Module 3

PRODUCTION AND COSTING

Production and costs are a very important part of modern economics and are essential in
determining a whole lot of things in production. We have to deal with various concepts like
production function, cost of production, and the necessary mathematical terms that are associated
with them. Being acquainted with all these terms would help us understand the various
industries' operations in an economy. The relationship between the inputs and the output in the
production process can be explained with the help of a production function.

Theory of Production:
Theory of production, in economics, an effort to explain the principles by which a business firm
decides how much of each commodity that it sells (its “outputs” or “products”) it will produce,
and how much of each kind of labour, raw material, fixed capital good, etc., that it employs (its
“inputs” or “factors of production”) it will use. The theory involves some of the most
fundamental principles of economics. These include the relationship between the prices of
commodities and the prices (or wages or rents) of the productive factors used to produce them
and also the relationships between the prices of commodities and productive factors, on the one
hand, and the quantities of these commodities and productive factors that are produced or used,
on the other.

The various decisions a business enterprise makes about its productive activities can be classified
into three layers of increasing complexity. The first layer includes decisions about methods of
producing a given quantity of the output in a plant of given size and equipment. It involves the
problem of what is called short-run cost minimization. The second layer, including the
determination of the most profitable quantities of products to produce in any given plant, deals
with what is called short-run profit maximization. The third layer, concerning the determination
of the most profitable size and equipment of plant, relates to what is called long-run profit
maximization.

However much of a commodity a business firm produces, it endeavors to produce it as cheaply

as possible. Taking the quality of the product and the prices of the productive factors as given,
which is the usual situation, the firm’s task is to determine the cheapest combination of factors of
production that can produce the desired output.

Production Function: Production function, in economics, equation that expresses the

relationship between the quantities of productive factors (such as labour and capital) used and the
amount of product obtained. It is the functional relationship between the amount of input
employed and the amount of output produced. This shows the technical relationship between
inputs and outputs which are in physical form.

Law of variable proportion

The Law of Variable Proportions concerns itself with the way the output changes when you
increase the number of units of a variable factor.
Hence, it refers to the effect of the changing factor-ratio on the output.
In other words, the law exhibits the relationship between the units of a variable factor and the
amount of output in the short-term.
This law exhibits the short-run production functions in which one factor varies while the others
are fixed.
Also, when you obtain extra output on applying an extra unit of the input, then this output is
either equal to or less than the output that you obtain from the previous unit.
The Law of Variable Proportions concerns itself with the way the output changes when you
increase the number of units of a variable factor. Hence, it refers to the effect of the changing
factor-ratio on the output.
In other words, the law exhibits the relationship between the units of a variable factor and the
amount of output in the short-term. This is assuming that all other factors are constant. This
relationship is also called returns to a variable factor.

The law states that keeping other factors constant, when you increase the variable factor, then the
total product initially increases at an increases rate, then increases at a diminishing rate, and
eventually starts declining.

Law of returns to scale

Returns to scale refer to the change in output that results from a change in the factor inputs
simultaneously in the same proportion in the long run.

When a firm changes the quantity of all inputs in the long run, it changes the scale of production
for the goods.

1. Increasing Returns to Scale:

In the first stage of Returns to Scale, the proportionate increase in total output is more than the
proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the
increase in output will be more than 100%.

2. Constant Return to Scale:

In the second stage of Returns to Scale, the proportionate increase in the total output is equal to
the proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the
increase in output will also be 100%.

3. Diminishing Returns to Scale:

In the third stage of Returns to Scale, the proportionate increase in the total output is less than the
proportionate increase in inputs. In simple terms, if all the inputs increase by 100%, then the
increase in output will be less than 100%

Types of Costs: The different types of costs include fixed costs, variable costs, semi-
variable costs, marginal cost, opportunity cost, economic cost, accounting costs, sunk cost,
among other types of costs. Fixed costs refer to the costs that do not change with
output—variable costs, on the other hand, are dependent on what is being produced and keep
varying. Marginal costs refer to the cost of producing an additional unit of a particular
commodity or service.

Cost Minimization:

Cost minimization is the rule in which producers seek to calculate the right balance between two
inputs in order to have the most cost-effective productivity. It is a basic rule used by producers to
determine what mix of labor and capital produces output at the lowest cost. In other words, what
the most cost-effective method of delivering goods and services would be while maintaining a
desired level of quality. An essential financial strategy it is important to understand why cost
minimization is important and how it works.

The Cost Minimization Problem

Firms perform cost minimization in order to determine the most efficient way of producing
goods and services from at least two inputs. For example, if a firm invests too much on its
workers and not enough on its capital, or vice versa, the cost for both will not be efficient.

Cost Minimization and Profit Maximization

Reflecting on substitute and complementary factors of production can help the way we think
about cost minimization and profit maximization. There are different combinations of inputs a
firm can calculate to minimize the cost of its capital and labor, in turn maximizing the firm's
profits.

