Module-2

Production & Cost

Syllabus
Production function-law of variable proportion-economies
of scale-internal and external economies-Isoquants, isocost
line and producers’ equilibrium- Expansion path- Technical
progress and its implications-Cobb-Douglass production
function-Cost concepts
Social costs: private cost & external cost- Explicit cost and
implicit cost- sunk cost- short run & long run curves-
Revenue (concepts)Shutdown point- Break-even point.
Production
• In Economics the word ‘production’ is used in a wider sense
to denote the process by which man utilises resources such
as men, material, capital, time etc, working upon them to
transform them into commodities and services so as to make
them satisfy human wants.
• In other words, production is any economic activity which
converts inputs into outputs which are capable of satisfying
human wants.
• Whether it is making of material goods or providing a service,
it is included in production provided it satisfies the wants of
some people.
• Therefore, in Economics, activities such as making of cloth
by an industrial worker, the services of the retailer who
delivers it to consumers, the work of doctors, lawyers,
teachers, actors, dancers, etc. are production.
FACTORS OF PRODUCTION
• Factors of production refer to inputs.
• An input is a good or service which a firm buys for use in its
production process.
• Production process requires a wide variety of inputs, depending on
the nature of output. The process of producing goods in a modern
economy is very complex.
• A good has to pass through many stages and many hands until it
reaches the consumers’ hands in a finished form.
• Land, labour, capital and entrepreneurial ability are the four factors
or resources which make it possible to produce goods and services.

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 results
from the use of these resources.
• More specifically, it states technological relationship between inputs
and output.
• The production function can be algebraically expressed in the form
of an equation in which the output is the dependent variable and
inputs are the independent variables.
• The equation can be expressed as: Q = f (a, b, c, d …….n).
 • Where ‘Q’ stands for the rate of output of given commodity and a, b,
c, d…….n, are the different factors (inputs) and services used per
unit of time.
Short-Run Vs Long-Run Production Function
• The production function of a firm can be studied in the context of
short period or long period.
• Short run is the period in which the firm cannot vary all the inputs for
a change in the output.
• Some inputs are flexible (can be changed) and some are fixed
(cannot be changed) under the short run.
• Inputs that can be changed in the short run are called variable inputs
or variable factors.
• For example, a firm can vary quantity of labour, quantity of raw
materials, energy [Link] increase the output. It may be possible for
the firm to change these variable inputs within a short period of time.
• But all the short run inputs cannot be changed. Such short run inputs
which cannot be changed are called fixed inputs or fixed factors.
• For example, size of the factory building, new machinery, new
technology etc. Since the time period is short, it may not be possible
for the firm to change these fixed inputs.
• Long run is the period in which the firm can vary all inputs for a
change in the output. So, in the long run, there is no fixed input,
ie.,all inputs are variable. Thus, the distinction between fixed inputs
and variable inputs exists only in the short run.
• There are two types of production functions based on the
arrangement of inputs or factors of production. They are:
I. Short Run Production Function
II. Long Run Production Function

Short Run Production Function

• It is an arrangement in which only input is varied, keeping all other
inputs constant. So, the proportion between the inputs changes. The
production function which operates in such situation is called short
run production function. Since the proportion between inputs
changes, it is also called as Law of Variable Proportion or Law of
Returns to a Factor.
 • In the short run, some factors of production are fixed, while others
are variable. Firms can only adjust the variable inputs (like labor and
raw materials) to change the level of output, but cannot easily alter
fixed factors (such as machinery or factory size).
• Example: A bakery might hire more workers during the holiday
season (variable input) but cannot expand its bakery space (fixed
input) in the short run.

