Chapter V Cost Analysis

Dr. GOPALAKRISHNA B.V. Faculty of MBA, SDM, Mangalore

• In technical sense, production is the transformation of resources into commodities over time and space. • In simply, production is the act of converting or transforming input into output. • A firm is a business unit which undertakes the activity of transforming inputs into outputs of goods and services. • In the production process, a firm combines various inputs in different quantities and proportions to produce different levels of outputs.

The concept of production function
• The term ‘production function’ refers to the relationship between the inputs and the outputs produced by them. • The terms factors of production and resources are used inter changeably with the term ‘inputs’ • The study of the production function is directed towards the maximum output which can be achieved with a given set of resources or inputs with given state of technology

Production Function

Inputs (L, K)

Production Function q = f(L, K)

Output q

Production Function
•A production function expresses the relationship between a combination of inputs (factors of production) and outputs (quantity of goods and services). • Production is a process in which the physical inputs are transformed into physical output. • The output is thus the function of inputs. • Production function can be algebraically expressed in an equation in which the output is the dependent variable and inputs are independent variables

Algebrical expression Q = f (a, b, c, d …..n)
• Q = stands fro the rate of output of given commodity. • A, b, c, d ….n are different factors and services • f = functional relationship

Production function depends on
1. Quantities of resources (raw-materials, labourers, capital, machinery etc). 2. State of technology is given. 3. Possible processes. 4. Size of the firms. 5. Nature of firms organization and 6. Relative price of inputs and the manner in which the inputs are combined.

Production function
In economic theory, there are three types of production function, they are – Production function with one variable input Production function with two variable input Production function with all variable input

1. 2. 3.

• Production function with one variable inputs are also called as law of variable proportions. • This law occupies an important place in economic theory. • The law states a technical physical relationship between the fixed and variable factors of production in the short run. • Here it is assumed that only one factor of production is a variable factor (labour) while other factor are assumed to remain fixed (land)

Assumptions of the law
1. The state of technology is assumed to be given and unchanged. 2. Only one factor is varied (labour) and all other factors remain unchanged (land, capital, equipment and raw-material etc). 3. The fixed factor and the variable factor are combined together in various proportions in the process of production. 4. The units of the variable factors are homogeneous. 5. The law operates in the short-run.

Table 5.1 Returns to Labour
Units of Labour Total Product (quintals) Marginal Product (quintals) 80 90 100 98 62 50 24 00 -9 -15 Average Products (quintals) 80 85 90 92 86 80 72 63 55 48

1 2 3 4 5 6 7 8 9 10

80 170 270 368 430 480 504 504 495 480

Average and Marginal Product Curves
Total Product
TP AP max & AP = MP MP max L Point of diminishing marginal returns Point of diminishing average returns AP MP L




Production with One Variable Input (Labor)
Outpu t per Month Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum Marginal Product




Average Product

10 10 Labor per Month

0 1

2 3


5 6

7 8


Total Product -First increases at increasing rate -Then the rate of increase changes from increase to diminishing rate Continues to increase at diminishing rate Diminishes

Marginal Product -Increases -Reaches a maximum and then starts diminishing - Continues diminishing

Average Product


-Increases First -Continues Stage increases

- Reaches a Second maximum stage AP = MP - Continues Third diminishing Stage

- Is negative

Three Stages of Production in the Short-Run
60 50 40 30 20 10
15 10 5 0 0 -5 2 4 6 8 10
Stage I Stage II Stage III

0 0 2 4 6 8 10

Three stages of the law of variable proportion
• • Stage I Total product will increases at an increasing rate. Average and marginal product also increase but marginal product rises at a faster rate than average product. Stage II Total product continues to increase but at a diminishing rate Marginal product is diminishing and becomes equal to zero Average product starts diminishing Stage III Total product starts declining Marginal product becomes negative Average product continues to decline.

• • • • • •

Table 5.2 Behaviour of TP, MP and AP during three stages of production
Different Total Product Marginal Product Average Stages (TP) (MP) Product (AP) Increases, reaches Increases at an its maximum and Increases and increasing rate then declines till MR reaches its = AP maximum Increases at a It diminishing and diminishing becomes equal to Starts declining rate till it zero reaches maximum Starts declining Become negative Continues to decline

Stage I

Stage II

Stage III

2. Production Function with two variable inputs
• To understand a production function with two variable inputs, it is necessary to understand iso-quant curve. • An iso-quant is also known as isoproduct curve, which are similar to indifference curves analysis. • These curve shows the various combinations of two variable inputs resulting in the same level of output

Iso-quant curve • The Iso-quants are thus contour lines which are trace the loci of equal outputs. • Iso-quant represents those combinations of inputs which will be capable of producing an equal quantity of output

