THEORY OF PRODUCTION AND COST

Meaning and Definition of production:

Production is one of the most important economic activities. Production is an activity directed to satisfy consumers wants through exchange. During the process of production material goods and services are produced or utility is created in the materials to satisfy human wants. Production is not merely transformation of material things or creation of utility but it involves the process of exchange through which goods and services reach the ultimate consumers to satisfy their wants. According to fundamental law of science Matter is neither created nor destroyed. Human beings can only create or add utility to existing matter.

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Definition of production:
Production can be defined as creation or addition of utility. According to Paul studenski, Economic production covers the complex of human activities devoted to the creation, with limited resources of goods and services capable of satisfying human wants and because of their limited supply, having limited value. According to Peterson, Production can be defined as any activity that creates present and future utility.

Methods of Creation of Utility: 1. Form Utility:

Form utility is created when the existing matter is transformed or rearranged, so that it becomes more useful. Through increase in its utility a material becomes more adapted to satisfy some particular human wants. For example, a carpenter transforms wooden planks into furniture; a baker converts flour into bread etc.

2. Place Utility:
Place utility is created by changing the place of the resources, from the place where they are of little or no use to another place where they are of greater use. Place utility can be obtained by (i) Extraction from earth e.g., removal of coal, iron-ore, gold-ore etc. from earth. (ii) Transferring goods or materials from one place to another where it is more useful, e.g., transferring sand from river bed to the place of construction work, sandalwood from forest to showroom in the city etc.

3. Time Utility :
Time utility is created by all forms of storage, insurance and speculation. There is always a time-lag between the production of goods and their consumption. Goods produced in the present time are available for consumption in the future. Ensuring availability of materials at times, when they are not normally available for production and consumption is time utility. For example, rice is harvested in winter, but its demand continues throughout the year. It is through stocking of rice that its supply can be ensured throughout the year, woolen garments are produced throughout the year but their demand is high in winter, through stocking they are made available when needed.

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4. Natural utility:
Natural utility is the utility available in the free goods provided by nature. For example, free natural goods are like air, water, sunshine etc. provide tremendous utility to sustain life on earth.

5. Knowledge utility:
Utility can be created through spread of knowledge. A number of machines, equipments, apparatus, tools etc., are useful only when people posses necessary knowledge to use and operate them. For example, a personal computer or a laptop is useless for a person if he or she does not know how to operate them.

6. Person Utility:
Person utility can be created by acquiring skills and talents. For example, the services of doctors, engineers, chartered accountants etc., are basis of person utility and services. 7. Possession utility: Utility is also created when a commodity is possessed by a person who can derive satisfaction out of it. For example, books lying in the college library are not useful left alone. Once these books reach in the possession of the readers they can derive utility out of them.

Conditions to be fulfilled to be called production:

Creation of utility is a necessary condition of production activity. Only those goods and services will be classified in production which posses the following characteristics: 1. These are mainly created by human labour and capital. 2. These are capable of satisfying human wants directly or indirectly, as producers goods. 3. These are comparatively scarce, and therefore, need to be economised and have economic value. 4. These either have a definite monetary price or cost or can be given one by charge.

Activities to be excluded from being called as production:

All kinds of activities directed for the production of goods and services for satisfaction of other peoples wants are not included in production. The following types of activities are excluded from production: 1. Any domestic work: Any work done by a family member out of love and affection towards family and not with the object of earning a reward should be excluded from production. 2. Voluntary services: Any services performed by the nationals or citizens of a country out of patriotic feelings and with the object of social welfare should not be included in the production. 3. Goods produced for self-consumption: Any goods produced for self-consumption do not constitute production. A large part of production of agricultural produce is retained by the farmers for their family consumption. It is not marketed to earn income. Therefore, it should be excluded from production. 4. Leisure-time activities: Any work of art and literature, pass-time hobbies do not fall in the ambit of production because they are done for self-satisfaction.

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Factors of Production:
Production requires the use of certain resources. It is the co-operative effort of the various factors of production. They are also known as inputs. Whatever goes into the production process to produce goods and services is called inputs. Factors of production or inputs are divided into two categories: A. Factor inputs. B. Non-factor inputs. A. Factor inputs: Factor inputs comprise land, labour, capital and enterprise. These are also known as primary inputs, because without these inputs production is not possible. B. Non-factor inputs. Production also requires certain non-factor inputs such as raw materials, semi-finished goods, and other inventories kept by the producing unit to keep the production process going uninterrupted.

1. Land:
Land includes all those resources, whose total supply in the economy is fixed or inelastic. In economics, land does not mean only surface of earths soil or physical territory alone but also all other scarce natural resources which are the free gift of nature such forests, mines, rivers and sea water, temperature, rainfall, etc. According to Marshall, land means the materials and the forces which nature gives freely for mans aid, in land and water, in air and light and heat. The moment these natural resources come under the ownership of an individual or the society, these start earning income in the form of rent, royalty, etc.

Characteristics:
1. Land is free gift of nature: Human beings can neither create land nor destroy it. Land comes to human beings as a free gift of nature, there is no need to pay any price for it so long as it is not owned and controlled by someone. 2. Inelastic Supply: The supply of land is fixed. Human being can simply change the uses of land; they can neither expand nor contract the land area. 3. Immobility of Land: Land is a static a factor of production. It cannot be shifted from one place to another like labour and capital. 4. Land is a passive factor of production: Land is a passive factor of production. Land itself cannot produce anything. Active assistance of labour and capital is needed to make land productive. It would not yield any result unless deployed usefully through human ingenuity and effort. 5. Lands differ is fertility. Land differs in fertility. No two pieces of land posses the same fertility Mineral resources, river system, forest resources, mountain formation, fertility of soil, etc., differ from one region to another.

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6. Specific factor of production: Land is a specific factor of production because without land we cannot produce anything. 7. Indestructible: According to Ricardo, land is an indestructible factor of production because it cannot be destroyed.

