MICRO ECONOMICS SLIDES FOR PCIU STUDENTS BY MMR

1. Unit -3: Production and Business Organization
and
Analysis of Costs

2. Production function
A production function relates physical output of a
production process to physical inputs or factors of
production.
Production function
The production function is the relationship between the
maximum amount of output that can be produced and
the inputs required to make that output.
Put in other way, the function gives for each set of
inputs, the maximum amount of output of a product
that can be produced. It is defined for a given state of
technical knowledge (If technical knowledge changes,
the amount of output will change.)

3. A production function provides an abstract
mathematical representation of the relation
between the production of a good and the
inputs used. A production function is
usually expressed in this general form:
Q =f(L, K)
where: Q = quantity of production or output,
L = quantity of labor input, and K = quantity
of capital input. The letter "f" indicates a
generic, as of yet unspecified, functional
equation.

4. A production function can be expressed in a
functional form as the right side of
where is the quantity of output and
are the quantities of factor
inputs (such as capital, labour, land or raw
materials).

5. Short run and long run production
function
 Economists define the short run as being the time
period when at least one of the factors of production is
completely fixed.
so the relationship between input and out put in short
run is called short term production function.
In short run , factors of production are both fixed and
variable.
Q= f(L,K)
Where, q=production
L= labour (variable)
K= capital (fixed)
Note: here capital means machinery

6.  If the situation is like that ,to increase production(Q)
we can change only the labour(L) and the capital(K) is
fixed, it will be treated as short term production
function.
 Example: ABC corporation is used to export RMG
products to Europe. It receives an order for 10,000
pieces of RMG products whereby it should supply as
per order with in 2 weeks. In this situation the owner
will not establish new building or machinery. He will
try to accomplish the order by increasing the number
of labour . so here we see labour is variable and capital
is fixed.
 The relationship between input and output in this
situation is called short term production function.

7. Long run production function: Economists define the
long-run as being the time period when all the factors of
production can be changed. In long run all the factors of
production are variable.
Q=f(L,K)
Where, Q=production
L= labour ,K= capital
If the situation is like that ,to increase production(q) we can
change both the labour(L) and capital(K) , it will be treated
as long term production function.
Example: after the order for 10,000 piec es, if the firm gets
order on continuous basis, it will establish new building
and machinery. That means in long run both the labour
and capital can be changed. So the production function is
called long run production function.

8. Law of returns or law of variable
proportions
 Law of returns, in economics, the quantitative change in
output of a firm or industry resulting from a proportionate
increase in one input , where other inputs are fixed.
Law of returns can be
1.Law of increasing return
2.Law of constant return
3.Law of diminishing return.
Note: law of returns is associated with short term , because in
short term there are some fixed factors and returns to scale is
associated with long term ,because in long run all the factors
are variable.

9. Example
 Look at the table below. Let us assume that the firm in
question is making computer laser printers and they
have four machines in the factory (capital = 4).
Capital Labour (L)
Marginal
product (MP)
Total product
(TP)
Average
product (AP)
4 0 - 0 -
4 1 5 5 5.0
4 2 8 13 6.5
4 3 10 23 7.7
4 4 11 34 8.5
4 5 10 44 8.8
4 6 7 51 8.5
4 7 4 55 7.9
4 8 1 56 7.0
4 9 -2 54 6.0

10. Law of increasing return
If the output of a firm increases at a rate higher than the
rate of increase in one input while others factors are
held constant, the production is said to exhibit
increasing returns to scale.
A concept in economics that if one factor of production
(number of workers, for example) is increased while
other factors (machines and workspace, for example)
are held constant, the output will rise increasingly at
the primary stage.

12. Law of constant returns:
If the output of a firm increases at a rate equal to the the
rate of increase in one input while others factors are
held constant, the production is said to exhibit
constant law of returns.
A concept in economics that if one factor of production
(number of workers, for example) is increased while
other factors (machines and workspace, for example)
are held constant, the output will rise proportionately
at the middle stage.

