Key Notes: Production and Costs | Economics Class 11 - Commerce PDF Download

Production

It is defined as the transformation of resources into commodities. 

Production Function
In the production function, the physical inputs are used. The relationship between the output and the production factors defines a firm’s production function. It is used for the manufacturing process. It displays the numbers of inputs that help produce a high level of output. 

The production function is presented as follows: Q = f(x1,x2)

Here, Q equals the final units of output; x1 and x2 are production factor 1 and production factor 2. The equation shows that production factors 1 and 2 can be used to produce units of the final output.
Types of Production Function: 

• Short-run Production Function: One factor is variable while the others are fixed in a short-run production function. Then, the law of return to a factor is applied to the production function. 
• Long-run Production Function: The law of diminishing returns to scale is applied. Thus, it is also referred to as the constant proportion type production function.  The long-run is an extended period of time in which all the variables involved in the production like machine, building, etc. can be modified by the producer.

Total product: It can be defined as the total sum of all the final units of output produced by a firm using the given amount of inputs for a particular given time period. The firm uses the given amount of inputs for a given time period. Besides, the other factors are held constant. The total product is the relationship between the variable factors of production and the final units of output. Further, the following formula  expresses the total product:
Total Product (TP) = ∑ Qx  
It depicts the relationship between the variable factors of production and the total output.
Average Production: The variable factor per unit production is the average production.
AP = TPVariable Input
Marginal Product (MP) of an Input: Change in Total Product / Change in Variable Product
Relationship between marginal, total, and average  product
MP = ΔTPΔL
MPn = TPn – TPn-1

• When Total Product  (TP) rises at an increasing rate, Marginal Product (MP) increases as well
• Marginal Product (MP) decreases as Total Product (TP) increases at a decreasing rate.
• When Total Product (TP) is at its maximum, Marginal Product (MP) equals zero.
• When Total Product (TP) starts to fall, Marginal Product (MP) becomes -ve

Returns to a factor: This term describes a scenario of the output behaviour when only one of the variable factor of production is increased in the short-run but all the fixed factors remain constant during that time period

Law of variable proportion

The law states that when more than one unit is used for increased output, the output initially increases at a specific rate. 

• Stage I (Increasing Return to factor): More units of variable factors will combine with fixed elements in the initial stage. The total physical production may increase, and then MP may also rise.
  The increased return occurs due to the following reasons: 
  • Underutilisation of fixed factors.
  • Indivisibility of factors.
  • Increased efficiency of the variable factor. 
• Stage II (Stage of Diminishing Return to factor): If TP increases at a decreasing rate, more units of variable factors are combined with other factors. The total product increases at a decreasing rate. Thus, MP decreases but remains positive till the end of this phase. 
• Stage III (Stage of negative return to factor): TP may fall as more units of variable factors combine with fixed factors, the total output falls, and the marginal product becomes negative. 
  • Cause of negative return. 
  • Miscoordination between fixed and variable factors. 
  • The excessive use of fixed factors. 
• Economic cost: The sum of explicit and implied costs is known as economic cost.
• Explicit cost: A company’s real money to buy and hire inputs is called explicit cost. These are recorded in the balance sheets, such as wages, rent, interest, purchases of raw materials, etc.
• Implicit cost: In any manufacturing process, implicit cost refers to the total cost of self-owned production resources. Or it is equivalent to the value of total inputs provided by the manufacturer/owner. Generally, these costs are not recorded explicitly in books of accounts.
• Normal profit: This is the bare minimum necessary to keep producers going. In other words, the minimum procurement price for the contractor. It is also known as the entrepreneurial salary.
• Total cost (TC): The total cost represents the sum of all fixed and variable costs—the total amount a business spends to produce a given quantity of a commodity.
  TC = TFC + TVC or TC = AC × Q
  TC = Total cost
  TFC = Total fixed cost
  TVC = Total variable cost
  AC = Average cost
  Q = Quantity/number of goods or services

These are total fixed cost (TFC), total variable cost (TVC) and total cost (TC) curves for a firm. Total cost is the vertical sum of total fixed cost and total variable cost.
Total fixed cost (TFC): This also represents an additional cost such as renting of land and buildings, interest on capital, licence fees, etc. So it is generally the total cost incurred by the manufacturer to provide for all the fixed resources.
TFC = TC − TVC or TFC = AFC × Q

Features of Total Fixed Cost: 
(a) It remains constant across all levels of production. Even on a zero exit level, it’s not zero, and further, the TFC curve will be parallel to the X-axis.
(b) Total cost at zero output level will be equal to the total fixed cost.

Total Variable Cost (TVC):

TVC varies with the amount of the total output that is produced. If the output level is zero then TVC is also zero.
TVC = TC – TFC or TVC = AVC × Q 

Salient Features of Total variable cost: 

• If the output is zero, then AVC will also be zero.
• There is an increase in output if the variable cost increases. 

