-run. In common usage, these terms may be used for
weeks, months and years but for the economist they indicate conditions of
production and have no reference to the calendar year. Even then, the concept
of time does creep in indirectly when the terms short-run and long-run are
discussed.
Generally, economists regard that period of time as short-run in which some
factors of production are fixed (at least one factor is fixed) and the firm
depends only on the variable factors of production to increase the level of
output. If the firm does not employ the variable factors at all, the output will be
zero in the short-run. However, the maximum quantity of output that can be
produced depends upon the quantity of the fixed factors of production. In the
long-run, all factors are variable and the quantity of the output can be increased
to any limit. For example, in a manufacturing industry the plants, machinery,
building of the factory, etc. are fixed resources in the short-run while the raw
materials, labour, power, etc. are variable. Therefore, to increase the amount of
output in this period, it will become necessary to employ more units of the
variable resources in conjunction with the fixed resources. Obviously, the 195
Production maximum output that can be obtained in this period will depend to a great
and Costs extent upon the total quantity of the fixed resources of production.

10.3.2 Long-Run Cost Function

In the long-run, total cost is a multivariable function which implies that total
cost is determined by many factors. The long-run cost function may be written
as
C = f(Q, T, Pf)
Where, C = total cost of production
Q = output
T = technology
Pf = prices of the relevant factors of production.
Graphically, the long-run cost function is shown on two dimensional diagram
as C=f(Q), ceteris paribus. With the assumption that the technology and the
prices of relevant factors of production remain constant, the long-run cost
function may be written as
C = f(Q, , f or C = f(Q)
However, the technology and the factor prices need not remain constant. When
these factors change, their effect on cost is shown by a shift of the cost curve. It
is this reason why the factors other than output are known as shift factors.
Theoretically there is no difference between the various factors which
determine the costs, and the distinction we have drawn above between the
output level and other factors determining costs can sometimes be misleading.
However, for showing costs on two dimensional diagrams this distinction has
to be made.

10.3.3 Short-Run Cost Function

In the short-run, in addition to output level, technology and factor prices, the
fixed factors such as capital equipment, land, etc. also determine costs of
production. Therefore, the short-run cost function is written as
C = f (Q, , f, )
Where, . In the discussion on the production function,
it has been stated that in the short-run certain factors like capital equipment,
land, factory building and top managerial staff remain constant.
the fact of the constancy of the fixed factors. Since the amount of fixed factors
does not change in the short-run under any circumstances,
factor like technology and factor prices.

10.4 THEORY OF COST IN THE SHORT-RUN

The short-run costs of a firm are divided into fixed and variable costs.
Therefore,
TC = TFC + TVC
where, TC = total cost
196
TFC = total fixed cost The Cost of
Production
TVC = total variable cost

10.4.1 Fixed Cost

Fixed cost is also known as supplementary cost. While engaging in

productive activity, the producer always has to incur some expenditure
which remains fixed whatever the level of production, so much so that
even if the producer stops production altogether, these costs have to be
incurred.
This is known as fixed cost of production. Interest paid by the producer on the
capital borrowed for purchasing plant and machinery, rent of the factory
building, depreciation of the machinery, the wages of foremen and organisers,
etc. are all fixed costs. These costs remain fixed even when the level of output
is varied. Even if the producer decides to close down production, he has to bear
these costs since the factory rent, wages of managers, interest on capital, etc.
have to be paid. This discussion makes it clear that larger the level of
production in a firm, the lower will be the per unit fixed cost (or average fixed
cost).

10.4.2 Variable Cost

The cost which keeps on changing with the changes in the quantity of
output produced is known as variable cost.

For instance, raw material has to be used in the process of production in a

manufacturing industry, labour has to be employed for running machines, and
energy (electricity) has to be arranged. Generally expenditure on these inputs
increases or decreases due to changes in the level of production. It is important
to remember in this context that when the producer abandons production in the
short run, these costs also vanish completely. In fact, it is due to this direct
relationship between expenditure on such inputs and the level of production
that these expenditures are known as variable costs.
The concepts of total cost, total variable cost and total fixed cost in the short-
run can be easily followed with the help of Table 10.3.
Table 10.3 : Short-Run Costs of a Hypothetical Firm

Output Total Fixed Cost Total Variable Total Cost

(Unit) (Rupees) Cost (Rupees)
(Rupees)
0 240 0 240
1 240 120 360
2 240 160 400
3 240 180 420
4 240 212 452
5 240 280 520
6 240 420 660
197
Production 10.4.3 Total Fixed Cost
and Costs

Total fixed cost is the total expenditure by the firm on fixed inputs.

From Table 10.3, it is clear that the total fixed cost of the firm remains constant
at Rs. 240 irrespective of the level of output. In our illustration, output varies
from 1 unit to 6 units, but the total fixed cost remains 240 in each case. Even
when the firm stops production altogether, implying that output is at zero level,
the total fixed cost remains unchanged. The firm’s total fixed cost function is
shown in Fig. 10.1.

Fig. 10.1 : Total Fixed Cost curve is parallel to X axis as total fixed cost remains the same
for all levels of output

10.4.4 Total Variable Cost

Total variable cost is firm’s total expenditure on variable inputs used to

carry out production.