2. Labour:
Labour is a physical or mental effort of human being in the process of production for economic purpose. Any work done for the sake of pleasure of love does not represent labour in economics. Marshall defines labour as any exertion of the body or mind undertaken wholly or partly with some object other than the pleasure derived from the labour itself. It is the human element which distinguishes it from other factors, for it gives rise to special problems regarding mobility, efficiency, unemployment and psychological attitudes.

Characteristics of Labour:
Labour is basically different from other factors of production. Unlike the other factors it is a living factor. The following are the main characteristics of labour as a factor of production: 1. Labour is an active factor of production: Without the active participation of labour, land and capital cannot produce anything. 2. Labour is perishable: It cannot be stored. If the labourer does not work on a particular day, that days labour goes for good. It implies that the labourer cannot store his labour and so he has no reserve price for his labour. 3. Labour is inseparable from the labourer: The labourer has to present himself physically at a place where production activities take place. It implies that the labourer embodies the services he performs. Labourer is the source of his own labour power. 4. Labour is directly connected with human efforts: All labour is manifestation of human efforts both physically and mentally. 5. Productivity of labour can improve: Through education, training, use of better machinery and equipment the productivity of labour can improved. 6. Labour makes a choice between the hours of labour and hours of leisure: The labourer has to make a choice between the hours of labour and hours of leisure. The supply of labour and wage rate is directly related. It implies that as wage rate rises, the labourer tends to increase the supply of labour by reducing the hours of leisure. However, beyond a minimum level of income the labourer reduces the supply of labour and increases the hours of leisure in response to a further rises in the wage i.e., hence, the supply curve of labour is backward bending. 7. supply of labour is inelastic during the short run: The supply of labour is related to population. It takes a child more than 15 years to develop into a labourer; therefore, supply of labour will be inelastic.

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8. Labour differs in productivity. Efficiency and productivity of one labourer differ from another. On the basis labour power, labour may be classified as unskilled labour, semi-skilled labour and skilled labour. 9. Labour in mobile: As compared to other factors, labour is more mobile. Labour can easily move from one place of work to another. 10. Labour has intelligence and Judgment: The labourer has the capacity to think, apply mind and act in the best interest of self and the organisation.

Types of labour:
Mental and Physical labour: The labour that applies more of mind and less of muscle power is called mental labour. The work of a teacher, an advocate, doctor, engineer, research scholar, etc., falls under the category metal labour. Conversely, the labour that uses more of muscle power and less of mental power is called physical labour. For example, the work of a collie, rickshaw-puller, mason, blacksmith etc., is put under the category of physical labour.

Division of labour:
According to Prof. Watson, Production by division of labour consists in splitting up the productive process into its component parts. In the words of Taussing, The division of labour means those people who carry on several operations of a given branch of industry combined for bringing about final results. Division of labour occurs when a labourer confines himself to the production of a single commodity or single sub-process and leaves the production of other commodities or processes to others. Division of labour implies two things; a. Specialization of functions, and b. Co-operation between different labourers.

Types of Division of Labour:

The following are the different forms of division of labour: 1. Product-based division of labour: It is also known as simple division of labour. In the primitive or traditional economies, a worker specialized in the production of single good such as cloth, furniture, ornaments, etc. 2. Process-based division of labour: It is also known as complex division of labour. In a modern economy, large business enterprises divided and sub-divided the process of production of a single commodity and each worker performance one or two of the several processes involved in the production of commodity. 3. Territorial Specialization: This type of specialization occurs when a particular area gets specialized in the production of a specific commodity. For example, labour at Surat has specialized in diamond work, at Srinagar in shawl-embroidery etc.

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Merits of Division of Labour: 1. Increase in productivity and reduction in wastage. 2. Better quality products can be manufactured at less cost in short period of time. 3. Scope for Mechanization, innovation and development widens. 4. Inventions may take place due to expertise of labour in a particular area of specialization. 5. It leads to high degree of Specialization. 6. It leads to better understanding among workers. Demerits of Division of Labour: 1. Loss of Pride and Responsibility. 2. Monotony in work. 3. Immobility of Labour. 4. Fear of over production increases.

Efficiency of labour:
Efficiency of labour means the amount of work which a labourer can do within a given time. The efficiency of labour refers to productivity of labour, both quantitative and qualitative during a given time. Efficiency of labour is a relative concept therefore; it is always understood and measured in relation to some predetermined standards. Efficiency of labour differs from one labourer to another and is subject to change over time. Efficiency of Labour depends upon; 1. Conditions of Work, 2. Quantity of production, and 3. Quality of production Advantages or significance of Efficiency of Labour. 1. Increase in National Income. 2. Better Employment Opportunities. 3. Less chance of Wastage. 4. Low Price and More Profits. 5. Innovations may take place in the course of time. 6. Less Supervision. Efficiency of Labour in a country depends upon the various factors. 1. Climatic conditions, Health and Strength of workers. 2. Personal Qualities, Education and Standard of living. 3. Social and political security, Level of wages and working conditions 4. Labour laws and Hours of work. 5. Mobility of labour.

Mobility of Labour:
Mobility of labour can take any of the following forms: 1. Territorial Mobility: It is also known as geographical mobility of labour. It relates of the movement of labour from one place to another. 2. Occupational Mobility: When a labourer leaves one occupation to join the other it is called occupational mobility. For example: If a worker leaves a cotton textile mill to join a jute mill it is called occupational mobility.
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3. Grade mobility: When a worker moves from one position to another in the same or other occupation, it is called Grade mobility. Grades are form according to different wage-groups. Grade mobility can assume two forms: a. Horizontal mobility: When a labourer moves from one occupation to another on the same grade it is called Horizontal mobility. b. Vertical mobility: When a labourer moves from one occupation to another for a higher position it is called Vertical mobility.

