Production & Cost

Basic Concepts
• Production is a process where inputs (factors of production) are converted
into an output
• An input is in the form of a service or a good that is used in process of
production.
• An output is a service or a good that results from the process of production.
• The short run is that time in which the supply of some of the factors of
production is inelastic or fixed.
• The long run is that time in which the supply of most of the factors of
production is elastic, though the production technology is assumed to
remain unchanged.
Basic Concepts
• Total Product - The total product is the total output of a good, which
is produced by a firm during a specific time. It can be increased by
applying additional amounts of the variable factor.
• Marginal Product: The marginal product is the change in the total
product when additional amounts of the variable factor are
employed.
• Average Product: The average product is the total product divided by
the amount of variable factor employed to produce the output
Production Function
• The production function is a technological relationship between the
physical inputs and outputs in a particular time given the technology.
• A general production function can be expressed as:
• X = f (L, K, M, N, T ) where X is output, L is labour, K is capital, M is materials,
N is land and T is technology. For the sake of convenience, when there are
only two factors of production, the production function is written as
• X = f (L, K) ceteris paribus.
Production – Short Run
• The law of variable proportions occurs in the short run when to increase
production only one of the factors of production is increased while the others
are kept fixed.
• As more and more units of the variable factor are applied to a given amount
of the fixed factors, the output will
• initially increase at an increasing rate
• Increase at a constant rate
• increase at a decreasing rate.
• Since the marginal increase, which occurs in the total output of the good,
diminishes eventually it is also called the law of diminishing marginal returns.
Production with
one fixed and
one variable
input
• Total output increases as
labor increases at an
increasing rate (up to 6.67
units of labor)
• Increases at a decreasing rate
(until slightly more than 14
units of labor).
• Output decreases as more
units of labor are deployed.
• Managers will never willfully
deploy labor in the latter
circumstance
Average & Marginal
Products of Labor
Average and Marginal Product
Curves of Labor
• Marginal product exceeds
average product when
the latter is increasing
and is less than average
product when the latter is
decreasing
Assumptions
• The period under consideration is the short run.
• There is only one variable input. All other inputs are fixed.
• Units are all homogenous or are equally efficient in production.
• There is a given time involved.
• The technology is assumed to be given.
• The prices of the factors of production do not change in the time
under consideration
Production Function
• Shows the relationship between quantity of inputs required to produce a
quantity of output.
• Marginal product of any input is the increase in output resulting from an
additional unit of that input keeping all other inputs constant
• Marginal productivity of labour
• MPL =
• Diminishing marginal product – the marginal product of an input declines
as the quantity of the input increases (other things being equal)
• Important for the producer in deciding if he should add an additional
input for production
Production – Long Run
• The law of returns to scale occurs in the long run where to increase
production all the factors of production are increased.
• The long-run production function can be written as X = f (L, K)
• We make use of Isoquants to analyze production in the long run
Production Function, Two Variable
Inputs, Thomas Machine Company
• How do we compute average
Product
• How do we compute
marginal product?
Isoquant
• An isoquant depicts the various
combinations of two factors of
production, for example, labour
and capital using which a fi rm can
produce the same level of output.
• A producer is indifferent among the
different combinations of labour
and capital which lie on the same
isoquant. Along an isoquant while
the level of output is the same, the
capital labour ratio differs.
Characteristics of isoquants
• Negatively sloped or downward sloping
• MRTS = (- ΔK/ ΔL)
MPK ΔK+MPL ΔL=0
MPL/MPK = ΔK / ΔL =MRTS
• Convex to the origin – Marginal rate of technical substitution decreases
as we move down an isoquant.
• The marginal rate of technical substitution of labour for capital, MRTSLK, is the
quantity of capital that a firm is ready to give up for an additional unit of labour
so that the level of output remains the same.
• Isoquants cannot intersect each other
Exceptions –
Complements/Substitutes
• Isoquants are linear - When the factors of production, capital and
labour, are perfect substitutes, the isoquant is a downward sloping
straight line.