Since higher output levels require greater utilisation of variable inputs, they
mean higher total variable cost. Table 10.3 shows that the total variable cost of
the firm increases as its output increases. However, when the firm stops its
production altogether, it does not require any variable input and, therefore, its
total variable cost is zero. Fig. 10.2 shows the firm’s total variable cost
function. Notice one peculiar feature of TVC – initially it rises sharply, then,
there is a moderation in its rate of rise and ultimately it resumes rising at a
faster pace.

198
 The Cost of
Production

Fig. 10.2 : Total Variable Cost Curve rises from left to right

10.4.5 Total Cost

Total cost is the sum of total fixed cost and total variable cost.
Thus, to obtain the firm’s total cost at a given output, we have only to add its
total fixed cost and its total variable cost at that output. The result is shown in
Table 10.3 and the total cost function is shown in Fig. 10.3. Since the total cost
function and the total variable cost function differ by only the amount of total
fixed cost which is constant, they have the same shape.

Fig. 10.3: Total Cost curve is obtained by adding the total fixed cost to total variable cost

199
Production In Fig. 10.4, all the three cost functions discussed above (total fixed cost
and Costs function, total variable cost function and total cost function) have been shown
together. Cost functions, when depicted graphically, are often called cost
curves.

Fig. 10.4 : Total Fixed Cost, Total Variable Cost and Total Cost

In Fig. 10.4, TFC is the total fixed cost curve. Since it is parallel to X-axis, it
indicates that whatever be the level of output the total fixed cost remains the
same (i.e., it does not change in response to a change in the level of
production). TC is total cost curve. It indicates the sum of total fixed cost and
total variable cost for the various output levels. If the level of production is to
be raised, the use of variable inputs will have to be increased and this will push
up the costs. The rising total cost curve TC from left to right (the positive slope
of TC curve) indicates this fact. The vertical distance between the total cost
curve TC and the total fixed cost curve TFC indicates total variable cost. For
example, if the firm wishes to produce OQ units of output, the total variable
cost will be GQ – MQ = GM and if the level of output is OR, the total variable
cost will be HR – NR = HN. The total variable cost has been depicted by the
curve TVC in Fig. 10.4. This is parallel to the total cost curve TC and the
vertical distance between the two curves (TC and TVC) indicates total fixed
cost.
Check Your Progress 2
1) Indicate the following statements as true (T) or false (F):
i) Cost function explains the relationship between product and costs
( )
ii) In the long run all factors are variable ( )
iii) Fixed cost is also known as supplementary cost ( )
iv) Total variable cost is the total expenditure by the firm for fixed
input ( )
2) Define and distinguish between long run cost function and short run cost
function.
.....................................................................................................................
.....................................................................................................................
200 .....................................................................................................................
3) Distinguish between fixed cost and variable cost. The Cost of
Production
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4) Define total fixed cost and total variable cost and trace the nature of the
total cost curve.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

10.5 SHORT-RUN COST CURVES

To find out the per unit profit, the firm has to compare the per unit cost (or
average cost) with per unit price. Therefore, it is necessary for us to understand
the concepts of average fixed cost, average variable cost and average total cost.

10.5.1 Average Fixed Cost

Generally, all those firms whose total costs of production include a significant
proportion of fixed costs try to increase the level of production to such an
extent that per unit fixed cost which is often known as average fixed cost, is
reduced substantially. To find out the average fixed cost, total fixed cost has to
be divided by the output.
In the form of a formula,

AFC =

where, AFC is the average fixed cost

TFC is the total fixed cost
Q is the output
Table 10.4: Average Fixed Cost, Average Variable Cost and Average Total
Cost of the Firm

Output Average Fixed Average Variable Average Total

(Units) Cost Cost Cost
TFC Q TVC Q TC Q
1 240 1=240 120 1=120 360 1=360
2 240 2=120 160 2=80 400 2=200
3 240 3=80 180 3=60 420 3=140
4 240 4=60 212 4=53 452 4=113
5 240 5=48 280 5=56 520 5=104
6 240 6=40 420 6=70 660 6=110

201
Production A mere look at Table 10.4 will show how the average fixed cost declines with
and Costs a rise in the level of output. When the firm produces only 1 unit, average fixed
cost is Rs. 240. As the ouput is expanded, there is a sharp decline in average
fixed cost and it is as low as Rs. 40 when 6 units of the commodity are
produced.

Fig. 10.5: Average Fixed Cost curve is a rectangular hyperbole

The fact that average fixed cost must decline with increases in output can be
easily understood with the help of average fixed cost curve in Fig. 10.5. In this
figure, when output is 1 unit, the average fixed cost is Rs. 240. When the
output is increased to 3 units and then to 6 units, average fixed cost declines
first to Rs. 80 and then to Rs. 40.
The average fixed cost curve (AFC) is a rectangular hyperbole because
multiplication of average fixed cost with the quantity of output produced
always yields a fixed value (the area under the curve is always same and
is equal to the total fixed cost).

