Business Economics – I (Micro)

Code: CLNL1014

Dr. Mir Khursheed Alam

PhD Indian Institute of Technology Mandi, Program: BA LLB (H)
(H.P), India
Semester II:
Cohort: B1 and B4
Assistant Professor (Senior Scale) of Economics,
UPES School of Business Year: 2024-25

Office Address: K1103 Classroom: K2002, K2003

Email: mirkhursheed.alam@ddn.upes.ac.in

1
 Business Economics – I (Micro) (Module 5)

Unit V: Theory of production and cost 9 lecture hours

Basic Concept of production; Factors of Production; The Production

function, Short & Long Run Production Function; Total, Average &
Marginal product; Law of diminishing Marginal product; Law of Variable
proportion, Law of Return to Scale, Expansion path, Concept of cost; Total,
Marginal & Average Cost, Short Run & Long Run Cost, Relation Ship
Between Marginal & Average cost

2
Basics of production theory

Factors of production
Factors of production and factor payments
 PRODUCTION

 Definition: Production is the process by which inputs are transformed into ‘output’.
 Production is carried out by producers or firms.
 A firm acquires different inputs like labour, machines, land, raw materials etc.
 It uses these inputs to produce output.
 This output can be consumed by consumers or used by other firms for further
production.
 Q

Output (Q) = f (Inputs- Land, Labour, capital/machines) 2

PRODUCTION FUNCTION

 The production function of a firm is a physical relationship between inputs

used and output produced by the firm, under a given technology.
 A mathematical functional/technical/engineering relationship between
inputs and output
 For various quantities of inputs used, it gives the maximum quantity of
output that can be produced.
 Qx = f (L, K) where Qx is the quantity of output of commodity x, f is the
function and L and k are the units of labor and capital respectively.
 It says that the quantity of output depends on units of labor and capital used
in production.
THE PRODUCTION FUNCTION

We measure units of labour along the

Q horizontal axis and output along the vertical
axis. With L units of labour, the firm can at
most produce Q units of output.

Production Function

D 𝑸= 𝒇 ( 𝑳)
• Output (Q) = f (Labour unit
C Inefficient point
• •B
Production Set

L
PRODUCTION IN THE SHORT RUN​

Our first task is to explore the nature of the production

function. ​

Consider a hypothetical firm that produces sandwiches​

​Assumptions:

Size of factory is fixed in short run​

Capital is fixed input /factor of production e.g. The firm owns

only one sandwich grill ​

The firm can vary the quantity of sandwiches produced only by

changing the number of workers ​
PRODUCTION WITH SINGLE VARIABLE – SHORT
RUN​
 Short run and long run Production
function
Long Run
Short Run

Fixed factors/inputs Variable inputs All inputs are variable.

Land or Capital L, L, K, Technology etc
Labour

Short-run Production function • Long run Production function

• Q = f (L, K)
• Output (Q) = f (Labour (L)),
other factors/variables are • In the long run all factors are
fixed. variable, >> expansion of output may
be achieved by varying all factors.
• Output may be increased by changing
• Labor is variable, Capital is all factors by the same proportion, or by
constant different proportions.
11

• Q = f (L) / Given K
 SHORT V/S LONG RUN

• In the long run, all

 In the short run, at least one of the
factor – labor or capital – cannot be
factors of production
varied, and therefore, remains fixed. can be varied.
 In order to vary the output level, the firm • A firm in order to
can vary only the other factor. produce different
 The factor that remains fixed is called levels of output in the
the fixed factor. long run may vary both
 The other factor which the firm can vary inputs simultaneously.
is called the variable factor. • So, in the long run,
there is no fixed factor.
 SHORT-RUN PRODUCTION FUNCTION SCHEDULE

Total Product/Output:

Total Output obtained

from the employment of
the variable input,
keeping all other inputs
constant,.