14. Law of diminishing returns
“A concept in economics that if one factor of
production (number of workers, for example)
is increased while other factors (machines and
workspace, for example) are held constant, the
output per unit of the variable factor will
eventually diminish.”
“The law of diminishing returns is a classic
economic concept that states that as more
investment in an area is made, overall return on
that investment increases at a declining rate,
assuming that all variables remain fixed.”

16. Returns to Scale
 returns to scale, in economics, the quantitative change
in output of a firm or industry resulting from a
proportionate increase in all inputs.
 If the quantity of output rises by a greater proportion—
e.g., if output increases by 2.5 times in response to a
doubling of all inputs—the production process is said
to exhibit increasing returns to scale. Such economies
of scale may occur because greater efficiency is
obtained as the firm moves from small- to large-scale
operations.
 Decreasing returns to scale occur if the production
process becomes less efficient as production is
expanded, as when a firm becomes too large to be
managed effectively as a single unit

17. Returns to Scale
 In economics, returns to scale describes what
happens when the scale of production increases
over the long run when all input levels are variable
(chosen by the firm).
 There are three stages in the returns to scale:
increasing returns to scale (IRS), constant returns
to scale (CRS), and diminishing returns to scale
(DRS).
 Returns to scale vary between industries, but
typically a firm will have increasing returns to
scale at low levels of production, decreasing
returns to scale at high levels of production, and
constant returns to scale at some point in the
middle .

18. Returns to Scale
 (1) Increasing Returns to Scale:

 If the output of a firm increases at a rate higher than
the rate of increase in all inputs, the production is said
to exhibit increasing returns to scale.

 For example, if the amount of inputs are doubled and
the output increases by more than double, it is said to
be an increasing returns returns to scale. When there
is an increase in the scale of production, it leads to
lower average cost per unit produced as the firm enjoys
economies of scale.

19. (3) Diminishing Returns to Scale:
The term 'diminishing' returns to scale refers to
scale where output increases in a smaller
proportion than the increase in all inputs.
For example, if a firm increases inputs by 100% but
the output decreases by less than 100%, the firm is
said to exhibit decreasing returns to scale. In case
of decreasing returns to scale, the firm faces
diseconomies of scale. The firm's scale of
production leads to higher average cost per unit
produced.
Increasing, constant, and diminishing returns to
scale describe how quickly output rises as inputs
increase

21. Explanation
 The figure 11.6 shows that when a firm uses one unit of
labor and one unit of capital, point a, it produces 1 unit
of quantity as is shown on the q = 1 isoquant. When the
firm doubles its outputs by using 2 units of labor and 2
units of capital, it produces more than double from q
= 1 to q = 3.
 So the production function has increasing returns to
scale in this range. Another output from quantity 3 to
quantity 6. At the last doubling point c to point d, the
production function has decreasing returns to scale. The
doubling of output from 4 units of input, causes output
to increase from 6 to 8 units increases of two units only.

22. Iso product curve/Iso quant curve
 An iso quant may be defined as a curve
showing all the various combinations of two
factors that can produce a given level of
output
 In Latin, "iso" means equal and "quant" refers to
quantity. This translates to "equal quantity". The
isoquant curve helps firms to adjust their inputs to
maximize output and profits.
 A graph of all possible combinations of inputs that
result in the production of a given level of output.

23.  An isocost line is a term used in economics. It
shows all combinations of inputs which cost
the same total amount.
 An isoquant is a firm’s counterpart of the
consumer’s indifference curve. An isoquant is a
curve that show all the combinations of inputs
that yield the same level of output. ‘Iso’ means
equal and ‘quant’ means quantity. Therefore, an
isoquant represents a constant quantity of output.
The isoquant curve is also known as an “Equal
Product Curve” or “Production Indifference Curve”
or Iso-Product Curve.”

