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MODULE II
PRODUCTION AND COST
PRODUCTION
Production is the process of transformation of inputs (like land, labour, capital,
entrepreneurship) into a more valuable output. The goods produced for sale through such a
process are known as output. The term processing includes transportation and storage in
addition to its normal meaning of manufacturing activity.
Fixed and variable inputs
Inputs are classified in to fixed and variable. Variable input is one that can be made to vary in
the short run. e.g, rawmaterial, unskilled/semiskilled labour etc. Fixed input is one that cannot
be varied in the short run, e.g, land, machine, technology, skill set etc.
Factors of production
Economists have used the term factors of production for identifying the broad categories of
inputs. All inputs used in the production can be put under any of these factors.
Land
Land is defined as anything which is the free gift of nature and not the result of human efforts.
Land includes all natural resources on or under the earth’s surface like forests, rivers, sunlight,
seas and minerals. The return from land is called rent.
Labour
The physical or mental effort of human being that undertakes the production process is
labour. Labour includes unskilled, semi-skilled and highly skilled labour. The return for labour
is termed as wages and salary.
Capital
Capital is that wealth which is used for further production. Modern economic theory
categorise capital into human and physical capital. Physical capital comprises of tangible
resources like equipments, buildings machines, intermediary goods etc. human capital
constitutes of the knowledge, skills and investments made by people through education,
experience and training that help to produce better goods. The return on capital is interest.
Enterprise
The ability and action to collect, coordinate, and utilise all the factors of production for the
economic gain is called enterprise. Entrepreneur’s remuneration is called profit.
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PRODUCTION FUNCTION
The relationship between inputs and output is called production function. A commodity may
be produced with various methods using different combinations of inputs, with a given
technology. Example, cloth may be produced using cotton, silk or polymer as raw material
with hand loom power loom or better technology. The production function establishes
technical relation and not economic relation between inputs and outputs. Technical relation
considers the relation between physical inputs and physical output and not the money values
of inputs and outputs.
A simple production function can be written as follows:
Q=f (L, K, I, R, E)
Where Q is physical quantity produce per unit of time
L=labour
R=raw material
K=capital
I=land
E=efficiency parameter(Technology)
Short run and the long run
Production analysis of a firm is done using two distinct frames, the short run and the long run.
In terms of production, the short run refers to a period of time when the firm cannot vary
some of the inputs. That is in the short run availability of some inputs of production is fixed.
Therefore, the producer will try to increase output in the short run with variable inputs. Long
run refers to a span of time sufficient to enable the firm to vary all the inputs, including
technology.
Forms of production function
Two major forms are
1. When only one input is variable and all other inputs are assumed to be constant:
It explains how the output responds to a change in the units of a variable input, assuming all
other inputs as constant. It is called law of returns and law of variable proportion.
2. When all inputs are variable
It shows the response of output to a change in all the inputs. It is called returns to scale.
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Factor productivities are of three types.
Total product
It refers to the total amount produced by a firm, using varying quantities of a variable input
with fixed inputs.
If labour is variable and capital is fixed, total product is a function of labour TPL=f (L, K)
If labour is fixed and capital is variable, total product is a function of capital TPK=f (L, K)
Average product
Average product is the per unit product of a variable input per period of time. It is obtained
after dividing the total product by the units of a variable input. It can be expressed as
𝑇𝑃𝐿 𝑇𝑃𝐾
APL= or APK=
𝐿 𝐾
Marginal product
Marginal product is the change in total product resulting from using one more(less) unit of
the variable factor.
MPn=TPn-TPn-1, where MPn is the nth unit of the variable input.
Production function with one variable input, Law of Variable Proportion (short run)
Law of variable proportion explains the production function with one variable factor, keeping
the quantities of other factors constant. It can be written as Q= f (L, K). Where Q is output, L
is labour and K denotes the fixed amount of capital. This also implies that it is possible to
substitute some of capital by labour.
In general if one of the factors of production (usually capital K) is fixed, the marginal product
of the variable factor (labour) will diminish after a certain range of production. The reason is
that, after a certain level when there are too many workers with fixed capital, a part of the
work force becomes ineffective and the marginal product of labour starts falling. As we
increase the units of labour, total output increases, but not in constant rate. In the beginning
output increases at an increasing rate and finally increases at diminishing rate. Therefore,
short run production function is governed by law of variable proportions.
