UNIT 4-Analysis of

Production/Cost/Revenues
1.Production Function
 1.Production Function

Production function expresses the

‘technological relationship between the
quantity of output and the quantities of
inputs used in the production at a
particular period of time’
 Production function depends on
 Quantities of resources (raw materials, labour,
capital,…)
 State of technology
 Possible processes
 Size of the firms
 Nature of firm’s organisation
 Relative price of inputs and the manner in
which the inputs are combined
 Transformation
Input Output
Process

Cost Revenue

Profit = Revenue - Cost

 Transformation
Input Output
Process

 Land
  Fixed Inputs  Short Run
Labour
 Variable Inputs 
 Capital Long Run
 …
 Factors of Production
Land is defined in economics as, all natural resources,
fertility of soil, water ,air, natural vegetation in addition
to soil or earth surface
Labour in economics is defined as various types of human
effort which require the use of physical exertion, skill
and intellect to get economic reward
Capital is defined as wealth , stock concept of initial
investment and flow concept 0f generating income
from finished goods
 Purely
Technological

Nature of
Differs from Continuous
Production
Firm to firm Function
Function

Economic
Importance
Which Production Process is Technically Efficient ?

P1 P2

Labour Inputs 2 3

Capital Inputs 4 4
 P1 P2

Labour Inputs 2 4

3
Capital Inputs P1
3 - Technical
1 Efficiency
- Economic Efficiency
Capital
P2
1

2 Labour 4
Types of Production Function…

1. Fixed proportion and Variable proportion

Production function
2. Short period and Long period
Production function
3. Cobb-Douglas Production function
 C P = 150 Units
Labour

B
P = 100 Units
A
P = 50 Units

Capital

Fixed Proportion Production Function

1.Production in the Short run
 Long-run and short-run production
 fixed and variable factors
 distinction between short run and long run
 The law of diminishing returns
 The short-run production function:
 total physical product (TPP)
 average physical product (APP)
 marginal physical product (MPP)
 the graphical relationship between TPP, APP
and MPP
What
 is law of diminishing returns ?

Law of diminishing returns states that an

additional amount of a single factor of
production will result in a decreasing
marginal output of production. The law
assumes other factors to be constant

Example :
You hire 2 workers for a specific work .You
later add on 2 more workers .The result is
work that was 50% load per head noe comes
down to 25%
 Short Period Production Function

E
ED IA B L

IX VA R
F
Land and Plant Machineries Labour
 Long Period Production Function

l e
ab
ir
Va
Land and Plant Machineries Labour
 Cobb-Douglas Production Function

1.Developed by Charles W. Cobb and Paul H. Douglas

2.Analyses relation between inputs and outputs
3.Applicable to Long run Production function
4.Useful for International and inter-industry comparison
5,It assumes if one of the inputs is zero then output also will be
zero
6.It states that average product of labour is equal to the ratio
between output and labour input
 Cobb-Douglas Production Function

P = bL C a 1-a
Where,

P = Total output
L = Index of employment of labour in manufacturing
C = Index of employment of capital in manufacturing
a and 1-a = exponents of elasticities of production
1.Cobb-Douglas Production Function

P = 1.01L0.75C0.25
1 % change in labour and capital remains
constant results in 0.75% change in the
output.

1 % change in capital and labour remains

constant results in 0.25% change in the
output.
2.Law of Variable Proportions
 30

Variable Proportion
Production Function
20
Labour

10

0 P4=400 units
0 10 20 P3=300 units
P2=200 units

Capital
 2.Law of Variable Proportions
(Law of diminishing returns)

‘As the quantity of one input is increased,

keeping the quantity of other inputs fixed
– the output increase in the beginning
and afterwards decreases’
 2.Illustration …

No. of Amount of Total Output

Machines Labour (Q)
5 0 0
5 1 20
5 2 60
5 3 120
5 4 160
5 5 190
5 6 216
5 7 224
5 8 224
5 9 216
5 10 200
 2.Illustration …

Average Marginal
No. of Amount of Total Product Product
Machines Labour (L) Output (Q) (Q/L) (dQ/dL)
5 0 0 0 0
5 1 20 20 20
5 2 60 30 40
5 3 120 40 60
5 4 160 40 40
5 5 190 38 30
5 6 216 36 26
5 7 224 32 8
5 8 224 28 0
5 9 216 24 -8
5 10 200 20 -16
3.Return to scale/Economies of Sale
 3.What is Return to scale ?

