UNIT -4 : PRODUCTION AND COST ANALYSIS

STRUCTURE
1. INTRODUCTION
2. OBJECTIVES
3. PRODUCTION FUNCTION
4. SHORT PRODUCTION FUNCTION – DIMINISHING MARGINAL RETURNS
5. LONG RUN PRODUCTION FUNCTION – RETURNS TO SCALE
6. OPTIMAL USE OF INPUTS
7. COST THEORY
8. SHORT RUN COST FUNCTIONS
9. LONG RUN COST CURVES
10. SUMMING UP
11. KEY WORDS
12. KNOW YOUR PROGRESS
13. FURTHER READINGS/REFERENCES
14. MODEL ANSWERS
1. INTRODUCTION
Production means transformation of inputs / resources into outputs of goods and
services. For example, a farmer hires workers and machinery, and buys raw materials in to
produce paddy. An output from this farm can be a final commodity or intermediate commodity
(which are used in the production of other goods such as milled rice or rice flour). The output
can also be a service rather than a good. Production refers to all the activities involved in the
production of goods and services, from borrowing to set up or expand production facilities, to
hiring workers, purchasing raw materials, running quality control, cost accounting, and so on
rather than referring merely to the physical transformation of inputs into outputs of goods and
services.

Inputs are resources used in the production of goods and services. Inputs may be fixed
or variable. Fixed inputs are those that can not changed during the time under consideration
(examples : firm’s plant and specialized equipment). Variable inputs are those that can be varied
easily and on very short notice (examples are raw material and unskilled labour).

Short run is the period in which atleast one input is fixed and the long run is all the
inputs are variable. The firm operates in the short run and plans increases or reduction in the
scale of operations in the long run.

2. OBJECTIVES
After completing this Unit, you will able to :
1. Understand the meaning of production and production function
2. Distinguish between different types of production functions
3. Make out how the output of the firm changes with increase in inputs both in the short run
and long run
4. Classify various cost concepts and find out their usefulness in managerial decision
making
5. Understand the various components of cost of production both in the short and long run
3. PRODUCTION FUNCTION

Production Function shows the physical relationship between inputs and output in a given
period of time. Technology is assumed to be constant. Let there be only capital and labour
inputs. Then the production function becomes

Q = f (L, K)

where Q = number of units of commodity produced; K = amount of equipment used in

production ; L = number of workers employed. The above equation says that the quantity of
output depends on the quantity of labour and quantity of capital. Quantity of output refers to the
number of units of the commodity produced, labour refers to the number of workers employed
and capital refers to the amount of the equipment used in the production.

K Q
6 10 24 31 36 40 39
5 12 28 36 40 42 40
4 12 28 36 40 40 36
3 10 23 33 36 36 33
2 7 18 28 30 30 28
1 3 8 12 14 14 12
1 2 3 4 5 6 L
Production Function with Two Variable Inputs

The Law of Diminishing Returns and Stages of Production

This law states :

“As additional units of variable input are combined with a fixed input, at some point the
additional output (the marginal product) starts to diminish”
Variable Total Product (TP) Marginal Product Average Product
Input (X) (MP) (AP)
0 0
1 8 8 8
2 18 10 9
3 29 11 9.7
4 39 10 9.8
5 47 8 9.4
6 52 5 8.7
7 56 4 8
8 52 -4 6.5
Diminishing returns are illustrated in both the numerical example in the above Table and
depicted in the above fig. From the table it is clear that the marginal product of the first unit of
the input is 8. Marginal product reaches its maximum of 11 between the second and third units
of input. It is precisely 2.5 units of input, that we can say that the law of diminishing returns will
began to take effect. Thus the law states that when additional units of a variable input are
combined with a fixed input, at some point, the marginal product of the input will start to
diminish. Therefore, it is reasonable to assume that a manager will only discover the point of
diminishing returns by experience and trial and error.

