Principles of Micro Economics (BBA 1st)
Chapter # 4 The Firms Cost of Production and Revenue
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State and explain the Law of Variable Proportions (Non-Proportional
Returns) with the help of schedule and diagram.
Ans:
Introduction:
The Law of Variable Proportions was presented by W.J.L Rayan. This law is the basis of the
study of production theory in short run. According to modern economists, increasing return and
decreasing return are infect the different phases of Law of Variable Proportion. This law is
universally applicable in every sector of the economy either industry or agriculture.
Definition:
According to Benham:
“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish.”
In simple words:
In a given state of technology, when units of variable factors of production are employed on the
fixed factors of production, marginal and average product increases in the beginning but when
the fixed FOP is fully utilized then employing more units of variable FOP gives less and less
marginal and average product.
Assumption:
The law of variable proportions is based on the following assumption:
1. No change in technology:
It is assumed that there is no change in technology. It means technical knowledge is given and
remains the same; otherwise the marginal and average product increase instead of decrease.
2. Homogeneous units:
It is assumed that all the units of variable factor of production are homogeneous. e.g. all
workers are equal in physical health and mental capabilities.
3. Variable proportions:
The various factors are not to be used in rigidly fixed proportion but the law is based upon the
possibility of varying proportions. It is also called the law of proportionality.
4. Variable and Fixed inputs:
It is also assumed that only one input is variable others being held constant.
5. Short run:
The law of variable proportions is a short run analysis of production because in the long run all
inputs become variable.
Schedule: Fixed Variable
T.P M.P A.P Stages
It is clear from the schedule that up to 3rd unit FOP FOP
of variable FOP, marginal and average 10 Acres 1 4 4 4 I
product is increasing. It is the stage I that 10 Acres 2 12 8 6 I
represents increasing return. From 4th to 5th 10 Acres 3 24 12 8 I
unit, marginal and average product is 10 Acres 4 32 8 8 II
decreasing. It is the stage II that represent 10 Acres 5 36 4 7.2 II
decreasing return. With the employing of 6th 10 Acres 6 36 0 6 III
and 7th unit, the marginal and average 10 Acres 7 32 -4 4.5 III
product becomes zero and then negative. It represents III stage of negative return.
Diagram:
The diagram explains the law of variable
proportion. The horizontal axis shows the units of
variable factors. The vertical axis shows the total,
average and marginal product. When units of
variable factor are increasing in relation to fixed
factors, the result is that total production
increases at first, and then it remains constant
and then starts falling. The total production curve
can be used to determine average production
and marginal production curves.
Stage I (Increasing Return):
In this stage, both MP and AP are increasing up to 3rd worker. But the note able point is that MP
is increasing rapidly than AP. It means MP curve is higher than AP curve. Here TP is increasing at
an increasing rate.
Stage II (Decreasing Return):
In this stage, both MP and AP are decreasing up to 6th worker. But note able point is that MP
curve intersects the AP curve when AP is maximum. Here TP is increasing at a decreasing rate.
Stage III (Negative Returns):
In this stage, MP becomes zero at 6th worker and then becomes negative at 7th worker. Here
MP is decreasing rapidly than AP. It means MP curve is lower than AP curve. Total production
decreases with the employment of more units of variable FOP.
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What do you understand by Cost of Production? Discuss the behavior
of short run cost curves.
Ans:
Cost of Production:
When we produce something by employing factors of production, we have to pay the reward of
these factors. If we make some expenditure on these factors, they will be termed as cost of
production.
Short Run Cost Curves:
Short run is a period of time during which some factors of production are fixed and some are
variable. The firm can increase or decrease the amount of variable factors such as labor and
capital and raw-material while fixed factors cannot be changed. Thus total cost consists of fixed
cost and variable cost. This may further be explained into average fixed cost and average
variable cost, average cost and marginal cost. These concepts of short-run are discussed below.
1. Total Fixed Cost (TFC):
The expenditure made upon fixed factors of production is known as total fixed cost. It is the
cost of a firm which does not change with the change in production. This cost is compulsory
borne by a firm whether it is working or not working. Fixed cost is also known as supplementary
cost, indirect cost or sunk cost. Total fixed cost includes:
Salaries of administrative staff Building repair and depreciation
Rent of land Depreciation of machinery
2. Total Variable Cost (TVC):
The expenditure made upon variable factors of production is known as total variable cost. It is
those expenditures of firm which change directly with the output. It is born by a firm only when
it starts working. Variable cost is also known as prime cost, direct cost or floating cost. Total
variable cost includes:
Cost of raw material Cost of direct labor
Running expenditures of fixed capital i.e. cost on fuel, ordinary repair and routine
maintenance, electricity expenditures, gas charges, water and telephone expenses and
transport cost.
3. Total Cost (TC):
It is the total expenditures made upon the production of a specific quantity of output. In other
words the total cost of a specific quantity of output is the sum of total fixed cost and total
variable cost i.e. TC = TFC + TVC
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4. Average Fixed Cost (AFC):
It is the fixed cost per unit of output. Average fixed cost is found by dividing fixed cost by the
level of output. TFC
AFC =
Q
Since total fixed cost is constant, the greater the output, the lower will be average fixed cost
per unit.
5. Average Variable Cost (AVC):
It is the variable cost per unit of output. Average variable cost is found by dividing total variable
cost by the level of output. TVC
AVC =
Q
The average variable cost falls initially as the productivity of variable factors increases. After
reaching at minimum point where the plant is operated optimally, it rises upwards.
6. Average Cost (AC):
It is the total cost per unit of output. Average total cost is obtained by dividing total cost by the
level of output. TC
AC =
Q
Average total cost is also obtained by adding average fixed cost and average variable cost.
AC = AFC + AVC
7. Marginal Cost (MC):
The addition made to the total cost by production of one more units of output is called
marginal cost. In other words, change in total cost resulting from one unit change in output is
known as marginal cost. Mathematically the marginal cost is the first derivative of total cost
function i.e. ∆TC
MC =
∆Q
Schedule:
Q TFC TVC TC AFC= TFC/Q AVC= TVC/Q AC= TC/Q MC= ∆TC/∆Q
1 20 15 35 20 15 35 15
2 20 25 45 10 12.5 22.5 10
3 20 30 50 6.67 10 16.67 5
4 20 40 60 5 10 15 10
5 20 55 75 4 11 15 15
6 20 75 95 3.34 12.5 15.83 20
7 20 100 120 2.86 14.29 17.14 25
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Diagram:
Schedule and diagram show that
Total fixed cost is constant for all units of output so TFC curve is parallel to X-axis.
Total variable cost increases at a decreasing rate in the beginning but later it increases with
increasing rate so TVC curve is as inverse S shape.
Total cost has the same behavior as that of total variable cost. It increases with decreasing
rate in the beginning but later it increases with decreasing rate. TC curve is also inverse S
shape.
Average fixed cost decreases with the increase in output so AFC curve decreases
continuously towards X-axis.
Average variable cost initially decreases as output increase but after the optimum point, it
begins to rise. AVC curve initially falls then reaches to its minimum point and then starts
rise.
Average cost has the same behavior as that of average variable cost. Initially it decreases as
output increases but after the optimum point, it begins to rise. AC curve initially falls then
reaches to its minimum point and then starts rise.
Marginal cost decreases in the beginning with the increase of output but after reaching its
minimum point, it begins to rise with the increase of output. MC curve falls in the beginning
and after reaching its minimum level, it begins to rise.