Unit -3

Production, cost and profit analysis

Production analysis
Production –production is the process of transforming inputs into output or
goods and services.
Concept of Total , average and marginal product
a. Total product(TP)
simple terms, we can define Total Product as the total volume or amount of final
output produced by a firm using given inputs in a given period of time.
It is the efforts of all factors of production.
TP is the sum of marginal product
TP=AP*L
b. Average product(AP)
It is defined as the output per unit of factor inputs or the average of the total
product per unit of input and can be calculated by dividing the Total Product by the
inputs (variable factors).
AP=TP/L
C. Marginal product (MP)
The additional output produced as a result of employing an additional
unit of the variable factor input is called the Marginal Product. Thus,
we can say that marginal product is the addition to Total Product when
an extra factor input is used.
• Marginal Product = Change in Output/ Change in Input
• Thus, it can also be said that Total Product is the summation of
Marginal products at different input levels.
• Total Product = Ʃ Marginal Product
 Production function
• Production function is the functional relationship between inputs and
outputs.
• It show the maximum possible output which can be produced by the
given quantities of inputs.
Production function can be expressed
Q= f(Ld, L, K,O,T)
Types of production function
1. Short run production function
2. Long run production function
1 – Short Run
• The firm cannot vary its input quantities in the short-run production function. The law of variable
proportion gets applicable here. There is no change in the level of activity in the short-run
function. The ratio of factors keeps changing because only one input changes concerning all the
other variables, which remain fixed. The manufacturing firms face exit barriers. As a result, they
can be shut down permanently but cannot exit from production.
• For any production company, only the nature of the input variable determines the type of
productivity function one uses. If one uses variable input, it is a short-run productivity function;
otherwise, it is a long-run function.
Short run expressed as
Q=f(L,K) where, L =labour which is variable factor) K=capital , which is fixed factor

2.Long run
The long-run production function, all the inputs are variable such as labor or raw materials during a
certain period. Therefore, the operation is flexible as all the input variables can be changed per the
firm’s requirements. Furthermore, in the production function in economics, the producers can use
the law of equi-marginal returns to scale. It leads to a smaller rise in output if the producer
increases the input even after the optimal production capacity. It means the manufacturer can
secure the best combination of factors and change the production scale at any time. Therefore, the
factor ratio remains the same here.
• Moreover, the firms are free to enter and exit in the long run due to low barriers.
Long run expressed as
Q=f(L,K) where L=unit of labour is variable factor K= capital which is variable factor
 Factors of production
The factors of production are the resources that are used in the process of producing goods and
services. Traditionally, economists recognize four main factors of production, which are often
referred to as the "inputs" needed for the production process. These factors are:
• Land:
• Land includes all natural resources used in the production process. This can encompass
physical land, minerals, water, forests, and other raw materials. It's important to note that
"land" in economics doesn't only refer to soil or terrain but to all natural resources.
• Labor:
• Labor represents the human effort and skill involved in the production of goods and services.
This factor includes both physical and mental contributions by individuals. It encompasses
not only the number of workers but also their skills, education, and training.
• Capital:
• Capital refers to the man-made tools, machinery, buildings, and equipment used in the
production process. It is divided into two types:
• Physical capital: Tangible assets like machinery and buildings.
• Human capital: The skills, knowledge, and expertise of the workforce.
• Entrepreneurship (Organization)
• Entrepreneurship involves the risk-taking individuals who bring together
the other factors of production (land, labor, and capital) to create and
organize a business. Entrepreneurs are responsible for making business
decisions, taking risks, and seeking opportunities in the market.

• These factors work together in the production process. For example,

entrepreneurs combine land, labor, and capital to create goods and
services that meet consumer needs. The efficiency with which these factors
are combined and used influences the productivity and success of the
production process.
• It's worth noting that some modern economic theories expand the factors
of production to include other elements like technology, information, and
organization, recognizing the changing nature of production in
contemporary economies.
 Law of variable proportion
• The Law of Variable Proportions, also known as the Law of Diminishing Marginal Returns, is an
economic principle that describes the relationship between the input factors of production and the
output of goods or services.
• It refers to the short run production function.
• This law was propounded by the economists like joan Robinson, Alfred marshall. Etc.
• This law assumes that all factors of production, except one, are held constant while analyzing the
impact of varying the quantity of that one factor.
At the quantity of variable factor is increased keeping the quantities of other factors constant, initially,
total product, increases at on increasing rate, but after a point increases at a decreasing rate , becomes
maximum, and finally it starts declining.

