Unit-3

Production concepts & analysis;

Production function, Types of production function,
Laws of production: Law of diminishing returns, Law
of returns to scale.

Cost concept and analysis:

Cost, Types of costs, Cost output relationship in the
short-run. Cost output relationship in the Long-run.
Estimation of revenue. Average Revenue, Marginal
Revenue . Case Studies
 Meaning of Production
• Production implies provisions of goods and services, often
described as ‘commodities.’ In technical sense, production is the
transformation of resources into commodities over time.

• In Economics the term production means a process by which

resources are transformed into a different more useful
commodity or service. In general, production means
transforming inputs into an output.

• In the economic sense production process may take a variety of

forms other than manufacturing. For example transferring a
commodity from one place to another where it can be used in
the process of production is production.
 Production Function
• Production function is a tool of analysis used to explain the
input-output relationship.

• A production function describes the technological relationship

between inputs and output in physical terms.

• In its general, it tells that production of a commodity depends on

certain specific inputs.

• In its specific form, it represents the quantitative relationship

between inputs and outputs.

There are two kinds of production functions:

• Short run production function
• Long run production function
• The Production function signifies a technical relationship
between the physical inputs and physical outputs of the firm,
for a given state of the technology.
• Q = f (a, b, c, . . . . . . z)
• Where a, b, c ....z are various inputs such as land, labor ,
capital etc. Q is the level of the output for a firm.

• If labor (L) and capital (K) are only the input factors, the
production function reduces to −
• Q = f(L, K)

• Production Function describes the technological relationship

between inputs and outputs.
• It is a tool that analysis the qualitative input–output
relationship and also represents the technology of a firm or
the economy as a whole.
 Attributes of Production Function

• There are following attributes of production function.

• Flow Concept: It relates to the flow of inputs and the

resulting flows of output of a commodity during a period
of time.

• Physical: It is technical relationship between inputs and

outputs expressed in physical terms and not in terms of a
monetary unit.
• State of technology and inputs: It implies that the
production of a firm depends on the state of technology
and inputs.

• Technology refers to the knowledge of the means and

methods of producing goods and services.

• Input refer to any thing that is used by the firm in the

process of production.
 Production Analysis
• Production analysis basically is concerned with the analysis
in which the resources such as land, labor, and capital are
employed to produce a firm’s final product.

• To produce these goods the basic inputs are classified into

two divisions −
• Variable Inputs: Inputs those change or are variable in the
short run or long run are variable inputs.

• Fixed Inputs: Inputs that remain constant in the short term

are fixed inputs.
 Time Element and Production Function

• The functional relationship between changes in input and

changes in output depends on the time element short run and
long run time periods.

• This time element considered here is the functional or

operational time period.

1. The Short Run: Short period refers to that period of time

during which it is possible to change the quantity of some
factors while the quantity of other factors cannot be increased
or decreased.
The term ‘short run’ is defined as a period of time over
which the inputs of some factors of production cannot to
be varied. Factors which cannot be altered in the short run
are called fixed factors.

Thus in the short period, some factors are fixed and some
are variable.

Elements of capital such as plant, machinery and

equipment are generally fixed in the short run.
• The Long Run: Long period refers to that period of time
during which the quantity of all factors can be increased or
decreased.
• In other words no factor is a fixed factor in the long period.
Even the fixed factors become variable factor with the
passage of time.
• There is no distinction between fixed and variable factors
in the long run as all factors become variable factors.

• The size of the plant which is usually fixed in short period

can be varied in the long run. Thus there is a full scope for
adjustment between factors in the production process.
 Laws of Production
• The laws of production describe the technically possible
ways of increasing the level of production.

• Laws of Production in economics deals with the

concepts of cost and producers equilibrium.

• It is an important aspect of economics as it helps a

business determine the level of output that leads to
maximum profits.

• It also defines the various variable and fixed costs of the

firm.
 Producer’s Equilibrium:
• A producer's equilibrium refers to the state where the combination of price and
output gives maximum profit to the producer. By producing any more goods
than the equilibrium state, the producer's profit would begin to decline.

• Equilibrium refers to a state of rest when no change is required. A firm (producer)

is said to be in equilibrium when it has no inclination to expand or to contract its
output. This state either reflects maximum profits or minimum losses.

• Economic production is the result of the output we produce by employing factors

like land, labour, capital, and entrepreneurship.
• It is possible to determine the optimum amount of
production possible considering different combinations of
these inputs. Such a determination is called the producer’s
equilibrium.

• In order to achieve this, producers first have to classify their

resources into different combinations. Each combination
would provide production in different quantities.

• The value of all assets used for production is limited.

Hence, the producer has to use such a combination of inputs
as would provide him with maximum output and profits.
• This optimum level of production, also called producer’s
equilibrium, is achieved when maximum output is derived
from minimum costs.

• The combination that provides the highest amount of produce

at the least amount of costs is the optimum level of
production.

• In order to find out producer’s equilibrium, we first need to

understand iso-quant curves and iso-cost lines.

