Production and Cost Analysis

Contents

◼ Concept of production function

◼ Production with one variable input
◼ Production with two variable inputs
◼ Marginal Rate of Technical Substitution
◼ Producer Equilibrium
◼ Cost concepts and cost curves in short and long run
◼ Economies and diseconomies of scale
◼ Different concepts of revenue
◼ Break even analysis
Overview
I. Production Analysis
❑ Total Product, Marginal Product, Average
Product
❑ Production Function with one variable

❑ Production Function with two variables

❑ Isoquants

❑ Returns to scale

II. Cost Analysis

❑ Total Cost, Variable Cost, Fixed Costs

❑ Cost Relations

❑ Scale Economies
Introduction

◼ In the supply process, people first offer their factors

of production to the market.
◼ Then the factors are transformed by firms into goods
that consumers want.
❑ Production - Transformation of factors into goods.
◼ The firm is an economic institution that transforms
factors of production into consumer goods – it:
❑ Organizes factors of production.
❑ Produces goods and services.
❑ Sells produced goods and services.
The Production Process: The Long
Run and the Short Run
◼ The production process can be divided into
the long run and the short run.
◼ A long-run decision is a decision in which
the firm can choose among all possible
production techniques (In the long run, all
inputs are variable).
◼ A short-run decision is one in which the firm
is constrained in regard to what production
decision it can make (In the short run, some
inputs are fixed).
 Analysis of Production Function:
Short Run
◼ In the short run at least one factor fixed in supply but all
other factors capable of being changed
◼ Reflects ways in which firms respond to changes in
output (demand)
◼ Can increase or decrease output using more or less of
some factors but some likely to be easier to change than
others
◼ Increase in total capacity only possible in the long run
 Analysing the Production Function:
Long Run
◼ The long run is defined as the period of time taken to
vary all factors of production
❑ By doing this, the firm is able to increase its total

capacity – not just short term capacity

❑ Associated with a change in the scale of

production
❑ The period of time varies according to the firm

and the industry

❑ In electricity supply, the time taken to build new
capacity could be many years; for a market stall
holder, the ‘long run’ could be as little as a few
weeks or months!
Production Function
Production Function
◼ States the relationship between inputs and outputs
◼ Function showing the highest output that a firm can produce
for every specified combination of inputs.
◼ Inputs – the factors of production classified as:
❑ Land

◼ Price paid to acquire land = Rent

❑ Labour
◼ Price paid to labour = Wages
❑ Capital – buildings, machinery and equipment
not used for its own sake but for the contribution
it makes to production
◼ Price paid for capital = Interest
Q = f (K, L, La)
Production
The theory of the firm describes how a firm makes cost-
minimizing production decisions and how the firm’s
resulting cost varies with its output.

◼ The Production Decisions of a Firm

The production decisions of firms are analogous to the
purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
Production Tables and Production
Functions
◼ A production table shows the output
resulting from various combinations of factors
of production or inputs.
❑ Total Product: is the aggregate amount of output
produced from all inputs
❑ Marginal product is the additional output that will
be forthcoming from an additional worker, other
inputs remaining constant.
❑ Average product is calculated by dividing total
output by the quantity of the output.
Marginal and Average Product

MPL = DQ/DL
◼ Measures the output produced by the last
unit used. Slope of the production function

APL = Q/L
Output Elasticity: MP / AP
Production Tables and Production
Functions
◼ Production function – a curve that
describes the relationship between the inputs
(factors of production) and outputs
◼ The production function tells the maximum
amount of output that can be derived from a
given number of inputs.
A Production Table

Number of Total output Marginal Average

workers product product

0 0 4 —
1 4 6 4
2 10 5
3 7
17 6 5.7
4 23 5.8
5
5 28 3 5.6
6 31 1 5.2
7 32 0 4.6
8 32 -2 4.0
9 30 -5 3.3
10 25 2.5
Production with
One Variable Input (Labor)
Output
per
Month D
112