Long Run Production Function

• The long run is a period of time (or planning horizon) in which all
factors of production are variable. It is a time period when the firm
will be able to install new machines and capital equipment’s apart
from increasing the variable factors of production.
• A long-run production function shows the maximum quantity of a
good or service that can be produced by a set of inputs, assuming
that the firm is free to vary the amount of all the inputs being used.
• In the short run, some factors of production are fixed, while others
are variable. Firms can only adjust the variable inputs (like labor and
raw materials) to change the level of output, but cannot easily alter
fixed factors (such as machinery or factory size).
• Example: A bakery might hire more workers during the holiday
season (variable input) but cannot expand its bakery space (fixed
input) in the short run.
Production Function is an expression of the technological relationship
between the physical inputs and outputs of a good.
The term "product" describes the volume of goods produced by a
business or industry over a certain period.
The product concept can be seen from three different perspectives:
1. Total Product
2. Marginal Product
3. Average Product

➢ Total Product (TP):

Total Product refers to the total quantity of goods produced by a
firm during a given period of time with a given number of units. For
example, if 5 labours produce 6 kg of wheat, then the total product
 is 30 kg. A company can increase TP in the short term by focusing
primarily on the variable components. But over time, both fixed and
variable elements can be increased to raise TP. Other names of
Total Product are Total Physical Product, Total Return, or Total
Output.

➢ Average Product (AP):

Average Product refers to output per unit of a variable input. For

example, if the total product is 30 kg of wheat produced by 5
labours(variable inputs), then the average product will be 30/5, i.e.,
6 kg. AP is calculated by dividing TP by units of the variable factor.
Formula:

➢ Marginal Product (MP):

Marginal Product refers to the addition to the total product when one
more unit of a variable factor is employed. It calculates the extra output
per additional unit of input while keeping all other inputs constant. Other
names of Marginal Product are Marginal Physical Product
(MPP) or Marginal Return.
Formula:
MPn = TPn - TPn-1

Where,
MPn = Marginal product of nth unit of the variable factor
TPn = Total product of n units of the variable factor
TPn-1 = Total product of (n-1) units of the variable factor
n = Number of units of the variable factor
For example, if 5 labours make 30 kg of wheat and 6 labours make 35
kg of wheat, then the MP of 6 labour will be:
 MP6= TP6 - TP5
MP6= 35 - 30 = 5 kg
One more way to calculate MP
MP is the change in TP when one additional unit of variable factor is used.
However, when the change in variable factor exceeds one unit, MP can
be calculated as:

The Law of Variable Proportion and the law of Marginal

Product.
The law of diminishing marginal product is related to short run
production function. In the short run, some inputs are variable and
some are fixed.
When we increase the units of a variable input, keeping other inputs
constant, the total product will increase up to a certain point after which
the resulting marginal product starts falling. This phenomenon is called
the law of diminishing marginal product or returns to a factor.
The law of variable proportion is a related concept of the law of
diminishing marginal product. This law states that when more and more
units of a variable inputs are added with fixed inputs, initially TP
 increases at an increasing rate, then increases at a diminishing rate,
reaches maximum and finally starts to decline. If we express in terms
of MP, the law states that when the quantities of a variable input are
added with fixed input, initially MP increases, then falls, becomes zero
and finally become negative.
Both the law of diminishing marginal product and the law of variable
proportion is the same. The law of variable proportion has three stages.
In other words, the total product and the marginal product pass through
three stages. They are:
I. Increasing Returns to a Factor
II. Decreasing Returns to a Factor
III. Negative Returns to a Factor

Three stages of law of variable proportions

The three phases can be identified by inspecting the behaviour of MP

of variable input in the above table. MP of variable input rises up to 3
units. This is phase I in which TP increases at an increasing rate. From
4th unit to 8th unit of variable input, MP falls but remains positive. This
is phase II in which TP increases at a decreasing rate. MP of variable
input becomes negative from 10th unit. This is phase III in which TP
starts falling. These three phases of the short-run law of production are
graphically illustrated by the relationship between TP and MP curves.
Phase I. Phase of Increasing Returns

In this phase, TP curve is increasing at an increasing rate. MP curve

rises and reaches at maximum. AP also increases and reaches its
maximum at the end of the first stage. This stage represents increasing
returns to a factor. A rational producer will not operate in this phase
because the producer can always expand through phase I.

Phase II. Phase of Diminishing Returns

It is the most important phase out of the three phases. TP curve

increases at a decreasing rate and reaches a maximum. MP curve is
maximum to the point where the MP curve falls and become zero (i.e.,
from point B to C). AP curve is also declining. A rational producer will
always operate in this phase. The law of diminishing returns operates
in phase II.

