Theory Of Production

Unit : III
Managerial Economics & Accounting
3rd Sem IT

Presented By : Yashwant Misale (BE ,MMS)

Faculty MBA Department DMIETR
 Theory of Production

Production: Basic concept

 Transformation of input into output
 Creation of utility
 Act of creation of utility by transforming the Input (land, labor, capital and raw material) into
output through organizing and combining the productive resources.
Production is related to:
 Physical change of the objects and Services that satisfies the intangible needs of human being.
 Therefore the scope of the term production covers the manufacturing activities like Rice,
cloth and cars as well as the services like banking, transportation, media etc.

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 Factors of Production

Hundreds and thousands of factors can be used, They can be

classified under 4 broad generic factors

 Land
 Labor
Capital
Entrepreneurship

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 Factors of Production

LAND
 It means all the natural resources, which yields income or which has
exchange value. In the other word, it refers to all the natural resources,
which is used in production.
Land – Features
 Land is free gift of nature
 It has fixed quantity of supply
 It is permanent in nature
 Lack of geographical mobility
 Infinite variety

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 Factors of Production

LABOR
Any “Human Effort” involved in the production function in exchange of
money.
Labor- Features
 Inseparable from laborer
 Has to be sold in person
 Doesn’t last long
 Late adjustment in supply as a result of change in price

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 Factors of Production

CAPITAL
It is that part of the produced elements that is further used in
production instead of being consumed directly
Capital – features
 Capital is produced element
 Capital has certain longevity
 It is mobile
 Amount capital can be increased through human effort
Income from capital is uniformed if it is used with same degree of
efficiency

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 Factors of Production

ENTREPRENEURSHIP
Human element that initiates and directs the production process by
combining the productive resources. Entrepreneur is responsible for
whole production process
Entrepreneurship – features
 Decision Maker
 Brings the productive resources together
 Risk taker
 Innovator

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 The Firm

A firm is an organisation, owned by one or jointly by a few or many

individuals which is engaged in productive activity of any kind for the sake
of profit or some other well-defined aim.

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 Production Function
• The relationship between the volume of physical inputs into production and the number
of units of output produced is known in economics as the ‘production function’. It
describes the technological relation:

q  f (x 1 , x 2 , x 3 , x 4 ,...., x n )
q = quantity of output of good

f(*) summarises the rate at which conversion of inputs into output takes place, everything
being expressed as rates per period of time.

Simplifying, q  f (L , K )
• where q = quantity of output per period of time
•L = labour hours per period employed
•K = units of capital services (machine hours)

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 Production Function
• There are different types of production function that has been empirically tested and
found their relevance. These are:
1. Cobb-Douglas production function
2. Constant Elasticity of Substitution (CES) production function
3. Trans Log production function

• The Cobb-Douglas production function is the most popular among these, mainly
because of various important properties that it exhibits and its simpler form. It can be
expressed as:
q  AL K 
,
• ,  constants, where A is the technological specification
• The production function defined above is technologically determined physical
relationship which puts outside influences on economic analysis.
• A firm cannot go out of the technological alternatives specified by the production
function, but the one that it chooses is a matter of economic consideration, mainly
determined by factor prices.

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 Short run and Long run

Short Run (SR)

• The short run is defined as the period of time over which some inputs (at least one
input), called fixed input, cannot be varied. E.g. capital – plant & equipment, land,
services of management or supply of skilled labour, etc. This is not of fixed duration in
all industries and is influenced by technological considerations.
The Long Run (LR)
• The long run is defined as the period long enough for all inputs to be varied, but not so
long enough that the basic technology of production changes.
• This is not of specified period of time – it varies; e.g. planning to go into business, or to
expand/ contract the scale of operations.
The Very Long Run
• It is concerned with situations in which technological possibilities open to the firm are
subject to change, leading to new and improved products and new methods of
production, e.g. changes through R&D, etc.
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 Variable and Fixed Factor

• A variable factor is one whose quantity can be changed in a relatively

short period of time;

• While the fixed factors are held constant during this period.
E.g. factory size is fixed in short period, and labour, electricity are
variable.

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 Average & Marginal Product

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 Relation between AP and MP

• Total product initially increases until it reaches the maximum; thereafter it

diminishes. Marginal product is always positive when output is increasing and
negative when output is decreasing.

• When the marginal product is greater than the average product, the average is
increasing.

• Similarly, when the marginal product is less than the average product, the
average product is decreasing.

• Because the MP is above the AP when the average product is increasing and
below the average product when the AP is decreasing, it follows that the MP
must equal the AP when the average product reaches its maximum.

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 Production with One Variable Input
TP TPmax

C Total
Product

A
Labour
per
month

AP, MPmax
MP
APmax
E

Average
Product

MP=0 Labour
per
Marginal month
Product
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 Law of Diminishing Returns

• The law states that if increasing quantities of a variable input are applied to a
given quantity of a fixed input, the marginal product and the average product of
the variable input will eventually decrease.

• This law applies to a given production technology. Overtime, however, inventions

and other improvements in technology may allow the entire total product curve to
shift upward, so that more output can be produced with same inputs.

