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U N I T- I I I
PRODUCER BEHAVIOUR AND SUPPLY

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CHAPTER

3
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COSTS

3.1 Production

3.2 Costs

In Chapter 2 we studied the consumers behaviour. In Chapters 3 and 4 we will be concerned with the producers behaviour. In this chapter in particular, we study important concepts associated with production and costs. A producer or a firm is in business to maximise profit.1 By definition, profit earned by a firm is equal to its total revenues minus the total costs. As an example, suppose that you are in the business of making hammers, and, during a month, you produce and sell 500 hammers. They are selling at the price of Rs. 20 each. Then the total revenues generated are equal to price quantity, that is, Rs. 20 500 = Rs. 10,000. Producing hammers requires inputs such as labour, building, equipment and raw materials. This is a technological relationship. In turn, inputs have to be paid. The sum total of payments to all inputs is the total cost of production. Let the total cost of making 500 hammers over the month be Rs. 6,500. Then your profit is equal to Rs. 10,000 Rs. 6,500 = Rs. 3,500.

In this chapter and others, we will use the term profit or profits. Both are correct uses.

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The above example is illustrative of some important linkages. On one hand, the amount produced, or, what is called output, is linked to total revenues in the product market. On the other hand, output is linked to inputs via technology, which is called production function (to be defined in a moment), and, the employment of inputs leads to their payments. This chain links output to costs.

output. In section 3.2, we will analyse that between output and payments to inputs. The link between output and revenues will be examined in Chapter 4 (and in Chapter 6 also). 3.1 PRODUCTION 3.1.1 Production Function The most basic concept here is what is called the production function, defined as a technological relationship that tells the maximum output producible from various combinations of inputs. For instance, a firm employs only two factors or inputs, say, labour (measured in hours) and land (in acres), and, Table 3.1 lists some factor combinations and the corresponding output levels. 1 hour of labour and 2 acres of land produce at the most 5 units output, 2 hours of labour and 4 acres of land produce at the most

Fig. 3.1

Linkages

These linkages are depicted in fig. 3.1. In Section 3.1, we will study the relationship between inputs and

Table 3.1 Production Function Labour (in hours) A B C D E F G H 0 1 2 3 4 5 6 7 Land (in acres) 0 2 4 6 8 10 12 14 Output (in units) 0 5 11 18 24 30 35 40

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11 units of output, and so on. It is normally assumed that inputs work to the best of their efficiency. Hence, instead of maximum output, we just say output, e.g., 2 hours of labour combined with 4 acres of land produce 11 units of output.2 Note that the notion of production function is not just confined to two inputs. There can be other inputs like capital, raw material etc.3 3.1.2 Returns to an Input A production function given in the tabular form such as in Table 3.1 does not reveal much about the contribution of a single factor towards production. A reasonable way to assess this will be to vary the employment of one input while keeping the employment of other inputs fixed. Three concepts arise in this experiment. One is total product or total physical product, denoted by TPP. It simply defines the total output at a particular level of employment of an input when the employment of all other inputs is unchanged. The next one is marginal product or marginal physical product (MPP). This is defined as the increase in the total physical product per unit increase in the employment of an input when the employment of other inputs is given.4 When the employment of an input changes, we call it a variable input.

Finally, we define Average Product or Average Physical Product (APP) as the TPP per unit employment of the variable input, i.e., APP = TPP/L, where L is the level of employment of the variable input. These are also respectively called total, marginal and average returns to an input. A numerical example showing a TPP schedule is given in Table 3.2, where the variable input, L, is called labour. If we graph a TPP schedule, we get a total physical product curve. Table 3.2 A Total Physical Product Schedule Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9 Total Physical Product (TPP) 0 10 22 33 43 51 56 56 48 36

2 3 4

Table 3.1 gives only some, not all, possible combinations of inputs and output. Also, we can differentiate between unskilled labour and skilled labour. These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.

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Fig. 3.2 shows the TPP curve for the TPP schedule given in Table 3.2.