Phase III. Phase of Negative Returns

In this phase, TP curve falls (after point C). Then MP becomes negative.
AP continues to decline, but never becomes zero. This stage represents
Negative returns to a factor. A rational producer will not operate in this
phase, even with free labour, because he could increase his output by
employing less labour. It is a non-economic and an inefficient phase.
Economies of scale – internal and external economies
Economies of scale refer to the cost advantage experienced by a
firm when it increases its level of output. There are two main types
of Economies of Scale – they are internal and external. Internal
economies of scale refer to benefits that occur within the firm. For
example, the firm may be able to obtain higher levels of credit due to its
size.

By contrast, external economies occur outside of the firm, but inside the
industry, that makes them more efficient.

Internal Economies

[Link] Economies

In large scale operations workers can do more specific tasks. With little
training they can become very proficient in their task, this enables
greater efficiency. A good example is an assembly line with many
different jobs.

[Link] Economies

Some production processes require high fixed costs e.g. building a

large factory. If a car factory was then only used on a small scale, it
would be very inefficient to run. By using the factory to full capacity,
average costs will be lower.
[Link] Economies

If you buy a large quantity, then the average costs will be lower. This is
because of lower transport costs and less packaging. This is why
supermarkets get lower prices from suppliers than local corner shops.

[Link] Economies

Some investments are very expensive and perhaps risky. Therefore

only a large firm will be able and willing to undertake the necessary
investment. E.g. pharmaceutical industry needs to take risks in
developing new drugs

5. Marketing economies of scale

There is little point a small firm advertising on a national TV campaign

because the return will not cover the high sunk costs

External Economies
This occurs when firms benefit from the whole industry getting bigger.
E.g. firms will benefit from better infrastructure, access to specialized
labour and good supply networks.

Isoquants
• It is a curve which shows various combinations of two factor
inputs which give the same level of output.

• ISO means equal and QUANT means quantity.

• It is also called Isoproduct curves and Equal product curves.

Properties of Isoquants
1. Isoquants are negatively sloped
An isoquant slopes downwards from left to right. The logic
behind this is the principle of diminishing marginal rate of technical
substitution. In order to maintain a given output, a reduction in the
use of one input must be offset by an increase in the use of
another input.

2. Isoquants are convex to the origin

An isoquant must always be convex to the origin. This is because
of the operation of the principle of diminishing marginal rate of
technical substitution. MRTS is the rate at which marginal unit of
an input can be substituted for another input making the level of
output remain the same.

The marginal rate of technical substitution (MRTS):

The rate at which one input can be substituted for another along
an isoquant is called the marginal rate of technical substitution
(MRTS), defined as:

∆K/∆L = MPL/MPK = MRTSL

3. Two isoquants cannot cut each other: If they intersect each other,
there would be a contradiction and we will get inconsistent results.

4. An isoquant lying above and to the right of another isoquant

represents a higher level of output.

This is because of the fact that on the higher isoquant, we have

either more units of one factor of production or more units of both
 the factors.

5. Isoquants need not be parallel

The shape of an isoquant depends upon the marginal rate of

technical substitution. Since the rate of substitution between two
factors need not necessarily be the same in all the isoquant
schedules, they need not be parallel.

Types of Iso-quant Curves

Linear Iso-quant Curve:

This curve shows the perfect substitutability between the factors
of production. This means that any quantity can be produced
either employing only capital or only labor or through “n” number
of combinations between these two

Right Angle Iso-quant Curve:

This is one of the types of iso-quant curves, where there is a strict
complementarity with no substitution between the factors of
production. According to this, there is only one method of
production to produce any one commodity. This curve is also
known as Leontief Iso-quant, input-output isoquant and is a right
angled curve.
Isocost line
An isocost line is a graphical representation of various
combinations of two factors (labor and capital) which the firm can
afford or purchase with a given amount of money or total outlay.

Mathematically, an isocost line can be expressed as

C=wL+rK
Where,
C = cost of production
w = price of labor
or wages
L = units of labor
r = price of capital or
interest rate
K =units of capital

In the given diagram, x-axis represents units of labor and y-axis

represents units of capital. Therefore, OB in the figure represents
50 units of labor and OA represents 40 units of capital.

