UNIT III

1 Factors of production
Anything that helps in production is the factor of production. These are the various factors
by mean any resource is transformed into a more useful commodity or service. They are the inputs
for the process of production. They are the starting point of the production process. Factors of
production are the parameters which affect the output of production.
Types of Factors of Production
Factors of production have been categorized into four types.

Land
It refers to all natural resources. All natural resources either on the surface of the earth or
below the surface of the earth or above the surface of the earth is Land. One uses the land to
produces goods. It is the primary and natural factor of production. All gifts of nature such as rivers,
oceans, land, climate, mountains, mines, forests etc. are land. The payment for land is rent.
Characteristics of Land as a Factor of Production
 The land is a free gift of nature.
 The land has no cost of production.
 It is immobile.
 The land is fixed and limited in supply.
Types of Land
 Residential
 Commercial
 Recreation
 Cultivation
 Extraction
 Uninhabitable
Labor
All human effort that assists in production is labour. This effort can be mental or physical. It is a
human factor of production. It is the worker who applies their efforts, abilities, and skills to produce.
The payment for labour is the wage.
Characteristic
 It is a human factor.
 One cannot store labour.
 No two types of labour are the same.
Types of Labor
 Unskilled
 Semi-skilled
 Skilled
 Professional
Capital
Capital refers to all manmade resources used in the production process. It is a produced factor of
production. It includes factories, machinery, tools, equipment, raw materials, wealth etc. The
payment for capital is interest.
Characteristics
 Capital is a manmade factor of production.
 It is mobile.
 It is a passive factor of production.
Types of Capital
 Fixed
 Working
  Venture
Entrepreneur
An entrepreneur is a person who brings other factors of production in one place. He uses them for
the production process. He is the person who decides;
 What to produce
 Where to produce
 How to produce
A person who takes these decisions along with the associated risk is an entrepreneur. The payment
for entrepreneur is profit.
Characteristics
 He has imagination.
 He has great administrative power.
 An entrepreneur must be a man of action.
 An entrepreneur must have the ability to organize.
 He should be a knowledgeable person.
 He must have a professional approach.

2 Production Function
The production function of a firm is a relationship between inputs used and output
produced by the firm. For various quantities of inputs used, it gives the maximum quantity of
output that can be produced.
Consider a manufacturer who produces shoes. She employs two workers – worker 1 and
worker 2, two machines – machine 1 and machine 2, and 10 kilograms of raw materials. Worker
1 is good in operating machine 1 and worker 2 is good in operating machine 2. If worker 1 uses
machine 1 and worker 2 uses machine 2, then with 10 kilograms of raw materials, they can
produce 10 pairs of shoes. However, if worker 1 uses machine 2 and worker 2 uses machine 1,
which they are not good at operating, with the same 10 kilograms of raw materials, they will end
up producing only 8 pairs of shoes. So with efficient use of inputs, 10 pairs of shoes can be
produced whereas an inefficient use results in production of 8 pairs of shoes. Production function
considers only the efficient use of inputs. It says that worker 1, worker 2, machine 1, machine 2
and 10 kilograms of raw materials together can produce 10 pairs of shoes which is the maximum
possible output for this input combination.
A production function is defined for a given technology. It is the technological
knowledge that determines the maximum levels of output that can be produced using different
combinations of inputs. If the technology improves, the maximum levels of output obtainable for
different input combinations increase. We then have a new production function. The inputs that a
firm uses in the production process are called factors of production. In order to produce output, a
firm may require any number of different inputs.
The objective of production function is as under:-
• The primary purpose of the production function is to address allocative efficiency in the
use of factor inputs in production and the resulting distribution of income to those factors.
• Production function is a function that specifies the output of a firm for all combinations
of inputs.
• The relationship of output to inputs is non-monetary; that is, a production function
relates physical inputs to physical outputs, and prices and costs are reflected in the
function.
• Influences economic decision-making.
Here we consider a firm that produces output using only two factors of production – factor
1 and factor 2. Our production function, therefore, tells us what maximum quantity of output can
be produced by using different combinations of these two factors. We may write the production
function as q = f (x1, x2)
It says that by using x1 amount of factor 1 and x2 amount of factor 2, we can at most produce q
amount of the commodity.
 Production function

