Production Process and costs Group No.

THE PRODUCTION PROCESS AND COST

INTRODUCTION

The theory of production and cost central to the economic management of the firm. It
more useful in the use of factors of production in a better way. The theory of production
occupies a very important place in economics analysis and it has great relevance to the
study of various economic problems.

1) It helps in the analysis of relations between costs and volume of output, it tells us
how a manufacturer combines various inputs in order to produce a given output in
an economically efficient manner i.e.; at the minimum unit cost.
2) The theory of production also provides a base for the theory of demand of firms
for productive resources.
3) The theory of production also explains the forces which determine the marginal
productivity of factors and so the prices that have to be paid for the factors of
production.
4) The theory of production to the theory of distribution.

MEANING OF PRODUCTION

Production refers to the economic process of converting of inputs into outputs.

Production uses resources to create a good or service that are suitable for exchange. This
can include manufacturing, storing, shipping, and packaging. Some economists 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.

Production is a process, and as such it occurs through time and space. Because it is a flow
concept, production is measured as a “rate of output per period of time”. There are three
aspects to production processes:

1) The quantity of the good or service produced,

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2) The form of the good or service created,

3) The temporal and spatial distribution of the good or service produced.

A production process can be defined as any activity that increases the similarity between
the pattern of demand for goods and services, and the quantity, form, shape, size, length
and distribution of these goods and services available to the market place.

PRODUCTION FUNCTION

In economics, the analysis of cost begins with the study of production function. The
production function is a statement of the relationship between a firm’s scarce resources
(i.e., its inputs) and the output that result from the use of these resources. We can define
production function as:

“A production function defines the relationship between inputs and the maximum
amount that can be produced within a given period of time with a given level of
technology.”

The general mathematical form of production function is:

Y =f (L, K, R, S, V, r)

Where

Y =output

L = labor

K = capital

R = Raw material

S = Land input
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V = Return to scale

The production function just explains the technological relationship between the
quantities of inputs and quantities of output. Prices of factors of production and the
output’s are not included in the production function because they are used by the firm liar
production decision. Practically, however it is observed that raw material constantly
related to output at all level of production and similarly land input “S”is constant for the
economy as a whole and these are not included in the aggregate production function.
Thus, the production function in the traditional economic theory assumes the following
form.

Y = f (L, K, V)

The factor “V” returns to scale refers to the long run analysis of the law of production.

TYPES OF PRODUCTION FUNCTIONS

The production function as determined by technical conditions of the production is of

two types.

(a) Short run production function

(b) Long run production function

SHORT RUN PRODUCTION FUNCTION

A situation in which some or at least one factor of production is assumed constant.

In short run, the technical conditions of the production are rigid so that the various input
resources used to produce a given out put are in fixed proportions. In short run it is
possible to increase the quantities of one input while keeping the quantities of other
inputs constant.
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For example, by keeping constant or fixed the quantities of capital such as machinery or
plant, the output may be increased by employing the units of labor. Mathematically it
may be expressed as follows.

Y = f (L, K, V, S) or

Y = f (L) K

This production function is known as classical production function, because according to

classical economist, output wholly depends upon the units of labor. According to them
keeping constant the units of capital, output will increase at different rate by employing
additional units of labor. This aspect of production function is known as law of variable
proportions.

LONG RUN PRODUCTION FUNCTION

The long run or flexible production function refers to a situation in which all factors of
production are variable. In the long run, a firm can change its plant or machinery and the
units of the labor at the same time. Such production function is named as Neo-Classical
production function.

The neo classical production function is given by the following mathematical equation:

Y = f (L, K, V, S)

MEASURES OF PRODUCTIVITY

Measures of productivity includes three types of production function

(1) Total production

(2) Average production

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(3) Marginal production

Total Production

The total output which is produced by the firm by employing the factors of production
such as labor is called total product or by employing a certain units of labor by the firm,
the output which is produced is called total product. If the 60 units of clothes are
produced by the firm, employing 5 units of labor is called total product.

Average production

The average product of an input is total product divided by the amount of the input used
to produce this amount. Thus average product is defined as the ratio between total output
and the units of labor employed. It can be written as:

AP = TPL / L

AP = 60 / 5 =12

Marginal production

The marginal production of a factor is defined as the change in total output resulting from
a change of this factor, keeping all other factors constant. Mathematically it can be
written as:

MPL = Change in output / Change in labor input

MPL = ∆Y/∆L
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The Slopes of product curves

Under Short run

Units of variable Total Output Average product of Marginal product of
factor labor(APL) labor(MPL)
1 8 8 8

2 20 10 12

3 36 12 16

4 48 12 12

5 56 11.2 8

6 60 10.0 4
7 60 8.6 0

8 56 7 -4
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Under Long Run

In the long run expansions of output may be achieved by varying all factors. In the long
run all factors of production are variable. The long run production function is given by
the following equation.