10.5.2 Average Variable Cost

To obtain the average variable cost, we divide the total variable cost by the
output. In the form of formula:

AVC=

where, AVC = the average variable cost

TVC = the total variable cost
and Q = the output.

In fact, the average variable cost curve (AVC) gives us the same
information in money terms that we obtain from the average product
curve of the variable factor in physical terms.

With an increase in the amount of variable factor, the efficiency in production

increases (resulting in an increase in average product) and the average variable
202
cost declines. If average productivity remains constant, average variable cost The Cost of
will also remain constant. If it declines, average variable cost increases. Production

Thus, average variable cost curve is the reciprocal of the average

variable (factor) product curve.

After having understood the relationship between average variable factor

productivity and average cost, it is easy to understand the nature of the AVC
curve. While discussing the laws of production, we had stated that if other
factors are kept constant and only the quantity of one factor is increased, then
initially the tendency of increasing returns is observed. Later on, it is followed
by constant returns and diminishing returns in that order. This means that in the
initial stages, average variable cost declines and, after reaching a minimum
point, starts increasing. This increase is due to the operation of the law of
diminishing returns. From Table 10.4 we learn that at the output level of 1 unit
the firm’s average variable cost is Rs. 120. It declines when output is increased
and is Rs. 53 when 4 units of the commodity are produced. Thereafter, it
increases and is Rs. 70 when output level is raised to 6 units. The average
variable cost curve is thus U-shaped as in Fig. 10.6.

Fig. 10.6: Average variable cost curve is a U-shaped curve

10.5.3 Average Total Cost
The average total cost is also known as average cost. To find out average cost,
we divide total cost (which is the sum of total fixed cost and total variable cost)
by the output. In the form of a formula:
AC or ATC= = +
The modern economists are generally agreed that in all areas of economic
activity, average total cost declines initially. The reasons are the same which
lead to increasing returns in the initial stages. Average cost declines initially
because some of the resources are indivisible and there are possibilities of
specialisation in the production process. As long as the indivisible factors are
not fully utilised, the average total cost falls and when expansion in output
leads to a stage where the indivisible resources are fully utilised, an optimum
proportion is established between the factors of production. Output obtained at
this point is the optimum output. Here, the average total cost is minimum. If
the output is expanded beyond this point (which denotes an optimum
combination of resources) by increasing the amount of variable inputs, then
total production increases at a diminishing rate. This leads to a rise in average
203
Production total cost. This shows why the average total cost curve is U-shaped as shown in
and Costs Fig. 10.7. The illustration given in Table 10.4 also makes this point abundantly
clear.

Fig. 10.7: Average Total Cost curve is obtained by dividing total cost by the output

We can understand the shape of average total cost curve ATC better with the
help of average variable cost curve AVC and average fixed cost curve AFC
drawn in Fig. 10.8. Since the ATC curve is obtained by vertically summing up
the AVC and AFC curves, when both AVC and AFC curves slope downward,
the ATC curve also slopes downwards. The point R on the AVC curve shows
the minimum average variable cost. After this point, the average variable cost
starts increasing and thus the AVC curve is sloping upward. However, the fall
in the average fixed cost more than compensates for the rise in average variable
cost. Hence, the ATC curve slopes downward. Since at point T on the AVC
curve the rate of increase of the average variable cost is the same as the rate at
which the average fixed cost falls corresponding to this level of output, average
total cost is minimum at this output level. As the level of output increases
beyond this point, the average variable cost rises far more rapidly than the rate
at which average fixed cost falls. Therefore, the ATC curve slopes upward.

Fig. 10.8: Average total cost is the vertical sum of AFC and AVC

10.5.4 Marginal Cost

The marginal cost is the increase in the total cost owing to a small increase in
204 output.
In symbols, The Cost of
Production
MC = or

where, MC is marginal cost

TC is change in total cost associated with a small change in output
TVC is change in total variable cost associated with a small change in
output
Q is small change in output
The concept of marginal cost can be understood with the help of an example.
In Table 10.5, the total cost of producing 2 units of output is Rs. 400 and the
total cost of producing 2 + l or 3 units of output is Rs. 420. Therefore, marginal
cost is Rs. 20 which is Rs. 420 – Rs. 400.

Table 10.5: Calculation of Marginal Cost

Output Total Cost Total Variable Marginal Cost

Units (Rs. ) Cost ( Rs.)
(Rs. )

0 240 0 -
1 360 120 120
2 400 160 40
3 420 180 20
4 452 212 32
5 520 280 68
6 660 420 140

Since fixed cost remains unchanged in the short run, marginal cost can also be
defined as the increase in total variable cost consequent upon a small increase
in output. From Table 10.5, we learn that the variable cost of producing 2 units
is Rs. 160 and that of 3 units Rs. 180. The marginal cost, thus, will be
Rs. 180 – Rs. 160 = Rs. 20.
The marginal cost (MC) curve as it would be clear from Fig. 10.9 is U-shaped.
This implies that the marginal cost curve MC first slopes downward and then at
the point where marginal cost is minimum, it starts sloping upward because
marginal cost after decreasing with increases in output at low output levels,
increases with further increases in output. The shape of marginal cost curve is
in fact attributable to the law of variable proportions. According to the law of
variable proportions, the marginal product of the variable input rises at low
output levels and then falls with the expansion in output. Hence, the marginal
cost curve will first fall and then rise. There are two important points to
remember about the marginal cost curve:
i) The MC curve reaches its minimum point before the ATC and the AVC
curves reach their minimum points; and
205
Production ii) When the MC curves rises, it cuts the AVC and the ATC curves at their
and Costs minimum points.