Fig. 3.2 The Total Physical Product Curve Corresponding to Table 3.2

the MPP at L = 2, which is 12, is equal to the difference between TPP at L = 2, which is 22, and TPP at L = 1, which is 10. The MPP schedule corresponding to the TPP schedule in Table 3.2 is given in column (2) of Table 3.3. Likewise, the APP schedule, given in column (3) of Table 3.3, is obtained through dividing TPP by L in Table 3.2. The graphs of an MPP schedule and an APP schedule are respectively called the marginal physical product curve and the average physical product curve. These graphs corresponding to Table 3.3 are given respectively in figs. 3.3 and 3.4. Note the following : 1. It is not true that the concepts of TPP, MPP and APP are applicable to

The marginal physical product, MPP, is derived from the total physical product, TPP, just as marginal utility is obtained from total utility. For instance, Table 3.3

Marginal Physical and Average Physical Product Schedules Marginal Physical Product (MPP) 10 12 11 10 8 5 0 -8 -12 Average Physical Product (APP) 10 11 11 10.75 10.20 9.33 8 6 4

Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9

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one particular input (e.g. labour) and not to others (e.g. land or

Fig. 3.3

The Marginal Physical Product Curve Corresponding to Table 3.3

variable input increases. This relationship is verified from TPP and MPP schedules. In Table 3.2, TPP increases up to L = 6; from Table 3.3, we see that MPP is positive in this range. In Table 3.2, TPP decreases from L = 8 onwards; in Table 3.3, MPP is negative in this range. 4. Although we have derived MPP and APP from TPP above, in general, given any one of these, we can derive the other two. Suppose MPPs are given to us. Then we can get TPP by adding MPPs (as TPP is the sum of MPPs). Once we get TPP, we can readily obtain APP by applying its definition. Similarly, if the APPs are known, we get TPP by multiplying APP with the level of employment. Then MPPs are obtained by applying its definition. Law of Variable Proportions and Law of Diminishing Returns As we will see later in this chapter and in the next, the most important schedule (curve) from our viewpoint is the marginal physical product schedule (curve). We notice from fig. 3.3 that the MPP initially increases with an increase in the employment of the input in question, then it diminishes and finally it becomes negative. This pattern of MPP is called the Law of Variable Proportions. Put differently, this law outlines three stages of production. In stage I, when the level of an inputs employment is sufficiently low, its MPP increases. In stage II, it decreases but remains positive, and, finally, in stage

Fig. 3.4

The Average Physical Product Curve Corresponding to Table 3.3

equipment). It is applicable to all inputs, but one at a time. 2. Since MPPs are additions to the TPP, TPP is the sum of MPPs ( just as total utility is the sum of marginal utilities). For example, in Table 3.2, the TPP at L = 3 is equal to 33. In Table 3.3, the MPPs at L = 1, 2 and 3 add up to 33. 3. The MPPs being additions to the TPP also implies that if MPP is positive, TPP must be increasing and if MPP is negative, TPP must be decreasing as the level of the

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III, it becomes negative. In our example, stage I holds till L = 2, stage II is operative between L = 3 and L = 7, and, stage III sets in at L = 8. Note that in stages I and II, TPP increases with the employment of the variable input as MPP in this range is positive. But in stage III, it decreases since MPP is negative. Closely associated with this law is another important law, called the law of diminishing marginal product or the law of diminishing marginal returns (which is similar to the law of diminishing marginal utility). More briefly, it goes by the name of the law of diminishing returns. This says that, the employment of other inputs remaining the same, as more of a particular input is used in production, after a certain level, its marginal physical product decreases with further employment of it. Fig. 3.5 illustrates these laws more clearly. Suppose that the input can be measured continuously like points on a line, not just in integer units like 1, 2, 3 etc. Then the resulting TPP, MPP and APP curves will look smooth. A smooth MPP curve is drawn in fig. 3.5. We observe that the MPP increases between 0 to A. This region marks stage I. The MPP diminishes but remains positive between A to B, which marks stage II. From the point B onwards, it is the stage III, wherein the MPP is negative. Diminishing returns holds in stages II and III. The reason behind the law of variable proportions or the law of diminishing returns is fundamentally

the same. As the employment of a particular input gradually increases while all other inputs are kept unchanged, the factor proportions become initially more suitable for production, but, after a certain level, the variable factor can work with other given inputs only less efficiently, that is, factor proportions become increasingly unsuitable for production. The significance of these stages of production is that a profit-maximising firm will never operate in stage III. It is because, by entering stage III, a firm will have to incur higher costs on one hand (as it is hiring more of the input), and, at the same time, since output is falling, in the output market, it will get less revenues. This implies that profits will be less. It is not obvious at this point, but we will learn in Chapter 7 that a profit-

