UNIT-III

Production and Cost Functions

Economists study the production of a good or service using two closely related tools:
production functions and cost functions. A production function shows the outputs that can be
produced with various combinations of inputs. A cost function show how much it costs to
produce various output levels given input prices.
Production Costs
 Production costs can include a variety of expenses, such as labour, raw materials,
consumable manufacturing supplies, and general overhead.
 Production costs refer to the costs a company incurs from manufacturing a product or
providing a service that generates revenue for the company.
 Total product costs can be determined by adding together the total direct materials
and labour costs as well as the total manufacturing overhead costs.
production function
In economics, a production function relates physical output of a production process to
physical inputs or factors of production. It is a mathematical function that relates the
maximum amount of output that can be obtained from a given number of inputs – generally
capital and labour.
Production function example

Here's an example: If one employee can make 500 snow cones in eight hours, the production
function would be Q = 500 L. Using a linear production function, where we assume that each
employee will produce at the same rate, we get this: As more employees are added, the output
increases.
The Relationship Between Total Cost and Production Function
 There is an inverse relationship between production and costs. The harder it is to
produce something, for example, the more labour it takes, the higher the cost of
producing it, and vice versa.
Cost Curves
In economics, a cost curve is a graph of the costs of production as a function of total quantity
produced. In a free market economy, productively efficient firms optimize their production
process by minimizing cost consistent with each possible level of production, and the result is
a cost curve.

Types of cost

 Fixed cost
 Variable cost
 Direct cost
 Indirect cost.

A fixed cost is an expense that does not change when sales or production volumes increase or
decrease. Fixed costs are the expenses a business incurs that do not change with the amount
of goods produced or services provided.
Examples
Fixed costs are rent and lease costs, salaries, utility bills, insurance, and loan repayments.
Some kinds of taxes, like business licenses, are also fixed costs.
Variable costs are expenses that vary in proportion to the volume of goods or services
Examples of variable costs are raw materials, piece-rate labour, production supplies,
commissions, delivery costs, packaging supplies, and credit card fees. In some accounting
statements, the Variable costs of production are called the “Cost of Goods Sold.”
The total cost (C) of production is the sum of fixed and variable costs of production;
C=FC+VC
There are three short-run average cost measures: average variable cost, average fixed cost,
and average total cost.
Average variable cost (AVC) is the variable cost per unit of output. Mathematically, it is
simply the variable cost divided by the output:
AVC=VC/Q

Note that since variable cost generally increases with the amount of output produced, the
average variable cost can increase or decrease as output increases.
Average fixed cost (AFC) is the fixed cost per unit of output. Mathematically, it is simply
the fixed cost divided by the output:
AFC=FC/Q
Because fixed cost does not change with the amount of output produced, the average fixed
cost always decreases as output increases.
Average total cost (AC), or simply average cost, of production is total cost per unit of
output. This is the same as the sum of the average fixed cost and the average variable cost:
AC=AC/Q=AFC+AVC
Marginal cost (MC) is the additional cost incurred from the production of one more unit of
output. Thus marginal cost is
MC=ΔC/ΔQ.
The only part of total cost that increases with an additional unit of output is the variable cost,
so we can re-write the marginal cost as
MC=ΔVC/ΔQ
Table 1 summarizes a firm’s daily short-run costs. The firm has a fixed cost of Rs.50 per day
of production. This cost is incurred whether the firm produces or not, as we can see by the
fact that Rs.50 is still a cost when output is zero. The firm’s fixed cost of Rs.50 does not
change with the amount of output produced. The data in the first two columns of table
8.1 allow us to draw the firm’s fixed cost curve. It is a horizontal line at Rs.50, as shown
in figure 1.
Table 8.1 An example of the seven short-run cost measures

Outpu Fixed Variable Total Marginal Average fixed Average variable Average
t cost cost cost cost cost cost cost

Q FC VC C MC AFC AVC AC

0 50 0 50 – – – –

1 50 40 90 40 50.0 40.0 90.0

2 50 70 120 30 25.0 35.0 60.0

3 50 90 140 20 16.7 30.0 46.7

4 50 100 150 10 12.5 25.0 37.5

5 50 120 170 20 10.0 24.0 34.0

6 50 150 200 30 8.3 25.0 33.3

7 50 190 240 40 7.1 27.1 34.3

8 50 240 290 50 6.3 30.0 36.3

9 50 300 350 60 5.6 33.3 38.9

10 50 370 420 70 5.0 37.0 42.0

 figure.1.

