Production and Cost Concepts for Business Decision Making

MADE BY:
RISHABH GUPTA
XII ‘B’
ROLL NO. 36

 Production means transformation of inputs into outputs.
 Supply of product refers to the quantity supplied at the
given price.
 Which depends upon
 Relationship between input and output
 Prices of inputs
 Managerial efficiency

 It states the maximum amount of output that can be
produced with any given quantities of various inputs.
 Particular period of time
 Flow concept : Flow of inputs leads to flow of output

 The functional relationship under given
technology between input and output, per
unit of time.
Q = f ( L, K)
Output
Inputs

Types
Short –Run
(Inputs kept constant
One input (Labour) is varied)
Long – Run
(Varying all inputs)
Law of variable
proportion
Law of returns to
scale

Basis Short Run Long Run
Meaning
Short run refers to the period in
which only variable factors are
changed
Long run refers to the period in
which all factors can be
changed.
Price Determination Demand is more active Both demand & supply
than supply. play an important role.
Classification Factors are classified as fixed & All factors are variable.
variable.

Variable factors versus
fixed factors
Variable factors: are factors of which
the employment varies with output.
Fixed factors: are factors of which the
employment does not vary with output.

Three variables are defined to measure
the output:
____________________: is the whole amount of output
produced by all the factors employed.
Total product (TP)
____________________: is the output per unit of the variable
factor employed.
____________________: the change in output resulting from
employing an additional unit of the variable factor.
Average product (AP)
Marginal product (MP)
TP = Q
L
Q
L
TP
AP  L
TP
MP




Units of
Labour
L
Total
Product
(Quintals)
Q
Marginal
Product
(Quintals)
Average
Product
(Quintals)
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 0 63
9 495 -9 55
10 480 -15 48
IR
DR
Negative

 One – factor varying, quantities of other factor as fixed
 Law of variable proportion:
It’s the study of the effect on output of variations in factor
proportion.
 As we increase quantity of only one input keeping other
inputs fixed, total product initially increases at an
increasing rate, then at a decreasing rate and finally at a
negative rate.
 It’s a new name for Law of Diminishing returns
 The state of technology is assumed to be given /
unchanged
 Some inputs whose quantities is fixed
 Measured in physical terms.

The slope of
TP curve is
MP.
The slope of
the line joining
the origin and
a point on TP
is AP.
Notice the
points where
MP = maxi.;
MP=AP &
MP = 0.
F
H
D
S
Stage 1 Stage 3Stage 2

Stage 1.
 TP increases at an increasing rate upto a point.
 MP of variable factor is rising
 Point F (Point of Inflection), TP curve rises but its
slopes decline – TP is increasing at a diminishing rate.
MP starts falling but its positive.
 AP reaches its highest point
 MP of variable factor rises and then falls
 MP of fixed factor is negative
 Quantity of fixed factor is too much to the variable
factor

Stage 2.
 TP increases at a diminishing rate, reaches its maximum
point
 MP, AP are diminishing but positive
 MP becomes Zero
Stage 3.
 TP slopes downwards
 MP of variable factor is Negative

 Stage 3 – No
MP of variable factor is negative
 Stage 1 – No
MP of fixed factor is negative
Full utilisation is not there
Stages of
Economic absurdity / Economic non-sense /
Non- economic regions
 Stage 2 – Yes
MP and AP are positive but diminishing

 Increasing Returns
 Quantity of fixed factor is abundant than variable factor
 Fixed factor are indivisible
 With addition of variable factor , fixed factor is more
effectively and intensively utilised.
 More units of variable factor are employed , the
efficiency of variable factor increases –
“specialisation of labour”.
 Diminishing Returns
 The maximum point has reached.
 The amount of the variable factor is sufficient to ensure
the efficient utilisation of fixed factor.
 The contribution to the production made by the variable
factor after a point become less as the additional units
of the variable factor have less of fixed factor.

 Negative Returns
Number of variable factor become too excessive to the
fixed factor Marginal Product of variable factor is negative.
 Diminishing returns occur because the factors of production
are Imperfect substitutes for one another.
There is a limit to which one factor of production can be
substituted for another.
Elasticity of substitution between factors is not infinite.

