Chapter V

Cost Analysis

Dr. GOPALAKRISHNA B.V.

Faculty of MBA,
SDM, Mangalore
 Introduction
● In technical sense, production is the
transformation of resources into
commodities over time and space.
● In simply, production is the act of converting or
transforming input into output.
● A firm is a business unit which undertakes the
activity of transforming inputs into outputs of
goods and services.
● In the production process, a firm combines
various inputs in different quantities and
proportions to produce different levels of outputs.
 The concept of production function

● The term ‘production function’ refers to

the relationship between the inputs and
the outputs produced by them.
● The terms factors of production and
resources are used inter changeably with
the term ‘inputs’
● The study of the production function is
directed towards the maximum output
which can be achieved with a given set of
resources or inputs with given state of
 Production Function

Production
Inputs Function Output
(L, K)
q = f(L, K) q
 Production Function

● A production function expresses the relationship

between a combination of inputs (factors of
production) and outputs (quantity of goods and
services).
● Production is a process in which the physical
inputs are transformed into physical output.
● The output is thus the function of inputs.
● Production function can be algebraically
expressed in an equation in which the output is
the dependent variable and inputs are
independent variables
 Algebrical expression
Q = f (a, b, c, d …..n)
● Q = stands fro the rate of output of given
commodity.
● A, b, c, d ….n are different factors and
services
● f = functional relationship
 Production function depends on
1. Quantities of resources (raw-materials,
labourers, capital, machinery etc).
2. State of technology is given.
3. Possible processes.
4. Size of the firms.
5. Nature of firms organization and
6. Relative price of inputs and the manner in
which the inputs are combined.
 Production function

In economic theory, there are three types of

production function, they are –
1. Production function with one variable input
2. Production function with two variable input
3. Production function with all variable input
● Production function with one variable inputs
are also called as law of variable
proportions.
● This law occupies an important place in
economic theory.
● The law states a technical physical
relationship between the fixed and
variable factors of production in the short
run.
● Here it is assumed that only one factor of
production is a variable factor (labour) while
 Assumptions of the law
1. The state of technology is assumed to be given
and unchanged.
2. Only one factor is varied (labour) and all other
factors remain unchanged (land, capital,
equipment and raw-material etc).
3. The fixed factor and the variable factor are
combined together in various proportions in the
process of production.
4. The units of the variable factors are
homogeneous.
5. The law operates in the short-run.
 Table 5.1 Returns to Labour
Units of Labour Total Product Marginal Average
(quintals) Product Products
(quintals) (quintals)
1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 00 63
9 495 -9 55
10 480 -15 48
 Average and Marginal
Product Curves
TP

AP max &
Total AP = MP
Product MP max
L
Point of diminishing
AP
marginal returns
MP Point of diminishing
average returns
AP
MP
L’ L” L
 Production with
One Variable Input (Labor)

Output
Observations:
per
Left of E: MP > AP & AP is increasing
Month
Right of E: MP < AP & AP is decreasing
E: MP = AP & AP is at its maximum
30
Marginal Product

E Average Product
20

10

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

Total Product Marginal Product Average Stages
Product
-First increases at -Increases -Increases First
increasing rate -Reaches a -Continues Stage
-Then the rate of maximum and then increases
increase changes starts diminishing
from increase to
diminishing rate
Continues to - Continues - Reaches a Second
increase at diminishing maximum stage
diminishing rate AP = MP
Diminishes - Is negative - Continues Third
diminishing Stage
Three Stages of Production in the
Short-Run
Stage Stage Stage
I II III
 Three stages of the law of variable
proportion
Stage I
● Total product will increases at an increasing rate.
● Average and marginal product also increase but
marginal product rises at a faster rate than average
product.

Stage II
● Total product continues to increase but at a diminishing
rate
● Marginal product is diminishing and becomes equal to
zero
● Average product starts diminishing

Stage III
 Table 5.2 Behaviour of TP, MP and AP during
three stages of production
Different Total Product Marginal Product Average
Stages (TP) (MP) Product (AP)

Increases, reaches its

Stage I Increases at an maximum and then Increases and
increasing rate declines till MR = AP reaches its
maximum
Increases at a It diminishing and
Stage II diminishing rate becomes equal to Starts declining
till it reaches zero
maximum

Stage III Starts declining Become negative Continues to

decline
2. Production Function with two variable
inputs
● To understand a production function with
two variable inputs, it is necessary to
understand iso-quant curve.
● An iso-quant is also known as
iso-product curve, which are similar to
indifference curves analysis.
● These curve shows the various
combinations of two variable inputs
resulting in the same level of output
 Iso-quant curve

● The Iso-quants are thus contour lines

which are trace the loci of equal outputs.
● Iso-quant represents those combinations
of inputs which will be capable of
producing an equal quantity of output
 Table 5.3 Labour and capital inputs in
relation to output

