Production Function: Meaning, Features, and Types

Production is a process that business uses to convert inputs into outputs. Production involves a
series of activities that convert the inputs into outputs that people can use for the fulfillment of
their needs. Production is basically the transformation of inputs into output. Input is anything
that is utilised in the creation of a commodity and Output is something that gets produced at
the end of the production process. The relationship between inputs and outputs is defined
using Production Function.

What is Production Function?

Production Function is the relationship between physical inputs (land, labour, capital, etc.)
and physical outputs (quantity produced). It is a technical relationship (not an economic
relationship) that studies material inputs on one hand and material outputs on the other hand.
Material inputs include variable and fixed factors of production.
In the words of Watson, “Production Function is the relationship between a firm’s production
(output) and the material factors of production (input).”

Assumptions of Production Function:

 Both inputs and outputs are divisible.
 There are only two factors of production, i.e., land (Variable element) and capital (Fixed
element).
 Factors of production are imperfect substitutes.
 Technology is constant.

Algebraic and Graphical Representation of Production Function

In a standard equation, the Production function is represented by Q, Labour (Variable element)
is represented by L, and Capital (Fixed element) is represented by K.
Q = f(L,K)
For example, When there are 4 units of labour and 5 units of capital, the equation for the
production function is Q = f(4,5).
In the above graph, X-axis represents inputs that are being used in the production process and
Y-axis represents outputs that get produced. Q is the Production Function.
Variable Factors are the factors that can be changed during the course of the short run.
Variable factors vary with the level of output. An increase in variable factors leads to more
production and vice-versa. Employment of variable factors is not required when there is no
production. Variable factors include labour, power, fuel, etc.
Fixed Factors are the factors that can not be changed in the short run. The number of fixed
factors always remains constant even when is zero production. Fixed factors include land,
capital, building, etc.
Note: Production in the short run can only be increased by increasing the variable factor.
Features of Production Function
1. Complementary: A producer will have to combine the inputs to produce outputs. Outputs
cannot get generated without the use of inputs.
2. Specificity: For any given output, the combination of inputs that may be used is clearly
defined. What types of factors are needed for the production of a particular product is clearly
mentioned before the actual production gets started.
3. Production Period: The period of the production process is clearly explained to the
production unit. Each stage of production is given some specific time. Production generally
gets completed over a long period of time.

Types of Production Function

Production function on the basis of the time period can be divided into two categories: Short
Run Production Function and Long Run Production Function. In these production
functions, the combination and behaviour of variable factors and fixed factors are different.

1. Short Run Production Function:

Short Run is a period of time where output can only be changed by changing the level of
variable inputs. In the short run, some factors are variable and some are fixed. Fixed factors
remain constant in the short run like land, capital, plant, machinery, etc. Production can be
raised by only increasing the level of variable inputs like labour. Therefore, the situation where
the output is increased by only increasing the variable factors of input and keeping the fixed
factors constant is termed as Short Run Production Function. This relationship is explained
by the ‘Law of Variable Proportions.’

2. Long Run Production Function:

Long Run is a span of time where the output can be increased by increasing all the factors of
production whether it is fixed (land, capital, plant, machinery, etc.) or variable (labour). Long
run is enough time to alter all the factors of production. All factors are said to be variable in the
long run. Therefore, the situation where the output is increased by increasing all the inputs
simultaneously and in the same proportion is termed Long Run Production Function. This
relationship is explained by the ‘Law of Returns to Scale.’

Concept of Product
Product or output refers to the volume of the goods that the company produces using inputs
during a specified period of time. The concept of product can be looked at from three different
angles: Total Product, Marginal Product, and Average Product.
1. Total Product:
Total Product (TP) refers to the total quantity of goods that the firm produced during a given
course of time with the given number of inputs. Total Product is also known as Total Physical
Product (TPP) or Total Output or Total Return. For example, if 6 labours produce 10 kg of
wheat, then the total product is 60 kg. A company can increase TP in the short term by
focusing primarily on the variable components. But over time, both fixed and variable
elements can be increased to raise TP.
 2. Average Product:
Average Product refers to output per unit of a variable input. AP is calculated by dividing TP
by units of the variable factor. For example, if the total product is 60 kg of wheat produced by
6 labours (variable inputs), then the average product will be 60/6, i.e., 10 kg.

