Analysis Of Cost

Made By:-

Abdullah

Production Function

Production Function
Production: Any activity leading to value addition Transformation of inputs into output Q= f (L,K)

Production Function
Short term : Time when one input (say, capital) remains constant and an addition to output can be obtained only by using more labour. Long run: Both inputs become variable.

Production Function
Production process is subject to various phasesLaws of production state the relationship between output and input.
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Laws of production
Short run : Relationship between input and output are studied by varying one input , others being held constant. Law of Variable Proportions brings out relationship between varying proportions of factor inputs and output
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Laws of production
Long run: Production function is subject to different phases described under the Law of Returns to Scale Studied assuming that all factor inputs are variable.

Law of Variable Proportions

Law of Variable Proportions (Short run Law of Production) Assumptions: One factor (say, L) is variable and the other factor (say, K) is constant Labour is homogeneous Technology remains constant Input prices are given
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Law of Variable Proportions

No of Workers L 1 2 3 4 5 6 7 8 Total Product (TPl) 24 72 138 216 300 384 462 528 Marginal Product (MPl ) 24 48 66 78 84 84 78 66 Average Product (APl ) 24 36 46 54 60 64 66 66 II) Diminishing Returns Stages of Returns I) Increasing Returns

9
10 11 12

576
600 594 552

48
24 -6 -42

64
60 54 46

III) Negative Returns

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Law of Variable Proportions

Panel A
T o t a l T o t a l Labour
10

TP rises at an increasing rate till the employment of the 5th worker.

TPl Beyond the 6th worker until 10th worker TP increases but rate of increase begins to fall TP turns negative from 11th worker onwards. This shows Law of Diminishing Marginal returns

Total Product

P r o d p r o d u c t

Law of Variable Proportions

Panel B
AP/MP
Panel B represents Marginal and average productivity curves of labour

APL

labour

M MPL P L

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Law of Variable Proportions

Increasing Returns- Stage I: TPl increases at an increasing rate. Fixed factor (K) is abundant and variable factor is inadequate. Hence K gets utilised better with every additional unit of labour

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Stage II- TPl continues to increase but at a diminishing rate. stage III- TPl begins to decline Capital becomes scarce as compared to variable factor. Hence over utilisation of capital and setting in of diminishing returns Causes of 3 stages: Indivisibility and inelasticity of fixed factor and imperfect substitutability between K and L

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Law of Variable Proportions

Significance of Law of Diminishing Marginal Returns: - Empirical law, frequently observed in various production activities - Particularly in agriculture where natural factors (say land), which play an important role, are limited. - Helps manager in identifying rational and irrational stages of operation
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Law of Variable Proportions

- It provides answers to questions such as: a) How much to produce? b) What number of workers (and other variable factors) to employ in order to maximize output In our example, firm should employ a minimum of 7 workers and maximum of 10 workers (where TP is still rising)
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Law of Variable Proportions

- Stage III has very high L-K ratio- as a result, additional workers not only prove unproductive but also cause a decline in TPl. - In Stage I capital is presumably underutilised. - So a firm operating in Stage I has to increase L and that in Stage III has to decrease labour.
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Law of Returns to Scale

In the long run, all factors are variable. Production can be increased by adding both L and K. Relationship between inputs and output is depicted in the form of isoquant curves. Isoquant curves represent different combinations of K and L that lead to the same level of output.
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ISOQUANT CURVES
Y
IQ300 Units of K

IQ200
IQ100 o Units of L X

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Law of Returns to Scale

Isocost line: Assume that labour costs Rs.10 per unit and capital, Rs. 7 per unit. Suppose the company has a budget of Rs. 70. It can buy 7 units of labour (with no capital), or 10 units of K (with no labour), or some inbetween combination. By joining the two extreme points we get an isocost line
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Law of Returns to Scale

Y 10

o Units of L 7

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Law of Returns to Scale

Y

Y
Capital

Producer has a constraintnamely, budget.

Q3=300 Producer attains equilibrium when he reaches highest attainable level of output.