• Isoquants are L shaped - When the factors of production, capital and
labour are perfect complements, the isoquant is L shaped
Economic Region of Production
• Above OU and below OV, the
isoquant slopes are positive,
• Increases in both capital and
labor are required to maintain
a specified output rate.
• The marginal product of one
or the other input is negative.
• The lines OU and OV are
called ridge lines
Optimal Combination of inputs
• Must consider costs as inputs are scarce.
• To maximize profit
• Minimize cost at a given output
• Maximize output from given cost
Isocosts
• The isocost line represents the various combinations of the factors,
for example, labour and capital, which the firm can purchase given
the total outlay and the prices of the factors of production. It is also
called the outlay line or factor price line.
• Assume that there are only two factors, labour and capital. The
isocost line can be expressed as C = L.PL + K.PK
• Slope of the isocost line
Isocost
• Because the slope of the isocost curve is the negative of PL/PK and the
slope of the isoquant is the negative of MPL / MPK
• Optimal combination of inputs is one where
• MPL / MPK = PL/PK .
Isocost
• Put differently, the firm should choose an input combination where
• MPL / PL = MPK/PK .
• Marginal Products per rupee spent on labor and capital are identical
• If there are more than two inputs, the manager maximizes output by
distributing costs among the various inputs so the marginal product of a
rupee’s worth of one input is equal to the marginal product of a rupee’s
worth of any other input used. In spirit, the manager chooses an input bundle
such that
Producer Equilibrium
• A producer is in equilibrium when he is using the optimum (least cost)
combination of the factors, labour and capital, to achieve a given level
of output
• Case 1 – Maximization of output given the cost
Producer Equilibrium
• At point E*, the isoquant I2 is tangential to the isocost line AB.
• Slope of the isoquant I2 is equal to the slope of the isocost line AB. Hence,
MRTSLK = PL/PK
• But MRTSLK = ΔK/ΔL =MPL/MPK
• PL/PK =MPL/MPK
• MPK/PK=MPL/PL
• Employs labour and capital such that the ratio of the marginal products of
the factors of production is equal to the ratio of the factors prices.
• Isoquant should be convex to origin
Producer Equilibrium
• Case 2 – Minimization of cost given output
Laws of Return to Scale
• Increasing returns to scale
• When all the factors of production are increased simultaneously in the same
proportion and there is an increase in the output, which is more than the
proportionate.
• Labour Economies
• Technical Economies
• Marketing Economies
• Financial Economies
• Risk bearing Economies
Constant Returns to Scale
• Constant returns to scale occur when
all the factors of production are
increased simultaneously in the same
proportion and there is an increase in
the output, which is in the same
proportion
• When the economies of scale have
reached their limit while
diseconomies of scale have not yet
appeared, the returns to scale
become a constant.
Decreasing Returns to Scale
• Decreasing returns to scale occur
when all the factors of production
are increased simultaneously in the
same proportion and there is an
increase in the output, which is less
than the proportionate.
• Managerial Diseconomies
• Technical Diseconomies
• Financial Diseconomies
Output Elasticity
• The percentage of change in output resulting from a 1% increase in all
inputs.
• Consider the Lone Star Company, a maker of aircraft parts, which has
the following production function Q = 0.8L0.3K 0.8
• Multiplying both inputs by 1.01. What happens to the output?
Estimation of production functions
• Cobb Douglas Form
• Where b and c are constants, b is the elasticity output with respect to
capital, c is the elasticity output with respect to labor. Q is the number
of parts produced per year (measured in millions of parts), L is the
number of workers hired, and K is the amount of capital used
Cost Function
Important Concepts
• Economic Profit & Accounting Profit
• Production function & marginal product
• Various types of cost and how they are related to each other
• Does cost decision of a firm change over time? How are costs
different in the short run and in the long run
• Economies of scale
Revenue, Cost & Profit
• Profit – Total Revenue – Total Cost
• Assumption – Firm’s objective is to maximize profits
• Cost – Explicit Cost and Implicit Cost
• Explicit Cost – Direct cost incurred by the producer which he has to pay
for in money terms, also known as accounting costs
• Implicit Cost – Value foregone of resources used, which could have been
used in other alternatives also known as Opportunity Cost
• Accounting Profit = Total Revenue – Explicit Cost
• Economic Profit = Total Revenue – Explicit Cost-Implicit cost
• Zero Economic Profit is Normal Accounting Profit
Basic Concepts
• Actual costs are the costs, which a firm incurs on raw materials, labour,
machinery, advertising and other such expenses.
