Theory of Production and Cost for CA Foundation
How output responds to inputs in the short and long run, and how costs behave as output changes.
Business EconomicsPaper 413 MCQs2 lessons2 flashcards3 memory tricks
Practise Theory of Production and Cost free
What you'll learn
- Production function and returns
Explain the law of variable proportions and returns to scale. - Cost concepts and curves
Calculate and interpret TC, TFC, TVC, AC, AVC, AFC and MC.
Key formulas
| Total cost | TC = TFC + TVC |
|---|---|
| Average fixed cost | AFC = TFC ÷ Q |
| Average variable cost | AVC = TVC ÷ Q |
| Average total cost | ATC = TC ÷ Q = AFC + AVC |
| Marginal cost | MC = TCₙ − TCₙ₋₁ |
Concepts explained
Total, average and marginal product
TP is total output, AP = TP ÷ L, MP = change in TP from one more unit of the variable input. Their shapes follow the law of variable proportions.
What it means
- TP is maximum when MP = 0.
- AP is maximum when MP = AP.
- Stage I: AP rising. Stage II: MP falling but positive (rational stage). Stage III: MP negative.
- TP with 1–4 workers: 10, 24, 33, 36
- MP = 10, 14, 9, 3
Answer: Diminishing returns begin with the 3rd worker
Related terms
- Returns to a factor: short-run change in output from one input
- Returns to scale: long-run change when all inputs change
Exam tip: The batting-average rule: a score (MP) above average raises the average (AP); below it lowers it.
Cost concepts and cost curves
TC = TFC + TVC. Fixed costs don't change with output; variable costs do. Average and marginal costs follow from these.
What it means
- AFC = TFC ÷ Q falls continuously (rectangular hyperbola).
- AVC, ATC and MC are U-shaped in the short run; MC cuts AVC and ATC at their minimum points.
- MC = TCₙ − TCₙ₋₁.
- Explicit costs are paid to outsiders; implicit costs are the owner's own resources (interest on own capital).
- TC of 10 units ₹500, of 11 units ₹540
Answer: MC of 11th unit = ₹40
- TC of 5 units ₹300, TFC ₹100
- TVC = ₹200
Answer: AVC = ₹40
Related terms
- Envelope curve: long-run AC curve
- Normal profit: part of economic cost
Exam tip: At zero output, total cost = total fixed cost.
Returns to scale
Returns to scale describe how output changes when all inputs are increased in the same proportion in the long run.
What it means
- Increasing returns: output rises more than proportionately.
- Constant returns: output rises in the same proportion.
- Decreasing returns: output rises less than proportionately.
- Cobb–Douglas Q = A Lᵅ Kᵝ: α + β = 1 constant, > 1 increasing, < 1 decreasing.
- Labour and capital doubled
- Output rises from 100 to 250
Answer: Increasing returns to scale
Related terms
- Economies of scale: cost savings as the scale of production grows
Exam tip: Don't confuse with diminishing returns, which is a short-run idea with one variable factor.
Memory tricks
Stage I increasing returns; Stage II diminishing but positive MP (rational); Stage III negative MP.
MC cuts AVC and ATC at their minimum points.
In Q = A Lᵅ Kᵝ, returns to scale depend on α + β.
Try 3 CA Foundation-style questions
Q1. Implicit costs are
- payments to outsiders such as wages and rent
- costs shown only in the cash book
- the costs of self-owned factors used in the business, such as interest on the owner's capital
- taxes paid to government
Show answer
Answer: (3) the costs of self-owned factors used in the business, such as interest on the owner's capital
Implicit (imputed) costs are the opportunity costs of the owner's own resources; explicit costs are payments to outsiders.
Q2. The short run is a period in which
- all factors are variable
- at least one factor of production is fixed
- only labour is fixed
- output cannot change
Show answer
Answer: (2) at least one factor of production is fixed
In the short run some inputs (like plant size) can't be changed, so output changes only by varying variable inputs.
Q3. Total cost of 5 units is ₹300 and total fixed cost is ₹100. The average variable cost is
- ₹40
- ₹60
- ₹20
- ₹200
Show answer
Answer: (1) ₹40
TVC = TC − TFC = 300 − 100 = ₹200; AVC = 200 ÷ 5 = ₹40.
Practise all 13 questions Free · explanations for every option · see where you go wrong