24.  The concept of isoquants can be easily explained with
the help of the table given below:
 Table 1: An Isoquant Schedule
Combinations of
Labor and Capital
Units of Labor (L) Units of Capital (K)
Output of Cloth
(meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100

25.  The above table is based on the assumption that only
two factors of production, namely, Labor and Capital are
used for producing 100 meters of cloth.
 Combination A = 5L + 9K = 100 meters of cloth
 Combination B = 10L + 6K = 100 meters of cloth
 Combination C = 15L + 4K = 100 meters of cloth
 Combination D = 20L + 3K = 100 meters of cloth
 The combinations A, B, C and D show the possibility of
producing 100 meters of cloth by applying various
combinations of labor and capital. Thus, an isoquant
schedule is a schedule of different combinations of
factors of production yielding the same quantity of
output.
 An iso-product curve is the graphic representation of an
iso-product schedule.

26. Thus, an iso quant is a curve showing all combinations of labor
and capital
that can be used to produce a given quantity of output.

27.  Isoquant Map
 An isoquant map is a set of isoquants that shows the
maximum attainable output from any given
combination inputs.

28. Isoquants Vs Indifference Curves
 Isoquants Vs Indifference Curves
 An isoquant is similar to an indifference curve in more
than one way. The properties of isoquants are similar
to the properties of indifference curves. However,
some of the differences may also be noted. Firstly, in
the indifference curve technique, utility cannot be
measured. In the case of an isoquant, the product can
be precisely measured in physical units. Secondly, in
the case of indifference curves, we can talk only about
higher or lower levels of utility. In the case of isoquants
, we can say by how much IQ2 actually exceeds IQ1
(figure 2).

29. Properties of isoquants:
 Properties of isoquants:
 1. Convex to the origin.
2. Slopes downward to the right.
3. Never parallel to the x-axis or y-axis.
4. Never horizontal to the x-axis or y-axis.
5. No 2 curves intersect each other.
6. Each iso quant is a part of an oval.
7. It cannot have a positive slope.
8. It cannot be upward sloping

30. Each iso quant is oval-shaped
 An important feature of an isoquant is that it enables
the firm to identify the efficient range of production
consider figure 11

31.  In economics an isocost line shows all
combinations of inputs which cost the same
total amount.
 The isocost line is an important component
when analysing producer’s behaviour. The
isocost line illustrates all the possible
combinations of two factors that can be
used at given costs and for a given
producer’s budget. In simple words, an
isocost line represents a combination of
inputs which all cost the same amount.
Iso cost curve:

32.  Now suppose that a producer has a total
budget of Rs 120 and and for producing a
certain level of output, he has to spend this
amount on 2 factors A and B. Price of factors
A and B are Rs 15 and Rs. 10 respectively.

33. Combinations Units of Capital Units of Labour Total expenditure
Price = 150Rs Price = 100 Rs ( in Rupees)
A 8 0 120
B 6 3 120
C 4 6 120
D 2 9 120
E 0 12 120

35. What is isocost line?
 What is isocost line?
 An isocost line is also called outlay line or price line or
factor cost line. An isocost line shows all the
combinations of labour and capital that are available
for a given total cost to the producer. Just as there are
infinite number of isoquants, there are infinite
number of isocost lines, one for every possible level of
a given total cost. The greater the total cost, the further
from origin is the isocost line. The isocost line can be
explained easily by taking a simple example.

37.  Let us examine a firm which wishes to spend
Rs.100 on a combination of two factors labour and
capital for producing a given level of output. We
suppose further that the price of one unit of labour
is Rs. 5 per day. This means that the firm can hire
20 units of labour. On the other hand if the price
of capital is Rs.10 per unit, the firm will purchase
10 units of capital. In the fig. 12.7, the point A
shows 10 units of capital used whereas point T
shows 20 ‘units of labour are hired at the given
price. If we join points A and T, we get a line AT.
This AT line is called isocost line or outlay line.
The isocost line is obtained with an outlay of
Rs.100.