Y = f (L, K)

Combinations Units of Labor(L) Units of Capital(K) Total Output(Y)

A 1 11 100
B 2 7 100
C 3 4 100
D 4 2 100
E 5 1 100

Long Run Product Curve

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Short-Run Costs

The short run is a period of time for which two conditions hold:
1).The firm is operating under a fixed scale (fixed factor) of production
2).Firms can neither enter nor exit an industry.

Fixed cost is any cost that does not depend on the firm’s level of output. These costs are
incurred even if the firm is producing nothing.

Variable cost is a cost that depends on the level of production chosen.

Total Cost = Total Fixed cost + Total Variable cost.

Fixed cost

Firms have no control over fixed costs in the short run. For this reason, fixed costs are
sometimes called sunk costs.
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Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units
of output (q):

T F C
A F = C
q

Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm

(1) (2) (3)

q TFC AFC (TFC/q)
0 $1,000 $ --
1 1,000 1,000
2 1,000 500
3 1,000 333
4 1,000 250
5 1,000 200

AFC falls as output rises; a phenomenon sometimes called spreading overhead

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Variable Costs

The total variable cost curve is a graph that shows the relationship between total variable
cost and the level of a firm’s output.

The total variable cost is derived from production requirements and input prices.

Average variable cost (AVC) is the total variable cost divided by the number of units of
output.

Marginal Cost
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Marginal cost (MC) is the increase in total cost that results from producing one more unit
of output. Marginal cost reflects changes in variable costs.

∆T C ∆T F C ∆T V C
M C= = +
∆Q ∆Q ∆Q

Derivation of Marginal Cost from

Total Variable Cost

TOTAL
UNITS OF VARIABLE MARGINAL
OUTPUT COSTS ($) COSTS ($)
0 0 0
1 10 10
2 18 8
3 24 6

Marginal cost measures the additional cost of inputs required to produce each successive
unit of output.

Graphing Total Variable Costs and Marginal Costs

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Total variable costs always increase with output. The marginal cost curve shows how
total variable cost changes with single unit increases in total output. Below 100 units of
output, TVC increases at a decreasing rate. Beyond 100 units of output, TVC increases
at an increasing rate.

Relationship between Average Variable Cost and Marginal Cost:

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When marginal cost is below average cost, average cost is declining. When marginal
cost is above average cost, average cost is increasing. Rising marginal cost intersects
average variable cost at the minimum point of AVC. At 200 units of output, AVC is
minimum, and MC = AVC.

Total Costs

Adding TFC to TVC means adding the same amount of total fixed cost to every level of
total variable cost. Thus, the total cost curve has the same shape as the total variable cost
curve; it is simply higher by an amount equal to TFC.
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Average Total Cost (ATC) is total cost divided by the number of units of output (q).

Relationship between Average Total Cost and Marginal Cost:

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If marginal cost is below average total cost, average total cost will decline toward
marginal cost. If marginal cost is above average total cost, average total cost will
increase. Marginal cost intersects average total cost and average variable cost curves at
their minimum points.

Cost function

Economists have been hard at work to define the ways in which costs behave since the
1930s. The term cost function is a financial term used by economists and mangers within
businesses to understand how costs behave. The cost function shows how a cost changes
as the levels of an activity relating to that cost change. There are three basic types of
linear cost functions: fixed, variable, and mixed. In fixed functions, the cost is the same
regardless of activity; variable functions change the cost depending on activity; and
mixed functions combine the two — a cost will be fixed to a certain point, then can
change based on related activity.

Cost is a function of output.

C= f (Q)

Q↑→ C↑

Q↓→ C↓

Optimal Input Combination and Cost Functions

In order to determine the firm’s optimum combination of factors of production we are

going to superimpose the isocost function on our isoquant map to determine the optimum
level of production while taking into account our isocost curve as illustrated below.
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In the above diagram we see that all points on Q3 are unattainable because the cost of
production exceeds the firm’s budget. Points A and C are both within the firms budget
but are technically inefficient because the firm could produce on a higher isoquant (Q2)
which means it will produce a higher output with the same amount of money. B reflects
the optimal combination of factors of production because at that point the slope of the
isoquant curve and the isocost are equal i.e. the two lines are tangent to each other. This
is because at this point the rule of optimal combination of factors holds. This rule states
that the firm is using its factors of production optimally if the ratio of the prices of its
factors equals to the ratio of their products. So (PK/PL)=(MPK/MPL) where PK/PL is
the slope of the isocost curve and MPK/MPL is the slope of the isoquant curve. This
explains why every firm in perfect competition operates where its price equals to its
marginal costs.

Average cost

Production cost per unit of output, computed by dividing the total of fixed costs and
variable costs by the number of total units produced (total output). Lower average costs
are a potent competitive advantage.

Formula: (Fixed costs + Variable costs) ÷ Total output.