Fig. 3.5 Three Stages of Production and Diminishing Returns

maximising firm will not operate in stage I either. That leaves out only stage II, in which the marginal returns to an

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input is positive but diminishing. From the viewpoint of the operation of the firm, this is the most relevant stage. Finally, note that the law of diminishing returns implies that the MPP curve is inverse U-shaped. In turn, this implies that the APP curve is inverse U-shaped also. 3.1.3 Returns to Scale

Suppose that, instead of increasing one input at a time, you increase the employment of all inputs by the same proportion (e.g. by 20%). The effect of this change on output is captured by the notion of returns to scale. Of course, the output is going to increase. But by how much? Will it increase (a) by more than 20%, (b) by less than 20% or (c) exactly by 20%? The possibilities (a), (b) and (c) respectively illustrate increasing returns to scale, decreasing or diminishing returns to scale and constant returns to scale. In other words, suppose all inputs are increased by a given proportion. Increasing (respectively decreasing) returns to scale hold when output increases more (respectively less) than proportionately. Constant returns to scale hold when output increases exactly by the proportion in which inputs are increased. You should not make the mistake that the ter ms decreasing, diminishing or constant mean that the output decreases or remains
5

constant: the output always increases when all inputs are increased.5 The production function outlined in Table 3.1 contains stages showing all three types of returns to scale. For example, from B to D there are increasing returns to scale. Why? In combination B, 1 unit of labour and 2 units of land produce 5 units of output. Compared to B, the combination C has double the amount of each input, but output (equal to 11) is more than double of the output at combination B. Similarly, from C to D, inputs increase by 50% but output increases by more than 50% (as 18 is more than 50% higher than 11). Likewise, you can calculate that, in the range from D to F, there are constant returns, and, finally from F onwards there are decreasing returns to scale. 3.2 COSTS We now move on to discuss some cost concepts. As fig. 3.1 suggests, cost concepts are very much related to concepts associated with the production function. This point will be clearer as we go along. 3.2.1 Short Run

Fixed and Variable Costs At a given point of time, a firm faces two types of costs: fixed costs and variable costs. Fixed costs are those that do not vary with the level of output. (These are also called overhead

This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.

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costs.) For example, you operate a garment factory. You pay a fixed rent for the factory building, fixed insurance payments for your machinery against fire etc. These are independent of how many garments per month you produce. There is a time element in interpreting these costs as fixed. That is, even if these costs are fixed at any given point of time or within a short time period, in a long run horizon, you can think of renting more or less space, having more or less number of machinery depending on your business outlook for the future. Hence the rent and insurance costs etc. that are fixed in the short run can vary in the long run. In other words, fixed costs are present only in the short run, not in the long run. Note that these notions of short run and long run do not refer to any particular calendar time. They refer only to different periods of planning horizon by producers in an industry. Hence, they can vary from one industry to another. Having noted this difference, we return to the short run situation. Besides fixed cost, there are variable costs those that change with the level of output, e.g., labour costs and costs of raw materials. If you want to produce more garments, you have to buy more cotton and other raw materials, hire more workers and so on. Variable costs increase with output. Instead of being termed simply fixed and variable cost, these are formally

