What is Production?

The process transforming inputs into outputs of goods or services that are
valued higher than the inputs collectively.

Inputs may be fixed in nature or may be variable

• Fixed inputs: Those inputs whose level of engagement cannot be

changed during the time when planning is completed and plant is in
operation e.g. Land, Machinery, Equated monthly instalments on loans

•Variable inputs: Those inputs whose level of engagement can be changed

while the plant is in operation e.g. Amount of raw material processed may
change daily; electricity as input may vary

Period of Analysis: Long vs Short Run

• Short Run: A period during which, out of many inputs that a
production process has, if at least one input can not be changed, that period
is called short run.

• Long Run: Any time period where all the inputs can be
changed is called Long Run.
 The Production Function

• Its the expression of relationship between two or

more inputs to yield maximum output in the given
time period
La Total Margi Averag Output
b Product nal e Elasticity
or Produ Produc
ct t
1 10 10 10 1.00
2 30 20 15 1.33
3 54 24 18 1.33
4 72 18 18 1.00
5 85 13 17 0.76
6 90 5 15 0.33
7 90 0 13 0.00
8 88 -2 11 -0.18
The Three Stages of Production
 Finding the Optimal level of Variable Input

• Labor will be hired till the time it is able to create a value more than what is paid
to it.

• Value that labor creates is called Marginal Revenue Product, which is a product
of MR and MPL
• MRP = (MP) (MR)
L L

• The cost of labour is the wage paid to labor for producing that additional unit or
the Marginal Resource Cost

• Optimal Level of Labor input

• FINDING THE OPTIMAL LEVEL OF VARIABLE INPUT

Marginal Marginal Marginal Marginal

Labo Product Revenue Revenue Resource
r Cost
MPL MR Product
1 10 10 100 65
2 20 9 180 65
3 24 8 192 65
4 18 7 126 65
5 13 5 65 65
6 5 3 15 65
7 0 0 0 65
8 -2 65

250

200

150

100

50

1 2 3 4 5
6 7

MRPL MRCL
 Agenda
• Isoquants – tool for understanding long run production function
• Efficient zone of isoquant – Ridge Lines
• Slope of isoquant – Ratio of Marginal Products
• Optimal input combination for long run production function
• Isocost lines – changes in shape as input price changes
• Expansion Path
• Returns to scale
Production Function with Two Variable Inputs
 Production Function with Two Variable Inputs

Marginal Rate of Technical Substitution

• It is defined as the rate at which one input can be substituted by

another

• Mathematically MRTS
 Optimal input combination – Long run

• Isocost Line is a locus of different combinations of inputs

that yield the same cost
 • In case there are only two inputs labor and capital then
C = wL + rK

Or K = (C/r) - (w/r)L

Where, C = Total Cost, w = wage rate or price of labor; and r = interest rate or
price of capital
Please note that slope of isocost line is (-w/r), the coefficient of L

Agenda

• Meaning of Cost Function

• Short-Run Cost Function
• Long-Run Cost Function

Cost Function
 Different interpretations of Cost
• Accounting Costs or Explicit Costs
These are the actual expenditures a firm has one. For instance - hire labor, rent a property or
machines and purchase inputs.

• Implicit Costs
The value of inputs owned and used by the firm in the production process.

Opportunity Cost – the cost of the next best alternative that has been sacrificed
 Short-Run Cost Functions

•
Q TFC TVC TC AFC AVC AC M

0 100 0 100
1 100 80 180 100.0 80.0 180 8
2 100 140 240 50.0 70.0 120 6
3 100 170 270 33.3 56.7 90 3
4 100 180 280 25.0 45.0 70 1
5 100 180 280 20.0 36.0 56
6 100 200 300 16.7 33.3 50 2
7 100 250 350 14.3 35.7 50 5
8 100 380 480 12.5 47.5 60 13
9 100 530 630 11.1 58.9 70 15
 Summary
• Cost is function of output. It increases with output but the
rate of increase keeps changing
• Explicit cost or accounting cost are the actual out of the pocket expenses
• Implicit cost is the value of an input which is owned by the producer and
used in the production process
• Opportunity cost is the cost of the next best alternative that has
been sacrificed to pursue the current option
• SAC is shaped by the law of diminishing returns while LAC is shaped
by the economies and diseconomies of scale