25.12.
2015
Topic 6. PRODUC TION AND
COST ANALYSIS
Production theory forms the foundation
for the theory of supply
• Managerial decision making involves four
types of production decisions:
1. Whether to produce or to shut down
2. How much output to produce
3. What input combination to use
4. What type of technology to use
Inputs : Fixed inputs and Variable inputs
Fixed inputs
 Remain the same in the short
period .
 At any level of out put, the
amount is remain the same.
 The cost of these inputs are
called Fixed Cost
 Examples:- Building, Land etc
( In the long run fixed inputs are become
varies)
1. Production theory
2. Cost theory
Some Basic Concepts
Production:
• Production means transforming inputs (Land, Labour,
Capital etc.) into an output.
Input and Output:
• An input is a good or service that goes into the process of
production. Land, Labour, Capital, Entrepreneur are
classified as inputs.
• An output is any good or service that comes out of the
production process.
Fixed Inputs & Variable Inputs:
• Fixed inputs remains fixed (constant) up to certain level of
output.
• Variable inputs change with the change in output.
• Production theory can be divided
Variable inputs
into short run theory or long run
 In the long run all factors theory.
of production are varies
according to the volume of
outputs.
 The cost of variable inputs
is called Variable Cost
 Example:- Raw materials,
labour, etc
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Long run and short run: Production function

• The Long Run is distinguished from the short • A production function is a table or a
run by being a period of time long enough for mathematical equation showing the
all inputs, or factors of production, to be maximum amount of output that can be
variable as far as an individual firm is produced from any specified set of inputs,
concerned
given the existing technology.
• The Short Run, on the other hand, is a period
so brief that the amount of at least one input
is fixed

Production Function
Factors of Production
• Production function is defined as “the functional
• Natural resources such as surface, mineral , air, rivers,
relationship between physical inputs ( i.e., factors
Land sea, etc of production ) and physical outputs, i.e., the
• Free gift of nature, fixed quantity of goods produced”.
• Mental or physical effort done by a man with the view
Labour of • Production function may be expressed as under:

Q = f ( K,L)
• Man made goods used in the production process
Capital • Most mobile factor
Where ;
Q = Output of commodity per
unit of time.
• Entrepreneur or coordinator of all other factors of K = Capital.
Organization production L = Labour.
f = Functional Relationship.

• Production function depends on : • The following points may be emphasized:

1. Production function represents a purely

1. Quantities of recourses used. technical relationship.
2. State of technical knowledge. 2. Output is the result of joint use of factors
3. Possible process. of production.
4. Size of firms. 3. Combination of factors depend on the
state of technical knowledge.
5. Relative prices of factors of production.
6. Combination of factors.
• Every management has to make choice of the
production function which gives maximum
outputs.

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Short run Production Function with Labour as Variable factor

Various concept of production
Labour (L) Capital (K) Total Average Product Marginal Product
Output (TP) (AP)
(MP)

0
Total Product (TP) - total amount of output produced at 0 10
1 10 10
different levels of inputs total amount of output
2 10 30
produced at different levels of inputs
3 10 60
Production with One Variable Input
4 10 80
Average Product (AP) Ratio of Total Product and one
5 10 95
variable inputs TP
APL  L 6 10 108
L 112
7 10
Marginal Product (MP)– The rate of change of out put 112
8 10
as a result changes in one variable input TP
MPL  L 9 10 108

L 10 10 100

D
Short run Production Function with Labour as Variable factor 112
Output per
Labour (L) Capital (K) Total Average Product Marginal Product month Total Product
Output (TP) C
(AP) (MP)

60 B
0 10 0 -
1 10 10 10 10 A
2 10 30 15 20
30 Labor per month
3 10 Production60with One Variable20
Input 3 4 8
4 10 80 20 20 30

5 10 95 19 15

6 10 108 18 13 E
20
7 10 112 16 4

8 10 112 14 0
Average product
-4 10
9 10 108 12
10 10 100 10 -8 Labor per month
3 4 8
Marginal product

Short run Production Function with Labour as Variable factor

• Both AP and MP first rise, reach a
Labour (L)Land Capital (K) Total Average Product Marginal Product
maximum and then fall. Output (TP)
(AP) (MP)
• MP = AP when AP is maximum.
0 10 10 0 -
• MP may be negative if Variable input is 1 10 10 10 10 10
First Stage
used too intensively. 2 10 10 30 15 20
10 30
• Law of diminishing marginal productivity 3
10
10 Production60with One Variable20
Input
20
4 10 80 20
states that in the short run if one input is 5 10 10 95 19 15
Second Stage
fixed, the marginal product of the variable 6 10 10 108 18 13

input eventually starts falling 7 10 10 112 16 4

8 10 10 112 14 0

9 10 10 108 12 -4
Third Stage
10 10 10 100 10 -8

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D
112
Output per
Stages in Law of diminishing marginal productivity
month Total Product (variable proportion)
C
First Stage: Increasing return
60 B  TP increase at increasing rate till the end of the stage.
 AP also increase and reaches at highest point at the end of the stage.
A  MP also increase at it become equal to AP at the end of the stage.
 MP>AP
Labor per month
3 4 8
Second Stage: Diminishing return
30 Second Stage
 TP increase but at diminishing rate and it reach at highest at the end of
Third Stage
the stage.
20
E  AP and MP are decreasing but both are positive.
 MP become zero when TP is at Maximum, at the end of the stage
 MP<AP.
First Stage Average product Third Stage: Negative return
10
 TP decrease and TP Curve slopes downward
8 Labor per month
3 4  As TP is decrease MP is negative. AP is decreasing but positive.
Marginal product