Fig. 10.9 : Marginal Cost Curve is a U-shaped Curve

10.5.5 Relationship between Marginal Cost and Average Cost

There is a close relationship between the marginal cost (MC) curve and the
average total cost (ATC) and average variable cost (AVC) curves. We shall
explain the relationship only between the MC curve and the ATC curve, but
the relationship between the MC curve and the AVC curve can be explained
along the same lines of reasoning.
Fig. 10.10 shows the MC curve together with the ATC curve and the AVC
curve. The relationship between the ATC curve and the MC curve is as
follows:

1) When the MC curve is below the AC curve (which means

marginal cost is less than average cost), the latter falls.
2) When the MC curve is above the AC curve (which means
marginal cost is more than average cost), the latter rises.
3) The MC curve intersects the AC curve at its minimum point.

206 Fig. 10.10: MC curve intersects both AVC curve and ATC curve at their minimum points
The reason for the above stated relationship between the MC curve and the The Cost of
ATC curve is simple. So long as the MC curve lies below the ATC curve, it Production
pulls the latter downwards; when the MC curve rises above the ATC curve, it
pulls the latter upwards. Consequently, marginal cost and average total cost are
equal where the MC curve intersects the ATC curve. Further when output is
small, marginal cost remains lower than average total cost; but when output is
expanded, marginal cost exceeds average total cost. Thus, it is natural that the
MC curve intersects the ATC curve at its minimum point.
Another important feature of the relationship between MC and AC curves is
that MC is affected only by variable costs. Fixed costs do not affect marginal
costs. This can be proved algebraically as follows:
MCN = TCN – TCN-1
= (TFCN + TVCN) – (TFCN-1 + TVCN-1)
Since, TFCN will always be equal to TFCN-1 we can also state as follows:
MCN = TFCN + TVCN – TFCN-1 – TVCN-1
= TVCN – TVCN-1
This proves that MC is affected only by TVC and not by TFC.
Check Your Progress 3
1) Indicate the following statement as true (T) or false (F):
i) Average fixed cost curve is a rectangular hyperbole ( )
ii) Average variable cost curve is the reciprocal of the average variable
factor productivity curve ( )
iii) The average total cost curve has inverted U shape ( )
iv) When the MC curve is below the AC curve, the latter rises ( )
2) What is average cost? What is the nature of the average total cost curve?
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Define and distinguish between average cost and marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) Explain the relation between the average cost and the marginal cost. How
is it possible that the marginal cost continues to rise while average cost
declines?
..................................................................................................................
..................................................................................................................
..................................................................................................................

207
Production 5) The following table gives information on total cost, total fixed cost and
and Costs total variable cost for a firm for different levels of output:
Output 0 1 2 3 4 5 6

TFC (Rs.) 120 120 120 120 120 120 120

TVC Rs.) 0 60 80 90 105 140 210
TC (Rs.) 120 180 200 210 225 260 330

Find (i) AFC (ii) AVC (iii) AC and (iv) MC.

..................................................................................................................
..................................................................................................................
..................................................................................................................
..................................................................................................................

10.6 LONG-RUN COST CURVES

In the long-run, all factors are variable. Due to the absence of fixed factors in
the production function, all costs of production are variable in the long-run and
therefore there is no need to distinguish between fixed and variable costs as is
done in the short-run. In the long-run, to increase the level of production, all
factors have to be increased and this results in an expansion of scale.
In the short-run, the production capacity of the firm depends upon the size of
the plant. Generally, there are many options before a firm. According to the
circumstance, it can choose any plant out of the large and small plants
available to it. Let us suppose that a firm has three options and corresponding
to them, the short-run average total cost (SATC) curves are as given in Fig.
10.11. We shall call the smallest plant as A, the medium size plant as B, and
the large size plant as C. The short-run average total cost curves corresponding
to these plants are designated SATCa, SATCb and SATCc.
The firm decides about the size of plant keeping the market considerations in
view. If the demand is small, the firm will use plant A for purposes of
production but in doing so it will have to incur a higher average total cost. If
the firm has to produce OQ2 quantity of output, it has two options open before
it: firstly, it can employ plant A. The optimum level of output that can be
produced with the help of this plant is itself OQ2. Secondly, it can opt for plant
B. If it does so, the capacity of plant B will not be fully utilised nevertheless
per unit cost of production will be lower than the cost of production the firm
will have to incur if it opts for producing OQ2 amount of output with the help
of plant A (even though OQ2 is the optimum level of output that can be
produced on plant A). This is due to the tendency of ‘increasing returns to
scale’. Not that plant C is larger in size than plant B yet, the curve SATCc is
higher than the SATCb curve. If the firm opts for plant C in this case, the
average total cost will increase due to the operation of ‘diminishing returns to
scale’.

