Class -12 Economics Notes Part-2 Production and Costs | Theory of Firm Under Perfect Competition

Class -12 

Economics Notes

Part-2

Production and Costs

Basic Definition
1. Production:
It is the transformation of resources into commodities.

2. Production Function:
Production function studies the functional relationship between physical input and physical output.

Y =F(L.K)
Here Y =Production, L = Labour, K = Capital.

3.Total Product:
It is the sum total of output produced by all units of labour.
TP= AP x L

Here. TP = Total product,
AP = Product per unit of labour
L = Units of labour

4. Marginal Product:
It is the change in total production as result of a unit change in input of a variable factor (ΔL).

where,
ΔTP = Change in total production
MP= TPn -TPn-1
or
MP=.ΔTP/ΔL

5. Average Product:
It is per unit production of the variable factor.
AP= TP/L

Here, AP =Average product
TP = Total product
L= Labour

6. Short run:
The time period during which a finn, in order to make changes in its production can change only in its variable factors but not in its fixed factor, is termed as short run.

7. Long run:
The time period in which a firm can change all the factors of production is termed as long run.
In the long period, a firm can change its scale of plant also.

Law of Diminishing Marginal Product

The law states that with the increase in variable factor, keeping all other factors constant the marginal product of the variable
factor diminishes after a certain level of production.

Reason for operating of law:
(i) Optimum combination
(ii) Change in factor combinations

Law of Variable Proportion

The law states that with the increase in a variable factor, keeping other factor constant, initially the marginal product
rises but after reaching a certain level of employment it starts declining.

Three stages of the law
(i) Increasing returns
(ii) Diminishing returns
(iii) Negative returns

Returns to Scale

When producers change all the factors of production in the same production, the proportional relationship between
output and factor inputs is known as returns to scale.

(i) Constant Returns to Scale When a proportional increase in all inputs results in an increase in output by the same proportion
is called constant returns to scale.

(ii) Increasing Returns to Scale IRS holds when proportional increase in all inputs results in an increase in output by more than the proportion.
(iii) Decreasing Returns to Scale DRS holds when proportional in all inputs results in an increase in output by less than the proportion.

Cost Function

The functional relationship between cost and quantity produced is termed as cost function.
C= F(Qx)
Here, C= Production – Cost
Qx = Quantity produced of x goods

Cost of Production Cost:
It is the expenditure incurred by the producers on purchase of factor inputs such and land, labour capital etc, non-factor inputs
such as raw material. fuel etc.

Explicit Cost:
The cost of those inputs whose payment is made to outsider of the firm. It is an accounting cost.

Implicit Cost:
The cost of self owned inputs used in the production process is called implicit cost. e.g.. rent of ownland, interest of own Implicit etc.

Total Cost (TC):
It is the sum total of fixed cost and variable cost corresponding to a given level of output.
‘I’C = TFC + TVC
Here, TFC = Total Fixed Cost
‘I’VC = Total Variable Cost
TC = Total Cost

Total Fixed Cost (TFC):
TFC arc the costs that are incurred on fixed factor inputs and do not vary with the output. e.g., Rent of factory, Interest on bonds,

TFC = Quantities of the fixed productive services x Factor price
or TFC=TC-TVC

Total Variable Cost:
The costs that are incurred on variable factor inputs and very directly with the output are called total variable costs.
e.g., Raw material, fuel, electric power.

TVC= Quantities of the variable productive service x Factor price
or TVC= TC – TFC

Average Cost (AC):
Average cost is the cost per unit of output produced.
AC= TC/Q ; Q= Units of output
AC=AFC+ AVC

AFC = Average Fixed Cost
AVC =Average Variable Cost

Average Fixed Cost:
Total fixed cost per unit of output incurred to a finn may be defined as average fixed cost. APC= TFC/Q

Averages Variable Cost (AVC):
Total variable cost. per unit output incurred to a firm is defined as the average variable cost. AFC= TVC/Q

Marginal Cost (MC):
It is the additional cost owing to the production of an additional unit of output.
MCn =TCn -TCn-1 Since additional cost can only be variable cost.

Shape of Curves

(i) AC, AVC, MC curve U shaped due to law of returns to factor.
(ii) TFC curve straight line || to X-axis.
(iii) TC and TVC curve upward sloping.
(iv) AFC curve downward rectangular hyperbola.