Labour (units) Capital (units) Output (units)

1 5 10
2 3 10
3 2 10
4 1 10
5 0 10
 y

Iso-quant Curve
A
, Capital
B

C
D

0 x
Labour
 Iso-quants map

Capita 3
l
2
Q3

1 Q2
Q1
1 2 3 4 5
Labor
 Properties of Isoquants

● Isoquants slope downwards from left to

right
● No two iso-quant can intersect each other
● Iso-quants curve are convex to the origin

7-23
 Properties of Iso-quants
1. Iso-quants slope downward from left to
right
When the quantity of on factor (labour)
increased, the quantity of other capital must
be reduced so as to keep output constant on
a given iso-quant.
2. No two iso-quants can interest each
other
Iso-quant curve never cut each other as
higher and lower curves show different
 Properties of Iso-quants
3. Iso-quants curve are convex to the Origin
● Iso-quant curve as similar to indifference curves
are convex to the origin and they cannot be
concave to the Origin.
● The marginal rate of technical substitution are
normally convex to the origin and it cannot be
concave.
● If the iso-quants were concave to the origin –
marginal rate of technical substitution increased
as more and more units of labour are substituted
Isoquant Curve

7-26
Figure 7.10: Properties of Isoquant

7-27
Marginal Rate of Technical Substitution
(MRTS)
● The Marginal Rate of Technical Substitution
(MRTS) production theory is similar to the
concept of Marginal Rate of Substitution of
Indifference curve analysis.
● MRTS - indicates the rate at which factors can
be substituted at the margin without altering the
level of output
● MRTS of labour for capital - defined as one
number of units of capital which can be replaced
by one unit of labour, the level of output
remaining unchanged..
Marginal Rate of Technical Substitution
(MRTS)
● The MRTS of factor X (labour) for a unit of
factor Y (capital).
● Each input combinations A, B, C, D & E yields
the same level of output.

Slope of Isoquant
 Table: 5.4 Marginal Rate of Technical
Substitution
Factor Units of Units of MRTS of
Combination Labour (L) Capital (K) L for K

A 1 12 -

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1
Figure: 5.1 MRTS
 Law of Returns to Scale
● In the long run all factors of production are
variable – no factor is fixed – all the factors
treated as variable factors.
● Accordingly, the scale of production can be
changed by changing the quantity of all factors
of production.
● It all factors of production is doubled, the total
output will also be doubled.
● According to this law, when all factor units are
increased, total product generally increases at
an increasing rate, later at a constant rate and
 Returns to Scale

Increasing Constant Returns Decreasing

Returns Returns
1. Increasing Returns to Scale
● increasing returns to scale or diminishing
cost refers to a situation when all factors
of production are increased, output
increases at a higher rate.
● It means if all inputs are doubled output
will also increase at the faster rate than
double.
● This increase is due to many reasons like
division of labour, specialisation and other
2. Constant Returns to Scale
● Constant returns to scale or constant cost refers
to the production situation in which output
increases exactly in the same proportion in
which factors of production are increase.
● In simple terms, if factors of production are
doubled output will also be doubled.
● In this case internal & external economies are
exactly equal to internal economies & external
diseconomies
● This is also known as Homogeneous Production
Function or Cobb-Douglas Linear homogeneous
3. Diminishing Returns to Scale
● DRS or increasing costs refers to that
production situation, where if all the
factors of production are increased in a
given proportion, output increases in a
smaller proportion.
● It means, if inputs are doubled, output will
be less than double
Figure 7.17: Returns to Scale

7-37
 Least Cost Combination of Inputs
● It is also known as producer’s equilibrium or
choice of optimal factor combination.
● Producer’s equilibrium occurs when he earns
maximum profit with optimal combination of
factors.
● A profit maximisation producer faces two choices
of optimal combination of factors (inputs)
1. To minimise its cost for a given output
2. To maximise its output for a given cost.
● Thus least cost combination – refers to a firm
producing the largest volume of output from a
given cost and producing a given level of output
 Economies of Scale
● Prof Stigler – economies of scale are also
known as returns to scale.
● As the scale of production is increased,
upto a certain point, one gets economies
of scale.
● It is a common experience of every
producer that costs can be reduced by
increased production. That is why the
producers are more keen on expanding
the size/scale of production.
 Economies of Scale

Economies of Scale

Internal External
Economies Economies
 Internal Economies
● Internal economies - are those economies
production which accrue to the firm when it
expands the output, so that the cost of
production would come down considerably and
place the firm in a better position to compete in
the market effectively.
● Economies arise purely due to endogenous
factors relating to efficiency of the
entrepreneur or his managerial talents the
marketing strategy adopted.
● Basically, internal economies are those which
 Internal Economies (checks this)

