(UNIT 3)

PRODUCTION & COST ANALYSIS

PRODUCTION FUNCTION
It refers to the technological or engineering
relationship between the inputs of a
commodity & the output produced by them
The 4 factors of production are
1.Land
2.Labour
3.Capital
4.Organisation or management
Production function (schedule)
Labour (L)
(No.of workers)
Output quantity
(Q)
1 5 20
2 15 30
3 35 42
250 500
Units of capital(K)
Production function (Equation)
Q = f (L, K, L
d
, M, T, etc.)
Where
Q -- Output of commodity X
L -- Labour employed in the production of X
K Capital employed in the production of X
L
d
Land employed in the production of X
M Managerial function employed in the
production of X
T Technology employed in the production of X
Two time frames of production
function
1.Short run :
--Here at least one of the inputs remain constant, while
other inputs vary
--Different output & capital for a constant input pattern of
production function is referred as return to a factor
&
2.Long Run
--A pattern of input combinations wherein both the inputs
increase or decrease relates to long run changes in
production function
--If input change in the same proportion, then the pattern of
production function is referred as return to scale
3 types of production function
1.production function with one variable input
2.production function with 2 variable input
3.Production function with all variable input
1.production function with one variable input
factor/short run analysis of production function
**It is explained with Law of variable Proportions/
Law of Diminishing Marginal Returns/Law of Diminishing
Marginal Productivity
Law of Variable Proportions:
It states that as more & more of one factor input is employed & if
all other input quantities are held constant, a point will
eventually be reached where additional quantities of varying
input will yield diminishing marginal contributions to total
product
Terms used in law of variable proportions:
1.Total Product (TP or Q)
2.Marginal Product (MP)
3.Average Product (AP)
If variable Labour is L, then
Marginal Product of Labour MP
L
= Q/ L
Average Product of Labour AP
L
=Q/L

Example:
Capital is Fixed
Var
input(L)
TP
MP(Q/ L)
AP(Q/L)
1 5 - (5/1)5
2 15 (15-5)/(2-1)=10 (15/2)7.5
3 35 (35-15)/(3-2)=20 (35/3)11.7
4 45 (45-35)/(4-3)=10 (45/4)11.25
5 50 (50-45)/(5-4)=5 (50/5)10
6 45 (45-50)/(6-5)=-5 (45/6)7.5
Output (Q)
Var input Labour (L)
x1
x2
x3
TP
L
AP
L
MP
L
X
Y
MP>1
0<MP<1
MP<0
STAGE I STAGE II
STAGE III
High Return Less Return
Negative Return
3 stages of production function
from the graph
1.STAGE 1: starts from 0 units of variable input (L) to AP of
at maximum (till X2)
2.STAGE 2:It follows stage I & then proceeds to a point
where MP
L
of (L) is 0(point X3).Here TP
L
is maximum
3.STAGE 3:It continues from Previous point
Interpretation:
-At stage I/stage III: No rational firm will operate.
-At stage I : The firm is grossly under utilizing its
fixed capacity. So in this MP
L
increases
-At stage III: The firm grossly over utilizes its fixed
capacity
2.production function with two variable
input factor/short run (only 2 var)or Long
run (more than 2 var) analysis of
production function

Example: 2 var input : Labour (L),capital (K)

Labour(L) Output Quantity (Q)
1 5 20 42
2 15 30 50
3 35 42 70
4 42 50 80
5 50 65 83
6 46 61 80
Units of
capital(K)
250 500 750
From the above table ,
If a firm want to produce 42 units of
output, then the possible combinations are
(4,250) (3,500) (1,750)
Plotting these points on graph & line
joining these combinations of labour &
capital is called as isoquant/iso-product
curve/Equal product curve/Production
indifference curve
Isoquant
It is defined as the locus of all those
combinations of 2 inputs that produce the
same amount of output
Unit of
Capital (K)
Units of labour (L)
0
y
x
Q = 42
Q=50
Characteristics of isoquant map
1.They are falling (reducing)
2.The higher the isoquant is, the higher is
the output
3.No 2 isoquant intersect with each other
4.They are convex towards the origin