Q2=200
1Q1=100 0 X 0 1 9

Labour

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Law of Returns to Scale

Point of tangency between isoquant and isocost is the point of least cost combination of inputs. At point B, labour and capital are combined in a proportion that maximises the output for a given budget.

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Law of Returns to Scale

= q/ q n /n where q/ q indicates proportionate change in output n /n indicates proportionate change in input If >1, then we have increasing returns to scale =1, then we have constant returns to scale <1, then we have decreasing returns to scale

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Law of Returns to Scale

Q140 Firm is subject to G increasing, Constant and Decreasing returns Q120 F to scale. Explanation for these E Q100 D phases is provided Q80 Through concepts C Q60 Called economies And diseconomies Q40 Of scale. Q 20 X L
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B B A o

ECONOMIES OF SCALE
ECONOMIES OF SCALE are advantages enjoyed by a firm from large scale production. Causes of increasing returns to scale Internal and external

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INTERNAL ECONOMIES
INTERNAL: Those advantages and disadvantages that accrue to the firm as a result of its scale of operation Indivisibilities- if some of the factors are indivisible, then it would be technically and economically undesirable to use the indivisible factor for a smaller scale of production e.g., Cant use a conveyor belt to unload a small truck, but need one for unloading a train or ship
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INTERNAL ECONOMIES
Dimensional economies A mere change in the size of capital can lead to a change in output which is proportionately more than the cost of enlarged input. e.g., Doubling the diameter of a pipeline more than doubles the water flow without doubling the cost; doubling the dimensions of a ship more than doubles its capacity without doubling costs
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INTERNAL ECONOMIES
Specialisation- In large scale production, a process can be broken into sub processes - specialised labour and specialised machines lead to increase in productivity and decrease in average cost of production. Managerial economies Commercial economies-bulk purchases
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INTERNAL ECONOMIES
Financial economies -Lower rate of interest, liberal terms and conditions because of reputation individual investors also like to invest money. Risk bearing economies: Diversification of output, markets and sources of supply
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INTERNAL DISECONOMIES
Internal Diseconomies Effective supervision no longer possible Unwieldy administration and ego clashes Industrial unrest Problems of re-conversion, storage and standing costs in case of stoppage of work or lack of demand
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External Economies of Scale

External Economies of Scale Arise out of sharing and cooperation received from other firms in a given industry.

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External Economies of Scale

Economies of concentration Supply of skilled labour in a region Common services Specialised institutions like training schools and research centres (Indian School of mines in Dhanbad), Reputation of a region
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External Economies of Scale

Economies of Information Trade associations, journals, seminars Economies of disintegration An ancillary firm may specialise in the production of only one part Waste and byproducts of all firms in the industry may be dealt with by a specialised firm.
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External Diseconomies of Scale

As firms expand along with expansion of the industry, after a point economies turn into diseconomies Excessive concentration leads to bottlenecks and diseconomies
Most firms experience these phases but some continue to defy these laws due to innovations and technological progress.
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Economies of Scope
Lowering of costs that a firm experiences when it produces more than one product together rather than each alone A smaller airline can profitably extend into cargo services, thereby lowering the cost of each service Using bye products to make something instead of throwing it away. Management should be alert to such possibilities.
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Learning Curve
As a firm gains experience in the production of a commodity or service, AC often declines. Learning Curve shows the decline in the average input cost of production with the rising cumulative total output over time. Eg, 1000 hours to assemble 100th aircraft, but only 700 hours to assemble the 200th .as managers and workers become more efficient as they gain production experience.
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Production Function
The production function specifies the maximum output that can be produced with a given quantity of inputs. It is defined for a given state of engineering and technical knowledge. For practical decision making purposes, it is necessary to obtain production and Cost Function.

Production Function
The Production Function

Total Product

Marginal Product

Average Product

Production Function
Total Production: The total amount of output produced, in physical units such as total number of shoes produced by a machine. It start from Zero for Zero Labor and then increases as additional units of labor are applied, and then reaching the maximum point at the maximum Capacity of Machine.

Production Function
Marginal Product : The Marginal product of an input is the extra output produced by each additional unit of that input while other inputs are held constant.

Production Function
Average Product : The average product is equal to the total number of output (product) divided by total number of input (labor).