Total Product

60

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

Production Function and The Law of
Diminishing Marginal Productivity

Diminishing Diminishing
b Diminishing Diminishing
32 marginal absolute
7 marginal absolute
30 returns returns
returns returns
28
26 6 c
24
22 TP 5
20 Increasing

Output per worker

Output

18 4
16 marginal
14 returns
3
12
10
8 2
AP
6
4 1
2
d
0 0
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Number of workers Number of workers MP
(a) Total product (b) Marginal and average product
The Law of Diminishing Marginal
Productivity
◼ MP rises first: the slope of TP curve gets
steeper
◼ MP reaches maximum, where slope of TP
curve is steepest
◼ When diminishing returns set in (MP falls), TP
becomes less steep
◼ AP rises at first. It continues rising as long as
the addition to output from the last worker (MP)
is greater than the average output (AP).
The Law of Diminishing Marginal
Productivity
◼ This continues beyond upper most point of MP (b). Even
though MP is now falling, the AP goes on rising as long
as the MP is still above the AP. Thus, AP goes on rising
until a point and beyond that point (c).
◼ After c, MP is below AP. New workers add less to output
than the average. This pulls the average down: AP falls
◼ As long MP is greater than zero, TP will go on rising;
new workers add to total output
◼ At point d, (when MP touches zero), TP is at a maximum
(its slope is zero). An additional worker will add nothing
to output.
◼ Beyond that TP fall and MP is negative
The Law of Diminishing Marginal
Productivity

◼ When the labor input is small, MP increases

due to specialization.

◼ When the labor input is large, MP decreases

due to inefficiencies.
Effect of Technological improvement
Labor productivity
(output per unit of
labor) can increase if
there are
improvements in
technology, even
though any given
production process
exhibits diminishing
returns to labor.
As we move from
point A on curve O1 to
B on curve O2 to C on
curve O3 over time,
labor productivity
increases.
PRODUCTION WITH TWO VARIABLE
INPUTS
Production in the Long Run

◼ In the long run, all inputs are variable.

◼ Isoquants defines combinations of inputs

that yield the same level of product
Isoquants

◼ Curves showing all possible combinations of

inputs that yield the same output. The
combinations of inputs (K, L) that yield the
producer the same level of output.
◼ The shape of an Isoquants reflects the ease
with which a producer can substitute among
inputs while maintaining the same level of
output
 PRODUCTION WITH TWO
VARIABLE INPUTS
◼ Isoquants Production with Two Variable Inputs
LABOR INPUT
Capital
Input 1 2 3 4 5
1 20 40 55 65 75
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

● isoquant Curve showing

all possible combinations
of inputs that yield the
same output.
PRODUCTION WITH TWO
VARIABLE INPUTS
● isoquant map Graph combining a number of
isoquants, used to describe a production function.
A set of isoquants, or
isoquant map, describes
the firm’s production
function.
Output increases as we
move from isoquant q1 (at
which 55 units per year
are produced at points
such as A and D),
to isoquant q2 (75 units
per year at points such as
B) and
to isoquant q3 (90 units
per year at points such as
C and E).
PRODUCTION WITH TWO
VARIABLE INPUTS
◼ Diminishing Marginal Returns

Holding the amount of

capital fixed at a particular
level—say 3, we can see
that each additional unit of
labor generates less and
less additional output.
 PRODUCTION WITH TWO
VARIABLE INPUTS
● Marginal Rate of Technical Substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra
unit of another input is used, so that output remains constant.
MRTS = − Change in capital input/change in labor input
= − ΔK/ΔL (for a fixed level of q)

Like indifference curves,

isoquants are downward sloping
and convex. The slope of the
isoquant at any point measures
the marginal rate of technical
substitution—the ability of the
firm to replace capital with labor
while maintaining the same level
of output.
On isoquant q2, the MRTS falls
from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP ) = −(DK / DL) = MRTS

L K
 PRODUCTION WITH TWO
VARIABLE INPUTS

Isoquants When Inputs Are

Perfect Substitutes

When the isoquants are

straight lines, the MRTS is
constant. Thus the rate at
which capital and labor can
be substituted for each
other is the same no matter
what level of inputs is being
used.
Points A, B, and C
represent three different
capital-labor combinations
that generate the same
output q3.
 PRODUCTION WITH TWO
VARIABLE INPUTS
● fixed-proportions production function Production function
with L-shaped isoquants, so that only one combination of labor
and capital can be used to produce each level of output.
The fixed-proportions production function describes
situations in which methods of production are limited.