Types of Isoquant:
1.Linear Isoquant
2.Input-Output Isoquant / Right angled
Isoquant / Leontief Isoquant
3.Kinked Isoquant /Convex Isoquant /Activity
analysis isoquant / Linear Programming
Isoquant
4.Smooth Convex Isoquant

1.Linear Isoquant
Natural Gas
Diesel Oil
x
y
Q1 Q2 Q3
Electric Power
It is assumed that perfect substitutability between Factors of
production is possible.
Example: Gas or oil to generate power
2.Input-Output Isoquant / Right angled
Isoquant / Leontief Isoquant






We assume strict Complementary /Zero substitutability
between the inputs
When there is only one method of production of any
commodity
Example: Wheels cannot be replaced by carts & vice versa
y
x
carts
wheels
Q1=1 vehicle
Q2=2 vehicle
Q3=3 vehicle
3.Kinked Isoquant /Convex Isoquant /Activity
analysis isoquant / Linear Programming
Isoquant
It is assumed limited substitutability of capital & Labour
Only few process is used for production.
substitutability of input factors is possible only at kinks
K3
K2
K1
L1 L2 L3
X
Y
Q1
Q2
Units of labour
Units of
leather
shoe
Example: labour(L1) & leather(K1)
or
labour(L2) & leather(K2)
(by reducing wastages)
or
more labour(L3) & more leather(k3)
(more carefully reducing wastages)

4.Smooth Convex Isoquant
It is assumes continuous substitutability of
capital & labour only over a certain range
beyond which input cannot be substituted
Units of
Capital(K)
Units of labour(L)
Q
x
Y
Least cost combination of inputs
To get least cost of production, optimal
combination of inputs(resources) will be
considered
Example:
Price of Labour (P
L
) : Rs 10 / unit
Price of capital (P
K
) : Rs 5 / unit
Production table
Q=2units Q=4 units Q=6 units
L k L K L K
1 17 2 17 3 15
2 10 3 12 4 11
3 9 4 11 5 10
If one needs to get 6 units of output , then
the possible combinations are (3,17)
(4,11) (5,10)
Calculation of least cost combination of
output
Method 1:Finding each output cost &
choosing the minimal one
Method 2:Finding by Geometrically
Method 1:Finding each output cost
For 6 units
Here 95 is minimal & (4,11) is chosen the best
L K Cost of production
3 15 (3x10)+(15x5)=105
4 11 (4x10)+(11x5)=95
5 10 (5x10)+(10x5)=100
Method 2:Finding by Geometrically
M = (L x P
L
)+ (K x P
K
)

Where
M sum of money available
L units of labour
P
L
Price of labour for each unit of labour
K units of capital needed to produce a
given quantity of output
P
K
Price of capital for each unit of capital


If the entrepreneur has Rs.95 then he can go for
(4,11)
Also he can buy 9.5 units of labour (L) with no
capita (K)
i.e., (L*10) + 0 = 95, Therefore L = 9.5
And he can buy 19 units of capital (K) with no
labour (L)
i.e., 0 + (K*5) = 95, Therefore K = 19
Under various combination of L & K represented
graphically called Isocost line for M=95
Isocost
Definition: An isocost (isocost line) is the locus
of all those combinations of input factors
(factors of production) that can be bought with
a given sum of money here Rs.95)

Units of
Capital (K)
x
M=95
y
Units of labour (L)
M=90
M=85
Determination of least cost input
combinations
Here isocost map is superimpose on isoquant map
It is possible because the axes in both maps represent
the same input variable
Units of
Capital (K)
x
y
Units of labour (L)
A
B
C
Scale line
3.Production function with all variable input
factors/long run production function/return to
scale
Two ways:
1. Both L & K change in same proportion i.e.,
K/L ratio of production remains same for any
output
2. L & K change in different proportion i.e.,
K/L ratio of production varies with change in
output

Therefore increase in output when all inputs vary
in same proportion is known as return to scale
3 alternative situation arise in
return to scale
1.Increasing return to scale
2.Constant return to scale
3.Decreasing return to scale