208
 The Cost of
Production

Fig. 10.11 : Long-run average cost curve envelopes short-run average total cost curves

Theoretically speaking, the long-run average cost (LAC) curve touches the
short-run average total cost (SATC) curves on their minimum points.
Geometrically this is possible only under those circumstances when the
tendency of constant returns to scale prevails. It is due to the fact that initially
increasing returns to scale and after some time diminishing returns to scale
prevail in the production process that the LAC curve touches the lowest SATC
curve at its minimum point. In the phase of increasing returns to scale when
average total cost is falling, the LAC curve touches the SATC curves to the left
of the minimum points of the SATC curves and in the phase of diminishing
returns towards the right of minimum points of these curves. In Fig. 10.11, the
curve LAC touches the SATCb curve at its minimum point K, the SATCa curve
towards the left of its minimum point (at L) and the SAT Cc curve towards the
right of its minimum point (at M).

In Economics, we say that the long-run average cost curve (LAC)

‘envelopes’ the short-run average total cost (SATC) curves.

10.6.1 Long Period Economic Efficiency

The behaviour of the firm which seems to be efficient in the short-run may be
found to be inefficient in the long-run. To understand this let us consider Fig.
10.12. Let us suppose that the firm is producing OQ1 quantity of output. If, due
to an increase in demand, the firm wishes to increase output by Q1Q2, plant
cannot be changed in the short-run and only variable factors will be increased.
Thus, the firm will advance on the curve SATC1. As a result, the efficiency of
the variable resources will improve and per unit production cost will decline
from BQ1 to JQ2. In the short-run the level of efficiency cannot improve further
because this is the optimum level of production that can be achieved with the
help of the plant available to the firm. However, in the long-run to produce the
level of output OQ2, the use of plant of such a small size is inefficient. If the
firm uses a plant of a larger size, it will benefit from the increasing returns that
would thus become available. As a result, the per unit cost will fall and come
down to the level KQ2. Though the full capacity of this plant will not be fully
utilised, even then it would be more efficient as compared to the earlier plant.

209
Production
and Costs

Fig. 10.12: Explanation of long-run economic efficiency

In a similar way when an expansion in scale leads to diseconomies or

diminishing returns to scale emerge, it will be in the interest of the firm to
reduce the level of production. If the firm is producing the output OQ4 in Fig.
10.12, it will not be a right strategy from the point of view of maximising
profits. The firm can cut down production by Q3 Q4 in the short-run and this
will enable it to reduce the average total cost from DQ4 to MQ3. This will
result in optimum use of the plant. However, in the long-run, this position will
not be satisfactory as the firm can reduce the average cost to the level NQ3 by
reducing the size of the plant. Since NQ3 < MQ3, the position which was
optimum for the firm in the short-run becomes inefficient in the long-run. It is
clear that when the firm uses plant of a relatively small size, it produces output
much larger than is technologically optimum yet the cost remains low because
it becomes possible to reduce the diseconomies of the large plant.

10.6.2 The Long-Run Average Cost Curve

We have explained in detail above that the short-run average total cost curve is
U-shaped. Let us now discuss the shape of long-run average cost curve. There
is general agreement that the long-run average cost falls initially due to
economies of scale. But whether it falls to a certain point and then becomes
constant or rises again, cannot be conclusively said.
In traditional analysis, the long-run average cost (LAC) curve is assumed to be
U-shaped (as in Fig. 10.12). The shape of the long-run average cost curve is
based on the assumption that ultimately the tendency of diminishing returns
operates in the production process. If this belief of the economists is correct
that every producer wishes to maximise profits and conditions of production
are perfectly competitive, then it is true that the LAC curve must ultimately
rise to the right.

210
10.6.3 Long-Run Marginal Cost Curve The Cost of
Production
After having understood the meaning of short-run marginal cost, it is not
difficult to understand what long-run marginal cost is. Long-run marginal cost
designates the change in total cost consequent upon a small change in total
output when the firm has ample time to accomplish the output changes by
making the appropriate adjustments in the quantities of all resources used,
including those that constitute its plant. As can be seen, this definition of long-
run marginal cost is practically the same as the definition of short-run marginal
cost given by us earlier. The only difference between the two is that whereas in
the short-run the existing plant will continue to be used for affecting an
increase in output, in the long-run the plant itself will be changed.
As far as the relationship between the long-run marginal cost curve and long-
run average cost curve is concerned, it is precisely the same as exists between
the short-run marginal cost curve and the short-run average total cost curve.
This would be clear from a mere glance at Fig. 10.13.

Fig. 10.13: Long-run marginal and average cost curves

10.6.4 Relationship between Long-Run Marginal Cost and

Short-Run Marginal Cost
When to produce a certain given level of output, a firm sets up the most
efficient plant, its short-run marginal cost (SMC) becomes equal to its long-run
marginal cost (LMC). Let us explain this with the help of Fig. 10.14. In this
figure, the given quantity of output is OQ1. This output can be produced at
lowest unit cost with the help of plant A. The short-run average cost curve of
the firm when it produces with the help of plant A is given by SAC. Short-run
average cost curves corresponding to other plants have not been drawn in Fig.
10.14. It is clear from the figure that at OQ1 level of output, SMC and LMC are
equal. However, we must see why they should be equal.

