(UNIT 3)

PRODUCTION & COST ANALYSIS

PRODUCTION FUNCTION
It refers to the technological or engineering relationship between the inputs of a commodity & the output produced by them The 4 factors of production are 1.Land 2.Labour 3.Capital 4.Organisation or management

Production function (schedule)

Labour (L) Output quantity (No.of workers) (Q) 1 5 20 2 3
Units of capital(K)

15 35 250

30 42 500

Production function (Equation)

Q = f (L, K, Ld, M, T, etc.) Where Q -- Output of commodity X L -- Labour employed in the production of X K Capital employed in the production of X Ld Land employed in the production of X M Managerial function employed in the production of X T Technology employed in the production of X

Two time frames of production function

1.Short run : --Here at least one of the inputs remain constant, while other inputs vary --Different output & capital for a constant input pattern of production function is referred as return to a factor & 2.Long Run --A pattern of input combinations wherein both the inputs increase or decrease relates to long run changes in production function --If input change in the same proportion, then the pattern of production function is referred as return to scale

3 types of production function

1.production function with one variable input 2.production function with 2 variable input 3.Production function with all variable input

1.production function with one variable input factor/short run analysis of production function
**It is explained with Law of variable Proportions/ Law of Diminishing Marginal Returns/Law of Diminishing Marginal Productivity Law of Variable Proportions: It states that as more & more of one factor input is employed & if all other input quantities are held constant, a point will eventually be reached where additional quantities of varying input will yield diminishing marginal contributions to total product Terms used in law of variable proportions: 1.Total Product (TP or Q) 2.Marginal Product (MP) 3.Average Product (AP) If variable Labour is L, then Marginal Product of Labour MPL= Q/ L Average Product of Labour APL=Q/L

Example:
Capital is Fixed
Var input(L) 1 2 3 4 5 6 TP 5 15 35 45 50 45
MP(Q/ L)

AP(Q/L) (5/1)5 (15/2)7.5 (35/3)11.7

(15-5)/(2-1)=10 (35-15)/(3-2)=20

(45-35)/(4-3)=10 (45/4)11.25 (50-45)/(5-4)=5 (45-50)/(6-5)=-5 (50/5)10 (45/6)7.5

Y MP>1

0<MP<1

MP<0

TPL

Output (Q)

STAGE I

STAGE II

STAGE III

High Return

Less Return

Negative Return

APL X x1 x2 x3 MPL

Var input Labour (L)

3 stages of production function from the graph

1.STAGE 1: starts from 0 units of variable input (L) to AP of at maximum (till X2) 2.STAGE 2:It follows stage I & then proceeds to a point where MPL of (L) is 0(point X3).Here TPL is maximum 3.STAGE 3:It continues from Previous point Interpretation: -At stage I/stage III: No rational firm will operate. -At stage I : The firm is grossly under utilizing its fixed capacity. So in this MPL increases -At stage III: The firm grossly over utilizes its fixed capacity

2.production function with two variable input factor/short run (only 2 var)or Long run (more than 2 var) analysis of production function
Example: 2 var input : Labour (L),capital (K)
Labour(L) 1 2 3 4 5 6 Units of capital(K) 5 15 35 42 50 46 250 Output Quantity (Q) 20 30 42 50 65 61 500 42 50 70 80 83 80 750

 From the above table , If a firm want to produce 42 units of output, then the possible combinations are (4,250) (3,500) (1,750) Plotting these points on graph & line joining these combinations of labour & capital is called as isoquant/iso-product curve/Equal product curve/Production indifference curve

Isoquant
It is defined as the locus of all those combinations of 2 inputs that produce the same amount of output
y

Unit of Capital (K) Q=50 Q = 42 x Units of labour (L)

Characteristics of isoquant map

1.They are falling (reducing) 2.The higher the isoquant is, the higher is the output 3.No 2 isoquant intersect with each other 4.They are convex towards the origin