Reasons for the occurrence of Diminishing returns

1. In the earlier numerical example, when no workers are employed total product is zero.
The first worker produces 8 units. Thus his marginal product is equal to 8 and also his
average product is also equal to 8. When two workers are used, their combined efforts
 yield a total output of 18. This implies that 2 people working together can produce more
than the sum of their efforts working as separate individuals (AP of one worker =8 and
AP of two workers 9). MP of second worker is greater than that of the first.
2. Because it is assumed in economic theory that each worker is equally productive, this
means that the effect of team work and specialization enables additional workers to
contribute more than those added previously to the production process, a phenomenon
that we can refer to as “increasing returns”
3. But as still more workers are added, there are fewer and fewer opportunities for
increasing returns through specialization and teamwork and at some point additional
workers result in diminishing returns.
4. In this case, the additional workers lead to negative marginal returns, causing the total
product to decrease. “too many cooks spoil the dish” seems to have realized.

Three Stage of Production in the short run

In the above figure it is clear that Stage I runs from zero to 4 units of variable input (i.e to the
point where the AP reaches maximum). Stage II begins from this point and proceeds to seven
units of input X (i.e to the point at which total product is maximized). Stage III continuous on
from that point. According to Economic theory, the rational firms operate till Stage II. Stage III
is irrational because the firm would be using more of its variable input to produce less output.
Stopping production at Stage I is also irrational because if it stops producing at this stage, it
would be grossly underutilizing its fixed capacity. That is, it would have so much fixed capacity
relative to its usage of variable inputs that it could increase the output per unit of variable input.

The long run production function

In the long run, the firm has enough time to change scale of its operations by changing the all of
its inputs.

Returns to scale is a long run phenomena. The increase in the total output as the two inputs
increase (say X and Y). If an increase in a firm’s inputs by some proportion results in an
increase in output by a greater proportion, the firm experiences increasing returns to scale. If
output increases by the same proportion as the inputs increase, the firm experience constant
returns to scale; A less than proportional increase in output is called decreasing returns to scale.

Why increasing returns to scale operate?

1. A larger scale of production might enable a firm to divide up tasks into more specialized
activities, thereby increasing labour productivity
2. Also a large scale of production might enable a company to justify the purchase of more
sophisticated (hence more productive) machinery.
These factors help to explain why a firm can experience increasing returns to scale.

Why decreasing returns to scale?

Operating on a larger scale might create certain managerial inefficiencies (eg communications
problems, bureaucratic red tape) and hence cause decreasing returns to scale.

Coefficient of output elasticity measures the returns to scale. It is defined as the percentage
change in output divided by percentage change in all inputs. If this elasticity is greater than 1,
the firm is experiencing increasing returns to scale; if it is less than one the firm experiences
decreasing returns to scale and if it is equal to one it is experiencing constant returns to scale
(figure above).
The Production Function with two variable inputs

Isoquants

An isoquant shows the various combinations of two inputs (say labour and capital) that the firm
can use to produce a specific level of output. A higher isoquant refers to higher output and vice
versa. The figure below shows that 12 unit of output can be produced with 1 unit of capital and
3 units of labour or with 1k and 6L. This output can also be produced with 1L and 4 K and 1L
and 5K. 28 Q can be produced with 2K and 3 L or 2 K and 6 L; 2L and 4 K and 2L and 5 K.
For producing higher quantity higher quantities of both the inputs are required.

