Law of variable proportion (Law of diminishing return):

Law of variable proportion is initially called law of diminishing return. According to Law of Variable proportion as more and more units of variable factors are combined with same quantity of fixed factors, total product first increases at increasing rate then at diminishing rate and finally starts diminishing. It implies that marginal product first rises and then diminishes eventually. Law of variable proportion is also known as law of returns to a factor; it is a short run concept. Law of diminishing return explains the stages of production in which the quantity of one input is increased with a fixed quantity of other input. Law of variable proportion states that as the quantity of variable input is increased, keeping the quantities of other inputs constant, total product will increase but after a point at diminishing rate.

Assumptions of Law of variable proportion: 1. The technology remains unchanged. 2. There must be some inputs whose quantity is kept fixed. 3. Law does not apply where factors are used in fixed proportion 4. Only physical inputs and outputs are considered.

Labour

Total Product

Average Product

Marginal Product

Analysis for law of variable proportion Stage I- law of increasing return

1 2 3

2 5 9

2 2.5 3

2 3 4

4 5 6 7 8 9

12 14 15 15 14 12

3 2.8 2.5 2.1 1.7 1.3

3 2 1 0 -1 -2

Stage II-law of decreasing return

Stage III-law of negative return

Stages Stage I

Total product Increases at increasing rate Increases at diminishing rate and reaches its maximum point Begins to fall

Average product Increases and reaches at maximum point After reaching its maximum point begins to decrease Continues to diminish

Marginal product Increases and reaches at maximum point Decreases and becomes zero

Stage II

Stage III

Becomes negative

Law of returns to scale: In long run, all factor inputs in the production
function can be changed. The behavior of output consequent to change in the quantities of all factor inputs in the same proportion (i.e. keeping, the factor proportions unaltered) is known as returns to scale. In other words returns to scale is the degree of responsiveness of output to a proportionate change in the quantity of all inputs. Returns to scale may be three types:

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 input is increased by 100% but the output is increased by 125%.
2. Constant returns to scale: Returns to scale 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 increased by 100%.
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 is increased by only 75%.

Economies and Diseconomies to scale

Y

Economies to scale
All factors which are responsible for B decreasing the cost of production and Increasin increasing revenue
g returns to scale Constant returns to scale C

Diseconomies to scale
All factors which are responsible for increase in cost of production and decreasing the Diminishing returns to revenue
scale

Marginal product

Internal
Efficient labor Good advertisement Good management Good plan Least wastage Best technology

D MP

External 0
Government rules Special economic zone etc...

External Internal
management No utilization of time Wastage money of

Poor All factors of input

Government steps Production of competitor etc...

Improper way

Isoquant and production function: Isoquants are geometric

representation of the production function. All factors of production are variable in long run, if a firm has two inputs, namely labor (L) and capital (K), both of which are variable, and then the long run production can be represented as follows: Q= f (L, K) It is possible to achieve the same level of output by various combinations of factor inputs. Assuming continuous variation in the possible combination of labor and capital, we can draw a curve by plotting all these alternatives combinations for a given level of output. Isoquant curve is also known as equal product curve or product indifference curve. Isoquant curve is the locus point of representing various combinations of labor and capital yielding the same amount of output. Infact, different input combinations can produce the same output is based on the assumption that labor and capital can be substituted from each other but at a diminishing rate, iso-product curve represent all possible combinations of two factors that will give the same total product.

Assumptions:
1. Producer can use only two types of inputs i.e... Labor and capital. 2. Labor and capital can be substituted for each other at diminishing rate. 3. The technology remains the same for the period of production. 4. The production function of the firm is Q= f (L, K).

5. Divisibility of different units of labor and capital. 6. There are only two factors of production labor and capital and there are different combinations are giving same level of output.

K4
B

K3 Capital (K)
C

K2
D

K1 Y X L1 K2 Capital (K) K1
Q= 100

L2

L3

L4

Q= 400 Q= 300 Q= 200

Labour (L)

Isoquant curve

Features of isoquants / Properties of isoquants: 1. Isoquants are down words sloping. That means if a firm wants to use more labour then it must use less of capital to produce the same level X of output or to be on the same isoquant. L2 L1 2. Isoquants are convex (curved out words) to the origin i.e. the iso product curve has the diminishing slope. Labour (L)

Isoquant map

3. Isoquants never cross each other because each isoquant represents a different production function. 4. An isoquant which lies to the right and above another isoquant represents higher level of output.

