UNIT - III

PRODUCTION FUNCTION

Introduction: The production function expresses a functional relationship between physical inputs
and physical outputs of a firm at any particular time period. The output is thus a function of inputs.
Mathematically production function can be written as

Q= f (A, B, C, D)

Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land,
labour, capital and organization. Here output is the function of inputs. Hence output becomes the
dependent variable and inputs are the independent variables.

The above function does not state by how much the output of “Q” changes as a consequence of
change of variable inputs. In order to express the quantitative relationship between inputs and
output, Production function has been expressed in a precise mathematical equation i.e.

Y= a+b(x)

Which shows that there is a constant relationship between applications of input (the only factor input
‘X’ in this case) and the amount of output (y) produced.

Importance:

1. When inputs are specified in physical units, production function helps to estimate the level of
production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without altering
the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’ and ‘law
of returns to scale’. Law of variable propositions explains the pattern of output in the short-run
as the units of variable inputs are increased to increase the output. On the other hand law of
returns to scale explains the pattern of output in the long run as all the units of inputs are
increased.
6. The production function explains the maximum quantity of output, which can be produced,
from any chosen quantities of various inputs or the minimum quantities of various inputs that
are required to produce a given quantity of output.

Production function can be fitted the particular firm or industry or for the economy as whole.
Production function will change with an improvement in technology.
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Assumptions:
Production function has the following assumptions.

1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.

Cobb-Douglas production function:

Production function of the linear homogenous type is invested by Junt wicksell and first tested by C.
W. Cobb and P. H. Dougles in 1928. This famous statistical production function is known as Cobb-
Douglas production function. Originally the function is applied on the empirical study of the American
manufacturing industry. Cabb – Douglas production function takes the following mathematical form.

Y= (AKX L1-x)
Where Y=output
K=Capital
L=Labour
A, ∞=positive constant

Assumptions:

It has the following assumptions

1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a linear function
of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology

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 ISOQUANTS:

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’
implies quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or
isoquants or production difference curves can represent a production function with two variable
inputs, which are substitutable for one another within limits.

Iqoquants are the curves, which represent the different combinations of inputs producing a particular
quantity of output. Any combination on the isoquant represents the some level of output.
For a given output level firm’s production become,

Q= f (L, K)

Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.

Thus an isoquant shows all possible combinations of two inputs, which are capable of producing equal
or a given level of output. Since each combination yields same output, the producer becomes
indifferent towards these combinations.

Assumptions:

1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.

An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50

Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a
product all other combinations in the table are assumed to yield the same given output of a product
say ‘50’ quintals by employing any one of the alternative combinations of the two factors labour and
capital. If we plot all these combinations on a paper and join them, we will get continues and smooth
curve called Iso-product curve as shown below.

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Labour is on the X-axis and capital is on the Y-axis (Below Figure). IQ is the ISO-Product curve which
shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a product.

Producer’s Equilibrium:

The tem producer’s equilibrium is the counter part

of consumer’s equilibrium. Just as the consumer is
in equilibrium when be secures maximum
satisfaction, in the same manner, the producer is in
equilibrium when he secures maximum output, with
the least cost combination of factors of production.

The optimum position of the producer can be found

with the help of iso-product curve. The Iso-product
curve or equal product curve or production
indifference curve shows different combinations of two factors of production, which yield the same
output. This is illustrated as follows.

Let us suppose. The producer can produces the given output of paddy say 100 quintals by employing
any one of the following alternative combinations of the two factors labour and capital computation of
least cost combination of two inputs.

L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost

Units Units Output Cost of cost of
labour capital
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182

It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost the producer
Rs. 20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting cost would be Rs. 172/-.
Substituting 10 more units of ‘L’ for 12 units of ‘K’ further reduces cost pf Rs. 154/-/ However, it will
not be profitable to continue this substitution process further at the existing prices since the rate of
substitution is diminishing rapidly. In the above table the least cost combination is 30 units of ‘L’
used with 16 units of ‘K’ when the cost would be minimum at Rs. 154/-. So this is they stage “the
producer is in equilibrium”.