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Labour Total Marginal Average Stages
1 20 20 Increasing
2 50 30 25 returns
3 90 40 30
4 120 30 30 Diminishing
5 140 20 28 returns
6 150 10 25
7 150 0 21.5
8 130 -20 16.25 Negative
9 100 -30 11.1 Returns
Three stages of law of variable proportion
In the figure, on the X-axis the quantity of variable factor is measure and on the Y-axis the
total product, marginal product and average product is measured. The total product curve TP
goes on increasing to a point and after that it starts declining, Average and marginal product
curves also rise and then decline, Marginal product curve starts declining earlier than the
average product curve.
The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of other can be divided in to three distinct stages.
Stage1
In this stage, the total product increases at an increasing rate. In the figure, from the origin to
the point F, slope of the total product curve TP is increasing, that is up to point F, the total
product increases at an increasing rate, which means that the marginal product rises. From
point F onwards, the total product increases at a diminishing rate i.e. marginal product falls,
but it is positive.
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The point F where the total product slopes increasing at an increasing rate and starts
increasing at the diminishing rate is called the point of inflexion. Corresponding vertically to
the point of inflexion, marginal product is maximum, after which it slopes downwards. The
stage 1 ends where the average product curve reaches its highest point. During this stage,
marginal product of the variable factor is falling still it exceed average product. This stage is
called the stage of increasing returns because average product of the variable factor increases
throughout this stage.
Stage2
This stage is called the stage of diminishing returns. In stage 2, the total product continues to
increase at a diminishing rat until it reaches its maximum point H, where the second stage
ends. In this stage both the marginal product and average product of the variable factor are
diminishing but are positive. At the end of the second stage, that is, at point M marginal
product of the variable factor is zero.
Stage3
In this stage total product declines and therefore the total product curve TP slopes
downwards. As a result, marginal product of the variable factor is negative and MP curve goes
below the X axis. In this stage, variable factor is too much relative to the fixed factor. This
stage is called tea stage of negative returns, because the marginal product of the variable
factor is negative during this stage.
PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS
In the long run, all the inputs are variable. And return to scale refers to the degree by which
the level of output changes in response to a given change in all the inputs in production
system. There are three possible outcomes.
Constant returns to scale
Decreasing returns to scale
Increasing returns to scale
Constant returns to scale: a proportional increase in all inputs yields an equal proportional
increase in output.
Decreasing returns to scale: A proportional increase in all inputs yield a less than proportional
increase in output.
Increasing returns to scale: A proportional increase in all inputs yields a more than
proportional increase in output.
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COBB-DOUGLAS PRODUCTION FUNCTION
It was propounded by Wicksell and tested against statistical evidence by Charles W Cobb and
Paul H Douglas in 1928. It is one of the most popular and commonly used production
functions. It considers the two most important inputs labour and capital and relates output
to them. Cobb-Douglas production function is represented as Q=AKαLβ
L=labour
K=capital
A=total factor productivity
α=output elasticity of labour
β=output elasticity of capital
The expression A, which is a measure of total factor productivity, can be interpreted as real output
per unit of input.
The sum of the two output elasticises determined the behaviour of output to variations in inputs.
If α+ β=1, the returns to sale are constant
If α+ β>1, the returns to sale are increasing
If α+ β<1, the returns to scale are decreasing
Returns to scale are increasing when a proportionate change in input lead to a more than
proportionate change in output
Returns to scale are decreasing when a proportionate change in input lead to a more than
proportionate change in output
Returns to scale are decreasing when a proportionate change in input lead to less than
proportionate change in output.
Isoquants
An isoquant is a curve that shows all the combinations of inputs that yield the same level of output.
‘Iso’ means equal and ‘quant’ means quantity. Therefore, an isoquant represents a constant quantity
of output. The isoquant curve is also known as an “Equal Product Curve” or “Production Indifference
Curve” or Iso-Product Curve.”
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Combinations of Labor and Units of Labor Units of Capital Output of Cloth
Capital (L) (K) (meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100
The above table is based on the assumption that only two factors of production, namely,
Labor and Capital are used for producing 100 meters of cloth.