Average Product =

3. Marginal Product:
Marginal Product refers to the addition to the total product when one more unit of a variable
factor is employed. It calculates the extra output per additional unit of input while keeping all
other inputs constant. Other names of Marginal Product are Marginal Physical Product
(MPP) or Marginal Return.
MPn = TPn – TPn-1
Here,
MPn = Marginal product of n th unit of the variable factor,
TPn = Total product of n units of the variable factor, and
TPn-1 = Total product of (n-1) units of the variable factor

Laws of Returns to Scale

Production is a crucial economic activity because it improves the utility of a product by
transforming it into the form required by the consumer. Leather, for example, is less commonly
utilized in its raw state until it is converted into attractive products such as shoes, bags, and other
accessories. To an economist, production refers to any process that transforms one or more
commodities into another. The link between a firm’s outputs and inputs is the production
function. Production refers to the transformation of inputs into outputs. The rate at which output
changes when all inputs are adjusted simultaneously is referred to as returns to scale. Returns to
scale is a metric that evaluates the change in productivity after increasing all production inputs
over time.

The law of Return to Scale in Production Functions

Changes in output when all factors change in the same proportion are referred to as the law of
return to scale. This law applies only in the long run when no factor is fixed, and all factors are
increased in the same proportion to boost production.

There are three stages in all.

 Increasing the scale’s return

 Constant scale returns
 Decrease in Returns on the scale

Unitof Unitof % increase in labour Total % increase Stages

Labour capital and capital production in TP

1 3 – 10 – increasing

2 6 100% 30 200%

3 9 50% 60 100%

4 12 33% 80 33% constant

5 15 25% 100 25%

6 18 20% 110 10%

diminishing

7 21 16.6% 120 8.3%

Increasing returns to scale

It describes a condition in which all of the factors of production are raised, resulting in a higher
rate of output. For example, if inputs are raised by 10%, the output will be increased by 20%.

Reasons

 Due to the economy of scale

 Specialisation through better division of labour

Constant returns to scale

It describes a condition in which all of the factors of production are increased at the same time,
resulting in a steady growth in output. For example, if inputs are raised by 10%, the output is
also increased by 10%.
 Reasons

As the firm’s production grows, it reaches a point where all of the economy’s resources have
been fully utilised, and output equals input.

Diminishing returns to scale

When all of the production factors are increased simultaneously, output grows at a slower rate.
For example, if inputs are raised by 10%, the output will be increased by 5%.

Reasons

 The major cause of diminishing returns to scale is large-scale economies, diseconomies of scale
occur when a company has grown to such a size that it is difficult to manage
 Lack of coordination

Assumptions of Return to scale

The following are the returns to scale assumptions:

Capital and labour are the only two variables of production used by the company.

In a fixed proportion, labour and capital are integrated.

Factor prices do not fluctuate, and the State of technology remains the same.

Difference between return to scale and return to a factor

 Return to factor has only one variable while the rest of the factors remain constant, whereas
return to scale has all of the variables changing
 In return for factor, the factor proportion changes as more and more variable factor units raise
production
 In return to scale, the factor proportion remains constant when factors are re-added in the same
proportion to increase output
 When you return to a factor, you get a negative return. Returning to scale has the effect of
decreasing returns
 Return to scale is a long-term phenomenon, whereas return to a factor is a one-time event
 Difference between variable factor and fixed factor

 Variable factors can be modified in the short run, whereas fixed factors cannot be changed in the
short run
 Variable factors fluctuate immediately with output, whereas fixed factors do not vary directly
with output
 Variable factors include raw materials, casual labour, power, and fuel, whereas fixed factors
include expenses related to buildings, plant and machinery, components, etc

What do you mean by short run and long run?

In the short run, the output can be modified by altering only variable factors, whereas, in the long
run, the output may be changed by changing all production factors. In the long run, all factors are
changeable. However, the production factors are increased simultaneously. Demand is active in
price determination in the short run since supply cannot be raised quickly with a rise in demand.
However, in the long run, both demand and supply play equal roles in the determination of price
because both may be increased.

Conclusion

Return to scale is a metric that evaluates the change in productivity after increasing all
production inputs over time. The rate at which output changes when all inputs are adjusted
simultaneously is referred to as returns to scale.

Return to scale is important to study as it is a metric in economics that is used to measure its
efficiency. A company’s production is efficient if it can maintain its current output while
utilizing fewer inputs or resources or increase output while using the same amount of input.

Law of Returns to Scale : Definition, Explanation and Its Types

In the long run all factors of production are variable. No factor is fixed. Accordingly, the
scale of production can be changed by changing the quantity of all factors of production.

