Unit-3 Production &Cost Analysis

Production function is a concept in economics that explains the relationship

between physical output and input. Output refers to the number of goods or
services produced in a given time period. Input, on the other hand, is the
number of resources or materials that are used to produce output. While
production is simply the process of creating goods and services for
consumption, production function is the concept explaining the quantitative
relationship between input and output.

 It refers to the relationship between the quantities of output of production and

the input or factors of production.
 It explains the amount of output that can be produced according to the quantity
of input.
 Four main factors of production exist: land, labour, capital, and
entrepreneurship.
 There are two types of factors of production: Fixed factors and Variable factors.
 Fixed factors refer to those aspects of production that remain the same
regardless of changes in the output.
 Variable factors are those that may change as output changes.
 The formula for production function is Q= f(K, L), where Q is the output, f
refers to function, K is the capital and L stands for labour.
 There are two kinds of production functions: Long Run and Short Run
Production Function.
 What is Production Function
 Production function can be defined as a technological relationship
between the physical inputs (i.e., factors of production) and the physical
output of the organisation. The production function is a statement of the
relationship between a firm’s scarce resources (i.e. its inputs) and the
output that results from the use of these resources. Inputs include the
factors of production, such as land, labour, capital, whereas physical
output includes quantities of finished products produced. The long-run
production function (Q) is usually expressed as follows:
 Q = f (lb, L, K, M, T, t)
 Where, lb = land and building
L = labour
K = capital
M = raw material
T = technology
t = time
Land – Land is the term for the natural resources on earth that are used to
produce a good or service. For example if a farmer rents or buys a field, he is
using land as an input to produce crops.

Labour – This is the human effort that is used in the production of a good or
service. If the farmer employs people to work on his land, he is using labour as
an input to produce crops.

Capital – Capital is the term used to describe human-made goods like tools and
machinery that are used to produce goods or services. If the farmer buys a
combine harvester to produce more crops, he is using capital as an input to
produce crops.

Enterprise – Entrepreneurship is when an individual takes an idea or

innovation and tries to combine all the factors of production in order to make
profit. If our farmer thinks of a new and potentially risky idea to increase the
profits of the farm, he is using entrepreneurship as an input to produce crops.
 TYPES OF PRODUCTION FUNCTION

 Short Run Production Function and Long Run Production Function are two
types of production function.
 Short run production function is the relationship between the specific variable
input and quantity of output.
 In the short run production function, only one factor is variable, while others
remain fixed.
 Long run production function explains the relationship between all inputs and
the quantity of output.
 In the long run production function, all factors of production, or inputs are
variable.

ISO-QUANT CURVE

In the long run all inputs are variables and therefore Iso-quant are used to
study production decision. An Iso-quant curve is the firm's counterpart of
consumer's Indifference curve. It is a curve showing all possible input
combinations capable of Producing a given level of output. Iso-quant are
the downward sloping curve, if greater amounts of labour are used, less
capital is required to Produce given Output.

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant
= quantity or product = output. an Iso-product or Iso-quant curve is that curve
which shows the different combinations of two factors yielding the same total
product. Thus it means equal quantity or equal product. Different factors are
needed to produce a good. These factors may be substituted for one another.
 Combinations of Units of Labour Units of Capital Output of Cloth
Labour and (L) (K) (meters)
Capital
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100

The above table is based on the assumption that only two factors of production,
namely, Labour and Capital are used for producing 100 meters of cloth.

1. Combination A = 5L + 9K = 100 meters of cloth

2. Combination B = 10L + 6K = 100 meters of cloth
3. Combination C = 15L + 4K = 100 meters of cloth
4. Combination D = 20L + 3K = 100 meters of cloth

The combinations A, B, C and D show the possibility of producing 100 meters of

cloth by applying various combinations of labor and capital. Thus, an isoquant
schedule is a schedule of different combinations of factors of production yielding
the same quantity of output.
An iso-product curve is the graphic representation of an iso-product schedule
LAW OF RETURNS TO SCALE

In the long run all factors of production are variable. No factor is fixed.
Accordingly, the scale of production can be changed by changing the quantity
of all factors of production. In the long run, output can be increased by
increasing all factors in the same proportion. Generally, laws of returns to scale
refer to an increase in output due to increase in all factors in the same
proportion. Such an increase is called returns to scale. “The term returns to
scale refers to the changes in output as all factors change by the same
proportion.” Returns to scale imply the behaviour of output when all the factor
inputs are changed in the same proportion given the same technology. In other
words, the law of returns to scale explains the proportional change in
output with respect to proportional change in inputs. The term returns to
scale refers to the changes in output as all factors change by the same
proportion.”