3 alternative situation arise in
return to scale
1.Increasing return to scale:
If output increases more than proportionate to increase in all inputs
Causes:
In large scale production work is divided to small parts & each individual can attain
specialization by handling only one part of the work
Some industries are not able to undertake production at small scale
Example: aircraft & shipping industry
Some industries increased single operation which gives some dimensional
advantages
Example: industries where storage is important such as chemical
2.Constant return to scale:
if output increases by same percentage as all inputs
3.Decreasing return to scale:
If increase in output is less than proportionate to increase in all inputs
Causes:
Coordination & control becomes increasingly difficult
Information in organisation is lost when transmitted down from top level managers &
vice versa when transmitted to top from down

Statistical production function
(charles & paul H.Douglas)

Q = A L
b
K
1-b (or)
Q = 1.01 L
0.75
K
0.25

Where
Q - total output
A - constant
L - units of labour
K - units of capital
b - parameters
Properties of Charles & Paul
H.Douglas production function
1.Both L & K should be positive for Q to
exist
2. Sum of the parameters (b , 1-b) = 1 which
is constant return to scale
Latest version is : Q = A L

K


when + = 1; return to scale is constant
when + > 1; return to scale is increasing
when + < 1; return to scale is decreasing
3.Parameter represents input factors - shares
in output
Example: =wage share & =rental share
total share total income
4.It is used to find short run relationship of
inputs & output
Marginal physical product of labour (MPP
L
)= (Q/L)
Marginal physical product of labour (MPP
L
)= (Q/K)
5.It has elasticity of substitution as unity ,
which is used in formulation of an income
policy

Managerial uses of Production
Function
Used to Compute least cost Input combination for
given output
Used to Compute maximum input output combination
for a given cost
It is useful in deciding on the value of employing a
variable input factor
It aids in long run decision making (increasing return
to scale implies increasing production)
decreasing return to scale implies decreasing
production
Producer is indifferent about increasing / decreasing
return to scale provided the demand is of no constraint

COST
It is the money spent (directly/indirectly) on
producing & selling a product to the
customers
It refers to the outlay of funds for
productive producing a good or service
It states from raw materials (procuring,
transporting, preparing) through
production costs (labour, power,
machinery) till selling (maintenance,
advertisement, salary, incentive) the
product to customer.
COST TYPES/COST CONCEPT

1.Actual Cost & opportunity cost
2.Incremental cost & sunk cost
3.Explicit cost & Implicit cost
4.Past cost & Future cost
5.Accounting & economic
6.Private & social
7.Direct & Indirect Cost
8.Controllable & Non Controllable costs
9.Replacement & Original Costs
10.Shut down & abandonment cost
11.Urgent & Postponable Cost
12.Business cost & full cost
13.Fixed & Variable Cost
14.Short run & Long run cost
15.Incremental & Marginal cost
16.Average cost, Marginal costs & total cost







1.(a) Actual Cost /acquisition
costs/outlay cost/absolute cost &
(b) opportunity cost/alternate cost

(a) Costs which a firm incurs for producing
/acquiring a product /service
Ex: raw material cost, labour cost
(b) * It is measured in terms of revenue / benefit,
which could have been generated / earned by
employing that good or service in some other
alternative use.
* Difference between actual & opportunity cost
is called as economic profit / economic rent
2.(a) Incremental cost/Differential
cost &
(b) sunk cost
(a) It is the additional cost due to a change
in the level / nature of business activity
Ex: adding new product line , changing
distribution channel
(b) Costs that are not altered by a change in
quantity produced & cannot be recovered
Ex: depreciation of Equipments
3. (a)Explicit /out of pocket/ paid
out cost & (b)Implicit /book/
imputed cost
(a) Those expenses which are actually paid
by the firm
It is recorded in profit & loss account
Ex: rent, wage paid
(b) These are theoretical costs that they go
unrecognized by the accounting system
Ex: for owner the cost spend is ignored
4.(a) Past cost & (b) Future cost

(a) They are actual costs incurred in the past
& are generally contained in financial
accounts
Ex:It helps for future
(b) Costs that are expected to occur in some
future period
It is concerned for the managerial
decision makers
5.(a) Accounting cost & (b)
economic cost
(a) It points how much expenditure has
already been incurred on a particular
process/ on production
It is used for tax planning purposes
(b) It is in nature of incremental costs both
imputed & explicit costs as well as the
opportunity costs
It is used in managerial decision making
6.(a) Private cost & (b) social cost
(a) Those costs which are actually incurred/
provided for the business activity by an
individual / business firm
(b) Total costs to society on account of
production of a good
Ex: Polluting land/water