Definition:
“The term returns to scale refers to the changes in output as all factors change by the same
proportion.” Koutsoyiannis

“Returns to scale relates to the behaviour of total output as all inputs are varied and is a long
run concept”. Leibhafsky
Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Explanation:
In the long run, output can be increased by increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an increase in output due to increase in all factors
in the same proportion. Such an increase is called returns to scale.

1. Increasing Returns to Scale:

Increasing returns to scale or diminishing cost refers to a situation when all factors of
production are increased, output increases at a higher rate. It means if all inputs are doubled,
output will also increase at the faster rate than double. Hence, it is said to be increasing
returns to scale. This increase is due to many reasons like division external economies of
scale. Increasing returns to scale can be illustrated with the help of a diagram 8.

In figure 8, OX axis represents increase in labour and capital while OY axis shows increase
in output. When labour and capital increases from Q to Q 1, output also increases from P to
P1 which is higher than the factors of production i.e. labour and capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all the
factors of production are increased in a given proportion, output increases in a smaller
proportion. It means, if inputs are doubled, output will be less than doubled. If 20 percent
increase in labour and capital is followed by 10 percent increase in output, then it is an
instance of diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that internal and external
economies are less than internal and external diseconomies. It is clear from diagram 9.
In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour and
capital are given while on OY axis, output. When factors of production increase from Q to
Q1 (more quantity) but as a result increase in output, i.e. P to P 1 is less. We see that increase
in factors of production is more and increase in production is comparatively less, thus
diminishing returns to scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which output
increases exactly in the same proportion in which factors of production are increased. In
simple terms, if factors of production are doubled output will also be doubled.

In this case internal and external economies are exactly equal to internal and external
diseconomies. This situation arises when after reaching a certain level of production,
economies of scale are balanced by diseconomies of scale. This is known as homogeneous
production function. Cobb-Douglas linear homogenous production function is a good
example of this kind. This is shown in diagram 10. In figure 10, we see that increase in
factors of production i.e. labour and capital are equal to the proportion of output increase.
Therefore, the result is constant returns to scale.
What is Cost?
Cost refers to the total expenditure made on inputs or resources that are used for the production
of final goods or services. The resources used by a firm are limited in nature and thus require
efficient allocation to maximise the firm’s profit. The cost or economic cost of a firm consists
of all the expenses it faces, can manage, and are beyond its control. For example, cost of labor,
capital, and raw materials. Besides other resources, a firm may also use those resources whose
expenses are not that clear but are still essential for the firm.
The cost is the sum of the Explicit Cost and Implicit Cost.
 Explicit Cost: The actual expenditure made on the inputs or the payments made to the
outsiders to hire their factor services is known as Explicit Cost. For example, wages paid
to the workers, payment for land, payment for raw materials, etc.
 Implicit Cost: The estimated value of the inputs supplied by the owners along with the
normal profits is known as Implicit Cost. For example, estimated rent on own land,
imputed salary for the entrepreneur’s services, etc.
There are different types of economic costs such as Opportunity Costs, Sunk Costs, Average
Costs, Marginal Costs, Fixed Costs, and Variable Costs.
What is Total Cost?
In the short run, some of the factors are fixed, while other factors are variable. In the same
way, the short-run costs are also categorised into two different kinds of cost; viz., Fixed
Costs and Variable Costs. The sum total of these costs is equal to the Total Cost.

1. Total Fixed Cost (TFC) or Fixed Cost (FC):

The costs on which the output level does not have a direct impact are known as Fixed
Costs. For example, salary of staff, rent on office premises, interest on loans, etc. Other names
of fixed costs are Supplementary Cost, Overhead Cost, Unavoidable Cost, Indirect
Cost, or General Cost. Fixed cost is the cost spent on fixed factors such as land, building,
machinery, etc. The amount spent on these factors cannot be changed in the short run. Also, the
payment made on these factors remains the same whether the output is small, large, or zero.

2. Total Variable Cost (TVC) or Variable Cost (VC):

The costs on which the output level has a direct impact are known as Variable Costs. For
example, fuel, power, payment for raw materials, etc. Other names of variable costs are Prime
Cost, Avoidable Cost, or Direct Cost. In other words, variable cost is the cost spent on
variable factors such as power, direct labour, raw material, etc. The amount spent on these
factors changes with the change in output level. Also, these costs arise till there is production
and become zero at zero output level.

