UNIT –III

PRODUCTION AND COST

ANALYSIS: (10HRS)
Production concepts & analysis; Production function, Types of production function, Laws of production : Law of diminishing returns , Law of returns to scale.
Cost concept and analysis: Cost , Types of costs, Cost output relationship in the short-run. Cost output relationship in the Long-run. Estimation of Revenue.
Average Revenue, Marginal Revenue
 INTRODUCTION
• The production analysis of the firm brings into focus the process of production and related costs
of production. We must take inputs into consideration applied for production and resulting into
output. There are different methods to produce a commodity. The firm has to identify the
technically efficient production processes for avoiding any wastage of resources. These
technically efficient production processes provide a choice for choosing the least-cost process.
• Major portion of goods and services consumed in a modern economy are produced by firms. A
firm is an organisation that combines and organises resources for the purpose of producing
goods and services for sale at a profit. The most important reason for a firm or business
enterprises exist is that firms are specialised organisation devoted to manage the process of
production.
 MEANING OF PRODUCTION
• Production refers to the transformation of inputs or resources into outputs or goods and
services. Production is a process in which economic resources or inputs (composed of
natural resources like labour, land and capital equipment) are combined by entrepreneurs
to create economic goods and services (outputs or products).
• Firms are required to take different but interrelated production decisions like:
1. Whether or not to actually produce or shut down?
2. How much to produce?
3. What input combination to use?
4. What type of technology to use?
 FIXED/ VARIABLE INPUTS
• Inputs are the resources used in the production of goods and services and are generally
classified into three broad categories – labour, capital and land or natural resources. They
may be fixed or variable.
• Fixed Inputs are those that cannot be quickly changed during the time period under
consideration except, perhaps at a very great expense, (e.g., a firms’ plant).
• Variable Inputs are those that can be changed easily and on very short notice (e.g., most
raw materials and unskilled labour).
 SHORT- RUN LONG- RUN
• The time period during which at least one input is fixed is called the, short run, while the
time period when all inputs are variable is called, the long run. The length of the long run
depends on the type of industry, e.g., the long run for a dry cleaning business may be a few
weeks or months.
• Generally, a firm operates in the short run and plans increases or reductions in its scale of
operation in the long run. In the long run, technology generally improves so that more
output can be obtained from a given quantity of inputs, or the same output can be
obtained from fewer inputs.
 PRODUCTION FUNCTION WITH ONE
VARIABLE INPUT
• A production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations
of inputs. In other words, it shows the functional relationship between the inputs used and the output produced.
• Mathematically, the production function can be shown as:

Q = f (X1, X2 ..................XK)
• where Q = Output, X1 .............. XK = Inputs used.
• For purposes of analysis, the equation can be reduced to two inputs X and Y. Restating,
Q = f (X, Y)
• where Q = Output
• X = Labour
• Y = Capital
 PRODUCTION FUNCTION
• ‘A production function defines the relationship between inputs and the maximum amount
that can be produced within a given period of time with a given level of technology’.
• A production function can be stated in the form of a table, schedule or mathematical
equation. But before doing that, two special features of a production function are given
below:
1. Labour and capital are both unavoidable inputs to produce any quantity of a good, and
2. Labour and capital are substitutes to each other in production.
 CONSTANT ELASTICITY OF
SUBSTITUTION, CES FUNCTION
• A form of production functions is the Constant Elasticity of Substitution, CES function,
Q = B[gL–h + (1 – g)K–h]–1h
• where h > –1 and B, g and h are constants.
• If h is assumed to be a variable, then the above function may be called the variable
elasticity of substitution, VES function.
 LEONTIEF FUNCTION