211
Production
and Costs

Fig. 10.14: Equality of SMC and LMC on use of an optimum size plant
To find out why SMC and LMC must be equal at the level of output OQ1, let
us consider the implications of a small change in the output by a small amount.
For instance, let us take the level of output OQ2. At this output level, short-run
average cost will be greater than long-run average cost (SAC > LAC). In other
words, short-run total cost is greater than long-run total cost (STC > LTC).
When output rises from the level OQ2 to the level OQ1 the short run total cost
becomes equal to the long-run total cost. If the level of output is raised to OQ3
then since SAC is greater than LAC at this output, STC will also be greater
than LTC. In other words, when output level is raised beyond OQ1, we find
that SMC exceeds LMC. Actually as we move from OQ2 to OQ1, we find that
rate of decline in SMC is declining. In fact, beyond OQ1, it stands rising. On
the other hand, LMC keeps falling over the entire range. Therefore, between
OQ1 and OQ3 SAC is rising and LAC is falling.
On practical considerations, the equality of short-run marginal cost and the
long-run marginal cost is very significant for a firm. If the firm has to increase
the level of output only by a very small amount whether it continues to employ
the existing plant and changes only the quantity of the variable resources or
makes a small change in the size of the plant, the results are the same.
Therefore, from the point of view of the firm, both the methods are equally
correct.
Check Your Progress 4
1) Indicate the following statements as True (T) or False (F):
i) There is no need to distinguish between fixed costs and variable
costs in the long-run. ( )
ii) Long-run average cost curve envelopes the short-run average total
cost curves. ( )
iii) Long-run marginal cost curve cuts the long-run average cost curve
from below at the latter’s lowest point. ( )
212
2) Discuss the nature of the long-run average cost curve. The Cost of
Production
..................................................................................................................
..................................................................................................................
..................................................................................................................
3) Discuss the concept of long period economic efficiency.
..................................................................................................................
..................................................................................................................
..................................................................................................................
4) What is the relationship between long-run marginal cost curve and long-
run average cost curve.
..................................................................................................................
..................................................................................................................
..................................................................................................................
5) Discuss the relationship between long-run marginal cost and short-run
marginal cost.
..................................................................................................................
..................................................................................................................
..................................................................................................................

10.7 LET US SUM UP

In this unit, we start with a discussion of the various concepts of cost like
private cost, social cost, and economic cost and accounting cost. This is
followed by a discussion of short-run and long-run cost functions. We then
proceed to define the distinction between fixed cost and variable cost. We note
that total fixed cost curve is a straight line while the total variable cost curve
and the total cost curve rise upwards to the right. We then turn to a discussion
of short-run cost curves .We note that the nature of the average fixed cost curve
is that of a rectangular hyperbola. When average variable cost curve is added to
the average fixed cost curve, we get the average cost curve. This is followed by
a discussion of the marginal cost and the nature of the marginal cost curve. The
marginal cost curve cuts the average cost curve from below at the latter’s
minimum point.

10.8 REFERENCES
1) Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta,
Microeconomics (Pearson Education, Seventh Edition, 2010). Chapter 6,
Section 6.1, 6.2, 6.3 and 6.4.
2) Dominick Salvatore, Principles of Microeconomics (Oxford University
Presss, Fifth Edition, 2010). Chapter 8, Section 8.1, 8.2, 8.3, 8.4 and 8.5

213
Production 3) A. Kountsoyiannis, Modern Microeconomics (The Macmillion Press
and Costs Ltd., Second edition, 1982), Chapter 4.
4) John P. Gould and Edward P. Lazear, Microeconomic Theory (All India
Traveller Bookseller, Sixth edition, 1996). Chapter 8.
5) Ahuja H.L., Advanced Economc Theory (S.Chand & Company Ltd., New
Delhi 2001), Chapter 20 Page 396-439.

10.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) (T) ; ii) (T) ; iii) (F) ; iv) (T) ; v) (T) ; vi) (F) .
2) See Sub-section 10.2.2 of Section 10.2.
3) See Sub-section 10.2.1 of Section 10.2.
4) See Sub-section 10.2.4 of Section 10.2.
5) See Sub-section 10.2.5 of Section 10.2.
Check Your Progress 2
1) (T) ; ii) (T) ; iii) (T) ; iv) (F)
2) See Section 10.3
3) See Sub-section 10.4.1 and 10.4.2 of Section 10.4
4) See Sub-section 10.4.3, 10.4.4 and 10.4.5 of Section 10.4
Check Your Progress 3
1) (T) ; ii) (T) ; iii) (F) ; iv) (F)
2) See Sub-section 10.5.3 of Section 10.5
3) See Sub-sections 10.5 .3 and 10.5.4 of Section 10.5
4) See Sub-section 10.5.5 of Section 10.5

