(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) Output quantity
(No.of workers)
(Q)
1 5 20
2 15 30
3 35 42
Units of capital(K) 250 500
 Production function (Equation)
Q = f (L, K, Ld, 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
Ld – 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 MPL= Δ Q/ Δ L
Average Product of Labour APL=Q/L
 Example:
Capital is Fixed
Var input(L) TP MP(ΔQ/Δ 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
 Y
0<MP<1 MP<0
MP>1

TPL

STAGE I STAGE II STAGE III

Output (Q)

High Return Less Return Negative Return

APL

X
x1 x2 x3
Var input Labour (L) MPL
 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 MPL of (L) is 0(point X3).Here TPL 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 MPL 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 250 500 750
capital(K)
• 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
y

Unit of
Capital (K)

Q=50
Q = 42
0 x
Units of labour (L)
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
y

Natural Gas Electric Power

x
Q1 Q2 Q3

Diesel Oil

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
y

carts
Q3=3 vehicle
Q2=2 vehicle

Q1=1 vehicle

x
wheels

• 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
 3.Kinked Isoquant /Convex Isoquant /Activity
analysis isoquant / Linear Programming
Y Isoquant
K1

Units of
leather K2 Q2
K3 Q1 shoe

X
L1 L2 L3
Units of labour

• It is assumed limited substitutability of capital & Labour

• Only few process is used for production.
• substitutability of input factors is possible only at kinks
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
Y

Units of
Capital(K)

Q
x
Units of labour(L)
 Least cost combination of inputs
• To get least cost of production, optimal
combination of inputs(resources) will be
considered
• Example:
Price of Labour (PL) : Rs 10 / unit
Price of capital (PK) : 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 PL)+ (K x PK)
Where
M – sum of money available
L – units of labour
PL – Price of labour for each unit of labour
K – units of capital needed to produce a
given quantity of output
PK – 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)
y

M=95

Units of
Capital (K) M=90

M=85
x
Units of labour (L)
 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

Scale line
Units of
Capital (K) C
B
A

x
Units of labour (L)
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 Lb K1-b (or)
Q = 1.01 L0.75 K0.25

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 Lα K β
when α + β = 1; return to scale is constant
when α + β > 1; return to scale is increasing
when α + β < 1; return to scale is decreasing
3.Parameter represents input factors - shares
in output
Example: α=wage share & β=rental share
total share total income
4.It is used to find short run relationship of
inputs & output
Marginal physical product of labour (MPPL)= α(Q/L)
Marginal physical product of labour (MPPL)= β(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

TFC FC

output

(b) The cost which vary with the output

VC

TVC

output
 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
 Short-Run output cost curves
MC
ATC

AVC
Costs

x
AFC

Outputfig
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. ATC2
Y ATC3
ATC1
E

Cost C D

X
0 A B
output
• 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
 Deriving a long-run average cost curve:

5
SAC
C1

4
2

SAC
SA C
A

C3
S

SA
Costs

LRAC (Envelope curve)

A1(E=D)

O
Output
 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 curve’s 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

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
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 + c2x2
(iii) Cubic : TC = a3 + b3x + c3x2 + d3x3
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.