PRODUCTION, COST ANALYSIS &

DECISION MAKING
Contents :
Production:
Hemant Shetty (40) & Kamakhya Narayan (19)
Cost Analysis:
Hetal Desai (10) & Gohil Jayesh (13)
Decision Analysis:
Kuntal Rastogi (33)
PRODUCTION :
Theory of Firm
- Production technologies
- Cost Constraints
- Input Choices

Factors of Production

Production function
q = F(K,L)
We will begin looking at the short run when
only one input can be varied
We assume capital is fixed and labor is
variable
Output can only be increased by
increasing labor
Must know how output changes as the
amount of labor is changed
Production: One Variable
Input
 Average product of Labor - Output per unit of
a particular product
 Measures the productivity of a firm’s labor in
terms of how much, on average, each worker
can produce
 Avg Prod of Labor = output/Labor Input
Production: One Variable
Input
 Marginal Product of Labor – additional output
produced when labor increases by one unit
 Change in output divided by the change in
labor
 Marg Prod of Labor = change in output/change in labor input
Production: One Variable
Input
Product Curves

 We can show a geometric relationship

between the total product and the average
and marginal product curves
 Slope of line from origin to any point on the total
product curve is the average product
 At point B, AP = 60/3 = 20 which is the same as the
slope of the line from the origin to point B on the
total product curve
Production: One Variable
Input
Product Curves

 Geometric relationship between total

product and marginal product
 The marginal product is the slope of the line
tangent to any corresponding point on the total
product curve
 For 2 units of labor, MP = 30/2 = 15 which is slope
of total product curve at point A
Production: Two Variable
Inputs
 Firm can produce output by combining
different amounts of labor and capital
 In the long run, capital and labor are both
variable
 We can look at the output we can achieve
with different combinations of capital and
labor – Table 6.4
Production: Two Variable
Inputs
Production: Two Variable
Inputs
 The information can be represented
graphically using isoquants
 Curves showing all possible combinations of
inputs that yield the same output
 Curves are smooth to allow for use of
fractional inputs
 Curve 1 shows all possible combinations of labor
and capital that will produce 55 units of output
Isoquant Map
Production: Two Variable
Inputs
 As labor increases to replace capital
 Labor becomes relatively less productive
 Capital becomes relatively more productive
 Need less capital to keep output constant
 Isoquant becomes flatter
A Production Function for
Wheat
 Farmers can produce crops with different
combinations of capital and labor
 Crops in US are typically grown with capital-
intensive technology
 Crops in developing countries grown with labor-
intensive productions
 Can show the different options of crop
production with isoquants
A Production Function for
Wheat
 Manager of a farm can use the isoquant to
decide what combination of labor and capital
will maximize profits from crop production
 A: 500 hours of labor, 100 units of capital
 B: decreases unit of capital to 90, but must
increase hours of labor by 260 to 760 hours
 This experiment shows the farmer the shape of
the isoquant
Isoquant Describing the
Production of Wheat
Capital Point A is more
capital-intensive, and
B is more labor-intensive.
120
A
100 B
90  K  - 10
80  L  260

40

Labor
250 500 760 1000
There are following types of costs:
Classification of costs into
- Direct costs
- Indirect costs
- Finance costs
Types of Costs
1) Opportunity cost
2) Money cost
- Explicit
- Implicit 
3) Sunk costs
4) Accounting Cost
Categorisation of costs (important for decision making process)

 Fixed costs (also known as Period costs, constant costs)

 Variable costs (also known as marginal costs)
 semi variable costs (split into Variable & fixed portion)
 Incremental costs (can be variable cost and / or fixed costs)
 Relevant costs & irrelevant costs
(used for short term decision making)

 All variable costs associated to a decision are –

relevant
 All historical costs – irrelevant
 All existing fixed costs (being sunk costs) –
irrelevant
 All future fixed costs associated to decision
making – relevant
 Opportunity costs (arising due to decision
making) – relevant
Cost in Short Run and Long Run
 How the COST & DECSION can be change
in Short Run and Long Run
 How the same costs are Fixed / Variable in
short Run / Long Run
 How the Law of Diminishing Marginal
Returns works only in Short run & useful to
Long run Decision
 PROFIT LOSSES & BREAKEVEN
 Break Even Analysis
 Minimum out put the firm need to produce its costs
TOTAL COST = TOTAL REVENUE
Where
P  Price
Q  Output in units
TFC  Total fixed cost
AVC  Average Variable cost
 Assumptions:
1. The cost and revenue functions are linear functions.
2. The firm can estimate the cost and revenues in advance.
3. Price remains uniform at all levels of out put.
4. The costs are made up of fixed and variable costs.
 PROFIT LOSSES & BREAKEVEN
Case 1:
Price is P0 or ‘a’
For profit
maximisation
output is y0
( refer the intersection
point of MC )

ATC (Average Total

Cost) is ‘b’

Profit per unit would be – ‘ab’

and the TOTAL PROFIT would be the total area
marked with dotted lines
 PROFIT LOSSES & BREAKEVEN
Case 2:
Price is P1 or ‘c’
(Point touching the
ATC curve)
Optimal output is y1

(refer the intersection

point of MC )

ATC (Average Total Cost)

is ‘C’

Profit per unit would be – ‘ZERO’

And the firm is at “BREAK EVEN”
 PROFIT LOSSES & BREAKEVEN
Case 3:
Price is P2 or ‘d’
(Point touching the
ATC curve)
Optimal output is y2
d
 (refer the intersection
point of MC )

ATC (Average Total Cost)

is ‘e’

Loss per unit would be – ‘ed’

And the TOTAL LOSSES would be the total area
marked
 PROFIT LOSSES & BREAKEVEN
Case 4:
Price is P3 or ‘f’
(i.e. min point of AVC)

output is y3
( refer the intersection
point of MC )

And P3 = AVC

Total Loss=Total Cost – Total Revenue

= (TFC + TVC) – TR
= TFC + AVC*y3 - p3*y3
= TFC (as P3 = AVC)
 PROFIT LOSSES & BREAKEVEN
Contd..

Case 5:
Price falls below P3 or‘f’ output is less than y3
(i.e. doesnot touch min point (refer the intersection point
of AVC) of MC )

i.e. If p3 < Min AVC (market price is less than Min AVC)

Total Loss=Total Cost – Total Revenue

= (TFC + TVC) – TR
= TFC + AVC*y3 - p3*y3
= TFC + (AVC - p3)*y3
 Then the losses would start exceeding the TFC ,
Hence reaches to “SHUT DOWN CONDITION”