If we join points A and B, we get isocost line for Rs. 200. And, the
straight line which joins points A and B will pass through all
combinations of labor and capital which the firm can buy with the
outlay of Rs 200, if it spends the entire sum on them at the given
prices.

This way, an isocost line is also known as price line or outlay line
Shift in Isocost Line
An isocost line may shift due to two reasons. They are

1. Change in total outlay to be made by the firm

2. Change in price of a factor-input

Change in total outlay to be made by the firm

When the firm decides to increase the total money to be spent on purchase
of inputs while prices of the inputs remain the same, the producer becomes
able to afford such combinations of inputs which were initially unattainable
to him. This causes isocost line to shift to a new position higher to the initial
line.

In the above figure, AB is the initial isocost line. When the firm increased its
total outlay, the isocost line shifted rightwards to a higher position A’B’ where
the producer could purchase combinations of inputs with higher units of labor
and capital. Likewise, if the firm reduces its total outlay, the isocost line will
shift leftwards to A”B”.
Change in price of a factor-input
Case I: Change in price of labour.

Figure: shift in isocost line due to change in price of labor

 Let us suppose that a firm has total outlay of Rs. 200 and AB is initial isocost
line. Let us also suppose that the price of labor was decreased by certain
amount, as a result of which the producer became able to purchase more
units of labor at the same outlay. However, the producer can’t increase
purchasing units of capital as price of capital is constant. Therefore, the
position of price line is changed in the x-axis but unchanged in y-axis.

Simply, decrease in price of labor causes anti-clockwise rotation and

increase in price of labor causes clockwise rotation.

Case II: Change in price of capital

Figure: shift in isocost line due to change in price of capital

Once again, let us assume that a firm has total outlay of Rs. 200 but this
time let us suppose that the price of capital has changed and not of labor.

In this case, the producer will be able to buy more units of capital at
same outlay but won’t be able to increase the purchasing units of labor.
As a result, the isocost line shifts its position in y-axis and not in x-axis.
In the diagram, we can see that isocost line AB shifts to new position
A’B as a result of decrease in price of capital. Likewise, the line shifts
to A”B as a result of increase in price of capital.
In other words, decrease in price of capital causes clockwise shift in
isocost line and increase in price of capital causes anti-clockwise shift.

Producer’s Equilibrium / Least cost combination

The point of least-cost combination of factors for a given level of

output is where the isoquant curve is tangent to an iso-cost line.
The iso-cost line GH is tangent to the isoquant 200 at point M.
The firm employs the combination of ОС of capital and OL of
labour to produce 200 units of output at point M with the given
cost-outlay GH. At this point, the firm is minimising its cost for
producing 200 units.

Any other combination on the isoquant 200, such as R or T, is

on the higher iso-cost line KP which shows higher cost of
production. The iso-cost line EF shows lower cost but output
200 cannot be attained with it. Therefore, the firm will choose
the minimum cost point M which is the least-cost factor
combination for producing 200 units of output.

Thus the equilibrium condition

W/r = MPL/MPK = MRTSLK

EXPANSION PATH
Expansion path is a line or a curve on which every point is an
equilibrium point. All these points indicate minimum cost
combinations of two factors at various levels of output. Expansion
path shows the path on which a rational producer would prefer to
increase scale of production in his firm.
Technical Progress and its implications

When there is a change in technical progress, the production function will

change. Thus production will increase. Technical progress may be
embodied and disembodied.

Embodied technical progress:

Improved technology which is attributed to investments in new
equipment. New technical changes that are made are embodied in the
equipment.

Disembodied technical progress:

Improved technology which results in output increases without
investing in new equipment.

