Rajesh.K.Chundambatta & Sangeetha.U

GHSS Kodumunda

Palakkad

Plus Two - Economics Chapter 3

Theory of the Firm ..

Production & Cost

• An economic unit that produces goods and

services is called the Producer / Firm

All resources used for production of goods are

called inputs. Land, Labour, Capital, Organisation = Factor inputs

Goods & Services produced using inputs are called

Output

Production refers to transformation of inputs into output.

• Production is the process of combining inputs to make outputs

• The firm buys inputs from households /other firms and sells its output to consumers

PRODUCTION FUNCTION

The relationship between inputs and output

is called production function.

Q = f (X1, X2)

Isoquant

• Isoquant represents all the possible

combinations of two inputs that

produce the same level of output.

The important factor that affect production is time period

Short Run and Long Run

• It is useful to categorize firms’ decisions into

– Short-run decisions

– Long-run decisions

• To guide the firm over the next several years – Manager must use the long-run lens

• To determine what the firm should do next week – Short run lens is best

Short Run

• Short run is the period in which the firm cannot change all inputs

The inputs in short run are classified into two

• Fixed inputs/ Fixed factors – In short run all the factors cannot be varied.

Such factors are called fixed factors.

eg: factory building, new machinery etc.

• Variable input/ Variable factors – Those factors which can be varied in the short run are

called variable factors.

eg: quantity of raw materials,quantity of labour etc

Long Run

• Long run is the period in which the firm can change all inputs

• In the long run all inputs are variable

Short run Production Function

The production function in which application

of one factor is varied, while all other factors

are kept constant is called short run

production function.

It is also known as law of variable proportion

or law of returns to a factor

Long Run Production Function

• In the long run, all factors of production

can be varied.

• A firm in order to produce different levels

of output in the long run may vary all

inputs.

• So, in the long run, there is no fixed input.

It is also known as law of returns to scale/

fixed proportion production function

Total Product (TP)

It is the relationship between a variable input and output, when all other inputs are held constant.

It is the total output at a particular level of employment of a variable input.

Total product is also sometimes called Total Return or Total Physical Product. (TPP)

Average Product (AP)

Average product is defined as the output per

unit of variable input

AP1 = TP

X1

Marginal Product (MP)

MP is defined as the change in output

per unit of change in input, when all other

inputs are held constant.

Marginal product are additions to the total

product.

MP = change in TP

change in variable input

The Law of Diminishing Marginal Product

&

The Law of Variable Proportions

• It is a short run production function.

According to this law if we keep increasing the

employment of an input, with other inputs fixed

eventually a point will be reached after which

the resulting addition of output (i.e. MP) will

start falling.

The Law of variable proportion also

explains 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.

• According to this theory, as we increase

the variable factor, the TP, AP and MP

passes through three distinct stages.

Stage 1 : Increasing Returns

• In the first stage TP increases at an

increasing rate.

• Then MP also increases and reaches

maximum, AP rising.

Stage 2 : Diminishing Returns

• In this stage MP and AP decline.

But TP continue to rise at a diminishing

rate.

Stage second ends with MP touching zero.

Stage 3 : Negative Returns

• Third stage begins with MP turning

negative.

• TP starts declining

When TP is maximum MP is zero.

When TP declines, MP turns negative.

The Law of Diminishing Marginal Product &

The Law of Variable Proportions

Returns to Scale

( Long Run Production Function )

• In the long run, there is no fixed input.

All factors are variable.

It is known as fixed proportion production

function because input ratios remain the

same.

Increasing returns to scale

• Increasing returns to scale (IRS)

holds when a proportional

increase in all inputs results in an

increase in output by more than

the proportion.

Constant returns to scale

• Constant returns to scale (CRS) is a

property of production function that

holds when a proportional increase in

all inputs results in an increase in

output by the same proportion.

Decreasing returns to scale

• Decreasing returns to scale (DRS)

holds when a proportional increase

in all inputs results in an increase in

output by less than the proportion.

Cobb-Douglas Production Function

• Consider a production function

q = x1α x2

β

where q is quantity of output, α and β are constants.

β = 1- α

The firm produces q amount of output using x1 amount of

factor.1 and x2 amount of factor.2.

• Cobb-Douglas production function is a

linearly homogenous production

function.

That means, if factors are increased ‘t’ times,

output will also increase ‘t’ times where (t > 1).

If α + β = 1, production function is CRS

If α + β > 1, production function is IRS

If α + β < 1, production function is DRS

Costs...

Costs

• In order to produce output, the firm needs to employ inputs.

• Costs refer to the Expenses incurred in

production.

• The firm’s goal is to earn the highest possible profit. To do

this, it must follow the least cost rule

• Wages, rent, interest, transportation etc are examples of

costs

Short Run Costs

• In short run, costs can be classified as TFC and TVC

• Fixed costs

– Costs on fixed factors are called fixed costs.

• Variable costs

– Costs on variable factors are called variable

factors.

Types of Total Costs

– Total Fixed Costs • Cost incurred for the purchase of fixed inputs.

• This Cost do not change with change in output

• eg: rent for land & building, salary etc

– Total Variable Costs • Cost incurred on variable inputs

• This Cost change as output changes

• eg: cost for raw materials, transportation etc

– Total Cost • Cost of all inputs—► fixed and variable

• TC = TFC + TVC

Shape of TFC, TVC and TC

TC

0

Cost

q Output

TFC

TFC

TVC

Short Run Average Costs

• Average fixed cost (AFC)

– Fixed cost per unit of output produced

• Average variable cost (AVC) – Variable cost per unit of output.

• Short run Average Cost

Total Cost per unit of output is called SAC

Q

TFCAFC

Q

TVCAVC

AVCAFC SAC

Q

TCSAC QSACTCie *,

AFC

Product

Cost

Average Fixed Cost Curve (AFC)

Average Variable Cost Curve (AVC)

Cost

AVC

Output

Shape of SAC curve

Output

SAC

Cost

Short run Marginal Cost (SMC)

- Addition to the Total Cost

- Change in TC due to the production of

one extra unit of output

- Tells us how much cost rises per unit

increase in output

ΔQ

ΔTCMC

Relation between SAC and AVC

SMC

AVC

SAC

Output

costs

20

15

10

5

10 30 40 50 60 0 20 70

Long Run Costs

• In the long run, all inputs and all costs are

variable. There are no fixed inputs or fixed

costs.

and Q

TCLRAC

ΔQ

ΔTCLRMC

Shapes of Long run Cost Curves

LRMC

LRAC

DRS IRS q

thank you...