NCERT Class 12 Economics Chapter 3: Production and Costs YouTube Lecture Handouts
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Production is the process by which inputs are transformed into ‘output’. Production is carried out by producers or firms. A firm acquires different inputs like labor, machines, land, raw materials etc. It uses these inputs to produce output.

Production is instantaneous: in our very simple model of production, no time elapses between the combination of the inputs and the production of the output.

Price for input = Cost of production

Inputs of firm = production factors

Output sold in market = revenue

Profit = revenue – cost (aim is maximize profit)
Production Function

Production function of a firm is a relationship between inputs used and output produced by the firm. For various quantities of inputs used, it gives the maximum quantity of output that can be produced.

Example, to produce (q) wheat – requires land (hectares as K) and labor (hours of work done as L)

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In our example, both the inputs are necessary for the production. If any of the inputs becomes zero, there will be no production.

Efficiency implies that it is not possible to get any more output from the same level of inputs.

A production function is defined for a given technology. It is the technological knowledge that determines the maximum levels of output that can be produced using different combinations of inputs.

If the technology improves, the maximum levels of output obtainable for different input combinations increase. We then have a new production function.
Isoquants

Isoquant is the set of all possible combinations of the two inputs that yield the same maximum possible level of output. Each isoquant represents a particular level of output and is labelled with that amount of output

It is similar to indifference curve

When marginal products are positive, with greater amount of one input, the same level of output can be produced only using lesser amount of the other. Therefore, isoquants are negatively sloped.
Short Run & Long Run

Factors that don’t vary = fixed variable

Factors that vary = variable factors

In Short Run, at least one factor cannot be varied (above table fix capital at 4 and vary labor)

In Long Run, all factors of production can be varied (no fixed factor) – longer time duration (by looking at whether all the inputs can be varied or not)
Total Product, Average Product & Marginal Product

Relationship between the variable input and output, keeping all other inputs constant, is Total Product (TP) of the variable input.

Average product is defined as the output per unit of variable input

Marginal product of an input is defined as the change in output per unit of change in the input when all other inputs are held constant. or
Law of Diminishing Marginal Productivity and Law of Variable Proportions

Tendency of the MP to first increase and then fall is called the law of variable proportions or the law of diminishing marginal product. Law of variable proportions say that the marginal product of a factor input initially rises with its employment level. However, after reaching a certain level of employment, it starts falling.

Factor proportions represent the ratio in which the two inputs are combined to produce output.

Initially, as we increase the amount of the variable input, the factor proportions become more and more suitable for the production and marginal product increases.

But after a certain level of employment, production process becomes too crowded with the variable input.
Total product curve in the inputoutput plane is a positively sloped curve

MP curve looks like an inverse ‘U’shaped curve

As long as the value of MP remains higher than the value of the AP, the AP continues to rise. Once MP has fallen sufficiently, its value becomes less than the AP and AP also starts falling

(compare left and right of L in image)

Returns to Scale

When a proportional increase in all inputs results in an increase in output by the same proportion, the production function is said to display Constant returns to scale (CRS).

When a proportional increase in all inputs results in an increase in output by a larger proportion, the production function is said to display Increasing Returns to Scale (IRS)

Decreasing Returns to Scale (DRS) holds when a proportional increase in all inputs results in an increase in output by a smaller proportion.

CobbDouglas Production Function


Here are constants, if both inputs increased t times we get new output.

When production function exhibits DRS
Costs

With the input prices given, it will choose that combination of inputs which is least expensive

Cost function describes the least cost of producing each level of output given prices of factors of production and technology
Short Run Costs

The cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC).

Total Cost = Total Variable Cost (TVC) + Total Fixed Cost (TFC)

As output increases, total variable cost and total cost increase.

Short run average cost (SAC) incurred by the firm is defined as the total cost per unit of output.

Average variable cost (AVC) is defined as the total variable cost per unit of output.

Average Fixed Cost

Hence,

Short run marginal cost (SMC) is defined as the change in total cost per unit of change in output
Just like the case of marginal product, marginal cost also is undefined at zero level of output.
AFC is the ratio of TFC to q. TFC is a constant. As q increases, AFC decreases. When output is very close to zero, AFC is arbitrarily large, and as output moves towards infinity, AFC moves towards zero.
TFC is calculated as area of rectangle
Finding AFC = (similarly we can find for AVC)

Marginal cost is the additional cost that a firm incurs to produce one extra unit of output. According to the law of variable proportions, initially, MP of a factor increases as employment increases, and then after a certain point, it decreases.

This means initially to produce every extra unit of output, requirement of the factor becomes less and less, and then after a certain point, it becomes greater and greater. As a result, with the factor price given, initially the SMC falls, and then after a certain point, it rises. SMC curve is, therefore, ‘U’shaped.

Then, as output increases, SMC falls

As AVC rises, SMC must be greater than the AVC. Therefore, SMC curve cuts AVC curve from below at the minimum point of AVC.
After a certain level of production, rise in AVC becomes larger than the fall in AFC. From this point onwards, SAC (AVC+AFC) is rising.

Long Run Costs

In the long run, all inputs are variable. There are no fixed costs. The total cost and the total variable cost therefore, coincide in the long run.

Long run average cost (LRAC)

Long run marginal cost (LRMC) is the change in total cost per unit of change in output.

Returns to scale (increasing, constant and decreasing) similar to short run
For any level of employment of an input, the sum of marginal products of every unit of that input up to that level gives the total product of that input at that employment level
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