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 Concept of Isoquant

• An Isoquant is a curve that shows all the

possible combinations of inputs that
yield the same output. Each Isoquant is
associated with a specific level of
output.
K1 (L1, K1)
• An Isoquant map is a set of isoquants,
each of which shows the maximum
output that can be achieved for any set
of inputs. An Isoquant map is a way of (L2, K2)
K2
describing a production function. The Isoquant
Q1
level of output increases as we move up L1 L2
Labour
and to the right of the Isoquant-map.

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 Concept of Isoquant

• With two inputs that can be varied, a manager would want to consider substituting
one input of the other.

• The slope of the Isoquant indicates how the quantity of one input can be traded off
against the quantity of the other, while keeping the output constant.

• When the negative sign is removed, the slope is called the Marginal Rate of
Technical Substitution (MRTS).

• The Marginal Technical Rate of Substitution is the amount by which the input of
capital can be reduced when on extra unit of labour is used, so that output remains
constant. .

Change in capital input K

MRTS    ( for a fixed level of output)
Change in labour input L
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 Elasticity of Substitution

• This shows the ease with which capital and labour or any other set of inputs can be
substituted for each other.

• In some cases, it may be possible to combine capital and labour in different

proportions for production of a given level of output, while in some other cases it
may not.

• The property of elasticity of substitution indicates such possibilities.

• Elasticity of substitution varies from zero to infinity. For fixed-proportions PF, it is

zero. For perfect substitutes, it is infinity; while for Cobb-Douglas PF, it may be
unitary. For CES PF elasticity of substitution remains constant, but not necessarily
unity.

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 Elasticity of Substitution: Special
Cases
Fixed-Proportions PF Perfect Substitutes Inputs PF

Blue Pen
Shovel

Red Pen
Labour

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 Concept of Returns to Scale

• To answer the question: “How does the output change as its inputs are
proportionately increased?” - we need the concept of returns to scale.

• It refers to the way that output changes as we change the scale of production. It is
essentially a long-run concept.

• If we scale all the inputs by some amount ‘t’ and output goes up by the same factor,
then we have constant returns to scale.

• If output scales up by more than ‘t’, we have increasing returns to scale; and

• If it scales up by less than ‘t’, we have deceasing returns to scale.

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 Significance Returns to Scale

• Returns to scale vary considerably across firms and industries. Other things
being equal, the greater the returns to scale, the larger firms in an industry are
likely to be.

• Manufacturing industries are likely to have increasing returns to scale than

service-oriented industries because manufacturing involves large investments
in capital equipment.

• Services are labour intensive and can usually be provided as efficiently in

small quantities as they can on a large scale.

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 Break Even Analysis

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 Break Even Analysis
 The Break-even Point is, in general, the point at which the gains equal the losses.

 A break-even point defines when an investment will generate a positive return.

 The point where sales or revenues equal expenses. Or also the point where total costs equal
total revenues.

 There is no profit made or loss incurred at the break-even point. This is important for
anyone that manages a business, since the break-even point is the lower limit of profit when
prices are set and margins are determined.
 
 Achieving Break-even today does not return the losses occurred in the past. Also it does not
build up a reserve for future losses. And finally it does not provide a return on your
investment (the reward for exposure to risk).
 
 The Break-even method can be applied to a product, an investment, or the entire company's
operations

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 THE RELATIONSHIP BETWEEN FIXED
COSTS, VARIABLE COSTS AND RETURNS

 Break-even analysis is a useful tool to study the relationship between fixed costs, variable
costs and returns.
 The Break-even Point defines when an investment will generate a positive return. It can be
viewed graphically or with simple mathematics.
 Break-even analysis calculates the volume of production at a given price necessary to cover
all costs. Break-even price analysis calculates the price necessary at a given level of
production to cover all costs. To explain how break-even analysis works, it is necessary to
define the cost items.
 Fixed costs: Costs which are incurred after the decision to enter into a business activity is
made, are not directly related to the level of production. Fixed costs include, but are not
limited to, depreciation on equipment, interest costs, taxes and general overhead expenses.
Total fixed costs are the sum of the fixed costs.
 Variable costs: Costs which change in direct relation to volume of output. They may
include cost of goods sold or production expenses, such as labor and electricity costs, fuel,
irrigation and other expenses directly related to the production of a commodity or
investment in a capital asset.
 Total variable costs : (TVC) are the sum of the variable costs for the specified level of
production or output.
 Average variable costs :(AVC) are the variable costs per unit of output or of TVC divided
by units of output.

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 BREAK-EVEN POINT CALCULATION

Calculation of the BEP can be done using the following formula:

 BEP = TFC / (SUP - VCUP)
where:
BEP   = break-even point (units of production)
TFC    = total fixed costs,
VCUP = variable costs per unit of production,
SUP   = selling price per unit of production.
BENEFITS OF BREAK-EVEN ANALYSIS
 The main advantage of break-even analysis is that it explains the relationship between cost, production volume and
returns.
 Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques.
 The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to
prevent losses.
 LIMITATIONS OF BREAK-EVEN ANALYSIS
 It is best suited to the analysis of one product at a time;
 It may be difficult to classify a cost as all variable or all fixed; and
 There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed.