called Total Fixed Cost (TFC) and Total Variable Cost (TVC). Total cost (TC) is then, by definition, total fixed costs + total variable costs. Table 3.4 presents a numerical example. Notice that TFC, given in column (2), do not change with output. But TVC, given in column (3), does. The columns (2) and (3) against column (1) are respectively total fixed cost and total variable cost schedules. Graphs of these schedules are the total fixed cost curve and the total variable cost curve respectively. Figure 3.6 depicts these, together with the total cost curve that graphs the TC schedule, given in the last column of Table 3.4. The TFC curve is horizontal because fixed costs do not change with the output. However, since TVC and TC increase with the output, these curves are upward sloping. By definition, the total cost curve is the vertical summation of the total fixed and total variable cost curves. Notice that, at the zero level of output, TC = TFC, because TVC is zero when output is zero. Average Costs If we divide total fixed cost and total variable cost by output, we respectively get the Average Fixed Cost (AFC) and the Average Variable Cost (AVC). That is, AFC = TFC/Output and AVC = TVC/ Output. Similarly, by dividing total cost by output, we obtain the Average Total Cost (ATC), i.e., ATC = TC/Output. Note that, by definition, ATC = AFC + AVC. Average total cost is sometimes loosely called average cost only. The AFCs, the AVCs and the ATCs corresponding to

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Table 3.4 Output 0 1 2 3 4 5 6 7 8 9

Total Fixed Costs and Total Variable Costs Total Variable Costs (Rs.) 0 8 13 16 20 26 35 47 63 83 Total Costs (Rs.) 10 18 23 26 30 36 45 57 73 93

Total Fixed Costs (Rs.) 10 10 10 10 10 10 10 10 10 10

ATC curves slope downwards initially and then upwards, i.e, they are U-shaped. The reason behind this shape will be discussed later. Marginal Costs There is another important cost concept, the marginal cost (MC). Similar to marginal utility or marginal product, this is defined as the increase in total cost when one extra unit is produced. Thus, it is the (additional) cost of producing an extra unit. In the example given in Table 3.4, suppose that the current level of output is 7. The MC of this output level is Rs. 12. It is because the 7th unit of output costs Rs. 57 Rs. 45 = Rs. 12. The MC schedule corresponding to Table 3.4 is given in Table 3.6.

Fig. 3.6

TFC, TVC and TC Curves corresponding to Table 3.4

Table 3.4 are given in Table 3.5, and fig. 3.7 graphs them. The AFC curve continuously decreases as output increases, because the numerator of the ratio TFC/Output is constant while the denominator increases. The AVC and

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Table 3.5 Output 0 1 2 3 4 5 6 7 8 9

AFC, AVC and ATC Schedules (Based on Table 3.4) AFC (Rs.) AVC (Rs.) ATC (Rs.) 10 5 3.33 2.50 2 1.66 1.43 1.25 1.11 8 6.50 5.33 5 5.20 5.84 6.71 7.875 9.22 18 11.50 8.66 7.50 7.20 7.50 8.14 9.125 10.33

Fig. 3.7 AFC, AVC and ATC Curves Corresponding to Table 3.5

Note that, since total costs and total variable costs differ only by a constant term (equal to the total fixed cost), MC can be equivalently defined as the increase in the total variable cost when one extra unit is produced. Moreover, TVC is equal to the sum of

MCs (just as total utility is the sum of marginal utilities). For example, the TVC of producing 2 units is Rs. 13, and, this is the sum of the MC of producing one unit (= Rs. 8) and that of producing two units (= Rs. 5). Fig. 3.8 graphs the MC schedule given in Table 3.6. It is the marginal cost curve. Assuming that the output is per fectly divisible, a smooth (hypothetical) marginal cost curve is drawn in fig. 3.9. Recall that the TVC is sum of the marginal costs. This implies a property associated with a smooth marginal cost. That is, the TVC is equal to the area under the marginal cost curve. For example, at output q0 , the TVC is equal to the area 0ABq0 . This result will be used in Chapter 4.

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As you see from fig. 3.8 or fig. 3.9, the MC curve is initially decreasing in output and then it is increasing, i.e, it is U-shaped. The reason behind the Ushape of the MC curve is the law of diminishing returns. As you recall, this law says that, as other inputs are kept Table 3.6 Output 0 1 2 3 4 5 6 7 8 9
Costs in Rs .
25 20 15 10 5 0 0 1 2 3 4 5 6 7 8

Marginal Costs (based on Table 3.4) Marginal Cost (Rs.) 8 5 3 4 6 9 12 16 20

unchanged, an increase in any given input leads first to an increase in its marginal physical product, and, then, after certain point, leads to a decrease in its marginal physical product. Let us suppose that this particular input is the only variable input, so that the total payment to it is equal to the total variable cost. Similarly, interpret the other inputs, which are kept unchanged, as the fixed factors, the total payment to which is the total fixed cost.