It states that the degree of change in input factors changes

the output proportionally and concurrently during the
production process.

It reflects the quantitative change that applies in the long-

term using similar technology.

It forms the basis of measuring a firm’s or industry’s

efficiency of production capacity.
3.Return to scale

27
3.Return to scale

28
 3.Return to scale
• 1. Law of Increasing Returns to Scale
• If production increases by more than the proportional change in factors of
production, this means there are increasing returns to scale.
• Increasing returns to scale happen when all the factors of production are
increased; at this point, the output increases at a higher rate.
• For example, if all inputs are doubled, the overall output will increase at
more than twice the rate—this is the increase in output relative to inputs
that “increasing” describes.
 3.Return to scale
• 2. Law of Constant Returns to Scale
• If production increases by the same proportional change as all factors of production are
also changing, then there are constant returns to scale.

• Constant returns to scale occur when the output increases in exactly the same proportion
as the factors of production.

• In other words, when inputs (i.e. capital and labor) increase, outputs likewise increase in
the same proportion as a result.

• As an example of constant returns to scale, if the factors of production are doubled, then
the output will also be exactly doubled.
 3.Return to scale
• 3. Law of Diminishing returns to Scale

• If production increases by less than that proportional change in factors of production, there are decreasing
returns to scale.

• Decreasing or decreasing returns to scale are taking place when all the factors of production increase in a
given proportion, but the output increases at a lesser rate than that of the increase in factors of production.

• To compare this to increasing returns to scale: for decreasing returns to scale, increasing inputs leads to
smaller increases in output; for increasing returns to scale, increasing inputs leads to the opposite—larger
increases in output.

• For example, if the factors of production are doubled, then the output will be less than doubled.
 3.Assumptions –Returns to scale
• All inputs can vary except the enterprise

• Workers accurately do their assigned work with provided tools

• No technology changes during production

•
There is perfect competition

• The output product is measured to quantities

 3.Economies of scale
• Economies of scale is when output increases leading to
declining of long-run average total cost
• Diseconomies of scale is when output increases leading to rise
in long term average cost
• Types of Economics of Scale
• Internal:
• Technical/Commercial/Managerial/Financial
• External:
• Cheaper raw matrial&Capital equipment
• Development of cheap labour
• Technological external economies
• Growth of Ancillary Industries

33
 3.Economies of Scale vs Return to scale

• The difference between economies of scale and returns to scale

• is that economies of scale show the effect of an increased output level on
unit costs,

• while the return to scale focus only on the relation

• between input and output quantities.
4.Producer’s surplus-Costs/Isoquants
 4.Isoquants

Isoquant curve is like ‘indifference curve’ –

It shows the different combinations of
two factors yielding the same level of
output’
 4. Meaning &Definition of Isoquants
• Isoquant is known as Production function with 2 variable inputs or equal
product curves
• Combination of all variable inputs which can yield the same output with
various combinations is termed as Isoquants
• Other names :
• Iso-product
• Iso-product curves
• Producer –indifference curve
• Equal Product curve
 4. Types of Isoquants
• Linear Isoquants
• Inputs are replaceable in direct proportion
• Example: Output required is, say 200 units. It can be obtained by
• 2 units of labour &1000units of capital or
• 4 units of labour &500 units of capital and so on
• Right angle Isoquants
• No substitutability between the inputs
• Example: For plastering a room 2 units of sand &1 unit of cement is required. Same
proportion for additional rooms too
• Convex Isoquants
• Substitution of inputs is not in totality
• Example: Increase in labour shortens the completion time
 4. Significance of Isoquant Curve in Cost
analysis
• Helps industries to slightly alter their inputs

