Theory Of Production and Cost

Basic Concepts of Production Theory

Productionis basically an activity of transformation ,
which connects inputs (factors of production) and
outputs.

The process of transforming inputs into outputs can be

any kinds like
◦ Change in the Form
◦ Change in the Place
 Basic Concepts of Production Theory

 Input - resources used to create goods and services.

 Classifications of Inputs

◦ (i) labour
◦ (ii) capital
◦ (iii) land
◦ (iv) raw materials
◦ (v) time
 Output - any good or service that comes out of a production process
 Inputs - variable or fixed
 Short run and Long run
 Fixed input and Variable input
Fixed Variable
 These inputs remain constant  These inputs vary directly with the
regardless of the level of production. level of output,
◦ Example: Factory Buildings, Machinery and ◦ example, Labor, raw materials, and the like.
Equipment and the like.
 In economic sense, a fixed input is one  In economic sense, a variable input is
whose supply is inelastic in the short
one whose supply in the short run is
run
elastic,
 In technical sense, a fixed input is one
 Technically, a variable input is one
that remains fixed (or constant) for
that changes with changes in output.
certain level of output
(In the long run, all inputs are variable)
 Short run and Long run
Short run Long run

– At least one input is fixed – All inputs are variable

– All changes in output achieved by – Output changed by varying usage of all
changing usage of variable inputs inputs
Production Function
A tool of analysis used in explaining the input-output
relationship.
In its general form, it holds that production of a given
commodity depends on certain specific inputs.
In its specific form, it presents the quantitative relationships
between inputs and outputs.
A production function may take the form of a schedule, a
graph line or a curve, an algebraic equation or a
mathematical model.
Production Function
An empirical production function is generally so complex to include a wide range

of inputs: land, labour, capital, raw materials, time, and technology.

These variables form the independent variables in a firm’s actual production

function.

A firm’s long-run production function is of the form:

• Q = f(Ld, L, K, M, T, t)

where Ld = land and building; L = labour; K = capital; M = materials; T =

technology; and, t = time.

Production Function
• For sake of convenience, economists have reduced the number of variables
used in a production function to only two:
capital (K) and labour (L).
Therefore, in the analysis of input-output relations, the production function is
expressed as:
• Q = f(K, L)
Increasing production, Q, will require K and L, and whether the firm can
increase both K and L or only L will depend on the time period it takes into
account for increasing production, that is, whether the firm is thinking in
terms of the short run or in terms of the long run.
Short run production function Q = f ( L,K ) = f ( L )
Long run production function Q = f ( L,K )
Basic Concepts
Production function
◦ Maximum amount of output that can be produced from any
specified set of inputs, given existing technology
Technical efficiency
◦ Achieved when maximum amount of output is produced with a
given combination of inputs
Economic efficiency
◦ Achieved when firm is producing a given output at the lowest
possible total cost
 Short run Production
 Total Product: The total quantity of
output produced by a given quantity of
inputs.

 Average Product: The output

produced per unit of input, calculated
by dividing the total product by the
quantity of input used.

 Marginal Product: The additional

output produced by adding one more
unit of a particular input, holding all
other inputs constant.
Total, Average & Marginal Product Curves
The Three Stages of Production

 Stage I: Stage of Increasing Returns

◦ AP is increasing and the MP is greater than the AP.
Up to point B on the TP curve Stage I exist
◦ AP is increasing, but MP is increasing first up to
point A then decreasing.
 Stage II: Stage of Decreasing Returns
◦ Both AP and MP is decreasing. But MP is positive.
◦ The portion of TP curve between B and C
represents this stage.
 Stage III: Stage of Negative Returns
◦ TP is diminishing and the MP is negative
◦ The portion of TP curve which lies to the right of
point C represents this stage
Law of Diminishing Returns
 As more units of a variable input are added to fixed inputs, the
additional output from each new unit of input will eventually
decrease.