Cost Curves:

Total cost curves represent the aggregate of all the expenses a company faces when producing a
certain quantity of product. Total cost is the sum of all costs that a company faces to produce a
certain level of output. Fixed costs include costs such as the costs of a building lease and
machinery used during the production process. A cost curve is a graph of the costs of production
as a function of total quantity produced. In a free market economy, productively efficient firms
optimize their production, productively efficient firms use these curves to find the optimal point
of production, where they make the most profits. There are various types of cost curves, all
related to each other.
The Short-Run Average Variable Cost Curve (SAVC):

Average variable cost (which is a short-run concept) is the variable cost (typically labour cost)
per unit of output- SAVC = W L/Q where w is the wage rate, L is the quantity of labour used,
and Q is the quantity of output produced. The SAVC curve plots the short-run average variable
cost against the level of output, and is typically U-shaped.

The long-run average cost curve:

The long-run average cost curve depicts the cost per unit of output in the long ran—that is, when
all productive inputs’ usage levels can be varied. The behavioural assumption underlying the
curve is that the producer will select the combination of inputs that will produce a given output at
the lowest possible cost. The LRAC curve is created as an envelope of an infinite number of
short-run average total cost curves, each based on a particular fixed level of capital usage.
Total, Average and Marginal Costs:
Total Cost (TC) describes the total economic cost of production. It is composed of variable, and
fixed, and opportunity costs.
Fixed costs
The accounting costs which do not change based on your level of output
Always determined to be fixed in the short term; if you could not change it on short notice it is
fixed
EXAMPLE building costs, insurance, property taxes
Variable costs
The accounting costs that do change based on your output level
Always determined in the short run (all factors are variable in the long run); if you could change
it on short notice it is variable
EXAMPLE number of widgets produced, number of low skilled employees, packaging costs
Opportunity Costs
All of the other things that you could be doing with your money if you were not doing what you
are doing
Not normally accounted for in accounting costs
EXAMPLE amount of interest you would earn on an investment, salary you could earn being
employed elsewhere
Average Costs
Average cost is equal to total cost divided by the number of goods produced (the output quantity,
Q). It is also equal to the sum of average variable costs (total variable cost divided by Q) plus
average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time
period considered (increasing production may be expensive or impossible in the short term, for
example). Average costs affect the supply curve and are a fundamental component of supply and
demand.
Marginal Costs
Marginal cost is the change in total costs that arises when the quantity produced changes by one
unit. That is, it is the cost of producing one more unit of a good. Mathematically, the marginal
cost (MC) function is expressed as the first derivative of the total costs (TC) function with
respect to quantity (Q). The marginal cost may change with volume, and so at each level of
production, the marginal cost is the cost of the next unit produced.

Marginal Cost Average Cost Total Cost

Long Run and Short Run Costs:

Cost in Short Run:

It may be noted at the outset that, in cost ac-counting, we adopt functional classification of cost.
But in economics we adopt a different type of clas-sification, viz., behavioural classification-cost
beha-viour is related to output changes.

In the short run the levels of usage of some input are fixed and costs associated with these fixed
inputs must be incurred regardless of the level of output produced. Other costs do vary with the
level of output produced by the firm during that time period.

The sum-total of all such costs-fixed and variable, explicit and implicit- is short-run total cost. It
is also possible to speak of semi-fixed or semi-variable cost such as wages and compensation of
foremen and electricity bill. For the sake of simplicity, we assume that all short run costs to fall
into one of two categories, fixed or variable.

Long-Run Costs:

The long-run is a spell of time in which all factors of manufacturing and costs are variable. In the
long run, enterprises are capable of modifying all cost prices, whereas, in the short run,
enterprises are only capable of impacting cost prices through modifications made to production
degrees.

There is no difference between the LTC or LRTC (long-run total costs) and long-run variable
costs as there are no fixed costs. It denotes the capability of an establishment of changing inputs
and sanctions it to manufacture at less price in the long run.
Tax and Subsidies:

The government can influence markets and its citizens in many ways. Two of these types of tools
are taxes and subsidies. Taxes are a charge the government imposes on individuals' and firms'
income and revenue. At the same time, subsidies are grants or tax breaks given to individuals and
firms to incentivize them to pursue a social objective that the government that issues the subsidy
wishes to promote.

These policies shift the supply or demand curve depending on who and how they're
implemented.

Taxes are monetary costs levied by governments on individuals and firms that are collected from
their income or revenue to be transferred to the public sector.

Subsidies are direct and indirect payments provided by the government to individuals and firms
to give the recipients a financial incentive to pursue a certain objective.

Taxes

Taxes are the mechanism by which governments collect funds from their constituents to provide
public services and address market failures. Commonly taxes are the way to provide necessary
structures that the market may struggle to provide universally; these things can range from public
defense, police, firefighters, healthcare, mail services, and roads.

