THEORY OF PRODUCTION AND COST ANALYSIS

THEORY OF PRODUCTION

The production function:-

According to samuelson,”the technical relationship which reveals the maximum
amount of output capable of being produced by each and every set of inputs”.
According to Michael R.Baye, “that function which defines the maximum amount of
output that can be produced with a given set of inputs.
From the above definitions, it can be seen that:
 The production function is more concerned with physical aspects of
productions. It is the concerns of the engineer rather than that of the manager.
To know how much be the production with a given set of inputs.
 Production function is defined at a given stage of technical knowledge. It
means that if there is any technological break through, there be further jump in
the volume of production for the given set of inputs.
 Production function is an engineering relation that expresses the maximum
amount of output that can be produced to within a given set of inputs.
 At any given time, the output from a given set of inputs is always fixed.
 Production function enables us to understand how best we can make use of
technology to its greatest potential.

Input-output relationship or production function:-

The inputs for any product or service are land, labour, capital, organization &
technology.
Q = f (L1, L2, C, OT)
Q = quantity of production
f = function is the type of relationship between inputs and outputs.
A manufacturer has to make a choice of the production function by considering his
technical knowledge. He uses lower costs of inputs for a given level of production.
Some factors of production may be important and the relative importance’s of the
factors depend upon the final product to be manufactured.

Ex: - in software industry, land is not an input factor as significant as that in case of an
agricultural product.
In the case of an agricultural product, increasing the other factors of production can
increase the production, but beyond a point increased output can be had only with
increased used agricultural land. Investment in land forms a significant portion of the
total cost of production for output; where as in the case of the software industry, other
factors such as technology, capital, management and others becomes significant. With
change in industry and the requirements the production function also needs to be
modified to suit to the situation.

Production function with one variable input and laws of returns:-

The law of return states that when at least one factor of production is fixed or factor
input is fixed and when all other factors are varied, the total output in the initial stages
will increase at an increasing rate, and after reaching certain level of output the total
output will increase at declining rate. If variable factor inputs are added further to the
fixed factor input, the total output, may decline. This law is of universal nature and it
proved to be true in agricultural and industry also. The law of returns is also called the
law of variable proportions or the law of diminishing returns.

Please draw TP, AP, MP graph here

from your note book

Units of Total product Marginal Average Stages

labour TP product MP product AP

0 0 0 0 Stage I
1 10 10 10
2 22 12 11
3 33 11 11 Stage II
4 40 7 10
5 45 5 9
6 48 3 8
Stage III
7 48 0 6.85
8 45 -3 5.62

In the short-run, it is assumed that capital is a fixed factor input and labour is variable
input. It is also assumed that technology is given and is not going to change. Under
such circumstances, the firm starts production with a fixed amount of capital and uses
more and more units of labour. In the initial stages, output increases at an increasing
rate because capital is grossly under utilized. Productivity will increase up to point ‘A’
where more and more units of labour are increased. After point ‘A’ output increases at
a declining rate till it reaches maximum at point ‘C’. After point ‘C’, the total output
declines and the margined product of labour is negative. Thus indicates that the
additional units of labour are not contributing anything positively to the total output.
Even if labour is available free of cost, It is not worth using it.

Production function with two variable inputs and law of returns:-

A production function requires two inputs, capital (C) & labour (L) to produce a given
product (Q). This can be more than two inputs in a real life situation, but for a simple
analysis, we restrict no. of inputs to two only. The production function based on two
inputs can be expressed as,
Q = f (C, 2)
Normally, both capital and labour are required to produce a product. These two inputs
can be substituted for each other. Hence the producer may choose any combination of
labour and capital that gives the required no. of units of output. For any given level of
output, a producer may hire both capital and labour, but he is free to choose any one
combination of labour and capital out of several such combinations. The alternative
combination of labour and capital yielding a given level of output are such that if the
use of one factor input is increased, that of another will decrease and vice versa.
However, the units of an input foregone to get one unit of the other input changes,
depends upon the degree of substitutability between the two input factors. Based on
the techniques or technology used, the degree of substitutability may vary.

ISOQUANTS:-

Iso means ‘equal’ Quant means ‘quantity’. Isoquant means ‘the quantities
throughout a given Is quant are equal’.
Isoquants are also called ‘isoproduct curves’. An Isoquant curve shows various
combinations of two input factors such as capital and labour, which yield the same
level of output.
An Isoquant curve represents all such combinations which yield equal quantity of
output; any or every combination is a good combination for manufacturer. Since he
prefers all these combination equally, an Isoquant curve is also called ‘product
indifference curve’.
Combination Capital No.of Labourer
s
A 1 20
B 2 15
C 3 11
D 4 8
E 5 6
F 6 5
 Please draw Isoquant graph here
from your note book

Labour
From the above figure, it shows the different combinations of input factors to
yield an output of 20,000 units of output. As the investment goes up, the no. of
labourers can be reduced. The combination of ‘A’ shows 1 unit of capital and 20 units
of labour to produce say 20,000 units of output. All the above combinations if inputs
can be plotted a graph, the locus of all the possible combinations of inputs shows up
Isoquant.

