UNIT – II

Objective:
 To understand the concept of production function
 Know about the various factors of production
 To analyze different costs in solving managerial problems.
 Identify economies and diseconomies of scale

Syllabus: Theory of Production and Cost Analysis

Production Function : Isoquant and Is costs , MRTS, least cost combinations of inputs , Cob-
Douglas production function , production function , laws of returns, internal and external
economies of scale .
Cost analysis- cost concepts &BEP Analysis break –Even point (simple problems)

Learning Outcomes:
 Understanding and estimating production function.
 Isoquant and Isocost and finding out optimal combinations of inputs.
 Understanding cost function and the difference between short-run and long-run cost
function.
 Understanding and calculating break-even point. • BEP and demand analysis.
 Access the minimum level of production that a firm should carry by using BEP and get
aware of costs incurred in the production

Learning Material

PRODUCTION FUNCTION

Introduction: The production function expresses a functional relationship between physical

inputs and physical outputs of a firm at any particular time period. The output is thus a function
of inputs. Mathematically production function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as
land, labour, capital and organization. Here output is the function of inputs. Hence output
becomes the dependent variable and inputs are the independent variables.
The above function does not state by how much the output of “Q” changes as a consequence of
change of variable inputs. In order to express the quantitative relationship between inputs and
output, Production function has been expressed in a precise mathematical equation i.e.
Y= a+b(x)
Which shows that there is a constant relationship between applications of input (the only factor
input ‘X’ in this case) and the amount of output (y) produced.
Importance:
 1. When inputs are specified in physical units, production function helps to estimate the
level of production.
2. It becomes is equates when different combinations of inputs yield the same level of
output.
3. It indicates the manner in which the firm can substitute on input for another without
altering the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’
and ‘law of returns to scale’. Law of variable propositions explains the pattern of output
in the short-run as the units of variable inputs are increased to increase the output. On the
other hand law of returns to scale explains the pattern of output in the long run as all the
units of inputs are increased.
6. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities of
various inputs that are required to produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole.
Production function will change with an improvement in technology.
Assumptions:
Production function has the following assumptions.
1. The production function is related to a particular period of time.
2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Cobb-Douglas production function:
Production function of the linear homogenous type is invested by Juntwicksell and first tested by
C. W. Cobb and P. H. Douglas in 1928. This famous statistical production function is known as
Cobb-Douglas production function. Originally the function is applied on the empirical study of
the American manufacturing industry. Cobb – Douglas production function takes the following
mathematical form.
Y= (AKX L1-x)
Where Y=output
K=Capital
L=Labour
A, ∞=positive constant

Assumptions:
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear
function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS
The term Isoquant is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or
isoquant or production difference curves can represent a production function with two variable
inputs, which are substitutable for one another within limits.
Isoquant are the curves, which represent the different combinations of inputs producing a
particular quantity of output. Any combination on the isoquant represents the some level of
output.
For a given output level firm’s production become,

Q= f (L, K)
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus an isoquant shows all possible combinations of two inputs, which are capable of producing
equal or a given level of output. Since each combination yields same output, the producer
becomes indifferent towards these combinations.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.
An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of
a product all other combinations in the table are assumed to yield the same given output of a
product say ‘50’ quintals by employing any one of the alternative combinations of the two
factors labour and capital.

LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale
I. Law of variable proportions:
The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms
production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour
which is a variable input when the firm expands output by employing more and more labour it
alters the proportion between fixed and the variable inputs. The law can be stated as follows:
“If equal increments of one input are added, the inputs of other production services being held
constant, beyond a certain point the resulting increments of product will decrease i.e. the
marginal product will diminish”. (G. Stigler)
The law of variable proportions refers to the behaviour of output as the quantity of one Factor is
increased Keeping the quantity of other factors fixed and further it states that the marginal
product and average product will eventually do cline. This law states three types of productivity
an input factor – Total, average and marginal physical productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in technology,
the average and marginal output will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law
does not apply to those cases where the factors must be used in rigidly fixed
proportions.
iii) All units of the variable factors are homogenous.
Three stages of law:
The behaviors of the Output when the varying quantity of one factor is combines with a fixed
quantity of the other can be divided in to three district stages. The three stages can be better
understood by following the table.

Fixed factor Variable factor Total product Average Marginal

(Labour) Product Product
 1 1 100 100 - Stage I
1 2 220 120 120
1 3 270 90 50
1 4 300 75 30 Stage
1 5 320 64 20 II
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III

Above table reveals that both average product and marginal product increase in the beginning
and then decline of the two marginal products drops of faster than average product. Total product
is maximum when the farmer employs 6 th worker, nothing is produced by the 7 th worker and its
marginal productivity is zero, whereas marginal product of 8 th worker is ‘-10’, by just creating
credits 8th worker not only fails to make a positive contribution but leads to a fall in the total
output.
Production function with one variable input and the remaining fixed inputs is illustrated as below

