BUS525 (Managerial Economics)

Group Assignment

Submitted to
Professor Dr. K. M. Zahidul Islam

Adjunct Professor

School of Business & Economics

North South University

Submitted By

Name Id number

Sheikh Sayma Siddika 2215046660

Shahriar Parvej 2215345660

Zahid Hassan 2215365660

Farha Mahjabin 2225358660

 Letter of transmittal
20th August, 2022
Dr. K.M. Zahidul Islam
Adjunct Professor
School of Business & Economics North South University
Subject: Submission of the group report on Production & Cost of Production.
Dear Sir,
We would really like to express our thankfulness for offering us the chance to work on this topic.
It was an honor and a remarkable satisfaction to work under your ultra pro-active guidance on
the topic of production and cost of production, we have prepared a research report. In this
writing, we covered a detailed overview of various production and cost-of-production principles.
We also illustrated how these things help us in making choices. We're excited to put together this
group report under your supervision.
If you find this report to be useful and informative, it would give us the ultimate pleasure, if you
have any other questions concerning any additional information, we would really be glad to
answer them in regards to our report.
Lastly we are delighted immensely after making this work and while doing this work, it has
made our understanding level much better.
Thank you.

Sincerely,
Sheikh Sayma Siddika

Shahriar Parvej

Zahid Hassan

Farha Mahjabin
Table of Contents

Introduction.................................................................................................................................................1
Production Curves.......................................................................................................................................2
Cobb-Douglas Production Function.............................................................................................................4
Regression Analysis: ln(Q) versus ln (K), ln (L).............................................................................................6
The relationship between average and marginal cost curve.....................................................................8
Short Run & Long Run Cost Curve Short Run Cost.....................................................................................11
The Short-run cost curve is inflexible........................................................................................................12
Cost minimization principle.......................................................................................................................14
Introduction

Production decision is most important in order to make a firm's operational decision. A firm
always looks after best possible output by utilizing least amount of resources. Effective
production planning plays vital role to achieve it. It helps a firm to set a price which is lower than
market standard that automatically creates a good vibes among key stakeholders like
Competitors, shareholders, customers and so on
In this report, we will try to show that in order to produce the efficient output, a mix of labor and
capital is necessary. We will cover various production theories, their effects and how production
costs are related to them. Additionally, we will demonstrate how the production choice differs in
the short term and long term. The ability to modify capital is less flexible in the short term, but
both labor and capital are more flexible over the long term.
We always do perform mathematical analysis with the provided production function often.
However, we will demonstrate how the Cobb-Douglas production function is created in this
report using through Excel. Production managers can benefit greatly from this function in a
variety of ways. Making successful and efficient manufacturing decisions will be made easier
with a descriptive analysis of this item. Additionally, the impact of learning is crucial during
manufacturing. Regularly performing a task increases a worker's effectiveness and production.
We have demonstrated how this element affects productivity in our study. One of the most
important tasks for production managers is cost minimization. They must choose the range of
input combinations he should take into account. We have discussed how to determine the point
of cost minimization in this paper. Along with the examples, we also provided the consequences
of cost minimization. In order to make it easier for readers, we have also included several other
production.

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Production Curves

A production function gives the technological relation between quantities of physical inputs
and quantities of output of goods. The production function is one of the key concepts
of mainstream neoclassical theories, used to define marginal product and to distinguish allocative
efficiency. One important purpose of the production function is to address allocative efficiency
in the use of factor inputs in production and the resulting distribution of income to those factors,
while abstracting away from the technological problems of achieving technical efficiency.
Amount of Amount of Total Output Average Marginal
labor (L) Capital (K) (q) Product (q/L) Product ( ∆ q/ ∆
L)
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8

Three Stages of Production in Short Run

 Stage 1: From origin to the point where AP of labor is highest. [ MP (Marginal product)
of Capital is Negative for capital intensive production function, but MPL is positive]

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  Stage 2: From Highest point of AP of labor to the point where MP of labor is Zero. [MP
of labor and MP of capital, both are positive, this stage is the optimal/efficient stage of
production]

 Stage 3: The point where MP of labor starts to be negative. [MP of labor is negative]

By using these concepts, a firm can use the labor and capital more effectively. If a firm is unable
to decide the production decision effectively, the firm will become inefficient and will be
outperformed by the competitors in the future. So, for this reason, this concept is extremely
beneficial for the manufacturing companies.