Features of an Isoquant:-

Downward sloping: -
These are downward sloping because, if one input increases, the other one
reduces. There is no question of increase in both the inputs to yield a given a given
output. A degree of substitution is assumed between the factors of production. In other
words, an Isoquant cant be increasing, as increase in both the inputs does not yield
same level of output remains constant though the use of one of the factors is
increasing, which is not true. Isoquants slope from left to right.

Convex to origin: -
Isoquants are convex to the origin. Because the input factors are not perfect
substitutes. One input factor can be substituted by other input factor in a diminishing
marginal rate. If the input factors were perfect substitutes, the Isoquant would be a
falling straight line. When the inputs are used in fixed proportion, and substitution of
one input for the other can’t take place, the Isoquant will be shaped.

Do not intersect: -
These two Isoquants don’t intersect, because each of these denote a particular level of
output, if the manufacturer wants to operate at a higher level of output, he has to
switch over to another Isoquant with a higher level of output & vice versa.

Do not touch the axes: -

The Isoquant touches neither X-axis nor Y-axis, as both inputs are required to produce
a given product.

Marginal rate of technical substitutes: -

The marginal rate of technical substitution (MRTS) refers to the rate at which one
input factor is substituted with the other to attain a given level of output. In other
words, the lesser units of one input must be compensated by increasing amounts of
another input to produce the same level of output. The below table shows the ratio of
MRTS between the two input factors, say capital and labour. 5 units of decrease in
labour are compensated by an increase in 1 unit of capital, resulting in a MRTS of 5:1.

Ratio of MRTS between capital and labour:

Combinations Capital (Rs. In Labour MRTS
lakh)

A 1 20 -
B 2 15 5:1
C 3 11 4;1
D 4 8 3:1
E 5 6 2:1
F 6 5 1:1

ISOCOSTS: -
It refers to that the cost curve that represents the combination of inputs that will cost
the producer the same amount of money. In other words, each isocost denotes a
particular level of total cost for a given level of production. If the level of production
changes, the total cost changes and thus the isocost curve moves upwards and vice
versa. The below figure shows three downward sloping straight line cost curves
(assuming that the input prices are fixed, no quantity discounts are available) each
costing Rs. 1.0 lakhs, Rs. 1.5 lakhs & Rs. 2.0 lakhs for the output levels of 20,000 ,
30,000 and 40,000 units. (The total cost, as represented by each cost curve is
calculated by multiplying the quantity of each input factor with its respective price).
Isocosts farther from the origin, for given input costs, are associated with higher costs.
Any change in input prices changes the slope of isocost lines.

Isocosts each representing different levels of total costs.

Least cost combination of inputs:

The manufacturer has to produce at lower costs to attain higher profits. The Isocosts
and Isoquants can be used to determine the input usage that minimizes the cost of
production.
Where the slope of Isoquant is equal to that of isocost, there lies the lowest point of
cost of production. This can be observed by superimposing the isocosts on isoproduct
curves, from the below figure, it is evident that the producer can with a total outlay of
Rs. 1.5 lakh, reach the highest Isoquant curve which is IQ2, of he wants to reach IQ3,
he has to bring additional resources, which is, let us assume, not possible he cant
compromise with IQ!, as it means lower output. There is no other input combination
on IQ2 other than point Q, which is cheaper than Rs. 1.5 lakh, so the obvious choice
for the producer is Q combination of inputs only on IQ2.
The points of tangency P, Q & R on each of the Isoquant curves represent the least
cost combination of inputs, yielding maximum level of output any output lower or
higher than this will result in higher cost of production.

Production function where input factors are multiple: -

Production function in a two input factor setting may look too easy to be useful. It has
been a valuable tool for the managers to decide what combination of inputs yields a
given output at the lowest costs. In case of multiple inputs factors, quantitative
techniques such as optimization techniques & linear programming provide solution.
Computers have further simplified function in a multiple input factor setting.

