Assignment # 1

Analyze the Production Theory and Cost Theory.

Production Theory:
Production theory is the study of production, or the economics process of producing output from
the inputs. Producton uses resources to create a good or service that are suitable for use or exchange
in a market economy. This can include manufacturing, storing,shipping, and pakaging. Some
economist define production broadly as all economic activity other than consumption. They see
every commercial activity other than the final purchase as some form of production.
There are three aspects to production process:
1 The quantity of the good or service produced
2 The form of the good or service created
3 The temporal and spatial distribution of the good or service produced.

Factors of production (Factor Inputs)

Factors of Production Are the Inputs Available To Supply

Goods And Services In An Economy

Natural resources
available for Land Labor The human input into
production the production system

Goods used in
Entrepreneur Enterpris Capital the supply of
Organize factors of
e other products.
production and take
e.g. tech
risks

Land:
Land is the economic resource encompassing natural resources found within the economy. This
resource includes timber, land, fisheries, farms and other natural resource. Using land for
industrial purposes allows nation to improve the production process for turning natural resources
into consumer goods
Labor:
Labor represents the human capital available to transform raw or national resources into
consumer goods. This factor of production is a flexible resource as workers can be allocated to
different areas of the economy for producing consumer goods or services.
Capital:
Man made goods use in the production process. Capital can represent the monetary resources
companies use to purchase natural resources, land and other capital goods
Enterprise:
Entrepreneur or coordinator of all other factors of production.
Input:
The factors of production that is carry out the production is called inputs
Land, labour, capital organizer, technology, are the example of inputs

Input Factor

Variable Input Fixed Inputs

Fixed Inputs: Variable Inputs:

Remain the same in the short period. The cost of variable inputs is called variable
Example: Building, Land etc. cost and long run factor.
Example: Raw Material, Labor, etc.
The theory of production functions:
In general, economic output is not a (mathematical) function of input, because any given set of
inputs can be used to produce a range of outputs. To satisfy the mathematical definition of
a function, a production function is customarily assumed to specify the maximum output
obtainable from a given set of inputs. The production function, therefore, describes a boundary
or frontier representing the limit of output obtainable from each feasible combination of input.
(Alternatively, a production function can be defined as the specification of the minimum input
requirements needed to produce designated quantities of output.) Assuming that maximum
output is obtained from given inputs allows economists to abstract away from technological and
managerial problems associated with realizing such a technical maximum, and to focus
exclusively on the problem of allocative efficiency, associated with the economic choice of how
much of a factor input to use, or the degree to which one factor may be substituted for another. In
the production function itself, the relationship of output to inputs is non-monetary; that is, a
production function relates physical inputs to physical outputs, and prices and costs are not
reflected in the function.
In the decision frame of a firm making economic choices regarding production—how much of
each factor input to use to produce how much output—and facing market prices for output and
inputs, the production function represents the possibilities afforded by an exogenous technology.
Under certain assumptions, the production function can be used to derive a marginal product for
each factor. The profit-maximizing firm in perfect competition (taking output and input prices as
given) will choose to add input right up to the point where the marginal cost of additional input
matches the marginal product in additional output. This implies an ideal division of the income
generated from output into an income due to each input factor of production, equal to the
marginal product of each input.
The inputs to the production function are commonly termed factors of production and may
represent primary factors, which are stocks. Classically, the primary factors of production were
land, labor and capital. Primary factors do not become part of the output product, nor are the
primary factors, themselves, transformed in the production process. The production function, as a
theoretical construct, may be abstracting away from the secondary factors and intermediate
products consumed in a production process. The production function is not a full model of the
production process: it deliberately abstracts from inherent aspects of physical production
processes that some would argue are essential, including error, entropy or waste, and the
consumption of energy or the co-production of pollution. Moreover, production functions do not
ordinarily model the business processes, either, ignoring the role of strategic and operational
business management. (For a primer on the fundamental elements of microeconomic production
theory, see production theory basics).
The production function is central to the margin list focus of neoclassical economics, its
definition of efficiency as allocative efficiency, its analysis of how market prices can govern the
achievement of allocative efficiency in a decentralized economy, and an analysis of the
distribution of income, which attributes factor income to the marginal product of factor input.

