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CHAPTER-1 INTRODUCTION

1.1 PRODUCTION A production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic choices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level A production function can be expressed in a functional form as the right side of Q = f(X1,X2,X3,...,Xn) where:Q = quantity of output X1,X2,X3,...,Xn = quantities of factor inputs (such as capital, labour, land or raw materials).

Fig 1.1 Stages of production

To simplify the interpretation of a production function, it is common to divide its range into 3 stages.  In Stage 1 (from the origin to point B) the variable input is being used with increasing output per unit, the latter reaching a maximum at point B (since the average physical product is at its maximum at that point). Because the output per unit of the variable input is improving throughout stage 1, a price-taking firm will always operate beyond this stage.

 In Stage 2, output increases at a decreasing rate, and the average and marginal physical product are declining. However, the average product of fixed inputs (not shown) is still rising, because output is rising while fixed input usage is constant. In this stage, the employment of additional variable inputs increases the output per unit of fixed input but decreases the output per unit of the variable input. The optimum input/output combination for the price-taking firm will be in stage 2, although a firm facing a downward-sloped demand curve might find it most profitable to operate in Stage 1.  In Stage 3, too much variable input is being used relative to the available fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin obstructs the production process rather than enhancing it. The output per unit of both the fixed and the variable input declines throughout this stage. At the boundary between stage 2 and stage 3, the highest possible output is being obtained from the fixed input.

1.2 PRODUCTION WITH ONE VARIABLE FACTOR Law of variable proportions Cobb Douglas production function

Q ! ALE K F
Production function-it is described as thetechnological relationship between inputs and outputs in physical terms. Q= f(Ld, K, L, M, E) But for simplicity we assume that there are only two inputs Labor and Capital.

There are two kinds of production function1) Short Run Production Function 2) Long Run Production Function SHORT RUN PRODUCTION It is the period in which output can be changed only by changing the level of variable input labour. This is explained with the help of law of variable proportions. LONG RUN PRODUCTION FUNCTION It is the period in which output can be changed by changing the level of all the factors of production. LAW OF VARIABLE PROPORTIONS This law states that as more and more variable factors are employed the addition to total production goes on decreasing. Assumptions: There are only two inputs labour and capital Technology is given Variable factors is homogeneous 1.3 STAGES OF PRODUCTION FIRST STAGE-increasing returns to factor SECOND STAGE-Diminishing returns to a factor THIRD STAGE-Negatives return to a factor Stages of Production Stage 1: Increasing Returns Point of inflection MP max End of stage where AP is maximum AP cuts MP at its maximum
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Stage 2: Diminishing Returns TP increases at a diminishing rate TP reaches maximum and is constant second stage ends. MP is zero when TP is maximum Stage 3: Negative Returns TP declines MP negative AP falling

Fig 1.2 Total, Average & Marginal product

Stages of production:Key points:First stage: TP increases at an increasing rate and MP increases reaches maximum. AP increases. Second stage: TP increases at decreasing rate,AP decreases but is positive, MP is falling but is positive. Third stage: TP decreases, AP decreases and MP becomes negative.

1.4 COBB -DOUGLAS PRODUCTION FUNCTION


The generalized form of this function is A, and are parameters. A: This is known as the efficiency parameter. It indicates the level of technology. : This indicates the elasticity of output with reference to capital. : This indicates the elasticity of output with reference to labour. This generalized function is homogeneous of degree one If and =1, this function becomes homogeneous of degree one or linearly homogeneous.

Cobb -Douglas Production Function


The generalized form of this function is

Q ! ALE K F
A, and are parameters. A: This is known as the efficiency parameter. It indicates the level of technology. : This indicates the elasticity of output with reference to capital. : This indicates the elasticity of output with reference to labour.
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This generalized function is homogeneous of degree one If and =1, this function becomes homogeneous of degree one or linearly homogeneous

1.5 COST
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production. More generalized in the field of economics, cost is a metric that is totaling up as a result of a process or as a differential for the result of a decision. Hence cost is the metric used in the standard modeling paradigm applied to economic processes. 1.6 DETERMINANTS OF COST FUNCTION: The cost of production may be defined as the aggregate of expenditure incurred by the producer in the process of production. Cost, is therefore, the valuation placed on the use of resources. C=f (S,O,P,T,M) Several concepts of costs such as; Fixed Cost, Variable Cost, Total Cost Average Cost, Marginal Cost, Money Cost, Real Cost, Implicit Cost, Explicit Cost, Private Cost, Social Cost, Historical Cost, Replacement Cost And Opportunity Cost. Fixed costs are those costs which remain fixed, irrespective of the output. They have to be incurred on equipment, building etc and they are incurred even when the output is zero. Fixed costs are also called Supplementary costs or Overheads or Indirect costs.