COBB- DOUGLAS production function:-

Cobb & Douglas put forth a production function relating output in American
manufacturing industries from 1899 to 1922 to labour & capital inputs. They used for
the following formula:
Formula: P = b L^a C^(1-a).
Where, P is total output.
L is the index of employment of labour in manufacturing.
C is the index of fixed capital in manufacturing.
The exponents ‘a’ and ‘1-a’ are the elasticities of production. These measure the
percentage response of output to percentage charges in labour and capital respectively.
The function estimated for the USA by Cobb & Douglas is
P = 1.01 L^0.75 C^0.25.
The production function shows that one percent change in labour input capital
remaining the same is associated with a 0.75 percentage change in output. Similarly
one percentage change in capital, labour remaining the same, is associated with a 0.25
percent change in output. The coefficient of determination (R^2) means that 94.3 of
the variations on the dependent variable (P) were accounted for by the variations in
the constant returns to scale which means that there are no economics or diseconomics
of large scale of production. On an average, large or small scale plants are considered
equally profitable in the US manufacturing industry. On the assumption that the
average and marginal production costs were constant.
Though cobb-douglas production function was based on macro-level study, it has
been very useful for interpreting economic results. later investigation revealed that the
sum of the exponents might be very slightly larger than unity, which implies
decreasing costs. But the difference was so marginal that constant costs would seem to
be safe assumption for all practical purposes.
Returns to scale & returns to factors: -
Returns to scale refers to the returns enjoyed by the firm as a result of change in all
the inputs. It explains the behaviour of the returns when the inputs are changed
simultaneously. The returns to scale are governed by laws of returns to scale.

Law of returns to scale: -

There are three laws of returns governing production function.
1. Law of increasing returns to scale.
2. Law of constant returns to scale.
3. Law of decreasing returns to scale.

Law of increasing returns to scale: -

This law states that the volume of output keeps on increasing with every increase in
the inputs. Where a given increase in inputs leads to a more than proportional increase
in the output, the law of increasing returns to scales is said to operate. We can
introduce division of labour and other technological means to increase production.
Hence the total product increases at an increasing rate.

Law of constant returns to scale: -

When the scope for division of labour gets restricted, the rate of increase in the total
output remains constant, the law of constant returns to scale is said to operate. This
law states that the rate of increase/decrease in volume of output is same to that of rate
of increase/decrease in inputs.

Law of decreasing returns to scale: -

Where the proportionate increase in the inputs does not lead to equivalent increase in
output, the output increases at a decreasing rate, the law of decreasing returns to scale
is said to operate. This results in higher average cost per unit.
These laws can be illustrated with an example of agricultural land. Take one acre land,
if you fill the land well with adequate bags of fertilizers and sow good quality seed,
the volume of output increases. The following table illustrates:

Capital Labour % increase in Output % increase Law of applicable.

(in (in units) both input (in units) in output
units)

1 3 - - - -
2 6 100 120 140 Law of increasing
4 returns to scale.
12 100 240 100 Law of constant
8 returns to scale.
 24 100 360 50 Law of decreasing
returns to scale.
From the above table, it is clear that with 1 unit of capital and 3 units of labour,
the firm produces 50 units of output. When the inputs are doubled two units of capital
and six units of labour, the output has gone up to 120 units. (From 50 units to 120
units). Thus when inputs are increased by 100 percent, the output has increased by
140% that is, output has increased by more than double. This governed by law of
increasing returns to scale.
When the inputs are further doubled that is to 4 units of capital and 12 units of labour
the output has gone up to 240 units (from 120 units to 240 units). Thus when inputs
are increased by 100%, the output has increased by 100%. That is output also has
doubled. This is governed by law of constant returns to scale, when the inputs are
further doubled, that is, to 8 units of capital and 24 units of labour, the output has gone
up to 360 units. (From 240 units to 360 units). Thus when inputs are increased by
100%, which has increased only 50%. This is governed by law of decreasing returns
to scale.

Returns to factors: -
It is also called factor productivities. Productivity is the ratio of output to the input.
Factor productivity refers to the short-run relationship of input and output. The
productivity of one unit of a factor of production will be equal to the output it can
generate. The productivity of a particular factor is measured with the assumption that
the other factors are not changed or remain unchanged. Only that particular factor
under study is changed.
Returns to factors refer to the output or return generated as a result of change in one or
more factors, keeping the other factors unchanged. Given a percentage of increase or
decrease in a particular factor such as labour,

The change in productivity can be measured in terms of:

Total productivity: -
The total output generated at varied levels of input of a particular factor (while other
factors remain constant), it is called total physical product.

Average productivity: -
The total physical product divided by the number units of that particular factor used
yields average productivity.

Marginal productivity: -
The marginal physical product is the additional output generated by adding an
additional unit of the factor under study, keeping the other factors constant.

The total physical product increases along with an increase in the inputs. However the
rate of increase is varied, not constant. The total physical product at first increases at
an increasing returns to scale, and later its rate of increasing declines because of the
law of decreasing returns to scale.

Economies and diseconomies of scale: -

Alfred marshal divided the economies of scale into 2 groups
1. Internal.
2. External.