As we go on employing more of one input, other input remaining same,

 the resulting increment of total product will first increase but decreases after a
particular point.
 the marginal productivity will diminish after some point.
(The shape of marginal product curve is therefore Inverted U Shaped)
Stages of Production
In Stage I, MP and AP both
are rising, and the MP is more
than AP.
◦ A given increase in variable
factor leads to a more than
proportionate increase in the
output
◦ The producer is not making the
best possible use of the fixed
factor. A particular portion of
fixed factor remains unutilized
Stages of Production
In Stage II, MP and AP both are
falling and MP though positive, is
less than AP
◦ There is less than proportionate change
in output due to change in labor force
◦ Hence at this stage the producer will
employ the variable factor in such a
manner that the utilization of fixed
factor is most efficient

•In Stage III, MP of variable factor is

negative and the TP is also decreasing.
Long run Production function
The law of production describes the technically possible
ways of increasing the level of output by changing all
factors of production, which is possible only in the long
run
Law of return to scale refers to long run analysis of
production
Returns to Scale
◦ It refers to the effects of scale relationship which implies that is
long run output can be increased by changing all factors by the
same or different proportion
Return to Scale
Q = F (L,K)
ZQ = f(pL, pK)
If all inputs are increased by a factor of p & output goes up
by a factor of z then, in general, a producer experiences
◦ Increasing returns to scale if z > p; output goes up proportionately
more than the increase in input usage
◦ Decreasing returns to scale if z < p; output goes up
proportionately less than the increase in input usage
◦ Constant returns to scale if z = p; output goes up by the same
proportion as the increase in input usage
 Recap
Production Demand Equivalent

 Product  Utility
◦ Total Product ◦ Total Utility
◦ Marginal Product ◦ Marginal Utility
◦ Diminishing returns ◦ Diminishing Marginal utility
◦ Recap
Isoquant
In the long run, all inputs are
variable & Isoquant are used
to study production decisions
◦ An Isoquant is the firm’s
counterpart of the consumer’s
indifference curve
◦ An Isoquant is a curve showing
all possible input combinations
capable of producing a given
level of output
Marginal Rate of Technical Substitution
The MRTS is the slope of an Isoquant & measures the
rate at which the two inputs can be substituted for one
another while maintaining a constant level of output
If the law of diminishing marginal product operates, the
Isoquant will be convex to the origin
A convex Isoquant means that the MRTS between L and
k decreases as L is substituted for K
 Isocost Lines
 Shows various combination of inputs
which may be purchased for given
level of cost and price of inputs
 Co = w.L + r.K
 This equation will be satisfied by
different combinations of L and K.
the locus of all such combinations is
called equal cost line/ or isocost line
 Optimal Combination of Inputs

◦ Minimize total cost of producing

by choosing the input combination
on the isoquant for which is just
tangent to an isocost curve
 Economic Region of Production
 Ridge Lines are lines connecting the points
here the marginal product of an input is
equal to zero in the isoquant map and 
forming the boundary for the economic
region of production.
 The upper ridge line implies that MP of
capital is zero and lower ridge line implies
MP of labor is zero.
 Economic Region of Production is the range
in an isoquant diagram where both inputs
have a positive marginal product. It lies
inside the ridge lines.
 Any production technique or any
combination of labour and capital within
this economic region is technically efficient
for producing output. The area outside these
ridge lines is the technically inefficient area
where production cannot take place.
 Cost of Production

The cost of production refers to the total expenses incurred by

a firm in the process of producing goods or services.
Business decisions are generally taken based on the monetary
values of inputs and outputs.
The quantity of inputs multiplied by their respective unit
prices will give the monetary value or the cost of production.
Importance of Production cost