3. Total Cost (TC):

The total expenditure incurred by an organisation on the factors of production which are
required for the production of a commodity is known as Total Cost. In simple terms, total cost
is the sum of total fixed cost and total variable cost at different output levels.
TC = TFC + TVC
As the Total Fixed Cost remains the same at all output levels, the change in Total Cost
completely depends upon Total Variable Cost.
What is Average Cost?
Average Costs are the per unit costs which explain the relationship between the cost and
output in a realistic manner. These per-unit costs are obtained from Total Fixed Cost, Total
Variable Cost, and Total Cost. The three different types of per-unit costs are as follows:

1. Average Fixed Cost (AFC):

The per unit fixed cost of production is known as Average Fixed Cost. The formula for
calculating Average Fixed Cost is:
With an increase in the output, Average Fixed Cost falls. It is because the total fixed cost
remains the same at all output levels.
AFC curve does not touches X-axis and Y-axis.
AFC is a rectangular hyperbola and hence approaches both the axes. The curve gets near to
the axes, but never touches them. It means that AFC can neither touch X-axis (because TFC
can never be zero) nor Y-axis (because TFC is positive at zero output level and if we divide
any value by zero, it will be an infinite value).

2. Average Variable Cost (AVC):

The per unit variable cost of production is known as Average Variable Cost. The formula for
calculating Average Variable Cost is:

Initially, Average Variable Cost falls with an increase in output. Once the output increases till
the optimum level, the average variable cost starts to rise.

3. Average Total Cost (ATC) or Average Cost (AC):

The per unit total cost of production is known as Average Total Cost or Average Cost. The
formula for calculating Average Total Cost is:

Another way to define Average Total Cost is by the sum of Average Fixed Cost and Average
Variable Cost; i.e., AC = AFC + AVC.
Just like Average Variable Cost, average cost also initially falls with an increase in output.
Once the output increases till the optimum level, the average cost starts to rise.
What is Marginal Cost?
The additional cost incurred to the total cost when one more unit of output is produced is
known as Marginal Cost. For example, if the total cost of producing 2 units is ₹400 and the
total cost of producing 3 units is ₹600, then the marginal cost will be 600 – 400 = ₹200.
MCn = TCn – TCn-1
Where,
n = Number of units produced
MCn = Marginal cost of the n th unit
TCn = Total cost of n units
TCn-1 = Total cost of (n-1) units
Another way to calculate Marginal Cost:
When the change in the units produced is more than one unit, then the previous formula of
calculating MC will not work. In that case, the formula for calculating Marginal Cost will be:

For example, if the total cost of producing 5 units is ₹700 and the total cost of producing 3
units is ₹250, then the marginal cost will be:

Marginal Cost = ₹225

Example:
For the following table, find out AVC and MC at each output level.

Solution:

* TFC = TC at 0 output
What is Cost?
Cost refers to the total expenditure made on inputs or resources that are used for the production
of final goods or services. The resources used by a firm are limited in nature and thus require
efficient allocation to maximise the firm’s profit. The cost or economic cost of a firm consists
of all the expenses it faces, can manage, and are beyond its control.
For example, cost of labor, capital, and raw materials. Besides other resources, a firm may
also use those resources whose expenses are not that clear but are still essential for the firm.
Relationship between Short-run Cost

1. Relationship between AC and MC

There is a close relationship between AC and MC.

 First of all, AC and MC both are determined from TC (Total Cost). While AC is the Total
Cost (TC) per unit of output, MC is the additional TC when one more unit of output is
produced.
 Secondly, because of the Law of Variable Proportion, both AC and MC curves are U-
shaped.
To better understand the relationship between AC and MC, let’s take an example.
The above table and graph tell about the following relationship between AC and MC:
1. When MC is less than AC, AC falls with an increase in output. It happens till 3 units of
output.
2. When MC is equal to AC; i.e., when the MC and AC curve intersect each other at A, AC is
constant and is also at its minimum. It happens at 4 units of output.
3. When MC is greater than AC, AC increases with an increase in output. It happens from 5
units of output.
Besides, AC and MC both increase, but, as compared to AC, MC increases at a faster rate.
Therefore, the MC curve is steeper than the AC curve.
AC depends on the nature of MC
Among AC and MC, MC is responsible for the changes in AC. It means that, when MC falls, it
also pulls down AC, and when MC rises, it pulls up AC. Simply put,
 When MC curve lies below the AC curve, it pulls the AC curve downwards.
 When MC curve intersects the AC curve, both are equal.
 When MC curve lies above the AC curve, it pulls the AC curve upwards.

Is it possible for AC to fall, when MC is rising?