38.  Let us assume’ now that there is no change in the market
prices of the two factors labour and capital but the firm
increases the total outlay to Rs.150. The new price line BK
shows that with an outlay of Rs.150, the producer can
purchase 15 units of capital or 30 units of labour. The new
price line BK shifts upward to the right. In case the firm
reduces the outlay to Rs.50 only, the isocost line CD shifts
downward to the left of original isocost line and remains
parallel to the original price line.
 The isocost line plays a similar role in the firm’s decision
making as the budget line does in consumer’s decision
making. The only difference between the two is that the
consumer has a single budget line which is determined by
the income of the consumer. Where as the firm faces many
isocost lines depending upon the different level of
expenditure the firm might make. A firm may incur low
cost by producing relatively lesser output or it may incur
relatively high cost by producing a relatively large quantity.

39. Iso cost curve:
 Although similar to the budget constraint in consumer
theory, the use of the isocost line relates to cost-
minimization in production, as opposed to utility-
maximization. For the two production inputs labour
and capital, with fixed unit costs of the inputs, the
equation of the isocost line is
 where w represents the wage rate of labour, r
represents the rental rate of capital, K is the amount of
capital used, L is the amount of labour used, and C is
the total cost of acquiring those quantities of the two
inputs

40. Least cost combination or producers
equilibrium
A rational firm combines the various
factors of production in such a way that
gives maximum output from minimum
input and minimum cost.
Such a combination is referred to as
the least cost combination.

41. 41
0 1 2 3 4 5 6 7 8 9 10
Capital,K(machinesrented)
2
4
6
8
10
Labor, L (worker-hours employed)
a
equ.
W = $6; R = $3;C = $30
Choose the recipe where the
desired isoquant is tangent to
the lowest isocost.
C = $18
12
C = $36

42. Producers equilibrium or least
cost combination
 producers equilibrium is achieved with isoquants and
isocost curves

43. Least Cost Decision Rule
The least cost combination of two inputs
(i.e., labor and capital) to produce a
certain output level
 Occurs where the iso-cost line is tangent to
the isoquant
 Lowest possible cost for producing that
level of output represented by that isoquant
 This tangency point implies the slope of the
isoquant = the slope of that iso-cost curve at
that combination of inputs

44. Explanation

45.  In figure 2, NM is the firm’s isocost line. Isoquants
IQ1, IQ2 and IQ3 represent different levels of
output. Equilibrium is attained at the point where
the isoquant is tangent to the isocost line. The
isocost line NM sets the upper boundary for the
purchase of the inputs when outlay and input
prices are given.
 Outlay is not sufficient to move to IQ3. Likewise,
the segments of isoquants falling below the isocost
line indicate under-utilization of his outlay fully.
Rationality on the part of the producer requires
full utilization of resources for optimization of
output.

46.  Points A and B also satisfy the tangency
condition and they lie within the reach of the
producer. However, at these points the firm
remains at a lower isoquant IQ1, which yields a
lesser level of output than that on IQ2. Thus, E is
the point of equilibrium from where there is no
tendency on the part of the producer to move
away. The firm will get its maximum output
when it employs OL0 units of labor and OK0
units of capital.

47. Cost functionCost function is the relationship between production
cost and production. Generally an increase in
production rises the production cost and an decrease
in production decreases the production cost.
C=f(q)

48. Short-run and long run cost function
 Short run cost function: it is the relationship between
production cost and quantity of production in short
term. Fixed cost exists in short term. In short term-
 Total cost= total fixed cost + total variable cost
 In short run some costs are not change in response to
increase or decrease in production. Those are fixed
costs.
 Example: abc corporation has 10 sewing machines and
10 workers . It receives an order for 10,000 pieces of
rmg products whereby it should supply as per order
with in 2 weeks. In this situation the owner will not
establish new machine. He will try to accomplish the
order by increasing the number of labours or workers.
so here we see labour is variable and capital is fixed.