Types of Isoquant:
1.Linear Isoquant 2.Input-Output Isoquant / Right angled Isoquant / Leontief Isoquant 3.Kinked Isoquant /Convex Isoquant /Activity analysis isoquant / Linear Programming Isoquant 4.Smooth Convex Isoquant

1.Linear Isoquant
y

Natural Gas

Electric Power

Q1 Q2 Q3 Diesel Oil

It is assumed that perfect substitutability between Factors of production is possible. Example: Gas or oil to generate power

2.Input-Output Isoquant / Right angled Isoquant / Leontief Isoquant

y

carts

Q3=3 vehicle Q2=2 vehicle Q1=1 vehicle x

wheels

We assume strict Complementary /Zero substitutability between the inputs When there is only one method of production of any commodity Example: Wheels cannot be replaced by carts & vice versa

3.Kinked Isoquant /Convex Isoquant /Activity analysis isoquant / Linear Programming Y Isoquant
K1

Units of leather K2 K3 X L1 L2 L3 Units of labour

Q2 Q1 shoe

It is assumed limited substitutability of capital & Labour Only few process is used for production. substitutability of input factors is possible only at kinks

Example:

labour(L1) & or labour(L2) &

leather(K1) leather(K2)
(by reducing wastages)

more

or labour(L3) & more leather(k3)

(more carefully reducing wastages)

4.Smooth Convex Isoquant

It is assumes continuous substitutability of capital & labour only over a certain range beyond which input cannot be substituted
Y

Units of Capital(K) Q x Units of labour(L)

 To get least cost of production, optimal combination of inputs(resources) will be considered Example: Price of Labour (PL) : Rs 10 / unit Price of capital (PK) : Rs 5 / unit Production table Q=2units L 1 2 k 17 10 Q=4 units L 2 3 K 17 12 Q=6 units L 3 4 K 15 11

Least cost combination of inputs

11

10

 If one needs to get 6 units of output , then the possible combinations are (3,17) (4,11) (5,10) Calculation of least cost combination of output Method 1:Finding each output cost & choosing the minimal one Method 2:Finding by Geometrically

Method 1:Finding each output cost

For 6 units Here 95 is minimal & (4,11) is chosen the best L K Cost of production

3
4 5

15 (3x10)+(15x5)=105
11 (4x10)+(11x5)=95 10 (5x10)+(10x5)=100

Method 2:Finding by Geometrically

M = (L x PL)+ (K x PK)

Where M L PL K

sum of money available units of labour Price of labour for each unit of labour units of capital needed to produce a given quantity of output PK Price of capital for each unit of capital

 If the entrepreneur has Rs.95 then he can go for (4,11) Also he can buy 9.5 units of labour (L) with no capita (K) i.e., (L*10) + 0 = 95, Therefore L = 9.5 And he can buy 19 units of capital (K) with no labour (L) i.e., 0 + (K*5) = 95, Therefore K = 19 Under various combination of L & K represented graphically called Isocost line for M=95

Isocost
Definition: An isocost (isocost line) is the locus of all those combinations of input factors (factors of production) that can be bought with a given sum of money here Rs.95)
y

M=95
Units of Capital (K) M=90

M=85 x Units of labour (L)

Determination of least cost input combinations

Here isocost map is superimpose on isoquant map It is possible because the axes in both maps represent the same input variable
y

Scale line

Units of Capital (K)

A

C B

x Units of labour (L)

3.Production function with all variable input factors/long run production function/return to scale
Two ways: 1. Both L & K change in same proportion i.e., K/L ratio of production remains same for any output 2. L & K change in different proportion i.e., K/L ratio of production varies with change in output Therefore increase in output when all inputs vary in same proportion is known as return to scale

3 alternative situation arise in return to scale

1.Increasing return to scale 2.Constant return to scale 3.Decreasing return to scale