Fig. 3.9

A Smooth Marginal Cost

MC

Output

10

Fig. 3.8 The MC Curve corresponding to Table 3.6

Let us now turn around the statement of the law of diminishing returns and say equivalently that, as more and more output is produced, initially, the rate of increase in the requirement of the variable input will be less and less, and, after a certain point, it will be more and more. This implies that, initially, the rate of increase in the variable cost which is same as the marginal cost will be less and less as output increases, and then, it will be more and more when output

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increases further. This explains the Ushape of the MC curve.6 Once we know that the MC curve is U-shaped, it follows that the AVC and the ATC curves are U-shaped also. There is indeed another relationship that holds between AVC, ATC and MC curves. Consider fig. 3.10, which depicts smooth AVC, ATC and MC curves. Observe that the MC curve cuts the AVC and ATC curves at their minimum points. The reason behind this is mathematical, not economic, and, it can be understood through the following example.7 Consider the game of cricket. Suppose that you are interested in calculating the average score of batsmen out as wickets continue to fall. Begin to calculate this after, say, 3 wickets are down. The runs scored by those already out are say 40, 105 and 2. The average is (40 + 105 + 2)/3 = 49. The game goes on and the fourth wicket falls. You calculate the average again and find that it has increased from 49 runs. Has then the fourth batsman, who got out, scored more or less than 49? The answer is more. Why, because otherwise the average wouldnt have increased. Similarly, if the average had fallen from 49, the fourth batsman must have scored less than 49. This simple deduction means the following. Think of the runs scored by the fourth batsman out as marginal (i.e.
6 7

Fig. 3.10

AVC, ATC and MC Curves

additional runs scored by the next unit or batsman, when 3 are already out). We are then saying that if the average increases (respectively decreases), the marginal should be above (respectively below) the average. Now go back to fig. 3.10. The AVC curve is decreasing in the range of output from 0 to q0. Then it must be true that, (a) at any output level in this range, MC < AVC. Likewise, (b) at any output greater than q 0 , AVC is increasing in output; hence MC > AVC. Now, statements (a) and (b) together imply that the MC curve must cut the AVC curve at the AVCs minimum point. By definition, MC is the addition to both the TVC and the TC. Hence the above logic applies to the relationship

Indeed, the MC curve is a mirror reflection of the MPP curve. This is contained in Richard Manning and Kenneth Henry, The Logic of Markets, The Dunmore Press Limited, New Zealand, 1983, Chapter 7.

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between MC curve and ATC curve also. The former cuts the latter at its minimum point too. 3.2.2 Long Run Recall that, in the long run, all inputs are variable, because costs that are fixed in the short run can be changed if the planning horizon of the producer is long enough. Accordingly, there are no TFC or AFC curves in the long run. There is no distinction between total costs and total variable costs; we simply use the term total costs. Similarly, there is no distinction between average total costs and average variable costs and we will use the term long-run average cost, denoted by LAC, where L stands for long run. The concept of marginal cost remains exactly the same however; we will abbreviate it to LMC. In what follows, we discuss the shapes of the LAC and LMC curves, the reasons behind their shapes and the relationship between them. Like the short run average and marginal cost curves, the LAC and LMC curves, in general, are U-shaped, and, the LMC curve cuts the LAC at its minimum point. However, the reason behind the U-shape is not the law of diminishing returns. Instead, since all inputs are variable, it is the pattern of the returns to scale, which determines the U-shape of these curves. 8
8

In particular, increasing returns to scale mean that if output is increased at a given rate (say 10%), inputs need to be increased only by less than proportionately (say by 7%). This implies that the average cost must fall as output expands. Similarly, decreasing returns to scale imply that the average cost must rise with output. Finally, if returns to scale are constant, the average cost is constant independent of output. We can summarise all this as follows: Increasing returns to scale LAC decreases with output Constant returns to scale LAC does not change with output Decreasing returns to scale LAC increases with output. Now look at fig. 3.11. It shows a U-shaped LAC curve. This means that, as output is gradually increased

Fig. 3.11 The Long-Run Average and Marginal Cost Curves

The short-run and long-run average or marginal cost curves are not unrelated however. As you will learn in a higher course in microeconomics, the LAC curve is flatter than short-run average variable cost curves.