Capital-Labour combination and output MRTS (Marginal rate of technical substitution): The rate at which one factor can be substituted for another is known as MRTS. Combination A B C D E Units of labour 1 2 3 4 5 Units of capital 30 20 15 12 10 1:30 1:10 1:5 1:3 1:2 MRTS

Cost concept and analysis: Because business decisions are taken on

the basis of money values of inputs and outputs. The cost of production is calculated by multiplying inputs by their respective prices and added together to give the money value of the inputs. Cost is very important in business decision making. It is the basis on which price of a product is calculated. Reasons for calculating cost:
1. Fix price of a product for a perspective buyer.

2. Find out whether a particular investment should be made or not. 3. Determine the profit of the firm.

4. Determining whether a commodity is worth producing at a given cost or not. 5. Determine the quantity which will give maximum profit. Cost analysis is concerned with financial aspect of production relation as against physical aspect considered in production analysis. A useful cost analysis needs a clear understanding of the various cost concepts.

Cost

Accounting cost
Opportunity and actual

Analytical cost
Fixed and variable

cost
Explicit and implicit

cost
Total, average and marginal cost Short run and long run

cost
Out of pocket and book

cost
Business cost and full

cost
Increment and sunk

cost
Past and future cost

cost
Historical and replacement

cost
Private and social

cost Economic cost (non accounting cost) and Accounting cost: The economic cost is the cost that a firm incurs in the production of goods refers to the payment it must make to all the resources (factors of production) employed by it in the production of that good.

Accounting cost= Explicit cost (salary, wages, machines, license fees, insurance, depreciation.)

Economic cost= Explicit cost (accounting) + implicit cost (rent, interest, wages) Accounting profit= Total revenue-explicit cost Economic profit= Total revenue- economic cost
Opportunity cost: Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the return from the second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources. Actual cost: Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. The actual costs or expenditures are recorded in the books of accounts of a business unit. Explicit cost: Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs are recorded in the books of accounts. Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc. Implicit cost: Implicit costs are a part of opportunity cost. They are the theoretical costs i.e., they are not recognised by the accounting system and are not recorded in the books of accounts but are very important in certain decisions. They are also called as the earnings of those employed resources which belong to the owner himself. Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity capital etc.

Factors hired from outside Seed Labour Tractor Fertilizer Tube well Total

Explicit cost 750 1900 2000 1000 1250 6900

Self factors employed Family labour Land

Implicit cost 3500 5000

8500

Book Cost: Book costs are those business costs which don't involve any cash payments but a provision is made in the books of accounts in order to include them in the profit and loss account and take tax advantages, like provision for depreciation and for unpaid amount of the interest on the owners capital.

Out Of Pocket Costs: Out of pocket costs are those costs are expenses which are current payments to the outsiders of the firm. All the explicit costs fall into the category of out of pocket costs. Examples: Rent Paid, wages, salaries, interest etc Business Cost: Business costs include all the expenses incurred by the firm to carry out business activities. Costs Include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment. Full Cost: Full costs include business costs, opportunity costs, and normal profits. An Opportunity cost is the expected return/earnings from the next best use of the firms resources like capital, land and building, owners efforts and time. A normal profit is necessary minimum earning in addition to the opportunity costs, which a firm must receive to remain in its present occupation. Historical Costs and Replacement Costs: Historical cost or an original cost of an asset refers to the original price paid by the management to purchase it in the past. Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. The distinction between the historical cost and the replacement cost result from the changes of prices over time. In conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm needs to adjust them to reflect price level changes. Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The amount $20,000 is the historical cost and the amount $40,000 is the replacement cost.
Fixed Costs: Fixed costs are the costs that do not vary with the changes in output. In other words, fixed costs are those which are fixed in volume though there are variations in the output level.. If the time period in volume under consideration is long enough to make the adjustments in the capacity of the firm, the fixed costs also vary. Examples: Expenditures on depreciation costs of administrative, staff, rent, land and buildings, taxes etc. Variable Costs: Variable Costs are those that are directly dependent on the output ie., they vary with the variation in the volume/level of output. Variable costs increase in output level but not necessarily in the same proportion. The proportionality between the variable costs and output depends upon the utilization of fixed facilities and resources during the production process. Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of fixed assets such as fuel, repairs, routine maintenance expenditure.