49.  Long run cost function:
economists define the long-run as being the time
period when all the factors of production can be
changed. In long run all the costs of production
are variable.
Relationship between variable costs and production
in long run is called long run production cost
function.
Short-run and long run cost function

50. Concepts of cost
Total cost is the cost incurred to produce a quantity of
output. A total cost schedule shows the total cost for
various output amounts
Fixed Cost
Fixed cost is the cost that does not increase with the
increase in production. Firms have to commit costs for
production capacity at the start of a period and they have
to incur these costs irrespective of the production
output. Such committed capacity costs are termed fixed
cost for a period.
Variable Cost
Variable cost is incurred when production is there and it
varies with the level of output.

51. Marginal Cost
At each output level or at any output level,
marginal cost of production is the additional cost
incurred in producing one extra unit of output.
Marginal cost can be calculated as the difference
between the total costs or producing two adjacent
output levels. The difference in variable cost of two
adjacent output levels also gives marginal cost, as
fixed cost is constant for the two levels.
Marginal cost is a central economic concept with a
crucial important role to play in resource
allocation decisions by organizations.

52. Average Costs or Units Costs
Average cost or unit cost is the total cost
divided by number of units produced.
Average fixed cost is total fixed cost
divided by number of units produced. It
keeps on decreasing as output increases.
Average variable cost is total variable cost
divided by number of units produced.

53. Relationship among total , average
and marginal cost
Quantity (Q) Total cost(TC) Average
cost(AC)
Marginal cost
(MC)
1 unit
2unit
3 unit
4 unit
Tk.5
Tk.8
Tk.12
Tk.20
Tk.5
Tk.4
Tk.4
Tk.5
Tk.5
Tk.3
Tk.4
Tk.8

54. 1.When the production increases total cost also
increases but average cost and
marginal cost decreases. That means total cost increases
in decreasing trend.
2.Marginal cost decreases at a rate higher than the rate
of decrease in average cost.
3.When the average cost is lowest it is equal to marginal cost
at this production level.
4.From this level of production , if we increases the
production total cost will increase
In increasing trend.
5.When average cost increases, marginal
cost increases at a higher rate than AC.

56. Relationship between production
function and cost function
1. when TP rises increasingly then TC rises
decreasingly. Again ,when TP rises decreasingly
then TC rises increasingly.

57.  2.If AP rises, MP rises at a higher rate. If AC
decreases, MC decreases at a higher rate.
3.When AP decreases , MP decreases at a
higher rate. when AC increases, MC
increases at a higher rate.
4.MP curve intersects AP curve at a point
where AP is highest. MC curve intersects ac
curve when ac is lowest.

59. Short-run
Economists define the short run as being the time period when at
least one of the factors of production is completely fixed. For
example, for a particular company this might mean that they
have reached full capacity in a warehouse or at a factory site.
These short-run costs consist of both fixed and variable costs.
These are both defined fully in the “Key Terms” section.
Long-run
In contrast, economists define the long-run as being the time
period when all the factors of production can be changed. So in
the example above, the company can now look to expand its
warehouse or factory capacity without any problems.
Cost in short and long run:
Long run costs have no fixed factors of production, while short run
costs have fixed factors and variables that impact production.

60. Producers equilibrium
 Producers equilibrium (MC = MR)

61. Concepts of revenue
 Meaning of Revenue:
 The amount of money that a producer receives in
exchange for the sale proceeds is known as revenue.
For example, if a firm gets Rs. 16,000 from sale of 100
chairs, then the amount of Rs. 16,000 is known as
revenue.
 Revenue refers to the amount received by a firm from
the sale of a given quantity of a commodity in the
market.
 Revenue is a very important concept in economic
analysis. It is directly influenced by sales level, i.e., as
sales increases, revenue also increases.

