Module 2

Production and cost

Topics
Production function – law of variable proportion – economies of scale – internal and external
economies – Isoquants, Isocost line and producer’s equilibrium – Expansion path – Technical
progress and its implications – Cobb-Douglas production function - Cost concepts – Social cost:
private cost and external cost – Explicit and implicit cost – sunk cost - Short run cost curves -
long run cost curves – Revenue (concepts) – Shutdown point – Break-even point.
Production Function
 Production function refers to the functional relationship between inputs and output.
 In other words, it is the transformation of inputs in to output.
Types Production function: Two types.
I. Short run Production function &
II. Long run Production function
Short run Production function Or Law of Variable Proportion
Or Production Function with One Variable input.
Law of Variable Proportion analyses the changes in output with one variable factor
by keeping other factors constant. This happens in the short run. Hence it is Short run
Production function.
When more and more units are produced with one variable factor and other fixed factors, TP
(Total product), MP (Marginal product) and AP (Average product) passes through three
Stages;
Stages I - Increasing Returns: -
During this stage TP increases at an increasing rate. MP and AP are also rising. MP is higher
than AP. First stage continues till MP=AP.
Stages II – Diminishing Returns: -
During this stage TP increases at a diminishing rate. But MP and AP are falling. This stage
ends when TP is maximum and MP=0. (i.e., when MP touches the X axis.)
Stages III –Negative Returns: -
During this stage TP declines and MP becomes negative (below the X axis).
The law can be explained with a diagram.

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 Laws of Returns to Scale or Fixed proportion or
Long run Production function:-
 In the long run all factors are variable.
 Since in the long run all factors are increased in the same (Fixed) proportion, long run
production function is also called Fixed Proportion. It is also called Returns to Scale.
o Initially the producer gets increasing returns to scale (Decreasing cost),
o Then constant returns to scale (Constant cost), and
o Finally decreasing returns to scale (Increasing cost).

Increasing Returns to scale: A-B

Constant Returns to scale: B- C
Decreasing Returns to scale: C-D
Cobb – Douglas Production function:-
 The Cobb-Douglas Production function is used to represent the technological relationship
between the amounts of two inputs (Capital and Labour), and the amount of output that
can be produced by those inputs.
 This function is written as; Q=ALα Kβ
Q- Total output, A-Total factor productivity, L- Labour, K- Capital,
α and β are the output elasticities of labour and capital.
 The Cobb-Douglas Production function is a homogeneous production function of degree
one. That is α+β=1.
*If α+β=1, it is the case of constant returns to scale.
*If α+β>1, it is the case of increasing returns to scale.
*If α+β<1, it is the case of decreasing returns to scale.
 MPL= α× (Q/L)
Where, MPL- Marginal product of Labour
Q/L is Average product of Labour (APL).
 MPK= β × (Q/K)
MPK -Marginal product of Capital.
Q/K is Average product of capital (APK).
Numerical Examples: -
1. In the production function Q= 2L 1/2 K1/2., if L=36
a) How many units of capital are needed to produce 60 units of output?

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 b) Determine the % increase in output if labour increased by 10%, keeping capital
constant.
Ans: a) 60=2 ×6 K1/2
60= 12 K1/2
K1/2=60/12=5
K=25
b) L=36+3.6= 39.6
Q= 2×39.6 1/2×251/2
= 62.92, =63
% increase in output= ( ∆Q/Q) × 100
(63-60)/60 × 100= 5%
2. Suppose the production function is given as Q= 2K 1/2 L1/2. L=36, and K= 16.
a) What will be the output?
b) What is MPL and APK?
c) Find the number of units of capital required to produce 40 units of output, if L=25.
Ans: Q= 2K 1/2 L1/2, L=36, and K= 16.
a) Q=2×4×6=48
b) MPL= α× (Q/L)= 1/2 × (48/36) =2/3
APK= Q/K =48/16=3
c) When Q=40 and L=25,
40= 2× K1/2 × 25 ½
40= 2× 5 K1/2
K1/2= 40/10=4
K=16
3. If production Q= 5L 1/2 K1/2,
a) Find maximum possible output with 100 units of labour and ioo units of capital
b) Find average productivity of labour.
4) A firm’s production function is given as Q = 2 L1/2 K1/2. What will be the output when L = 25
and K = 9? Suppose the firm increases the number of units of capital to 16 and they want to
produce 80 units of output. What should be the number of units of labour?
5) a) In a production function, Q = 2 L1/2 K1/2. If L = 36, how many units of capital are needed to
produce 60 units of output?
b) In the production function, Q = 2 L1/2 K1/2 determine the percentage increase in output if
labour is increased by 10% assuming capital is held constant.
6) Suppose the production function is given as Q = 3L1/2 K1/2. Find average and marginal
product
of labour when Labour equals 36 and K (capital) equals 16.
7) Assume the production function Q = 2L1/2 K1/2
i) If L = 100, K = 200, what is the maximum quantity that can be produced?
ii) If the firm changes the amount of labour and capital by 10 times what will happen to the
output? Why?
8) Assume the production function Y = 2K1/4 L3/4, where K= L = 1,
i) How much output is produced? ii) If labour is decreased by 10% how much K needed to
increase to produce the same level of output.

