UNIT-6

Production Analysis
Production in simple language is transformation of input into output

Inputs Process Output

Man Machine Material Goods Services

 Factors of Production

Resources which are required for the production are known as factors of production.
For example :
► labour,
► capital,
► raw material,
► land etc.
 Production function
Production function refers to the technical relationship between the quantity
produced (outputs) and the resources which are used for producing (inputs)

Mathematically, production function can be expressed as :

Q = f ( L, C, La, R )

Where :

Q = Quantity of output

L = Labour

C = Capital

La = Land.

R = Raw material
 Cost of Production
Cost of Production
► Opportunity cost
Opportunity cost is the forgone cost of taking next best alternative.
1. “Interest” which is sacrificed by employing capital in own business
2. “Salary” that an entrepreneur could get from somewhere else, if he works.
3. “Rent” which is sacrificed by using own land in own business
Graphical representation
 Accounting cost and Economic cost :

► Accounting costs is the cost which includes all direct expenses related to the
business like:
1. cost of raw material,
2. wages,
3. electricity expenses,
4. administrative expenses etc.
These direct cost are also known as explicit cost

Accounting cost = Explicit costs

► Economic costs include both explicit and implicit costs. Implicit costs is the
opportunity cost in terms of revenue lost by forgoing the next best alternative,

Economic cost = Explicit cost + Implicit cost

For example :
A person running his business which includes following costs
Raw material = ` 200000/month
Salary = ` 20000/month
Administration expense = ` 10000/month
Additional information : Person is running his business in his own building
and if he could rent out this land the rent could be ` 10000/ month. Then find
out the accounting and economic cost.
Ans.
Accounting cost = Explicit cost (all direct cost)
= 200000 + 20000 + 10000
= 230000
Economic cost = explicit cost + implicit cost
= (200000 + 20000 +10000) + (10000)
= 240000
 Cost Output Relationship

Cost output relationship shows how the cost changes if output level change. Every
cost shows different type of behaviour with change level of output.

Short Run Cost Long Run Cost

“Short run is the period where firm can vary its output by varying its variable cost
only. Firm cannot change its fixed cost in short run. “

“Long run is the period where all the costs can vary. In other words in long run, no
cost is fixed cost.”
 Short run Total cost
In short run the Total Cost (TC) comprises total fixed cost and total variable cost.
STC = SVC +SFC
Fixed cost is the cost which does not vary with level of production.
Variable cost is the cost which varies with the level of production.
 Short run Average cost :

Average fixed cost :

Average fixed cost is total fixed cost (TFC) divided by output (Q),

TFC
AFC =
Q
► 2. Average variable cost
Average variable cost (AVC) is found by dividing total variable cost (TVC) by output
(Q)

AVC = TVC/Q
► 3. Average Cost Average total cost (AC) is found by dividing total cost (TC) by
output (Q).

AC = TC/Q
We can also say that with the help of all above cost formula
TC = FC + VC
Or ATC = AFC + AVC
►
► Short run marginal Cost
Marginal cost (MC) is the cost of producing additional units of output.

MC = Change in total cost /change in total quantity

Short run cost and output relationship
 Long Run Costs

(a) Long run total cost

As we know the total cost is the cost of production. In long run total cost is all
variable.
TC = VC

(b) Long run average cost

1. Average cost: In long run average cost can be identified by dividing total
cost (TC)to output(Q)

AC = TC/Q

2. Average variable cost: In long run average variable cost can be identified
by dividing variable cost (VC) by output (Q)

AVC = VC/Q
(c) Long run marginal cost

Marginal cost in long run can be calculated by the following formula

MC = Change in total cost /change in output

► In connection with Long run average cost curve following points are to be noted:

1. The LAC curve is tangential to the various SAC curves. It is said to envelop

them and is often called as the “envelope curve” since no point on an SAC

curve can ever be below the LAC curve.

2. The LAC curve is U-shaped or like a “dish.” The U-shape of the LAC curve

implies lower and lower average cost in the beginning until the optimum scale

of the enterprise is reached. And successively higher average costs thereafter,

i.e., with plants larger than that of the optimum scale.