𝑻𝑷
𝐀𝐏 =
𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓

MP = TPn-TPn-1
MP
MARGINAL PRODUCT AND AVERAGE PRODUCT

 Average Product: Average product is defined as the output per unit of

variable input.
 AP calculates it as:

 When capital is held constant, the marginal product of labor is:

MP = or TPn-TPn-1
Marginal Product: Marginal product of an input is defined as the change in
output per unit of change in the input when all other inputs are held constant.
 THE LAW OF DIMINISHING MARGINAL PRODUCT

In the short run the production function

can be defined with the Law of
diminishing marginal product.

This tendency of the MP to first increase

and then fall is called the law of variable
proportions or the law of diminishing
marginal product.

Law of variable proportions say that the

marginal product of a factor input
initially rises with its employment level.
But after reaching a certain level of
employment, it starts falling.
SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT
AND AVERAGE PRODUCT

 The total product curve in the input-output plane is a positively sloped curve
 According to the law of variable proportions, the marginal product of an input
initially rises and then after a certain level of employment, it starts falling. The MP
curve therefore, looks like an inverse ‘U’-shaped curve
 AP is also a inverse U shaped curve. Now as we increase the amount of input, the
MP rises. AP being the average of marginal products, also rises, but rises less than
MP. Then, after a point, the MP starts falling. However, as long as the value of MP
remains higher than the value of the AP, the AP continues to rise. Once MP has
fallen sufficiently, its value becomes less than the AP and the AP also starts falling.
So AP curve is also inverse ‘U’-shaped.
 REASON OF DIMINISHING RETURNS?

As we hold one factor fixed and keep increasing the other, the factor proportions change.
Initially, as we increase the amount of the variable input, the factor proportions become
more and more suitable for the production and marginal product increases.
But after a certain level of employment, the production process becomes too crowded
with the variable input.

Example: Suppose, output of a farmer who has 4 hectares of land, and can choose how
much labor he wants to use. If he uses only 1 worker, he has too much land for the worker
to cultivate alone. As he increases the number of workers, the amount of labor per unit
land increases, and each worker adds proportionally more and more to the total output.
Marginal product increases in this phase.
When the fourth worker is hired, the land begins to get ‘crowded’. Each worker now has
insufficient land to work efficiently. So the output added by each additional worker is
now proportionally less. The marginal product begins to fall.
Law of variable
proportion
Explains short-run production
behavior

Labour is variable, Capital is constant

Based on short-run production

function

Output (Q) = f (Labour (L)), other

factors/variables are fixed
Phase I: Increasing Returns
to a factor. This law is based on law of
diminishing returns to a
Phase II: Diminishing factor
Returns to a factor
As more and more units of a
Phase III: Negative Returns variable factor (labour) are
to a factor employed with fixed factors and18

technology, its marginal product

(of labour) eventually declines.
 Relationship between TP, AP, and MP
Derivation of the demand curve
Av. Product. Mar.
Product.

2
TP, AP AND MP


 THE PRODUCTION PROCESS WITH
ONE VARIABLE INPUT​

When Marginal Product is greater than the average product, the average product is increasing
[MP>AP; AP ]
i.e., When you get an assignment mark higher than your average, your average increases

When Marginal Product is less than the average product, the average product is decreasing [MP<AP;
AP ]
i.e., When you get an assignment mark lower than your average, your average decreases

Therefore Average Product is maximized when it equals marginal product

RELATIONSHIP BETWEEN TP AP and MP

As long as MPP increases, TPP

increases at an increasing rate.

When MPP falls but remains

positive, TPP increases but at a
diminishing rate.

When MPP becomes zero, TPP is

maximum.

