PRODUCTION AND COST ANALYSIS

IN SHORT TERM AND LONG TERM

 WHAT IS PRODUCTION

• Production is basically an activity of transformation which connects factor input and output.

• It means, production is basically the activity which converts the inputs (land ,labour, capital,
entrepreneurship) into the output . So, we can call it a process, we can call it a technique, we
can call it a activity, and which transform the different kind of inputs into the outputs.

• The process of transforming inputs into outputs can be any of the following kinds:
✔ Change in the form (raw material transformed to finished goods)
✔ Change in place(supply chain, factory to retailer)

• With these kinds of transformations, usability of the good or materials increases

• Production is an activity that increases consumer usability of goods and services

 BASIC CONCEPT OF PRODUCTION
THEORY: CLASSIFICATION OF INPUT

1. Labour
2. Capital
3. Land
4. Raw materials

• These variables are measured per unit of time and hence referred to as flow
variables

• Entrepreneurship has been added as part of the production inputs, though

this can be measured by the managerial expertise and the ability to make
things happen
 BASIC CONCEPT OF PRODUCTION
THEORY

• An input is a good or service that goes into the production process. Economist refer
input, as anything which a firm buy for use in its production process

• An output is any good or service that comes out of a production process.

• Input are considered variable or fixed depending on how readily their usage can be
changed

• Fixed input: An input for which the level of usage cannot readily be changed
• In economic sense, a fixed input is one whose supply is inelastic in the short run
• In technical sense, a fixed input is one that remains fixed(or constant) for certain level
of output
 BASIC CONCEPTS IN
PRODUCTION THEORY
• Variable input: a variable input is one whose supply in the short run is elastic
Example: labour, raw material .Users of such inputs can employ a larger quantity in the short
run

• Technically a variable input is one that changes with changes in output

• In the long run, all input are variable, because long run is sufficiently long time period, to
alter the factors of production

• Short run
✔ At least one input is fixed
✔ All changes in output achieved by changing usage of variable inputs

• Long run
✔ All inputs are variable
✔ Output changed by varying usage of all input
 PRODUCTION FUNCTION

• All tool of analysis in explaining the input-output relationship

• It describes the technical relationship between input and output in physical term

• In its general form ,it holds that production of a given commodity depends on certain
specific inputs

• In its specific form ,it presents the quantitative relationships between input and output

• A production function may take the form of a schedule ,a graph line or a curve, an
algebraic equation or a mathematical model

• The production function represents the technology of a firm

 PRODUCTION FUNCTION

• An empirical production function is generally so complex to include a wide

range of inputs: land, labour,capital ,raw material, time, and technology.These
variables form the independent variables in a firm’s actual production function

• A firm long-run production function is of the form:

Q=f(Ld, L,K,M,T)
• Where Ld=land and building
L=labour
K=capital
M=material
T=technology
 PRODUCTION FUNCTION

Land is defined as anything which is gift of nature and not the result of human
effort. It includes all natural resources on or under the earth surface. Since these
are fixed in supply ,therefore the return from land is called rent.

Labour :No production process can take place without human effort. Labour
includes unskilled ,semi skilled and highly skilled labours. The return on labour is
termed as wages and salary
 PRODUCTION FUNCTION

Capital: It is the wealth which is used for further production. It is not gift of nature, but
is produced by human beings. Physical capital includes tangible resources like
equipment's, buildings, machines .Human capital includes skills, investment made by
people through experience and training that help to produce more or better goods or
services. Return to capital is interest

Enterprise: The ability and action to collect ,coordinate and utilize all the factors of
production for the purpose of economic gains is known as enterprise. The special
features of this factor of production is that the returns herein are expected, but not
certain. All the other factors contribute to production process for definite returns,
without any risk and uncertainty. Entrepreneurship is also defined as the ability to take
risk. Hence, the entrepreneur’s remuneration is profit
 PRODUCTION FUNCTION

• For sake of convenience economist have reduced the number of variables used in
a production function to only two: capital (K)and labour (L) therefore in the
analysis of input-output relations, the production function is expressed as
Q=f (K , L)
• Increasing production, Q ,will require K and L ,and whether the firm can increase
both K and L or only L will depend on the time period it takes into account for
increasing production ,that is ,whether the firm is thinking in terms of the short run
or in terms of the long run

• Economist believe that the supply of capital (K) is inelastic in the short run and
elastic in the long run

• Thus in the short run firms can increase production only by increasing labour,
since the supply of capital is fixed in the short run.
• In the long run, the firm can employ more of both capital and labour, as the
supply of capital becomes elastic over time
 SHORT RUN PRODUCTION

• In the short run, capital is fixed only changes in the variable labour input can
change the level of output

✔ In short run production function shows the maximum output a firm can
produce when only one of its inputs can be varied, other inputs remaining fixed.
• This law applies only in the short run when we can’t change all the factors of
production. Further, it studies the change in output by varying the quantity of
one input.

• This theory is represented in the form of three curves, called marginal product
curve, total product curve, and average product curve.
 TP,MP,AP

• Product: the volume of goods produced by a firm during a specified period of time

• Total product : it gives maximum of output that can be produced at different levels
of one input, assuming that the other input is fixed at a particular level (The TP
curve show the total amount of production.