In this graph we input the data we found using the data. We can see that at 4 th unit AP and MP is
equal. An organization should not hire more than this point. If they do so they will see that MP
will decrease and can be negative too. If we don’t want incur any losses, we should hire labor till
that point where AP = MP.

3
Cobb-Douglas Production Function

The Cobb–Douglas production function is a particular functional form of the production

function, widely used to represent the technological relationship between the amounts of two or
more inputs (particularly capital and labor) and the amount of output that can be produced by
those inputs.

In its most standard form for production of a single good with two factors, the function is

Q= AK α L β

where:

 Q = total production
 L = Labor input
 K = Capital input
 A = Total factor productivity
 α and β are the output elasticities of capital and labor, respectively. These values
are constants determined by available technology.

Output elasticity measures the responsiveness of output to a change in levels of either labor or
capital used in production, ceteris paribus. For example, if α = 0.45, a 1% increase in capital
usage would lead to approximately a .45% increase in output.

Sometimes the term has a more restricted meaning, requiring that the function display constant
returns to scale, meaning that doubling the usage of capital K and labor L will also double
output Q. This holds if

α + β = 1,

If

α + β < 1,
returns to scale are decreasing, means that a percentage increase in capital K and labor L will
produce a smaller percentage increase in output Q.

and if

4
 α + β > 1,

returns to scale are increasing, means that a percentage increase in capital K and labor L will
produce a larger percentage increase in output Q.

Now we will try to demonstrate, how the Cobb-Douglas production function is generated with
the output, capital & labor data for some period. The following table shows the output level of
different periods with the combination of labor & capital.

CAPITAL LABOR Ln(Q) Ln(K) Ln(L)

TIME OUTPUT (K) (L)
1 225 12 20 5.416100402 2.48490665 2.995732274
2 240 14 22 5.480638923 2.63905733 3.091042453
3 278 10 24 5.627621114 2.302585093 3.17805383
4 212 14 18 5.356586275 2.63905733 2.890371758
5 205 12 20 5.323009979 2.48490665 2.995732274
6 297 16 24 5.693732139 2.772588722 3.17805383
7 242 16 20 5.488937726 2.772588722 2.995732274
8 155 10 14 5.043425117 2.302585093 2.63905733
9 212 8 20 5.356586275 2.079441542 2.995732274
10 180 8 14 5.192956851 2.079441542 2.63905733
To get the function, we transformed the data to the ln form. Now, we will use Excel to analyze
the data. It will generate a regression equation

5
Regression Analysis: ln(Q) versus ln (K), ln (L)

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.94
R Square 0.88
Adjusted R Square 0.84
Standard Error 0.08
10.0
Observations 0

ANOVA
Significanc
df SS MS F eF
Regression 2.00 0.29 0.15 24.79 0.00
Residual 7.00 0.04 0.01
Total 9.00 0.33
Coefficient Standard P- Lower Upper Lower Upper
s Error t Stat value 95% 95% 95.0% 95.0%
Intercep
t 2.58 0.40 6.45 0.00 1.64 3.53 1.64 3.53
Ln(K) 0.08 0.11 0.72 0.50 -0.19 0.35 -0.19 0.35
Ln(L) 0.88 0.15 5.76 0.00 0.52 1.25 0.52 1.25
LN(A) 2.58
A 13.24

So, from the regression analysis in Excel, the generated regression equation is,

Ln(Q)= 2.58 + 0.08 ln(K) + 0.88 ln (L)

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The Cobb- Douglas production function is,

Q= AK α L β

Here,

A = exponent of constant coefficient in the regression equation

= e^2.58

= 13.24

a= Coefficient of ln(K)

= 0.08

𶿉 ß=¿ Coefficient of ln(L)

= 0.88

Now, putting these values in the Cobb – Douglas function we get,

Q= 13.24 K^0.08 L^0.88

So, this is the Cobb-Douglas function of our data set. Using this data production manager can
take many decisions related to production. This production function makes the task easy to
generate the optimum level.

Also, it helps us to identify Returns to scale (RTS). From our result, we will try to see if it is
CRS, IRS, or DRS.

From the function the value of

a= 0.08

𶿉 ß=¿ 0.88

a+ 𶿉 ß=¿ 0.08+0.88

= 0.96

7
So, the function displays decreasing returns to scale (DRS). It means that increasing capital &
labor by 1% will decrease output. So, it is difficult to make production decisions based on this
data as the output is decreasing.