If MPP becomes negative, TPP 22

starts decreasing.
Exercise: Plot TP, AP and MP of labour from this production scenario and comment on
the relationship between TP, AP, and MP

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SESSION SESSION SESSION SESSION SESSION SESSION SESSION
15 16 17 18 19 20 21

THE PRODUCTION PROCESS WITH ONE VARIABLE INPUT​

The Slopes of the Product Curve

The total product curve in (a) shows the output produced for
different amounts of labor input.
The average and marginal products in (b) can be obtained (using
the data in Table) from the total product curve.
At point A in (a), the marginal product is 20 because the tangent
to the total product curve has a slope of 20.
At point B in (a) the average product of labor is 20, which is the
slope of the line from the origin to B.
The average product of labor at point C in (a) is given by the
slope of the line 0C.
20

The Law of Diminishing Returns to Factor/

Diminishing Marginal Product
As additional units of a variable input are combined with a
fixed input, at some point, the additional output (i.e.,
marginal product) starts to diminish.
SESSION SESSION SESSION SESSION SESSION SESSION SESSION
15 16 17 18 19 20 21

THE PRODUCTION
PROCESS WITH ONE
VARIABLE INPUT
The Slopes of the Product
Curve

To the left of point E in (b), the marginal product is

above the average product and the average is
increasing; to the right of E, the marginal product is
below the average product and the average is
decreasing.

As a result, E represents the point at which the 20

average and marginal products are equal, when the
average product reaches its maximum.

At D, when total output is maximized, the slope of the

tangent to the total product curve is 0, as is the
marginal product.
Long Run Production Function -Returns To Scale
 Original PF >>Qo = f (L, K)
 The firm increased the L and K by λ units proportionately.
 New production function: Q = f(λL, λK)
 Constant returns to scale: If Q increases by the same proportion λ as the
inputs.
 [ 40% increase in K and L leads to 40% increase in output]
 increasing returns to scale: If Q increases more than proportionally with the
increase in the factors, [40% increase in K and L leads to 60% increase in
output
 decreasing returns to scale: If Q increases less than proportionally with the
increase in the factors [40% increase in K and L leads to 10% increase in 2

output]
 Long Run Production Function -Returns To Scale

 Long run Production function Qo = f (L, K)

 In the long run all factors are variable, >> expansion of output may be
achieved by varying all factors.
 Output may be increased by changing all factors by the same proportion, or
by different proportions
 Returns to scale refers to the changes in output as all factors change by the
same proportion.

 The laws of returns to scale refer to the effects of scale relationships.

 MEASURING RETURNS TO SCALE
One way to measure returns to scale is to use a coefficient of output
elasticity, :

If , we have increasing returns to scale (IRTS).

If , we have constant returns to scale (CRTS).

If , we have decreasing returns to scale (DRTS)

 MEASURING RETURNS TO SCALE
•Another way of looking at the concept of returns to scale is based
on an equation of following type:

•Assume each input is increased by, say, some proportion

•
• is expected to increase by some proportion as a result of the
increase in the inputs.

•Let represent the magnitude of this increase

RETURNS TO SCALE
Returns to scale may be presented in the following way:

1. If , the firm experiences increasing returns to scale

2. If , the firm experiences constant returns to scale

3. If , the firm experiences decreasing returns to scale

 LEARNING BY DOING EXERCISE
Suppose we have the following production function

• What will be the output if we use:

1. 8 units of L and 12 units of K.
2. Now let us increase each input by 25 % (i.e., ).
3. What type of returns to scale does the firm follow?
 LEARNING BY DOING EXERCISE

• Suppose we have the following production function of perfect substitutes:

• If we use 8 units of L and 12 units of K, the output will be

• Now let us increase each input by 25 % (i.e., ). This will give us

LONG RUN PRODUCTION FUNCTION

LABOUR CAPITAL OUTPUT(TP) MARGINAL STAGES

PRODUCT

2 1 12 - INCREASING
RETURNS TO
4 2 16 4 SCALE

6 3 24 6

8 4 32 8

10 5 42 10 CONSTANT
RETURNS TO
12 6 52 10 SCALE

14 7 62 10

16 8 72 10 DIMINISHING
RETURNS TO
18 9 78 6 SCALE

20 10 82 4
Stages of Returns To Scale
Increasing Returns- Stage I:
• TP increases at an increasing rate.
• Fixed factor (K) is abundant and variable factor is inadequate. Hence K
gets utilized better with every additional unit of labor

