Chapter six

6. Production and Cost analysis

6.1 Production Function
A production function can be an equation, table or graph presenting the maximum amount of a
commodity that a firm can produce from a given set of inputs during a period of time. The
concept of production function portrays the ways in which the factors of production are
combined by a firm to produce different levels of output. More specifically, it shows the
maximum volume of physical output available from a given set of inputs or the minimum set of
inputs necessary to produce any given level of output.
The production function is determined by a given state of technology. When the technology
improves the production function changes, because the new production function can yield greater
output from the given inputs or smaller inputs will be enough to produce a given level of output.
Further, the production function incorporates the idea of efficiency. Therefore, the production
function includes all the technically efficient methods of producing an output.
Example: Technically Efficient Method of Production
Let us suppose that commodity X is produced by two methods by using labour and capital:

In the above example, method B is inefficient compared to method A because method B uses
more of labour and same amount of capital as compared to method A. Aprofit maximising firm
will not be interested in improvident or inefficient methods of production.
If method A uses less of one factor and more of the other factor as compared with any other
method C, then method A and C are not directly comparable. For example, let us suppose that a
commodity is produced by two methods:

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In the above example, both methods A and C are technically efficient and are included in the
production function, which one of them would be chosen depends on the prices of factors. The
choice of any particular technique from a set of technically efficient techniques (or methods) is
an economic one, based on prices and not a technical one.
In a production function, the dependent variable is the output and the independent variables are
the inputs. Thus, the production function can be expressed as
Q = ƒ (N,L,K,E,T)
Where, Q = Quantity Produced, N = Natural resources, L = Labour, K = Capital, E
=Entrepreneur or organizer and T = Technology.
For simplicity, only the inputs of labour and capital are considered independent variables in a
production function. Normally, land does not enter the production function explicitly because of
the implicit assumption that land does not impose any restriction on production. However, labour
and capital enter production explicitly. A simple specification of a production function is
Q = ƒ (L, K)
Where Q, as above, is the output, L and K are the quantities of labour and capital and ƒ shows
the functional relation between the inputs and output.
6.1.1 TYPES OF PRODUCTION FUNCTION
Production function is of two different forms:
1. The fixed proportion production function
2. The variable proportion production function
1. Fixed Proportion Production Function
A fixed proportion production function is one in which the technology requires a fixed
combination of inputs, say capital and labor, to produce a given level of output. There is only one

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way in which the factors may be combined to produce a given level of output efficiently. In this
type of production, there is no possibility of substitution between the factors of production.
The fixed proportion production function is illustrated by isoquants which are ‘L’shaped or ‘right
angle’ shaped. This is shown in Fig. 6.1 below.

Suppose that at point A, the output is one unit. The isoquant Q1 passing through the point A1
shows that one unit of output is produced by using 2 units of capital and 3 units of labour. In
other words, the capital-labour ratio is 2:3. In this case with 2 units of capital, any increase in
labour beyond 3 units will not increase output and, therefore, labour beyond 3 units is redundant.
Similarly, with 3 units of labour, any increase in capital beyond 2 units is redundant. The kink
point shows the most efficient combination of factors. The capital labour ratio must be
maintained for any level of output. The output can be doubled by doubling the quantity of inputs,
that is, two units of output can be produced by 4 units of capital and 6 units of labour. Thus
isoquant Q2, the line OA describes a production process, that is, a way of combining inputs to
obtain certain output. The slope of the line shows the capital labor ratio.
The fixed proportion production function is characterized by constant returns to scale, that is, a
proportionate increase in inputs leads to a proportionate increase in outputs.
This type of production function provides the basis for the input-output analysis in economics.
Thus, this type of isoquant is also called input-output isoquant.

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2. Variable Proportions Production Function
The variable proportion production function is the most familiar production function. In this
case, a given level of output can be produced by several alternative combinations of factors of
production, say capital and labour. It is assumed that the factors can be combined in infinite
number of ways. The common level of output obtained from alternative combinations of capital
and labour is given by an isoquant Q in Fig. 6.2, given below:

Fig. 3.2: Variable Proportions Production Function

The isoquant Q is the locus of efficient points of factor combinations to produce a given level of
output. The isoquant is continuous, smooth and convex to the origin. It assumes continuous
substitutability of capital and labour over certain range, beyond which factors cannot substitute
each other.