5) (I )AFC = (ii) AVC = (iii) AC = (iv) MC =

Check Your Progress 4

1) (i) T (ii) T (iii) T
2) See section 10.6
3) See Sub-section 10.6.1 of Section 10.6
4) See Sub-sections 10.6.2 and 10.6.3 of Section 10.6
5) See Sub-section 10.6.4 of Section 10.6

214
GLOSSARY
Average Product : Total product divided by the number of units of
the input used is average product.
Accounting Cost : Accounting cost refers to actual expenses of the
firm plus depreciation charges for capital
equipment.
Barter : Exchange of goods/services against other
goods/services.
Budget Line : The Budget Line, also called as Budget
Constraint shows all the combinations of two
commodities that a consumer can afford at
given market prices and within the particular
income level.
Comforts : Goods which are used for increasing our
productive capacity and for making our lives
more comfortable.
Consumption : Using up of Utility of goods in the satisfaction
of a want.
Change in Demand : Shift of the entire demand of curve.
Change in Quantity : Movement on a demand curve itself caused by
Demanded a changes in the price of the commodity in
question.
Contraction in Supply : The decrease in quantity supplied because of a
fall in the price of the commodity.
Curvilinear Supply : The supply curve which is not a straight line.
Curve
Cardinal Utility : The Cardinal Utility approach is propounded
by neo-classical economists, who believe that
utility is measurable, and the customer can
express his satisfaction in cardinal or
quantitative numbers, such as 1, 2, 3 and so on.
Consumer Equilibrium : The point at which a consumer
reaches optimum utility, or satisfaction, from
the goods and services purchased, given the
constraints of income and prices.
Constant Returns to : Constant returns to scale implies that when all
Scale inputs are increased in a given proportion,
output increases in the same proportion.
Complementary : It is the commodity whose demand is directly
Commodity related to the demand of the commodity in
question.
Demand : The amount of goods which the buyers are
ready to buy, per period of time, at a given
price per unit.

215
Production Dependent Variable : A variable which changes only with the change
and Costs in the independent variable.
Decrease in Supply : The decrease in quantity supplied at a given
price of the commodity.
Diminishing Returns to : Diminishing returns to scale refers to the case
Scale when output grows proportionally less than
input.
Economic Laws : Statements of tendencies. They depict the
standardised or generalised response of
economic units to different forces and stimuli.
Exchange Value : The price which an item commands in the
market.
Elasticity of Demand : It quantifies the strength relationship between
the quantity demanded of commodity and the
price of the commodity or income of the
consumer or price of another commodity which
is related to the commodity in question.
Elasticity of Supply : The responsiveness of quantity supplied to a
given percentage change in the price of the
commodity.
Extension in Supply : The rise in quantity supplied due to a rise in the
price of the commodity.
External Economies : When a firm enters production, it obtains a
number of economies for which the firm’s own
strategies/policies are not responsible. These
are economies external to the firm.
External Diseconomies : When the scale of operations is expanded,
many such diseconomies accrue that have no
particular ill-effect on the firm itself but their
burden falls on the other firms. These are
known as external diseconomies.
Economic Cost : Economic cost refers to cost to a firm utilising
economic resources in production including
opportunity cost.
Explicit Cost : Explicit costs arise from transaction between
the firm and other parties in which the former
purchases inputs or services for carrying out
production.
Flow Variable : A variable which can be measured only with
reference to a period of time.
Goods : Items which have a utility or can be used for
the production of other goods or services.
Giffen Good : A good where higher price causes an increase
in demand (reversing the usual law of demand).
The increase in demand is due to the income
effect of the higher price outweighing the
216
substitution effect.
Historical Cost : Historical cost is the cost that was actually Glossary
incurred at the time of purchase of an asset.
Inductive Reasoning : The technique of analysis in which factual
information is used to discover the behaviour
pattern of different economic units in response
to various forces and stimuli.
Inferior Commodity : A commodity in which there is an inverse
(Good) relationship between the income of the
consumer and quantity demanded of a
commodity.
Income Elasticity of : It is the responsiveness of demand to a given
Demand proportional change in the income of the
consumer.
Inequalities of Income : The distribution of income among different
income groups of an economy.
Increase in Supply : The rise in quantity supplied at a given price of
the commodity.
Income Effect : A change in the demand of a good or service,
induced by a change in the consumers’ real
income. Any increase or decrease in price
correspondingly decreases or increases
consumers’ real income which, in turn, causes a
lower or higher demand for the same or some
other good or service.
Isocost Line : An isocost line represents various combinations
of inputs that may be purchased for a given
amount of expenditure.
Isoquant : An isoquant is the of all the combination of two
factrors of production that yield the same level
of output.
Increasing Returns to : Increasing returns to scale refer to the case
Scale when output grows proportionally more than
inputs.
Internal Economies : Those economies that accrue to a firm on
expansion of its own size are known as internal
economies.
Internal Diseconomies : When the scale of production is continuously
expanded, a point is reached where the increase
in production becomes less than proportionate
to the increase in the factors of production. As
this point, internal diseconomies set in.
Implicit Cost : Implicit costs are the costs associated with the
use of firm’s own resources. Since these
resources will bring returns if employed
elsewhere, their imputed values constitute the
implicit costs.
Incremental Cost : An incremental cost is the increase in total
costs resulting from an increase in production
or other activity
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Production Luxuries : Goods which are meant for status or social
and Costs standing.
Law of Supply : It shows the direct relationship between the
price of a commodity and its quantity supplied,
other factors influencing supply (except price
of the commodity) remaining constant.
Law of Diminishing : As more units of an input are used per unit of
Returns time with fixed amounts of another input, the
marginal product of the variable input declines
after a point.
Linear Homogeneous : When output increases in the same proportion
Production Function in which inputs are increased, the production
function is linear homogeneous. For example, if

production function is linear homogeneous.