Theory of Firm Under Perfect Competition

Perfect Competition

A perfectly competitive market has the following defining features:
1. The market consists of a large number of buyers and sellers
2. Each firm produces and sells a homogenous product. i.e., the product of one firm cannot be differentiated from the product of any other firm.
3. Entry into the market as well as exit from the market are free for firms.
4. Information is perfect.

Conclusion
A market in which we find perfect competition between a large number of buyers and a large number of sellers of a homogeneous product
and uniform price is called perfect competition market.

REVENUE

A firm earns revenue by selling the good that it produces in the market.
Let the market price of a unit of the good = p.
Let be the quantity of the good produced = q

Then, total revenue (TR) of the firm is defined as the market price of the good (p) multiplied by the firm’s output (q).
Hence, TR = p × q

Marginal revenue (MR):
MR of a firm is defined as the increase in total revenue for a unit increase in the firm’s output.
i.e. MarginalRevenue (MR) = Change in total revenue/Change in quantity

Price Line

The line plotted for different values of output in the output price plane is called price line.
In perfect competitive market for an individual firm price line and demand curve are same.

PROFIT MAXIMISATION

A firm produces and sells a certain amount of a good.
The firm’s profit, denoted by π, is defined as the difference between its total revenue (TR) and its total cost of production (TC ).

i.e. π= TR – TC
Here, the difference between TR and TC is the firm’s earnings net of costs.
A firm wishes to maximise its profit.

Here say, q₀ is the quantity to be produced by the firm at which its profits are maximum.
By definition, then, at any quantity other than q₀, the firm’s profits are less than at q₀.

For profits to be maximum, three conditions must hold at q₀:
1. The price, p, must equal MC
2. Marginal cost must be non-decreasing at q₀
3. For the firm to continue to produce, in the short run, price must be greater than the average variable cost (p > AVC); in the long run, price must be greater
than the average cost (p > AC).

Shape of TR, AR, MR, curves in Perfect Competition

(i) Under Perfect. Competition TR curve in an upward slopping straight line starting from the origin.
(ii) Under Perfect Competition AR and MR curve is same and || to X-axis.

Some points

Profit:
It is the difference between revenue and cost. Profit= (π)= Revenue – Cost.

Break Even Point:
Break even for a firm occurs when it is able to cover its all costs of production.
Accordingly, break- even point is defined as a situation when
TR= TC or AR = AC Under this situation, the firm earns only normal profits.

Shutdown Point:
It occurs when firm is just able to cover its variable costs, increasing the loss of fixed cost of production.
Accordingly shut down point is defined as a situation when TR= TVC or AR= AVC

Producer Equilibrium or Profit Maximisation

A producer is said to be in equilibrium, when he maximises his profits or minimises his losses.
Condition of profit maximisation

(i) MR =MC
(ii) Me is rising or MC should cut MR from below.

Profit Maximisation in the Shurt-run under Perfect Competition

Condition-1:
MR= MC or AR = P
Condition-2:
MC curve should cut the MR= AR curve from below.
Condition-3: P ≥ AVC

Short run Supply Curve:
The supply curve of a firm tells us the quantity of the product that a profit maximising firm is willing to produce at each possible price.

Supply

Supply:
It means the amount of a commodity that firms are able and willing to offer for sale in the market in a given period of time and at a given price.

Supply Schedule:
Tabular statements of relationship between price and supply of commodity is called supply schedule.

Supply Curve:
Graphical presentation of relationship between price and supply of a commodity is called supply curve.

Market Supply Curve:
The market supply curve for a commodity shows relationship between the price of a given commodity and quantity sellers are inclined to sell.

Determinant of Supply Curve:
(i) Technological progress
(ii) Input price
(iii) Unit tax

Elasticity of Supply:
It is a measure of the degree of responsiveness of quantity supplied to changes in the commodity’s own prices.

Measurement of Elasticity of Supply:
Percentage method E =% Change in quantity supplied / % Change in price or ΔQ/ΔP = P/Q

Here, P = Actual Price, Q= Actual Quantity
ΔP = Change in Price, ΔQ = Change in Quantity

Two Extreme Cases of Elasticity of Supply:
(i) Perfect elastic supply (es= ∞)
(ii) Perfect inelastic supply (es = 0)