7.(a) Direct /traceable/assignable cost& (b)
Indirect /non traceable/common/non
assignable Cost
(a) Which have direct relationship with a unit
of operation like a product , a process or
a department of a firm
(b) Costs whose course cannot be easily &
definitely traced to the plant , a product ,
a process or department
Ex: land cost, building cost cannot be
directly attributed to cost of per unit of
product
8.Controllable & Non Controllable
costs
(a) Costs which are capable of being
controlled/regulated by the managers
(b) Costs which are not capable of
controlling
Costs which are involved in
obsolescence & depreciation
9.Replacement & Original Costs
(a) Costs that the firm incurs if it wants to
replace/acquire the same assets now
(b) Costs paid for assets such as land ,
building, cost of plant, equipment &
materials at price paid originally for them
10.Shut down & abandonment cost

(a) Cost which the firm incurs if it temporarily
stops its operation
Example: fixed costs, sheltering cost of
equipment
(b) Costs of retiring altogether a fixed asset
from use
Example: war time use machines
11.Urgent & Postponable Cost


(a) The cost the firm must incur so that the
operations of the firm continue
Example: Cost of material , labour, fuel
(b) Cost where postponement does not
affect the operational efficiency of firm
Example: maintenance cost
12.Business cost & full cost

(a) Costs which are known in profit & loss
account for legal & tax purposes
(b) It is the sum of Opportunity costs &
normal profits
13.Fixed & Variable Cost


(a) Costs of firm which is part of total cost &
which does not vary with output




(b) The cost which vary with the output
TFC
output
output
TVC
FC
VC
14.Short run & Long run cost
(a) A period in which supply of at least one
of inputs cannot be changed by firm
Example: building, machinery
(b) A period in which inputs can be varied as
desired
15.Incremental & Marginal cost

(a) It is important when dealing with decision
where discrete alternatives are
compared
It is change in any number of units of
output or even a change in quality of
output
(b) It is the amount added to TC by a unit
increase in output
16.Average cost, Marginal costs &
total cost
Average cost = total cost
units produced
Marginal cost=extra cost of producing one
additional unit

Total cost = fixed cost + variable cost
DETERMINANTS OF COST
Level of Output
Prices of input factors
Production lot size
Size of plant
Output stability
Laws of returns
Level of capacity utilization
Period under consideration
Technology
Learning effect
Breadth of product range
Geographical location
COST-OUTPUT RELATIONSHIP
The 2 aspects are
1.Cost output relationship in short run (firms
cannot alter its fixed equipment)
2.Cost output relationship in Long run (firms
has sufficient time to alter its fixed
equipments)
1.Cost output relationship in
short run
It is studied in terms of
(a)Average Fixed Cost & output
(b)Average Variable Cost & Output
(c)Average Total Cost & Output
(a) Average Fixed Cost (AFC) & output

Increase in output results in decrease in FC/unit
Total Fixed cost(TFC) is same for any output
Average Fixed cost(AFC) = TFC
units of o/p produced
Example,
(a) when TFC is Rs.1000, O/P units is 10
Then AFC =1000/10 = 100 units
(b) when TFC is Rs.1000, O/P units is 20
Then AFC =1000/20 = 50 units
Therefore AFC falls as O/P increases


(b) Average Variable Cost (AVC) & Output

It will first decrease & then rise as more & more
units are produced
Because when increase in variable factors will
leads to efficiency of inputs which first increases
& then decreases
Once optimum capacity of production is
reached, any future increase in output beyond
optimum capacity will surely increase the AVC
Example: To produce increase in output after
reaching optimum level , more & more workers
have to be appointed which leads to
overcrowding & results in high wage rates.
(c) Average Total Cost (ATC) & Output

It decreases with increase in output to
certain level & then starts to increase up
Turning point in cost from downward trend
to upward trend in ATC comes little later
than in case of AVC
ATC = AFC + AVC
Least cost output level is where ATC is
minimum & not AVC
fig
Output
C
o
s
t
s