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 9) Consider the production function Y = K1/3 (H*L) 2/3, with K =10, H = 10, L = 5.
i) Find the average productivity of labour (APL) ii) what is the APL if H is increased to 12.
10) Given below is the production function of Firm
A Q = 100 K0.3L0.7
The firm use 20 units of Labour (L) and 10 units of Capital (K). Calculate the output.
Economies of Scale: -
Economies of Scale mean advantages of large-scale production, which help in reducing the
average cost of production.
The economies of scale can be broadly classified as;
1. Internal economies and
2. External economies.
Internal economies:
o Internal economies (advantages) emerge within the firm itself. Internal economies are
entirely enjoyable by the firm itself.
Forms of Internal economies:
There are different forms of internal economies.
1. Labour economies:
2. Technical economies:
3. Managerial economies:
4. Marketing economies:
5. Financial economies
6. Risk minimising economies.
External economies.

Types
1. Economies of localisation
2. Economies of information
3. Economies of vertical disintegration
4. Economies of by- product
Diseconomies of Scale:
 Diseconomies of scale means disadvantages of large production.
Types of diseconomies:
The following are the important types of diseconomies.
1. Difficulties of management
2. Difficulties of co ordination
3. Difficulties in decision making
4. Communication problem
5. Labour diseconomies
6. Scarcity of inputs, 7. Marketing diseconomies.
Cost of production
Cost is the expenditure incurred by a firm in the production of a commodity.

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 Cost concepts: -
1. Explicit Cost and Implicit Cost: -
Explicit Cost: - The expenses for purchasing or hiring inputs. These costs are recorded in
the books of account of a firm.
Implicit Cost: - The costs of factor inputs that factors are owned by the producer or the
owner. It does not involve cash payment and not appear in the books of account.
2. Social cost: - Social cost is the summation of private cost and external cost.
Private cost is the cost incurred by the producer in the production of a commodity. These are
the expenses of the producer in buying or hiring factor services.
External cost: When a commodity is produced it may cause damages to the environment in
the form of air pollution, water pollution, etc. These are the external cost and it is met by the
society.
3. Sunk cost: - It is the cost which has already been incurred and cannot be recovered.
4. Short run cost –and Long run cost: -

Short run cost: -

In the short run; the total cost (TC) is the sum of total fixed cost (TFC) and total variable cost
(TVC). Symbolically;
TC = TFC+TVC
TFC is the cost which does not vary with the level of output. It has to be met even at zero level
of output. It is a horizontal straight line.
TVC is the cost that vary with the level of output. That is, when zero output is zero, variable
cost is also zero and as output increases variable cost also increases.
The TVC curve is an inverse ‘S’ shaped curve.
TC curve has the same shape of the TVC curve.