Fixed-Proportions
Production Function
When the isoquants are L-
shaped, only one
combination of labor and
capital can be used to
produce a given output (as at
point A on isoquant q1, point
B on isoquant q2, and point C
on isoquant q3). Adding more
labor alone does not increase
output, nor does adding more
capital alone.
Production in the Long Run

◼ The long run production process is

described by the concept of returns to
scale.
◼ Returns to scale describes what happens to
total output as all of the inputs are changed
by the same proportion.
RETURNS TO SCALE

● returns to scale Rate at which output increases as

inputs are increased proportionately.

● increasing returns to scale Situation in which output

more than doubles when all inputs are doubled.

● constant returns to scale Situation in which output

doubles when all inputs are doubled.

● decreasing returns to scale Situation in which output

less than doubles when all inputs are doubled.
 RETURNS TO SCALE

When a firm’s production process exhibits However, when there are increasing
constant returns to scale as shown by a returns to scale as shown in (b), the
movement along line 0A in part (a), the isoquants move closer together as
isoquants are equally spaced as output inputs are increased along the line.
increases proportionally.
Returns to Scale
Decreasing
K
6

4 30

3
20
2
10
1

0
0 5 10 15 L
Production in the Long Run

One way to measure returns to scale is

to use a coefficient of output elasticity:
Percentage change in Q
EQ =
Percentage change in all inputs

◼ If E>1 then IRTS

◼ If E=1 then CRTS
◼ If E<1 then DRTS
Production in the Long Run

◼ Economists hypothesize
that a firm’s long run
production function may
exhibit at first increasing
returns, then constant
returns, and finally
decreasing returns to
scale.
Cost Analysis
Costs Analysis
❑ Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin costs.
They can change but not in relation to output Fixed
costs are those that are spent and cannot be changed
in the period of time under consideration.
◼ In the long run there are no fixed costs since all
costs are variable.
◼ In the short run, a number of costs will be fixed.

❑ Variable Costs – costs directly related to variations in

output. Raw materials primarily
◼ Workers represent variable costs – those that
change as output changes
 The Short Run Cost Function

◼ A firm’s short run cost function tells us the minimum

cost necessary to produce a particular output level.
◼ For simplicity the following assumptions are made:
❑ the firm employs two inputs, labor and capital

❑ labor is variable, capital is fixed

❑ the firm produces a single product

❑ technology is fixed

❑ the firm operates efficiently

❑ the firm operates in competitive input markets

❑ the law of diminishing returns holds

Costs

◼ Total Cost - the sum of all costs incurred in

production
◼ TC = FC + VC
◼ Average Cost – the cost per unit
of output
◼ AC = TC/Output
◼ Marginal Cost – the cost of one more or one fewer
units of production
◼ MC = TCn – TCn-1 units
◼ MC = ΔTC/ ΔQ (Note that all marginal costs are
variable, since, by definition, there can be no extra
fixed costs as output rises)
The Short Run Cost Function
The Short Run Cost Function
◼ Graphically, these results are be depicted
in the figure below.