Table 5.3 Labour and capital inputs in relation to output
Labour (units) 1 2 3 4 5 Capital (units) 5 3 2 1 0 Output (units) 10 10 10 10 10


, Capital

Iso-quant Curve B C D


x Labour

Iso-quants map
5 4 Capital 3 2 1 Q1 1 2

Q3 Q2 3 4 5

Properties of Isoquants • Isoquants slope left to right • No two iso-quant other • Iso-quants curve origin downwards from can intersect each are convex to the


Properties of Iso-quants
1. Iso-quants slope downward from left to right When the quantity of on factor (labour) increased, the quantity of other capital must be reduced so as to keep output constant on a given iso-quant. 2. No two iso-quants can interest each other Iso-quant curve never cut each other as higher and lower curves show different levels of satisfaction.

Properties of Iso-quants
3. Iso-quants curve are convex to the Origin • Iso-quant curve as similar to indifference curves are convex to the origin and they cannot be concave to the Origin. • The marginal rate of technical substitution are normally convex to the origin and it cannot be concave. • If the iso-quants were concave to the origin – marginal rate of technical substitution increased as more and more units of labour are substituted for capital

Isoquant Curve


Figure 7.10: Properties of Isoquant


Marginal Rate of Technical Substitution (MRTS)
• The Marginal Rate of Technical Substitution (MRTS) production theory is similar to the concept of Marginal Rate of Substitution of Indifference curve analysis. • MRTS - indicates the rate at which factors can be substituted at the margin without altering the level of output • MRTS of labour for capital - defined as one number of units of capital which can be replaced by one unit of labour, the level of output remaining unchanged..

Marginal Rate of Technical Substitution (MRTS)
• The MRTS of factor X (labour) for a unit of factor Y (capital). • Each input combinations A, B, C, D & E yields the same level of output.
increase in capital ∆K − MRTS = = increase in labor ∆L
Slope of Isoquant

Table: 5.4 Marginal Rate of Technical Substitution
Factor Units of Units of MRTS of Combination Labour (L) Capital (K) L for K A B C D E 1 2 3 4 5 12 8 5 3 2 4 3 2 1

Figure: 5.1 MRTS

Law of Returns to Scale
• In the long run all factors of production are variable – no factor is fixed – all the factors treated as variable factors. • Accordingly, the scale of production can be changed by changing the quantity of all factors of production. • It all factors of production is doubled, the total output will also be doubled. • According to this law, when all factor units are increased, total product generally increases at an increasing rate, later at a constant rate and finally decreasing rate.

Returns to Scale

Increasing Returns

Constant Returns

Decreasing Returns

1. Increasing Returns to Scale  increasing returns to scale or diminishing cost refers to a situation when all factors of production are increased, output increases at a higher rate.  It means if all inputs are doubled output will also increase at the faster rate than double.  This increase is due to many reasons like division of labour, specialisation and other external economies of scale.

2. Constant Returns to Scale • Constant returns to scale or constant cost refers to the production situation in which output increases exactly in the same proportion in which factors of production are increase. • In simple terms, if factors of production are doubled output will also be doubled. • In this case internal & external economies are exactly equal to internal economies & external diseconomies • This is also known as Homogeneous Production Function or Cobb-Douglas Linear homogeneous production function

3. Diminishing Returns to Scale  DRS or increasing costs refers to that production situation, where if all the factors of production are increased in a given proportion, output increases in a smaller proportion.  It means, if inputs are doubled, output will be less than double

Figure 7.17: Returns to Scale


Least Cost Combination of Inputs
  It is also known as producer’s equilibrium or choice of optimal factor combination. Producer’s equilibrium occurs when he earns maximum profit with optimal combination of factors. A profit maximisation producer faces two choices of optimal combination of factors (inputs)
1. To minimise its cost for a given output 2. To maximise its output for a given cost.

Thus least cost combination – refers to a firm producing the largest volume of output from a given cost and producing a given level of output with the minimum cost.

Economies of Scale
• Prof Stigler – economies of scale are also known as returns to scale. • As the scale of production is increased, upto a certain point, one gets economies of scale. • It is a common experience of every producer that costs can be reduced by increased production. That is why the producers are more keen on expanding the size/scale of production. • Economies of scale have been classified by Marshall into – internal and external economies.

Economies of Scale
Economies of Scale

Internal Economies

External Economies

Internal Economies
• Internal economies - are those economies production which accrue to the firm when it expands the output, so that the cost of production would come down considerably and place the firm in a better position to compete in the market effectively. • Economies arise purely due to endogenous factors relating to efficiency of the entrepreneur or his managerial talents the marketing strategy adopted. • Basically, internal economies are those which are special to each firm. These solely depend on the size of firm and will be different for different firms.