• Opportunity cost is the cost of the alternative option, which has been lost
by putting the scarce resources in the present option. This cost arises
because resources of the society are scarce.
• Variable cost is the cost, which varies with the level of output. Fixed cost is
the cost, which does not vary with the level of output.
• Short-run costs are those incurred over the short run, which is that time in
which the supply of some of the factors of production is inelastic or fixed.
Long-run costs are those incurred over the long run, which is that time in
which the supply of most of the factors of production is elastic
Cost Function
• The cost function is a derived function since it is obtained from the
production function.
• The element of time is very important in cost theory.
• A short-run cost function can be expressed as C = f (X, PF , T, K*).
• A long-run cost function can be expressed as C = f (X, PF , T).
Traditional Theory of Costs
• Short run Cost Analysis
• Supply of some of the factors of production is fixed. Thus, in the short
run while some costs are fixed, others are variable.
• Total Cost is the cost incurred to produce a given level of output in
the short run by utilizing both the fixed and the variable factors.
• Total Cost = Total Fixed Cost + Total Variable Cost
• Total Fixed Cost - which do not vary with the level of output.
Whatever is the level of output, these costs have to be incurred.
Traditional theory of costs
• Total Variable Cost – cost which varies with the level of output.
Includes cost of raw material, labour, fuel and others
• The total variable cost curve is shown as inverse S-shaped curve. This
is due to the law of diminishing returns
Traditional theory of costs
• Total cost is obtained by adding total fixed cost and total variable cost
at the different levels of output.
• The total cost curve is also an inverse S-shaped curve like the total
variable cost curve and is everywhere higher than the total variable
cost curve by the same amount as the total fi xed cost. From the total
cost curves explained above, we can now arrive at the per-unit cost
curves.
• Average Cost = Average Fixed Cost + Average Variable Cost
Traditional theory of Costs
• Total Cost Curve Average Cost Curve
Traditional theory of costs
• Average Fixed Cost Curve Average Variable Cost Curve
Traditional theory of costs
• Marginal cost is the change in the total
cost or the total variable cost due to a
unit change in the level of output.
• Marginal Cost = TCN − TCN − 1
Long Run Cost Analysis
• In the long run, the supply of
most of the factors of production
is elastic.
• Long Run Average Cost - average
per unit cost of production when
all the factors of production are
variable in the long run.
• The long-run average cost curve
is called the envelope curve as it
envelops the SAC’s.
Long Run Marginal Cost
• The long-run marginal cost curve is the locus of points, which is
formed by the point where the vertical line, drawn from the point of
tangency of the SAC with the long-run average cost curve, intersects
the corresponding SAC curve
• When long-run average cost is at its minimum point, long-run
marginal cost is equal to long-run average cost, or the long-run
marginal cost curve intersects the long-run average cost curve.
• At this point
• Long-run Average Cost = Short-run Average Cost = Short-run Marginal
Cost = Long-run Marginal Cost Or LAC = SAC = SMC = LMC
Long Run Total Cost
• The long-run cost curves are formed by the short-run cost curves.
• Long-run average cost curve can be derived from the short-run
average cost curves
Break Even Analysis – Linear Cost &
Revenue Functions
• The break-even level of output is that level of output at which a fi rm
neither makes profits nor losses. It is the level of output at which total
cost is equal to total revenue. SP and AVC assumed constant
Break Even Analysis – Cost &
Revenue is Non Linear