• These two concepts help us calculate optimum production.

Isoquant Curve
 Isoquant curve shows the varying combinations of
production factors of production such as labour and capital
that can be used to produce with given state of technology.

• The isoquants have three important properties:

(1)No two isoquants can intersect;

(2) Isoquants slope downwards from left to right;

(3) They are convex to the origin.

• Iso-quant Curves:
• These lines represent various input combinations which
produce the same levels of output.
• The producer can choose any of these combinations
available to him because their outputs are always the same.
Thus, we can also call them equal–product curves or
production indifference curves.

• Just like indifference curves, iso-quants are also negatively-

sloping and convex in shape.
• They never intersect with each other. When there are more
curves than one, the curve on the right represents greater
output and curves on the left show less output.
Consider the table below. It shows four combinations,
i.e. A, B, C and D, which produce varying levels of
output.

Factor Units of Labour Units of Capital

combinations
A 5 9
B 10 6
C 15 4
D 20 3
• The X-axis shows units of labour, while the Y-axis
represents units of capital. Points A, B, C and D are
combinations of factors on which IQ is the level of output,
i.e. 100 units. IQ1 and IQ2 represent greater potential
output.
• If the isoquant in Fig. reflects 100 units of
production per period, then anywhere along
that curve it is possible to determine the
combination of factors required to produce
100 units.
• Iso-cost Lines
• Iso-cost lines represent combinations of two factors that
can be bought with different outlays.
• In other words, it shows how we can spend money on two
different factors to produce maximum output. These lines are
also called budget lines or budget constraint lines.
• Example:
• Let’s assume that a farmer has Rs. 1,000 to spend on labour
costs and ploughs for farming.
• The cost of one such plough and wage per labourer is Rs.
100.
• Considering his total outlay of Rs. 1,000, he can spend that
money in the following combinations:
Plough Labour
0 1000
100 900
200 800
300 700
400 600
500 500
600 400
700 300
800 200
900 100
1000 0
 Laws of Diminishing Return
• The law of diminishing marginal returns was originally
explained by the classical economists with reference to
agriculture.

• It was studied in relation to the land which was kept

constant while other factors were increased. The output did
not increase proportionately. It is experience of farmer that
the out put of land cannot be doubled by doubling the
labour and capital on a given piece of land.

• As this is not possible on a given piece of land, additional

land is brought under the plough.
• Marshall stated this law as follows:

“ An increase in capital and labour applied in the

cultivation of land cause in general a less than
proportionate increase in the amount of produce
raised, unless it happens to match with an
improvement in the arts of agriculture.”

Although this law was originally explained in connection

with land and agriculture, it is not peculiar land only. It is
applicable in all fields of industry like industry, mining,
fishing, house, construction etc.
• The Law of Returns are classified into two categories:
1. Law of Variable Proportion 2. Law of Returns to Scale

1. Law of Variable Proportions:

This is modern version of the law of diminishing marginal
returns.
Under this law, it is assumed that only one factor of production
is variable while other factors are fixed.

As we increase the quantity of variable factor, while keeping

the other factors constant the output of variable factor may
increase more than proportionately in the initial stage of
production but finally, it will not increase proportionately.
• According to Leftwitch, “the law of variable proportions states
that if the input of one resource is increased by equal increments
per unit of time while the inputs of other resource are held
constant, total out put will increase, but beyond some point the
resulting output increases will become smaller and smaller.”

• Assumptions:
• Only one factor is variable while all other factors are fixed or
constant.
• All units of the variable factor are homogenous, i.e. all the units
have identical characteristics and equal efficiency.
• There are no change in the technique of production.
• The scale of output is unchanged, and the production palnt or
size efficiency of the firm remain constant.
2. The Law of Returns to Scale:
• All the factors become variable in the long run. No factor
is a fixed factor. That means in the long run, the size of a
firm can be expanded as the scale of production is
enhanced. Accordingly scale of production can be
changed by changing the quantity of all factors.

• Economists uses the phrase "return to scale” to describe

the output behaviour in the long run in relation to the
variations in factor inputs.

• The term “Returns to Scale” refers to the changes in

output as all factors change by the same proportion.
• The principle of returns to scale as follows:
• “As firm in the long run increases the quantities of all
factors employed, the out put may rise initially at a more
rapid rate than the rate of increase in inputs, then output
may increase in proportion in the same proportion of
input, and ultimately, output increases less
proportionately.”

• Assumptions:
• Technique of production is unchanged.
• All units of factors are homogenous.
• Returns are measured in physical terms
 Cost Concept and Analysis
• In order to produce a good, every firm, make use of
factors of production. The amount spent on the use of
factors of production is called cost of production. Cost of
production mainly depends on quantity of production.

• There are three important components in cost:

• 1. Labour
• 2. Material
• 3. Expenses
• In economics, the Cost Analysis refers to the measure of the
cost – output relationship, i.e. the economists are concerned with
determining the cost incurred in hiring the inputs and how well
these can be re-arranged to increase the productivity (output) of
the firm.