• Still another form is the fixed proportion production function

also called the Leontief function.
𝐾 𝐿
[ , ]
• It is represented by Q = minimum
𝑎 𝑏
• where a and b are constants and ‘minimum’ means that Q equals
the smaller of the two ratios.
 LINEAR PRODUCTION FUNCTION
• Finally there is a very simple linear production function. Assuming that the inputs are
perfect substitutes so that all factors may be reducible to one single factor, say, labour, L,
than the linear production function may be, Q = aL, where ‘a’ is the constant term and L
stands for labour. In order to analyse the relationship between factor inputs and outputs,
economists classify time periods into short runs and long runs.
 TOTAL PRODUCT, AVERAGE
PRODUCT AND MARGINAL PRODUCT.
1. Total product is the total quantity produced by that many units of a variable factor (i.e.,
labour). For example, if on a farm 2000 Kg. of wheat were produced by 10 men, the total
product would be 2000 Kg.
2. Average product is the total output divided by the number of units of the variable factor
(or the number of men). Thus AP = TP/L. On the same farm, the average product would
be 2000/10 = 200 Kg.
3. Marginal product is the change in total output resulting from the change (using one
more or one less unit) of the variable factor. If an eleventh man is now added to this farm
and the output rose to 2,100 Kg, the marginal product (of labour) would be 100 Kg. Thus,
MP = d(TP)/dL.
• For a two-input production process, the total product of labour (TPL) is defined as the
maximum rate of output coming up from combining varying rates of labour input with a
fixed capital input K . (Note: A bar over K or over any other variable means, that variable
has been fixed, and therefore is no more variable.)
TPL = f (K,L)
and total product of capital function is
TPK = f (K,L)
By holding the quantity of input constant and changing the other, we can derive TP of the variable
input.
Example: By holding capital constant at one unit (K = 1) and increasing units of labour used from 0 to
6 units, we get total product of labour as in column (2) in Table.
• Marginal product (MP) of labour (MPL) is the change in total product or extra output per unit change
in labour used. Average product of labour (APL) equals total product divided by the quantity of
labour used.

• Output elasticity of labour (EL) measures the percentage change in output divided by percentage
change in quantity of labour used.

• This means that from zero units of labour (and with K = 1), TP or output grows proportionally to the
growth in the labour input. For the second unit of labour EL = 1.25 (that is, TP or output grows more
than proportionally to the increase in L), and so on.
 10 158 223 274 316 354 387 418 447 474 500
9 150 121 260 300 335 367 397 424 450 474
8 141 200 245 283 316 346 374 400 424 447
SHORT RUN AND LONG 7 132 187 226 264 296 324 350 374 397 418
RUN PRODUCTION 6 122 173 212 245 274 300 324 346 367 387
FUNCTION 5 115 158 194 224 250 274 296 316 335 354
The above features show that some quantity 4 100 141 173 200 224 245 264 283 300 316
of both the inputs is required to produce a 3 87 122 150 173 194 212 229 245 260 274
given quantity of output. A two input long run
production function for quantities of labour 2 70 100 122 141 158 172 187 200 212 224
and capital upto 10 units can be expressed as
in Table 1 50 70 87 100 112 122 132 141 150 158
Example: For K = 2, the short-run production K/ L 1 2 3 4 5 6 7 8 9 10
function would be as in Table.

Labor (L) 1 2 3 4 5 6 7 8 9
Output (Q) 70 100 122 141 158 172 187 200 212
 Q= 158
12

LONG RUN 10 10

PRODUCTION
8
FUNCTION
The given table shows the units of output that can be
produced with different combinations of capital and 6
labour.
Before we proceed, it is important to note here that 5
four combinations of K and L
• 10K + 1L, 4
• 5K + 2L,
• 2K + 5L,
• 1K + 10L 2 2
Produce the same output. i.e. 158 units. When these 1
combinations of K and L producing the same output
are joined by a line, it produces a curve as shown I the 0
table.
1 2 5 10
This curve is called ‘Isoquant’.
Q= 158
PRODUCER’S
EQUILIBRIUM
Before discussing the concept of
producer’s equilibrium, we must
discuss the concepts of Isoquants,
marginal rate of technical
substitution and isocost line. After
learning these concepts, you will be
able to understand the concept of
producer’s equilibrium better.
 • Any quantity of a good can be produced by using
many different combinations of labour and capital
(assuming both can be substituted for each other).
An isoquant or an iso-product curve is the line which
ISOQUANTS joins together different combinations of the factors
Isoquants are a geometric representation of production (L, K) that are physically able to
of the production function. The same produce a given amount of output.
level of output can be produced by
various combinations of factor inputs. • Suppose isoquant refers to 100 Kg. of output. This
Imagining continuous variation I the output can be produced by a large number of
possible combination of labour and different combinations of labour and capital. All the
capital, we can draw a curve by plotting
all these alternative combinations for a different combinations for the same amount of
given level of output. This curve which is output would lie on the same isoquant.
the locus of all possible combination is
called the ‘isoquant’.
 TYPES OF ISOQUANTS
Types of Isoquants Description
Linear Isoquants This type assumes perfect substitutability of factors of production. A given
commodity may be produced by using only capital, or only labour, or by an
infinite combination of K and L.
Input-output This assumes strict complementarity, that is, zero substitutability of the factors
Isoquants of production. There is only one method of production for any one commodity.
The isoquant takes the shape of a right angle. This type of isoquant is called
"Leontief isoquant."
Kinked Isoquants This assumes limited substitutability of K and L. There are only a few processes
for producing any one commodity. Substitutability of factors is possible only at
the kinks. It is also called "activity analysis isoquant" or "linear-programming
isoquant" because it is basically used in linear programming.
Smooth, Convex This form assumes continuous substitutability of K and L only over a certain
Isoquants range, beyond which factors cannot substitute each other. This isoquant appears
as a smooth curve convex to the origin.
 MARGINAL RATE OF TECHNICAL
SUBSTITUTION (MRTS)
• Marginal Rate of Technical Substitution (MRTS) is the amount by which the quantity of one
input has to be reduced (– x2) when one extra unit of another input is used ( x1 = 1), so that
output remains constant (y = y ).

