EABD: Unit III – Production and Cost Function (Baseline Information)

MEANING OF PRODUCTION FUNCTION

In simple words, production function refers to the functional relationship between the quantity of
a good produced (output) and factors of production (inputs).

“The production function is purely a technical relation which connects factor inputs and output.”

Defined production function as “the relation between a firm’s physical production (output) and
the material factors of production (inputs).” Prof. Watson

FORMULA OF PRODUCTION FUNCTION = X=f (K, L, M, N, T, Ma)

X=output
f= function
K = Capital
M = Machine
N= Land
T = Technology
Ma= Material

SHORT RUN PRODUCTION

In general, economic output is not a (mathematical) function of input, because any given set of
inputs can be used to produce a range of outputs. To satisfy the mathematical definition of a
function, a production function is customarily assumed to specify the maximum output
obtainable from a given set of inputs. The production function, therefore, describes a boundary
or frontier representing the limit of output obtainable from each feasible combination of input.
(Alternatively, a production function can be defined as the specification of the minimum input
requirements needed to produce designated quantities of output.) Assuming that maximum
output is obtained from given inputs allows economists to abstract away from technological and
managerial problems associated with realizing such a technical maximum, and to focus
exclusively on the problem of allocative efficiency, associated with the economic choice of how
much of a factor input to use, or the degree to which one factor may be substituted for another. In
the production function itself, the relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and prices and costs are not
reflected in the function.

In the decision frame of a firm making economic choices regarding production how much of
each factor input to use to produce how much output and facing market prices for output and
inputs, the production function represents the possibilities afforded by an exogenous technology.
Under certain assumptions, the production function can be used to derive a marginal product for

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

each factor. The profit-maximizing firm in perfect competition (taking output and input prices as
given) will choose to add input right up to the point where the marginal cost of additional input
matches the marginal product in additional output. This implies an ideal division of the income
generated from output into an income due to each input factor of production, equal to the
marginal product of each input.

The inputs to the production function are commonly termed factors of production and may
represent primary factors, which are stocks. Classically, the primary factors of production were
Land, Labour and Capital. Primary factors do not become part of the output product, nor are the
primary factors, themselves, transformed in the production process. The production function is
not a full model of the production process: it deliberately abstracts from inherent aspects of
physical production processes that some would argue are essential, including error, entropy or
waste, and the consumption of energy or the co-production of pollution. Moreover, production
functions do not ordinarily model the business processes, either, ignoring the role of strategic and
operational business management. (For a primer on the fundamental elements of microeconomic
production theory, see production theory basics).

The production function is central to the marginalist focus of neoclassical economics, its
definition of efficiency as allocative efficiency, its analysis of how market prices can govern the
achievement of allocative efficiency in a decentralized economy, and an analysis of the
distribution of income, which attributes factor income to the marginal product of factor input.

STAGES OF PRODUCTION

To simplify the interpretation of a production function, it is common to divide its range into 3
stages. In Stage 1 (from the origin to point B) the variable input is being used with increasing
output per unit, the latter reaching a maximum at point B (since the average physical product is
at its maximum at that point). Because the output per unit of the variable input is improving
throughout stage 1, a price-taking firm will always operate beyond this stage.

In Stage 2, output increases at a decreasing rate, and the average and marginal physical product
both decline. However, the average product of fixed inputs (not shown) is still rising, because
output is rising while fixed input usage is constant. In this stage, the employment of additional
variable inputs increases the output per unit of fixed input but decreases the output per unit of the
variable input. The optimum input/output combination for the price-taking firm will be in stage
2, although a firm facing a downward-sloped demand curve might find it most profitable to
operate in Stage 1. In Stage 3, too much variable input is being used relative to the available
fixed inputs: variable inputs are over-utilized in the sense that their presence on the margin
obstructs the production process rather than enhancing it. The output per unit of both the fixed
and the variable input declines throughout this stage. At the boundary between stage 2 and stage
3, the highest possible output is being obtained from the fixed input.

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

SHORT RUN PRODUCTION FUNCTION GRAPH AS FOLLOWS

LONG RUN PRODUCTION FUNCTION

In the long run production function, the relationship between input and output is explained under
the condition when both, labor and capital, are variable inputs. In the long run, the supply of both
the inputs, labor and capital, is assumed to be elastic (changes frequently). Therefore,
organizations can hire larger quantities of both the inputs. If larger quantities of both the inputs
are employed, the level of production increases. In the long run, the functional relationship
between changing scale of inputs and output is explained under laws of returns to scale. The laws
of returns to scale can be explained with the help of isoquant technique.