3. Capital:
Capital is man-made material factor of production. It is stock concept. All capital is wealth but all wealth is not capital. According to J.S. Mill Capital is the accumulated; product of past labour destined for the production of further wealth. Capital comprises man-made materials which are used for the further production. Goods produced with the help of different factors of production are broadly classified into two categories: 1) Consumer goods 2) Producers goods Capital consists of producers goods and stocks of consumer goods not yet in the hands of consumers. Capital consists of following: (a) Structures, such as private residential houses, factory buildings, commercial buildings, Government buildings etc. (b) Equipments that includes three types of goods, a. Durable consumer goods, like furniture, TV sets, etc. which are yet reach consumers. b. Durable Capital goods, like machinery, plant, tools, roads, bridges, dams etc. c. Inventories, such as stock of Raw-materials, intermediate goods and finished goods lying unsold with the wholesalers and Retailers (c) Money used for production purposes. Characteristics of Capital: 1. Capital is the result of past labour. 2. Capital is the result of Savings. 3. Capital is prospective. 4. Capital is a highly mobile factor of production. 5. Capital is not a Free Gift. Functions of Capital: 1. Capital increases the productivity of labour. 2. Capital Secures Continuity in production. 3. It is helpful for further Capital Formation. 4. It acts as Source of research and Development.

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Distinction between capital and other related concepts:

1. Capital and Money: Money is anything that is generally accepted by the people as medium of exchange and a measure of value, and is also used to meet other kinds of business obligations. But, all money is not capital, that part of money which used further production is called capital. 2. Capital and Income: Earnings regularly drawn either from the ownership assets or by doing dome economic activity are called income. That part of income which is saved and used for further production is called capital. Capital is a stock, whereas income is flow. 3. Capital and Wealth: Wealth comprises the stock of all reproducible and irreproducible goods. All wealth is not capital. That part of wealth which is used for further production of wealth is called capital; on the other hand, all capital is wealth.

Classification of capital:
Capital assists in production if different ways. Capital, on the basis of its use, can be conveniently classified in the following forms: 1. Fixed and Circulating Capital: Fixed capital is one which is durable and which is used in production for a considerable long time. The examples of fixed capital are machines, plants, equipment, factory buildings, dams, irrigation canals, etc. Circulating capital refers to the capital which is used only one once in production. It loses its utility after single use. The examples of the circulating capital are raw materials, seeds, coal, petrol, gas etc. It regularly needs replacement. 2. Material and Personal Capital: Material capital consists of objects which exist in concrete and tangible form and are capable of being transferred from one person to another. Examples of the material capital are machines, tools, transformers, etc. Personal capital comprises all those energies, faculties and habits which contribute to make labour efficient. It includes all the personal qualities of an individual which are non-transferable. Examples of personal capital are art of dancing and singing, art of painting, art of oratory, etc. 3. Sunk and Floating Capital: Sunk or specialized capital is one which can be used in a specific occupation. Once invested in a particular business, it cannot be withdrawn. Examples of sunk capital are railway bridges, factory buildings, roads, dams etc. Capital is said to be floating or free when it can be changed at will for employment in any branch of industry and can at any time assume a different form. Examples of floating capital are wood, raw materials, electricity etc. 4. Remuneratory and Auxiliary Capital : Remuneratory or wage capital is one which is applied to the payment of labour engaged in production. Auxiliary capital is that which assists the labour to carry out their duties smoothly. Machines, tools, equipment, etc., are the examples of the auxiliary capital. 5. Production and Consumption Capital: Production capital comprises all those articles which help the labour directly in production. Examples of production capital are raw materials, machines, tools, equipment, etc. Production capital may be material as well as personal. Consumption capital consists of

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those materials which indirectly assist in the process of production. Examples of consumption capital are food, clothes, residential accommodation, vehicles, etc. 6. Internal and External Capital: This classification of capital is based upon the criterion of place. The capital which is the result of domestic savings in the country is called internal capital. Capital which is imported or invited from abroad and used in recipient country is called external capital. The capital received in India from the World Bank, International Finance Corporation etc., is an example of external capital.

Capital Formation:
Production is a continuous process. Whatever goods and services are produced in an accounting year are not consumed instantaneously. A part of current production is consumed, while the remaining part is retained for further production. We may define capital formation as The surplus of production over consumption in an accounting year which is used for further production. Capital formation is regarded as a social process whereby a societys capital stock increases during a given period. According to Prof. Nurkse, The meaning of capital formation is that society does not apply the whole of its current productive activity to the needs and desires of immediate consumption, but directs a part of it to the making of capital goods, tools and instruments, machines and transport facilities, plant and equipment all the various forms of real capital that can so greatly increase efficacy of productive effort. Capital formation plays a vital role in the development of an economy. Generally speaking, higher the rate of capital formation more economically developed an economy would be. It determines the production potential of an economy.

Stages of Capital Formation:

There are mainly three stages of capital formation, which are as under:

1. Real Savings:
Savings is the foundation stone upon which the edifice of capital formation is erected. A part of the resources is withdrawn from current consumption so as to increase the real savings of a community. The magnitude of the real saving depends upon the will to save, power to save and the facilities to save. (a) Will to save: How much a person would be willing to save depends upon the individuals nature. If an individual is foresighted and wants to make his old age secure, he will save more. Some persons are miserly by nature, and whatever the hardships they will save a certain proportion of their money income. Out of family affection people may like to save more with a view to have comfortable future of their dependents. Sometimes people save more in order to command greater respect in the society. Allurement to earn a high rate of interest may also induce people to save more. (b) Power of save: It is the capacity, or the ability to save that depends upon the income of an individual. Higher incomes are generally followed by higher savings. The availability of abundant natural resources and high level of economic development will create and lead to greater wealth in a country, and therefore the capacity to save will increase. If the distribution of wealth is equitable, everyone will have more money income, and therefore, the power to save will increase.
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(c) Facilities to save: If the country is free from internal disturbances and threat of foreign aggression, people will have opportunities to save. Stability of money value also facilitates savings. Frequent fluctuations in the money value, and particularly inflation reduce the purchasing power of the people, as a result, savings get discouraged. Facilities of investment in productive activities encourage saving.