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LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.

These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale

I. Law of variable proportions:

The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms
production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour
which is a variable input when the firm expands output by employing more and more labour it alters
the proportion between fixed and the variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a variable input
while the quantities of other inputs are held constant, the increase in total production becomes after
some point, smaller and smaller”.

“If equal increments of one input are added, the inputs of other production services being held
constant, beyond a certain point the resulting increments of product will decrease i.e. the marginal
product will diminish”. (G. Stigler)

“As the proportion of one factor in a combination of factors is increased, after a point, first the
marginal and then the average product of that factor will diminish”. (F. Benham) The law of variable
proportions refers to the behaviour of output as the quantity of one Factor is increased Keeping the
quantity of other factors fixed and further it states that the marginal product and average product
will eventually do cline. This law states three types of productivity an input factor – Total, average
and marginal physical productivity.

Assumptions of the Law: The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in technology, the
average and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This law does
not apply to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.

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Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed
quantity of the other can be divided in to three district stages. The three stages can be better
understood by following the table.

Fixed factor Variable factor Total product Average Marginal

(Labour) Product Product
1 1 100 100 - Stage
1 2 220 120 120 I
1 3 270 90 50
1 4 300 75 30 Stage
1 5 320 64 20 II
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III

Above table reveals that both average product and marginal product increase in the beginning and
then decline of the two marginal products drops of faster than average product. Total product is
maximum when the farmer employs 6th worker, nothing is produced by the 7th worker and its
marginal productivity is zero, whereas marginal product of 8th worker is ‘-10’, by just creating credits
8th worker not only fails to make a positive contribution but leads to a fall in the total output.

Production function with one variable input and the remaining fixed inputs is illustrated as below

From the above graph the law of variable

proportions operates in three stages. In the first stage,
total product increases at an increasing rate. The
marginal product in this stage increases at an
increasing rate resulting in a greater increase in total
product. The average product also increases. This stage
continues up to the point where average product is
equal to marginal product. The law of increasing
returns is in operation at this stage. The law of
diminishing returns starts operating from the second
stage awards. At the second stage total product
increases only at a diminishing rate. The average
product also declines. The second stage comes to an end where total product becomes maximum and
marginal product becomes zero. The marginal product becomes negative in the third stage. So the
total product also declines. The average product continues to decline.

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We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “ A. P; When
‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts falling, ‘M. P.’
falls faster than ‘ A. P.’.

Thus, the total product, marginal product and average product pass through three phases, viz.,
increasing diminishing and negative returns stage. The law of variable proportion is nothing but the
combination of the law of increasing and demising returns.

II. Law of Returns of Scale:

The law of returns to scale explains the behavior of the total output in response to change in the
scale of the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in
response to a simultaneous and proportional increase in all the inputs. More precisely, the Law of
returns to scale explains how a simultaneous and proportionate increase in all the inputs affects the
total output at its various levels.

The concept of variable proportions is a short-run phenomenon as in these period fixed factors can
not be changed and all factors cannot be changed. On the other hand in the long-term all factors can
be changed as made variable. When we study the changes in output when all factors or inputs are
changed, we study returns to scale. An increase in the scale means that all inputs or factors are
increased in the same proportion. In variable proportions, the cooperating factors may be increased
or decreased and one faster (Ex. Land in agriculture (or) machinery in industry) remains constant so
that the changes in proportion among the factors result in certain changes in output. In returns to
scale all the necessary factors or production are increased or decreased to the same extent so that
whatever the scale of production, the proportion among the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically there are three
possibilities. (i) The total output may increase proportionately (ii) The total output may increase
more than proportionately and (iii) The total output may increase less than proportionately. If
increase in the total output is proportional to the increase in input, it means constant returns to
scale. If increase in the output is greater than the proportional increase in the inputs, it means
increasing return to scale. If increase in the output is less than proportional increase in the inputs, it
means diminishing returns to scale.

Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single
output production system.