Figure 2 presents a typical short-run production function, which leads to the shape of the
variable cost curve in figure.1. The production function exhibits increasing marginal returns
to labour initially: as the labour input is increased from zero, the output increases at an
increasing rate. Eventually, however, the addition of extra hours of labour leads to additional
output at a decreasing rate. This happens as we increase labour input from ten hours of
labour.

Figure.2
Figure.3 presents the four remaining short-run cost curves: marginal cost (MC), average
fixed cost (AFC), average variable cost (AVC), and average total cost (AC).
 Figure.3
Direct cost is a price that can be directly tied to the production of specific goods or services.
A direct cost can be traced to the cost object, which can be a service, product, or department.
Direct expenses mean all expenses directly connected with the manufacture, purchase of
goods, and bringing them to the point of sale. Direct expenses include carriage inwards,
freight inwards, wages, factory lighting, coal, water and fuel, royalty on production, etc
Indirect Expenses are those expenses that cannot be assigned directly to any activity since
these are completely incurred while operating a business or as a part of a business, examples
of which include business permits, rent, office expenses, telephone bills, depreciation, audit,
and legal fees.

Production cost formula

Production cost is the sum of all expenses affecting the production of a good or service.
Production Cost = Cost of Raw Materials + Cost of Direct Labour + Cost of Overhead
Example of a production cost
Some costs of production are labour, raw materials, consumable manufacturing supplies and
overhead. Any costs that a company incurs when manufacturing its products or providing its
service that'll create revenue for that company can be considered a cost of production.
Factors of production
Factors of production is an economic concept that refers to the inputs needed to produce
goods and services. The factors are land, labour, capital, and entrepreneurship. The four
factors consist of resources required to create a good or service, which is measured by a
country’s gross domestic product (GDP).
In factors of production, the word “production” refers to a process of transforming inputs into
outputs, which are finished products that can be sold as a good or service. In order to do so,
the input will go through a production process and various stages to reach the hands of
consumers.
Long-Run Cost Curve
The long-run cost curve is a cost function that models this minimum cost over time, meaning
inputs are not fixed. Using the long-run cost curve, firms can scale their means of production
to reduce the costs of producing the good.
Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production.
The land, labour, capital goods, and entrepreneurship all vary to reach the the long run cost of
producing a good or service.

There are three principal cost functions (or 'curves') used in microeconomic analysis:
 Long-run total cost (LRTC) is the cost function that represents the total cost of
production for all goods produced.
 Long-run average cost (LRAC) is the cost function that represents the average cost
per unit of producing some good.
 Long-run marginal cost (LRMC) is the cost function that represents the cost of
producing one more unit of some good.
Firms have a variety of methods of using various amounts of inputs, and they select the
lowest total cost method for any given amount of output (quantity produced). For example, if
a micro-enterprise wanted to make a few pins, the cheapest way to do so might be to hire a
jack-of-all-trades, buy a little scrap metal, and have him work on it at home. However, if a
firm wanted to produce thousands of pins, the lowest total cost might be achieved by renting
a factory, buying specialized equipment, and hiring an assembly line of factory workers to
perform specialized actions at each stage of producing the pins. In the short run, the firm
might not have time to rent a factory, buy specialized tools, and hire factory workers. In that
case, the firm would not be able to achieve short-run minimum costs, but the long-run costs
would be much less. The increase in choices about how to produce in the long run means that
long-run costs are equal to or less than short run costs, ceteris paribus.
The term curves does not necessarily mean the cost function has any curvature. However,
many economic models assume that cost curves are differentiable so that the LRMC is well-
defined. Traditionally, cost curves have quantity on the horizontal axis of the graph and cost
on the vertical axis.