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Assumption of Returns to Scale

1.The assumptions of returns to scale are as follows:

2. The firm is using only two factors of production that are capital and
labour.

3. Labour and capital are combined in one fixed proportion.

4. Prices of factors do not change.

5. State of technology is fixed.

CONSTANT RETURNS TO SCALE

A constant return to scale implies the situation in which an increase in output is

equal to the increase in factor inputs.

For example in the case of constant returns to scale, when the inputs are
doubled, the output is also doubled. a movement from A to B shows that the
amount of input is doubled. When labour and capital are doubled from 2 to 4
units, output also doubles from 50 units to 100 units. This is constant returns to
scale.
DIMINISHING RETURNS TO SCALE

Diminishing returns to scale refers to a situation in which output increases in

lesser proportion than increase in factor inputs. when capital and labor are
doubled, but the output generated is less than double, the returns to scale would
be termed as diminishing returns to scale movement from A to B shows that the
amount of input is doubled. When labour and capital are doubled from 2 to 4
units, output increases less than double that is from 50 units to 80 units. This is
diminishing returns to scale. Diminishing returns to scale is due to
diseconomies of scale, which arises because of managerial inefficiency.
INCREASING RETURNS TO SCALE

It is a situation in which output increase by a greater proportion than increase in

factor inputs.

For example, to produce a particular product, if the quantity of inputs is

doubled and the increase in output is more than double, it is said to be
an increasing returns to scale. When there is an increase in the scale of
production, the average cost per unit produced is lower This is because at this
stage an organisation enjoys high economies of scale. a movement from A to B
shows that the amount of input is doubled. When labor and capital are doubled
from 2 to 4 units, output increases more than double, that is, from 50 units to
120 units. This is increasing returns to scale, which occurs because of
economies of scale
 TOTAL PRODUCT, MARGINAL PRODUCT, AVERAGE PRODUCT

 Total Product refers to the total amount of goods and services produced in a
given period of time within a given input.
 Marginal Product is the quantity of total goods and services when an additional
unit of the variable factor is used.
 Average Product refers to the total product per unit of variable factors or input.
 The relationship between total product and marginal product is:

1. An increase in total product at an increasing rate results in an increase in

marginal product.
2. The increase of total product at a diminishing rate causes the marginal product
to decrease.
3. Finally, as the total product begins to decrease, the marginal product falls and
becomes negative.

 The relationship between average product and marginal product can be

explained as:

1. When the average product is greater than the marginal product, the average
product increases.
2. As the marginal product becomes more than the average product, the average
product decreases.
3. As both marginal and average product fall, the marginal product falls at a
greater rate and eventually becomes negative, while average product remains
positive.
 THE LAW OF VARIABLE PROPORTIONS/LAW OF DIMINISHING
RETURN

 The Law of Variable Proportions states that as the quantity of only one input
increases, the total product first rises at an increasing rate, then at a decreasing
rate, finally the total output ends up falling.
 Total product refers to the total amount of goods and services produced within
the given input in a specific period of time.

The Law has some assumptions:

1. Only one input will be variable, others are fixed.

2. It operates on the short run production function.
3. The condition of technology is given and is fixed.
4. The price of input or factors of production are fixed.
5. The proportion of variable factor units can be changed.

 There are three phases of this law:

1. Increasing Returns: In this phase, the increase in one input leads to increase in
the quantity of output at an increasing rate until it reaches its highest point. This
phase sees an increase in both the total product and the marginal product.
2. Diminishing Returns: This stage is when the quantity of output increases but at
a decreasing or diminishing rate. In the second phase, the total product increases
but the marginal product starts decreasing but is positive.
3. Negative Returns: In this phase, the output begins to decrease at a diminishing
rate. Here, both total product and marginal product decrease. The marginal
product becomes negative.
Units of Labour Total Products Average Products Marginal Products
1 2
2 6
3 12
4 16
5 18
6 18
7 14
8 8
 Total Product, Marginal Product, Average Product

 Total Product refers to the total amount of goods and services produced in
a given period of time within a given input.
 Marginal Product is the quantity of total goods and services when an
additional unit of the variable factor is used.
 Average Product refers to the total product per unit of variable factors or
input.