Law of Diminishing Returns

(Diminishing Marginal Product) Assumptions of the Law.
Holding all factors constant except one, the The law holds good under the following assumptions:
law of diminishing returns says that: 1. Short run. The law assumes short run situation. The
time is too short for a firm to change the quantity of
 As additional units of a variable input are fixed factors. All the, resources apart from this one
combined with a fixed input, at some point variable, are held unchanged in quantity and quality.
the additional output (i.e., marginal
product) starts to diminish 2. Constant technology. The law assumes that the
technique of production remains unchanged during
production.
e.g. trying to increase labor input 3. Homogeneous factors. Each factor unit in assumed to
without also increasing capital will bring he identical in amount and quality.
diminishing returns

The law of diminishing returns has

Technological Progress and Diminishing Returns
vast general applicability.
It is helpful in understanding clearly the process of • In today’s scenario the Technological progress can suspend
production. It explains the input output relations. We the operation of diminishing returns by continually improving
can find out by-how much the total product will
increase as a result of an increase in the inputs. the techniques of production.

The law tells us that the tendency of diminishing returns is

found in all sectors of the economy which may be AP4
agriculture or industry. AP3
Output
AP2
The law tells us that any increase in the units of variable
factor will lead to increase in the total product at a AP1
diminishing rate. The elasticity of the substitution of the
variable factor for the fixed factor is not infinite.
Labour Force

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Production in the Long-Run In other words Isoquant is a curve representing the

various combinations of two inputs that produce the
same amount of output
All inputs are now considered to be variable (both L
and K in our case) Also called as equal product curve
Both the factors are taken as variables
How to determine the optimal combination of
inputs?
Factor Labour Capital
To illustrate this case we will use production isoquants. Production
A 1 12 Isoquant
K
An isoquant is a curve showing all possible combinations B 2 8
of inputs physically capable of producing a given fixed
C 3 5
level of output.
D 4 3
E 5 2 L

Isoquants and the Production Function

General Properties of Isoquant
• An Isoquant is downward sloping to the right:
If more of one factor is used then less of the other
factor is needed for producing same level of output • Slope of an isoquant indicates the rate at which
factors K and L can be substituted for each other
• Higher Isoquant represents larger output while a constant level of production is maintained.
• The slope is called Marginal Rate of Technical
• No two isoquants can intersect each other
Substitution (MRTS)
Same amount of factors can produce two levels of
output

• Isoquants are convex to the origin

Slope of isoquants diminishes from left to right

ISOQUANT MAP- A family or a

group of isoquants is called an ISOQUANT • Slope of an isoquant indicates the rate at which
MAP
factors K and L can be substituted for each other
while a constant level of production is maintained

K1 A
Iq4 = 400
K2
ΔK B
• The slope is called Marginal Rate of Technical
Units of K

ΔL Iq3 = 300
K3 ΔK C Substitution (MRTS)
ΔL
Iq2 = 200
ΔK D
K4
ΔL
Iq1 = 100
0
L1 L2 L3 L4
Units of L

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The Marginal Rate Marginal Rate of Technical Substitution

of Technical Substitution
• The absolute value of the slope of the isoquant is the
marginal rate of technical substitution, MRTS, between two
resources

• Thus, the MRTS is the rate at which labor substitutes for

capital without affecting output
• when much capital and little labor are used, the marginal
productivity of labor is relatively great and the marginal
productivity of capital relatively small
• one unit of labor will substitute for a relatively large amount
of capital

Marginal Rate of Technical Substitution

Law of Diminishing Marginal
Rate of Technical Substitution: • Anywhere along the isoquant, the marginal rate of
technical substitution of labor for capital equals the
Table 7.8 Input Combinations
marginal product of labor divided by the marginal
for Isoquant Q = 52 product of capital, which also equals the absolute value of
Combination L K L K MRTS the slope of the isoquant
A 6 2 -2 1 2
B 4 3
C 3 4
-1 1 1
D 2 6 -1 2 1/2 • MRTS = MPL / MPC
E 2 8 0 2

Producers Equilibrium or the Least Cost Combination of

Choice of Input Combinations Factors
• A producer desires to minimise his cost of production for producing a
• The profit maximizing firm wants to produce its chosen given level of output with the least cost combination of factors.
output at the minimum cost  it tries to find the isocost
closest to the origin that still touches the chosen Y
isoquant. How producers ultimately arrives the
point of equilibrium ?
•The equilibrium is achieved at the point
Where MRTS LK = PL/PK ie
Isocost Line - is a line that shows the various combinations C A • The slope of isoquant =Slope of
A S
of two inputs that can be bought for a given dollar cost. P isocost
I •Or , MRTS LY = MPL = PL
The equation for an isocost line is: T MPK PR
C =L. PL +K. PK A E Or, MPL = MPK
L
PL PK

T IQ
Q2
Q1
O B X
LABOUR

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Isoquants and Cost Minimization Expansion Path

K
IQ 3
IQ 2 • If we imagine a set of isoquants representing
10

• M each possible rate of output, and given the

relative cost of resources, we can then draw
IQ 1

• isocost lines to determine the optimal

8

N P” combination of resources for producing each

•
Units of Cap[ital

• P
rate of output
6

TC=Rs10
0 Q=300
4

TC=Rs=75
Q=200
• P’
2

TC=Rs50

Q=100
0

L
0 2 4 6 8 10 12 14 16 18 20
37
Units of
Labour

Expansion Path • Expansion Path leads to Total Cost Curve

• Expansion Path may be defined as the locus of efficient combinations of
• An expansion path is a long-run concept
the factors. (because all inputs can change)
• Each point on the expansion path
represents a cost-minimizing combination
of inputs
• Given input prices, each point represents a
total cost of producing a given level of
output when the entrepreneur can choose
any input combination he or she want