62. Concept of Revenue
 The concept of revenue consists of three important
terms; Total Revenue, Average Revenue and Marginal
Revenue.

63.  Total Revenue (TR):
 Total Revenue refers to total receipts from the sale of a
given quantity of a commodity. It is the total income of a
firm. Total revenue is obtained by multiplying the quantity
of the commodity sold with the price of the commodity.
 Total Revenue = Quantity × Price
 For example, if a firm sells 10 chairs at a price of Rs. 160 per
chair, then the total revenue will be: 10 Chairs × Rs. 160 =
Rs 1,600
 Average Revenue (AR):
 Average revenue refers to revenue per unit of output sold. It
is obtained by dividing the total revenue by the number of
units sold.
 Average Revenue = Total Revenue/Quantity
 For example, if total revenue from the sale of 10 chairs @
Rs. 160 per chair is Rs. 1,600, then:
 Average Revenue = Total Revenue/Quantity = 1,600/10 = Rs
160

64.  Marginal Revenue (MR):
 Marginal revenue is the additional revenue generated from the
sale of an additional unit of output. It is the change in TR from
sale of one more unit of a commodity.
 MRn = TRn-TRn-1
 Where:
 MRn = Marginal revenue of nth unit;
 TRn = Total revenue from n units;
 TR n-1 = Total revenue from (n – 1) units; n = number of units sold
 For example, if the total revenue realised from sale of 10 chairs is
Rs. 1,600 and that from sale of 11 chairs is Rs. 1,780, then MR of the
11th chair will be:
 MR11 = TR11 – TR10
 MR11 = Rs. 1,780 – Rs. 1,600 = Rs. 180

65.  AR and Price are the Same:
 We know, AR is equal to per unit sale receipts
and price is always per unit. Since sellers
receive revenue according to price, price and
AR are one and the same thing.
 This can be explained as under:
 TR = Quantity × Price … (1)
 AR = TR/Quantity …… (2)
 Putting the value of TR from equation (1) in
equation (2), we get
 AR = Quantity × Price / Quantity
 AR = Price

66. Additional data
 Total cost (TC) is the sum of all the different
costs they incur when producing and selling their
product.
Average cost (AC) is the total cost divided by the
quantity of goods:
 AC = TC/q
 Marginal cost (MC) is the extra cost incurred in
producing one more of the product. This can be
found by measuring the slope of the TC curve:
 MC = (change in TC)/(change in q)

67.  Costs can also be broken down into
types of costs:
 Total variable costs (TVC) refers to costs
which vary with the amount of goods a firm
makes and sells. An example of TVC could
be the cost of chocolate chips, if the firm
makes chocolate chip cookies.
 Total fixed costs (TFC) refers to costs THAT
a firm has to pay, no matter how much or
how little it produces. One example might
be the monthly rent on a store.

68.  Added together, TVC and TFC are equal to
TC:
 TVC + TFC = TC
 TVC and TFC, when divided by q, yield
average variable cost (AVC) and average
fixed cost (AFC):
 AVC = TVC/q
AFC = TFC/q
 Added together, AVC and AFC are equal to
AC:
 AVC + AFC = AC

69.  We can also find the marginal variable cost
(MVC) and the marginal fixed cost (MFC) by
taking the slopes of the two curves. Because
fixed costs don't change with quantity, however,
the MFC will be 0:
 MVC = (change in TVC)/(change in q)
MFC = (change in TFC)/(change in q) = 0
 Added together, MVC and MFC are equal to MC,
but since MFC is 0, the marginal cost is equal to
the marginal variable cost:
 MVC + MFC = MC
MVC + 0 = MC
MVC = MC

70.  If we can combine a firm's costs and
revenues, we can calculate the firm's profits.
Using the variables we have been working
with, we can represent profit as:
 Profit = TR - TC
TR - TC = q(AR - AC) = q(P - AC)
Profit = q(P - AC)