The relationship between total product and marginal product is:

1. An increase in total product at an increasing rate results in an increase in

marginal product.
2. The increase of total product at a diminishing rate causes the marginal product
to decrease.
3. Finally, as the total product begins to decrease, the marginal product falls and
becomes negative.

 The relationship between average product and marginal product can be

explained as:

1. When the average product is greater than the marginal product, the average
product increases.
2. As the marginal product becomes more than the average product, the average
product decreases.
3. As both marginal and average product fall, the marginal product falls at a
greater rate and eventually becomes negative, while average product remains
positive.

Labour Total Product Marginal Products Average Products

 (TP)
1 80
2 170
3 270
4 368
5 430
6 480
7 504
8 504
9 495
10 480
ECONOMIES AND DIS-ECONOMIES OF SCALE

Economies of scale may be defined as the cost advantages that can be achieved
by an organisation by the expansion of their production in the long run.
Therefore, the advantages of large scale expansion are known as Economies of
Scale. The lower average cost per unit achieves the advantage in
cost. Economies of Scale are a long term concept that is achieved when there is
an increase in the sales of an organisation. Due to the lowering of production
cost, the organisation can save more and invest it in buying a bulk of raw
materials which can again be obtained at a discount. These are the benefits of
Economies of Scale. When there is a massive expansion in an organisation, the
cost per unit may increase with the increase in output. Diseconomies of Scale
may arise due to internal issues resulting from technical, organisational, or
resource constraints.

Types of Economies of Scale

The Economies of Scale may be divided into two categories-

1) Internal Economies

2) External Economies.

Internal Economies: Internal Economies are the real economies that arise from
the expansion of the organisation. These economies are the result of the growth
of the organisation itself. In Internal Economies cost per unit depends upon
size of the firm.

Technical Economies of Scale: This occurs when an organisation invests in

modern technology which helps in lowering the cost of production. It enables an
organisation to produce a large number of goods in a lesser period.
Financial Economies of Scale: This occurs when large organisations take a
loan with a low rate of interest. The banks easily give them loans since they
have good credibility.

Managerial Economies of Scale: This occurs when large organisations employ

people with a special skill set that helps to maximize the profits of the
organisation like an accountant or manager.

Marketing Economies of Scale: This occurs when large organisations increase

their budget. They can then spread their market by setting up branches or
buying more raw materials in bulk at a lower price.

Cournot Dilemma

It has also highlighted that in several industrial areas there exist several
enterprises with varying sizes and organizational structures. This conflict,
among the actual data and the conceptual opposition among economies of scale
and competitiveness, has been termed the ‘Cournot dilemma’. Whereas the
study is expanded, including the issues involving the growth of information and
the structuring of interactions, it is possible to infer that economies of scale do
not necessarily result in dominance. In reality, the comparative benefits
resulting from the growth of the firm's competencies and from the
administration of dealings with suppliers and consumers might offset those
supplied by the scale. Thereby it neutralizes the inclination to a monopoly
implicit in economies of scale. In other words, the variability of the
organizational forms and of the size of the firms functioning in a field of
business can be decided by variables concerning the reliability of the goods, the
manufacturing flexibility, the contractual methods, the educational
opportunities, the heterogeneity of choices of clients who convey a
distinguishable requirement with respect to the reliability of the product, and aid
before and after the sale. Such as, for instance, flexible production on a large
scale, small-scale adaptable production, mass production, industrial production
predicated on strict technologies affiliated with flexible organizational systems
and related artisan production.

External Economics: External Economics are the economies that originate

from factors outside the organisation. These economies result in the increase in
the main organisation by the increase in the quality of factors outside the
organisation like better transportation, better labour, infrastructure, etc. Due to
the betterment of these external factors, the cost of production per unit of an
item in the organisation decreases. In External Economies cost per unit
depends upon size of the Industry and not the Firm.

Types of Diseconomies of Scale Similar to the Economies of Scale,

Diseconomies of Scale is of two types-

Internal Diseconomies of Scale and External Diseconomies of Scale.