ECONOMIES OF SCALE

Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size
of production by increasing all the factors, it secures certain advantages known as economies of
production. Marshall has classified these economies of large-scale production into internal economies
and external economies.
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Internal economies are those, which are opened to a single factory or a single firm independently of
the action of other firms. They result from an increase in the scale of output of a firm and cannot be
achieved unless output increases. Hence internal economies depend solely upon the size of the firm
and are different for different firms.

External economies are those benefits, which are shared in by a number of firms or industries when
the scale of production in an industry or groups of industries increases. Hence external economies
benefit all firms within the industry as the size of the industry expands.

Causes of internal economies:

Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization.

1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed
minimum size. For instance, if a worker works half the time, he may be paid half the salary. But he
cannot be chopped into half and asked to produce half the current output. Thus as output increases
the indivisible factors which were being used below capacity can be utilized to their full capacity
thereby reducing costs. Such indivisibilities arise in the case of labour, machines, marketing, finance
and research.

2. Specialization.
Division of labour, which leads to specialization, is another cause of internal economies.
Specialization refers to the limitation of activities within a particular field of production. Specialization
may be in labour, capital, machinery and place. For example, the production process may be split
into four departments relation to manufacturing, assembling, packing and marketing under the
charge of separate managers who may work under the overall charge of the general manger and
coordinate the activities of the for departments. Thus specialization will lead to greater productive
efficiency and to reduction in costs.

Internal Economies:
Internal economies may be of the following types.

A). Technical Economies.

Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm, which
employs costly and superior plant and equipment, enjoys a technical superiority over a small firm.
Another technical economy lies in the mechanical advantage of using large machines. The cost of
operating large machines is less than that of operating mall machine. More over a larger firm is able
to reduce it’s per unit cost of production by linking the various processes of production. Technical
economies may also be associated when the large firm is able to utilize all its waste materials for the

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development of by-products industry. Scope for specialization is also available in a large firm. This
increases the productive capacity of the firm and reduces the unit cost of production.

B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the large size
firms can afford. There may be a separate head for manufacturing, assembling, packing, marketing,
general administration etc. Each department is under the charge of an expert. Hence the
appointment of experts, division of administration into several departments, functional specialization
and scientific co-ordination of various works make the management of the firm most efficient.

C). Marketing Economies:

The large firm reaps marketing or commercial economies in buying its requirements and in selling its
final products. The large firm generally has a separate marketing department. It can buy and sell on
behalf of the firm, when the market trends are more favorable. In the matter of buying they could
enjoy advantages like preferential treatment, transport concessions, cheap credit, prompt delivery
and fine relation with dealers. Similarly it sells its products more effectively for a higher margin of
profit.

D). Financial Economies:

The large firm is able to secure the necessary finances either for block capital purposes or for
working capital needs more easily and cheaply. It can barrow from the public, banks and other
financial institutions at relatively cheaper rates. It is in this way that a large firm reaps financial
economies.

E). Risk bearing Economies:

The large firm produces many commodities and serves wider areas. It is, therefore, able to absorb
any shock for its existence. For example, during business depression, the prices fall for every firm.
There is also a possibility for market fluctuations in a particular product of the firm. Under such
circumstances the risk-bearing economies or survival economies help the bigger firm to survive
business crisis.

F). Economies of Research:

A large firm possesses larger resources and can establish it’s own research laboratory and employ
trained research workers. The firm may even invent new production techniques for increasing its
output and reducing cost.

G). Economies of welfare:

A large firm can provide better working conditions in-and out-side the factory. Facilities like
subsidized canteens, crèches for the infants, recreation room, cheap houses, educational and medical
facilities tend to increase the productive efficiency of the workers, which helps in raising production
and reducing costs.

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External Economies.
Business firm enjoys a number of external economies, which are discussed below:

A). Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and
financial services, supply of power and benefits from subsidiaries. All these facilities tend to lower the
unit cost of production of all the firms in the industry.

B). Economies of Information

The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.