AFC
The Short Run Cost Function

◼ Important Observations
❑ AFC declines steadily over the range of
production.
❑ In general, AVC, AC, and MC are u-shaped.
❑ MC measures the rate of change of TC
❑ When MC<AVC, AVC is falling
When MC>AVC, AVC is rising
When MC=AVC, AVC is at its minimum
❑ The distance between AC and AVC represents
AFC
Relationship Between Marginal and
Average Costs
◼ The position of the marginal cost relative to
average total cost tells us whether average
total cost is rising or falling.
◼ To summarize:
If MC > ATC, then ATC is rising.
If MC = ATC, then ATC is at its low point.
If MC < ATC, then ATC is falling.
◼ Marginal cost curves always intersect
average cost curves at the minimum of the
average cost curve.
Average and Marginal Cost Curves

◼ The average fixed cost curve looks like a

child’s slide – it starts out with a steep
decline, then it becomes flatter and flatter.
◼ It tells us that as output increases, the same
fixed cost can be spread out over a wider
range of output.
The U Shape of the Average and
Marginal Cost Curves
◼ When output is increased in the short-run, it
can only be done by increasing the variable
input.
◼ The law of diminishing marginal productivity
sets in as more and more of a variable input
is added to a fixed input.
◼ Marginal and average productivities fall and
marginal costs rise.
The U Shape of the Average and
Marginal Cost Curves
◼ And when average productivity of the variable
input falls, average variable cost rise.
◼ The average total cost curve is the vertical
summation of the average fixed cost curve
and the average variable cost curve.
 The Relationship Between
Productivity and Costs

Productivity of workers at this output

$18 9
16 MC 8
14 7
Costs per unit

12 AVC 6 A
10 5
8 4 AP of
6 3 workers
4 2
2 1 MP of workers
0 4 8 12 16 20 24 Output 0 4 8 12 16 20 24 Output
The Long-run Cost Function
Making Long-Run Production
Decisions
◼ To make their long-run decisions:
❑ Firms look at costs of various inputs and the
technologies available for combining these inputs.
❑ Then decide which combination offers the lowest
cost.
◼ The firm makes long-run decisions on the
basis of the expected costs and expected
usefulness of inputs.
The LR Relationship Between
Production and Cost

◼ In the long run, all inputs are variable.

◼ In the long run, there are no fixed costs
◼ The long run cost structure of a firm is
related to the firm’s long run production
process.
◼ The firm’s long run production process is
described by the concept of economies of
scale.
The LR Relationship Between
Production and Cost
◼ Economists hypothesize that a firm’s long-run
production function may exhibit at first increasing
returns, then constant returns, and finally
decreasing returns to scale.
◼ When a firm experiences increasing economies of
scale
❑ A proportional increase in all inputs increases output by a
greater percentage than costs.
❑ Costs increase at a decreasing rate
The LR Relationship Between
Production and Cost
◼ When a firm experiences constant economies of
scale
❑ A proportional increase in all inputs increases output by the
same percentage as costs.
❑ Costs increase at a constant rate
◼ When a firm experiences decreasing economies of
scale
❑ A proportional increase in all inputs increases output by a
smaller percentage than costs.
❑ Costs increase at an increasing rate
A Typical Long-Run Average Total
Cost Table
Total Costs Total Cost Total Costs = Average Total
Quantity of Labor of Machines TCL + TCM Costs = TC/Q

11 381 254 635 58

12 390 260 650 54
13 402 268 670 52
14 420 280 700 50
15 450 300 750 50
16 480 320 800 50
17 510 340 850 50
18 549 366 915 51
19 600 400 1,000 53
20 666 444 1,110 56
Economies of Scale

◼ The advantages of large scale production

that result in lower unit (average) costs (cost
per unit)
◼ AC = TC / Q
◼ Economies of scale – spreads total costs
over a greater range of output
Economies of Scale

Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•Assume each unit of capital = Rs. 5, Land = Rs.

8 and Labour = Rs. 2
•Calculate TC and then AC for the two different
‘scales’ (‘sizes’) of production facility
•What happens and why?
Economies of Scale
Capital Land Labour Output TC AC

Scale A 5 3 4 100 57 0.57

Scale B 10 6 8 300 164 0.54

•Doubling the scale of production (a rise of 100%) has led

to an increase in output of 200% - therefore cost of
production
•PER UNIT has fallen
•Don’t get confused between Total Cost and Average Cost
•Overall ‘costs’ will rise but unit costs can fall
Economies and Diseconomies of
Scale

$64 Economies Constant Diseconomies

62 of Scale returns of Scale
to Scale
Costs per unit

60 Average
58 total cost
56
54
52
50
48
11 12 13 14 15 16 17 18 19 20 Quantity
Economies of Scale

◼ Economies of scale – long run average total

costs decrease as output increases.