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6.1.1 SHORT RUN AND LONG RUN PRODUCTION FUNCTION
The short run is a phase in which the organization can alter manufacturing by changing variable
factors such as supplies and labor but cannot change fixed factors such as capital.
The long run is a phase adequately long so that all factors together with capital can be altered.
The factors which can be increased in the short run are called variable factors, since they can be
easily changed in a short period of time. Hence, the level of production can be increased within
the limits of existing plant capacity during the short run. Thus, the short run production function
proves that in the short run the output can be increased by changing the variable factors, keeping
the fixed factors constant. The behavior of production in the short-run where the output can be
increased by increasing one variable factor keeping other factors fixed is called law of variable
proportions.
6.2 Cost Function
Cost function is a derived function. It is derived from the production function, which describes
the efficient method of production at any given time. The production function specifies the
technical relationships between inputs and the level of output. Thus, cost will vary with the
changes in the level of output, nature of production function, or factor prices. Thus,
symbolically, we may write the cost function as
C = ƒ(X, T, Pf)
Where, C = Total cost, X = Output, T = Technology, Pf = Prices of factors.
Total cost is evidently, an increasing function of output, C = ƒ (X), ceterius paribus. The clause
'ceteris paribus' implies that 'all other factors which determine costs are constant'. If these factors
change, they will affect the cost. The technology is itself determined by the physical quantities of
the factor inputs, the quality of the factor inputs, the efficiency of the entrepreneur, both in
organizing the physical side of the production and in making the correct economic choice of
techniques. Thus, any change in these determinants will shift the production function and hence
will shift the cost curve. For instance, the introduction of a better method of organising
production or the application of an educational programme to the existing labour will shift the
production function upwards and hence will shift down the cost curve. Similarly, the
improvement of raw material, or the improvement in the use of the same raw materials will lead
to a downward shift of the cost function.

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Of all the determinants of cost, the cost-output relationship is considered as the most important
one. Thus, in economic analysis the cost function is analysed with respect to output. This is
because the cost-output relationship is subject to faster and more frequent changes. The
relationship between cost and output is analysed with respect to short-run and long-run.
6.2.1 SHORT RUN COST FUNCTION
In the short-run the firm cannot change or modify overhead factors such as plant, equipment and
scale of its organization. In the short-run output can be increased or decreased by changing the
variable inputs like labor, raw material, etc. Thus, the short-run costs of production are
segmented into fixed and variable costs. On the other hand, in the long-run all factors can be
adjusted. Hence, in the long run all costs are variable and none are fixed.
1) Total Cost: Fixed and Variable
The total cost (TC) of the firm is a function of output (q). It will increase with the increase in
output, that is, it varies directly with the output. In symbols, it can be written as
TC = ƒ(q)
Since the output is produced by fixed and variable factors, the total cost can be divided into two
components: total fixed cost (TFC) and total variable cost (TVC).
TC = TFC + TVC
 Fixed Cost
Fixed costs are those which are independent of output. They must be paid even if the firm
produces no output. They will not change even if output changes. They remain fixed whether
output is large or small. Fixed costs are also called 'overhead costs', 'sunk costs' or
'supplementary costs'. They comprise payments such as rent, interest, insurance, depreciation
charges, maintenance costs, property taxes, administrative expense like manager’s salary and so
on. In the short period, the total amount of these fixed costs will not increase or decrease when
the volume of the firms output rises or falls (See Table 6.1).
 Variable Cost
Variable costs are those which are incurred on the employment of variable factors of production.
They vary with the level of output. They increase with the rise in output and decrease with the
fall in output. By definition, variable costs remain zero when output is zero. They include
payments for wages, raw materials, fuel, power, transport and the like. The relation between total

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variable cost and output may not be linear, that is, variable cost may not increase by the same
amount for every unit increase in output. This is shown in the table mentioned below:
Table 6.1: A Schedule of a Firm's Total Cost
Output (q) Total Fixed Total Total Cost
(1) Cost (TFC) (2) Variable(3) (TC)(4)
0 100 0 100
1 100 25 125
2 100 40 140
3 100 50 150
4 100 70 170
5 100 100 200
6 100 145 145
7 100 205 305
8 100 285 385
9 100 385 485
10 100 515 615

Table 6.1 shows a simplified cost schedule showing the relation between costs for each different
levels output. We can observe the following relations:
The column (2) shows that TFC remains fixed at all levels output.
The column (3) shows that TVC varies with the output and it is zero when the output is nil. It
can also be observed from the column (3) that TVC does not change in the same proportion. In
the beginning, as output increase, TVC increase at decreasing rate but after a point it increases at
an increasing rate. This is due to the operation of the law of variable proportions.
The column (4) shows that total costs are equal to fixed plus variable costs. TC varies with the
change in output in the same proportion as the TVC.
The above costs and output relations are also shown in Fig 6.3. data of Table 6.1, graphically and
joining the plotted points by smooth curves, we can obtain total fixed, total variable and total
cost curves.