Short Run Cost Curves

The short run cost curve definition is when the company can only increase or decrease its
variable factors to affect output levels. The short-term period in economics is the time frame
where there are both fixed and variable factors
Land as a Factor of Production
Land is a broad term that includes all the natural resources that can be found on land, such as
oil, gold, wood, water, and vegetation. Natural resources can be divided into renewable
and non-renewable resources.
Renewable resources are resources that can be replenished, such as water, vegetation, wind
energy, and solar energy.
Non-renewable resources consist of resources that can be depleted in supply, such as oil,
coal, and natural gas.
All resources, whether it is renewable or non-renewable, can be used as inputs in production
in order to produce a good or service. The income that comes from using land and its natural
resources is referred to as rent.
Labour as a Factor of Production
Labour as a factor of production refers to the effort that individuals exert when they produce
a good or service. For example, an artist producing a painting or an author writing a book.
Labour itself includes all types of labour performed for an economic reward, such as mental
and physical exertion. The value of labour also depends on human capital, which is
determined by the individual’s skills, training, education, and productivity.
Productivity is measured by the amount of output someone can produce in each hour of work.
The income that comes from labour is referred to as wages. Note that work performed by an
individual purely for his/her personal interest is not considered to be labour in an economic
context.
The following are several characteristics of labour in terms of being a factor of production:
 First, labour is considered to be heterogeneous, which refers to the idea of how the
efficiency and quality of work are different for each person. It differs because it
depends on an individual’s unique skills, knowledge, motivation, work environment,
and work satisfaction.
 Additionally, labour is also perishable in nature, which means that labour cannot be
stored or saved up. If an employee does not work a shift today, the time that is lost
today cannot be recovered by working another day.
 Also, another characteristic of labour is that it is strongly associated with human
efforts. It means that there are factors that play an important role in labour, such as the
flexibility of work schedules, fair treatment of employees, and safe working
conditions
Capital as a Factor of Production
Capital, or capital goods, as a factor of production, refers to the money that is used to
purchase items that are used to produce goods and services. For example, a company that
purchases a factory to produce goods or a truck that is purchased to do construction are
considered to be capital goods.
Other examples of capital goods include computers, machines, properties, equipment, and
commercial buildings. They are all considered to be capital goods because they are used in a
production process and contribute to the productivity of work. The income that comes from
capital is referred to as interest.
Below are several defining characteristics of capital as a factor of production:
 Capital is different from the first two factors because it is created by humans. For
example, capital goods like machines and equipment are created by individuals,
unlike land and natural resources.
 Additionally, capital is also a factor that can last a long time, but it depreciates in
value over time. For example, a building is a capital good that can endure for a long
period of time, but its value will diminish as the building gets older.
 Capital is also considered to be mobile because it can be transported to different
places, such as computers and other equipment.
Cost minimization is a financial strategy that aims to achieve the most cost-effective way of
delivering goods and services to the required level of quality. It is important to remember that
cost minimisation is not about reducing quality or short-changing customers – it always
remains important to meet customer needs.
cost reduction examples are: Reducing labour costs by automating routine tasks or by
outsourcing non-core business functions. Bringing down office expenses, such as electricity
bills, by opting for energy-saving technologies or scaling down on office space by offering
remote working options.
Benefits of cost minimization
Cost reduction has many potential benefits, including improved profitability, cash flow, and
competitiveness. When done correctly, cost reduction can also help improve quality and
service levels while still maintaining or improving bottom-line results.
Cost efficiency
Cost efficiency is the act of saving money by changing a product or process to work in a
better way. This is done to improve the organization's bottom line by decreasing procurement
costs and improving efficiencies across the board.
Monopoly
A monopoly is a type of imperfect competition in which a company and its product dominate
the sector or industry. This situation arises when there is no competitor in the market for the
same product.
Monopolies enjoy a significant market share due to the absence of any competitors. They can
control the price of the product by knowing that the product will sell.
Competitors are unable to enter the market due to the high barrier of entry. The organisation
can change the prices at their will due to the resources at their disposal, and in this way, kill
the competition from small scale manufacturers.
Monopolistic Competition
A monopolistic competition is a type of imperfect competition where there are many sellers
in the market who are competing against each other in the same industry. They position their
products, which are near substitutes of the original product.
In a monopolistic competition, the barriers of entrance and exit are comparatively low. The
companies try to differentiate their products by offering price cuts for their goods and
services. The examples of such industries are hotels, e-commerce stores, retail stores, and
salons.
Difference between a monopoly and monopolistic competition
A monopoly exists when a single company controls the market for a particular product or
service, while monopolistic competition involves multiple firms offering similar but
differentiated products
Equilibrium in perfect competition
A point where market demands will be equal to market supply. A firm's price will be
determined at this point. In the short run, equilibrium will be affected by demand. In the long
run, both demand and supply of a product will affect the equilibrium in perfect competition.
Conditions of Equilibrium of the Firm and Industry
A firm is in equilibrium when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits in by equating its marginal cost
with its marginal revenue, i.e. MC = MR.