2. Moblilisation of Savings:
In case people save money but it is hoarded or does not enter into circulation, it will not facilitate the process of capital formation. There should be a widespread network of banking and other financial institutions to collect public saving and take them to prospective investors.

3. Investment:
Process of capital formation gets completed only when real savings get converted into real capital assets. A country should have an entrepreneurial class which is prepared to bear the risk of business and invest the saving in productive occupations so as to create new capital assets. If the process of capital formation is to succeed, all these stages should be interlinked. In the absence or slackness of any of these stages the process of capital formation will remain incomplete.

4. Enterprise:
Business is full of risks and uncertainties. The task of bearing risks is called enterprise. The man who bears the risk of business is called an entrepreneur. Several types of risks are involved in business. Sometimes, the demand falls short of supply; at another time, the supply fall short of demand. The market fluctuations may cause heavy losses therefore; the services of entrepreneurs are required to bear all such risks of business.

Functions of entrepreneur:
Besides risk bearing, the entrepreneur has to perform several other important functions which are as follows: 1. Risk-bearing function: The most important function of an entrepreneur is to bear the risk of business. There is always a time-lag between production and consumption of goods. The goods produced in present are consumed in the future. Therefore, heavy risk is involved in equating the current production to future demand. No other factor production except the entrepreneur bears the risk of the business. 2. Decision-taking function: Decision-taking is an important function of an entrepreneur an entrepreneur has to take decisions as regards the followings matters: a. Selection of the product: An entrepreneur would choose a trade which seems to be more profitable, subject to such qualification as his personal interest, the degree of risk involved his temperament, his technical knowledge, the amount of capital required and estimate of his own ability. b. Selection of the type of the firm: The entrepreneur has to decide whether he would prefer sole proprietorship, partnership or a joint stock company. Further, he has to decide whether it should be private limited company or a public limited company.
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c. Selection of the location of plant: The entrepreneur has to decide where to install the plant, so that advantages of location can be obtained. Economic and non-economic factors, both are essential while making choice about the location of a plant. d. Selecting techniques of production: An entrepreneur aims maximising his output and minimise the cost of production. He has to decide about the most suitable combination of land, labour and capital so as to obtain maximum production. e. Selection of the size of the firm: The entrepreneur has also to decide whether to produce on a large scale, or on a small scale. He will have to take into account the cost of production, returns to scales, economies of scale, and profitability, while taking any decision as regards the size of the firm.

3. Distributive function:
Peaceful and congenial atmosphere inside the factory premises is essential for smooth production activity. The entrepreneur has to keep all factors of production contended. He has to decide about the share that each factor of production should receive from the total produce.

4. Innovative function:
Innovation is considered as an important as an important function of an entrepreneur. Innovation is defined as the commercial use invention. Individuals and experts working for corporation conduct basic research and invent new products, new technology, new sources of energy, and soon the entrepreneur makes use of these inventions for commercial purposes. Innovation is never static. A progressive and talented entrepreneur should always take a lead to introduce a new product or a new technique of production. It does involve some risk but risk-bearing is prime function of entrepreneur. Innovations help a firm to earn large profits.. In modern economies, the role of organizing the factors of production is regarded as a managerial function, which can be performed by a paid manager i.e. by a highly skilled form of labour. What really distinguishes enterprise from other factors of production is that it has to carry all the risks and uncertainties, and is rewarded for bearing these, in the form of profits. Qualities of a good Entrepreneur: 1. Far-sightedness. 2. Courage. 3. Quality of leadership 4. Quality of organizing the labour. 5. Experience. 6. Knowledge of business. 7. Moral qualities. 8. Knowledge of psychology.

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Concept of Production function and Laws of production:

Introduction:
Production is a continuous process. Goods and services are produced by a firm. A part of it is consumed and the remaining is retained for further production. Production of the commodities is the outcome of combined efforts of various factors of production and the quantity of production depends directly upon quantity of these factors. Production is defined as the transformation of inputs into output. Production includes production of physical goods and production services. The producer combines the various factors of production in a technical proportion to maximize the output and minimize the cost by means of the least cost combination of factors of production.

Production function:
The term Production function means physical relationship between inputs used and the output produced. Production function is purely a technical and functional relation which connects which connects quantity of inputs required to produce a good to the quantity of output produced. Production function is the process of getting maximum output from given quantity of inputs in a particular time period.

Characteristics of production function:

1. Production function is a physical concept: Production function establishes technical relationship between inputs and outputs expressed in physical terms and not in terms of a monetary unit such rupees. 2. Production function is a flow concept: Production function is a flow concept. It relates to the flow of inputs and the resulting flows of output of a commodity during a period of time. 3. Production function is functional relationship between inputs and output: Production function is a functional relationship between inputs and resulting output. Change in input by one unit has an effect on the output of the firm. 4. Production function is determined by the state of technology and inputs: Production function is dependent on the state of technology and inputs available with the firm. Technology refers to the sum total of knowledge of the means and methods of producing goods and services. Input is anything that is used by the firm in the process of production. Thus, input includes every type of productive resource available with the firm. 5. Change in inputs determines nature of output: Change in inputs is essential to change production function. The proportion of change in inputs and output is not same always. 6. Production function includes only technically efficient combinations of inputs: Production function in economic analysis refers to combination factor inputs which maximise the output and minimise the cost of production.

Mathematical expression of general production function:

Production function can be expressed in the form of a mathematical equation which shows that the output is a dependent variable and inputs are independent variables.

P = f (La, Lb, C, E)
Where, P is the level of output.
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La is the land input. Lb is the labour input. C is the capital input. E is role of enterprise.

Types of production function:

There are two types of production function: 1. Short-run production function: Shortrun production function refers to production in the short-run where there are some fixed factors and some variable factors. In the short-run, production will increase when more units of variable factors are used with fixed factors. 2. Long-run production function: Long-run production function refers to production in the long-run where all factors are in variable supply. In the long-run, production will increase when all factors are increased in the same proportion.

