Production and Cost Analysis

Meaning
In economics production refers to all such activities which create any of the following utilities
Form Utility Place Utility Time Utility

Some basic concepts

Input
Good or service that goes into the process of production

Output
Good or service that comes out of the process of production

 Fixed Input
An input whose supply is inelastic in the short run

Variable Input
An input whose supply is elastic in the short run

 Short Run
Refers to a period of time in which the supply of certain inputs is fixed or inelastic.

Long Run
Refers to a period of time in which the supply of all inputs is elastic, but not enough to permit a change in technology.

Very Long Run

Refers to a period of time in which the technology also changes.

Various elements in production decision .

Where to locate the production unit? How much to produce in the short-run and in the long-run? What should be the scale of production? What should be the product-mix?

Production Function
The relationship between inputs to the production process & the resulting output is described by a production function. Qx=f(Ld, L, K,M,T, t) Qx=Output Ld=land L= labour K=capital M=materials T=technology t=time

 Qx=f(L, K) Short Run production function (Single variable production function) Qx=f(L) Long Run production function Qx=f(L, K)

Assumption underlying production function

Perfect divisibility of both outputs and inputs Only two factors of production. Limited substitution of one factor for another. A given technology Inelastic supply of fixed factors in the short run.

Important production functions

Cobb Douglas production function CES production function

Laws of production
Short Run Laws of production Law of Diminishing Returns (Laws of Returns to Variable Inputs ) (Laws of Returns to Returns to Factor) (Law of Variable proportions) Long Run Laws of production Laws of Returns to Scale

TP, MP and AP of variable factor

TOTAL PRODUCT(TP) It is the sum total of output produced by all the units of a variable factor used in the process of production along with some amount of the fixed factors

MARGINAL PRODUCT(MP) MP is additional output attributed to an additional unit of the variable factor, other factor remaining constant AVERAGE PRODUCT(AP) AP is the output per unit of the variable factor used in the process of production

L(units of labour)

TP(total product)

AP(average product)

MP(marginal product)

1 2 3 4 5

50 90 120 140 150

50/1=50 90/2=45 120/3=40 140/4=35 150/5=30

50-0=50 90-50=40 120-90=30 140-120=20 150-140=10

RETURNS TO A FACTOR
Law of Diminishing Returns Or Law of Variable Proportions

 Law of diminishing returns states that as more and more and more of the variable factor is combined with fixed factor, a stage must ultimately come when marginal product of the variable factor starts declining.

A Production Table
Number of workers 0 1 2 3 4 5 6 7 8 9 10 Total output 0 4 10 17 23 28 31 32 32 30 25 Marginal product 4 6 7 6 5 3 1 0 2 5 Average product 4 5 5.7 5.8 5.6 5.2 4.6 4.0 3.3 2.5

A Production Function
32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 7 6 TP Output per worker 5 4 3 2 1 1 2 3 4 5 6 7 Number of workers 8 9 10 3 4 5 6 7 Number of workers (b) Marginal and average product 0 1 2 8 9 MP 10 AP

Output

(a) Total product

Causes of Increasing Returns to Factor

Fuller utilization of the fixed factor Increased efficiency of the variable factor Better co-ordination between the factors

Causes Of Diminishing Returns To Factor

Fixity of a factor Imperfect factor substitutability Poor co-ordination between the factors

Profit maximisation in the short run

One variable input MRP=MW MRP=MPxP (Marginal revenue productivity MP= Marginal physical productivity P=Price) MW = Marginal wages

Returns to Scale
Long Run Laws of production

 Returns to scale relates to the behaviour of total output as all inputs are varied in same proportion and it is a long run.

THREE ASPECTS OF RETURNS TO SCALE

Increasing returns to scale Constant returns to scale Diminishing returns to scale

Increasing Returns to Scale

Increasing returns to scale occur when a given %age increase in all factor inputs causes proportionately greater increase in output.

Causes of Increasing Returns to Scale

Technical and managerial indivisibilities Higher degree of specialisation Dimensional relations

Constant Returns to Scale

Constant returns to scale occurs when a given % increase in all factor inputs causes equal % increase in out put.

Diminishing Returns to Scale

Diminishing returns to scale occur when a give % increase in all factor inputs causes proportionately lesser increase in output

Isoquants
Isoquant means that the quantities throughout a given isoquant are equal . An isoquant curve shows various combinations of 2 input factors such as capital and labour, which yield the same level of output.
Combinations A B C Capital (Rs. In lakh) 1 2 3 No.of Labourees 20 15 11

D E

4 5

8 6

Features Of an Isoquant
Downward sloping Convex to origin Do not intersect Do not touch axis

Isoquant map

Economic region of production

The Optimal Input- Output Combination

Capital

Optimal combinaton

labour
35

The Optimal Input- Output Combination

Capital

Budget line

labour
36

The Optimal Input- Output Combination

Capital

Optimal combination

labour
37