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starting from a small level, there are increasing returns to scale (in the output range 0 to q0) such that LAC falls, then there are constant returns to scale (at q0), and finally decreasing returns to scale prevail at output levels higher than q0, such that LAC increases with output. In fig. 3.11, increasing, constant and decreasing returns to scale are written in short forms as IRS, CRS and DRS respectively. Now the question is why do IRS occur first, followed by CRS and DRS? Starting from a relatively smallscale operation (output), as the scale of operation increases, a firm would be able to reap the advantages of (a) division of labour and (b) volume discounts. To cite an example in case of for mer, suppose that a fir m has only o ne manag er, wh o s e speciality is in marketing but who is looking into both marketing and manufacturing. Now, as the firm increases its production and hires another manager who expertise is in manufacturing, then each manager can specialise in their expertise and be more efficient. This is called division of labour, meaning allocation of tasks according to the specialisation of workers. 9 In case of volume discounts, for instance, a garment factory buys 100 tons of yarn at a certain price. If, instead, it
9

plans to buy 200 tons of yarn it can negotiate a better price. However, as the output level goes beyond a certain limit, difficulties in managing an enterprise crop up. Crowding and congestion occur typically, which lead to decreasing returns to scale. In between IRS and DRS, a firm experiences constant returns to scale. It is shown at point q0 in fig. 3.11. More generally, CRS may prevail over a range of output, rather than at a single level of output. In this case, the LAC will have a flat portion in the middle. A couple of remarks are in order: First, given that initially increasing returns, then constant returns and finally decreasing returns to scale occur as output increases, the long run average cost is minimised where constant returns to scale prevail, such as at point q0. In some sense, this is the level at which production is most efficient. Second, the U-shape of the LAC curve implies the U-shape of the LMC curve. This is different in nature from the short run, where the U-shape of the marginal cost curve implies the U-shape of the average cost curve. The concepts developed in this chapter will be used very much in the following chapters.

The same applies to other kinds of workers and to machinery and land. For instance, at a small scale of operation, the firm may have only one room, which is used as a storage as well as office space for its employees. Storing merchandise and taking them out generate traffic, which would adversely affect the productivity of other employees. If, instead, the firm acquires an additional room, one of them can be used as storage only and as a result the productivity of employees will improve.

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SUMMARY
l l

l l l

l l l l l l l

l l l l

l l

TPP is equal to the sum of MPPs. There are generally three stages of production. In the initial stage, the MPP increases with input employment, then it diminishes but remains positive and finally it becomes negative. A profit-maximising firm will never employ an input at such a level that its MPP is negative. The MPP and APP curves are generally inverse U-shaped. The law of diminishing returns explains why the MPP curve is inverse Ushaped. In turn, the inverse U-shape of the MPP curve implies a similar shape of the APP curve. In the short run, there are fixed costs and variable costs. In the long run, there are only variable costs. The AFC curve is downward sloping. The MC, AVC and ATC curves are generally U-shaped. The sum of MCs equals the TVC. The area under the MC curve is equal to the TVC. The law of diminishing returns explains why the MC curve is U-shaped. In turn, the shape of the MC curve implies the similar shape of the AVC and ATC curves. The MC curve cuts the AVC curve and the ATC curve at their minimum points. The long run marginal cost (LMC) curve and the long run average cost (LAC) curve are generally U-shaped. The LMC curve cuts the LAC curve at the latters minimum point. The U-shape of the LAC curve follows from a firm experiencing increasing returns to scale initially, followed by constant returns to scale and then by decreasing returns to scale. The U-shape of the LAC curve implies the U-shape of the LMC curve. In the long run, the sources of increasing returns to scale lie in the division of labour and volume discounts.