• Cost Analysis
• In other words, the cost analysis is concerned with determining
money value of inputs (labor, raw material),

• The analysis of cost is important in the study of managerial

economics because it provides a basis for two important
decisions made by managers:
• (a) whether to produce or not and
• (b) how much to produce when a decision is taken to produce.
 Actual Cost

• Actual cost refers to the physical quantities of various

factors used in producing a commodity.

• Actual costs are those costs, which a firm incurs

while producing or acquiring a good or service like
raw materials, labour, rent, etc..

• Sometimes the actual costs are also called acquisition

costs or outlay cost.
 Opportunity Cost
• The opportunity cost is measured in terms of the foregone
benefits from the next best alternative use of a given
resource.
• In other word the opportunity cost of producing a certain
commodity is the value of the other commodity that the
resources used in the production could have produced
instead.
• The opportunity cost of one unit of product A is the
amount of product B that has been sacrificed by
allocating the resources to produce A rather than B.
• For example a farmer can grow both wheat and gram
on a farm. If he grows only wheat and foregoes the
production of gram. If the price of the quantity of
gram, that he foregoes is Rs.1000, then the
opportunity cost of growing wheat will be Rs.1000.
 Explicit Cost
• All those expense that a firm incurs to make payment to others
are called explicit costs. In other words “explicit costs are those
cash payments which firm.

• Explicit costs are those costs that involve an actual payment to

other parties. Therefore, an explicit cost is the monitory payment
made by a firm for use of an input owned or controlled by others.
Explicit costs are also referred to as accounting costs.

• Explicit costs include purchase of raw materials,

renting a building, amount spent on advertising etc.
 Implicit Costs
• On the other hand, implicit cost represent the value of foregone
opportunities but do not involve an actual cash payment.

• This implicit cost generally is not reflected in

accounting statements, but rational decision-making requires that
it be considered.

• Therefore, an implicit cost is the opportunity cost of using

resources that are owned or controlled by the owners of the firm.
• Implicit costs are just as important as explicit costs but
are sometimes neglected because they are not as obvious.

• For example, a manager who runs his own business fore

goes the salary that could have been earned working for
someone else as we have seen in our earlier example.
 Controllable and Non-Controllable Costs
• Controllable costs are those which are capable of being controlled
or regulated by executive vigilance and, therefore, can be used for
assessing executive efficiency.

• Non-controllable costs are those, which cannot be subjected to

administrative control and supervision.

• Most of the costs are controllable, except, of course, those due to

depreciation.

• The level at which such control can be exercised, however,

differs: some costs (like, capital costs) are not controllable at
factory’s shop level, but inventory costs can be controlled at the
shop level.
 Fixed Cost and Variable Cost
• The Fixed Cost is the cost that remains fixed for a certain
volume of output.
• In other words, the cost that does not change with the
change in the output or sales revenue, i.e. it remains fixed
irrespective of the volume of output is called the fixed
cost.
• The concept of fixed cost is associated with the short run
since all the costs vary over time, and no cost remains
purely fixed for a longer period.
• For example, the fixed cost would be the company’s rent
of the machine. Suppose a firm uses a certain machine on
rent then it is required to pay rent every month, even if
the machine was left idle at any point in time. Thus, the
amount of rent paid every month is fixed that a firm has
to incur irrespective of the usage of the machine.

• Variable Cost:
• The Variable cost is the cost proportionally related to the
level of output, i.e. it increases with the increase in the
production and contracts with the decrease in the total
output. Simply, the cost which varies with the change in
the total output is called the variable cost.
• The most common form of variable costs is raw material,
direct labor related to the level of output, sales
commission, and the cost of all other inputs that vary with
the total production.

• For example, if the company pays 3% sales commission

for every sale made by the salesperson, then 3% is the
variable cost which varies with the change in the sales
volume.

• The variable costs and Fixed costs together make up the

total cost of the firm. Symbolically,
• Total Cost = Fixed Cost + Variable Cost
 Average Cost
• The Average Cost is the per unit cost of production
obtained by dividing the total cost (TC) by the total output
(Q).

• By per unit cost of production, we mean that all the fixed

and variable cost is taken into the consideration for
calculating the average cost.

• Thus, it is also called as Per Unit Total Cost.

 • AC = TC/Q
• Also,
• AC = Average Variable cost (AVC) + Average Fixed
cost (AFC)
• Where,
• Average variable cost =
• Total Variable Cost (TVC) / Total output (Q)

• Average fixed cost =

• Total Fixed Cost (TFC) / Total output (Q)
• The average cost is greatly influenced by the time period of
production, such as increasing or expanding the production
in the short run might be quite expensive or impossible.

• Thus, the economists study both the short-run average

costs and long-run average costs to decide the production
for a given period.
 Marginal Cost

• The Marginal Cost refers to the change in the

total cost as a result of the production of one more
unit of the product.

• In other words, the marginal cost is the increase or

decrease in the total cost due to the production of
one additional unit of the product.