Economic Region of Production

In the below figure isoquants have positively sloped portions also. However, these portions are
irrelevant. That means the firm will not operate on the positively sloped portion of an isoquant
because it could produce the same level of output with less capital and less labour. For exmaple.,
the firm would not produce 36 Q at point u in the below figure with 6L and 4 K because it could
produce 36 Q by using smaller quantities of L and K indicated by point V in the below figure.
Similarly the firm will not produce at point W with 4 L and 6K because it could produce 36 Q at
point Z with less L and K. Ridge lines separate the relevant (negatively sloped) from the
irrelevant (positively sloped) portions of the isoquants. In the fig below the ridge line OVT joins
points on the various isoquants where the isoquants have zero slope. The isoquants are
negatively sloped towards the left of the ridge line and positively sloped towards the right of the
ridge line. The isoquants are negatively towards the right of the ridge line and positively towards
the left the ridge line. The MPL is negative to the right of the ridge line of OVT. The MPK is
negative to the left of the ridge line OZT. This corresponds to the stage III of production of
labour and capital (diminishing returns).

Marginal Rate of Technical Substitution

The rate at which one input is substituted for another is called marginal rate of technical
substitution (MRTS). In order to be on the same level of output (on a particular isoquant), the
firm should give up some amount of one input to gain some amount of another input. MRTS is a
slope of an isoquant.

MRTSKL=∆ K / ∆ L = MPK/ MPL

MRTSLk=∆ L / ∆ K = MPL / MPK

The shape of an isoquant reflects the degree to which one input can be substituted for another in
production. The smaller the curvature, the greater is the degree of the substitutability of inputs in
production and vice versa. If isoquants are straight lines as in below figure the labour and capital
are perfect substitutes. That means the rate at which labour is substituted for capital is constant.
That means labour can be substituted for capital (vice versa) at the constant rate given by the
absolute slope of the isoquant.
In the above figure it is clear that 2L can be substitute for 1 K regardless of the point of
production on the isoquant. Infact, point A on the X axis shows that the level of output indicated
by the middle isoquant can be produced with input X (say labour) alone (without any capital).
Similarly point B on capital axis indicates that the same level of output can be produced with
capital alone (without any labour). The above figure shows that the isoquants are rightangled. In
this case, labour and capital are perfect complements. That is, labour and capital should be used
in the fixed proportion. In this case there is zero substitutability between the two inputs. While
perfect substitutability and perfect complementarity of inputs are production, in most cases
isoquants exhibit some curvature (i.e inputs are imperfect substitutes). This means that in the
usual production situation labour can be substituted for capital to some degree.

Isocost Line:

Iso cost line shows the various combinations of inputs that a firm can purchase or hire at a given
cost. Let us assume that firm uses only two inputs such as labour and capital in production. The
total cost incurred by the firm then is:

C = wL + r K

Where C = total cost; w is the wage rate; L is the quantity of labour used; r is the rental price of
capital and K is the quantity of capital used. This equation is called isocost line. If prices of the
inputs change, then isocost line also changes. If C = Rs 100 w = Rs 10 and r = Rs 10. The firm
could either hire 10 L or rent 10 K or any combination of L and K as shown in the isocost line
AB in the figure below. If total cost changes given the input prices, the isocost line shift
parallel. If the total cost increases from Rs 100 to Rs 140 then the isocost line shifts towards
right. With this increased cost the firm will employ 14 L or rent 14 K or any combination of L
and K.. If the total cost decreases, given the input prices, the isocost line shifts leftward.

Optimum combination of inputs for minimizing costs or maximizing output

The firm maximizes output with the optimal combination of inputs at a point where the isoquant
line is tangent to the isocost line. In the above figure it is clear that the firm maximizes output at
point E where isoquant 10 Q is tangent to isocost line AB. At this point firm produces 10 units
with 5 L at a cost of Rs 50 and 5 K at a cost of Rs 50, for a total cost of Rs 100.