Merit Goods : The goods whose consumption is believed to be
desirable for the benefit of the society and the
consuming individuals.
Macroeconomics : Branch of economic analysis that focuses on
the workings of the whole economy or large
sectors of it.
Margin : The value of the variable under consideration
related to the last unit of an item.
Marginal Utility : The additional or extra satisfaction yielded
from consuming one additional unit of a
commodity.
Microeconomics : Branch of economic analysis that focuses on
individual economic units or their small groups
and micro-variables like individual prices of
individual commodities, etc.
Money Exchange : Sale of goods/services against money.
Monopolist : A producer who controls the whole supply of a
commodity.
Marginal Product : Marginal product of an input is defined as the
change in total output due to a unit change in
the amount of an input while quantities of other
inputs are held constant.
Marginal Rate of : Marginal rate of technical substitution of factor
Technical Subsitution L for factor K ( ) is the quantity of K
( ) that is to be reduced on increasing the quantity
of L by one unit for keeping the output level
unchanged.
Necessities : Goods which are used for satisfying basic of
existence.

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Normative Economics : That part of economic analysis which is Glossary
concerned with what ought to be, and the way it
can be achieved by changing the existing
situation.
Ordinal Utility : The Ordinal Utility approach is based on the
fact that the utility of a commodity cannot be
measured in absolute quantity. However, it will
be possible for a consumer to tell subjectively
whether the commodity gives more or less or
equal satisfaction when compared to another.
Optimality : The point where maximum possible output is
being achieved given the use of different
factors of production.
Private Goods : Goods whose availability can be restricted to
selected users. It is divisible in that sense.
Production Possibility : A graphic representation of the combinations of
Curve maximum amounts of goods X and Y which
can be produced with the given productive
resources of the economy and under certain
other simplifying assumptions.
Public Goods : Goods or services whose availability cannot be
restricted to selected users only. The benefits of
the goods are indivisible and people cannot be
excluded.
Positive Economics : That part of economic reasoning which covers
what is, without going into its desirability or
otherwise, and without suggesting ways for
changing the existing state of affairs.
Price Effect : The impact that a change in its price has on the
consumer demand for a product or service in
the market. The price effect can also refer to the
impact that an event has on something’s price.
The price effect is a resultant effect of the
substitution effect and the income effect.
Point of Inflexion : The point where total product stops increasing
at an increasing rate and begins increasing at a
decreasing rate is called the point of inflexion.
Production Function : The technical law which expresses the
relationship between factor inputs and output is
termed production function.
Rectangular Hyperbola : It is a curve in which every rectangle drawn
with one corner on the curve has the same area.
Ridge Lines : The lines forming the boundaries of the
economic region of production are known as
the ridge lines.

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Production Replacement Cost : Replacement cost is the cost that will have to
and Costs be incurred now to replace that asset (i.e., the
replacement cost is the current cost of the new
asset of the same type).
Stock Variable : A variable which can be measured only with
reference to a point of time.
Supply : The quantity of goods which the sellers are
ready to sell, per unit of time, at a given price
per unit.
Substitution Effect : It shows how with a change in the price of a
commodity, prices of other commodities
remaining unchanged, a consumer substitutes
one commodity for the other.
Substitute Commodity : It is the commodity whose demand is inversely
related to the demand of the commodity in
question.
Supply Schedule : A table having two columns, one showing
different prices of the commodity and the other
showing quantities supplied during a given
period at each of these prices.
Supply Curve : A curve showing the relationship between price
of a commodity and its quantity supplied
during a given period, other factors influencing
supply remaining unchanged.
Sub-optimality : It is a point where optimality has not been
achieved, i.e. output is less than the possible
maximum given the use of the resources.
Sunk Cost : Sunk cost is a cost that has already been
incurred and can’t be recovered.
Technology : The method employed to produce a commodity
or service.
Total Utility : The total satisfaction derived from all the units
of an item.
Use Value : Utility of goods.
Utility : The want satisfying capacity of goods. It is the
service or satisfaction an item yields to the
consumer.

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 Glossary
SOME USEFUL BOOKS
1) Kautsoyiannis, A. (1979), Modern Micro Economics, London:
Macmillan.

2) Lipsey, RG (1979), An Introduction to Positive Economics, English

Language Book Society.

3) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),

Micro Economics, An imprint of Pearson Education.

4) Case, Karl E. and Ray C. Fair (2015), Principles of Economics, Pearson

Education, New Delhi.

5) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi.

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