Total cost: T.C= cost per unit*no of units produced Average cost: A.C= Total cost of production/No of units produced Marginal Cost: M.C= TCn-TCn-1 Short term cost output relationship: Short run is a period of time over which the firm is unable to vary all its inputs. Some of inputs are fixed,

others are variable. Therefore the costs associated with the both fixed and variable inputs form a part of short run costs. Short run total cost (TC) is a sum of total fixed cost (TFC) and total variable cost (TVC) TC= TFC+TVC
1. Total cost: It is the actual cost that must be incurred to produce a

given quantity of output in the short run, using both fixed and variable inputs.
TC TV C TF C TFC

Cost

Output

a) Total fixed cost: the total fixed costs are those costs which in total Y

dont vary with the changes in output. These costs are fixed in nature even if the level of output is zero, they will still have to be incurred. For example: Payment for building rent, salaries of administrative staff etc.
Cost (in Rupees)

Total fixed Cost (TFC)

X Output (in units)

b) Total variable cost: They are the costs that are incurred on variable

factors, whose amount can be altered in the short run. Variable costs will increase when output rises and vice-versa. Total variable cost is zero when output is zero and it increase with an increase in output. For example: Raw material, labour etc.

Y Total variable cost TVC

Cost (in Rupees)

X Output (in units)

2. Average cost: Average cost is the total cost of production divided by the total number of units produced. Average cost= Total cost/No. of units produced
2. Marginal cost: It is the cost added to the cost due to increase in

output by one unit. Marginal cost= Change in total cost/No. of additional units produced

Relationship between average cost and marginal cost:

Outp ut (Unit s) 0 1 2 3 4 5 6 7 8 9 Total fixed cost (TFC) 10 10 10 10 10 10 10 10 10 10 10 18 24 28 32 38 46 56 68 Total variable cost (TVC) 10 20 28 34 38 42 48 56 66 78 10 5 3.3 2.5 2 1.67 1.43 1.25 1.11 Total cost (TC) Averag e fixed cost (AFC) Averag e variabl e cost (AVC) 10 9 8 7 6.4 6.33 6.57 7 7.55 20 14 11.3 9.5 8.4 8 8 8.25 8.67 10 8 6 4 4 6 8 10 12 Averag e total cost (AC) Margin al cost (MC)

AFC= Total fixed cost/ no. of output AVC= Total variable cost/ no. of output ATC= Total cost/ no. of output MC= Change in total cost/ change in output

Short Run Cost: These costs are which vary with the variation in the output with size of the firm as same. Short run costs are same as variable costs. Broadly, short run costs are associated with variable inputs in the utilization of fixed plant or other requirements. Long Run Cost: These costs are which incurred on the fixed assets like land and building, plant and machinery etc., Long run costs are same as fixed costs. Usually, long run costs are associated with variations in size and kind of plant. Incremental Cost: Incremental costs are addition to costs resulting from a change in the nature of level of business activity. As the costs can be avoided by not bringing any variation in the activity in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever incremental costs resulting from a contemplated change is the Future, they are also called as "Differential Costs" Example: Change in distribution channels adding or deleting a product in the product line. Sunk Cost: Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision - making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs" or "Inescapable costs". Examples: All the past costs are considered as sunk costs. The best example is amortization of past expenses, like depreciation.

Private and social cost: Private costs are those incurred by the firm producing the goods/services, whereas social costs are those paid for by society. Determinants of cost: There are many factors that determines the cost behaviour 1. Size of the plant. 2. Period. 3. Capacity utilization. 4. Prices of factors of production. 5. Technology. 6. Efficiency in the use of inputs. 7. Lot size of the product. 8. Level of output. 9. Geographical location. 10. Institutional factors.

Why are AVC, ATC and MC curves U shaped? Production and cost function: It is due to law of variable proportion. Law of variable proportion (law of 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, MC rises. It is the behavior of MC, which determines behavior of AC. Long run average cost curve (LAC)/ Envelop curve or planning curve: A long run cost curve depicts (draw) the functional relationship between output and the long run cost of production. In 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 long run the firm will produce the output at which SAC is minimum. It is clear that 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.