 As long as MPP increases,
TPP increases at an
increasing rate.
 When MPP decreases, TPP
increases diminishing rate.
 When MPP is Zero, TPP is
maximum.
 When MPP is negative, TPP
starts decreasing.

 Cost is the value of the inputs used to
produce its output; e.g. the firm hires labor,
and the cost is the wage rate that must be
paid for the labor services

For factors hired or employed
by a firm:
The costs are (the value of) the highest-valued alternative use
of the money spent in hiring them.
They are called explicit costs , as they involve a transfer of
money.

For factors owned by a
firm:
The costs of using these factors are (the value of) the highest-
valued alternative uses of the factors.
They are called implicit costs or imputed costs , as they
do not involve a transfer of money.

 Cost function : Functional relationship
between output and cost.
C=f(q)
Where f=functional relationship
c= cost of production
Output
= ???

Total cost
 is the whole amount of payments to all
factors used in producing a given
amount of output (Q), composed of:
 Total fixed cost (TFC): is the whole amount
of payments to fixed factors.
 Total variable cost (TVC): is the whole
amount of payments to variable factors.

TVC = w x L• total variable
cost:
Formula:
TC = TFC +TVC
Total Cost:
Assume two factors only:
 Capital (fixed factor) and labour (variable
factor)
 L units of labour are employed at a wage
rate of w.
a constant independent
of output
• total fixed
cost:

Basis TVC TFC
Meaning Vary with the level of output Do not vary with the level of output
Time period Can be changed in short period Remain fixed in short period
Cost at zero output
Zero Can never be zero
Factors of production
Cost incurred on all variable factors
Cost incurred on fixed factors of
production
Shape of the cost curve
Upward sloping Parallel to x axis

 TFC is horizontal to x axis.
 TC and TVC are S shaped (they
rise initially at a decreasing rate,
then at a constant rate & finally
at an increasing rate) due to law
of variable proportions.
 At zero level of output TC is
equal to TFC.
 TC and TVC curves parallel to
each other.

Average cost / Average total cost
(ATC)
 is the cost per unit of output,
composed of :
•average fixed cost (AFC): the
fixed cost per unit of output.
•average variable cost (AVC): the
variable cost per unit of output.

Formula:
AVCAFC
Q
TVCTFC
Q
TC
ATC 


Average Total Cost:
Q
TFC
AFC average fixed cost:
AP
w
L
Q
w
L
Q
L
Lw
Q
Lw
Q
TVC
AVC 




average variable cost:

ATC curve and AVC curve will come
closer and closer as the amount of output
increases (∵ATC = AFC + AVC and AFC
drops continuously).
AVC curve is U-
shaped. (∵ AVC =
w/AP and AP is
inverted-U shaped.)
AFC curve drops
continuously. (∵AFC
= TFC/Q)
Features:

The turning point of ATC curve (b) occurs at a larger
output than the turning point of AVC curve (a).
(b)(a)
∵ At (a), the fall in AFC is > the rise in AVC initially
but at (b), the fall in AFC is < the rise in AVC
eventually

Marginal Cost
is the change in total cost for producing an
additional unit of output, composed of :
• marginal fixed cost (MFC): is the change in
fixed cost
for producing an additional unit of output
• marginal variable cost (MVC): is the change
in variable cost for producing an additional unit
of output.

Formula:
0



Q
TFC
MFCmarginal fixed cost:
MVCMFC
Q
TVCTFC
Q
TC
MC 






Marginal cost:
marginal variable cost:
MP
w
L
Q
w
L
Q
L
Lw
Q
Lw
Q
TVC
MVC 















MC curve passes through the minimum points
of AVC curve and ATC curve.
MC or MVC
curve is
U-shaped
As TFC is a constant, MFC = 0. So MC = MVC.
MC = MVC = w/MP. As MP curve is inverted-U
shaped, MC
or MVC curve is U-shaped.

 Revenue refers to the amount received by a
firm from the sale of a given quantity of
commodity in the market.

 Total Revenue (TR)
It refers to total receipts from sale of a given
quantity of a commodity.
TR = Quantity x Price.
 Average Revenue (AR)
It refers to revenue per unit of output sold.
AR = Total Revenue / Quantity.
 Marginal Revenue (MR)
It refers to the additional revenue generated
from the sale of an additional unit of output.
MR = change in TR /change in no. of units.