C). Economies of Welfare:

An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local bodies for setting up housing colonies
for the workers. It may also establish public health care units, educational institutions both general
and technical so that a continuous supply of skilled labour is available to the industry. This will help
the efficiency of the workers.

D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it
becomes possible to spilt up some of the processes which are taken over by specialist firms. For
example, in the cotton textile industry, some firms may specialize in manufacturing thread, others in
printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result
the efficiency of the firms specializing in different fields increases and the unit cost of production
falls.Thus internal economies depend upon the size of the firm and external economies depend upon
the size of the industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that
expansion of a firm’s output may lead to rise in costs and thus result diseconomies instead of
economies. When a firm expands beyond proper limits, it is beyond the capacity of the manager to
manage it efficiently. This is an example of an internal diseconomy. In the same manner, the
expansion of an industry may result in diseconomies, which may be called external diseconomies.
Employment of additional factors of production becomes less efficient and they are obtained at a
higher cost. It is in this way that external diseconomies result as an industry expands.

The major diseconomies of large-scale production are discussed below:

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Internal Diseconomies:

A). Financial Diseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be easily available in
the required amount at the appropriate time. Lack of finance retards the production plans thereby
increasing costs of the firm.

B). Managerial diseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not
work efficiently, wastages arise, decision-making becomes difficult, coordination between workers
and management disappears and production costs increase.

C). Marketing Diseconomies:

As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw
materials may not be available in sufficient quantities due to their scarcities. Additional output may
depress the price in the market. The demand for the products may fall as a result of changes in
tastes and preferences of the people. Hence cost will exceed the revenue.

D). Technical Diseconomies:

There is a limit to the division of labour and splitting down of production p0rocesses. The firm may
fail to operate its plant to its maximum capacity. As a result cost per unit increases. Internal
diseconomies follow.

E). Diseconomies of Risk-taking:

As the scale of production of a firm expands risks also increase with it. Wrong decision by the
management may adversely affect production. In large firms are affected by any disaster, natural or
human, the economy will be put to strains.

External Diseconomies:
When many firm get located at a particular place, the costs of transportation increases due to
congestion. The firms have to face considerable delays in getting raw materials and sending finished
products to the marketing centers. The localization of industries may lead to scarcity of raw material,
shortage of various factors of production like labour and capital, shortage of power, finance and
equipments. All such external diseconomies tend to raise cost per unit.

COST ANALYSIS

Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its
ability to earn sustained profits. Profits are the difference between selling price and cost of
production. In general the selling price is not within the control of a firm but many costs are under its
control. The firm should therefore aim at controlling and minimizing cost. Since every business

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decision involves cost consideration, it is necessary to understand the meaning of various concepts
for clear business thinking and application of right kind of costs.

COST CONCEPTS:

A managerial economist must have a clear understanding of the different cost concepts for clear
business thinking and proper application. The several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. The various relevant concepts of
cost are:

1. Opportunity costs and outlay costs:

Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred
by the firm these are the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based
on accounting cost concept.On the other hand opportunity cost implies the earnings foregone on the
next best alternative, has the present option is undertaken. This cost is often measured by assessing
the alternative, which has to be scarified if the particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very
important in capital expenditure budgeting. This concept is very important in capital expenditure
budgeting. The concept is also useful for taking short-run decisions opportunity cost is the cost
concept to use when the supply of inputs is strictly limited and when there is an alternative. If there
is no alternative, Opportunity cost is zero. The opportunity cost of any action is therefore measured
by the value of the most favorable alternative course, which had to be foregoing if that action is
taken.

2. Explicit and implicit costs:

Explicit costs are those expenses that involve cash payments. These are the actual or business costs
that appear in the books of accounts. These costs include payment of wages and salaries, payment
for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.Implicit costs
are the costs of the factor units that are owned by the employer himself. These costs are not actually
incurred but would have been incurred in the absence of employment of self – owned factors. The
two normal implicit costs are depreciation, interest on capital etc. A decision maker must consider
implicit costs too to find out appropriate profitability of alternatives.

3. Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as
the original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset.
During periods of substantial change in the price level, historical valuation gives a poor projection of
the future cost intended for managerial decision. A replacement cost is a relevant cost concept when
financial statements have to be adjusted for inflation.

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4. Short – run and long – run costs:
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in
output during this period is possible only by using the existing physical capacity more extensively. So
short run cost is that which varies with output when the plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant
and capital equipment. Long-run cost analysis helps to take investment decisions.

5. Out-of pocket and books costs:

Out-of pocket costs also known as explicit costs are those costs that involve current cash payment.
Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid
interest, salary of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a
period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost
of self-owned factors of production.

6. Fixed and variable costs:

Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is
increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output
results in an increase in total variable costs and decrease in total output results in a proportionate
decline in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials,
labour, direct expenses, etc.

7. Post and Future costs:

Post costs also called historical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not actual
costs. They are the costs forecasted or estimated with rational methods. Future cost estimate is
useful for decision making because decision are meant for future.

8. Traceable and common costs:

Traceable costs otherwise called direct cost, is one, which can be identified with a products process
or product. Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product.
They are incurred collectively for different processes or different types of products. It cannot be
directly identified with any particular process or type of product.

9. Avoidable and unavoidable costs:

Avoidable costs are the costs, which can be reduced if the business activities of a concern are
curtailed. For example, if some workers can be retrenched with a drop in a product – line, or volume
or production the wages of the retrenched workers are escapable costs.

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The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost
even if reduction in business activity is made. For example cost of the ideal machine capacity is
unavoidable cost.

10. Controllable and uncontrollable costs:

Controllable costs are ones, which can be regulated by the executive who is in change of it. The
concept of controllability of cost varies with levels of management. Direct expenses like material,
labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to
various processes or products in some proportion. This cost varies with the variation in the basis of
allocation and is independent of the actions of the executive of that department. These apportioned
costs are called uncontrollable costs.

11. Incremental and sunk costs:

Incremental cost also known as different cost is the additional cost due to a change in the level or
nature of business activity. The change may be caused by adding a new product, adding new
machinery, replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future decisions. Investments
in fixed assets are examples of sunk costs.

12. Total, average and marginal costs:

Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of output.
If is obtained by dividing the total cost (TC) by the total quantity produced (Q)
TC
Average cost = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost
of the marginal unit produced.

13. Accounting and Economics costs:

Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and
ton statements to meet the legal, financial and tax purpose of the company. The accounting concept
is a historical concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning,
and choice, while the accountant describes what has happened, the economics aims at projecting
what will happen.

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 COST-OUTPUT RELATIONSHIP

A proper understanding of the nature and behavior of costs is a must for regulation and control of
cost of production. The cost of production depends on money forces and an understanding of the
functional relationship of cost to various forces will help us to take various decisions. Output is an
important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing,
promotion etc. The relation between cost and its determinants is technically described as the cost
function.

C= f (S, O, P, T ….)

Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology

Considering the period the cost function can be classified as (a) short-run cost function and (b) long-
run cost function. In economics theory, the short-run is defined as that period during which the
physical capacity of the firm is fixed and the output can be increased only by using the existing
capacity allows to bring changes in output by physical capacity of the firm.

(a) Cost-Output Relation in the short-run:

The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.

Total cost is the actual money spent to produce a particular quantity of output. Total cost is the
summation of fixed and variable costs.

TC=TFC+TVC

Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc,
remains fixed. But the total variable cost i.e., the cost of labour, raw materials etc., Vary with the
variation in output. Average cost is the total cost per unit. It can be found out as follows.

TC
AC=
Q
Q
The total of average fixed cost (TFC/Q) keep coming down as the production is increased and
average variable cost (TVC/Q) will remain constant at any level of output.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 15
Marginal cost is the addition to the total cost due to the production of an additional unit of product. It
can be arrived at by dividing the change in total cost by the change in total output.

In the short-run there will not be any change in total fixed cost. Hence change in total cost implies
change in total variable cost only.