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Fig. 6.3: Total Cost Curves
It can be seen from Fig 6.3 that since total fixed cost remains constant, TFC curve is parallel to
the X-axis. The TVC curve begins at zero and then rises gradually in the beginning and
eventually, becomes steeper as the output rises. The TC curve is obtained by adding up vertically
TFC and TVC curves. The shape of the TC curve is exactly the same as that of TVC curve
because the same vertical distance separates TC and TVC curves.
2) Unit Costs
There are four different kinds of unit costs, viz. average total cost (or as usually called average
cost), average fixed cost, average variable cost and marginal cost.
Average Total Cost (ATC)
One of the most important cost concepts is average total cost. when we compared price or
average revenue it will allow a business to determine whether or not it is making a profit.
Average total cost is total cost divided by the number of units produced i.e.

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Since, the total cost is the sum of total fixed cost and total variable cost, the average total cost is
also the sum of average fixed cost (AFC) and average variable cost (AVC).
Average Total Cost (ATC) = Average Fixed Cost (AFC) + Average Variable Cost (AVC).
Average Fixed Cost (AFC)
By dividing total fixed cost by output we get average fixed cost

Since, the same amount of fixed cost is shared equally between the various, units of output; AFC
falls continuously as output rises.
Average Variable Cost (AVC)
Average variable cost is total variable cost divided by output. Thus,

Marginal Cost (MC)

Marginal cost is the extra or additional cost of producing one extra unit of output. In economics
the term ‘marginal’ whether applied to utility, cost, production, consumption or whatever means
‘incremental’ or ‘extra’. Thus, marginal cost is the total cost of n units of output minus cost of n-
1 units. In symbol

Since, fixed costs do not change with outputs; MC is independent of fixed cost. On the other
hand, variable costs vary with output in the short-run and therefore, MC can be calculated from
total variable cost. Hence, marginal cost is the addition to the total variable cost for producing an
additional unit of output. In other words, marginal cost is equal to the change in TVC.
Computation of AC, AFC, AVC and MC

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The computation of AC, AFC, AVC and MC and their relationships are illustrated by a
hypothetical example and it is shown in Table 6.2
Output Total Fixed Total Total Marginal Average Average Average
(q) Cost (TFC) Variable Cost Cost, Total Cost Fixed Variable
(TC), ATC =TC/q Cost Cost
TC =TFC or ATC AFC = AVC =
+ TVC =AVC + AFC TFC / q TFC / q
(1) (2) (3) (5) (6) (7) (8)
(4)
0 100 0 100 -
1 100 25 125 25 125 100 25
2 100 40 140 15 70 50 20
3 100 50 150 10 50 33.3 16.7
4 100 70 170 20 42.5 25 17.5
5 100 100 200 30 40 20 20
6 100 145 145 45 40.8 16.6 24.2
7 100 205 305 60 43.6 14.3 29.3
8 100 285 385 80 48.1 12.5 35.6
9 100 385 485 100 53.9 11.1 42.8
10 100 515 615 130 61.5 10 51.5
Column (7) shows that AFC declines continuously as output increases. We can observe from
column (8) that AVC falls initially, reaches a minimum and eventually rises with the increase in
output. From column (6) we can see that ATC too falls initially, reaches the minimum and then
rises as output increases. It can also be seen that ATC is the sum of AFC and AVC. Column (5)
shows that MC too behaves in the same way as AVC and ATC.
Relationship between AC, AFC, AVC and MC Curves
The relationship between AC, AFC, AVC and MC is explained graphically by drawing
respective cost curves in Fig. 6.4. The behavior of cost curves is explained below.

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The relationship between AVC, ATC and MC can be summarized as follows:
• AVC, ATC and MC fall first, then reach a minimum and finally rise as output increases.
• The rate of change in MC is greater than that in AVC and therefore the MC is lowest at an
output lower than the output at which AVC is lowest.
• The ATC falls for a longer range of output than the AVC and therefore the minimum ATC is at
a larger output than the minimum AVC.
• MC = AVC, when AVC is lowest.
• MC = ATC, when ATC is minimum.
RELATION BETWEEN AC AND MC
The relationship between AC and MC are the following:
If MC is below AC, then AC must be falling. This is because, if MC is below AC, then the last
unit produced costs less than the AC of all the earlier units produced. If the last unit costs less
than the earlier ones, then the new AC must be less than the old AC. Hence, AC must be falling.
If MC is above AC, then the cost of the last unit produced will be higher than the AC of the
earlier units. Hence, the new AC must be higher than old AC. Therefore, when MC is above AC,
AC must be rising.

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If MC is equal to AC, the last unit costs exactly the same as the AC of all earlier units. Hence the
new AC is equal to old AC. Thus, the AC curve is flat when AC equals MC. The above
mentioned relationship between AC and MC can be seen clearly with the help of figure 6.5

Fig; 6.5 AC and MC relationship

LONG RUN COST FUNCTION
Corresponding to each scale or size of the plant there will be an average cost curve. Hence, the
long run is a series of alternative short run average cost curves, associated with different plants,
out of which a choice is to be made by the firm for its actual operation. The long run average
cost curve is derived from a number of short run average cost (SAC) curves.