 When a firm has no control over price, it can sell any amount at a
given price. Accordingly, firms demand curve (or AR curve) is a
horizontal straight line as in.
 When a firm has partial or full control over price, it can sell more
of a product only by lowering its price. Accordingly, its demand
curve (or AR curve) slopes downward, showing a negative
relationship between price and output as in.

 When marginal revenue curve declines till point M
in part B, total revenue is increasing at diminishing
rate as shown by the segment O to B in part A.
 When marginal revenue becomes zero at point M in
part B, total revenue is at its maximum as shown by
point B in part A.
 When marginal revenue falls, the average revenue
also falls but lies above the marginal revenue
curve. Implying that in a situation of falling price,
MR falls even faster.
 After point M, marginal revenue becomes negative.
Now total revenue starts diminishing.
 A situation of zero AR obviously implies a situation
of zero TR. (Zero price situation is not a general
phenomenon, but, of course has examples as in
government or charitable hospitals where medicines
are given to the patients at zero price.)
Note Carefully
Marginal revenue can be positive, zero or negative but average revenue (or price) cannot be negative

In microeconomics, break-even is said to
occur when:
TR = TC
Or, or P = AC
A firm is just covering all its costs.
Break-even is struck at point Q where
AR (= Price) = AC = LQ = OP. A firm is
just covering its costs as price (= OP)
happens to be equal to AC (average
cost) = LQ. Equilibrium is at point Q. It
is to be carefully noted that the break-
even point Q also happens to be the
point of firms equilibrium where both
the conditions of equilibrium are
satisfied, viz
(i) MC = MR, and
(ii) (ii) MC is rising.

Shut-down point occurs when a firm is just
covering its variable costs only. Or, it is a
situation when:
TR = TVC or or AR = AVC
Here, the firm is incurring loss of fixed cost.
Does it mean that the firm will suspend
production of the commodity? Not necessarily.
It may continue to produce because the loss
of fixed cost is to be incurred even when
output is suspended.
Shut-down is struck at point Q where
AR (Price) = AVC = LQ = OP.
A firm is operating with a price just covering
its AVC. Thus, price (or average revenue = OP)
= average variable cost (= LQ). Note that
shut-down point Q also happens to be a point
of equilibrium where both the conditions of
equilibrium are satisfied, viz.
(i) MR = MC, and
(ii) (ii) MC is rising.

 Having understood the behavior of revenue
and costs for a firm, it is time now to
understand how a producer strikes his
equilibrium. As a producer, you will always
like to maximize the difference between
your total revenue (TR) and total cost (TC),
so that your profit is maximized.
 We will be studying how a producer attains
equilibrium through MR-MC Approach.

 Under perfect
competition, a firm is in
equilibrium in short-run
when following two
conditions are fulfilled.
1) MR = MC
2) MC cuts MR from below
or MC is rising at the
point of equilibrium.
Producer’s equilibrium is determined at OQ
level of output corresponding to point E as at
this point: (i) MC=MR; and (ii) MC is greater
than MR after MC=MR level of output.

 Both conditions are needed for producer’s
equilibrium
I. MC=MR: we know, MR is the addition to TR from sale of one
more unit of output and MC is the addition to TC for increasing
production by one unit. Every producer aims to maximize his
profits. For this, a firm compares its MR with its MC. Producer
is not in equilibrium when MC<MR as it is possible to add more
profits and also not when MC>MR as benefit is less than cost. It
means firm will be at equilibrium when MC=MR.
II. MC is greater than MR after MR=MC output level: MC=MR is a
necessary condition but not sufficient enough. It is because
MR=MC may occur at more than one level of output. But only
that output level is the equilibrium output when MC becomes
greater than MR after the equilibrium. It is because if MC is
greater than MR, then producing beyond MC=MR output will
reduce profits. But if MC is less than MR beyond MC=MR
output, it is possible to add to profits by producing more.

 Individual supply refers to quantity of a
commodity that an individual firm is willing
and able to offer for sale at a given price
during a given period of time.
 Individuals supply factors of production to
intermediaries or firms.

 The analysis of the supply of produced goods
has two parts:
– An analysis of the supply of the factors of
production to households and firms.
– An analysis of why firms transform those
factors of production into usable goods and
services.

 There is a direct relationship between price
and quantity supplied.
 Quantity supplied rises as price rises, other
things constant.
 Quantity supplied falls as price falls, other things
constant.