X2
Factors
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
2 0 3 10 18 24 29 33
X1 3 0 7 18 30 40 46 50
4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60
A numerical example of production function is given in the table. The left column shows
the amount of factor 1 and the top row shows the amount of factor 2. As we move to the right
along any row, factor 2 increases and as we move down along any column, factor 1 increase. For
different values of the two factors, the table shows the corresponding output levels. For example,
with 1 unit of factor 1 and 1 unit of factor 2, the firm can produce at most 1 unit of output; with 2
units of factor 1 and 2 units of factor 2, it can produce at most 10 units of output; with 3 units of
factor 1 and 2 units of factor 2, it can produce at most 18 units of output and so on. Both the
inputs are necessary for the production. If any of the inputs becomes zero, there will be no
production. With both inputs positive, output will be positive. As we increase the amount of any
input, output increases.

Short Run production function or Law of variable proportions

In the short run, a firm cannot vary all the inputs. One of the factors – factor 1 or factor 2
– cannot be varied, and therefore, remain fixed in the short run. In order to vary the output level,
the firm can vary only the other factor. The factor that remains fixed is called the fixed input
whereas the other factor which the firm can vary is called the variable input.
Consider the example represented through Table. Suppose, in the short run, factor 2
remains fixed at 5 units. Then the corresponding column shows the different levels of output that
the firm may produce using different quantities of factor 1 in the short run. This aspect of the
production function is known as the Law of Variable Proportions.
The law of diminishing returns is based on the following assumptions:
 Only one factor is variable while others are held constant.
 All units of the variable factor are homogeneous.
 There is no change in technology.
 It is possible to vary the proportions in which different inputs are combined.
 It assumes a short run situation, for in the long run all factors are variable
Stages of Law
The behaviour of the output when the varying quantity of one factor is combined with the
fixed quantity of the other can be divided into three stages. They are;
Stage of Increasing Returns
The stage ends where the average product reaches its highest point. During the stage, the
average product and the marginal product are increasing. Though marginal product starts
declining, it is greater than average product so that the average product continues to rise.
Stage of Decreasing Returns
The stage ends where the marginal product is zero. In this stage, the total product
continues to increase but at a decreasing rate. At the end of this stage, the total product is
maximum and the marginal product is zero.
Stage of Negative Returns
In this stage, the marginal product becomes negative. The total product and the average
product are declining.
Long Run production function or Law of returns to scale
In the long run, all factors of production can be varied. A firm in order to produce
different levels of output in the long run may vary both the inputs simultaneously. So, in the long
run, there is no fixed input. For any particular production process, long run generally refers to a
longer time period than the short run. For different production processes, the long run periods
may be different. It is not advisable to define short run and long run in terms of say, days,
months or years. We define a period as long run or short run simply by looking at whether all the
inputs can be varied or not
Three Phases of Returns to Scale The changes in output as a result of changes in the scale can
be studied in three phases. They are ;
Increasing Returns to Scale
If the increase in all factors leads to a more than proportionate increase in output, it is
called increasing returns to scale. In this case marginal product will be rising.
Constant Returns to Scale
If we increase all the factors in a given proportion, the output will increase in the same
proportion. In this case, the marginal product is constant.
Decreasing Returns to Scale
If the increase in all factors leads to a less than proportionate increase in output, it is
called decreasing returns to scale. In this phase, marginal product will be decreasing.
Law of variable proportions Law of returns to scale
1. Short run production function 1. Long-run production function
2. Only one factor is varied and others are kept 2. All factors are varied
constant 3. Factor proportions are not changed. Only the
3. Factor proportions are changed scale changes
4. Law does not apply when factors must be 4. Law does apply when the factors must be
used in fixed proportions to produce a product. used in fixed proportions to produce a product.