Cost – output relations

Units of Total Total Total Average Average Average Marginal

Output fixed variable cost variable fixed cost cost
Q cost TFC cost (TFC + cost cost (TC/Q) MC
TVC TVC) TC (TVC / (TFC / AC
Q) AVC Q) AFC
0 - - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42

The above table represents the cost-output relation. The table is prepared on the basis of the law of
diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance etc. The table shows that fixed cost is
same at all levels of output but the average fixed cost, i.e., the fixed cost per unit, falls continuously
as the output increases. The expenditure on the variable factors (TVC) is at different rate. If more
and more units are produced with a given physical capacity the AVC will fall initially, as per the table
declining up to 3rd unit, and being constant up to 4th unit and then rising. It implies that variable
factors produce more efficiently near a firm’s optimum capacity than at any other levels of output.

And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising
from the 5th unit onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’
declines ‘AC’ also will decline. ‘AFC’ continues to fall with an increase in Output. When the rise in
‘AVC’ is more than the decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage
where the ‘AVC’, the total cost again begin to rise thus there will be a stage where the ‘AVC’ may
have started rising, yet the ‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in
‘AFC’.

Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing
returns or diminishing cost in the second stage and followed by diminishing returns or increasing cost
in the third stage.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 16
The short-run cost-output relationship can be shown graphically as follows.

In the above graph the “AFC’ curve continues to fall as

output rises an account of its spread over more and more
units Output. But AVC curve (i.e. variable cost per unit) first
falls and than rises due to the operation of the law of variable
proportions. The behavior of “ATC’ curve depends upon the
behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial stage of
production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also
decline. But after a certain point ‘AVC’ starts rising. If the rise
in variable cost is less than the decline in fixed cost, ATC will
still continue to decline otherwise AC begins to rise. Thus the
lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped.
The lowest point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total
average cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the
maximum output level rather it is the point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

b. Cost-output Relationship in the long-run:

Long run is a period, during which all inputs are variable including the one, which are fixes in the
short-run. In the long run a firm can change its output according to its demand. Over a long period,
the size of the plant can be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their operation by bringing or
purchasing larger quantities of all the inputs. Thus in the long run all factors become variable.

The long-run cost-output relations therefore imply the relationship between the total cost and the
total output. In the long-run cost-output relationship is influenced by the law of returns to scale.

In the long run a firm has a number of alternatives in regards to the scale of operations. For each
scale of production or plant size, the firm has an appropriate short-run average cost curves. The
short-run average cost (SAC) curve applies to only one plant whereas the long-run average cost
(LAC) curve takes in to consideration many plants.

The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 17
To draw on ‘LAC’ curve (Below Figure) we have to start with a number of ‘SAC’ curves. In the above
figure it is assumed that technologically there are only three sizes of plants – small, medium and
large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If
the firm wants to produce ‘OP’ units of output, it will choose the smallest plant. For an output beyond
‘OQ’ the firm wills optimum for medium size plant. It does not mean that the OQ production is not
possible with small plant. Rather it implies that cost of production will be more with small plant
compared to the medium plant.
For an output ‘OR’ the firm will choose the
largest plant as the cost of production will
be more with medium plant. Thus the firm
has a series of ‘SAC’ curves. The ‘LCA’
curve drawn will be tangential to the
entire family of ‘SAC’ curves i.e. the ‘LAC’
curve touches each ‘SAC’ curve at one
point, and thus it is known as envelope
curve. It is also known as planning curve
as it serves as guide to the entrepreneur
in his planning to expand the production
in future. With the help of ‘LAC’ the firm
determines the size of plant which yields
the lowest average cost of producing a
given volume of output it anticipates.

BREAKEVEN ANALYSIS

The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in
two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total
revenue is equal to total cost. It is the point of no profit, no loss. In its broad determine the probable
profit at any level of production.

Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 18
Merits:

1. Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how
changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct material,
direct labour, fixed and variable overheads.