3 alternative situation arise in return to scale

1.Increasing return to scale: If output increases more than proportionate to increase in all inputs Causes: In large scale production work is divided to small parts & each individual can attain specialization by handling only one part of the work Some industries are not able to undertake production at small scale Example: aircraft & shipping industry Some industries increased single operation which gives some dimensional advantages Example: industries where storage is important such as chemical 2.Constant return to scale: if output increases by same percentage as all inputs 3.Decreasing return to scale: If increase in output is less than proportionate to increase in all inputs Causes: Coordination & control becomes increasingly difficult Information in organisation is lost when transmitted down from top level managers & vice versa when transmitted to top from down

Statistical production function (charles & paul H.Douglas)

Q = A Lb K1-b
Where (or)

Q = 1.01 L0.75 K0.25

Q A L K b

- total output - constant - units of labour - units of capital - parameters

Properties of Charles & Paul H.Douglas production function

1.Both L & K should be positive for Q to exist 2. Sum of the parameters (b , 1-b) = 1 which is constant return to scale Latest version is : Q = A L K
when + = 1; return to scale is constant when + > 1; return to scale is increasing when + < 1; return to scale is decreasing

3.Parameter represents input factors - shares in output Example: =wage share & =rental share total share total income 4.It is used to find short run relationship of inputs & output
Marginal physical product of labour (MPPL)= (Q/L) Marginal physical product of labour (MPPL)= (Q/K)

5.It has elasticity of substitution as unity , which is used in formulation of an income policy

Managerial uses of Production Function

Used to Compute least cost Input combination for given output Used to Compute maximum input output combination for a given cost It is useful in deciding on the value of employing a variable input factor It aids in long run decision making (increasing return to scale implies increasing production) decreasing return to scale implies decreasing production Producer is indifferent about increasing / decreasing return to scale provided the demand is of no constraint

COST
It is the money spent (directly/indirectly) on producing & selling a product to the customers It refers to the outlay of funds for productive producing a good or service It states from raw materials (procuring, transporting, preparing) through production costs (labour, power, machinery) till selling (maintenance, advertisement, salary, incentive) the product to customer.

COST TYPES/COST CONCEPT

1.Actual Cost & opportunity cost 2.Incremental cost & sunk cost 3.Explicit cost & Implicit cost 4.Past cost & Future cost 5.Accounting & economic 6.Private & social 7.Direct & Indirect Cost 8.Controllable & Non Controllable costs 9.Replacement & Original Costs 10.Shut down & abandonment cost 11.Urgent & Postponable Cost 12.Business cost & full cost 13.Fixed & Variable Cost 14.Short run & Long run cost 15.Incremental & Marginal cost 16.Average cost, Marginal costs & total cost

1.(a) Actual Cost /acquisition costs/outlay cost/absolute cost & (b) opportunity cost/alternate cost
(a) Costs which a firm incurs for producing /acquiring a product /service Ex: raw material cost, labour cost (b) * It is measured in terms of revenue / benefit, which could have been generated / earned by employing that good or service in some other alternative use. * Difference between actual & opportunity cost is called as economic profit / economic rent

(a) It is the additional cost due to a change in the level / nature of business activity Ex: adding new product line , changing distribution channel (b) Costs that are not altered by a change in quantity produced & cannot be recovered Ex: depreciation of Equipments

2.(a) Incremental cost/Differential cost & (b) sunk cost

(a) Those expenses which are actually paid by the firm It is recorded in profit & loss account Ex: rent, wage paid (b) These are theoretical costs that they go unrecognized by the accounting system Ex: for owner the cost spend is ignored

3. (a)Explicit /out of pocket/ paid out cost & (b)Implicit /book/ imputed cost

4.(a) Past cost & (b) Future cost

(a) They are actual costs incurred in the past & are generally contained in financial accounts Ex:It helps for future (b) Costs that are expected to occur in some future period It is concerned for the managerial decision makers