Isoquant Curve:

The relationships between changing input and output is studied in the laws of returns to scale,
which is based on production function and isoquant curve. The term isoquant has been derived
from a Greek work ISO, which means equal. Isoquant curve is the locus of points showing
different combinations of capital and labor, which can be employed to produce same output.

It is also known as equal product curve or production indifference curve. Isoquant curve is
almost similar to indifference curve. However, there are two dissimilarities between isoquant

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

curve and indifference curve. Firstly, in the graphical representation, indifference curve takes
into account two consumer goods, while isoquant curve uses two producer goods. Secondly,
indifference curve measures the level of satisfaction, while isoquant curve measures output.

According to Ferguson, “An isoquant is a curve showing all possible combinations of inputs
physically capable of producing a given level of output.”

According to Peterson, “An isoquant curve may be defined as a curve showing the possible
combinations of two variable factors that can be used to produce the same total product”

From the aforementioned definitions, it can be concluded that the isoquant curve is generated by
plotting different combinations of inputs on a graph. An isoquant curve provides the best
combination of inputs at which the output is maximum

Following are the assumptions of isoquant curve:

i. Assumes that there are only two inputs, labor and capital, to produce a product
ii. Assumes that capital, labor, and good are divisible in nature
iii. Assumes that capital and labor are able to substitute each other at diminishing rates
because they are not perfect substitutes
iv. Assumes that technology of production is known
On the basis of these assumptions, isoquant curve can be drawn with the help of different
combinations of capital and labor. The combinations are made such that it does not affect the
output. An isoquant curve for four combinations of capital and labor:

IQ1 is the output for four combinations of capital and labor. All along the curve for IQ1 the
quantity of output is same that is 200 with the changing combinations of capital and labor. The
four combinations on the IQ1 curve are represented by points A, B, C, and D.

MRTS can be calculated with the help of the following formula:

MRTS = ∆K/∆L

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

Where, ∆K = Change in Capital

∆L= Change in Labor

Forms of Isoquants:

The shape of an isoquant depends on the degree to which one input can be substituted by the
other. Convex isoquant represents that there is a continuous substitution of one input variable by
the other input variable at a diminishing rate.

However, in economics, there are other forms of isoquants, which are as follows:

i. Linear Isoquant:

Linear isoquant represents a perfect substitutability between the inputs, capital and labor, of the
production function. It implies that a product can be produced by using either capital or labor or
using both, if capital and labor are perfect substitutes of each other. Therefore, in a linear
isoquant, MRTS between inputs remains constant.

L-shaped Isoquant
Refers to an isoquant in which the combination between capital and labor are in a fixed
proportion. The graphical representation of fixed factor proportion isoquant is L in shape. The L-
shaped isoquant represents that there is no substitution between labor and capital and they are
assumed to be complementary goods. It represents that only one combination of labor and capital
is possible to produce a product with affixed proportion of inputs. For increasing the production,
an organization needs to increase both inputs proportionately.

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

It can be seen OK1 units of capital and OL1 units of labor are required for the production of Q1.
On the other hand, to increase the production from Q1 to Q2, an organization needs to increase
inputs from K1 to K2 and L1 to L2 both.

Kinked Isoquant

In real life, there can be several ways to perform production with different combinations of
capital and labor. For example, there are two machines in which one is large in size and can
perform all the processes involved in production, while the other machine is small in size and
can perform only one function of production process. In both the machines, combination of
capital employed and labor used is different.

The graphical representation of kinked isoquant is shown following

We have studied that MRTS is associated with the slope of an isoquant and represents ratio of
marginal changes in inputs. MRTS does not represent the substitutability between the two inputs,

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

capital and labor, with different combinations of inputs. However, it is important to measure the
degree of substitutability between the two inputs. Therefore, economists have developed a
formula for estimating the extent of substitutability between the two inputs, capital and labor,
which is known as elasticity of factor substitution. Elasticity of factor substitution (a) refers to
the ratio of percentage change in capital-labor ratio to the percentage change in MRTS.

Concept of Cost Function

The relationship between output and costs is expressed in terms of cost function. By
incorporating prices of inputs into the production function, one obtains the cost function since
cost function is derived from production function. However, the nature of cost function depends
on the time horizon. In microeconomic theory, we deal with short run and long run time.

Total Cost = Total Fixed Cost + Total Variable Costs.

Marginal Cost = TCn –TC n-1
Average Cost = TC/Q
Cost in Short Run
It may be noted at the outset that, in cost accounting, we adopt functional classification of cost.
But in economics we adopt a different type of classification, viz., behavioural classification-cost
behaviour is related to output changes.