Internal Diseconomies of Scale: Internal Diseconomies of Scale are the

Diseconomies resulting from the internal difficulties within the organisation.
The Internal Diseconomies are the factors that raise the cost of production of an
organisation like lack of supervision, lack of management and technical
difficulties.

External Diseconomies of Scale: External Diseconomies of Scale are the

external factors that result in the increase in the production per unit of a product
within an organisation. The external factors that act as a restrain to expansion
may include the cost of production per unit, scarcity of raw materials, and low
availability of skilled labours.

Solutions to Diseconomies of Scale

Approaches to the diseconomies of scale for large organizations may entail
separating the corporation into smaller groups. This can either occur by
consequence when the firm is in financial problems, sells off its successful
sections, or closes down the remainder. It can also happen intentionally if the
management is willing. To prevent the adverse consequences of diseconomies
of scale, a business must keep to the lowest average production cost. It must
strive to detect any external diseconomies of scale. Furthermore, on obtaining
the lowest average cost, a business must either extend to other nations to
generate demand for its products or explore new markets or manufacture new
items that do not conflict with its original products. Nevertheless, neither of
these activities would definitely eradicate connectivity and management
challenges commonly associated with huge firms.A comprehensive examination
and redesign of business operations, in order to minimize complication, can
offset diseconomies of scale. This allows for greater productivity. Better
management systems and more effective supervision of labour and activities can
decrease costs.

Cobb-Douglas Production Function

The Cobb-Douglas production function is based on the empirical study of the

American manufacturing industry made by Paul H. Douglas and C.W. Cobb. It
is a linear homogeneous production function of degree one which takes into
account two inputs, labour and capital, for the entire output of the
manufacturing industry.

Q = ALa Cb

where

Q is output and L and С are inputs of labour and capital respectively.

A, a and b are positive parameters where = a > O, b > O.

The equation tells that output depends directly on L and C, and that part of
output which cannot be explained by L and С is explained by A which is the
‘residual’, often called technical change.

The production function solved by Cobb-Douglas had 1/4 contribution of

capital to the increase in manufacturing industry and 3/4 of labour so that the C-
D production function is

Q = AL3/4 C1/4

which shows constant returns to scale because the total of the values of L and С
is equal to one:

(3/4 + 1/4), i.e.,(a + b = 1)

The coefficient of labourer in the C-D function measures the percentage

increase in (Q that would result from a 1 per cent increase in L, while holding С
as constant.

The C-D production function is criticised because it shows constant returns to

scale. But constant returns to scale are not an actuality, for either increasing or
decreasing returns to scale are applicable to production.

The Cobb Douglas production function {Q(L, K)=A(L^b)K^a}, exhibits the

three types of returns:

If a+b>1, there are increasing returns to scale.

For a+b=1, we get constant returns to scale.

If a+b<1, we get decreasing returns to scale

COST ANALYSIS

1. TFC = TOTAL FIXED COST (Machinery, Equipments, Land)

2. TVC (Raw material, Labours)

3. TC = TFC+ TVC

4. AFC = TFC/ UNITS

5. AVC = TVC/ UNITS

6. ATC = TC/ UNITS

7. MC = CHANGE IN TC/Change in Units

Formula and Calculation of Variable Costs

The total variable cost is simply the quantity of output multiplied by the variable cost
per unit of output:

Total Variable Cost = Total Quantity of Output X Variable Cost Per Unit of
Output

TFC:- Total fixed cost is the total amount of money a business must pay to keep their
operations running regardless of how many products they make or sell. Total fixed
cost does not change regardless of production or lack of production.

AFC:- The average fixed cost (AFC) is the fixed cost that does not change with the
change in the number of goods and services produced by a company. To put it in a
nutshell, the average fixed cost (AFC) is the fixed cost per unit and is calculated by
dividing the total fixed cost by the output level.

ATC:- Average total cost is referred to as the sum total of all production costs
divided by the total quantity of output. In other words, the average cost is the
combination of total fixed and variable costs, which is divided by the total number of
units that are produced by the firm.

AVC:- In Economics, the average variable cost is the variable cost per unit. Average
variable cost is determined by dividing the total variable cost by the output. The firms
use the average variable cost to determine when to stop their production in the short
term.

Q1. A company's average fixed cost is Rs 60 at 5 Units of outputs calculate

what will be at 4 units of outputs.