From the above graph the law of variable proportions operates in three stages. In the first stage,
total product increases at an increasing rate. The marginal product in this stage increases at an
increasing rate resulting in a greater increase in total product. The average product also increases.
This stage continues up to the point where average product is equal to marginal product. The law
of increasing returns is in operation at this stage. The law of diminishing returns starts operating
from the second stage awards. At the second stage total product increases only at a diminishing
rate. The average product also declines. The second stage comes to an end where total product
becomes maximum and marginal product becomes zero. The marginal product becomes negative
in the third stage. So the total product also declines. The average product continues to decline.
II. Law of Returns of Scale:
The law of returns to scale explains the behavior of the total output in response to change in the
scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in
response to a simultaneous and proportional increase in all the inputs. More precisely, the Law of
returns to scale explains how a simultaneous and proportionate increase in all the inputs affects
the total output at its various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed factors
cannot be changed and all factors cannot be changed. On the other hand in the long-term all
factors can be changed as made variable. When we study the changes in output when all factors
or inputs are changed, we study returns to scale. An increase in the scale means that all inputs or
factors are increased in the same proportion. In variable proportions, the cooperating factors may
be increased or decreased and one faster (Ex. Land in agriculture (or) machinery in industry)
remains constant so that the changes in proportion among the factors result in certain changes in
output. In returns to scale all the necessary factors or production are increased or decreased to the
same extent so that whatever the scale of production, the proportion among the factors remains
the same.
When a firm expands, its scale increases all its inputs proportionally, then technically there are
three possibilities. (i) The total output may increase proportionately (ii) The total output may
increase more than proportionately and (iii) The total output may increase less than
proportionately. If increase in the total output is proportional to the increase in input, it means
constant returns to scale. If increase in the output is greater than the proportional increase in the
inputs, it means increasing return to scale. If increase in the output is less than proportional
increase in the inputs, it means diminishing returns to scale.
Let us now explain the laws of returns to scale with the help of isoquants for a two-input and
single output production system.
COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its
ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general the selling price is not within the control of a firm but many costs are
under its control. The firm should therefore aim at controlling and minimizing cost. Since every
business decision involves cost consideration, it is necessary to understand the meaning of
various concepts for clear business thinking and application of right kind of costs.
COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. The various relevant concepts
of cost are:
1. Opportunity costs and outlay costs:
Out lay cost also known as actual costs obsolete costs are those expends which are actually
incurred by the firm these are the payments made for labour, material, plant, building, machinery
traveling, transporting etc., These are all those expense item appearing in the books of account,
hence based on accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best alternative, has
the present option is undertaken. This cost is often measured by assessing the alternative, which
has to be scarified if the particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very important
in capital expenditure budgeting. This concept is very important in capital expenditure
budgeting. The concept is also useful for taking short-run decisions opportunity cost is the cost
concept to use when the supply of inputs is strictly limited and when there is an alternative. If
there is no alternative, Opportunity cost is zero. The opportunity cost of any action is therefore
measured by the value of the most favorable alternative course, which had to be foregoing if that
action is taken.
2. Explicit and implicit costs:
Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. These costs include payment of wages and salaries,
payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These
costs are not actually incurred but would have been incurred in the absence of employment of
self – owned factors. The two normal implicit costs are depreciation, interest on capital etc. A
decision maker must consider implicit costs too to find out appropriate profitability of
alternatives.
3. Historical and Replacement costs:
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset
as the original price paid for the asset acquired in the past. Historical valuation is the basis for
financial accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor
projection of the future cost intended for managerial decision. A replacement cost is a relevant
cost concept when financial statements have to be adjusted for inflation.
4. Short – run and long – run costs:
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase
in output during this period is possible only by using the existing physical capacity more
extensively. So short run cost is that which varies with output when the plant and capital
equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and books costs:
Out-of pocket costs also known as explicit costs are those costs that involve current cash
payment. Book costs also called implicit costs do not require current cash payments.
Depreciation, unpaid interest, salary of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a
period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the
cost of self-owned factors of production.
6. Fixed and variable costs:
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by
the changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output
results in an increase in total variable costs and decrease in total output results in a proportionate
decline in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials,
labour, direct expenses, etc.
7. Past and Future costs:
Past costs also called historical costs are the actual cost incurred and recorded in the book of
account these costs are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not actual costs.
They are the costs forecasted or estimated with rational methods. Future cost estimate is useful
for decision making because decision are meant for future.
8. Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products
process or product. Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They
are incurred collectively for different processes or different types of products. It cannot be
directly identified with any particular process or type of product.
9. Avoidable and unavoidable costs:
Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in a product – line, or
volume or production the wages of the retrenched workers are escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this
cost even if reduction in business activity is made. For example cost of the ideal machine
capacity is unavoidable cost.
10. Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in change of it. The
concept of controllability of cost varies with levels of management. Direct expenses like
material, labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various
processes or products in some proportion. This cost varies with the variation in the basis of
allocation and is independent of the actions of the executive of that department. These
apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs:
Incremental cost also known as different cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future decisions.
Investments in fixed assets are examples of sunk costs.
12. Total, average and marginal costs:
Total cost is the total cash payment made for the input needed for production. It may be explicit
or implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of
output. If is obtained by dividing the total cost (TC) by the total quantity produced (Q)
TC
Average cost = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the
cost of the marginal unit produced.
13. Accounting and Economics costs:
Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit
and ton statements to meet the legal, financial and tax purpose of the company. The accounting
concept is a historical concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning, and
choice, while the accountant describes what has happened, the economics aims at projecting
what will happen.

BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the
point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its broad
determine the probable profit at any level of production.
Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.
Merits:
1. Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals
how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material,
direct labour, fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations such
as capital amount, marketing aspects and effect of government policy etc., which are
necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major drawback of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may
be opening stock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known
defect of BEC.
Important terms in BEP
1. Fixed cost
2. Variable Cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit Volume Ratio
7. Break – Even- Point

Some assumptions are made in illustrating the ВЕР. The price of the commodity is kept constant
at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total revenue is increasing
proportionately to the output. All the units of the output are sold out. The total fixed cost is kept
constant at Rs. 150 at all levels of output.

The total variable cost is assumed to be increasing by a given amount throughout. From the
Table we can see that when the output is zero, the firm incurs only fixed cost. When the output
is 50, the total cost is Rs. 300. The total revenue is Rs. 200. The firm incurs a loss of Rs. 100.

Similarly when the output is 100 the firm incurs a loss of Rs. 50. At the level of output 150
units, the total revenue is equal to the total cost. At this level, the firm is working at a point
where there is no profit or loss. From the level of output of 200, the firm is making profit
 Assignment-Cum-Tutorial Questions

I) Objective Questions
1. When different combinations of inputs yield the same level of output is known as -----------
2. _________ is a ‘group of firms producing the same or slightly different products for the
same market or using same raw material’
3. When Total Fixed Cost (TFC) and Total Variable Cost (TVC) are added, we get
________________
4. The quantities of output through a given __________________ are equal.
5. The cost that are to be paid currently if the asset were to be replaced to be are called
__________________ .
6. The rate at which one input factor is substituted with the other to attain a given level of
output is called _______________
7. Addition to costs as a result of change in the level of business activity is called
________________ .
8. Production function mathematically can be written as_________.
9. P/V ratio is also known as________.
10. Conversion of inputs into output is called as _________________.

II) Descriptive Questions

1. Explain the operation of law of diminishing returns and its business implications.
2. Explain Cobb-Douglas Production function.
3. How come Iso-Quants and Iso cost analysis help in Production decision making.
4. Briefly explain various Economies of scale.
5. Break even analysis is highly important in output Decision making. Discuss?
6. Define cost. Explain the different cost concepts used in the process of cost analysis.
7. Explain the following with reference to production functions
a. MRTS
b. Variable proportion of factor

I) Multiple Choice Questions:

1. When a firm expands its size of production by increasing all factors, it secures certain
advantages, known as ( )
(a) Optimum Size (b) Diseconomies of Scale
(c) Economies of Scale (d) None

2. When Proportionate increase in all inputs results in less than Equal Proportionate increase in
output, then we call _____________. ( )
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None

3. The point of no profit and no loss is_________ ( )

(a) Maximum point (b) Minimum point
(c) Break-Even point (d) Average point
4. The price of pen is Rs.18/- and the variable cost to produce 1 unit is Rs.7/-.calculate
contribution per unit?
(a) 10 (b) 11
(c) 21 (d) 25

5. A curve showing equal amount of outlay with varying Proportions of two inputs are called
______________. ( )
(a) Total Cost Curve (b) Variable Cost Curve
(c) Isocost Curve (d) Marginal Cost Curve

6. _____cost is the additional cost to produce an additional unit of output. ( )

(a) Incremental (b) Sunk
(c) Marginal (d) Total

7. The cost incurred to purchase machinery worth Rs.1,00,000/- is _______ Cost

(a) Incremental (b) Variable
(c) Fixed (d) Total.
8. Telephone charges or Electricity charges are _____ costs.
(a) fixed (b) Variable
(c) Semi-Fixed and Semi variable (d) Total.
9.” Delegating routine matters to the office staff and leaving managers free to concentrate on
problem areas” represent ___________ economies. ( )

(a) Managerial (b) Technical

(c) Decision (d) Delegation.
10. The line representing the least cost combination of inputs for different levels of output ( )
(a) Straight line (b) Expansion path.
(c) Engel line (d) output path

II) Problems:

1. The information about Raj & Co are given below:

PV ratio : 20%
Fixed Cost : Rs. 36,000/-
Selling Price per Unit: Rs. 150/-
Calculate (i) BEP in rupees (ii) BEP in Units.
2. Mrs. Venu and co. is producing Water purifiers. The cost incurred in the production are
as below
a) Fixed cost Rs.1, 20,000/-.
b) Variable cost per unit is Rs.400/-
When the organization is selling each unit Rs.800/-find the Break-even point in volume
and sales.