In all business decisions, especially those decisions

concerning:
◦ the location of the weak points in production management;
◦ cost minimisation
◦ finding the optimal level of output;
◦ determination of price and dealers’ margin; and,
◦ estimation of the costs of business operation.
Category of cost
Concepts used for accounting purposes; and
Analytical cost concepts used in economic analysis of
business activities.
Accounting Cost Concepts
Opportunity Cost and Actual Cost
◦ Opportunity cost can be seen as the expected returns from the
second best use of an economic resource which is foregone due
to the scarcity of the resources
◦ The actual or explicit costs are those out-of-pocket costs of
labour, materials, machine, plant building and other factors of
production
Business and Full Costs

◦ All the expenses incurred to carry out a business are referred to

as business costs
Similar to actual or real costs, and include all the payments and
contractual obligations made by the firm, together with the book cost of
depreciation on plant and equipment
Used in calculating business profits and losses and for filing returns for
income tax and for other legal Purposes.
◦ Full costs include business costs, opportunity costs and normal
profit, while normal profit represents a necessary minimum
earning in addition to the opportunity cost, which a firm must
receive to remain in business
Accounting Cost Concepts
Explicit Costs
◦ These are costs falling under business costs and are those entered in the books
of accounts. Payments for wages and salaries, materials, insurance premium,
depreciation charges are examples of explicit costs
◦ These costs involve cash payments and are recorded in accounting practices
Implicit costs
◦ Those costs that do not involve cash outlays or payments and do not appear in
the business accounting system are referred to as implicit or imputed costs.
◦ Implicit costs are not taken into account while calculating the loss or gains of
the business
The explicit and implicit costs together (explicit +implicit costs) form
the economic cost.
Other cost concepts
 Fixed and Variable Costs
 Total, Average, and Marginal Costs
 Short-Run and Long-Run Costs
 Incremental Costs and Sunk Costs
 Historical and Replacement Costs
 Private and Social Costs
 Book cost
 Out of pocket cost
Total, Average, and Marginal Costs
The Total Cost (TC) refers to the total expenditure on the
production of goods and services
◦ It includes both explicit and implicit costs.
The Average cost (AC) is obtained by dividing total
cost(TC) by total output (Q).
◦ AC = TC/Q
Marginal Cost (MC) is the addition to total cost on
account of producing one additional unit of a product
◦ MC = Change in TC/ Change in Q = ΔTC/ ΔQ
The theory of costs
The theory of costs basically deal with cost-output
relations
The basic economic principle states that total cost
increases with increase in output
However, focus is not the absolute increase in total cost,
but the direction of change in the average cost (AC) and
the marginal cost (MC)
The direction of changes in AC and MC will depend on
the nature of the cost function.
Cost – Output Relationship
A cost function is a symbolic statement of the
technological relationship between the cost and output
◦ C = TC = f(Q), and ΔQ > 0,
The specific form of the cost function depends on the
time framework for cost analysis: short-or long-run
Short Run Costs
Total Variable cost (TVC)
◦ Total amount paid for variable inputs
◦ Increases as output increases
Total Fixed Cost (TFC)
◦ Total amount paid for fixed inputs
◦ Does not vary with output
Total Cost (TC) = TVC + TFC
Short-Run Total Cost Schedules
Average Costs
 Short Run Marginal Cost