 Average Cost (AC): - AC = TC/Q

TC/Q= (TFC/Q) + (TVC/Q)
(Since TFC/Q=AFC & TVC/Q = AVC,)
AC = AFC + AVC,
AC curve is ‘U’ shaped.
 Average Fixed Cost (AFC):- AFC = TFC/Q

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 AFC is downward sloping.
 Average Variable Cost (AVC):- AVC = TVC/Q
AVC curve is ‘U’ shaped.
 Marginal Cost (MC):- is the addition to total cost when one more unit of output is
produced. MC curve is also ‘U’ shaped.
MCn = TCn –TCn-1

The Relation between MC and AC (or MC and AVC):-

1. When MC < AC, AC decreases.
2. When MC = AC, AC is the minimum.
3. When MC > AC, AC increases.
The same relation exists between MC and AVC.
Long Run Cost:
All the factors are variable in the long run and therefore there is no fixed cost.
Long Run Total Cost (LTC): LTC curve is derived from the short run total cost
curves (STCs). LTC is also inverse ‘S’ shape.

Long Run Average Cost (LAC):- is the cost per unit of output in the long run. It is
also derived from the short run average cost curves (SACs).
Since LAC curve is an envelope of SAC curves, it is also called Envelope curve. LAC curve is
also ‘U’ shaped and it will be flatter than SAC curves.

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Long Run Marginal Cost (LMC):- is the addition to total cost when one more unit
of output is produced in the long run. It is derived from the short run marginal cost curves.
LMC curve is also ‘U’ shaped.

Numerical Example:
Complete the following schedule;
Units of TC TFC TVC MC
Output
0 100 ---- ----
1 150 ---- ---- 50
2 ---- ---- ---- 40
3 ---- ---- 120 ----

Ans:
Units of TC TFC TVC MC
Output
0 100 100 0 0
1 150 100 50 50
2 190 100 90 40
3 220 100 120 30
Isoquants:
An isoquant is a curve which shows various combinations of two inputs which give the same
level of output.
Isoquant can be explained with the help of a diagram;

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Properties of an Isoquant:
The following are the important features of Isoquants.
1. Isoquants are negatively sloped:
2. Isoquants are convex to the origin.
3. Two isoquants never intersect.
4. Higher isoquant represents higher levels of output.
A set of isoquants drawn is called an isoquants map. In isoquant map higher isoquant
represents higher levels of output.

Isocost Line/ Price Line:

An isocost line shows various combinations of two inputs that cost the same amount.
A price line is shown in the diagram.

Producer’s Equilibrium- Least cost Combination:

Producer’s equilibrium is attained at that point where the isoquant is tangent to the isocost
line. This is shown in the diagram.

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In the diagram, producer is in equilibrium at point E, where the highest possible isoquant is
tangent to the isocost line.

Expansion Path:
We can obtain the expansion path by joining the point of tangency between isoquants and
isocost lines of a firm. An expansion path is shown in the diagram.

In our diagram, Q1,Q2, andQ3 are isoquants. A1B1, A2B2, andA3B3 are iso cost
lines. E1,E2, andE3 are the points of tangency between isoquants and isocost lines. The line
joining these tangency points shows an Expansion Path.
Technical Progress and its implications.
When there is a change in technical progress, the production function will shift upward.
Technical Progress may be embodied and disembodied.
It is embodied or investment specific when new capital (machinery) is used in the
production process. It is disembodied or investment neutral, when output increases without
any increase in investment but by an innovation through research.
Types of Technical Progress:
There are three types of production function.

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1. Neutral Technical Progress: Technical Progress is Neutral, when change in marginal
product of labour and capital (MPL and MPK) are same.
2. Labour Augmenting Technical Progress: Technical Progress is Labour
Augmenting when the MPL increases faster than MPK.
3. Capital Augmenting Technical Progress: Technical Progress is Capital Augmenting
when the MPK increases faster than MPL.
Shut Down Point:
Shut down point is a point where the firm experiences no benefit for continuing its
operations/ production.
This happens when price (P) is equal to average variable cost (AVC).
That is, P = AVC is the Shutdown point, where the firm stop its production.
When price is greater than AVC but less than AC (AVC< P<AC), it can cover AVC as well
as a part of AF. Hence it is beneficial for the firm to produce.