Yes, it is possible for AC to fall, when MC is rising. It can happen only when MC is less than
AC. In simple terms, as long as the MC curve is below the AC curve, AC will continue to fall
even if MC is rising. In the above example, when we move from 2 units to 3 units, even though
AC falls, MC keeps on rising because at these points MC < AC.

Is it possible for AC to rise, when MC is falling?

No, it is not possible for AC to rise, when MC is falling because when MC falls, AC also falls.

2. Relationship between AVC and MC

The relationship between AVC and MC is quite similar to the relationship between AC and
MC in the following ways:
 First of all, AVC and MC both are determined from TVC (Total Variable Cost). While
AVC is the Total Variable Cost (TVC) per unit of output, MC is the additional TC when
one more unit of output is produced.
 Secondly, because of the Law of Variable Proportion, both AVC and MC curves are U-
shaped.
To better understand the relationship between AVC and MC, let’s take an example.
The above table and graph tell about the following relationship between AVC and MC:
1. When MC is less than AVC, AVC falls with an increase in output. It happens until 2 units
of output.
2. When MC is equal to AVC; i.e., when MC and AVC curves intersect each other at B,
AVC is constant and is also at its minimum. It happens at 3 units of output.
3. When MC is greater than AVC, AVC increases with an increase in output. It happens
from 4 units of output.
Besides, AVC and MC both increase, but, as compared to AVC, MC increases at a faster rate.
Therefore, the MC curve is steeper than the AVC curve.

3. Relationship between AC, AVC, and MC

To better understand the relationship between AC, AVC, and MC, let’s take an example:
The above table and graph tell about the following relationship between AC, AVC, and MC:
1. When MC is less than both AC and AVC, they both fall with an increase in the output.
2. When MC becomes equal to AC and AVC, both become constant. The MC curve cuts the
AC curve at point A and the AVC curve at point B at their minimum points.
3. When MC is more than both AC and AVC, both of them rise with an increase in output.

4. Relationship between AC and AVC

The relationship between AC and AVC is as follows:

1. AC is greater than AVC, and the amount of increment is equal to AFC.
2. With an increase in the output, the vertical distance between the AC curve and AVC curve
continues to fall. It is because of the gap between them which is equal to AFC and
continues to decline with an increase in output.
3. As AFC can never be zero, AC and AVC curves never intersect each other.
4. Because of the Law of Variable Proportions, both AC curve and AVC curve are U-shaped.
5. AVC and AC curves are cut by MC curve at their minimum points.
6. The minimum point of the AC curve; i.e., point A, always lies to the right of the minimum
point of the AVC curve; i.e., point B.
5. Relationship between TC and MC

The relationship between TC and MC is as follows:

1. MC is the additional TC when one more unit of output is produced. The formula for
calculating MC is TC n – TCn-1.
2. When TC increases at a decreasing rate; i.e., up to point Q in the above diagram, MC
declines.
3. At point Q, the Total Cost stops rising at a declining rate. It is because MC is at its
minimum; i.e., point E.
4. After point Q, the Total Cost starts increasing at an increasing rate. It is because now MC is
rising.

6. Relationship between TVC and MC

As we already know, MC is the additional TC when one more unit of output is produced.
Therefore, TVC can be determined by adding MC’s of all the units produced. Besides, if it is
assumed that the output is perfectly divisible, then the total area under the MC curve will be
the same as TVC.

In the above diagram, it can be seen that at OQ output level, the Total Variable Cost is equal to
the shaded area OQLP.

Revenue
In economics, the income generated by a firm from the sale of goods or services to the customers
is called revenue. In this article, we will discuss total revenue and other forms of revenue and
their relation to each other.

Revenue is the total amount of income generated by an enterprise through the sale of goods and
services concerning the primary operations of the business. Several types of revenue include total
revenue, average revenue, marginal revenue, etc. Revenue is essential for every enterprise
because long-term sustainability would become problematic if the company does not earn
revenue.

Types of Revenue

Total Revenue

Total revenue is the total amount the seller collects from the sale of goods or services to the
customers. The price of the commodity can be expressed as P× Q. It implies that the cost price of
the commodity multiplies with the number of quantities sold. Total revenue can be defined as a
market cost price of the goods multiplied by the number of units produced. Therefore, it can be
said that TR= p × q, where TR Stands for total revenue, P stands for the price, and q stands for
quantity. Total revenue is equal to the submission of all the marginal revenues TR = Total of
MR.