Average Cost (AC)

Average cost is defined as the cost of producing one unit of a commodity. It is represented as the sum of the average fixed cost and average variable cost.
Average fixed cost: The fixed cost of producing a commodity per unit. 

• AC = TCQ or AC = AFC + AVC
• AFC = TFCQ or AFC = AC = AVC

Features of AFC:

The average fixed cost curve is a rectangular hyperbola. The area of the rectangle OFCq1 gives us the total fixed cost.

• If the AFC decreases, then the output also increases. 
• The AFC curve is represented as a rectangular hyperbola.
• The AFC cannot cross the X or Y axis. 

Average variable cost: The variable cost of producing per unit of a commodity. As per the law of variable proportion, AVC is U-shaped.
AVC = TVCQ or AVC = AC − AFC
The area of the rectangle OVBq0 gives us the total variable cost at q0

Relation between short-term costs

The total cost curve can be kept parallel to the total variable cost curve.
Relation between MC and AVC: 

• If MC < AVC, then AVC falls.
• If MC = AVC, then AVC is minimum and constant. 
• If MC > AVC, AVC rises, and the MC curve cuts to the lowest point. 

Relation between MC and AC:

• If AC falls, then MC < AC. 
• if AC rises, then MC > AC. 
• if AC is constant and minimum, then MC = AC.

Revenue: 

Revenue is defined as the total amount of money earned from the sale of any product or service.
Total Revenue (TR) is the total quantum of money received by a firm from the sale of a specific number of units of a product.
TR = AR X Q  or   TR = ∑MR
TR = Total Revenue
MR = Marginal Revenue
AR = Average Revenue
Q = Quantity of a product

Relationship between TR, AR, and MR for more quantity sold at the same price:

• At all levels of output, average and marginal revenue remains constant. The AR and MR curves remain parallel to the x-axis. 
• Total revenue can grow at a constant rate. The MR is constant, and then the TR curve is a positively sloped straight line through the origin. 

Relationship between TR, AR, and MR for more quantity sold at a lower price:

• The slopes of average revenue and marginal revenue curves can be negative. Thus, the MR curve is located beneath the AR curve. 
• Marginal revenue declines twice as fast as average revenue. 

Relationship between AR and MR (General relationship)

• AR is maximum and constant when MR = AR. MR can be negative but AR cannot be negative.
• When MR < AR, AR falls. When TR increases at any rate, then MR and AR increase. 

Concept of Producer’s Equilibrium: The producer’s equilibrium is when the producer makes the most profit for the least amount of money. In addition, it has no incentive to increase or decrease output.
MR and MC Methodology: According to MR and MC methodology, the conditions for producer’s equilibrium are: 

• MC = MR and also AR = MR, so AR = MR = MC. MC should be on the rise. 
• The MC curve should cut the MR curve from below. Thus after the equilibrium point, MC > MR due to an increase in output. 

Normal Point: The normal point is a situation without any profit or loss, when P = AC. This is the minimum return on investment the producer expects to obtain from their capital in the company.
Break-even point: If AR = AC or when TR =TC, then the firm generates no economic profit, or we can say it is simply covering all of its expenses.
Shut-down point: Shut-down point will occur when a firm only covers its variable costs. In such a scenario the company suffers a total loss on all its fixed costs. (TR < TVC   Or  AR < AVC)
Supply: Supply is defined as the commodity that a firm or seller is willing to sell at different prices during a given period of time.

Production

• It is defined as the transformation of resources into commodities. Further, the production function is the relationship between the output and the factors of production. Students will get to revise the concepts that define the production function. 
• The production function can be classified into short-term and long-term based on the variables used. In production, one factor is fixed while the others are variable. All the factors of production are variable if there is a long-term function. 
• By studying Class 12 Microeconomics Chapter 3 Notes,  students can understand how to quantify the total product with the help of an equation. The CBSE revision notes will help the students explain the concept of average and marginal products. In addition, they will be able to differentiate between intermediate products and borderline products. Furthermore, they will get an idea to distinguish between fixed and variable factors. 
• Poor coordination between the fixed and variable factors, and over utilisation of fixed factors causes negative returns in the third stage of negative returns to factors. 

Law of Diminishing Returns

The laws of diminishing have three stages, which have been explained in the notes and the effect of these stages has also been discussed. The first stage is dedicated to increasing returns to the factors caused by the underutilisation of fixed factors, increased efficiency of the variable factor, and indivisibility of factors. The second stage is diminishing returns caused by optimal use of fixed and imperfect factors. There will be negative returns if there is poor coordination between the fixed and variable factors. This is the third stage of negative returns to factors.