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 Concepts of Cost
• Given a firm’s production technology, managers must decide ‘how’ to produce. As the inputs can
be combined in various ways to yield the same amount of output, we are interested in how the
‘optimal’ (cost-minimising) combination of inputs is chosen, given the factor prices.

• There are differences with the concept of cost between the economists and the accountants, who
are concerned with the firm’s financial statements.

• Accounting cost includes depreciation expenses for capital equipment, which are determined on
the basis of the allowable tax treatment according to the Taxation Rules of the country.

• Economists are concerned with what cost is expected to be in the future, and with how the firm
might be able to rearrange its resources to lower its cost and improve profitability. Thus, they are
concerned with “opportunity cost”.

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 Cost in the Short Run

• Total cost of production has two components:

– Fixed cost, FC, which is borne by the firm whatever level of output it produces,
– Variable cost, VC, which varies with the level of output.

• Depending upon the circumstances, FC may include expenditures for plant

maintenance, insurance, and perhaps a minimal no. of employees – this cost
remains same no matter how much the firm produces.

• Fixed cost must be paid even if there is no output.

• Variable cost includes expenditures for wages, salaries, and raw materials –
this cost increases as output increases.

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 Cost in the Short Run

Marginal cost (MC)

• It is the increase in cost that results from producing one extra unit of
output. Because FC does not change as the firm’s level of output
changes, MC is just the increase in variable cost that results from an extra
unit of output.
VC
MC 
Q

• MC tells us how much it will cost to expand the firm’s output by one
unit.

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 Cost in the Short Run

Average cost (AC)

• Average cost is the cost per unit of output. Average Total cost (ATC) is the
firm’s total cost divided by its level of output. ATC has two components:
– Average Fixed Cost – AFC is the fixed cost divided by the level of output
– Average Variable Cost – AVC is variable cost divided by the level of output

TC  FC  VC
TC FC VC
 
Q Q Q
ATC  AFC  AVC
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 Shapes of Cost Curves in the Short
Run

Cost
Total Cost

Total Variable Cost

Total Fixed Cost

Quantity

• Variable and total costs increase with output. The rate at which these costs increase depends on the
nature of the production process, and in particular on the extent to which production involves
diminishing returns to variable factors.

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 Shapes of Cost Curves in the Short
Run
AP
AFC

Average Product

AC
AFC Average Cost

Quantity

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32
 Relation between Cost Curves
in the Short Run
MC, AVC

Average Variable Cost

Marginal Cost

Quantity

• Whenever marginal cost lies below average cost, the AVC curve falls. Whenever MC
lies above average cost, the AVC curve rises. And when average cost is at a minimum,
MC curve equals average cost.

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 Relation between Cost Curves in the
Short Run
• Since the difference between ATC and AVC is the AFC, which continuously declines as output
increases, the gap between ATC and AVC curves narrows further; however AVC & ATC curves
never meet as AFC never becomes zero. The MC curve passes through the minimum points of
both ATC and AVC curves

MC, AVC
ATC

Average Total Cost

Marginal Cost

Average Variable Cost

Quantity

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Relation between Cost Curves in the
Short Run

• Knowledge of short-run costs is particularly important for firms that

operate in an environment in which demand conditions fluctuate
considerably. If the firm is currently producing at a level of output at
which MC is sharply increasing, and demand may increase in future,
the firm might consider expanding its production capacity to avoid
higher costs.

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 Long-run Average Cost

• The most important determinant of the shape of the long-run average and marginal cost
curves is whether there are increasing, constant, or decreasing returns to scale.

• If the firm’s production process exhibits constant returns to scale at all levels of output,
then a doubling of inputs leads to a doubling of output. Because input prices remain
unchanged as output increases, the average cost of production must be same for all
levels of output.

• If the firm’s production process exhibits increasing returns to scale at all levels of
output, then a doubling of inputs leads to more than doubling of output. Then the
average cost of production falls with output because a doubling of costs is associated
with more than two-fold increase in output.

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Long-run Average Cost

• In the long-run, most firms’ production technology first exhibit

increasing returns to scale, then constant returns to scale, and
eventually decreasing returns to scale.

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Shape of Long-run Average Cost

• Economists think that the LRAC is U-shaped mainly because of:

– Downward falling section is due to Economies of Scale

– Flat section – mainly due to constant returns to scale

– Upward rising section of LRAC is due to Diseconomies of Scale

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 Long-run Marginal Cost

• LRMC measures the change in long-run total costs as output is increased

incrementally. LMC lies below the LRAC curve when long-run average cost is falling;
and above the LRAC curve when long-run average cost is increasing.

• The two curves intersect where the LRAC curve achieves its minimum.

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 Long-run Marginal Cost

• Q* is the optimal plant size/ scale. At this level of output, SRAC is also at its
minimum, and hence is said to operate at the optimum level of output. Any
level of output below or above would exhibit below capacity or above capacity.

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