The firm could also produce 10 Q at point G (with 3L and 11 K) or at point H (with 12 L and 2
K) at a cost of Rs 140/-. But this would not represent the least cost input combination required to
produce 10 Q. In fact, with a cost of 140 the firm will be on a higher isocost and will be able to
produce more output (it will be on a higher isoquant. Thus the optimum input combination
needed to minimize the cost of producing a given level of output or the maximum output that the
firm can produce at a given cost outlay is given at the tangency of an isoquant and an isocost.
Joining points of tangency of isoquants and isocosts (joining points of optimal input
combinations) gives the expansion path of the firm. With optimal input combinations, the slope
of the isoquant or marginal rate of technical substitution of labour for capital to the slope of
isocost line or ratio of input prices. That is

MRTS = w / r

Where MRTS = MPL / MPK

So MPL / MPK = w / r

Or MPL / w = MPK / r …………………..1

The meaning of the above equation is that to minimize the production cost (or maximize the
output for a given cost outlay), the marginal product per rupee spent on labour must be equal to
the marginal product per rupee spent on capital. If MP L = 5 and MPK = 4 and w = r, the firm
would not maximize the output or minimize the cost since it is getting more extra output for a
rupee spent on labour than on capital. To maximize output or minimize cost, the firm would
have to hire more labour and rent less capital. As the firm does this, the MPL decline and MPk
increases. The process would have to continue until condition 1 to hold.

Effect of change in Input Prices

Starting from the optimal input combination, if the price of an input declines, the firm will
substitute the cheaper input for other inputs in production in order to reach a new optimal input
combination. For example, if r remains at Rs 10, but w falles to 5, the isocost line becomes AB*
and the firm can produce 14 Q iisoquant with C = Rs 100 (point N in the below fig). The firm
can reach isoquant 10 Q with C = Rs 70. This is given by isocost A*B’, which is parallel to AB*
and is tangent to isoquant 10Q at point R. Thus, with a reduction in w, a lower C is required to
produce a given level of output.

7. THEORY OF COSTS

Cost is an important consideration in managerial decision making. Firms cost functions are
derived from the optimal input combinations. There are different types of costs - explicit costs
and implicit costs.
Explicit costs (also called accounting costs) are actual expenditure of firm to hire, rent or
purchase in the inputs it requires for production.

Implicit costs are those which are owned by the firm and used it as an input for production.
Though the firm is not incurring any actual expenditure towards this input but it could have
earned some money to the firm if it was given on rent. Examples are the highest salary the
entrepreneur could earn in his or her best alternative employment or the firm could receive from
investing its capital in the most rewarding alternative use or rent etc. In economics, explicit and
implicit costs or opportunity costs (economic costs) of all inputs whether purchased or owned
should be taken in account. Accounting costs are useful for financial reporting for tax purpose.
Economic / implicit/opportunity costs are relevant costs are important managerial decision
making.

8. SHORT RUN COST FUNCTION

Short run is defined as the time period during which some of the firm’s inputs are fixed. These
costs are total fixed costs (TFC). Eg., interest payment on borrowed capital, leased plant and
expenditure, top management salaries that are fixed for the contract etc. Variable inputs are
those that the firm can vary easily and on short notice. These are called total variable costs
(TVC). Eg., raw material cost, fuels labour wages, etc. Total costs (TC) equal total fixed costs
and total variable costs. TC = TFC + TVC

Dividing TFC, TVC and TC by number of units produced we can obtain average fixed (AFC),
average variable (AVC) and average total costs (AC). Marginal cost (MC) is defined as the
change in total costs or the change in total variable costs per unit change in output.