Variable costs are those costs which vary with the output. For example the cost of raw materials, electricity, gas, fuel etc. the Variable costs are also called Prime costs, direct costs or Operating costs.

Marginal cost changes due to variable cost and hence is independent of fixed cost. -Secondly the shape of Marginal Cost is determined by the law of variable proportions. -Price of a factor input remains constant is a vital assumption

MC= TC - TC
n

MC !
n-1

=(TVCn + TFC) (TVCn-1 + TFC) =TVC + TFC- TVC TFC


n n-1

MC ! MC ! MP !

MC = TVC TVC
n

n-1

1 ! MP MC !

(TC (Q (TVC (Q (L w* (Q (Q (L (L (Q w MP

-The difference between the short-run and long run production function is based on the distinction between fixed and variable costs. In the short-run production function, the output is increased only by employing more units of variable factors; other factors of production remaining fixed. In the long run all factors are variable and thus all costs are variable.

1.7 MARGINAL PRODUCT AND MARGINAL COST: When Marginal Product is increasing Marginal Cost is decreasing and when Marginal Product is decreasing MC is increasing. MC increases in the range where production faces diminishing returns.

Fig 1.3 Total Cost Curve

Total cost Average cost and Marginal Cost Total cost is the aggregate (sum-total) cost of producing all the units of output. It is the summation of total fixed cost and total variable cost. Thus,

TC = TFC + TVC The Total Fixed Cost curve is a horizontal straight line, parallel to the X-axis.
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The total variable cost curve slopes upwards as output increases. The total cost curve is parallel to the total variable cost curve as it is the lateral summation of total fixed cost and total variable cost curves.

Average Cost: The Average Cost is the cost per unit of output produced. Thus, the Average Cost is obtained by dividing the total cost by the total output. TC = TFC and TVC.

AC can be rewritten as AC = TFC + TVC Q Therefore AC= AFC+AVC


The Average Fixed Cost is the fixed cost per unit of output. i.e. AFC = TFC Q

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Fig 1.4 AFC Curve Now, if the output goes on increasing, the AFC will go on falling because the total fixed cost will be thinly spread over the number of units of output. AVC=TVC Q 1. In the starting the average variable cost is rather high. 2. When more and more units of output are produced, the firm starts enjoying several advantages in the form of transport, commercial and marketing economies and thus the average variable cost goes on falling. 3. Any further effort to increase the output brings about disadvantages in marketing and other processes involved in production, mainly associated with the employment of variable factors and thus the average variable cost begins to rise.

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Fig 1.5 AVC Curve

The Average Cost Curve in the Short-Run The AC curve is the lateral summation of the average fixed and variable cost curves. AC = AFC + AVC The average fixed cost curve slopes downwards from left to right (AFC curve) and average variable cost curve first goes downwards and then bends upwards (AVC curve). Each point of AC curve can be plotted as the sum of AFC and AVC.

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Fig 1.6 Average cost curves

The U-Shape of Average Cost Curve is explained in two ways : The Geometrical explanation: The shape of AC curve depends on the slopes of AFC and AVC curves. Therefore, the AC curve acquires Ushape. The Theoretical explanation :Economies of Scale

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TC ! AC.Q d (TC ) MC ! dQ d ( AC.Q ) MC ! dQ d ( AC ) MC ! Q  AC dQ d ( AC ) measures  slope  of dQ AC d ( AC ) 0, MC AC dQ d ( AC ) " 0, MC " AC dQ d ( AC ) ! 0, MC ! AC dQ

1.When AC is falling, the MC lies below it 2. Secondly MC cuts the AC at the lowest point of AC curve 3. when AC curves begin to rise, the marginal cost curve will be above the AC curve

Fig 1.7 AC & MC Curves


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i) When AC is falling, the MC lies below it. ii) Secondly MC cuts the AC at the lowest point of AC curve. iii) Thirdly, when AC curves begin to rise, the marginal cost curve will be above the AC curve showing that MC rises faster than the AC curve. 1.8 LONG- RUN AVERAGE COST CURVE: Long- Run Average Cost Curve will envelope the related series of all short-run AC curves In case of short-run since some factors are Indivisible the producer has to remain contented by making best use of the given plant; whereas in the long run the scale of operation can be altered and the producer will choose the most feasible plant. There will be a new short run average cost each time the scale is revised.