Equations of MPL and MPK

MPL= 13.24*0.88*K^0.08*L^0.88-1 = 11.6512*K^0.08*L^-0.12

MPL= 13.24*0.08*K^0.08-1*L^0.88 = 1.0592*K^-0.92*L^0.88

Suppose,

K=10, L=25

MPL = 11.6512*10^.08*25^-0.12 = 11.6512*1.202*1.68 = 23.528

MPK = 1.592*10^-0.92*25^0.88 = 1.0592*0.120*16.99 = 2.1595

The relationship between average and marginal cost curve

Marginal Cost Sometimes called incremental cost is the increase in cost that results from
producing one extra unit of output as fixed cost does not change as the firm’s level of
output changes. On the other hand, Average cost, also known as AC or unit cost is
calculated by total cost divided by numbers of quantity produced. In general, when
marginal cost is greater than average cost than the average cost in increasing and when
marginal cost is Lower than average cost than the average cost in decreasing.

MC > AC AC Increasing.
MC < AC AC Decreasing.

8
Figure 1: Diagram of MC Figure 2: Diagram of AC

Initially Average Cost Curve starts to fall due to declining fixed cost, however, it rises
later on as average variable costs increases. On the other hand, the marginal Cost Curve
is declining initially when the output increases in starting point and then move linearly
upwards when the additional output gets increases.

For an example, a hypothetical cost table has been shown below:

Average Average Average

Units of Fixed Variable Total Marginal
Fixed Cost Variable Total Cost
Output Cost (FC) Cost (VC) Cost (TC) Cost (MC)
(AFC) Cost (AVC) (ATC)
0 4,650 0 4,650 - - - -
1 4,650 4,650 9,300 4,650 4650 4,650 9,300
2 4,650 7,254 11,904 2,604 2325 3,627 5,952
3 4,650 9,114 13,764 1,860 1550 3,038 4,588
4 4,650 10,416 15,066 1,302 1163 2,604 3,767
5 4,650 12,090 16,740 1,674 930 2,418 3,348
6 4,650 13,950 18,600 1,860 775 2,325 3,100
7 4,650 16,275 20,925 2,325 664 2,325 2,989
8 4,650 18,972 23,622 2,697 581 2,372 2,953
9 4,650 22,506 27,156 3,534 517 2,501 3,017
10 4,650 27,900 32,550 5,394 465 2,790 3,255
11 4,650 35,805 40,455 7,905 423 3,255 3,678

9
Here,

Total cost = Fixed Cost + Variable Cost

Marginal Cost = Change in cost divided by change in Units of output

Average Total Cost = Total cost divided by level of Output

Average Variable Cost = Total variable cost divided by the units of output

In this table, the fixed cost has remained same for all levels of output and the variable cost
increases with additional level of quantities. Here, the marginal cost and average variable cost is
same on 7 units of output where MC is $2325 as same as AVC at which fixed cost remain same
at $4650. Average Total Cost of producing at a rate of 5 units of output is $3348 (TC/Q). Basically,
average total cost tells us the per unit cost of production. Fixed cost is constant and average fixed
cost declines as the rate of output increases. Average Variable Cost (AVC) is variable cost
divided by level of output, VC/Q. The average Variable Cost of Producing 5 Units of Output is
$2418 (12090/5).

10
 MC

AVC
$2325

Figure: Point of Intersection (MC=AVC)

From the table we can see, the marginal cost and average total cost is same on 7 units of
Output. Where total Cost is $20925 and the Average Total Cost is $2989. So, the point,
7, from where MC exceeds AVC, short run supply starts which means Average Variable
Cost is increasing.

Short Run & Long Run Cost Curve Short Run Cost

The short run is a specific time period where at least one factor of production remains unchanged
while the change in other factors results in changing price or output. We know that, Q=F (k, L).
if K remains constant then the quantity of output will depend upon labor. If we increase labor
then the quantity of output will increase on the other hand if we think labor is constant then
quantity will only depend on capital.

Long-run cost

In the long run, considering a time period, every component of production can be changed. There
is no concept of making any single factor constant. In Long run, production decision comes from
thinking about economic profit and losses. In long run, all factors can be varied based on
production requirements. There is no fixed production function of components.

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The relationship between long run and short-run cost:

In the Short run, both VC and FC can arise but in long run, there is no fixed cost. When FC and
VC both are present, there is no choice of making choices between different combinations of
production factors as that becomes expensive and we might incur loss but in long run, we can not
only change the factors of production, but we also can change the product as well. For example:
A shoe company in the short run produce only male shoes, In the long run they can change the
production they can do women’s products as well.