Combination A = 5L + 9K = 100 meters of cloth
Combination B = 10L + 6K = 100 meters of cloth
Combination C = 15L + 4K = 100 meters of cloth
Combination D = 20L + 3K = 100 meters of cloth
The combinations A, B, C and D show the possibility of producing 100 meters of cloth by
applying various combinations of labor and capital. Thus, an isoquant schedule is a schedule
of different combinations of factors of production yielding the same quantity of output.
Properties of an isoquqnt
[Link] isoquant slopes downward from left to right.
[Link] higher and more to the right an isoquant is on a graph, the higher the level of output it
represents.
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[Link] isoquants can not intersect each other.
4. An isoquant is convex to its origin point.
Isoquant Map
An isoquant map is a set of isoquants that shows the maximum attainable output from any
given combination inputs.
Iso-cost lines
Iso-cost lines represent the prices of factors. An iso-cost line graphically represents all the
combinations of the inputs which the firm can achieve with a given budget for production or
given outlay.
Suppose the firm has 100 Rs. which it can spend on combinations of factor X and factor Y,
the former priced at Rs. 10 per unit and the latter priced at Rs. 20. The firm can spend the
entire amount on factor X or factor Y.
Further, there will be various combinations of both factors which amount to the outlay. The
iso-cost line represents all these combinations. Q1, Q2 and Q3 are three different iso-costs.
The iso-cost on the right represents a higher outlay.
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Producer’s Equilibrium
A firm (producer) is said to be in equilibrium when it has no inclination to expand or to
contract its output. This state either reflects maximum profits or minimum losses.
The graph below shows how we can use isoquant curve and iso-cost lines to determine
optimum producer’s equilibrium.
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In the figure shown above, the isoquant curve represents targeted output, i.e. 200 units. Iso-
cost lines EF, GH and KP show three different combinations in which we can utilize the total
outlay of inputs, i.e. capital and labour.
The isoquant curve crosses all three iso-cost lines on points R, M and T. These points show
how much costs we will incur in producing 200 units. All three combinations produce the same
output of 200 units, but the least costly for the producer will be point M, where iso-cost line
GH is tangent to the isoquant curve.
Points R and T also cross the isoquant curve and equally produce 200 units, but they will be
more expensive because they are on the higher iso-cost line of KP. At point R the producer will
spend more on capital, and labour will be more expensive on point T.
Thus, point M is the producer’s equilibrium. It will produce the same output of 200 units, but
will a more profitable combination as it will cost less. The producer must, therefore, spend OC
amount on capital and OL amount on labour.
Expansion Path
Expansion path is a graph which shows how a firm’s cost minimizing input mix changes as it
expands production. It traces out the points of tangency of the iso-cost lines and isoquants.
An expansion path provides a long-run view of a firm’s production decision and can be used
to create its long-run cost curves.
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Technical progress
Technical progress may also change the shape (as well as produce a shift) of the isoquant.
Hicks has distinguished three types of technical progress, depending on its effect on the rate of
substitution of the factors of production.
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Capital-deepening technical progress:
Technical progress is capital-deepening (or capital-using) if, along a line on which the K/L
ratio is constant, the MRSL K increases. This implies that technical progress increases the
marginal product of capital by more than the marginal product of labour.
Labour-deepening technical progress:
This implies that the technical progress increases the MPL faster than the MP K. The
downwards-shifting isoquant becomes steeper along any given radius through the origin.
Neutral-technical progress:
Technical progress is neutral if it increases the marginal product of both factors by the same
percentage, so that the MRSL K (along any radius) remains constant. The isoquant shifts
downwards parallel to itself.
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CONCEPT OF COST
Cost of production refers to the expenses incurred by a business firm on factor inputs. In other words,
cost is a sacrifice or foregoing that has already occurred or has potential to occur in future with an
objective to achieve a specific purpose measured in monetary terms. In other words, it refers to the
money expenses incurred in the production of a commodity. Cost of a product is determined by
various factors and each factor has significant implications for cost decisions. The main determinants
are prices of factors of production, technology, marginal efficiency and productivity etc. The level of
output also affects cost, especially direct cost. Hence cost function can be mathematically written as,
C=f(Q,T,Pf). Where, C=cost; Q=output; T=Technology; Pf=Price of input
KINDS OF COSTS
There are different types of costs incurred by a firm under different circumstances. Costs of a firm may
be include, money or may not be measurable in money terms. Besides monetary outlays, such cost
may also include rent on property, interest on own capital, insurance premium etc.