Diminishing Returns - Stage II

• TP continues to increase but at a diminishing rate.
• both the marginal product and average product of labour are diminishing
but are positive

Negative/Decreasing Returns - stage III

TP begins to decline –Capital becomes scarce as compared to variable
factor. Hence over utilization of capital setting in diminishing returns
Increasing returns to scale. In this case, a proportionate increase in all input
quantities results in a greater than proportionate increase in output.

Constant returns to scale. In this case, a proportionate increase in all input

quantities results in the same proportionate increase in output.

Decreasing returns to scale. In this case, a proportionate increase in all input

quantities results in a less than proportionate increase in output
PRODUCTION WITH TWO
VARIABLES – LONG RUN

Returns to Scale
Rate at which output
increases as inputs are
increased
proportionately.
 Long Run Production Behaviour (With Two Variable Inputs, L and K)
Is Illustrated By Isoquants–

Isoquant shows all the combinations of labour

and capital that can produce a total output (Total
Physical Product TPP) of 4,000.

•20 capital and 18 labour or (more capital

intensive)
•9 capital and 35 labour. (more labour intensive

An isoquant is usually shaped convex to the

origin because of the law of Marginal Rate of
Technical Substitution (MRTS) which means
there are diminishing returns from using more of
one factor of production.

Slope of isoquant = Marginal rate of factor substitution

 ISOQUANTS

 An isoquant is the set of all possible

combinations of the two inputs that yield the
same maximum possible level of output.
 Each isoquant represents a particular level of
output and is labeled with that amount of output.
 For example, an Output of 10 units can be
produced in 3 ways:
 (4L, 1K), (2L, 2K), (1L, 4K).
 All these combinations of L, and K lie on the
same isoquant, which represents the level of
output 10
 Stages of RETURNS TO SCALE can be illustrated by Isoquant
Maps

Constant returns to scale: Situation in which output doubles when all inputs are doubled.
Increasing returns to scale: Situation in which output more than doubles when all inputs are doubled.
Increasing returns to scale: Situation in which output more than doubles when all inputs are doubled.
ISOQUANT FOR WHEAT PRODUCTION

2
 ISOQUANT CURVE MAP

• A set or collection of Isoquant curves is

called an isoquant map.

• A higher isoquant curve will give a

higher level of output, while a lower
isoquant curve will give a lower output.

• A shift of an isoquant curve to a higher

position indicates growth in the size of a
firm. That will happen when a firm has
more units of factors of production
available for producing goods and
services.
2
Slope of Isoquant: Marginal Rate of Technical Substitution
(MRTS)

Marginal rate of technical

substitution (MRTS)

The amount by which the

quantity of one input can
be reduced when one
extra unit of another input
is used so that output
remains constant.

2
ISOQUANT FOR WHEAT PRODUCTION

2
Plot an Isoquant on your notebook

 Similarly, the output 50 can be produced by (6L,3K) , (3L,6K)

and (4L,4K).
 Isoquant helps in identifying the best possible way to produce a
specific level of output with different methods suitable for the
firm.
 If the firm is capital-abundant, It will choose a combination that
has more capital and less labor.
 If the firm is labor-abundant, It will choose a combination that
has more labor and less capital.
Iso-cost line and Least Cost Combination

An isocost line shows various combinations To maximise profits, a firm will wish to
of two inputs—labour and capital—that
can be bought for a given amount of
produce at the point of the highest
expenditure. possible isoquant and minimum possible 2

isocost
 Expansion Path (Long Run Expansion Path Graph)