3 Isoquant
Isoquant is just an alternative way of representing the production function. Consider a
production function with two inputs factor 1 and factor 2. An isoquant is the set of all possible
combinations of the two inputs that yield the same maximum possible level of output. Each
isoquant represents a particular level of output and is labeled with that amount of output.

4 Cost
A cost is a total amount of money spent on production of a commodity.
Types of costs
Fixed Costs (FC)
The fixed costs don’t vary with changing output. Fixed costs might include the cost of
building a factory, insurance and legal bills. Even if your output changes or you don’t produce
anything, your fixed costs stay the same. In the above example, fixed costs are always Rs.1,000.

Variable Costs (VC)

Costs which depend on the output produced. For example, if you produce more cars, you
have to use more raw materials such as metal. This is a variable cost.
Semi-Variable Cost
Labour might be a semi-variable cost. If you produce more cars, you need to employ
more workers; this is a variable cost. However, even if you didn’t produce any cars, you may still
need some workers to look after an empty factory.
 Total Costs (TC) = Fixed + Variable Costs
Average Cost = Total Cost / Output (Quantity produced)
Average Fixed Cost = Total Fixed Cost / Output (Quantity produced)
Average Variable Cost = Total Variable Cost / Output (Quantity produced)
Marginal Costs
Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is 1550,
and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350.
Opportunity Cost
Opportunity cost is the next best alternative foregone. If you invest £1million in
developing a cure for pancreatic cancer, the opportunity cost is that you can’t use that money to
invest in developing a cure for skin cancer.
Economic Cost
Economic cost includes both the actual direct costs (accounting costs) plus the
opportunity cost. For example, if you take time off work to a training scheme. You may lose a
weeks’ pay of Rs.350, plus also have to pay the direct cost of Rs.200. Thus the total economic
cost is Rs.550.
Accounting Costs
This is the monetary outlay for producing a certain good. Accounting costs will include
your variable and fixed costs you have to pay.
Sunk Costs
These are costs that have been incurred and cannot be recouped. For example, if you
spend money on advertising to enter an industry, you can never claim these costs back. If you
buy a machine, you might be able to sell if you leave the industry. See: Sunk cost fallacy
Avoidable Costs
These are costs that can be avoided and sometimes known as an escapable cost. If you
stop producing cars, you don’t have to pay for extra raw materials and electricity.
Explicit costs
These are costs that a firm directly pays for and can be seen on the accounting sheet.
Explicit costs can be variable or fixed, just a clear amount.
Implicit costs
These are opportunity costs, which do not necessarily appear on its balance sheet but
affect the firm. For example, if a firm used its assets, like a printing press to print leaflets for a
charity, it means that it loses out on revenue from producing commercial leaflets.
Economics Cost = Explicit Cost + Implicit Cost
Real cost
It is a psychological concept and can’t be measured. Examples: Overtime duties,
sacrificing family functions for the work, etc.,
5 Cost – Output Relationship
Types of cost function
1. Short run cost function
2. Long run cost function
Short run cost output relationship
In short run one some inputs are variable and others are held constant. To increase or
decrease output, the variable inputs are increased or decreased.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:
1. If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.
2. When ‘AFC’ falls and ‘AVC’ rises
3. ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
4. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
5. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
Long run cost output relationship
Long run is a period, during which all inputs are variable including the one, which is
fixed in the short-run. In the long run a firm can change its output according to its demand. Over
a long period, the size of the plant can be changed, unwanted buildings can be sold and staff can
be increased or reduced. The long run enables the firms to expand and scale of their operation by
bringing or purchasing larger quantities of all the inputs. Thus in the long run all factors become
variable.
The long-run cost-output relations therefore imply the relationship between the total cost
and the total output. In the long-run cost-output relationship is influenced by the law of returns to
scale.
In the long run a firm has a number of alternatives in regards to the scale of operations.
For each scale of production or plant size, the firm has an appropriate short-run average cost
curves. The short-run average cost (SAC) curve applies to only one plant whereas the long-run
average cost (LAC) curve takes in to consideration many plants. The long-run cost-output
relationship is shown graphically with the help of “LAC’ curve.
 In the long run all factors are variable and the average cost may fall or increase to A, B
respectively but all these costs are above the long run cost average cost. LAC is the lower
envelope of all the short run average cost curves because it contains them all.
 At point ‘E’ the SAC1 and SMC1 intersects each other, in case the organization increases
its output from OM to OM1 they have to spend OC1 amount.
 In case the organization purchases one more machine (increase in fixed cost) then they
will get a new set of cost curves SAC2, and SMC2.
 But the new average cost curve reduces the cost of production from OC1 to OC2.That
means they can save the difference of C1C2 which is nothing but AB.
 Therefore in the long run due to business expansion a firm can reduce their cost of
production. During their business life they will meet many combinations of optimum
production and minimum cost in different short periods.
 In the long run due to law of diminishing returns the long run average cost curve LAC
also slopes like boat shape.
6 Relation between Average Cost and Marginal Cost