Short run marginal cost (SMC) measures rate of change in total

cost (TC) as output varies
Average & Marginal Cost Schedules
Short-Run Production & Cost Relations
Relations Between Short-Run Costs & Production
When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
When marginal product = average product at maximum
AP, marginal cost = average variable cost at minimum
AVC
Short run Cost Function
Cost-output relations are normally determined by the cost function
and are exhibited by cost curves.
The shape of cost curves depends on the nature of the cost function
which are derived from actual cost data
Linear Cost Function.
TC = C = a + bQ
◦ where a = Total Fix Cost (TFC),bQ = Total Variable Cost(TVC)
The Average and Marginal cost functions can be obtained from the
Total Cost Function as follows:
◦ Average Cost (AC) = TC / Q
◦ Marginal Cost (MC) = dTC/dQ
The Long-Run Cost-Output Relations
 long-run is a period for which all inputs change or become variable.
 long-run cost output relations imply the relationship between the
changing scale of a firm and the firm’s total output,
 whereas in the short-run, this relationship is essentially one between
the total output and the variable costs such as, labour and raw materials
 The long-run cost curve (LTC) is composed of a series of short-run cost
curves.
 Assumes that the firm has only one plant, with the corresponding short-
run cost curve given by STC1, Suppose the firm decides to add two
more plants with associated two more short-run cost curves given by
STC2 and STC3
The long-run total cost curve (LTC) is then drawn through the minimum of the
short-run cost curves, STC1,STC2, and STC3
The Long-Run Average Cost Curve (LAC) is derived by combining the short-run average cost curves
(SACs)
Optimum Plant Size and Long-Run Cost Curves
The short-run cost curves are extremely helpful in the determination
of the optimum utilization of a given plant, or in the determination of
the least-cost-output level.
Long run cost curves, on the other hand, can be used to show how a
firm can decide on the optimum size of the firm
The LAC curve is also known in economics as the ‘Envelope Curve’
or ‘Planning Curve’ as it serves as a guide to the entrepreneur in plans
to expand production
The optimum size of the firm is one which ensures the most efficient
utilization of the resources.
The optimum size of a firm is one in which the long-run average cost (LAC)
is minimised
 Recap
Cost-Output Relationships in Short run
◦ Marginal, Average and Total costs
Cost-Output Relationships in Long run
◦ Total cost curve
◦ Average cost curve
 Economies of Scale
 Diseconomies of Scale
 Optimum level
Break-Even Analysis (profit contribution analysis)
A break-even analysis is a financial calculation that
determines the point at which a business, project, or
product will become profitable.
Break-even point (BEP) represents the production
quantity for which the total cost of producing the goods
equals the total sales price.
In this point, a business neither earns any profit nor
suffers any loss. Break-even point is therefore also
known as no-profit, no-loss point or zero profit point.
Break-Even Analysis: Linear Cost and Revenue
Functions
 A cost function is linear when the total cost changes at a constant rate
with changes in the level of output.
 The function can be expressed as:
TC = FC + VC x Q

 A revenue function is linear when the total revenue changes at a

constant rate with changes in the level of output.
 The function can be expressed as:
TR = P x Q
.
 Break-Even Point: Linear Cost and Revenue Functions

At BEP,
Total Revenue (TR) = Total Cost (TC)

Fixed Costs are costs that do not change with the level of production or
sales, such as rent, salaries, insurance, and depreciation.

Variable Costs are costs that vary directly with the level of production or
sales, including costs of raw materials, direct labor, and sales commissions.

Sales Price per unit is the amount at which each unit of the product is sold
Break-Even Chart
Break-even chart is a graphical representation of inter-relationship between quantity
produced, cost of producing and sales return.
Example
The cost function implies a total fixed cost (TFC) of
Rs.100. Its variable cost varies at a constant rate of Rs.10
per unit in response to increases in output
The revenue function implies that the market price for the
firm’s product is Rs.15 per unit of sale
In order to exemplify the break-even analysis under linear
cost and revenue conditions, Let us assume linear cost
function and a linear revenue function as follows:
◦ Cost function: C = 100 + 10Q
◦ Revenue function: R = 15Q
Break-Even Analysis
The break-even analysis is a technique of previewing profit
prospects and a tool of profit planning
It integrates cost and revenue estimates to ascertain the profits
and losses associated with different levels of output.
At the break-even point,
◦ Total Revenue (R) = Total Cost (C), so that in this example,
◦ 15Q = 100 + 10Q
◦ 5Q = 100
◦ Q = 20
It follows that the break-even level of output is 20 units
 Limitations
Breakeven analysis is applicable
only if the cost and revenue
functions are linear.
In case of linear cost and revenue
function, TC and TR are straight
lines and they intersect only at one
point dividing the whole range of
output into two parts-Profitable and
non profitable.
Limitations
Implication for this that the
whole output beyond the break
even level is profitable
In the real life this is not the fact
as the conditions are difference
due to changing price and cost
(i.e In reality cost and revenue
functions may non linear )
Break-Even Analysis: Non Linear Cost and Revenue
Functions
 A cost function is non-linear when the total cost does not change at a constant rate with
changes in the level of output. These functions can take various forms, such as quadratic,
cubic, or exponential.
 A common non-linear cost function is the quadratic cost function:

TC = FC + VC x (Q + aQ2)
a is a coefficient that represents the rate of increase in variable costs as output increases.

 A revenue function is non-linear when the total revenue does not change at a constant rate
with changes in the level of output. This can result from factors such as volume discounts,
price elasticity, or market saturation.
 A revenue function that decreases per unit price as sales increase might be:

TR = P x (Q - bQ2)
b is a coefficient representing the rate at which the price per unit decreases as more units are
sold.
Example
A firm producing more than
Q1 and less than Q2 will be
making profits
The profitable range of output
lies between Q1 and Q2 units
of output.
Producing less or more than
these limits will give rise to
losses
Contribution Analysis
Contribution Margin: contribution Margin is the difference between total revenue
and variable cost arising out of business decision.
◦ Contribution margin shows the aggregate amount of revenue available after
variable costs to cover fixed expenses and provide profit to the company.
CM = Sales Revenue − Variable Costs
CM per Unit = Selling Price per Unit − Variable Cost per Unit
 Contribution Analysis

 Q, the breakeven level of output,

contribution equals fixed cost.
 Below the output Q, the total
contribution is less than fixed cost- This
amount to loss.
 Beyond output Q, contribution exceeds
fixed cost – the difference is a
contribution towards profits resulting
from a business decision
 Contribution over the time period under
review is plotted in order to indicate the
commitment that the management has
made to fixed expenditure and to find the
level of output from which it will be
 Learning Curve
The learning curve is a graphical
representation of how the average
cost per unit of output decreases
as the cumulative output increases.
This is due to the fact that tasks
will require less time and
resources the more they are
performed because of
proficiencies gained as the process
is learned
 Learning Curve
 The acquired knowledge and experience
helps firms in reducing LAC almost
continuously. They learn over time to get
work done in
◦ Shorter period of time
◦ Reduce cost of production
◦ Increase Factor Productivity

 The learning rate, typically expressed as a

percentage, indicates the rate at which
production costs decrease. For example, an
80% learning rate means that each time
cumulative production doubles, the unit cost
decreases to 80% of its previous value.
 Learning Curve
 In business, the slope of the learning
curve represents the rate in which
learning new skills translates into cost
savings for a company.
 A learning curve is usually described
with a percentage that identifies the
rate of improvement.
 The steeper the slope of the learning
curve, the higher the cost savings per
unit of output. the total output right
from the beginning of production of a
commodity
 Economies of Scale & Economies of Scope
 Economies of scale occur when increasing the scale of production leads to
a lower cost per unit of output. This happens because fixed costs are spread
over a larger number of goods.
Example: A car manufacturer reduces the cost per vehicle by doubling
production, spreading the fixed costs (e.g., factory, machinery) over more
units.

 Economies of scope occur when a company can reduce costs by producing

a wider variety of products. The focus is on the cost savings generated by
leveraging efficiencies across different products.
Example: A dairy company producing milk, cheese, and yogurt can share the
same supply chain, production facilities, and marketing efforts, thereby
reducing the overall cost for each product.
 Economies of Scale Vs Scope

Scale Scope

 Reduces the cost of one product  Reduces the cost by production of a

 Deals with Production of goods in variety of products
bulk  Deals with Production of a variety of
 Reduction occurs due to Bulk products within the same task
production of any product  Reduction occurs due to a variety of
 More resources are utilised goods produced during the production
process.
 Less resources are utilised