Fig 1.8 Two SAC Curves

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Fig 1.9 Three SAC Curves

1.9 LONG-RUN COSTS Another way to look at the long-run is that in the long-run a firm can choose any amount of fixed costs it wants for making short-run decisions. In the long-run there are no fixed inputs, and therefore no fixed costs. All costs are variable. 1.10 THE LONG-RUN AVERAGE COST CURVE The long-run average cost curve shows the minimum average cost at each output level when all inputs are variable, that is, when the firm can have any plant size it wants. There is a relationship between the LRAC curve and the firm's set of short-run average cost curves.

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1.11 SR AND LR AVERAGE COSTS Economists use the term plant size to talk about having a particular amount of fixed inputs. Choosing a different amount of plant and equipment (plant size) amounts to choosing an amount of fixed costs. Economists want you to think of fixed costs as being associated with plant and equipment. Bigger plants have larger fixed costs. Economists use the term plant size to talk about having a particular amount of fixed inputs. Choosing a different amount of plant and equipment (plant size) amounts to choosing an amount of fixed costs. Economists want you to think of fixed costs as being associated with plant and equipment. Bigger plants have larger fixed costs. If each plant size is associated with a different amount of fixed costs, then each plant size for a firm will give us a different set of short-run cost curves. Choosing a different plant size (a long-run decision) then means moving from one short-run cost curve to another Economists usually assume that plant size is infinitely divisible (variable). In the case of finely divisible plant size, the LRAC curve might look like this:
Each small U-shaped

$/Q

curve is a SAC curve.

The LRAC curve.

Fig 1.10Average costs for a typical firm.


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In the preceding graph, each short-run cost curve corresponds to a particular amount of fixed inputs. As the fixed input amount increases in the long run, you move to different SR cost curves, each one corresponding to a particular plant size. Notice in the graphs of LRAC curves presented so far that the curves have been drawn to be U-shaped. That is, when output is increasing LRAC at first falls, and then eventually rises. The overall shape of the long-run average cost curve depends on the technology of production. For example, advantages implicit in large scale production (with large plants) may allow firms to produce large outputs at lower cost per unit. On the other hand, firms may get so big that ever increasing managerial and monitoring costs may cause unit costs to rise.

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CHAPTER-2 PRACTICAL ILLUSTRATION

2.1 IILUTRATION FROM SHOE INDUSTRY The data is collected from a shoe industry named BATA. The data is followed as:-

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Table 2.1 DATA FROM BATA

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2.2 PRODUCTION STAGES


The three stages of production are characterized by the slope and shape of the total product curve. The first stage is characterized by an increasingly positive slope, the second stage by a decreasingly positive slope, and the third stage by a negative slope. Because the slope of the total product curve IS marginal product, these three stages are also seen with marginal product. In Stage I, marginal product is positive and increasing. In Stage II, marginal product is positive, but decreasing. And in Stage III, marginal product is negative.

Fig 2.1 Production stages

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Fig 2.2 TP , AP, MP curve

2.3 SHORT RUN COST CURVES A firm faces three production options in the short run based on a comparison between price, average total cost, and average variable cost. If price is greater than average total cost, a firm earns an economic profit by producing the quantity that equates marginal revenue with marginal cost. If price is less than average total cost but greater than average variable cost, a firm incurs an economic loss, but produces the quantity that equates marginal revenue with marginal cost. If price is less than average variable cost, a firm shuts down production in the short run, incurring an economic loss equal to total fixed cost.

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Fig 2.3 Short run cost curve

2.4 AVERAGE COST CURVES A curve that graphically represents the relation between average fixed cost incurred by a firm in the short-run product of a good or service and the quantity produced. This curve is constructed to capture the relation between average fixed cost and the level of output, holding other variables, like technology and resource prices, constant. The average fixed cost curve is one of three average curves. The other two are average total cost curve and average variable cost curve. A related curve is the marginal cost curve.

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Fig 2.4 Average Cost Curve

2.5 TOTAL COST CURVE


The total cost of producing a good can be represented by three related curves, total cost curve, total variable cost curve, and total fixed cost curve. The total cost curve is the vertical summation of the total variable cost curve and the total fixed cost curve.

Fig 2.5 Total Cost Curve

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