The LRAC curve contains several SRATC curves. SRATC shows the lowest unit cost at which
the firm can produce a certain level of output, but the LRAC Curve shows the lowest unit cost at
which a firm can produce any given level of output.

A short run cost curve shows the outputs of DMR but a long run cost curve shows the outputs of
increasing RTS.

The Short-run cost curve is inflexible

When a firm operates in the short run, its cost of production may not be minimized because of
inflexibility in the use of capital inputs. Output is initially at level q1. In the short run, output q2
can be produced only by increasing labor from L1 to L3 because capital is fixed at K1. In the

12
long run, the same output can be produced more cheaply by increasing labor from L1 to L2 and
capital from K1 to K2.

Long Run Average total cost curve- LRATC-

Long run ATC curve shows the lowest unit cost at which the firm can produce any given level of
output in the long run.

Economies of scale:

Situation in which output can be doubled for less than doubling of cost. ATC decreases as Q
increases. For example, if a firm increases cost by $1 to $1.5, output will increase from 3 to 6.
Output increases in this ratio because of technology in the long run.

Constant Return to Scale:

In this situation input and output increases and decreases at a same ration. If we increase 2% of
the input the output will also increase by 2%, this is called CRS.
13
Diseconomies of scale:

Situation in which a doubling of output requires more than a doubling of cost. Suppose, if we
increase output $2 from $5 than the output will increase 3 to 6. Here, ATC increases as Q
increases. This concept is total opposite of economies of scale.

Cost minimization principle

The theory of the firm relies on the assumption that firms choose inputs to the production process
that minimize the cost of producing output. If there are two inputs, capital K and Labor L, the
production F (K, L) describes the maximum output that can be produced for every possible
combination of inputs. We assume that each factor in the production process has positive but
decreasing marginal products. Therefore, writing the marginal product of capital and labor as
MPK (K, l) and MPL (K, L), respectively, it follows that

A competitive firm takes the prices of both labor w and capital r as given. Then the cost-
minimization problem can be written as

C= wL + rK

Subject to the constraint that a fixed output q0 be produces;

F ( K, L) = q0

C represents the cost of producing the fixed level of output q0.

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To determine the firm’s demand for capital and labor inputs, we choose the values of K and L
that minimize the subject to. We can solve this constrained optimization problem in three steps-

 Step 1: Set up the Lagrangian, which is the sum of two components: the cost of
production (to be minimized) and the Lagrange multiplier l times the output constraint
faced by the firm: C = wL + rK - l[F(K, L) - q0]

 Step 2: Differentiate the Lagrangian with respect to K, L, and l. Then equate the resulting
derivatives to zero to obtain the necessary conditions for a minimum.

 Step 3: In general, these equations can be solved to obtain the optimizing values of L, K,
and l. It is particularly instructive to combine the first two conditions in to obtain
MPK(K, L)/r = MPL(K, L)/w

The equation will choose its factor inputs to equate the ratio of the marginal product of each
factor divided by its price.
Suppose output increases by one unit. Because the marginal product of capital measures the extra
output associated with an additional input of capital and measures the extra capital needed to
produce one unit of output. Therefore, measures the additional input cost of producing an
additional unit of output by increasing capital. Producing a unit of output using additional labor
as an input. In both cases, the Lagrange multiplier is equal to the marginal cost of production
because 0it tells us how much the cost increases if one unit increases the amount produced.

15
Suppose, the production function for a product is given by q 100KL. If the price of capital is
$120 per day and the price of labor $30 per day, what is the minimum cost of producing 1000
units of output?
Given that,
Q = 100KL
R = rent = Taka 120, W =Wage = Taka 30
Cost minimization Principle: Slope of Isoquant = Slope of Iso-cost
MPL/MPK = w/r
Q = 100KL
MPL = dQ/dL = 100K
MPK = dQ/dK = 100L
MPL/MPK = 100K/100L = K/L
Slope of Iso-cost = w/r = Input price ratio = Taka 30/ Taka 120 = 30/120 = ¼
Apply 2-step Approach:
1) MPL/MPK = w/r [Isoquant quant slope = Iso-cost slope]
K/L = ¼ L = 4K
Q = 1000 = 100KL = 100K*4K = 400K^2; K^2 = 1000/400; K^2 = 2.5; K* = 1.58
L* = 4K = 4*1.58 = 6.32
The Isocost equation: wL + rK = C* [ from budget equation we know PxX + PyY= M]
Taka 30*6.32 + Taka 120*1.58 = Taka 379.2

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