Assumption
1.No change in technology
2. At least one factor of production is fixed
3. Labour is variable factor
4, All variable factors are equally efficiency
5. This law applied on production only
• On the basis of above given assumption, the law of variable proportion ca be explain
with help of table.
Capital Labour TP AP MP
(Lakh)
10 0 0 0 0
10 1 10 10 10
10 2 30 15 20
10 3 60 20 30
10 4 80 20 20
10 5 90 18 10
10 6 90 15 0
10 7 80 11.4 -10

• From the above table , capital is fixed factors and labour is a variable factor. TP first
increases rate upto 3rd unit of labour and then increases at a decreasing rate upto 5th unit
of labour. It maximum at 5th unit of labour. It become stable at 6th . Thereafter
• Three Stages:
• The law is often explained in terms of three stages:
• Stage 1 - Increasing Returns: Initially, as more units of the
variable factor are employed, the total output increases at an
increasing rate. first stage ends at point E where AP and MP are
equal AP=MP
• Stage 2 - Diminishing Returns: It begins the point B of TP. After a
certain point, additional units of the variable factor lead to a
diminishing increase in total output. Marginal returns start to
decline. second stage ends When TP is maximum and constant
,MP is zero
• Stage 3 - Negative Returns: it begin from point D. If the variable
factor continues to be increased, there comes a point where total
output starts to decrease, and the business experiences negative
returns. It is clear that when TP declines, MP becomes negative.
Iso-quant
• Isoquant is defined as the locus of different combination of any two inputs
(Labour and capital) along which there same level of output.
• This term isoquant has been derivedfrom greek word iso means equal and quant
means quantity.
• Also known as producers indifferences curve, or equal producer curve.
Assumptions.
1. Only two inputs labour and capital
2. Two inputs are imperfect substitutes.
Isoquant schedule
Combination Labours Capital Output
A 1 11 100
B 2 7 100
C 3 4 100
D 4 2 100
E 5 1 100
Isoquant curve
 Isoquant map
• Isoquant map represents a set of isoquants which represents different levels of output.
• In an isoquant map each isoquant shows various combinations of labour and capital which are
capable to produce a given level of output.
• A higher isoquant represents higher level of output and lower isoquant represents a lower level of
output.
Isoquant map
 Properties of isoquant
1. Isoquant has negative slope
2. Isoquant is convex to the origin,
3. Isoquant never intersect with each other.
4. Higher isoquant, higher will be output.

1. Isoquant has negative slope – when unit of labour are increased

unit of capital must be reduced so that output remains same.
2. Isoquant is convex to the origin – convex to the origin due to diminishing
marginal rate of technical substation. Less and less units of capital substituted by
labour in order to maintain same level of output.

3. Isoquant never intersect with each other- if two isoquant intersect with each
other the point of intersection would imply different level of output which is not
possible, so it never intersect eachother
4. higher isoquant higher output- it is due the more units of both
factors.
Slope of the isoquant=MRTSLK = - 𝒅𝑲
𝒅𝑳
=−
𝑴𝑷𝑳
𝑴𝑷𝑲
Where, MRTS = marginal rate of technical substitution
MRTSLK= marginal rate of technical substitution of labour for capital.
MPL= marginal productivity of labour
MPK= marginal productivity of capital.

Isocost line
• An isocost line is a term commonly used in microeconomics to represent all the possible
combinations of two input factors (usually labor and capital) that result in the same total cost for
a firm.
• As isocost line also shows the price of various combination , it is also known as price line.
• Denotes different way to produce a given rate of output.
• An isocost line is defined as the locus of output.
• Isocost line plays a crucial role in determining the combination of inputs.
• The slope of the isocost line shows the ratio of the price of labour to the price of capital or vice
versa.