AFC = TFC/Q ; AVC = TVC/Q ; AC = TC/Q ; MC = ∆ TC / ∆ Q

Relationship between Short Run cost Curves

Quantity TFC TVC TC AFC AVC ATC MC

of output

0 60 0 60 0 0 0 0
 1 60 20 80 60 60 120 20

2 60 30 90 30 15 45 10

3 60 45 105 20 15 35 15

4 60 80 250 15 20 35 35

5 60 135 195 12 27 39 55

The table and above figure shows that TFC is Rs 60 even when the output is zero. But TVC is
zero when the output is zero and when output rises TVC also rises. Up to point G’ the firm uses
little of variable input to the fixed input and the laws of diminishing returns will not operate.
Thus the TVC curve rises at a decreasing rate. After this point diminishing returns operate and
the TVC curve rises at an increasing rate. TC curve has the same slope of TVC as the TFC is
fixed but TC is Rs 60 above it at each output level. From the graph it is clear that AVC, ATC
and MC curves first fall and then rise and then rise (they are U shaped). AFC is not drawn
because the vertical distance between ATC and AVC is nothing but AFC. AFC declines
continuously as the output expands as the given total fixed costs are spread over more and more
units of output. MC curve reaches minimum before and intercepts from below the AVC and
ATC curves at their lowest points.

Why AVC / ATC and MC are U shaped?

With labour is the only the variable input, the average physical product of labour (APL) usually
rises first reaches maximum, and then falls. It follows that the AVC curve first falls, reaches a
maximum, and then rises. Since AVC is U shaped ATC is also U shaped.

MC is U shaped because the marginal product of labour first rises, reaches maximum and then
falls. It follows that the MC curve first falls, reaches a minimum, and then rises. Thus the rising
portion of the MC curve reflects the operation of the law of diminishing returns.

9. LONG RUN COST CURVES

The long run is the time period in which all inputs are variable. As a result all costs are variable.
The length of the time depends on the industry. The long run total cost (LTC) is derived from
the firm’s expansion path. The expansion path shows the optimal input combinations to produce
various levels of output. For eg., point A shows that in order to produce 1 unit of output (1 Q)
the firm uses 4 L and 4 K. If the wage labour is Rs 10 per unit and rental price of capital is Rs 10
per unit. Then the minimum total cost of producing 1 Q is (4L)(Rs 10) + (4K)(Rs 10) = 80

This is the point A’ on the middle figure. Other points on the LTC curve are similarly obtained.
LTC starts at the origin because there are no fixed costs in the long run. From LTC, LAC and
LMC can be derived as :

LAC = LTC / Q ; LMC = ∆ LTC / ∆ Q

The U shape of short run SAC is due to the operation of diminishing returns. The U shape of
LAC is due to the operations of increasing, constant and decreasing returns to scale.

Long Run Average and Marginal Cost Curves

The LAC curve shows the lowest average cost of producing each level of output when the f irm
can build the most appropriate plant to produce each level of output. The below fig shows that
the minimum average cost of producing 1 unit of output is Rs 80 and results when the firm
operates the scale of plant given by SAC1. The firm can produce 1.5 Q at an average cost of Rs
70 by using either the scale of plant given SAC1 or the larger scale of plant given by SAC2 at
point B*. To produce 2 Q, the firm will use scale of plant SAC2 at point C” (Rs 50) rather than
smaller scale of plant SAC1 at point c* (the lowest point on SAC1, which refers to the average
cost of Rs 67). Thus, the firm has more flexibility in the long run than in the short run. To
produce 3 Q, the firm is indifferent between using plant SAC2 or larger plant SAC1 at point E*
(Rs 60). The minimum average cost of producing 4 Q (Rs 30) is achieved when the firm
operates plant SAC3 or larger plant SAC4 at point J* (Rs 60). Finally, the minimum cost of
producing 6 Q is achieved when the firm operates plant SAC4 (the largest plant)at point R’ (Rs
50).