Demerits:

1. Break-even chart presents only cost volume profits. It ignores other considerations such as
capital amount, marketing aspects and effect of government policy etc., which are necessary
in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In
actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may increase
the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be
opening stock.
10.When production increases variable cost per unit may not remain constant but may reduce on
account of bulk buying etc.
11.The assumption of static nature of business and economic activities is a well-known defect of
BEC.
1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 19
1. Fixed cost:
Expenses that do not vary with the volume of production are known as fixed expenses. Eg.
Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only
within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a
price fixing policy. Fixed cost per unit is not fixed.

2. Variable Cost:
Expenses that vary almost in direct proportion to the volume of production of sales are called
variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It should be
noted that variable cost per unit is fixed.

3. Contribution:
Contribution is the difference between sales and variable costs and it contributed towards fixed
costs and profit. It helps in sales and pricing policies and measuring the profitability of different
proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued
among different products.

Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.

4. Margin of safety:
Margin of safety is the excess of sales over the break even sales. It can be expressed in absolute
sales amount or in percentage. It indicates the extent to which the sales can be reduced without
resulting in loss. A large margin of safety indicates the soundness of the business. The formula for
the margin of safety is:
Profit
Present sales – Break even sales or
P. V. ratio

Margin of safety can be improved by taking the following steps.

1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

5. Angle of incidence:
This is the angle between sales line and total cost line at the Break-even point. It indicates the
profit earning capacity of the concern. Large angle of incidence indicates a high rate of profit; a small
angle indicates a low rate of earnings. To improve this angle, contribution should be increased either
by raising the selling price and/or by reducing variable cost. It also indicates as to what extent the
output and sales price can be changed to attain a desired amount of profit.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 20
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying
the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed
in percentage. Therefore, every organization tries to improve the P. V. ratio of each product by
reducing the variable cost per unit or by increasing the selling price per unit. The concept of P. V.
ratio helps in determining break even-point, a desired amount of profit etc.

Contributi on
The formula is, X 100
Sales
7. Break – Even- Point: If we divide the term into three words, then it does not require further
explanation.

Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of
no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum
point of production where total costs are recovered. If sales go up beyond the Break Even
Point, organization makes a profit. If they come down, a loss is incurred.

Fixed Expenses
1. Break Even point (Units) =
Contributi on per unit
Fixed expenses
2. Break Even point (In Rupees) = X sales
Contributi on

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 21
 QUESTIONS

 Why does the law of diminishing returns operate? Explain with the help of a diagram.

 Explain the nature and uses of production function.

 Explain and illustrate lows of returns to scale.

 a. Explain how production function can be mode use of to reduce cost of

Production.
b. Explain low of constant returns? Illustrate.

 Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing returns to scale.

 Explain the following with reference to production functions

(a) MRTS
(b) Variable proportion of factor

 Define production function, explain is equate and is cost curves.

 Explain the importance and uses of production function in break-even analysis.

 Discuss the equilibrium of a firm with isoquants.

 (a) What are isocost curves and iso quants? Do they interest each other
(b) Explain Cobb-Douglas Production function.

 What cost concepts are mainly used for management decision making? Illustrate.

 The PV ratio of matrix books Ltd Rs. 40% and the margin of safety Rs. 30. You are required to
work out the BEP and Net Profit. If the sales volume is Rs. 14000/-

 A Company reported the following results for two period

Period Sales Profit

I Rs. 20,00,000 Rs. 2,00,000
II Rs. 25,00,000 Rs. 3,00,000

Ascertain the BEP, PV ratio, fixes cost and Margin of Safety.

 Write short notes on the following

a) Profit – Volume ratio
b) Margin of Safety

 Write short notes on: (i) Suck costs (ii) Abandonment costs

 The information about Raj & Co are given below:

PV ratio : 20%
Fixed Cost : Rs. 36,000/-
Selling Price Per Unit: Rs. 150/-
Calculate (i) BEP in rupees (ii) BEP in Units
(iii) Variable cost per unit
(iv) Contribution per unit

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 22
  Define opportunity cost. List out its assumptions & Limitation.

 (a) Explain the utility of BEA in managerial decision making

(b) How do you explain break even chart? Explain.