Short-run and long-run:

1. Short-run: Short-run refers to a period in which some of the factors of production like land and capital are in fixed supply and others like labour are in variable supply. 2. Long-run: Long-run refers to a period long enough to permit changes in all the factors of production. A firm has enough time to install a new plant or raise a new building in response to increased demand.

Fixed factors of production and variable factors of production:

1. Fixed factors of production: Fixed factors of production refer to those factors whose supply cannot be changed during short-run. For example, land, plant & machinery, equipment, building etc. remain in fixed supply during short-run. 2. Variable factors of production: Variable factors of production refer to those factors whose supply can be varied or changed. For example, raw materials, labour, power, fuel etc. are in variable supply in the short-run as well as in the long-run. The distinction between fixed and variable factors disappears in the long-run as all factors are in variable supply in the long-run.

Level of production and scale of production:

1. Level of production: Level of production can be changed by changing the quantity of variable factors like raw materials, labour, fuel etc. level of production is related to short-run. 2. Scale of production: Scale of production is related to capacity of production. Scale of production can be changed by changing the quantity of all variable factors of production. Scale of production is related to long-run.

Production in the short-run:

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1. Total Production (TP): Total product is defined as the total quantity of goods produced by a firm during a specified period of time. Total Product is the total output resulting from the efforts of all the factors of production combined together at any time. Total product can be increased by employing more and more units of the variable factor. 2. Average Production (AP): Average product or average physical product may be defined as the amount of output per unit of the variable factor input employed. Average product measures the productivity of the firms labour in terms of how much output each labour produces on an average. 3. Marginal Production (MP): Marginal product is defined as the change in total product resulting from the employment of an additional unit of a variable factor. Marginal Product is the change in Total Product due to change in the quantity of variable factor i.e., labour. The knowledge of marginal product helps the firm in its decision making process as it tells the firm how much will be the addition in output by adding one more unit of labour. 4. 1. 2. 3. Relationship Between AP And MP: Both AP and MP can be calculated by TP When AP rises them MP also rises but MP>AP When AP is maximum then MP = AP or say MP curve cuts the AP curve at its maximum point 4. When AP falls then MP also falls but MP < AP 5. There may be a situation when MP decreases but AP increases but opposite never happened

Labour
1 2 3 4 5 6 7 8 9

TP AP MP Analysis
2 5 9 12 14 15 15 14 12 2 2.5 3 3 2.8 2.5 2.1 1.7 1.3 2 3 4 3 2 1 0 -1 -2 MP & AP both increases; MP > AP TP also increases MP = AP, AP = Maximum MP & AP both decreases, MP < AP; TP increases MP = 0, TP = maximum AP > MP both decreases TP decreases

Law of Variable Proportion:

Law of Variable Proportions occupies an important place in economic theory. This law is also known as Law of Proportionality. Keeping other factors fixed, the law explains the production function with one factor variable. In the short run when output of a commodity is sought to be increased, the law of variable proportions comes into operation. Therefore, when the number of one factor of production is increased or decreased while other factors of production are constant, the proportion between the factors is altered. Due to change in the proportion of factors there will also emerge a change is total output at different rates. This tendency in economics is called the Law of Variable proportions.

Assumptions:
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The law of variable proportions is based on following assumptions: 1. Constant technology: The state of technology is assumed to be given and constant. If there is an Improvement in technology the production function will move upward. 2. Factor proportions are variable: The law assumes that factor proportions are variable, if factors of production are to be combined in a fixed proportion, the law has no validity. 3. Homogeneous factor units: The units of variable factor are homogeneous. Each unit of variable factor is identical in terms quality and quantity with every other unit. 4. Short-run: The law of variable proportions operates in the short-run when it is not possible to vary all factor inputs available with the firm. 5. Except one all the other inputs are fixed: There are many fixed inputs and only one variable input. 6. Only physical input and output are considered: The law explains only the physical inputs and output in the production function.

Statement of the law:

Law of variable proportion states that when total output or production of a commodity is increased by adding units of a variable input, while the quantities of other inputs are held constant, the increase in total production becomes, after some point, smaller and smaller. In other words, as more and more units of a variable factor are combined with same quantity of fixed factors, total product first increases at an increasing rate then at diminishing rate and finally starts diminishing. It implies that marginal product first rises and then diminishes eventually.

Law of variable proportions has three stages: Stage: I Law of increasing returns; Stage: II Law of decreasing returns; and Stage: III Law of Negative returns.
Law of variable proportion has Three stages: Labour TP AP MP Analysis 1 2 2 2 Stage I Law of increasing returns 2 5 2.5 3 3 9 3 4 AP = MP and AP is maximum 4 12 3 3 Stage II Law of decreasing returns 5 14 2.8 2 6 15 2.5 1 MP = 0, TP is maximum 7 15 2.1 0 Stage III Law of Negative returns 8 14 1.7 -1 9 12 1.3 -2 The position of three stages can also be explained as under: 4.15

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Stages Stage I

Stage II

Stage III

Total Product (TP) Increases at an increasing rate, then increases at diminishing rate. Increases at diminishing rate and reaches its maximum point Begins to fall

Marginal Product (MP) Increases and reaches at maximum point and begins to decrease. Decreases and becomes zero Becomes Negative

Average Product (AP) Increases and reaches its maximum point After reaching its maximum point, begins to decrease Continues to diminish

Explanation of increasing returns:

1. Indivisibility of fixed factors: The fixed factors employed in the production process are indivisible, i.e. they cannot be divided into smaller parts. Thus, when more units of variable factor are combined with fixed factor, output keeps increasing. 2. Fuller Utilisation of fixed factors: In the initial stages of the production the fixed factors are underutilised in relation to variable factor employed on it. Fuller utilisation of fixed factors calls for greater application of the variable factor which in turn leads to increase in total and marginal product. 3. Division of labour and specialization: Due to increase the scale of production, it enables the firm to adopt division of labour and specialisation. Division of labour & specialisation enables increase in skill, efficiency of labourers, saving of time and innovation in the application of technique of production in the production process by the workers which leads to increasing returns to scale. 4. Perfect combination between fixed and variable factors: With the increase in the variable inputs in the production process the firm tries to achieve the perfect combination of fixed and variable factors input ratio in the production process which increases the productivity at an increasing rate. Explanation of diminishing returns: 1. Fixity and Inadequate relative of fixed factors: Once the point is reached at which the amount of variable factor is sufficient to ensure the efficient utilization of the fixed factor, then further increases in the variable factor will cause marginal and average product to decline because the fixed factor then becomes inadequate relative to the quantity of variable factors. 2. Imperfect substitutability: According to Mrs. Joan Robinson factors of production are not perfect substitutes of each other. There is a limit to the extent to which one factor of production can be substituted for another. Beyond this limit perfect ratio between various factors gets disturbed and productivity tends to increase at a diminishing rate. Explanation of diminishing returns: 1. Too excessive quantity of variable factor: In this stage the quantity of variable factor becomes too excessive relative to the fixed factor so that they get in each others way with a result that the total output falls instead of rising. In such a situation a reduction in the units of the variable factor will increase the total output. Stage of Operation: 4.16

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Theory of production and cost.

The three stages together constitute the law of variable proportions. Since the second stage is the most important. So stage II will be stage of operation and because of that in practice we normally refer to the law of variable proportion as the law of diminishing returns.

Production in the long-run:

Law of Returns to Scale:
The law of returns to scale is applicable in the long-run, where all the factors of production are in variable supply. In the long-run output can be increased by increasing all the factors of production or scale of production.

Statement of the law:

The law of returns to scale states that when all factors of production are increased in the same proportion, output will increase however, the increase may be at increasing rate or constant rate or decreasing rate.

Three stages of returns to scale:

1. Increasing Returns to scale 2. Constant Returns to Scale. 3. Diminishing Returns to scale. 1. Increasing Returns to Scale: Increasing returns to scale occur when a simultaneous increase in all the inputs in the same given proportion result in a more than proportionate increase in the output. For example, if the input is increased by 100% however, the output increases by 125% then it is the situation of Increasing Returns to Scale. 2. Constant Returns to Scale: Returns to scales are said to be constant when a proportionate increase in all the inputs results in proportionate increase in output. For example if input is increased by 100% but the output also increases by 100% then it is the situation of Constant Returns to Scale. 3. Diminishing Returns to Scale: Diminishing returns to scale occur when a simultaneous increase in all inputs in the same given proportion result in a less than proportionate increase in the output. For example, if input is increased by 100% but the output increases only by 75% then it is the situation of Diminishing Returns to Scale.

Causes of the application of the law of returns to scale:

Internal Economies and Diseconomies: Internal economies are those economics, which are firm specific. Those are available to that particular firm in the industry, which seeks to increase its level of output by way of increasing its scale of production 1. Technical Economics: Large scale production: As the firm increases its scale of operations; it becomes possible to use more specialized and efficient form of all factors, specially capital equipment and machinery. Secondly, when the scale of production is increased and the amount of labour and other factor becomes larger, introduction of greater degree of division of labour or specialization becomes possible and as a result cost per unit declines.

General Economics

4.17

Theory of production and cost.

Diseconomies: However, beyond a certain point a firm experiences net diseconomies of scale. When the firm has reached a size large enough to allow utilization of all the possibilities of division of labour and the employment of more efficient machinery, further increase in the size of the plant will entail high long run costs because of difficulties of management. When the scale of operations becomes too large, it becomes difficult for the management to exercise control. 2. Management Economies: When output increases, division of labour can be applied to management. Since individual activities come under the supervision of specialists, managements efficiency and productivity greatly improve. Diseconomies: However, as scale of production increases beyond a certain limit, management finds it difficult to exercise control and bring co-ordination among various departments. The managerial structure becomes more complex. All those affect the efficiency and productivity of management and the firm itself. 3. Commercial Economies: For large scale production the firm places bulk orders for materials and components and enjoy lower prices for them. Economies can also be achieved in selling the product. Finally, when the business is sufficiently large, division of labour can be introduced on the commercial side, with expert buyers and sellers being employed. Diseconomies: These economies become diseconomies after an optimum scale. For example, advertisement expenditure and other marketing overheads will increase more proportionately after the optimum scale. 4. Financial economies: Large firm can offer better security to bankers and, raise money at lower cost, since investors have confidence in it. Diseconomies: however, these financial costs will rise more proportionately after the optimum scale of production. 5. Risk bearing economies: Large firms with diverse and multi production capability is in a better position to withstand business risks. Diseconomies: However, risk may rise if diversification results in more economic disturbances. External Economies: External economies are those economies, which are industry-specific; these are available to all the firms in the industry, when the scale of operation of the industry as a whole expands. 1. Cheaper raw material and capital equipment: The expansion of an industry may result in exploration of new and cheaper sources of raw material, machinery and other types of capital equipment. 2. Technological external economies: When the whole industry expands, it may result in the discovery of new technical knowledge and in accordance with that the use of improved and better machinery than before. This will reduce their cost of production.

General Economics

4.18

Theory of production and cost.

3. Development of skilled labour: when an industry expands in an area the labour in that area is well accustomed to do the various productive processes and learns a good deal from the experience, which has a favourable effect on the level of productivity and cost of the firms in that industry. 4. Growth of ancillary industries: With the growth of an industry, a number of ancillary industries may specialize in production of raw materials, tools and machinery etc., This will tend to reduce the cost of production in general. 5. Better transportation and marketing facilities: The Expansion of an industry may make possible the development of transportation, marketing and communication network which will greatly reduce cost of production of the firms. External Diseconomies: However, external diseconomies may arise due to expansion of an industry. An example of external diseconomies is the rise in some factor prices. Moreover, too many firms in an industry at one place may also result in higher transportation cost, marketing cost and high pollution control cost. The government may also prohibit or restrict expansion of and industry at a particular place.