• Utilized to find the change in production levels &also probabilities of output

• Illustrates various combinations of 2 factors at prescribed cost &budget

• Helps an industry to select the level of output needed using the variable factors
in most efficient manner to lower the cost
 4.Properties of Iso-quants

 Convex to the origin

 Slope towards from left to right
 Never intersect with each other
 30
Constructing an isoquant curve
a
28
26 Labour Capital
24 30 6
22 24 7
20 20 8
18 14 10
16 10 13
8 15
Capital

14
12 6 20
10
8
6
4
2
b
0
0 2 4 6 8 10 12 14 16 18 20 22 P = 100
Units

Labour
 Isoquant map

Capital

P4=400 units
P3=300 units
P2=200 units
P1=100 units

Labour
4.Marginal Rate of Technical Substitution
(MRTS)

The amount of one input which can be

substituted for another input in the
production process, without changing the
level of output.
4. Illustration…

*MRTS of labour for capital can be defined as – the

amount of capital which can be substWhat is MRTS in
Economics uted or replaced for a unit factor of labour,
without changing the level of output.
*Marginal rate of Technical substitution

L
MRTS =
K
30 a
DK = 4 MRTS = 4
26 b

DL = 1 MRTS = L/K
20
Capital

MRTS = 1

10 c DK = 1
d
D L= 1

0
0 10 20
6 7 13 14
Labour
 4.Iso-Cost Curves
A4
Shows all
A3 combinations of
A2
inputs having equal
total cost (that can
A1 be purchased for a
Input 2

given expenditure)

B1 B2 B3 B4
O
Input 1
 4.Iso-Cost Curves
A4
If
A3 Price of Input A = Rs. 4 &
Price of Input B = Rs. 5 &
A2
Total Outlay is Rs. 200, Then
A1
…
Input 2

B1 B2 B3 B4
O
Input 1
 4.Producer’s Equilibrium

 Producer’s Equilibrium refers to the situation of ‘Profit Maximization’.

 A producer attains the situation of equilibrium at that level of output where

his profit is maximized.

 The output at which producer strikes the equilibrium or maximum profit is

known as equilibrium output.
 4.Optimum level of output @ given cost

Capital

Iso-cost Curve

IQ3(3000)
IQ2(2000)
O IQ1(1000)
Labour
 4.Optimum level of output @ given
cost4.

r Optimum Point
Minimum Cost and
s
Capital Maximum Output

K1 t

x
IQ3 (3000)
v
IQ2 (2000)
O L1 IQ1 (1000)
Labour
 4.Expansion Path

Output produced by a firm increases with

the increase in its financial resources.
 4.Expansion Path

Capital

B1 IQ1
O
Labour
 4.Expansion Path

Capital

IQ2
B1 B2 IQ1
O
Labour
 4.Expansion Path

Capital

IQ4
IQ3
IQ2
B1 B2 B3 B4 IQ1
O
Labour
 4.Expansion Path

Expansion Path
(Least cost method
of producing different
Capital

levels of output)

IQ4
IQ3
IQ2
B1 B2 B3 B4 IQ1
O
Labour
5.Least Cost Combination-Types and Costs
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60
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63
64
65
 5.Types of Costs

 Opportunity cost
 Fixed and Variable Costs
 Marginal Cost and Average Cost
 Explicit and Implicit Cost
 Accounting Cost and Economic Cost
 Economic Cost and Social Costs
 Direct and Indirect Costs
 Incremental and Sunk Costs
66
5.Cost and Production Function

 A cost function determines the behavior of costs with

the change in output.
 Cost Function :
C = f(Q)
 Cost functions are derived functions which are derived
from production functions.