Internal Economies (checks this)
• For example, one firm will enjoy the advantage of good management other may specialisation in the techniques of production. to Cairncross – internal • According economies are those which are open to a single factory or a single firm independently of the action of other firms. • Prof Koutsoyannis has divided the internal economies into two parts.

Internal Economies

Real Economies

Pecuniary Economies

Types of Internal Economies
1. Technical Economies – Technical economies are those which accrue to a firm from the use of better machines and techniques of production. As a result, production increases and cost per unit of production decreases. • Technical economies are 5 kinds –
1. 2. 3. 4. 5. Economies of increased dimensions Economies of linked processes Economies of the use of by-products Economies in power Economies of increased specialisation

1. Economies of increased dimensions
• • • Certain technical economies may arise on account of increased dimensions. For example, a double decker bus is more economical than a single decker. One driver and one conductor may needed. Whether it is a double decker or a single decker bus.

2. Economies of linked processes • A big firm can also enjoy the economies of linked process. • A big firm carries all productive activities, these linked activities save time and transport cost to the firm.

3. Economies products






• A large firm is in a better position to utilise the by products efficiently and attempt to produce another new product. • For example large sugar factory uses molasses – producing alcohol

4. Economies in power
• Large size machines without continuous running are often more economical than small sized machines • Big boiler consumes more/less the same power of small boiler

5. Economies of increase Specialisation • A large firm can dived the work into various subprocesses. • Division of labour and specialisation become possible. • For example, only a well established big school can have specialised teachers.

2. Marketing Economies
• When the scale of production of a firm is increased it enjoys numerous selling or marketing economies. • Advertisement economies, opening up of show rooms, appointment of sole distributors, Research & Development (R & D)

3. Financial Economies • The credit requirements of the big firms can be meet from banks and other financial institutions easily. • A large firm is able to mobilise much credit at cheaper rates.
1. Investors have more confidence in investing money – large firms. 2. Shares and debentures of a large firm can easily sold in the stock market.

4. Managerial Economics • On the managerial side also economies can be achieved. • When output increases, specialists can be more fully employed. • A large firm can divide its big departments into various subdepartments and each department such as finance, marketing, legal, administration , sales etc.

5. Economies of Research • A large sized firm can spend more money on its research activities. • Spend hug sum money in order to innovate new varieties of products or improve the quality of the existing products. • In cases of innovation it will become an asset of the firm. innovations/new methods of • New producing a product may help to reduce its average cost.

6. Risk bearing Economies • The big firms always involved risk-bearing. • A big firm produces a large number of items and of different varieties so that the loss in one can be counter balanced by the gain in another. 7. Economies of Transport and Storage • A firm producing on large scale enjoys the economies of transport and storage. • A big firm can have its own means of transportation to carry finished as well as – raw-material from one place to another. • Moreover big firms also enjoy the economies of storage facilities. • The big firm also has its own storage and godown facilities.

External Economies
• External economies refers to all those benefits which accrue to all the firms operating in a given industry. • External economies can be enjoyed by all the firms in the industry irrespective of their size. • The emergence of external economies is due to localisation. • According to Cairncross – “External economies are those benefits which are shared in by a number of firms/industries when the scale of production in any industry increases”.

External Economies……. • He divided the external economies into the following parts as – 1. Economies of Concentration 2. Economies of Information 3. Economies of Disintegration 4. Economies of Localisation 5. Economies of By-products

1. Economies of Concentration • As the number of firms in an area increases each firm enjoys some benefits like, transport and communication, availability of raw-materials, research and invention etc. • Financial assistance from banks and nonbank institutions easily accrue to firm. • Therefore, concentration of industries lead to economies of concentration.

2. Economies of Information • When the number of firms in an industry expands they become mutually dependent on each other – they do not feel the need of independent research on individual basis. • Many scientific and trade journal are published – these journals provide information to all the firms which relates to new markets, sources of raw-materials, latest techniques of production etc.

3. Economies of Disintegration • As an industry develops, all the firms engaged in it decided to divide and sub-divide the process of production among themselves. • Each firm specialises in its own process. • For example – cotton Textile Industry – some firms may specialise in manufacturing thread, some others in producing dhoties, some in knitting baniqus some in weaving sarees etc. • The disintegration may be horizontal or vertical. Both will help the industry in avoiding duplication and saving time materials.

4. Economies of Location • The localisation of an industry means the concentration of firms producing identical product in a particular area. • For example railway is an industry – where parcel agency, post and telegraph department – post office, state electricity department installers power transformer and transport companies. • As a result, all the firms get these facilities at low prices, consequently the average cost of production in the industry declines.

5. Economies of By-Products • The growth and expansion of an industry would enable the firms to reduce their cost of production by making use of waste materials. • The waste material of one firm may be available and useable in the other firms. • Thus, wastes are converted into by products. • The selling firms reduce their costs of production by realising something for their wastes.