Chapter- 04: Production Theory

Production Theory:

A) Production function:
A production function represents input – output relationship.

Q = f (X, Y, Z)

Where, Q = output (or production volume)

X = Labour
Y = Land called input factors or factors of production
Z = Capital

Q = Dependent variables
XYZ = Independent variables

B) The Law of Diminishing Returns:

The Law of Diminishing Returns states that the additional or marginal product of a
variable input factor X (say labour) successively decreases as we go on increasing that
input factor at a particular point of time, other input factors Y (say land) and Z (say
capital) remaining fixed.

Example: Land = 1 Acre, Capital Tk. 10,000/- , Labour change as under-

Labour (X) MPx TPx APx

1 15 15 15
2 17 32 16
3 18 50 16.66
4 15 65 16.25
5 12 77 15.40
6 7 84 14
7 0 84 12
8 -9 75 9.38

Where, MPx = Marginal product of input factor x

TPx = Total product of input factor x
APx = Average product of input factor x

Mathematically, MPx = Δ TPx/ ΔX

TPx = ∑ MPxi (i = 1 + n)

MPx is the additional product produced by one additional unit of input factor X.

TPx is the sum of all MPx.

Figure: MPx, TPx and APx

100

80

60
MPx
40 TPx
Apx
20

0
1st 2nd 3rd 4th
-20 Qtr Qtr Qtr Qtr

Relationship between MPx and TPx:

TPx is the sum of all MPx, that is TPx = ∑ MPxi

When MPx > 0 then TPx increases.
When MPx < 0 then TPx decreases.
When MPx = 0 then TPx is at its maximum.

Q. Why does the law of work (or function) in real time?

Ans. In every production function there exists an optimal input factor ratio to get the
optimal output.

Return to scale:
a. Increasing returns to scale
b. Constant returns to scale
c. Decreasing returns to scale

a. Increasing returns to scale- denotes a situation whereby a proportional increase

in all input factors leads to a more-than-proportional increase in output.

b. Constant returns to scale- denotes a situation whereby a proportional increase in

all input factors leads to the same proportional increase in output.

c. Decreasing returns to scale- denotes a situation whereby a proportional increase

in all input factors leads to a less- than-proportional increase in output.
Example:

Situation-1: Situation-2: Let us increase all input factor

by 100% or two times
Input Output Input Output
Land : 1 acre Q= 50 monds Land : 2 acre Q= 110 or 90
Labour : 3 paddy Labour: 6 or 100 monds
Capital: Total Tk 10,000/- Capital: Total Tk 20,000/- paddy

When Q = 110; This is the case of increasing returns to scale.

When Q = 90; This is the case of decreasing returns to scale.
When Q = 100; This is the case of constant returns to scale.

Isoquant: (Iso- equal, quant- quantity)

An isoquant represents equal amount of output that can be produced from different
combinations of two input factors.

Slope of isoquant = MRTS= MPx/MPy (MRTS- Marginal Rate of Technical

Substitution)

Isocost: (means equal cost)

An isocost shows equal amount of cost that a firm can incur from purchase of different
combinations of two input factors.

Slope of isocost = Px/Py

Figure: Isoquant Figure: Isocost

Least –cost or optimal input combination:

Two conditions need to be satisfied here:

(a) Necessary condition:
slope of isoquant = slope of isocost Figure:

MPx/MPy = Px/Py

(b) Sufficient condition:

MPx/Px = MPy/ Py

Graphically in point of tangency of an isoquant to the isocost line.

Higher levels of combination show higher levels of output. Hence Q3 > Q2 > Q1
Chapter- 5: Cost Concepts, Relationships & Practical Applications
A. Fixed & variable cost concepts:

Fixed costs are those costs that do not change with changes in output levels.
Example: Rent, Insurance premium, Depreciation of building etc.

Variable costs are those costs that do change (vary) with changes in output levels.
Example: Raw materials cost, Direct wages.

Figure: TFC Curve Figure: TVC Curve

TFC = Total Fixed Cost

TVC = Total Variable Cost
TC = TFC + TVC
AC = TC/Q
AFC = TFC/Q
AVC = TVC/Q
AC = AFC + AVC
MC = Δ TC/ ΔQ

Marginal principal is a very important principle in economics

B. Direct & indirect costs:

Direct costs are those costs that can be calculated per product or per process unit.
Example: Direct raw material costs, Direct wages etc.

Indirect costs are those costs that can not per calculated per product or process unit
Example: Rent, Utility bills, Depreciation etc.

C. Explicit & Implicit costs:

Explicit costs are cash expenses (or expenses paid on cheques)
Example: Salary, Wages, Raw material costs etc.

Implicit costs are non-cash expenses.

Example: Depreciation, Opportunity cost etc.

D. Sunk cost:
Sunk costs are irrecoverable expenses that is, these are expenses incurred that can’t be
recovered in future.
Example: Lottery ticket money when the lottery is lost, non-refundable tender bid money
when the tender is lost.

E. Marginal & Incremental costs:

Marginal cost is the additional cost for one additional product unit.
MC = TC/ Q

Incremental cost is the additional cost associated with implementation of one additional
management decision.
Example: If IIUC management decides to open a new department then the additional cost
associated with the opening of a new department will be called incremental cost.

F. Opportunity costs:
Opportunity cost is the potential benefit foregone (lost) from the next best decision
alternative.
The basic principal of opportunity cost is ‘if we do one things then we have to give
something else up’.
Opportunity cost is the potential benefit foregone from the alternative given up. The life
involves trade offs.

Example: Opportunity cost of Tk 100.00 million of Jb. K. A. Habib

Investment opportunity Return on investment Ranking Remarks

alternative
Fisheries 25% iv.
Flower cultivation 30% iii
Fruit cultivation 35% ii Next best
Meat processing 45% i Best

A rational investment will go for the best alternatives. In our example case the meat
processing investment decision is right.

G. Economic & Accounting cost concepts:

Fixed and variable cost concepts, direct and indirect cost concepts are accounting cost
concept.

Explicit and implicit, marginal and incremental, and opportunity cost concepts are
economic cost concepts.

Long- Run Total Cost (LRTC) Curves:

In the long-run there is nothing called fixed cost. That is, all costs are variable in the
long-run
A. B.

Figure: LRTC Curve showing increasing Figure: LRTC Curve showing decreasing
returns to scale returns to scale
In this case Q > C. In this case Q < C
Rate of change output is greater than the rate of
Here, rate of change output is smaller than
change input.
the rate of change input.

C. D.

Figure: LRTC Curve showing constant Figure: LRTC exhibiting variable returns to
returns to scale. scale

The rate (or percentage) increase or This figure initially exhibits increasing
decrease in output is equal to the rate (or returns to scale and after certain output
percentage) increase or decrease in cost. level (Q*) level, it exhibits decreasing
returns to scale.

E.

Figure: LRTC exhibiting variable returns to scale.

This figure initially exhibits decreasing returns to scale and after certain
output level (Q*) level, it exhibits increasing returns to scale.

Relationships between MC, AVC, AC and AFC curves:

MC curve is U-shaped. And again MC curve determines the shapes of AVC and AC
curves. Hence both AVC and AC curves are also U-shaped

Figure: MC, AVC, AC and AFC curves

AC = AFC + AVC
AC > AVC

MC must cut both AC and AVC curve at the bottoms (or lowest points) from below.
AFC curve is hyperbola. That means, it goes on decreasing as output is increased. AFC
continuously decreased. It never cut the both X and Y axis. Its value never be zero.