◼ In real-world production processes,

economies of scale are extremely important
at low levels of production.
Reasons for Economies of Scale

❑ Specialization in the use of labor and capital

❑ Indivisible nature of many types of capital equipment
❑ Productive capacity of capital equipment rises faster
than purchase price
❑ Discounts from bulk purchases
❑ Lower cost of raising capital funds
❑ Spreading promotional and R&D costs
❑ Principle of multiples – firms using more than one
machine of different capacities - more efficient
❑ Increased dimensions – bigger containers can reduce
average cost
Diseconomies of Scale

◼ Diseconomies of scale refer to decreases in

productivity which occur when there are
equal increases of all inputs (no input is
fixed).
◼ Diseconomies of scale occur on the right side
of the long-run average cost curve where it is
upward sloping, meaning that average cost is
increasing.
Diseconomies of Scale

◼ As the size of the firm increases, monitoring costs

generally increase.
◼ As the size of the firm increases, team spirit or
morale generally decreases.
◼ Disproportionate rise in transportation costs
◼ Input market imperfections
◼ Management coordination and control problems
◼ Disproportionate rise in staff and indirect labor
Diseconomies of Scale

◼ The disadvantages of large scale production that

can lead to increasing average costs
❑ Problems of management
❑ Maintaining effective communication
❑ Co-ordinating activities – often across
the globe!
❑ De-motivation and alienation of staff
Importance of Economies and
Diseconomies of Scale
◼ Economies and diseconomies of scale play
important roles in real-world long-run
production decisions.
◼ The long-run and the short-run average cost
curves have the same U-shape, but the
underlying causes of these shapes differ.
◼ Economies and diseconomies of scale
account for the shape of the long-run total
cost curve.
Economies of Scale

◼ Because of the importance of economies of scale,

business people often talk of a minimum efficient
level of production.
◼ The minimum efficient level of production is the
amount of production that spreads setup costs out
sufficiently for firms to undertake production
profitably.
◼ The minimum efficient level of production is reached
once the size of the market expands to a size large
enough so that firms can take advantage of all
economies of scale.
A Typical Long-Run Average Total
Cost Curve
$64
62
Costs per unit

60 Average
58 total cost
56 Minimum efficient
54 level of production
52
50
48
11 12 13 14 15 16 17 18 19 20 Quantity
Importance of LRAC

◼ The point from where the diseconomies of scale

sets in- sets a limit to the size of firms and hence to
the pressure for mergers and acquisitions.
◼ DRS can lead to break-up of very large firms
◼ IRS over the whole range of output means that a
single producer can supply the entire market at a
lower cost than two or more competing firms.
Optimum Combination of Inputs
A Numerical Example
Bundles of: Labor Machine rental
with C = Rs.30 (Rs.6 per labor hour) (Rs.3 per machine hour)

a 0 10
b 1 8
c 2 6
d 3 4
e 4 2
f 5 0

Points a through f lie on the isocost line for C = Rs.30/hour.

67
The Isocost Line
Capital, K (machines rented)

a
10
b
8
c
6
d
4
e
2
f
0 1 2 3 4 5 6 7 8 9 10
Labor, L (worker-hours employed)
68
 Isocost
◼ The combinations of K
inputs that cost the
producer the same
amount of money
◼ Changes in input prices C0 C1
change the slope of the L
isocost line K
New Isocost Line for
a decrease in the
wage (price of
labor).