5.(a) Accounting cost & (b) economic cost

(a) It points how much expenditure has already been incurred on a particular process/ on production It is used for tax planning purposes (b) It is in nature of incremental costs both imputed & explicit costs as well as the opportunity costs It is used in managerial decision making

6.(a) Private cost & (b) social cost

(a) Those costs which are actually incurred/ provided for the business activity by an individual / business firm (b) Total costs to society on account of production of a good Ex: Polluting land/water

7.(a) Direct /traceable/assignable cost& (b) Indirect /non traceable/common/non assignable Cost

(a) Which have direct relationship with a unit of operation like a product , a process or a department of a firm (b) Costs whose course cannot be easily & definitely traced to the plant , a product , a process or department Ex: land cost, building cost cannot be directly attributed to cost of per unit of product

8.Controllable & Non Controllable costs

(a) Costs which are capable of being controlled/regulated by the managers (b) Costs which are not capable of controlling Costs which are involved in obsolescence & depreciation

9.Replacement & Original Costs

(a) Costs that the firm incurs if it wants to replace/acquire the same assets now (b) Costs paid for assets such as land , building, cost of plant, equipment & materials at price paid originally for them

10.Shut down & abandonment cost

(a) Cost which the firm incurs if it temporarily stops its operation Example: fixed costs, sheltering cost of equipment (b) Costs of retiring altogether a fixed asset from use Example: war time use machines

11.Urgent & Postponable Cost

(a) The cost the firm must incur so that the operations of the firm continue Example: Cost of material , labour, fuel (b) Cost where postponement does not affect the operational efficiency of firm Example: maintenance cost

12.Business cost & full cost

(a) Costs which are known in profit & loss account for legal & tax purposes (b) It is the sum of Opportunity costs & normal profits

13.Fixed & Variable Cost

(a) Costs of firm which is part of total cost & which does not vary with output

TFC

FC

output

(b) The cost which vary with the output

VC TVC

output

14.Short run & Long run cost

(a) A period in which supply of at least one of inputs cannot be changed by firm Example: building, machinery (b) A period in which inputs can be varied as desired

15.Incremental & Marginal cost

(a) It is important when dealing with decision where discrete alternatives are compared It is change in any number of units of output or even a change in quality of output (b) It is the amount added to TC by a unit increase in output

16.Average cost, Marginal costs & total cost

Average cost = total cost units produced Marginal cost=extra cost of producing one additional unit Total cost = fixed cost + variable cost

DETERMINANTS OF COST
Level of Output Prices of input factors Production lot size Size of plant Output stability Laws of returns Level of capacity utilization Period under consideration Technology Learning effect Breadth of product range Geographical location

COST-OUTPUT RELATIONSHIP
The 2 aspects are 1.Cost output relationship in short run (firms cannot alter its fixed equipment) 2.Cost output relationship in Long run (firms has sufficient time to alter its fixed equipments)

1.Cost output relationship in short run

It is studied in terms of (a)Average Fixed Cost & output (b)Average Variable Cost & Output (c)Average Total Cost & Output

(a) Average Fixed Cost (AFC) & output

Increase in output results in decrease in FC/unit Total Fixed cost(TFC) is same for any output Average Fixed cost(AFC) = TFC units of o/p produced Example, (a) when TFC is Rs.1000, O/P units is 10 Then AFC =1000/10 = 100 units (b) when TFC is Rs.1000, O/P units is 20 Then AFC =1000/20 = 50 units Therefore AFC falls as O/P increases

(b) Average Variable Cost (AVC) & Output

It will first decrease & then rise as more & more units are produced Because when increase in variable factors will leads to efficiency of inputs which first increases & then decreases Once optimum capacity of production is reached, any future increase in output beyond optimum capacity will surely increase the AVC Example: To produce increase in output after reaching optimum level , more & more workers have to be appointed which leads to overcrowding & results in high wage rates.