Production is defined as the functional relationship between physical inputs (factors of

production) and physical outputs (the quantity of goods produced). It shows the maximum
amount of output that can be produced from a given set of inputs in the existing state of
technology. The output changes with the changes of inputs.

Q = f (Ln, L, K,O)

Where Ln = Land, L= Labour, K= Capital , O= Organization

Generally Q = f (L, K), where MPL = ∂Q/ ∂L > 0, MPK =∂Q/ ∂K > 0

MPL = Marginal product of Labour, MPK = marginal Product of Capital

If we increase the amount of inputs, the volume of output will be increased. But the increase of
output depends on various returns to scales or the level of production
Cost Theory:

Definition of Cost:
It is the firm of the individual operating in a marketing has a influence on the market supply of
the commodity.
In order to make use of the various factor and non - factor inputs.
In common, the common spend on these input is called the cost of production.
TC = TFC + TVC
TC = Total Cost, TFC= Total Fixed Cost and TVC = Total Variable Cost.
TFC means the cost is fixed in nature and the firms have to bear the cost irrespective of the
amount of output produced. Such as land, building, capital equipment’s etc. Firms cannot change
the fixed cost in the short run. It is known as overhead cost.
TVC means the cot vary with the level of output produced. Such as raw materials, labor, working
capital etc. The TVC increases as output increases. It is known as Prime cost.
Concept of Cost:
Money cost: The amount spend in terms of money for the production of the commodity is known
as money cost.
Nominal cost: it is the money cost of production
Real cost: it is the mental and physical and sacrifices undergone with a view to producing a
commodity
Opportunity cost: the real concept of production of given commodity is the next best alternative
sacrificed in order to obtain that commodity.
Sunk cost: expenditure on the equipment is a sunk cost.
Accounting or business cost: cash payment which firms make for factor or non- factor input.
Social cost: It is the amount of cost the society bears due to industrialization.
Short run cost:
In the short run at least one factor of production is fixed. Output can be variable only by adding
more variable factors.
Fixed cost:
Remain constant. Also known as short run cost. This cost includes:
 Cost on managerial staff.
 Expenditure on depreciation
 Maintenance cost of the factory
Variable cost:
 Vary directly with the level of output
 Used in the actual production of process
 Function of output changes.
 Cost of raw material.
 Cost indirect label
Total cost: sum of total fixed cost and total variable cost.
When a company is making its budget, it could use the cost function formula to test different
scenarios so that it is in a position to choose the optimum product mix.
Cost function:
C(x) = F + Vx
C = Total cost
F = Fixed cost
V = Variable cost per unit
x = Number of units produced
To understand how the cost function formula works, it’s important to remember that the total
cost of production is the sum of fixed costs and variable costs.
Fixed costs remain the same regardless of the level of production. These could include costs like
rent, machinery costs, and insurance premiums.
Variable costs increase with a rise in output. Examples of variable costs include material costs,
packaging, and labor costs that are directly related to the level of production.
Cost Function Breakeven Point Calculation:
R(x) = C(x). 5x = 100 + 3x. x = 100
It means the merchandiser has to sell not less than 100 cakes every single day to breakeven. The
implication is that the profit will increase if he can sell more than 100 cakes each day, and he
makes $2.00 extra on each extra cake after 100.
A breakeven analysis, which is a must-have tool for every business, defines a company’s level of
productivity. It helps the company project on its profit and acts as a comprehensive guide for
evaluating its performance.
It is part of a business plan since it builds cost structures. It also outlines the number of units that
would bring a profitable margin. However, even as the business runs, breakeven analysis is
applicable. It plays a significant role in the pricing and promotion processes. Additionally, it
comes in handy during cost control.
Fixed Costs/ (Unit Selling Price – Variable Costs) = Break-even Point
The recovery of a breakeven point means the company has recovered all its costs, both fixed and
variable, and anything after this is an additional profit. The bottom line is that a breakeven
analysis acts as a tool of safety for business.