● For example, one firm will enjoy the

advantage of good management other
may specialisation in the techniques of
production.
● According to Cairncross – internal
economies are those which are open to a
single factory or a single firm
independently of the action of other firms.
● Prof Koutsoyannis has divided the
 Internal Economies

Real Economies Pecuniary

Economies
 Types of Internal Economies

1. Technical Economies – Technical economies

are those which accrue to a firm from the use of
better machines and techniques of production.
As a result, production increases and cost per
unit of production decreases.
● Technical economies are 5 kinds –
1. Economies of increased dimensions
2. Economies of linked processes
3. Economies of the use of by-products
4. Economies in power
5. Economies of increased specialisation
1. Economies of increased dimensions
● Certain technical economies may arise on
account of increased dimensions.
● For example, a double decker bus is more
economical than a single decker.
● One driver and one conductor may needed.
Whether it is a double decker or a single decker
bus.
2. Economies of linked processes
● A big firm can also enjoy the economies of linked
process.
3. Economies of the use of by products
● A large firm is in a better position to utilise the by
products efficiently and attempt to produce
another new product.
● For example large sugar factory uses molasses
– producing alcohol
4. Economies in power
● Large size machines without continuous running
are often more economical than small sized
machines
● Big boiler consumes more/less the same power
5. Economies of increase Specialisation
● A large firm can dived the work into various
sub-processes.
● Division of labour and specialisation become
possible.
● For example, only a well established big school
can have specialised teachers.
2. Marketing Economies
● When the scale of production of a firm is
increased it enjoys numerous selling or
marketing economies.
● Advertisement economies, opening up of show
3. Financial Economies
● The credit requirements of the big firms
can be meet from banks and other
financial institutions easily.
● A large firm is able to mobilise much credit
at cheaper rates.
1. Investors have more confidence in investing
money – large firms.
2. Shares and debentures of a large firm can
easily sold in the stock market.
4. Managerial Economics
● On the managerial side also economies
can be achieved.
● When output increases, specialists can be
more fully employed.
● A large firm can divide its big departments
into various sub-departments and each
department such as finance, marketing,
legal, administration , sales etc.
5. Economies of Research
● A large sized firm can spend more money
on its research activities.
● Spend hug sum money in order to
innovate new varieties of products or
improve the quality of the existing
products.
● In cases of innovation it will become an
asset of the firm.
● New innovations/new methods of
6. Risk bearing Economies
● The big firms always involved risk-bearing.
● A big firm produces a large number of items and
of different varieties so that the loss in one can
be counter balanced by the gain in another.
7. Economies of Transport and Storage
● A firm producing on large scale enjoys the
economies of transport and storage.
● A big firm can have its own means of
transportation to carry finished as well as –
raw-material from one place to another.
● Moreover big firms also enjoy the economies of
storage facilities.
● The big firm also has its own storage and
 External Economies
● External economies refers to all those
benefits which accrue to all the firms
operating in a given industry.
● External economies can be enjoyed by all
the firms in the industry irrespective of
their size.
● The emergence of external economies is
due to localisation.
● According to Cairncross – “External
economies are those benefits which are
shared in by a number of firms/industries
 External Economies…….

● He divided the external economies into the

following parts as –
1. Economies of Concentration
2. Economies of Information
3. Economies of Disintegration
4. Economies of Localisation
5. Economies of By-products
1. Economies of Concentration
● As the number of firms in an area
increases each firm enjoys some benefits
like, transport and communication,
availability of raw-materials, research and
invention etc.
● Financial assistance from banks and
non-bank institutions easily accrue to firm.
● Therefore, concentration of industries lead
to economies of concentration.
2. Economies of Information
● When the number of firms in an industry
expands they become mutually dependent
on each other – they do not feel the need
of independent research on individual
basis.
● Many scientific and trade journal are
published – these journals provide
information to all the firms which relates to
new markets, sources of raw-materials,
3. Economies of Disintegration
● As an industry develops, all the firms
engaged in it decided to divide and
sub-divide the process of production
among themselves.
● Each firm specialises in its own process.
● For example – cotton Textile Industry –
some firms may specialise in
manufacturing thread, some others in
producing dhoties, some in knitting
baniqus some in weaving sarees etc.
● The disintegration may be horizontal or
4. Economies of Location
● The localisation of an industry means the
concentration of firms producing identical
product in a particular area.
● For example railway is an industry – where
parcel agency, post and telegraph
department – post office, state electricity
department installers power transformer
and transport companies.
● As a result, all the firms get these facilities
at low prices, consequently the average
5. Economies of By-Products
● The growth and expansion of an industry
would enable the firms to reduce their cost
of production by making use of waste
materials.
● The waste material of one firm may be
available and useable in the other firms.
● Thus, wastes are converted into by
products.
● The selling firms reduce their costs of
production by realising something for their