 An expansion path (also called a scale line)

is a path connecting optimal input
combinations as the scale of production
expands.
 It is often represented as a curve in a graph
with quantities of two inputs, typically
physical capital and labor, plotted on the
axes.
 It refers to the trajectory of a firm's
production and output as it increases its
scale of operations. This concept is often
associated with the long-run production
2
function, where all inputs can be varied.
Expansion Path

The expansion path of the firm is given by

connecting all the points of tangency
between all relevant isoquant curves
and isocost curves. These are illustrated
in the long-run expansion path graph
above at points X, Y, and Z.
Drawing a straight line through these
points and through the origin gives us
the expansion path, as illustrated by the
red line.
The expansion path shows us the efficient
combinations of labor and capital i.e.,
those that minimize costs at various
output levels. 2
Expansion Path

Expansion path is the

combination of inputs that
minimize costs for every
level of output, and it can be
graphed as a curve
X, Y and Z are the least cost
combinations of producing
different levels of output
using several combinations
of L and K.
2
 RETURNS TO SCALE VERSUS
DIMINISHING MARGINAL RETURNS

• It is important to understand the

distinction between the concepts of
returns to scale and marginal returns.

• Returns to scale pertains to the impact

of an increase in all input quantities
simultaneously.

• Marginal returns (i.e., marginal product)

pertains to the impact of an increase in
the quantity of a single input, such as
labor, holding the quantities of all other
inputs fixed.
 ISOCOST Line and its slope

An isocost shows all the combinations of two

inputs—labour and capital that cost the same to
employer.
Profit maximization by a firm
Costs
Cost is defined as the expenditure incurred by a firm or producer to purchase or
hire factors of production in order to produce a product.

Cost function: cost is a function of output. Cost = f (Output) or C = f (Q)

Nature of cost in the production process

Cost in the short run: Fixed vs. variable cost

Fixed costs are those costs that do not change with any changes in the quantity of
production or size of output during the period. They remain constant during the whole
period at any level
of output.

Variable costs are those costs that vary with the change in the quantity of output or
production. Their cost increases with an increase in output and decreases with a
decrease in output.
52
Total fixed cost (TFC) and
Total Variable Cost (TVC)

53
TC = TFC + TVC

TC stands for total

cost,

TFC for total fixed

cost

TVC for total

variable
cost.
54
(i) As long as MPP increases, TPP increases at an increasing rate.
(ii) When MPP falls but remains positive, TPP increases but at a diminishing
rate.
(iii) When MPP becomes zero, TPP is maximum.
(iv) If MPP becomes negative, TPP starts decreasing.

55
 Short Run

Short run
Fixed factors/inputs Variable inputs
Land or Capital
Labour

Cost Cost

Total Fixed Cost Total Variable

Total Cost =
(TFC) + (TVC)
57
58
Marginal Cost (MC) is the addition to TC/TVC by the production of
an additional unit of the product

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60
61
2
LONG RUN AVERAGE AND MARGINAL COST

 Long-run average cost curve

(LAC) Curve relating the
average cost of production to
output when all inputs,
including capital, are variable.

long-run marginal cost curve

(LMC) Curve showing the
change in long-run total cost as
output is increased incrementally
by 1 unit.
2
Economies of scale: The property whereby long-run average total
cost falls as the quantity of output increases

Total revenue: The amount a firm receives for the sale of its output

Total cost is the market value of the inputs a firm uses in production

Profit = total revenue minus total cost,

2
Revenue of Firms

Total revenue is the sum of all sales, receipts or

income of a firm.
• Total revenue at any output is equal to price
per unit multiplied by quantity sold.

• TR = P Q sold

Average revenue refers to the revenue obtained by

the seller by selling the per unit commodity. It is
obtained by dividing the total revenue by total output.

• AR = TR / Q
Marginal Revenue: net revenue obtained by selling an
additional unit of the commodity.
2

MR = ∆TR/∆q
2