2Q.From the following table calculate TFC, TVC, AFC, AVC, MC

Qty 0 1 2 3 4 5
(Units)
TC 40 70 95 130 170 220

Q3. The form has Total fixed cost of Rs. 300, Calculate

TC, MC, AC.

Qty 1 2 3 4 5 6
(Units)
TVC 500 640 720 740 800 900
Q4. Total fixed cost of a firm is Rs. 600. Calculate TC, TVC, AFC, AVC, AC

Qty 1 2 3 4 5 6
(Units)
MC 20 10 15 30 30 40

Q5.COMPLETE THE COST SCHEDULE OF FOLLOWING.

Output TC MC TFC TVC AFC AVC ATC

(Units)
0 250
1 100
2 210
3 220
4 510
5 60
6 100
7 60
8 590
9 90
WHAT IS INDIFFERENCE CURVE

An indifference curve is a graphical representation of a combined products that gives

similar kind of satisfaction to a consumer thereby making them indifferent. Every
point on the indifference curve shows that an individual or a consumer is indifferent
between the two products as it gives him the same kind of utility.

Indifference Curve Analysis

The indifference curve analysis work on a simple graph having two-dimensional. Each
individual axis indicates a single type of economic goods. If the graph is on the curve
or line, then it means that the consumer has no preference for any goods, because all
the good has the same level of satisfaction or utility to the consumer. For instance, a
child might be indifferent while having a toy, two comic book, four toy trucks and a
single comic book.

Indifference Map

The Indifference Map refers to a set of Indifference Curves that reflects an

understanding and gives an entire view of a consumer’s choices. The below diagram
shows an indifference map with three indifference curves.
 FOLLOWING ARE THE FEATURES OF INDIFFERENCE CURVE

 An indifference curve has a negative

(a) INDIFFERENCE CURVE ALWAYS slope, i.e. it slopes downward from
SLOPES DOWNWARDS FROM LEFT left to right.
TO RIGHT  Reason: If a consumer decides to
have one more unit of a commodity
(say apples), quantity of another good
(say oranges) must fall so that the
total satisfaction (utility) remains
same.
 IC is strictly Convex to origin i.e.
(a) INDIFFERENCE CURVE IS MRS xy is always diminishing
ALWAYS CONVEX TO THE ORIGIN  Reason: Due to the law of
diminishing marginal utility a
consumer is always willing to
 sacrifice lesser units of a commodity
for every additional unit of another
good.

 Higher indifference curve represents

(c) HIGHER INDIFFERENCE CURVE larger bundles of goods i.e. bundles
REPRESENTS which contain more of both or more
HIGHER LEVEL OF SATISFACTION of at least one.

 It is assumed that consumer’s

preferences are monotonic i.e. he
always prefers larger bundle as it
gives him higher satisfaction.

 In the diagram, IC1 and IC2 are the two indifference curves. IC2 is the higher
indifference curve than IC1.

 Combination ‘L’ contains more of both goods ‘X’ and Y than combination ‘M’
on IC1. Hence IC2 curve gives more satisfaction
Difference between Iso-quants and
Indifference Curves

An iso-quant is analogous to an indifference curve in more than one way. In it, two
factors (capital and labour) replace two commodities of consumption. An isoquant
shows equal level of product while an indifference curve shows equal level of
satisfaction at all points.

The properties of iso-quants, as we shall study below, are exactly similar to those of
indifference curves. However, there are certain differences between iso-quants and
indifference curves.

Firstly, an indifference curve represents satisfaction which cannot be measured in

physical units. In the case of an iso-quant the product can be measured in physical
units.

Secondly, on an indifference map one can only say that a higher indifference curve
gives more satisfaction than a lower one, but it cannot be said how much more or less
satisfaction is being derived from one indifference curve as compared to the other,
whereas one can easily tell by how much output is greater on a higher iso-quant in
comparison with a lower iso-quant.

In Figure 1 output on the curve 1Q1 is double, and on the IQ2 treble than on the curve
IQ. Lastly, since satisfaction on indifference curves cannot be measured in physical
units, they are given arbitrary numbers 1, 2, 3, 4, etc. The isoquants have an added
advantage over the former because they can be labelled in physical units, as 100, 200,
300, etc. in Figure 1, to indicate the output level to which each curve corresponds.