• where MP1 and MP2 are the marginal products of input 1 and input 2, respectively. Along
an isoquant, the MRTS shows the rate at which one input (e.g. capital or labour) may be
substituted for another, while maintaining the same level of output. The MRTS can also be
seen as the slope of an isoquant at the point in question.
 ISOCOST LINE
• If a firm uses only labour and capital, the total cost or expenditure of the firm can be represented
by:
C = wL + rK
where C = total cost
w = wage rate of labour
L = quantity of labour used
r = rental price of capital
K = quantity of capital used
• The equation shows that the total cost of the firm (C) is equal to the sum of its expenditures on
labour (wL) and capital (rK). This equation is a general one of the firm's isocost line or equal-cost
line. It shows the various combinations of labour and capital that the firm can hire or rent at a given
total cost.
No. of workers (N) Total Product (TPL) Marginal Product* Average Product
(Tonnes) (MPL) (APL)
1 24 24 24
2 72 48 36
3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66
8 528 66 66
9 576 48 64
10 600 24 60
11 594 -6 54
12 552 -42 46
 COST CONCEPTS
• Costs play a very important role in managerial decisions involving a selection between
alternative courses of action. It helps in specifying various alternatives in terms of their
quantitative values.
• The kind of cost to be used in a particular situation depends upon the business decisions to
be made. Costs enter into almost every business decision and it is important to use the
right analysis of cost. Hence, it is important to understand what these various concepts of
costs are, how these can be defined and operationalised.
• This requires the understanding of the two things, namely,
• that cost estimates produced by conventional financial accounting are not appropriate
for all managerial uses, and
• that different business problems call for different kinds of costs.
 TYPES…
• Future and Past Costs
• Incremental and Sunk Costs
• Incremental aka avoidable costs, escapable costs or differential costs.
• Out-of-Pocket and Book Costs
• Replacement and Historical Costs
• Example: If the price of bronze at the time of purchase, say, in 1974, was 15 a kg and if the present price is 18 a kg, the
original cost of 15 is the historical cost while 18 is replacement cost. Replacement cost means the price that would have
to be paid currently for acquiring the same plant.
• Explicit Costs and Implicit or Imputed Costs (Accounting Concept of Cost and Economic Concept of Cost)
• Actual Costs and Opportunity Costs
• Direct (or Separable or Traceable) Costs and Indirect (or Common or Non-traceable) Costs
• Shut-down and Abandonment Costs
• Private and Social Costs
 DND
• Accounting cost
• Opportunity cost and actual cost
• Business cost and full cost
• Actual or explicit cast and implicit and imputed cost
• Out of pocket and book costs
• Analytical Cost
• FC/ VC
• TC/ AC/ MC
• SRC and LRC
• Incremental and sunk costs
• Historical and replacement cost
• Private and social cost
SHORT RUN TOTAL COST CURVE
 SHORT RUN AND LONG RUN COSTS

The short run is a period of time in which the output can be increased or decreased by
changing only the amount of variable factors such as labour, raw materials, chemicals, etc.
• In the short run the firm cannot build a new plant or abandon an old one.
• If the firm wants to increase output in the short run, it can only do so by using more labour and more raw
materials.
• It cannot increase output in the short run by expanding the capacity of its existing plant or building a new plant
with larger capacity.