 Write short motes on:

(i) Fixed cost & variable cost
(ii) Out of pocket costs & imputed costs
(iii) Explicit & implicit Costs
(iv) Short rum cost

 Write short note on the following:

(c) PV ratio
(d) Margin of Safety
(e) Angle of incidence
(f)
 Explain Cost/Output relationship in the short run.

 Appraise the usefulness of BEA for a multi product organization

 Describe the BEP with the help of a diagram and its uses in business decision making.

 If sales in 10000 units and selling price Rs. 20/- per unit. Variable cost is Rs. 10/- per unit and
fixed cost is Rs. 80000. Find out BEP in Units and sales revenue what is profit earned? What should
be the sales for earning a profit of Rs. 60000/-

 How do you determine BEP in terms of physical units and sales value? Explain the concepts of
margin of safety & angle of incidence.

 Sales are 1,10,000 producing a profit of Rs. 4000/- in period I, sales are 150000 producing a profit
of Rs. 12000/- in period II. Determine BEP & fixed expenses.

 When a Mc change does Ac changed (a) at the same rate (b) at a higher rate or (c) at a lower
rate? Illustrate your answer with a diagram.

 Explain the relationship between MC, AC and TC assuming a short run non-linear cost function.

 Sale of a product amounts to 20 units per months at Rs. 10/- per unit. Fixed overheads is Rs.
400/- per month and variable cost is Rs. 6/- per unit. There is a proposal to reduce prices by 107.
Calculate present and future P-V ratio. How many units must be sold to earn a target profit of
present level?

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 23
 QUIZ

1. How many types of input-output relations discussed by the Law of production.

( )
(a) Five (b) Four
(c) Two (d) Three

2. How many stages are there in ‘Law of Variable Proportions’? ( )

(a) Five (b) Two
(c) Three (d) Four

3. Congregation of body of persons assembling together to work at a certain

Time and place is called as ( )
(a) Firm (b) Industry
(c) Plant (d) Size

4. When a firm expands its Size of production by increasing all factors,

It secures certain advantages, known as ( )
(a) Optimum Size (b) Diseconomies of Scale
(c) Economies of Scale (d) None

5. When producer secures maximum output with the least cost combination
Of factors of production, it is known as_______ ( )
(a) Consumer’s Equilibrium (b) Price Equilibrium
(c) Producer’s Equilibrium (d) Firm’s Equilibrium

6. The ‘Law of Variable Proportions’ is also called as ____________. ( )

(a) Law of fixed proportions (b) Law of returns to scale
(c) Law of variable proportions (d) None

7. _________ Is a ‘group of firms producing the same are slightly

Different products for the same market or using same raw material’. ( )
(a) Plant (b) Firm
(c) Industry (d) Size

8. When proportionate increase in all inputs results in an equal

Proportionate increase in output, then we call____________. ( )
(a) Increasing Returns to Scale (b) Decreasing Returns to Scale
(c) Constant Returns to Scale (d) None

9. When different combinations of inputs yield the same level of output

Known as ___________. ( )
(a) Different Quants (b) Output differentiation
(c) Isoquants (d) Production differentiation

10. Conversion of inputs in to output is called as _________________. ( )

(a) Sales (b) Income
(c) Production (d) Expenditure

11. When Proportionate increase in all inputs results in more than equal
Proportionate increase in output, then we call _____________. ( )
(a) Decreasing Returns to Scale (b) Constant Returns to Scale

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 24
 (c) Increasing Returns to Scale (d) None

12. When Proportionate increase in all inputs results in less than Equal
Proportionate increase in output, then we call _____________. ( )
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None

13. A curve showing equal amount of outlay with varying Proportions of

Two inputs are called ________________. ( )
(a) Total Cost Curve (b) Variable Cost Curve
(c) Isocost Curve (d) Marginal Cost Curve

Note: Answer is “C” for all the above questions.

Copyright © 2010 B.Tech Study Circle. All Rights Reserved Submitted by Deepak 25