Module 3: Theory of production, cost and

revenue
Concept of production function:
● The functional relationship between physical inputs and physical
outputs of a commodity is called production function.
● Q= f(x1,x2……..xn)
It says that by using physical quantities of various inputs
x1,x2….xn we can at most produce Q amount of the commodity.
● Thus, the production function is a technological relationship that
shows the maximum output producible from various
combinations of inputs.

Production with one variable input:

● It is the effect of change in the quantity of one input on the total
output by keeping all other input fixed. The relationship between
variable input and output is called the short run production
function; the quantity of fixed input can't be changed.
● Example:
labor is the variable input with additional workers output
increases it reaches maximum and then decreases the average
product of labor AP for output per workers increases and then
decreases.
AP= output(Q)/labor input(L)= Q/L

Production with two variable input:

● A firm may increase its output by using more of two variable
inputs that are substitutes for each other.
● Example: labor and capital
There may be various technical possibilities of production of a
given output by using different factor combinations; these
combinations can be graphically represented in terms of iso-quant
curve for also called iso-product curve.
● Isoquant curve- isoquant curve or an iso-product curve is the
line which joins together different combinations of FOP (LK) that
are physically able to produce a given amount of output.

The law of variable proportion:

● According to the law of variable proportion as more and more
units of a variable factor are employed with fixed factors the total
product TP increases at an increasing rate in the beginning then
increases at a diminishing rate and finally starts falling.
● The law of variable proportion is also known as the law of return
to a factor; it implies the resultant increase in the total product
when only one factor is increased keeping all other factors fixed.

Concept of iso-quant:
Isoquant are geometrical representations of the production function;
the same level of output can be produced by various combinations of
factor inputs. Assuming continuous variation in the possible
combination of labor and capital we can draw a curve by plotting all
these alternative combinations for a given level of output; this curve
which is the goal of all possible combinations is called the iso-quant.

Properties of isoquant:
1. Slope downwards to the right
2. It is convex to origin
3. It is both and continuous
4. Two iso-quant curve do not intersect
5. Higher iso-quant denotes higher level of output
Types of isoquants:
● Linear iso-quant:

This type assumes perfect suitable substitute ability of factors of

production a given commodity may be produced by using only capital
for only labor or by an infinite combination of K and L.
● Input/output iso-quant:
 This assumes strictly complementary there is 0 substitute ability
of the factor of production there is only one method of production for
any commodity the isoquant takes the shape of right angle this type of
isoquant is called lenoite iso-quant.
● Kinked iso-quant:

This assumes Limited substitutability of K and L there are only a

few processes for producing any one commodity. Substitute ability of
factors is possible only at the kinks.It is also called as linear
programming isoquant.
● Convex iso-quant:

This form assumes continuous substitute ability of K and L only

ever a certain range beyond which factors cannot substitute
each other. This iso-quant appears as a smooth curve convex to
the origin.

Marginal rate of Technical substitution:

● The marginal rate of Technical substitution of L and K denoted
by MRTS (L,K) is defined as the number of units of input K that a
producer is willing to sacrifice for an additional unit of L so as to
maintain the same level of output that (remains on the same iso-
quant).
● The MRTS (L,K) is also equal to the ratio of marginal product of
capital to the marginal product of labor.
● Slope of the iso-quant= -dk/dl
MRTS(L,K)= MPL/MPK
 ● According to the principle of diminishing MRTS the value of
MRTS diminishes as one moves a long and isoquant down
towards right.
Producer's equilibrium through isoquant:
● producer's equilibrium can be obtained with the help of isoquant
and isocost line. and myself and enables a producer to get those
combinations of factors that yield maximum output. On the other
hand, iso-cost lines provide the ratio of prices of factors of
production and the amount the producer is willing to send. For
attaining equilibrium, a producer needs to attain a combination
that helps in producing maximum output with the least price.

● As shown in the figure the producer can produce to St unit of

output using and combination that is R,Q and S on the curve IP’.
he would select the combination that would obtain the lowest
cost, it can be seen from the figure that Q lies on the lowest
isocost line and would yield same profit as on R&S points at the
lowest cost. in you, therefore it would be selected by the
producer.
Cost concept:
● Normal cost- it is the money cost of production also called
expenses of production.
● Real cost- as per Marshall, it includes real cost of efforts of
various qualities and real cost of waiting.
● opportunity cost- it is the next best alternative sacrificed in order
to obtain a commodity.
● Sunk cost- it is one which is not affected or altered by a change
in the level or nature of business activity. Example- depreciation
● Explicit cost- it is that expense which is actually paid by the firm
paid out cost. This causes it to appear in the accounting records
of the firm, for example salary and wages to the employee price
of raw material and semi finished material overhead cost etc.
● Implicit cost- are theoretical costs in the sense that they go and
recognised by the accounting system this cost may be defined
as the earning of those employed resources which belong to the
owner himself. Example opportunity cost of the owner service,
returned earned on entrepreneur own investment.
● Fixed cost they are independent of output that is they do not
change with changes in output. Example- rent, insurance fees,
maintenance cost etc.
● Variable cost- variable cost are those which vary or change with
the change in output level.
● Total cos-t total cost of a business is the sum of its total variable
cost and total fixed cost. Thus, TC= TFC + TVC.
 ● Short run cost- it is a period of time in which the output can be
increased or decreased by changing only the amount of variable
factors such as labor, raw material, chemicals etc.
● Long run cost- it is defined as the period of time in which the
quantities of all factors may be varied. In other words it is that
time span in which all adjustments and changes are possible to
realize.
Total cost= total fixed cost + total variable cost
AFC= TFC/Q, Q= Quantity
AVC= TVC/Q
AC= AFC+ AVC
MC= Total C/ total Q

Theory of cost in the short run clash total, average and marginal cost
in the short run
 ● The shape of the cost curve shows how the change in the
output affects the cost. There will be a shift in the cost curve, if
factors other than a change in output affect the cost.
● The TFC being fixed for all units of outputs, air AC is a falling
curve in the abc curve at first Falls and then arises on their
emergence as the diseconomy of large production. As the output
increases the AL Falls but when diminishing marginal return set
in the AC starts increasing that is why AC curve is v shape.
● Marginal cost curve also Falls first due to more efficient use of a
Avf as output increases and then it arises due to efficient use of
variable factors. The AFC curve is a rectangular hyperbola.

Long run average cost curve slash why are long run average cost
curve U shaped
 ● In the short run the form will adjust the output to demand by
varying the variable factors. if all the f o p can be used in wearing
proportion, it means that the scale of operation of the firm can be
changed. age time, the scale of operation is changed and a new
short run cost curve will have to be drawn for the firm like SRAC,
SRAC2, etc.
● These short run curves are intersecting each other, the
intersection points are so close that we get a continuous cough.
It is known as LRAC curve or annual up curve. The LRAC is
tangent to all SRAC curves SAC1, SAC2 etc. Therefore LRAC is
is U shape
● The LRAC curve is a U shaped curve which reflects the law of
return to scale.

Revenue concept:
● The relationship between marginal revenue,average revenue
and the price elasticity of demand.
● Price elasticity of demand(ep)= Average Revenue/ AR- MR
Or MR= AR(ep-1)/ep
● Example- Rupee elastic(ep) equals=2 at that price,calculate the
marginal utility.
AR=100, ep= 2
MR= 100(2-1)/2= 50