L
Cost Minimization
Capital, K (machines rented)
12
10

8 C = Rs.36

6
W = Rs 6; R = Rs.3;C = Rs.30
4 equ.
2
C = Rs.18

0 1 2 3 4 5 6 7 8 9 10
Labor, L (worker-hours employed)
71
Break- Even

◼ Break Even occurs when net income from the

project is zero
◼ Let your total output be TO which is p*Q where p is
selling price and q is quantity, VC is variable cost
(that varies with quantity), FC is fixed cost (remains
constant with quantity) and D is depreciation; then
your break even point is where
TO = VC +FC +D
Therefore TO –FC-VC-D = 0 ---- Break even point
Numerical

Q TC TFC TVC AC AVC ATC

0 50 50
1 100 50
2 140 50
3 190 50
4 235 50
5 280 50
6 330 50
7 370 50
Numerical
Q TC TFC TVC AC AVC AFC
0 50 50 0

1 100 50 50 100.00 50.00 50.00

2 140 50 90 70.00 45.00 25.00
3 190 50 140 63.33 46.67 16.67
4 235 50 185 58.75 46.25 12.50
5 280 50 230 56.00 46.00 10.00
6 330 50 280 55.00 46.67 8.33
7 370 50 320 52.86 45.71 7.14
Numerical

◼ Total cost= Total fixed cost + Total Variable

cost (TC= TFC+TVC)
◼ In following

Cost= 100+70Q-2Q2
Total cost for 20 quantities is
Total cost (TC)= 100+ 70(20)- 2(20)2
TC= 100 + 1400-800 = 1500-800= 700
TFC= 100
TVC= TC-TFC= 700-100= 600
Principle of Derivation

◼ Y= 3q2
◼ dy/dq = 2*3.q(2-1) = 6X

◼ Y = 4q3

◼ Y= 7q4
Marginal cost
◼ Use of derivatives
MC= d (TVC)/d (q)
Example Cost= 100+70Q-2Q2 + Q3
For 8 quantities
Total cost= 100+ 70 *8 - 2*(8)2+ Q3
TC= 100+560-128 +512= 1044
TVC= 70Q-2Q2 + Q3
MC= d(70q -2q2+q3)/d(q)
MC= 70- 2*2 q +3Q2= 70-4 (8) +3 (8)2
MC= 70- 32+ 192= 230
Minimum AVC

◼ AVC= TVC/Q
◼ Minimum AVC= d (AVC)/d (q) = 0

Example Cost= 100+70Q-2Q2 + Q3

Total variable cost (TVC)= 70Q-2Q2 + Q3
AVC= TVC/q = (70Q-2Q2 + Q3)/q= 70- 2Q +Q2
Minimum AVC = d(70- 2Q +Q2)/d(q) = 0
Minimum AVC = -2+2q= 0
Minimum AVC = 2q= 2
Q=1
◼ The short run total cost function of a firm is
TC: 200 + 60Q - 12Q2 + Q3
Where TC is total cost and Q is a fixed level of output

◼ Calculate for 5 units of output

❑ Total cost (TC),

❑ Average total cost (ATC),

❑ Average variable cost (AVC) and

❑ Marginal cost (MC)

◼ Calculate the level of output at which average variable cost (AVC) is

minimum
◼ C= 20000+20Q-4Q2 +Q3
1. What is total fixed cost for 500 units of
output, 1000 units of output and 5000 units
of output
2. What is AFC at 500 units of output, 1000
units of output and 5000 units of output
3. Determine- TVC, AVC, MC and AC at 100
units
1. Calculate average total cost (ATC), average variable cost (AVC) and marginal cost
(MC) for each quantity.
2. Graph all three curves and explain– 1. What is the relationship between the
marginal cost curve and the average cost curve and 2. What is the relationship
between the marginal cost curve and the average variable cost curve.

Q VC TC
0 0 60
1 20 80
2 50 110
3 90 150
4 140 200
5 200 260
6 270 330
A competitive firm has the following data

Output (Q) TFC (Rs) TVC (Rs.)

0 100 0

1 100 50

2 100 90

3 100 140

4 100 200

5 100 280

6 100 380

◼ If price = Rs 60, how many units will the firm produce

◼ What will be the level of profits/losses at this level of production
◼ Will the firm operate in the short-run
◼ What will happen in the long run
Thank You