Internal economies:-
Internal economies refer to the economies in production costs which accrue to the
firm alone when it expands its output. The internal economies occur as a result of
increase in the scale of production.
These are types of internal economies:
1. Marginal economies.
2. Commercial economies.
3. Financial economies.
4. Technical economies.
5. Marketing economies.
6. Risk-bearing economies.
7. Indivisibilities and automated machinery.
8. Economies of larger dimention.
9. Economies of research & research.

Marginal economies: -
An the firm expands, the firm needs qualified managerial personal to handle each of
its functions; - marketing, finance, production, human resources and others in a
professional way. Functional specialization ensures minimum wastage & lowers the
cost of production in the long-run.

Commercial economies: -
The transactions of buying and selling raw materials and other operating supplies such
as spares and so on will be rapid and the volume of each transaction also grows as the
firm grows. There could be cheaper savings in the procurement, transaction & storage
costs. This will lead to lower costs and increased profits.

Financial economies: -
There could be cheaper credit facilities from the financial institutions to meet the
capital expenditure or working capital requirements. A larger firm has larger assets to
give security to the financial institution which can consider reducing the rate of
interest on the loans.

Technical economies: -
Increase in the scale of production follows when there is sophisticated technology
available and the firm is in a position to hire qualified technical man power to make
use of there could be substantial savings in the hiring of man power due to larger
investments in the technology. This lowers the cost per unit substantially.

Marketing economies: -
As the firm grows larger and larger. It can afford to maintain a full fledged marketing
department independently to handle the issues related to design of customer surveys,
advertising materials, and promotion campaign handling of sales and marketing staff,
renting of hoardings, launching a new product and so on. In the normal course, the
firm spends large amounts on issues in marketing and is still not sure of the results
because these are handled by different outride groups, on whom there is little control
for the firm.

Risk bearing economies: -

As there is growth in the size of the firm, there is increase in the risk also. Sharing the
risk with the insurance companies is the risk priority for any firm. The firm can insure
its machinery and other assets against the hazards of fire, theft & other risks, the large
firms can spread their risk so that they do not keep all their eggs in one basket. They
purchase raw material from different sources.

Indivisibilities and automated machinery: -

To manufacture goods, a plant of certain maximum capacity is required whether the
firm would like to produce and sell at the full capacity or not, because the production
is lesser, the firm can’t hire half the manager or half the telephone. The minimum
quality can be produced in the firm. A firm producing below such minimum quantity
will have to bear higher costs.

Economies of larger dimention: -

Large scale production is required to take advantage of bigger size plant and
equipment. For example, the cost of a 1,00,000 units capacity plant will not be double
that of 50,000 units capacity plant like wise, the cost of a 10,000 tonnes oil tanker will
not be double that of a 5,000 tonnes oil tanker. Engineering go by what is called two
third (2/3) rule. When the volume is increased by 100%, the material required will
increase by 100%, the material requires will increase only by two-thirds.
Technical economies are available only from large size, improved methods of
production processes & when the products are standardized.

Economies of research & development: -

Large organizations such as Dr. Reddy’s labs, Hindustan lever spend heavily on
research and development and bring out several innovative products, only such firms
with strong research & development base can cope with competition globally.

External economies: -
These refer to all the firms in the industry because of growth of the industry as a
whole or because of growth of auxillary industries. External economies benefit all the
firms in the industry as the industry expands. This will lead to lowering the cost of
production and thereby increasing the profitability.

The external economies are grouped to 3 types.

1. Economies of concentration.
2. Economies of research and development.
3. Economies of welfare.

Economies of concentration: -
All the firms are located one place. Than there is better infrastructure in terms of
 Approach roads.
 Transportation facilities such as railway lines.
 Banking & communication facilities.
 Availability of skilled labour.

Economies of research and development: -

All the firms can pool resources together to finance research and development
activities and thus share the benefits of research. There could be a common facility to
share journals, news papers & other valuable reference material of common interest.

Economies of welfare: -
There could be common facilities such as
 Canteen.
 Industrial housing.
 Community halls.
 Schools and colleges.
 Hospitals.
 Those are commonly used by employees

Diseconomies: -
Diseconomies are mostly managerial in nature. Problems of planning, coordination
communication and control may become increasingly complex as the firm grows in
size resulting in increasing average cost per unit. Sometimes the firm may also
collapse.
Diseconomies of scale are said to result when an increase in the scale of production
leads to a higher cost per unit.
Ex:- All inputs an increase by 10%, but production increased by 5%, it is called
diseconomies.
As the firm grows layer, it may need to seek permission to operate in foreign markets.
Any degree of bureairatic inefficiency will affect the firm’s profitability and this leads
to diseconomies of scale.
When a firm is not in a position to respond to the business environment in which
operates diseconomies are bound to result in. modern organizations have started
delaying their organizations to make them flat and lean to overcome the problems of
diseconomies