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Fig; 6.7 Long run Average Cost Curve

The above figure is drawn on the assumption that there are three plants and they are depicted by
the short run average cost curves SAC1, SAC2 and SAC3. A given plant is best suited for a
particular level of output. It can be seen from Fig. 6.7 that output OL can be produced at a lower
cost with the plant SAC1, than with the plant SAC2. The cost of producing OL output on plant
SAC1, is AL and it is less than the cost of producing the same output with plant SAC2. The
difference in cost is equal to AB. If the firm wants to produce ON output it can produce it either
by plant SAC1, or plant SAC2. But it would be advantageous for the firm to use the plant SAC2
for ON level of output because the larger output OM can be obtained at the lowest average cost
from this plant. Thus, output larger than ON but less than OQ can be produced at a lower average
cost with plant SAC2. For output larger than OQ the firm will have to employ plant SAC3. For
instance output OP can be produced at average cost of PE with plant SAC3.
Hence, the LAC curve is the locus of the points of the lowest average cost of producing various
levels of output.

6.8 Long run Smooth Envelope Curve

It should be noted that, with one exception, the LAC curve is not tangent to the minimum points
of the short run average cost curves. This exception occurs at the optimum level of output. In

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Fig. 6.8, this occurs at output OM at which the lowest point of SAC3 coincides with the
minimum point on the LAC curve at point R. The plant SAC which produces the optimum
output OM at the minimum cost RM is the optimum plant. For outputs less than OM the lowest
long run costs occur on the falling portions of SAC curves. In Fig. 6.8, LAC curve is tangent to
falling portions of SAC1 and SAC2 at points S and T are not the minimum points of SAC1 and
SAC2. On the other hand, for outputs greater than OM, the lowest long run average costs occur
on the rising portions of short run average cost curves.
6.3 Economies and Diseconomies of scale
Economies of scale allude to the cost advantages that a business obtains due to expansion.
'Economies of scale' is a long run concept and refers to reductions in unit cost as the size of a
facility and the usage levels of inputs increases. Diseconomies of scale are the opposite.
Economies and diseconomies of scale are of two types- internal and external.
Internal economies and diseconomies are those which a firm reaps as a result of its own
expansion. On the other hand, external economies and diseconomies are those which a firm
accrues as a result of the growth of industry as a whole. They are external because they accrue to
the firms from outside.
The internal economies and diseconomies of scale affect the shape of the long run average cost
curve. Internal economies of scale cause the long run average cost to fall, while internal
diseconomies of scale causes the long run average cost to rise as output increases.
On the other hand, external economies and diseconomies of scale affect the position of both the
short run and long run average cost curves. External economies shift down the cost curve, while
external diseconomies shift up the cost curve.
1. Internal Economies of Scale
Internal economies of scale are the advantages of large scale production. They are enjoyed by the
firm when it increases its scale of production. They accrue to the firm from their own actions.
They affect the shape of the long-run average cost curve. They are responsible for increasing
returns to scale.
2. Internal Diseconomies of Scale
If the size of the plant increases beyond this optimum size there arise diseconomies of scale (i.e.
decreasing returns to scale) especially from managerial diseconomies. It is argued that technical
diseconomies can be avoided by duplicating the optimum technical size of the plant.

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Thus, increase in the size of the plant beyond a certain large size makes the managerial structure
more complicated and reduces the overall efficiency of the management.
Another cause for diseconomies of scale may be the exhaustible natural resources.
E.g., increasing the fishing fleet may not cause an increase in catching of the fish.

3. External Economies
The external economies arise outside the firm as a result of improvement in the industrial
environment in which the firm operates. They are external to the firm, but internal to the industry
to which the firms belong. They may be realized from the actions of other firms in the same
industry or in another industry. Their effect is to cause a change in the prices of factors employed
by the firm. They cause a shift in the short-run and long-run cost curves of the firm.
4. External Diseconomies
The expansion of an industry is likely to generate external diseconomies which raise the cost of
production. An increase in the size of industry may raise the prices of some factors like raw
materials and capital goods which are in short supply. Expansion of an industry may also elevate
the wages of skilled labour, which are in short supply. It may also create transport bottlenecks.
As the size of an industry expands lakes, rivers and seas may be polluted by firms. This will
create external diseconomies to some other firms or industries, for example, the fishing industry.
Pollution of this sort will also create health hazards to the people in the adjoining areas.
Expansion of an industry may also pollute the air from the smoke of factories or fumes of
vehicles. This too will have similar diseconomies.
Thus, several external diseconomies may be generated by the expansion of the size of an industry
(or industries) and they will raise the costs of the individual firms.

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