Average Revenue

Average revenue represents the revenue per unit of output sold. Average revenue aggressively
adds to the profit of any enterprise. To calculate the average revenue, the total cost is to be
subtracted from the total profit. It is considered more profitable for an enterprise to manufacture
more output. AR = TR/q; q = p× q / q = p (Where AR stands for average revenue, TR stands for
total revenue, p stands for the price, and q stands for quantity)

Marginal Revenue

The term marginal revenue can be defined as revenue earned from the sale by adding a new unit
or product. In other words, it can be said that marginal revenue is revenue generated by an
enterprise by selling an additional unit. Company management uses marginal revenue to analyse
customer demands, plan production schedules and set a new price for the products. By the law of
diminishing returns, the revenue margin remains constant up to a certain level of output and then
begins to slow down as the output increases. MR = change in total revenue/ change in quantity or
TR/ Q (Where MR stands for marginal revenue, TR stands for total revenue and q stands for
quantity).
 Relationship Between TR, MR, AR

 TR, MR, and AR are equal when the first units are sold. Due to this, all three come from the
starting point. So as long as the MR is positive, TR tends to slope downward.

 When the AR tends to decrease, MR should decrease faster than the AR. It means the downward
sloping MR curve will be below the downward sloping AR (usually happens in monopoly or
monopolistic competition).

 When the AR is constant, then MR is equal to the AR. Both are to be indicated by a similar
horizontal straight line.

 MR can be negative, but AR cannot be negative.

Basic Concepts of Revenue

Revenue, in simple words, is the amount that a firm receives from the sale of the output. According
to Prof. Dooley, ” The Revenue of a firm is its sales receipts or income.‘ In a firm, revenue is of
three types:

1. Total Revenue
2. Average Revenue
3. Marginal Revenue
Let’s look at each one of them in detail:

Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the output.
Therefore, the total revenue depends on the price per unit of output and the number of units sold.
Hence, we have

TR = Q x P

Where,

 TR – Total Revenue
 Q – Quantity of sale (units sold)
 P – Price per unit of output
Average Revenue
Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold.
Therefore, you can get the average revenue when you divide the total revenue with the total units
sold. Hence, we have,

AR=TRQ

Where,

 AR – Average Revenue
 TR – Total Revenue
 Q – Total units sold
Marginal Revenue
Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In
other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence,
we have

MR = TRn – TRn-1

Or

MR=ΔTRΔQ

Where,

 MR – Marginal Revenue
 ΔTR – Change in the Total revenue
 ΔQ – Change in the units sold
 TRn – Total Revenue of n units
 TRn-1 – Total Revenue of n-1 units
MR pertains to a change in TR only on account of the last unit sold. On the other hand, AR is based
on all the units that the firm sells. Therefore, even a small change in AR causes a much bigger
change in MR. In fact, when AR reduces, MR reduces by a far greater margin.

Similarly, when AR increases, MR increases by a greater extent too. AR and MR are equal only
when AR is constant. It is also important to note that the firm does not sell any unit if the TR or AR
becomes either zero or negative. However, there are times when the MR is negative (especially if
the fall in price is big).

The relationship between TR, AR, and MR

In order to understand the basic concepts of revenue, it is also important to pay attention to the
relationship between TR, AR, and MR. When the first unit is sold, TR, AR, and MR are equal.

Therefore, all three curves start from the same point. Further, as long as MR is positive, the TR
curve slopes upwards.

However, if MR is falling with the increase in the quantity of sale, then the TR curve will gain
height at a decreasing rate. When the MR curve touches the X-axis, the TR curve reaches its
maximum height.

Further, if the MR curve goes below the X-axis, the TR curve starts sloping downwards.

Any change in AR causes a much bigger change in MR. Therefore, if the AR curve has a negative
slope, then the MR curve has a greater slope and lies below it.

Similarly, if the AR curve has a positive slope, then the MR curve again has a greater slope and lies
above it. If the AR curve is parallel to the X-axis, then the MR curve coincides with it.

Here is a graphical representation of the relationship between AR and MR:

In the left half, you can see that AR has a constant value (DD’). Therefore, the AR curve starts from
point D and runs parallel to the X-axis. Also, since AR is constant, MR is equal to AR and the two
curves coincide with each other.

In the right half, you can see that the AR curve starts from point D on the Y-axis and is a straight
line with a negative slope. This basically means that as the number of goods sold increases,
the price per unit falls at a steady rate.

Similarly, the MR curve also starts from point D and is a straight line as well. However, it is a locus
of all the points which bisect the perpendicular distance between the AR curve and the Y-axis. In
the figure above, FM=MA.