 In the diagram, when price falls to P3, the firm will stop production, where P= AVC.
Break - Even Analysis:
 Break –even analysis is a method that is used to analyse the relationship between total cost,
total revenue, and profit of an organization at different levels of output. The most
important aspect of break –even analysis is identifying the break –even point (BEP).
 Break –even point is the point at which total revenue equals total cost.
That is TR= TC, or TR – TC =0. It is no profit, or no loss point.
There are two approaches (or methods) to break –even analysis.
1. Graphical method
2. Analytical or Algebraic method.

Graphical method:-
The graphical method to construct the break –even chart.

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 At point ‘E’, TR = TC. Hence, E is the break – even point (BEP. The gap between the TC
and TR curves beyond the OQ level of output shows profit, because TR > TC. The gap
below this level of output shows loss because TC > TR. At the BEP, there is no loss or
profit.
TC=TFC + TVC
TR= Number of units produced × Selling Price
TVC= Number of units produced × Variable cost.
Profit = TR - TC
Analytical or Algebraic method:-
1. BEP=F/(S-V)
Where, F- Fixed cost, S-selling price, V- Variable cost.
Since S- V = Contribution (C), BEP=F/C
2. P/V Ratio (or Profit Volume Ratio) = (C/S) ×100.
Where, C-Contribution, S-Sales. Since Contribution = S-V,
P/V Ratio = (S-V)/S
P/V Ratio = (S-V)/S ×100.
3. BEP in terms of Turn over (or Sales): -
BEP = F/ (P/V Ratio)
(If we take TR and TVC to estimate the ratio, it will not make any difference. Here BEP
can be estimated by this formula)
4. Margin of Safety:- is the difference between actual sales(planned sales) and
Break- even sales
Margin of Safety = Actual Sales – BE Sales
5. Sales to earn a desired profit= (TFC +Desired profit) / P/V ratio

Uses of Break –even analysis: -

It helps in the;
1. Determination of selling price which will give the desired profits.
2. Fixation of sales volume to get a desired level of revenue.
3. Making inter-firm comparison of profitability.
4. Determination of costs, revenue, and profit at various levels of output.
5. Managerial decision-making.
Numerical examples:-
1) Consider the following data of a company for the year 2021

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 Sales = Rs. 80,000, Fixed Cost=Rs. 15,000, Variable cost= Rs. 35,000
Find 1) Margin of safety 2) Profit 3) Breakeven sales 4) Contribution.
Ans: BE Sales= F/ (P/V Ratio)
P/V ratio =C/S ×100
Contribution(C) =S-V=80,000-35,000=45,000
BE Sales= F/ (P/V Ratio)= 15,000/56.25%=15,000×(100/56.25)=26,666.66
Margin of Safety =Actual sales- BE sale=80,000-26,666.66 =53,333
Profit=80,000 -15,000+35,000)=80,000-50,000=30,000
2) (i)Calculate Break Even Quantity from the following data
Fixed Cost=Rs. 25,000; Average Variable Cost =Rs. 12; Selling Price= Rs. 17
(ii) What will be the Break-Even Quantity, if selling price increases by Rs.3?
Ans: i)
3) a) Calculate Break Even Quantity from the following data
Fixed Cost: Rs. 1,00,000 ; Average Variable Cost : Rs. 9 ; Selling Price : Rs. 14
(b) What will be the Break-Even Quantity, if selling price increases by Rs.10%?
ANS:
4) If a company has the following details;
Sales=Rs.2, 40,000, Fixed Cost=Rs. 45,000, Variable cost= Rs. 105,000. Calculate,
a) Margin of safety b) Profit c) Breakeven sales d) Contribution
5) Suppose the PV ratio of a firm is given as 0.25 and its total fixed cost is Rs.10000. What is
the
break – even sales of the firm? I f the actual sales is Rs. 60000/, what is the margin of safety?
6) If a company has the following details,
Fixed cost = Rs. 40, 00,000, Variable cost per unit = Rs. 100, Selling price per unit = Rs.
200,
Calculate
i) Break even quantity.
ii) If the actual production quantity is 1, 20,000, what will be the profit?
7) Consider the following data of a company for the year 2022.
Sales = Rs.1, 60,000. Fixed Cost = Rs. 30,000, Variable cost = Rs. 70,000
Find a) Margin of safety b) Profit c) Break even sales d) Contribution.
END
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