Explore CBSE Notes

Theory of Production, Cost and Revenue

 

Fixed factors and Variable factors :

Fixed factors - fixed foctors are those factor inputs whose quantity remains same. they do not vary with the volume of output. for e.g. land is a fixed factor and rent paid for land is a fixed cost.

Variable factors - Varible foctors are Those factors which change with a change in the level of output. for e.g. raw material, labour etc.  

Short Run and Long Run Production :

Short Run : Short run is that period (only one input is variable and all other inputs are assumed to be constant) where atleast one of the factors of production is fixed.

Long Run : It refers to that period where all factors of production become variable.

Production Functions :

• The functional relationship between input and output is known as production function.
• As per production function, output is a dependent variable and input is an independent variable.
• Production function states that production is a functional relationship between production and its various factors.

     Q_x = f (L,K,T ..... n)

Where,

    Q_n = output

    L = labour

    K = capital

    T = level of technology

    n = other inputs employed in production.

Assumptions of production funtion :

• The level of technology remains constant.
• The firm uses its input at maximum level of efficiency.
• It relates to particular unit of time.
• A change in any of the variable factors produces a corrosponding change in the level of output.
• The inputs are divisible into most viable units.

There are two types of production function :

(a) Short run production function.

(b) Long run production function.

Short Run Production function : In short run production function, the quantity of only one inputs varies. It occurs in the short run.

Long Run Production function : It occurs in the long run where a firm can change all factors of production.

Returns to factor (Law of variable Proportion) :

• Law of variable proportion states that ''as we increase more and more units of variable factors on a given fixed factors, output first increase at an increasing rate, then at a diminishing rate and finally declines".
• It occurs in the short run.
• This law is also known as "law of diminishing returns".
• Classical economists call this law as law of Diminishing returns whereas it is called as law of variable proportion by modern economist.

Units of Land	Units Of Labours	Total Product   (TP)	Marginal Product   (MP)
1	1	2	2
1	2	5	3
1	3	9	4
1	4	12	3
1	5	14	2
1	6	15	1
1	7	15	0
1	8	14	-1

Assumptions of Law of variable Proportion :

• Technology remains constant.
• There are two factors of production one inputs factor is variable and other factor is kept constant.
• All units of variable factors are identical in size and quantity.
•  A particular production can be produced under varying production of the input combinations.
• Operates in short run.

Concepts of product :

Total product - It refers to the volume of goods and services produced during a specified period of time.

Average Product - It is the per unit production of variable factor. It is calculated by dividing total product with the number of units of variable factor:

   AP = TP/N

Marginal Product - Marginal product is the change in the total product resulting from an additional unit of variable factor. It can be expressed as follow:

   MP_n = TP_n - TP_n-1

Where,

 MP_n = marginal product of n^th unit

 TP_n = total product of n^th unit

 TP_n-1 = total product of previous unit

Reason for Returns:

1. Increasing Returns -

   (a) Fuller utilization of fixed factor.

   (b) Division of labour.

2. Diminishing Returns -

   (a) Disturbing the optimum proportion.

   (b) Imperfect substitutability of factors of production.

3. Negative Returns -

   (a) Over crowding.

   (b) Management problem.

Law of Returns to Scale:

• Returns to scale relates to the behaviour of total output as all inputs are varied in the same proportion.
• It is a long run concept, where all factors are variable.
• There are three types of returns to scale -

     (a) Increasing Returns to scale.

     (b) Constant Returns to scale.

     (c) Diminishing Returns to scale.

Theory of Production, Cost and Revenue

Theory of Cost:

The cost of supplying the product is dermined by the productivity and the prices of inputs used.

Cost function :

• Cost functios denotes "the functional relationship between output and the cost incuured to produce it".
• It can be expressed as :

            C = f (q)

Where,

  C = cost

  q = output.

Cost concept :

Fixed Cost - The cost incurred for fixed factors of production arte called fixed cost. They do not change with a change in output. For e.g- rent of land, gate keepers salary etc.

Variable Cost - Those cost which are incurred on variable factors  are known as vaariable cost. They vary with a change in level of output. For e.g- cost of raw material. wages of labour etc.

Total Cost - It is the  sum total of fixed cost and variable cost. It can be expressed as

TC = FC+VC

Averege Cost - Per unit cost of production is termed as average cost. It is drived by dividing total cost with the number of units produced. Average cost is expressed as:

AC = Total cost / No. of units produced

Marginal Cost - It is the addition made to the total cost by producing one more unit of a commodity. It can be referred as a change in total cost with the production of an additional unit.

MC_n = TC_n - TC_n-1

Where,

MC_n = marginal cost of n^th unit

TC_n = total cost of n^th unit

TC_n = total cost of previous unit.

Short Run and Long Run Costs:

Short Run Costs - Short run is a period where both fixed and variable factors exist. Hence, in the short run the firm incurs both fixed and variable cost.

Long Run Cost: - In the long run, no factor is fixed and hence there is no fixed cost. Here total cost is equal to variable cost. i.e total cost changes in direct proportion to output. All factors are variable. Hence, all cost are also variable.

Theory of Production, Cost and Revenue

 

Theory of Revenue:

Revenue is defined as the money received from the sale of output. It is the product of price and quantity sold.

Concept of Revenue:

Total Revenue (TR) - Total revenue refers to the total amount of money or payment received by a firm from the sale of its output.

It is expressed as -

  TR = Q * P

Where,

 Q = quantity sold

 P = per unit price

Average Revenue (AR) - Average revenue is the per unit revenue received. 

It is expressed as:

  AR =TR / Q

Where,

 TR = total revenue

 Q = quantity sold.

Marginal Revenue (MR) - It is the addition made to the total revenue by producing one more unit of a commodity. It can be referred as a change in total revenue due to an additional unit.

  MR_n = TR_n- TR_n

       OR

 MR = dTR/dQ = change in TR/change in Quantity

Relationship between AR and MR :

Under perfect competition market: -

• Under perfect competition, the price remains constants and hence AR= MR = P.
• Average Revenue curve is also known as the demand curve.

Under imperfect competition market -

• Under imperfect competition price will not be same and hence AR is not equal to MR.
• Here with the increase in output AR falls and MR Falls at a faster rate than AR.

Theory of Production, Cost and Revenue

 

Producers Equilibrium :

Producer's equilibrium refers to that level of output at which producer attains maximum profit.

Profit = TR - TC

The point where TR - TC is maximum is the equilibrium level of output for producers.

Approaches to producer equilibrium

(a) TC - TR approach

(b) MC - MR approach (Marginal Cost inclusive of normal profit).

(a) TC - TR approach - Conditions for producers equilibrium:

= TR - TC should be maximum.

= Profit falls if more unit of output is produced

(b) MC - MR approach - Conditions for producers equilibrium:-

= MR = MC

= MC cuts MR from below to become greater than MR after MR = MC level of output.

The point where both the conditions are satisfied is the equilibrium point.