67
5.Total Fixed Cost

68
5.Average Fixed Cost

69
5.Total Variable Cost

70
5.Average Variable Cost

71
5.Total Cost

72
5.Marginal Cost

73
5.Average Cost

74
6.Short/Long run costs
 6.Short Run Cost Function

Y  Shot run cost

MC
function help in
Costs determining the
SATC
relationship
E AVC between output
Minimum
ATC and costs
 SATC is Short
run Average
Total Cost

O Q X
Quantity
76
 6.Long Run Cost Function

Y  In the long run,

the firm chooses
the combination of
Costs LAC inputs that
SAC6
SAC1 minimize the cost
SAC5
SAC2 SAC4
of production at a
SAC3
desire level of
E output.

O Q X
Quantity 77
7.Revenue analysis-TR/AR/MR
 7.Concept of Total Revenue

 It refers to the total income of a firm or producer or seller

from the sale of total goods and services.
 Total revenue is also equal to the sum of all the marginal
revenues. Thus,
 TR = Price x Quantity

79
7.Total Revenue Curve

80
7.Concept of Average Revenue

 Average revenue is the revenue per unit of output sold in

the market. In simple words, it is the price per unit of the
commodity.
 We calculate the Average revenue by dividing the Total
revenue with the number of units of output to be sold in the
market. Thus,
 AR=TR/Q

81
7.Concept of Average Revenue

82
 7.Concept of Marginal Revenue

 Marginal revenue refers to the additional revenue that a

firm or producer obtains by selling every additional unit of
the commodity in the market.
 In other words, the change in total revenue is marginal
revenue. Thus,
 MR=ΔTR/ΔQ

83
7.Marginal Revenue Curve

84
8.Breakeven Analysis
 8.Break Even Analysis

 It studies the inter-relationship among the firm’s revenues,

cost and operating profit at various levels of production.
 It measures the effect of changes in selling prices, fixed costs
and variable cost on output level.
 It is used for determining the financial viability of new
marketing plans and product line.

Cont……….. 86
 Break Even Analysis
Costs/Revenue TR Total
The Initially
break
revenue even
a firm
is
TR TC The lower the
determined
point
Aswill
price, occurs
incur
output
the by
where
is
lessfixed
VC The
the
total
total
costs,
price
costs
revenue
steep
therefore thecharged
generated, these the
total
and
equals
dothenot
total
quantity
incur –
depend
firm willcurve.
revenue costs
(assuming
sold
the on
firm,
– output
variableagain
incosts
this
this
or –
accurate
will
example,
sales.
be vary
these would
forecasts!) is the
determined
have to sell by
Q1 to
sum of FC+VC the
directly with
expected
generate
amount sufficient
forecast
revenue
produced. sales
to cover its
initially.
costs.

FC

Q1 Output/Sales

87
 Break Even Analysis
Costs/Revenue If the firm
TR (p = £3) TR (p = £2) TC chose to set
VC price higher
than £2 (say
£3) the TR
curve would
be steeper –
they would not
have to sell as
many units to
break even

FC

Q2 Q1 Output/Sales

88
 Break Even Analysis
TR (p = £1)
Costs/Revenue TR (p = £2) If the firm
TC chose to set
VC prices lower
(say £1) it
would need to
sell more units
before
covering its
costs.

FC

Q1 Q3 Output/Sales

89
 Break Even Analysis
TR (p = £2)
Costs/Revenue TC

Profit VC

Loss
FC

Q1 Output/Sales

90
 A Margin of safety
shows how far sales can
Assume current sales at Q2. fall before losses made.
If Q1 higher price would

Break Even Analysis lower the break even

point and the margin of
TR (p = £3) TR (p = £2) safety would widen. =
Costs/Revenue TC

VC
1000 and Q2 = 1800,
sales could fall by 800
units before a loss
would be made.

Margin of Safety

FC

Q3 Q1 Q2 Output/Sales

91
 8.Break Even Analysis

Y A TC
D Maximum
Costs Profit at
Profit TR
output level
B Q2
C
Break Even
Loss Point Q1 & Q3
TFC

O Q2 Q3 X
Q1
Quantity 92
 8.Shut Down Point.

Y  In short run if AVC<P then

MC
Costs,
firm has to shut down
Price ATC  In the long run if ATC<P
E AVC then firm has to shut down
P
E1
P1

O Q1 Q X
Quantity
93