 Law of Supply
 As the price of a product rises, producers will be
willing to supply more.
 The height of the supply curve at any quantity
shows the minimum price necessary to induce
producers to supply that next unit to market.
 The height of the supply curve at any quantity
also shows the opportunity cost of producing
the next unit of the good.

 The law of supply is accounted for by two
factors:
– When prices rise, firms substitute
production of one good for another.
– Assuming firms’ costs are constant, a
higher price means higher profits.

 The supply curve is the graphic
representation of the law of supply.
 The supply curve slopes upward to the right.
 The slope tells us that the quantity supplied
varies directly – in the same direction – with
the price.

S
A
Quantity supplied (per unit of time)
0
Price(perunit)
PA
QA

 Supply refers to a schedule of quantities a
seller is willing to sell per unit of time at
various prices, other things constant.

 Quantity supplied refers to a specific
amount that will be supplied at a specific
price.

 Changes in price causes changes in quantity
supplied represented by a movement along a
supply curve.

 A movement along a supply curve – the
graphic representation of the effect of a
change in price on the quantity supplied.

 If the amount supplied is affected by
anything other than a change in price,
there will be a shift in supply.

 Shift in supply – the graphic
representation of the effect of a
change in a factor other than price on
supply.

Change in quantity
supplied (a movement
along the curve)
Price(perunit)
S0
$15
A
1,250 1,500
B

Price(perunit)
S0
Shift in Supply
(a shift of the curve)
S1
$15 A B
1,250 1,500

 Other factors besides price affect how much
will be supplied:
 Prices of inputs used in the production of a good.
 Technology.
 Suppliers’ expectations.
 Taxes and subsidies.

Prices of Related
Goods and Services
Number
Of
Producers
Expectations
Of
Producers
Technology
And
Productivity
Resource
Prices
Supply

 When costs go up, profits go down, so that
the incentive to supply also goes down.

 Advances in technology reduce the number
of inputs needed to produce a given supply
of goods.
 Costs go down, profits go up, leading to
increased supply.

 If suppliers expect prices to rise in the
future, they may store today's supply to reap
higher profits later.

 As more people decide to supply a good the
market supply increases (Rightward Shift).

 Market supply refers to quantity of a
commodity that all the firms are willing and
able to offer for sale at a given price during
a given period of time.
 The market supply curve is derived by
horizontally adding the individual supply
curves of each supplier.

Quantities
Supplied
A
B
C
D
E
F
G
H
I
(1)
Price
(per DVD)
(2)
Ann's
Supply
(5)
Marke
tSupply
(4)
Charlie's
Supply
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
0
1
2
3
4
5
6
7
8
0
0
1
2
3
4
5
5
5
0
0
0
0
0
0
0
2
2
0
1
3
5
7
9
11
14
15
(3)
Barry's
Supply

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
PriceperDVD
Charlie Barry Ann
Quantity of DVDs supplied (per week)
Rs. 4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0
I
H
G
F
E
D
C
B
A
Market Supply
CA

 The opportunity cost of producing and selling
any good is the forgone opportunity to
produce another good.
 If the price of alternate good changes then
the opportunity cost of producing changes
too!
 Example Mc Don selling Hamburgers vs.
Salads.

 When taxes go up, costs go up, and profits go
down, leading suppliers to reduce output.
 When government subsidies go up, costs go
down, and profits go up, leading suppliers to
increase output.

 Measures the responsiveness of supply due
to a change in price.
D E F : - THE RATIO BETWEEN % CHANGE
IN QUANTITY SUPPLIED TO THE %
CHANGE IN PRICE.

Percentage Change in Quantity Supplied
Percentage Change in Price
PES =
Remember:
Es = coefficient of price elasticity
QS = Quantity Supplied
P = Price
PES =
% ∆QS
% ∆P

•PEs > 1 supply is elastic
•PEs < 1 supply is inelastic
•PEs = 1 Unitary Elastic
•PEs= ∞ Totally Elastic
•PEs= 0 Totally In-Elastic

PRICE
P1
P2
0
Q1 Q2
S
QUANTITY

 Time
 Production capacity
 Producer or chief
 Stored products

Production and Cost Concepts for Business Decision Making

Production and Cost Concepts for Business Decision Making

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