While government handling market failures is inefficient as it is not subject to competition,

government-controlled markets aim to provide more socially equitable outcomes than
productively efficient ones.

The majority of criticisms of taxes and government spending come from the non-universal
benefits that the government provides; services vital to one aspect of a community may do
nothing for another, who then see it as a waste of money.

However, all citizens benefit to some degree from the government's management of things like
roads, weather events, and trash services. Services provided by the government save citizens
time and effort that can be quantified, such as a shorter commute due to well-maintained and
efficient roads.
Businesses benefit from government tax expenditures in various ways, whether providing
support to their labor pool or infrastructure and roads for their business. While businesses are
taxed heavily, it is common for them to receive some tax relief through loopholes.

Additionally, governments may address market fluctuations by providing subsidies that are paid
for by taxation. The benefits we receive from taxation often aren't seen in the dollar value they
provide us. Check out this example below to learn more.

Consider someone who wishes to go shopping; to get to the store, they must drive on roads
maintained by tax dollars. If the road isn't maintained, potholes may damage their car, or traffic
will move slower and take way longer to get to the store.

Once at the store, the consumer can shop knowing that product and safety regulations guarantee
that items purchased won't have adverse health effects. Suppose the shopper decides to walk to a
nearby store. In that case, they benefit from public sidewalks and the discouragement of criminal
behavior from frequent police presence.

These subtle things provide value through safety and time that many are willing to pay for.

Subsidies

Subsidies are a financial tool regulators use to address market failures. The collection of taxes
pays for subsidies.

Commonplace areas that receive subsidies range from healthcare, unemployment assistance,
fossil fuel, agriculture, and housing.

The government intervenes in these instances, as the free market does not always provide a low
enough cost for enough citizens. Governments can provide subsidies through tax reduction,
buying surplus, loans, or cash.

The most popular uses of subsidies worldwide protect food production and agricultural
industries. Countries guard their food supply to maintain autonomy. Governments can pay
farmers for each product which will lower prices for consumers, or provide low-interest loans to
help farmers get through tough growing seasons.
These government interventions are bad for competition and disrupt the free market's natural
efficiency. However, they may provide a more equitable and stable market, or at least they try to.
Consumers benefit from subsidies paid to businesses directly; read this example to learn more.

Recently, criticism has fallen upon subsidies paid to fossil fuel industries. However, if these
subsidies were removed, the gas price for consumers would increase to make up for it. These oil
subsidies keep the cost lower, which may help vulnerable citizens more than they pay for the
subsidies.

However, the benefit is not universal as electric car owners, walkers, and bikers have some of
their taxes on lowering drivers' gas prices. Though, the non-gas commuters benefit from lower
transportation costs in the market, which effectively lowers the price of goods they consume.

Taxes and subsidies have many uses and far-reaching implications for all aspects of our
economy. Part of an economist's job is to measure the effectiveness of these policies.

Intertemporal Consumption:

Economic theories of intertemporal consumption seek to explain people's preferences in relation

to consumption and saving over the course of their lives.

Intertemporal choice is an economic term describing how current decisions affect what options
become available in the future. Theoretically, by not consuming today, consumption levels could
increase significantly in the future, and vice versa.

 Intertemporal choice refers to decisions, such as spending habits, made in the near-term
that can affect future financial opportunities.
 Theoretically, by not consuming today, consumption levels could increase significantly in
the future, and vice versa.
 A preference for focusing on current consumption leads many individuals to make
intertemporal choices that accommodate near-term needs and wants.

Suppliers’ Income Effect:

A supplier is a person, organization, or other entity that provides something that another person,
organization, or entity needs. During transactions, there are suppliers and buyers. Suppliers
provide or supply products or services, while buyers receive them. We commonly use the term
‘vendor’ with the same meaning as ‘supplier.’ In business, for example, every company has at
least one supplier.

The income effect is the change or shift in the level of consumption of goods and services when
the purchasing power of consumers changes. This can be due to the fluctuations in the
consumer’s income, which changes their consumption patterns which in turn changes the prices
of goods.

The demand change for the chosen goods or services depends on the consumer’s purchasing
power. If the consumer’s income increases, they tend to purchase more goods and services,
provided other things remain constant. Similarly, if income decreases while other things remain
constant, the demand also decreases.

 The definition of income effect in economics states that it is a change in the consumer’s
purchasing power as a result of the price changes of the commodity.
 If a consumer’s income rises, they are more likely to buy more goods and services as
long as other factors remain constant.
 A negative income effect occurs when an increase in the consumer’s income has a
negative impact on the items produced. Here, the income and substitution effects are not
in the goods’ favor. The positive income effects have a positive impact on the price of
goods.

Income effect in economics is stated as the increase or decrease in the consumer’s purchasing
power due to the price change. The income effect and substitution effect are part of the demand
curve. They are used to explain the negative slope of the demand curve. Income effect in
economics is considered in cases of normal goods.