Law of Return to scale
Introduction
The laws of returns to scale refer to the effects of a change in the scale of
factors (inputs) upon output in the long-run when the combinations of factors are
changed in some proportion.
The returns to scale can be shown diagrammatically on an expansion path “by the
distance between successive ‘multiple-level-of-output’ isoquants, that
is, isoquants that show levels of output which are multiples of some
base level of output, e.g., 100, 200, 300, etc.”
Levels of Return
1. Increasing Return
2. Constant Return
3. Decreasing Return
Increasing Returns to Scale

Increasing Returns to Scale:

The case of increasing returns to scale where to get equal increases in output, lesser
proportionate increases in both factors, labor and capital, are required.
► 100 units of output require 3C + 3L
► 200 units of output require 5C + 5L
► 300 units of output require 6C + 6L
The increasing returns to scale are attributed to the following factors:
1. Specialization and division of labor
2. internal economies of production
3. external economies
Constant Returns to Scale

Constant Returns to Scale:

the case of constant returns to scale. Where the distance between the isoquants
100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE = EE It
means that if units of both factors, labour and capital, are doubled, the output is
doubled.
► 100 units of output require 1 (2C + 2L) = 2C + 2L
► 200 units of output require 2(2C + 2L) = 4C + 4L
► 300 units of output require 3(2C + 2L) = 6C + 6L
Returns to scale are constant due to the following factors:

► 1. The returns to scale are constant when internal economies enjoyed by a firm
are neutralized by internal diseconomies so that output increases in the same
proportion.

► 2. Another reason is the balancing of external economies and external

diseconomies.

► 3. Constant returns to scale also result when factors of production are perfectly
divisible, substitutable, and homogeneous and their supplies are perfectly
elastic at given prices.
Decreasing Returns to Scale

Decreasing Returns to Scale

The case of decreasing returns where to get equal increases in output, larger
proportionate increases in both labor and capital are required.
► 100 units of output require 2C + 2L
► 200 units of output require 5C + 5L
► 300 units of output require 9C + 9L
so that along the expansion path OR, OG < GH < HK.
 Economies of Scale
In long run, due to bulk production some cost advantages come to the firm and these
advantages are known as economies of scale
► (1) Internal economies of scale
► (2) External economies of scale.

► Internal Economies :
Internal economies of scale are those economies which are on account of the size
and operations of an individual firm itself and not from the outside factors. Internal
economies are available exclusively to an expanding firm.
(a) Managerial Economies : 100 units 10 labour ……. 500 units 50 labour
Managerial economies arise from
(i) specialization in management
(ii) mechanization of managerial functions.
Managerial economies means with the expansion of the firm whole expanded scale is
looked after by the specialized personnel in the organization and this makes possible
for the firm to divide the firm into specialized department. In case of economies,
administrative cost decreases with the increase in output
 Specialization Economies :
When firm expands more and more workers of specialized skills and qualifications
are employed. With the increase in number of labour it is easy for the firm to divide
the labour according to their specialization. This is known as division of labour which
provides more efficiency to the firm production. And cost of production also reduces
due to division of labour in a business firm.
► Marketing Economies :

Marketing economies are concerned with the bulk purchases of raw material
while producing on the large scale leads to decrease in the cost of production.
Marketing economies arises due to
(i) economies in advertisement cost
(ii) economies in large scale distributor through wholesaler.

With the expansion of the firm the production cost increases but the advertising
expenditure does not increase proportionately.
Technical economies
Technical economies arise on account of large scale production in the use of plant,
machinery and work processes. Advanced technology is used which reduces the cost
of production when the production is carried on a large scale.
External Economies
External economies arise on account of the external factors and they are enjoyed by
all the firms in the area or industry as a whole. When an area is industrially well
developed then there will be
► development of labour market
► banking, insurance,
► Financial institutions,
► means of communication and
► transportation,
► social overhead and CSR
► cheap water,
► electricity
 Diseconomies of Scale
► Like every other thing the economies have a limit too. This limit reached when the
advantages of division of labour and potential personnel are fully exploited,
expanded capacity of plan fully used. Then diseconomies begin and to overweigh
economies and cost begins to rise.