Accounting costs
Financial management, including accounting, auditing, costing recognises only money cost or nominal
costs that can be recorded in the book of accounts. Hence they are referred as accounting costs.
Examples are, cost of raw materials, wages, salary, interest on loans and capital costs like cost of
factory building, equipment and overheads like electricity, telephone etc. Accounting cost is also
termed as explicit cost, these are the cost for which explicit payment has been made in the past, or
for which the firm is committed for payment in the future.
Real cost
Real costs cover all aspects of sacrifice involved in acquiring a product. For ex. a person involved in
manufacturing sacrifices leisure and is not able to attend family and social needs, attaches emotions
to the particular business activity and takes the risk of failure. This cannot be measured in terms of
money. This is the real cost of a product or services. Real costs are more or less social and psychological
in nature and non-quantifiable in money terms. Since real costs do not cause any outflow of cash or
any increase in liabilities, accounts do not consider these costs.
Opportunity Cost
It helps in evaluation of the alternative uses of an input other than its current use in production. For
example, if a person has a sum of money, he can put it in a saving account of a bank and earn interest
on it. He can alternatively invest in equity and earn dividend. Interests from bank are certain, but
normally lower than the dividend from equity, which is uncertain. If he prefer security in investment
(savings account), dividend on equity, is the opportunity cost of this decision.
Implicit Cost
These are costs that do not involve actual payment or cash outflow or reduction in assets, or increase
in liability by the firm for some of the factors of production. Example of implicit cost is a self-owned
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resource, if the owner of the firm is also the manager no salary is paid to him for the job of a manager
or rent forgone on use of own property, interest on the use of own capital etc.
Explicit Cost
These are also known as out of pocket costs or accounting costs. These are the costs which go to the
trading and profit and loss account. Out of the pocket costs refer to costs that involve current payment
to outsiders to the firm, for buying raw materials. Contrary to explicit costs, book costs (like
depreciation) are costs that do not involve current cash expenditure.
Social Costs
Social costs of a firm are those that the society in general has to bear because of the firms activities.
An example is pollution caused by industrial wastes and emissions.
Social costs would broadly have two components.
a)Private costs of the firm (as resources it uses in its production activity could have been used
elsewhere)
b) Social costs paid by the society .Imagine a firm manufacturing chemicals is located by the side of a
river. Its marginal cost is equal to only the private marginal cost of chemicals. If the firm dumps the
wastes of production in the river, there is also a social cost for the people living along the river, due to
the polluted water.
A firm can generate negative social costs (equivalent to social benefits) by way of clearing
surroundings or by preserving greenery Ex. Reliance petrochemicals had adopted a village after
Gujarat earthquake.
Replacement Cost
Replacement costs (current costs) refer to the current price or cost of buying or replacing any input at
present. With expiry of economic life of the equipment, a new machine replaces the old one. Hence
the expenditure is known as replacement cost.
COSTS IN THE SHORT RUN
In the short run some factors of production remain fixed (land, machine and technology) and only few
are variable. Therefore short run costs are divided in to two
Fixed cost
Variable cost
Fixed cost
The cost incurred on all fixed inputs by the firm is fixed cost(FC).These costs do not vary with input.
Before a firm actually starts producing, it needs to spend on plant, machinery, equipment etc. Even if
there is no output, the firm has to bear these costs. Since such costs do not vary with the level of
output, any decision regarding volume of output does not depend on fixed cost. So it is also called
subsidiary cost.
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Variable cost
It is the cost incurred on variable inputs. It varies with output and is incurred in getting more and more
inputs. Variable costs equal to zero if there is no output. Example cost of raw materials, wages etc.
Total cost
Total cost is the sum of fixed cost and variable cost. ie, TC=TFC+TVC. Out of these, FC is constant. But
VC depends on the level of output. Therefore, for a higher level of output TC is higher.
Average Cost
Average cost is cost per unit of output. The Average Fixed cost, Average Variable Cost, and Average
Cost can derive from total fixed, total variable and total costs respectively.