AFC
AVC
MC
x
ATC
z
y
Short-Run output cost curves
Relationship between ATC, AVC & MC
3 costs fall atfirst & then remains constant
& rise as output increases
Rate of change in MC is less than AVC &
hence minimum MC is at output lower than
output at which AVC is minimum
ATC falls for a longer range of output than
AVC & hence the minimum AVC
AVC = MC, when AVC is the least
ATC =MC , when ATC is the least
Cost Output relationship in long run
There wont be any fixed cost in long run
It also referred as cost of producing different
levels of output by changing size of plant / scale
of production.

Cost
output
0
ATC1
ATC2
ATC3
C
D
E
X
Y
A B
A minimum point of ATC2 is at C,
produces output of OA
If output increases to OB & when firm
continues in old scale, then the least cost
point in ATC2 is E
If the output increases to OB with increase
in scale, then the new least cost point is D
in ATC3 curve
Here BD will be less than BE
Long run Average cost (LAC) curve is
drawn using no. of Short run Average Cost
(SAC) curves
LRAC (Envelope curve)
C
o
s
t
s

Output
O
Deriving a long-run average cost curve:
A1(E=D)
Nature of Long Run Cost Curves
1.LAC curve is tangential to SAC curve & also
called as envelope curve
2.LAC curve is U shape, it is because lower
average costs at first till optimum scale of
production & then it rise
3.LAC curve never cut by any SAC curve
4.LAC curve will touch the optimum scale curve at
optimum scale curves least cost point(A1)
5.At A1, Economies = Diseconomies
Usefulness of LAC curve
It helps the organization to determine size of
plant to be adopted for producing the given
output
When firm operate in increasing return to scale,
it is economical to under use a slightly larger
plant operating at less than its minimum cost
output level than to over use a smaller plant
Economies & Diseconomies of scale
The existence of this is responsible for U shaped
LAC curve
It is concerned with behavior as plant size
changes
When LAC declines as output increases which
says the cost structure is characterized by
economies of scale
When LAC increases as output increases which
says the cost structure is characterized by
Diseconomies of scale
When LAC is constant it is neither economies
nor diseconomies of scale

A typical long-run average cost curve
Output
O
C
o
s
t
s

LRAC
Economies
of scale
Constant
costs
Diseconomies
of scale
2 types of economies & Diseconomies
a) External Economies
which are available to all firms in an industry
Ex: Constructing railway line will decrease transport cost
for all firms
b) Internal Economies
Which are available to a particular firm & gives it an
advantage over other firms engaged in production of
same products in industry
Various factors involved are
(1)Labour economies & Diseconomies
(2)Technical Process economies & Diseconomies
(3)Managerial economies & Diseconomies
(4)Marketing economies & Diseconomies
(5)Financial economies & Diseconomies
(6)Diversification in output economies & Diseconomies
(7)Diversification of market economies & Diseconomies
(8)Risk spreading economies & Diseconomies
ESTIMATION OF COST OUTPUT RELATIONSHIP
It can be estimated through the following 3 approaches
(1)Accounting Method
Here the TC is classified to fixed, variable & semi-
variable costs
Average VC, range of o/p within which the semi variable
is fixed & amount of FC are determined on the basis of
inspection & experience
After these steps TC, average & marginal costs for each
output level is obtained through simple arithmetic
(2)Engineering Method
It is derived by estimating the physical units of various
input factors i.e., plant size, man hours, etc
Once it is determined, they are multiplied by the
respective current/expected factor prices & added
together to yield cost estimates for that output level
(3)Econometric Method
Expressions of common forms are
(i) Linear : TC = a1 + b1x
(ii) Quadratic : TC = a2 + b2x + c2x
2
(iii) Cubic : TC = a3 + b3x + c3x
2
+ d3x
3
where,
x - O/P
a1,b1,c1,d1 --- constant
To determines not only partial cost function cost output
relationship on assumption that other determinants
of cost (factor prices technology) are constant but
also to determine the comprehensive cost function
, which allows variations in all the factors
influencing cost.