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EXERCISES

Section I
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 What is a production function? List any three inputs used in production. What is meant by total physical product? What is meant by average physical product? What is meant by marginal physical product? How is total physical product derived from the marginal physical product schedule? What will you say about the marginal physical product of a factor when total physical product is falling? What is the general shape of the MPP curve? What is the general shape of the APP curve? What do returns to scale refer to? Give the meaning of increasing returns to scale. Give the meaning of constant returns to scale. Give the meaning of decreasing returns to scale. Classify the following into fixed cost and variable cost. (a) Rent for a shed. (b) Minimum telephone bill. (c) Cost of raw materials. (d) Wages to permanent staff. (e) Interest on capital. (f) Payment for transportation of goods. (g) Telephone charges beyond the minimum. (h) Daily wages. How does total fixed cost change when output changes? How is total variable cost derived from a marginal cost schedule? How can one obtain total variable cost from a marginal cost curve? What is the general shape of the AFC curve? What is the general shape of the MC curve? What is the general shape of the AC curve? What will happen to ATC when MC > ATC? What does division of labour mean? What are volume discounts? Name two factors behind increasing returns to scale in the long run.

3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 3.24

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Section II
3.25 3.26 What is meant by the law of variable proportions? Calculate the APPs and the MPPs of a factor from the following table on its TPP schedule. Level of Factor Employment 0 1 2 3 4 5 6 7 3.27 TPP 0 5 12 20 28 35 40 42

The following table gives the MPP of a factor. It is also known that the TPP at zero level of employment is zero. Determine its TPP and APP schedules. Level of Factor Employment 1 2 3 4 5 6 MPP 20 22 18 16 14 6

3.28

The following table gives the APP of a factor. It is also known that the TPP at zero level of employment is zero. Determine its TPP and MPP schedules.

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Level of Factor Employment 1 2 3 4 5 3.29

APP 50 48 45 42 39

3.30 3.31 3.32 3.33 3.34 3.35 3.36

6 35 Explain the law of diminishing marginal returns. In other words, why does the marginal product of an input decline with further employment of it? How does the total physical product change with the change in the marginal physical product of an input? What is meant by the law of diminishing returns? Distinguish between fixed and variable costs. With the help of a suitable diagram, explain the relationship between TC, TFC and TVC. Do ATC and AVC curves intersect? Give reasons. Why is the MC curve in the short run U-shaped? A firm is producing 20 units. At this level of output, the ATC and AVC are respectively equal to Rs. 40 and Rs. 37. Find out the total fixed cost of this firm.

Section III
3.37 A firms total cost schedule is given in the following table. Output (in units) 0 1 2 3 4 5 6 7 8 Total Cost In (Rs.) 40 120 170 180 210 260 340 440 550

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(a) (b) 3.38

What is the total fixed cost of this firm? Derive the AFC, AVC, ATC and MC schedules. Complete the following table if the AFC at 1 unit of production is Rs. 60. Output 1 2 3 4 5 6 7 8 TC 90 105 115 120 135 160 200 260 TVC TFC AVC AFC ATC MC

3.39

A firms fixed cost is Rs. 2,000. Compute the TVC, AVC, TC and ATC from the following table.

Output (in units) 1 2 3 4 5 6 7

Marginal Cost (in Rs.) 2,000 1,500 1,200 1,500 2,000 2,700 3,500

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3.40

Suppose that a firms total fixed cost is Rs. 100, and the marginal cost schedule of a firm is the following. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs.) 10 20 30 40 50 60 70

(a) (b) 3.41 3.42

Is the MC curve U-shaped? Derive the AVC schedule. Will the AVC curve be U-shaped? Discuss why or why not. Explain the relationship between ATC, AVC and MC with a suitable illustration. Tables A and B below outline two production technologies or production functions. There are two factors: unskilled labour and skilled labour. Show that the production function given in Table A satisfies increasing returns to scale and that in Table B satisfies decreasing returns to scale. Table A Unskilled Labour (in hours) 8 10 12 14 Skilled Labour (in hours) 4 5 6 7 Output (in units) 2 3 4 5

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Table B Unskilled Labour (in hours) 8 10 12 14 3.43 Skilled Labour (in hours) 4 5 6 7 Output (in units) 6 7 8 9

Increasing and decreasing returns to scale respectively imply downward and upward sloping portion of the long run average cost curve. Defend or refute.