Long run, on the other hand, is defined as the period of time in which the quantities of all
factors may be varied.
• All factors being variable in the long run, the fixed and variable factors dichotomy holds good only in the short run.
• In other words, it is that time-span in which all adjustments and changes are possible to realise.
 SHORT RUN AVERAGE COSTS AND
OUTPUT
• Short Run Average Fixed Cost (AFC)
• Average fixed cost is the total fixed cost divided by the number of units of output
produced. Therefore,
AFC = TFC/Q
• where Q represents the number of units of output produced.
• Thus, average fixed cost is the fixed cost per unit of output. Since total fixed cost is a
constant quantity, average fixed cost will steadily fall as output increases. Therefore,
average fixed cost curve slopes downward throughout its length. As output increases, the
total fixed cost spreads over more and more units and, therefore, average fixed cost
becomes less and less.
 AVERAGE VARIABLE COST (AVC)
• variable cost is the total variable cost divided by the number of units of output produced.
Therefore,
• AVC = TVC/ Q
• Since the total variable cost (TVC) is equal to the amount of the variable factor multiplied by
the price per unit (w) of the variable factor, (TVC= L*w). Therefore
• AVC = L*w/Q
• Since Q = AP* L
• AVC = L*w/ AP*L
 Since the total cost is the sum of total variable cost and
total fixed cost, the average total cost is also the sum
of average variable cost and average fixed cost. This
can be proved as follows:

AVERAGE TOTAL
COST (ATC)
The average total cost or what is called simply
average cost is the total cost divided by the
number of units of output produced.
Therefore,

Average total cost is also known as unit cost, since it is

cost per unit of output produced.
 Units of Total Total Total Average Avearge Average
Output Fixed Variable Cost Fixed Variable Total
Cost Cost (TC) Cost Cost Cost
AVERAGE FIXED COST, (AFC) (AVC) (ATC)
AVERAGE VARIABLE (Q) (TFC) (TVC) (2) + (3) (2)/(1) (3)/ (1) (5) + (6)
COST AND AVERAGE 1 2 3 4 5 6 7
TOTAL COST 0 50 0 50 0 0 0
1 50 20 70 50 20 70
2 50 35 85 23 17.50 42.50
3 50 60 110 16.67 20.00 36.67
4 50 100 150 12.50 25.00 37.50
5 50 145 195 10.00 29.00 39.00
6 50 190 240 8.33 31.67 40.00
7 50 237 287 7.14 33.86 41.00
8 50 284 334 6.25 35.50 41.75
 SHORT RUN MARGINAL COST (MC)
AND OUTPUT
• Marginal cost is the addition to the total cost caused by producing one more unit of output. In other
words, marginal cost is the addition to the total cost of producing n units instead of n-1 units.

• In symbols, marginal cost is rate of change in total cost with respect to a unit change in output,
i.e.,

• where d in the numerator and denominator indicates the change in TC and Q respectively. It is
worth pointing out that marginal cost is independent of the fixed cost. Since fixed costs do not
change with output, there are no marginal fixed costs when output increases in the short run.
 SHORT RUN MARGINAL COST (MC)
AND OUTPUT
• The independence of the marginal cost from the fixed cost can be proved algebraically as
follows:
 COSTS IN THE LONG RUN

a. Increasing Returns in b. Decreasing Returns in c. Constant Returns to

Scale Scale Scale
When returns to scale are increasing, inputs When returns to scale are decreasing, total When returns to scale are constant, total
are increasing less than in proportion to cost increases at a faster rate than does cost and output move in the same direction
increases in output. It follows that total cost output. This relationship is shown in Figure and same proportion. This is also shown in
also must be increasing less than in (b). Figure (c).
proportion to output. This relationship is
shown in Figure (a).
The LTC curve gives the least total cost for various levels of output
when all the factors of production are variable. Its shape is such that
the curve is first concave and then convex as looked from the output
axis. As seen above its shape follows from the operations of the varying
degrees of returns of scale, given the factor prices.
 ECONOMIES AND DISECONOMIES OF
SCALE

External or Pecuniary
Internal or Real Economies
Economies

Economies
Bulk Large scale
Economies Economies in Massive
Managerial Purchase acquisition
in in Transport Adv
Economies of Raw of ext.
production Marketing and Campaigns
material finance
storage