Thus if the firm could build only the four scales of plant shown in the below fig, the long run
average cost curve of the firm would be A”B*C’E*G”J*R”. LAC curve is the “envelope” to the
SAC curves and shows the minimum average cost of producing various levels of output in the
long run, when the firm can build any scale of plant. At point G’ (the lowest point on the LAC
curve)does the firm utilize the optimal scale of plant at its lowest point. To the left of point G’,
the firm operates on the declining proportion of the relevant SAC curve, while to the right of
point G’ the firm operates on the rising portion of the appropriate SAC curve.
10. SUMMING UP
This unit covers theoretical insights on production process. It starts with production function and
points out that it a technical relation between inputs and output. Production decisions are based
on short-and long-run considerations. In the short run, producer can produce more by changing
the variable inputs like labour and raw materials. In the long run, production can be enhanced by
changing all inputs, including machinery and building etc. To carry on production in both the
periods, it helps understand the productivity concepts of average and marginal products. The
average product (AP) is the output produced per unit of an input. Marginal product (MP), on the
other hand, gives change in the total product due to a unit change in one of the inputs. The
production process brings out the relationship between AP and MP. It is seen that when AP is
rising MP>AP, when AP is maximum, MP = AP and when AP is falling MP<AP. The total
production passes through three distinct stages (I, II and III). In stage –I, the total product curve
shows an increasing trend, while in stage –III it declines. A producer usually chooses to
operation in stage-II of the product curve when AP reaches the maximum point. Isoquant
measures a definite level of output obtained by different combinations of inputs. The slope of
isoquant is MRTS which is the ratio of MP labour and MP of capital. Producer equilibrium is
obtained when the slope of isocost line is tangent to isoquant. Simultaneous change of all inputs
in the long run results in a change in output in proportion to greater, equal or lower scale. Such a
feature is studied through returns to scale.

11. KEY WORDS

1. Production Function: The functional relationship between inputs and output.

2. Average Product: Total product per unit of an input
3. Constant Returns to Scale: The case where a proportionate change in all inputs
changes output by the same proportion.
4. Decreasing Returns to Scale: The case where a proportionate increase in all inputs
leads output to increase by a small proportion
5. Diminishing Marginal Rate of Substitution: The declining marginal rate of
substitution as one input is substituted for another.
6. Economic Region of Production: The downward sloping segment of an isoquant
7. Elasticity of Substitution: A measure of the responsiveness of the input ratio
to a change in the input-price ratio.
8. Increasing Returns to Scale: A situation where proportionate increase in all inputs
causes output to increase by a large proportion.
9. Isoquant : The locus of points representing various combinations of inputs yielding a
specified and of output.
10. Long Period Production: A period of time sufficient for altering the quantities of all
inputs into the production process.
11. Marginal Rate of Technical Substitution: The rate at which one input can be
substituted for another without affecting the level of output.
12. KNOW YOUR PROGRESS
1. What is a production function?
2. Define marginal productivity of labour
3. Why marginal productivity of labour declines?

4. The producer must choose the second stage from the total production curve. Why?
5. Define an iso-quant.
6. What is MRTS ?
7. What is elasticity of substitution?
8. What do you mean by returns to scale?
9. What is economic region of production?
.
13. FURTHER READINGS/REFERENCES
1. Dominick Salavatore (1996), Managerial Economics in Global Econoy, McGraw-Hill
College
2. Koutsoyiannis, A. (1979), Modern Microeconomics, Second edition, London:
Macmillian.
3. Ravindra H Dholakia, Ajay N Oza (1996). Microeconomics for Management Students,Oxford
University Press

14. MODEL ANSWERS

Answers to the above know your progress questions

1 A technical relation between inputs and output.

2. Change in output due to a unit change in labour with level of other factors kept
constant.
3. Because contribution of other factors to production cannot be perfectly substituted by
labour. If a variable input is continuously added to a fixed input the marginal
productivity of the variable input initially increases as long as the fixed factor is
underutlised and once the fixed factor is completely used any more additions of
variable input to a fixed input results in diminishing returns.
4. At this state AP reaches the maximum.
5. Isoquant is different combinations of inputs producing a fixed level of output.
6. The rate at which one input is substituted for the other is called marginal rate of
technical substitution.
7. Returns to Scale is change in output by changing all inputs simultaneously. If output
increases same proportion as input, it is constant returns to scale. If output increases
more than proportionate increase in inputs it is called increasing returns to scale. If
output increases less than proportionate increase in inputs it is called decreasing
returns to scale.