Production and Costs - Introduction
Production and costs are a very important part of modern economics and are essential in determining a whole lot of things in production. We have to deal with various concepts like production function, cost of production, and the necessary mathematical terms that are associated with them. Being acquainted with all these terms would help us understand the various industries' operations in an economy. To begin with, we all know that production incurs a cost, which is the money spent on all the various factors of production. The relationship between the inputs and the output in the production process can be explained with the help of a production function.
Production Function
Production and costs can be explained with the help of the production function. The production function is just the function relationship between the various production factors and the output produced through this process. Arithmetically this is depicted as Q= f(L, K). The Q over here is the output, while ‘L’ and ‘K’ are the different inputs that go into the production process. There may be various other factors involved, but over here, we are working with a two-factor model.
Types of Costs in Economics
The different types of costs include fixed costs, variable costs, semi-variable costs, marginal cost, opportunity cost, economic cost, accounting costs, sunk cost, among other types of costs. Fixed costs refer to the costs that do not change with output—variable costs, on the other hand, are dependent on what is being produced and keep varying. Marginal costs refer to the cost of producing an additional unit of a particular commodity or service.
Time Period And Production Function
The total cost of production also depends on the period of production. In the short run, there is a relationship between the output and anyone variable factor. The long-run output is different from this and has all the various factors of production in the same proportion. The law that works in the case of the short-run output is called the law of returns to a factor, and the law that works in the case of the long-run output is called the law of returns to scale.
Total Product, Average Product, And Marginal Product
The production function is used to denote a physical relationship between the physical inputs and output. The total production refers to the total production by a firm in a given period. On the other marginal production is the additional one unit produced. On the other hand, the average product is the average of the total production per unit of a factor of production consumed. This is obtained by dividing the total product by the variable factors or the inputs that have gone into production. They help us to determine the cost of production.
Behaviour of Cost in The Short Run
In the short run, there are fixed inputs that cannot be changed. The short-run cost function is a relationship between the output and the cost of production. This explains how the cost of production changes with the change in the level of output if all other things remain unchanged. The Total fixed cost consists of the value of the various fixed inputs in production, and they do not change with any alterations in production or output. The total variable cost, on the other hand, refers to the cost of the varying factors of production and change with different levels of production. When production is zero, the total variable cost is also zero. The total cost is the addition of the total variable cost and the total fixed cost.
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Did You Know?
In the long run, all the different factors of production are variable, and the long-run total cost is just the minimum cost of production. This can be less or equal to the average costs in the short-run average cost. The long-run average cost curve is the average of the long-run total cost curve, or in other words, it is simply the cost per unit of output In the long run. The long-run marginal cost is the cost of an additional unit being produced in the long run, with all the factors of production being variable.
Solved Example
Why is the Long-Run Average Cost Referred to as the Envelope Curve?
Answer: The long-run average cost is the different producers' optimization problem, and the firm can operate in the long run. In contrast, all the different factors of production are variable. The firm tries to keep its cost minimum and the LAC that is derived by joining the different SAC curves, which are producing different levels of output. This causes an envelope curve.
FAQs on Production and Costs: Explained
1. What is a production function and what are its key inputs?
A production function illustrates the technical relationship between the physical inputs used and the maximum physical output that can be produced. It is expressed as Q = f(L, K), where 'Q' represents the quantity of output. The key inputs are:
- Labour (L): The human effort involved in the production process.
- Capital (K): The machinery, tools, and buildings used to produce goods.
In the short run, at least one input (like capital) is fixed, while in the long run, all inputs are variable.
2. What are the main differences between fixed costs and variable costs? Provide examples.
The primary difference lies in their behaviour with changes in output. Fixed Costs (FC) are expenses that do not change regardless of the level of production, such as rent for the factory, salaries of permanent staff, and insurance. In contrast, Variable Costs (VC) are expenses that fluctuate directly with the level of output, such as the cost of raw materials, wages for daily-wage labour, and electricity bills.
3. How do you differentiate between Total Product (TP), Average Product (AP), and Marginal Product (MP)?
These three concepts measure a firm's productivity in the short run:
- Total Product (TP): This is the total quantity of goods produced by a firm with a given amount of inputs over a specific period.
- Average Product (AP): This is the output per unit of a variable input. It is calculated as AP = TP / Units of Variable Input.
- Marginal Product (MP): This is the additional output generated by adding one more unit of a variable input, while keeping other inputs constant. It is calculated as the change in TP divided by the change in the variable input.
4. Why is the relationship between Average Cost (AC) and Marginal Cost (MC) important for a firm?
The relationship between AC and MC is crucial for a firm's decision-making on output levels. The key principles are:
- When MC is less than AC, the average cost of production falls.
- When MC is greater than AC, the average cost of production rises.
- When MC equals AC, the average cost is at its minimum point.
This intersection point signifies the level of output where the firm achieves maximum productive efficiency, producing at the lowest possible cost per unit.
5. Explain the Law of Variable Proportions with its three stages.
The Law of Variable Proportions, also known as Returns to a Factor, describes the behaviour of production in the short run when one input is varied while others are fixed. It operates in three stages:
- Stage 1: Increasing Returns to a Factor: In this stage, the Total Product (TP) increases at an increasing rate, and the Marginal Product (MP) also rises. This is due to better utilisation of the fixed factor.
- Stage 2: Diminishing Returns to a Factor: Here, TP continues to increase but at a diminishing rate, and MP starts to fall. This is the optimal stage of production for a rational producer.
- Stage 3: Negative Returns to a Factor: In this final stage, TP starts to decline, and MP becomes negative. This occurs because the variable input is excessive in relation to the fixed input.
6. Why is the Long-Run Average Cost (LAC) curve called an 'envelope curve'?
The Long-Run Average Cost (LAC) curve is called an 'envelope curve' because it is formed by tangentially enclosing or 'enveloping' an infinite number of Short-Run Average Cost (SAC) curves. Each SAC curve represents a specific plant size or scale of operation. In the long run, a firm can choose any plant size. The LAC curve shows the lowest possible average cost for producing any given level of output, allowing for the adjustment of all factors of production.
7. How does an economist's definition of cost differ from an accountant's?
The main difference lies in the inclusion of implicit costs. An accountant considers only explicit costs, which are the direct monetary payments made for inputs like wages, rent, and raw materials. An economist, however, includes both explicit costs and implicit costs. Implicit costs represent the opportunity cost of using self-owned resources, such as the salary a business owner could have earned elsewhere. Therefore, Economic Cost = Explicit Costs + Implicit Costs, which is a broader measure used for decision-making.