Mathematically, the isocost line is represented by the equation:

Total outlay( C) =Total expenditure on labour + Total expenditure on capital
C=w⋅L+r⋅K
where:
• C is the total cost.
• w is the wage rate (the cost of one unit of labor).
• L is the quantity of labor.
• r is the rental rate of capital (the cost of one unit of capital).
• K is the quantity of capital.
 Shift in isocost line
Isocost line shifts when there are changes in total outlay or price of
factors of production shifts.
1. Effect of change in total outlay
The outlay is the total amount of expenditure allocated for purchasing factors of
production.
if the total outlay of firm change price of labour and capital remains constant there
is shift in isocost line.
2. Effect of change in price of factors of production or inputs
The isocost line will swing if factor price change, the outlay remaining the constant.
if the price labour rate decrease, the isocost line will swing rightward and vice
versa.
Optimal use/ employment of one variable inputs
• It is short-run production phenomenon.
• It explain how much labour should used by firm in order to maximize
profit.
• at least one factors remain constant.
Assumptions
- Profit maximization is the main objective.
- Single commodity is produced X.
- No change in technology.
- Use only one variable input. (labour)
- Existence of prefect competition. So price remain constant
The equilibrium condition of the firm can be expressed as
DL=SL--- (i)
1. Demand for labour (DL)
-MRPL, VMPL is the demand curve for labour.
- MRPL is the change In TR due to an additional unit of labor employed by the firm.
𝒅𝑻𝑹 𝒅𝑻𝑹 𝒅𝑸
- i.e MRPL= .
𝒅𝑳 𝒅𝑸 𝒅𝑳
- MRPL =MR.MPL =Px . MPL
- MRPL = MR. MPL =Px . MPL
Where ,
MRPL = marginal revenue product of labour
MR= marginal revenue
MPL= marginal product of labour
Px = price ( which is constant) Px=MR
- MRP=DL is downward sloping curve because constant is multiplied with diminishing
MPL.
• 2. Supply of labor (SL)
- Due to constant wage rate, SL curve is horizontal.
- It represents the marginal expenditure (ME) of the firm
Where ,
𝒅𝑻𝑬
ME= (ME=W )
𝒅𝑳

For equation (i)

DL=SL
Or, MRPL= W equilibrium condition
If MRPL >W : labor is increased
If MRPL < W : Labor is decreased.
Optimal use/employment of two variable inputs
• Optimum employment of two inputs is the producer’s equilibrium situation which is also
known as the least cost combination of two inputs.
• The rational producer always seeks to maximize profit. For maximizing profit, a producer
has two ways; either minimize cost of production for producing a given quantity of output
or maximize output for the given level of cost outlay.
• The producer is free to choose any suitable combination or technical possibilities of
factors or inputs which is cost effective. It depends on the possible quantity of outputs
and prices of inputs.
Assumptions:
The concept of least cost combination of two inputs is based on the following assumptions:
• The producer is assumed to be rational.
• There are employed only two inputs labour and capital.
• The prices of inputs and total cost (money outlay) are given.
• All units of inputs are homogenous (same quality).
• MRTS must be diminishing.
• The factor market is perfectly competitive.
• The isoquant map and isocost line exist in case of output maximization and
cost minimization respectively.

Graphical tools
i. Iso-quant
ii. Iso-cost line
Equilibrium condition
1. iso-quant and isocost line must be tangent to each other , ie
slope of IQ=slope of IC line
or MRTS=r/w
2. IQ must be convex to the origin , i.e. MRTS is diminishing
• Case-1 when cost / total cost outlay is given ( constrained output
maximization)
Objective
maximize Q= f(K,L)
Subject to C = rK +wL
Case 2 when output is given ( constrained cost manimization)
Objective
minimize C= rk+Wl
Subject to Q=f(K, L)
Laws of returns to scale
• This law is related to long run production function.
• Where all the factors of production (INPUTS) are changeable.
• It states when all factors of production increase in the same ratio, the
output will also increase, but the increase may be :
-At increasing rate
-At constant rate
- At decreasing rate
There are three types of law to return to scale which are
1. Increasing returns to scale
2. Constant returns to scale
3. Decreasing returns to scale
1.Increasing Returns to Scale:
• This occurs when a proportional increase in all inputs leads to a more than
proportional increase in output.
• In other words, doubling the inputs results in more than a doubling of output.
• This situation is often associated with economies of scale, where the average cost
per unit of output decreases as production increases.

2. Constant Returns to Scale:

• This occurs when a proportional increase in all inputs results in an equal proportional
increase in output.
• Doubling the inputs leads to a doubling of output.
• In this case, the average cost per unit of output remains constant as production
scales up.
3. Decreasing Returns to Scale:
• This occurs when a proportional increase in all inputs leads to less than a
proportional increase in output.
• Doubling the inputs results in less than a doubling of output.