• Marginal product: change in the output resulting from a very small change in one
factor input ,keeping the other factor inputs constant .The marginal product curve
shows how the production of the product changes when one input unit is added.

• Average Product: total production per unit of output .Average product curve
shows the average production by the work force.
 LAW OF DIMINISHING RETURNS OR
THE LAW OF VARIABLE PROPORTION
OR RETURNS TO FACTORS

• Sometimes also referred to as the law of variable proportions, this "law" economists
make about the nature of technology when it is possible to combine the same
factors of production in a number of different proportions to make the same
product.

• The shape of total product curve is determined by the law of diminishing return

• The law of diminishing returns, states that with a given state of technology if the
quantity of one factor input is increased, by equal increment, the quantities of
other factor inputs remaining fixed, the resulting increment of total product will
first increase but decrease after a particular point

• It states that as we go on employing more of one factor of production ,other

factor remaining same, the marginal productivity will diminish after some point.
The shape of marginal product curve is therefore inverted U shaped
 ASSUMPTIONS

1. State of technology is given, there is no change in techniques of production

2. One factor of production must always be kept constant at a given level. K

has to be constant

3. The law is not applicable when two inputs are used in a fixed proportion

4. All units of variable factors are homogeneous (i.e. each workers has the same
skills)
Fixed Factor Variable Factor Total Product Marginal Average Stages
(Land in (Labour in (in tonnes) Product Product
hectare) units)
10 0 0 0 0 Stage I
10 1 8 8 8 OR
10 2 20 12 10 Increasing return

10 3 33 13 11
10 4 44 11 11
10 5 50 6 10 Stage II
10 6 54 4 9 OR
10 7 56 2 8 Diminishing
return
10 8 56 0 7 Stage III

10 9 54 -2 6 OR

10 10 50 -4 5 Negative return
 LAW OF DIMINISHING RETURNS OR
THE LAW OF VARIABLE PROPORTION
 POINTS TO REMEMBER

Stage: I
• Infection point: When MP is maximum
• It ends when AP is maximum and AP=MP
• It is also known as stage of increasing returns because MP> AP
Stage II
• Producer operates at this stage
• It is also called stage of diminishing returns
• MP and AP ,both decreases throughout this stage and MP < AP
Stage III
• MP is negative
• It is also known as stage of negative return
 AT WHICH STAGE THE
PRODUCER WILL PRODUCE

In third stage if the producer will add one more unit of labour TP & AP
decreases MP becomes negative

In first stage till MP >AP the producer will keep on producing as soon as MP<
AP the producer will stop production

Therefore producer will operate at 2nd stage as the combination of input are fully
utilized
 RELATIONSHIP BETWEEN TP
AND MP

• When MP is increasing, TP will increase at an increasing rate

• When MP is decreasing ,TP will increase at a decreasing rate

• When MP is negative, TP decline

 RELATIONSHIP BETWEEN MP
AND AP

• When MP is above AP,AP is increasing

• When MP is below AP,AP is decreasing

• When MP equals AP,AP is at its maximum

 THREE STAGE OF PRODUCTION

Stage: I :Stage of increasing return

• AP is increasing and the MP is greater than AP. Upto point B on the TP curve
stage 1 exist

• AP is increasing ,but MP is increasing first upto point A then decreasing

• In stage 1 MP and AP both are rising, and the MP is more than AP

• A given increase in variable factor leads to a more than proportionate increase

in the output

• The producer is not making the best possible use of the fixed factor. A
particular portion of fixed factor remains unutilized
 THE THREE STAGE OF
PRODUCTION

Stage: II :Stage of diminishing return

• In stage II MP and AP both are falling and MP through positive,is less than AP

• There is less than proportionate change in output due to change in labor force

• Hence at this stage the producer will employ the variable factor in such a manner
that the utilization of fixed factor is most efficient

Stage: III :Stage of negative return

• MP of variable factor is negative and the TP is also decreasing

 REASONS OF LAW OF VARIABLE
PROPORTION
Stage I
• Better utilization of fixed factors
• Increased efficiency of variable factors

Stage II
• Optimum combination of factors in this stage, beyond this TP will fall

• Imperfect substitutes: because fixed and variable factors become imperfect substitutes. There is
a limit for which these can be substituted with one another. after that limit they become
imperfect substitutes which leads to diminishing return (More and more of labour cannot be
continuously used in place of capital. Accordingly, diminishing returns are bound to set in if
only the variable factor is increased to increase output)

Stage III
• Limitation of fixed factors
• Poor coordination of fixed and variable factors
 TOTAL AVERAGE AND MARGINAL
PRODUCTS

• The point 1 on the total product curve is called as the point of inflexion.
Because at this point, the curve is changing its curvature and at corresponding
to this the MP will be maximum, AP is maximum at this point 2 and also the
AP is equal to MP

• Since the MP is decreasing when the average product is maximum, the MP

curve reaches maximum before the AP curve

• When AP is rising, MP is greater than AP

• When AP is falling MP is less than AP
• When AP reaches it maximum, AP=MP
THE THREE STAGE OF
PRODUCTION