(c) Average Total Cost (ATC) & Output

It decreases with increase in output to certain level & then starts to increase up Turning point in cost from downward trend to upward trend in ATC comes little later than in case of AVC ATC = AFC + AVC Least cost output level is where ATC is minimum & not AVC

Short-Run output cost curves

MC
ATC

AVC

Costs

z y x AFC

Outputfig

Relationship between ATC, AVC & MC

3 costs fall atfirst & then remains constant & rise as output increases Rate of change in MC is less than AVC & hence minimum MC is at output lower than output at which AVC is minimum ATC falls for a longer range of output than AVC & hence the minimum AVC AVC = MC, when AVC is the least ATC =MC , when ATC is the least

Cost Output relationship in long run

There wont be any fixed cost in long run It also referred as cost of producing different levels of output by changing size of plant / scale of production. ATC2
Y ATC1 ATC3 E

Cost

output

 A minimum point of ATC2 is at C, produces output of OA If output increases to OB & when firm continues in old scale, then the least cost point in ATC2 is E If the output increases to OB with increase in scale, then the new least cost point is D in ATC3 curve Here BD will be less than BE Long run Average cost (LAC) curve is drawn using no. of Short run Average Cost (SAC) curves

Deriving a long-run average cost curve:

Costs

LRAC (Envelope curve)

A1(E=D)

Output

Nature of Long Run Cost Curves

1.LAC curve is tangential to SAC curve & also called as envelope curve 2.LAC curve is U shape, it is because lower average costs at first till optimum scale of production & then it rise 3.LAC curve never cut by any SAC curve 4.LAC curve will touch the optimum scale curve at optimum scale curves least cost point(A1) 5.At A1, Economies = Diseconomies

Usefulness of LAC curve

It helps the organization to determine size of plant to be adopted for producing the given output When firm operate in increasing return to scale, it is economical to under use a slightly larger plant operating at less than its minimum cost output level than to over use a smaller plant

Economies & Diseconomies of scale

The existence of this is responsible for U shaped LAC curve It is concerned with behavior as plant size changes When LAC declines as output increases which says the cost structure is characterized by economies of scale When LAC increases as output increases which says the cost structure is characterized by Diseconomies of scale When LAC is constant it is neither economies nor diseconomies of scale

A typical long-run average cost curve

Costs

Economies of scale

Constant costs

Diseconomies of scale

LRAC

Output

2 types of economies & Diseconomies

a) External Economies which are available to all firms in an industry Ex: Constructing railway line will decrease transport cost for all firms b) Internal Economies Which are available to a particular firm & gives it an advantage over other firms engaged in production of same products in industry Various factors involved are (1)Labour economies & Diseconomies (2)Technical Process economies & Diseconomies (3)Managerial economies & Diseconomies (4)Marketing economies & Diseconomies (5)Financial economies & Diseconomies (6)Diversification in output economies & Diseconomies (7)Diversification of market economies & Diseconomies (8)Risk spreading economies & Diseconomies

ESTIMATION OF COST OUTPUT RELATIONSHIP

It can be estimated through the following 3 approaches (1)Accounting Method Here the TC is classified to fixed, variable & semivariable costs Average VC, range of o/p within which the semi variable is fixed & amount of FC are determined on the basis of inspection & experience After these steps TC, average & marginal costs for each output level is obtained through simple arithmetic (2)Engineering Method It is derived by estimating the physical units of various input factors i.e., plant size, man hours, etc Once it is determined, they are multiplied by the respective current/expected factor prices & added together to yield cost estimates for that output level

(3)Econometric Method Expressions of common forms are (i) Linear : TC = a1 + b1x (ii) Quadratic : TC = a2 + b2x + c2x2 (iii) Cubic : TC = a3 + b3x + c3x2 + d3x3 where, x - O/P a1,b1,c1,d1 --- constant To determines not only partial cost function cost output relationship on assumption that other determinants of cost (factor prices technology) are constant but also to determine the comprehensive cost function , which allows variations in all the factors influencing cost.