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Short-run average cost

Average cost is distinct from the price, and depends on the interaction with demand
through elasticity of demand and elasticity of supply. In cases of perfect competition,
price may be lower than average cost due to marginal cost pricing.

A typical average cost curve will have a U-shape, because fixed costs are all incurred
before any production takes place and marginal costs are typically increasing, because of
diminishing marginal productivity. In this "typical" case, for low levels of production
marginal costs are below average costs, so average costs are decreasing as quantity
increases. An increasing marginal cost curve will intersect a U-shaped average cost curve
at its minimum, after which point the average cost curve begins to slope upward. For
further increases in production beyond this minimum, marginal cost is above average
costs, so average costs are increasing as quantity increases.

Long-run average cost

The long run is a time frame in which the firm can vary the quantities used of all inputs,
even physical capital. A long-run average cost curve can be upward sloping, downward
sloping, or downward sloping at relatively low levels of output and upward sloping at
relatively high levels of output, with an in-between level of output at which the slope of
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long-run average cost is zero. The typical long-run average cost curve is U-shaped, by
definition reflecting economies of scale where negatively-sloped and diseconomies of
scale where positively sloped.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all
its inputs are unaffected by how much of the inputs the firm purchases, then it can be
shown that at a particular level of output, the firm has economies of scale (i.e., is
operating in a downward sloping region of the long-run average cost curve) if and only if
it has increasing returns to scale. Likewise, it has diseconomies of scale (is operating in
an upward sloping region of the long-run average cost curve) if and only if it has
decreasing returns to scale, and has neither economies nor diseconomies of scale if it has
constant returns to scale. In this case, with perfect competition in the output market the
long-run market equilibrium will involve all firms operating at the minimum point of
their long-run average cost curves (i.e., at the borderline between economies and
diseconomies of scale).

Marginal cost

In economics marginal cost is the change in total cost that arises when the quantity
produced changes by one unit. That is, it is the cost of producing one more unit of a
good. Mathematically, the marginal cost (MC) function is expressed as the first
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derivative of the total cost (TC) function with respect to quantity (Q). Note that the
marginal cost may change with volume, and so at each level of production, the marginal
cost is the cost of the next unit produced.

A typical marginal cost curve with marginal revenue overlaid

Relationship between AC, AFC, AVC and MC

1. The Average Fixed Cost curve starts from a height and goes on declining continuously
as production increases.

2. The Average Variable Cost curve, Average Cost curve and the Marginal Cost curve
start from a height, reach the minimum points, then rise sharply and continuously.

3. The Average Fixed Cost curve approaches zero asymptotically. The Average Variable
Cost curve is never parallel to or as high as the Average Cost curve due to the existence
of positive Average Fixed Costs at all levels of production; but the Average Variable
Cost curve asymptotically approaches the Average Cost curve from below.
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4. The Marginal Cost curve always passes through the minimum points of the Average
Variable Cost and Average Cost curves, though the Average Variable Cost curve attains
the minimum point prior to that of the Average Cost curve.

Fixed and sunk costs

Fixed cost is the potion of the total cost which does not vary with the output such as cost
of machinery and plant, rent of land and building, interest on capital etc. It is also called
the indirect or supplementary cost.

Sunk costs are expenditures that have been made in the past or that must be paid in the
future as part of a contractual agreement. The cost of inventory and future rental
payments on a warehouse that must be paid as part of a long-term lease are examples.

Economies of scale

Economies of scale, in microeconomics, refers to the cost advantages that a business

obtains due to expansion. There are factors that cause a producer’s average cost per unit
to fall as the scale of output is increased. "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 other
inputs increase. Diseconomies of scale are the opposite. The common sources of
economies of scale are purchasing (bulk buying of materials through long-term
contracts), managerial (increasing the specialization of managers), financial (obtaining
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lower-interest charges when borrowing from banks and having access to a greater range
of financial instruments), marketing (spreading the cost of advertising over a greater
range of output in media markets), and technological (taking advantage of returns to
scale in the production function). Each of these factors reduces the long run average costs
(LRAC) of production by shifting the short-run average total cost (SRATC) curve down
and to the right. Economies of scale are also derived partially from learning by doing.

Economies of scale is a practical concept that is important for explaining real world
phenomena such as patterns of international trade, the number of firms in a market, and
how firms get "too big to fail". The exploitation of economies of scale helps explain why
companies grow large in some industries. It is also a justification for free trade policies,
since some economies of scale may require a larger market than is possible within a
particular country — for example, it would not be efficient for Liechtenstein to have its
own car maker, if they would only sell to their local market. A lone car maker may be
profitable, however, if they export cars to global markets in addition to selling to the
local market. Economies of scale also play a role in a "natural monopoly."

Bibliography:

Zahir, Faridi, Micro Economic Theory.

Ramzan, Sheikh, Economics.

Prem, L. Mehta, Micro Economics, 6th edition.

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