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4.19

Theory of production and cost.

THEORY OF COST
COST ANALYSIS: Cost analysis refers to the study of the behaviour of cost in relation to one or more production criteria, namely, size of output, scale of operations, prices of factors of production and other relevant economic variables. It is concerned with financial aspects of production.

Cost Concepts:
1. Accounting costs and Economic costs: Accounting costs relate to those costs only, which involve cash payments by the entrepreneur of the firm. Accounting costs are also called explicit cost. Costs of factors owned by the entrepreneur himself and employed in his own business are called implicit costs. Implicit costs also known as Non accounting costs. For example, 1. Rent of self owned building. 2. Interest of self owned capital. 3. Wages of self owned entrepreneur. Thus, economic costs include both accounting costs and implicit costs. Economic cost = Accounting cost (Explicit cost) + Non Accounting Cost (Implicit cost) Economic Profit = Total Revenue Economic cost Accounting Profit = Total Revenue Explicit cost. 2. Outlay costs and Opportunity costs: Outlay costs involve actual outlay of funds on wages, material, rent and interest etc. whereas opportunity costs refer to the profits foregone or sacrificed from alternative ventures not taken up as the limited factors of production are used for a particular purpose. The opportunity costs are not recorded in the books of account as they represent only the sacrificed alternative. The opportunity costs arise when the factors of production can put to a number of uses and if they are used in a particular process of production, they cannot be put to an alternative use. Opportunity cost is then defined as the maximum return that could be obtained from an alternative use of resources, but is foregone by employing the resources in their present use. Examples of opportunity costs: 1. In a cotton-textile mill that spins its own yarn and uses it, the opportunity cost is the revenue that could have been secured if the yarn would have been sold. 2. At the personal level a student who decides to take-up a full-time course of study, has to give up a paid occupation. His opportunity cost of studies is the potential earning from the paid occupation sacrificed. Opportunity cost concept is useful in incurring capital expenditure. An investor has to calculate the profitability of different projects before investing in one of them. He has also another alternative of investing in a project or earning interest by depositing the money in the bank. Similarly, investment in equity shares involves opportunity costs measurable in terms of sacrificed income from alternative investment. In business decisions, the concept of opportunity costs plays a very important role. The business firm should not concentrate on what the business firm is doing. It has to take into consideration the other alternatives and opportunities available to it. The success of the business is governed by the opportunity costs taken into consideration. Opportunity cost of factor refers to its value in its next best alternative use or it is the cost of forgone opportunity.
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4.20

Theory of production and cost.

3. Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are costs that are readily identified and are traceable to a particular product, operation or plant. Example: Direct material, direct labour and manufacturing costs. Indirect costs are not readily identified and not visibly traceable to a particular product, operation or plan. For Example: Indirect material, indirect labour and indirect expenses. 4. Fixed and variable costs: Fixed costs are those costs which do not vary with the level of firms output. They are the costs of fixed or indivisible factors. Fixed factors are those factors which cannot be easily varied with size of the output. It requires a comparatively longer period to make changes in them, i.e. buildings, machinery etc., these costs require a fixed expenditure irrespective of the level of output e.g. rent, property taxes, interest on loans. Even if the output is zero, fixed costs must be incurred. As output expands, they remain the same. However, these costs vary with the size of the Plant and are a function of capacity. On the other hand, Variable Costs are those costs which vary directly with the level of output. They are the cost of variable factors. Variable factors are those factors which can be easily varied with the changes in the level of output, e.g. operative Labour, raw-material, fuel for running the machines, wear, and tear on equipment, when output is Zero, variable costs are nil. As output increases variable costs also increases. COST FUNCTION. Cost function is a functional relationship between cost of a product and the various determinants of cost. In cost function, cost is the dependent variable and all the other variables are the independent variables. Cost function is a mathematical relationship between cost of production and the various determinants of costs. Cost functions are derived from the production function, which describes the technically efficient method of producing a commodity at any point of time. Cost function can be expressed as follows: C= f (O, S, T, P) Where, C= Cost of output O= Size of output S= size of plant T= Time under consideration P= Prices of factors of Production Thus, cost is basically a function of the level of output of firm, the size of its plant, time and prices of factors or production. Cost function can be linear or curvi-linear depending upon the behaviour of the variables under study.

Determinants of Costs:
1. Size of Output: Cost is affected by the size of output. Generally, as the level of total output increases the total cost also increases. Average and marginal costs, in such a case, however, will fall initially but rise afterwards. 2. Size of Plant: Cost is inversely related with the size of plant. As the size of plant increases, costs decline and as the size of plant decreases, costs rise. Fixed costs, however, of bigger plant are higher than that of smaller plant.

General Economics

4.21

Theory of production and cost.

3. Prices of input: Higher the prices of inputs, higher will be the costs of production. However, change in cost depends upon the contribution which that factor of production makes to the total product. If price of factor which is negligibly used in production increase, cost will rise marginally only. 4. Period under Consideration: During Short period, costs tend to rise sharply as compared to long-period during which the increase is not that sharp. 5. Technology: State of technology has big influence over cost, the factor Technology is itself a multidimensional factor, determined by the physical quantities of factor inputs, the quality of factor inputs, the efficiency of the entrepreneur, both in organizing the physical side of the production and making entrepreneur both in organizing the physical side of the production and making the correct economic choice of techniques. 6. Level of Capacity Utilization: Cost not only depends upon the size but also on the efficiency in utilization of capacity, costs, specially fixed costs tend to fall with higher utilization of capacity.