In the short run the levels of usage of some input are fixed and costs associated with these fixed
inputs must be incurred regardless of the level of output produced. Other costs do vary with the
level of output produced by the firm during that time period.

Short-Run Total Cost

A typical short-run total cost curve (STC) is shown in Fig below. This curve indicates the firm’s
total cost of production for each level of output when the usage of one or more of the firm’s
resources remains fixed.

When output is zero, cost is positive because fixed cost has to be incurred regardless of output.
Examples of such costs are rent of land, depreciation charges, license fee, interest on loan, etc.
They are called unavoidable contractual costs. Such costs remain contractually fixed and so
cannot be avoided in the short run.

Clearly, variable cost and, therefore, total cost must increase with an increase in output. We also
see that variable cost first increase at a decreasing rate (the slope of STC decreases) then increase

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

at an increasing rate (the slope of STC increases). This cost structure is accounted for by the law
of Variable Proportions.

Average and Marginal Cost:

One can gain a better insight into the firm’s cost structure by analysing the behaviour of short-
run average and marginal costs. We may first consider average fixed cost (AFC).

Average fixed cost is total fixed cost divided by output,

i.e., AFC = TFC /Q

Since total fixed cost does not vary with output average fixed cost is a constant amount divided
by output. Average fixed cost is relatively high at very low output levels. However, with gradual
increase in output, AFC continues to fall as output increases, approaching zero as output
becomes very large. In Fig. 14.4, we observe that the AFC curve takes the shape of a rectangular
hyperbola.

We now consider average variable cost (AVC) which is arrived at by dividing total variable cost
by output,

Relation between MC and AC:

There is a close relation between MC and AC. When AC is falling, MC is less than AC.

So it is the ratio of MC to AC.

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

The properties of the average and marginal cost curves and their relationship to each other are as
described in Fig. From the diagram the following relationships can be discovered.

(1) AFC declines continuously; approaching both axes asymptomatically (as shown by the de-
creasing distance between ATC and AVC) and is a rectangular hyperbola.

(2) AVC first declines reaches a minimum at Q2and raises thereafter. When AVC is at its
minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its
minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter. MC equals both AVC and
ATC when these curves are at their minimum values.
The lowest point of the AVC curve is called the shut (close)- down point and that of the ATC
curve the break-even point. These two concepts will be discussed in the context of market
structure and pricing. Finally, we see that MC lies below both AVC and ATC over the range in
which these curves decline; contrarily, MC lies above them when they are rising.

Let us learn the aforementioned cost concepts numerically with the help of Table

BREAK-EVEN ANALYSIS/POINT

A break-even analysis is a financial tool which helps you to determine at what stage your
company, or a new service or a product, will be profitable. In other words, it’s a financial
calculation for determining the number of products or services a company should sell to cover its
costs (particularly fixed costs). Break-even is a situation where you are neither making money
nor losing money, but all your costs have been covered.

Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

an example, a company has a fixed cost of Rs.0 (zero) will automatically have broken even upon
the first sale of its product.

Break-Even Point in Units

As the break-even point is the point of no profit no loss, it is that level of output at which the
total contribution equals the total fixed costs, It can be calculated with the help of following
formula:

The different costs used in break-even analysis are explained as follows:

(a) Fixed Costs:

Refer to the costs incurred at the initial stage of the project and does not depend on the
production level or operation level of the project. For example, cost of a machinery and rent.

(b) Variable Costs:

Refer to the costs that depend on the volume of production. Wages and raw materials are the
examples of variable costs.

(c) Total Cost:

Refers to the sum total of fixed costs and variables costs.

As shown in cited above Figure, at point P, the total cost is equal to the total revenue. Therefore,
the project can be said to have achieved break even at point P.

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur

 EABD: Unit III – Production and Cost Function (Baseline Information)

SUPPLY

Definition: Law of supply states that other factors remaining constant, price and quantity
supplied of a good are directly related to each other. In other words, when the price paid by
buyers for a good rises, then suppliers increase the supply of that good in the market.

Description: Law of supply depicts the producer behavior at the time of changes in the prices of
goods and services. When the price of a good rises, the supplier increases the supply in order to
earn a profit because of higher prices.

The above diagram shows the supply curve that is upward sloping (positive relation between the
price and the quantity supplied). When the price of the good was at P3, suppliers were supplying
Q3 quantity. As the price starts rising, the quantity supplied also starts rising.

Dr K R Kumar, MBA Program, Adhiyamaan College of Engineering (Autonomous) Hosur