AC=AFC+AVC
AFC is fixed cost per unit of output and is thus equal to the ratio of TFC and units of output.
AVC is variable costs per unit of output and is thus equal to the ratio of TVC and units of output.
AC is the total Cost per unit of output and is thus equal to the ratio of TC and Units of output.
𝑇𝐹𝐶
AFC= 𝑄
𝑇𝑉𝐶
AVC=
𝑄
𝑇𝐶
AC= 𝑄
Marginal Cost
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Marginal cost is the change in total cost due to a unit change in output. Since the fixed component of
cost cannot be altered, MC is the change in variable cost per unit change in output. Therefore, it is
also known as the rate of change in total cost.
Average and Marginal Cost curves
AFC is are rectangular hyperbola. As the number of units of output is increased, fixed cost remaining
same, AFC falls steeply at first then gently
The AVC curve and AC curve are both U shaped.
AC being the sum of AFC and AVC at each level of output lies above both AFC and AVC curves. AVC
curve and AC curve are U-shaped. Costs decline when there are increasing returns, stabilize when
there are constant returns and cost increase with diminishing returns.
The magnitude of marginal cost is interlinked with the changes in average cost. When average cost
decline MC lies below AC; when average cost are constant (at the minimum), MC equal AC when
average cost rise, MC curve lies above [Link] shows change in variable cost per unit change output.
Thus, when both AC and AVC fall, MC lies below them. When they are constant MC is equal to AC and
AVC. When AC and AVC rise MC lies above them.
COSTS IN THE LONG RUN
All costs are variable in the long run since factors of production, size of plant, machinery and
technology are all variable. The long run cost function is often referred to as the planning cost function
and the long run average cost (LAC) is known as the planning curve. As all costs are variable, only the
average cost curve is relevant to the firm’s decision- making process in the long run. The long run cost
curve is the composite of many short run cost curves.
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Long run average cost
When the plant size and other fixed inputs of the firm increase in the long run, the short run cost
curves shifts to the right. Suppose, in the long run the firm operates with three different plant size and
can switch over to a different plant size, depending on cost considerations. Thus SAC1 relates to
average cost of the firm when its plant size is I; when plant size increases to II, the corresponding SAC
curve is SAC2, and so on. LAC function is an envelope of the short run cost functions and the LAC curve
envelopes the SAC curves; hence the LAC curve is known as an envelope curve.
Long run total cost
Long run marginal cost
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Long run marginal cost shows the change in total cost due to the production of one more unit of
∆LTC
commodity. It is derived from the short run marginal cost curves. LMC= ∆𝑄
BREAK EVEN ANALYSIS, COST-VOLUME-PROFIT ANALYSIS AND OPERATING LEVERAGE
Break-even analysis examines the relationship between total revenue, total cost and total profits of a
firm at different levels of output. Breakeven analysis is about determining profit at various projected
levels of sales, identifying the breakeven point, and making a managerial decision regarding the
relationship between likely sales. Breakeven point is the point where total cost is just equals to total
revenue, in other words it is the no profit, no loss point. There are several approaches to breakeven
point. Two main approaches are
o Graphical method and
o Algebraic Method
Graphical Method
Under graphical method break even chart is constructed by plotting the firms total cost and total
revenue on vertical axis and output on horizontal axis. Total revenue line begins at the origin and rises
with a slope equal to the selling price per unit. The total cost line intercepts the vertical axis at a point
equal to the total fixed cost and rises with a slope equal to the variable cost per [Link] the total
revenue line lies below the total cost line, a loss region is defined. Similarly, when the total revenue
line lies above the total cost line, a profit relation is defined. The point where a total revenue line and
total cost line intersect is BEP.
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Algebraic Method
Total revenue(TR)=P.Q
Total cost =TFC+TVC=TFC+AVC.Q
TR=TC
P.Q=TFC+AVC.Q
(P-AVC)Q=TFC
𝑇𝐹𝐶
Q=
𝑃−𝐴𝑉𝐶
Shut-Down Point
It is the point where, a firm experiences no benefit in continuing its operation. In the short
run, the firm should get at least minimum point of Average Variable Cost (AVC)as price, in
order to remain in the production process. So the minimum point of AVC is known as shut
down point in the short run.
In the short run if AVC > Price, the firm will shut down.
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