Short-Run Total Costs

Short-Run: Short Run is a period in which some factors are fixed and some factors are variable. Fixed factor have fixed cost and variable factor have Variable cost. So law of variable proportion applies here. In short-run, output can be increased or decreased by changing variable factors only but fixed factors cannot be varied. Long-Run: Long is a period in which all the factors can be varied. There is only variable cost. In the long run, there are no does fixed cost. So, The Law of Returns to Scale applies here. In long-run output can be increased or decreased by changing all the factors. Both short period and long period cannot be quantified. Total cost (TC): Total cost of production is the sum of all expenditure incurred in producing a given volume of output. In other words, TC = TFC + TVC Total Fixed Cost (TFC): Fixed cost does not change with changes in the level of output. If plotted on graph, TFC is parallel to Xaxis. Even at zero output, fixed cost remains the same. For example Rent and insurance do not change with the change in the level of output. Total Variable Cost (TVC): Variable costs are those costs that change with changes in level of output. It has inverse S shape. If output is zero cost is also zero and as output increases cost increases. For Ex. Raw material, power etc.

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4.22

Theory of production and cost.

Output (Q) 0 1 2 3 4 5 6 7 8 9

TFC 10 10 10 10 10 10 10 10 10 10

TVC 0 8 13 16 20 26 35 47 63 83

TC 10 18 23 26 30 36 45 57 73 93

Short-run average cost

1. Average Fixed Cost (AFC): Average fixed cost is the total fixed cost divided by the output. (Per unit FC) or TFC/Q. The general shape of the AFC curve is downward sloping it does not touch the X axis as AFC cannot be zero. It is not U shape. This curve is also called Rectangular Hyperbola (R.H). 2. Average Variable Cost (AVC): Average variable cost is the total variable cost divided by the output. (Per unit VC) or TVC/Q. The average cost curve will first fall, then reach a minimum and then rise again. It has U shape 3. Average Total Cost (ATC): Average total cost is total cost divided by the output. (Per unit TC) or TC/Q or AFC + AVC. The ATC curve first falls, reaches its minimum and then rises. The ATC curve is U shape due to law of variable proportions. 4. Marginal Cost (MC): Marginal cost is the change in total cost due to change in the output. Or MC = total cost / qty. produced or MC = total Variable Cost / Qty. produced. The MC curve is also U shape. Output Total Total (Unit) fixed Variable cost TFC TVC 0 10 -1 10 10 2 10 18 3 10 24 4 10 28 5 10 32 6 10 38 7 10 46 8 10 56 9 10 68 Total Cost TC 10 20 28 34 38 42 48 56 66 78 Average Average Fixed Cost Variables AFC AVC -----10 10 5 9 3.33 8 2.5 7 2 6.4 1.67 6.33 1.43 6.57 1.25 7 1.11 7.55 Average total AC ---20 14 11.3 9.5 8.4 8 8 8.25 8.67 Marginal cost(Rs.) MC --10 8 6 4 4 6 8 10 12

General Economics

4.23

Theory of production and cost.

Relationship between Average Cost and Marginal Cost: Relationship between Average Cost and Marginal Cost From the above table the following relations can be explained: 1. MC and AC both can be calculated by TC. 2. When AC falls, MC also falls but AC > MC 3. When AC rises, MC also rises but now MC > AC 4. When AC is minimum, the MC = AC. In other words, MC curve cuts to AC curve at its minimum point (i.e., optimum point). 5. There is also abnormal situation when AC falls then MC rises. In the figure given below from A to E AC falls but from B to E MC rises. But opposite never happened.
Output Total Cost Average Total Marginal cost Analysis (Rs.) TC Cost AC (Rs.) MC

0 1 2 3 4 5 6 7 8 9

10 20 28 34 38 42 48 56 66 78

---20 14 11.3 9.5 8.4 8 8 8.25 8.67

---10 8 6 4 4 6 8 10 12

AC > MC AC decreases MC also decreases

AC = MC is minimum AC < MC: both increases

Why AVC, ATC and MC are curves U-shaped? : Production and Cost Function. It is due to Law of Variable Proportions. Law of variable proportions (diminishing returns) states that as the units of variable factor is increased, MP first rises and then falls. When MP rises, MC falls and when MP falls. When MP rises, MC falls and when MP falls, MC rises. It is the behaviour of MC, which determines the behaviour of AC. when MP is maximum then AC is minimum and when AP is maximum then AC is minimum. Under 2nd stage MC and AC both raises. Long-run average cost curve (LAC), Envelop curve or planning curve: A long cost curve depicts the functional relationship between output and the long-run cost of production. In the long-run, all inputs are variable, because costs that are fixed in the short run can be changed in long run. Accordingly, there are no TFC or AFC curves in the long-run. There is no distinction between TC and TVC; we simply use the term TC. Similarly, there is no distinction between ATC and AVC and we will use the term LAC. In the long-run the firm will produce the output at which SAC is minimum, it is clear than in the long-run the firm has a choice in the employment of plant and it will employ the plant, which yields minimum possible unit cost for producing a given output. It is to be noted in the above figure, that LAC curve is not tangent at the minimum point of SACs. When LAC declines SAC is tangent to the falling portion of SAC. When LAC rising - SAC is tangent to the rising portion of SAC. When LAC minimum SAC is tangent to the minimum point of SAC.

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4.24

Theory of production and cost.

The long-run average cost curve will be a smooth curve enveloping all short run average cost curves, so it is called enveloping curve. Long-run cost curves are often called a Planning curve because a firm plans to produce any output in the long-run by choosing a plant on the LAC curve corresponding to the given output The long-run average cost curve helps the firm in the choice of the size of the plant for producing a specific output at the least possible cost. Explanation of the U Shape of the LAC Curve: LAC curve is a U shape curve. This shape of LAC depends upon the returns to the scale. Returns to scale may be increasing; constant or decreasing. We can summarize all this as follows: Returns to scale LAC Internal & External Increasing returns to scale: LAC decreases Economies arise here Constant returns to scale LAC minimum Set off economies by diseconomies Decreasing returns to scale LAC increases Diseconomies arise here

General Economics

4.25

Theory of production and cost.