When AC Falls, MC is lower than AC:

When average cost falls, marginal cost is less than AC. In Table, AC is falling till it
becomes Rs.8, and MC remains less than Rs.8. In Fig., AC is falling till point E, and MC
continues to be lower than AC. In this case, marginal cost falls more rapidly than the average
cost. That is why when marginal cost (MC) curve is falling; it is below the average cost (AC)
curve. It is shown in Fig. 9.
When AC Rises, MC is Greater than AC:
When average cost starts rising, marginal cost is greater than average cost. In Table,
when AC rises from Rs.8 to Rs.9, MC rises from Rs.8 to Rs.16. In Fig. , AC starts rising from
point E. And, beyond E, MC is higher than AC.
When AC does not Change, MC is Equal to AC:
When average cost does not change, then MC = AC. It happens when falling AC reaches
its lowest point. In Table, at the 7th unit, average cost does not change. It sticks to its minimum
level of Rs.8. Here, marginal cost is also Rs.8. Thus, Fig. shows that MC curve is intersecting
AC curve at its minimum point E.
7 Relation between Total Cost and Marginal Cost
(i) Marginal cost is estimated as the difference between total costs of two successive
units of output. Thus,
MCn = TCn – TCn-1
(ii) When MC is diminishing, TC increases at a diminishing rate.
(iii) When MC is rising, TC increases at an increasing rate.
(iv) When MC reaches its lowest point (point Q in Fig), TC stops increasing at a
decreasing rate

8 Revenue
The term revenue refers to the income obtained by a firm through the sale of goods at different
prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or income’. The
revenue concepts are concerned with Total Revenue, Average Revenue and Marginal Revenue.

Total Revenue
The income earned by a seller or producer after selling the output is called the total
revenue. In fact, total revenue is the multiple of price and output. The behavior of total revenue
depends on the market where the firm produces or sells.
Average Revenue
Average revenue refers to the revenue obtained by the seller by selling the per unit commodity. It
is obtained by dividing the total revenue by total output.

Marginal Revenue
Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. Thus, marginal revenue is the addition made to the total revenue by selling one more
unit of the good. In algebraic terms, marginal revenue is the net addition to the total revenue by
selling n units of a commodity instead of n – 1.
Therefore,
Table Representation:
The relationship between TR, AR and MR can be expressed with the help of a table

From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the
output sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at
6th unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way,
when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is
clear that when AR falls, MR also falls more than that of AR: TR increases initially at a
diminishing rate, it reaches maximum and then starts falling.
9 Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:
In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.

Formulae to calculate BEP

BEP (Value) = Fixed cost / Profit Volume ratio
BEP (in Units) = Fixed Cost / Contribution per unit
Profit volume ratio = (Contribution / Sales) * 100
Contribution = Sales – Variable cost or Fixed cost + Profit
Margin of safety = Actual sales – Sales at BEP
Amount of Sales required earning the expected profit
= (Expected profit + Fixed cost) / Profit volume ratio
Profit to be earned from given sales
= Contribution – Fixed cost
Contribution = given sales * Profit volume ratio