Cobb-Douglas Production Function

A famous statistical production function is Cobb-Douglas production
function. Paul H. Douglas and C.W. Cobb of the U.S.A. studied the
production function of the American manufacturing industries.
In its most standard form for production of a single good with two factors,
the function is:
Cobb- Douglas production function is a linearly homogeneous production
function. That is, if we increase the inputs ‘t’ times, output will also increase
‘t’ times.
Cost
Costs refer to all expenses incurred by the producer or a firm to produce
goods and services. A firm requires inputs to produce goods and services.
Production is the result of effective combination of inputs. The expenses
incurred for purchasing this combination of inputs are called costs. Thus,
cost is the expenditure incurred for purchasing different combinations of
inputs required for producing goods and services. Rent, wages, interest,
electricity charges, cost of raw materials, transportation, wear and tear,
depreciation, expenses for training employees, etc, are examples of costs.
As mentioned earlier, a particular level of output can be produced with
different combinations of inputs. From all these combinations of inputs,
the firm will choose the combination which is least expensive. This output-
cost relationship is known as the cost function. The cost function can be
written as C= f (q)
C= Cost
q= Output

Cost Concepts
1. Explicit Cost: It is the expenses actually met by the producer
while producing a commodity. (Raw materials)
2. Implicit Cost: It is the opportunity cost of the factor services
supplied by the firm itself. (Rent)
3. Accounting Costs: This is the monetary outlay for producing a
certain good. Accounting costs will include your variable and fixed
costs you have to pay.
4. Sunk Costs: These are costs that have been incurred and cannot
be recouped. (Adv cost)
5. Social Costs: This is the total cost to society. It includes private
costs plus any external costs.
6. Private cost: It is the cost incurred by the producer in the production
of a good.
7. External Cost: When a commodity is produced it may cause
damages to the environment in the form of air pollution, water
pollution etc.
 8. Replacement cost: It is the amount of money required to replace
an existing asset with an equally valued or similar asset at the
current market price.

Types of Cost

Short run cost: Cost refers to a certain period of time where at least one
input is fixed while others are variable. It refers to a certain period of time
where at least one input is fixed while others are variable.
Long run cost: The long run is a period of time in which all factors of
production and costs are variable.
➢ The total cost/Short run total cost (SRTC) refers to the actual cost
that is incurred by an organisation to produce a given level of output.
The Short-Run Total Cost (SRTC) of an organisation consists of two
main elements:

➢ Total Fixed Cost (TFC): These costs do not change with the
change in output. TFC remains constant even when the output is
zero. TFC is represented by a straight line horizontal to the x- axis
(output).
➢ Total Variable Cost (TVC): These costs are directly proportional to
the output of a firm. This implies that when the output increases,
TVC also increases and when the output decreases, TVC
decreases as well.
SRTC is obtained by adding the total fixed cost and the total variable cost.
SRTC = TFC + TVC
As the TFC remains constant, the changes in SRTC are entirely due to
variations in TVC.
Short Run Average Cost
The average cost is calculated by dividing total cost by the number of
units a firm has produced. The short-run average cost (SRAC) of a firm
refers to per unit cost of output at different levels of production. To
calculate SRAC, short-run total cost is divided by the output

Short Run Marginal Cost

Short Run Marginal cost (SRMC) or Marginal Cost (MC) is the change in
total cost due to the production of an additional unit of output.

Position of short run average and marginal cost curves

 The short-run marginal cost (SRMC), short-run average cost
(SRAC) and average variable cost (AVC) are U-shaped due to
increasing returns in the beginning followed by diminishing returns.
SRMC curve intersects SRAC curve and the AVC curve at their lowest
points.

LONG RUN COST

The long run is a period of time in which all factors of production
and costs are variable. According to the long run, all inputs are
variable. There is no fixed cost.

Long Run Total Costs

Long run total cost refers to the minimum cost of production. It is the
least cost of producing a given level of output.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC
curve or the cost per unit of output in the long run. It is derived from the
short run average cost curves.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing

an extra unit of the output in the long-run
Revenue
Revenue is the money payment received from the sale of a commodity.

Concepts
Total Revenue (TR)
TR is defined as the total or aggregate of proceeds to the firm from the
sale of a commodity
TR = P.Q where
P = Price

Q = Quantity sold
Average Revenue
AR is revenue per unit of output sold. It is obtained by dividing total revenue by the

number of units sold.

AR = Total Revenue / Number of units sold

Marginal Revenue (MR)

MR is addition made to total revenue when one more unit of output is sold.

MR = TR n - TR n-1
 MR = d(TR) / d(Q)

Shutdown point

A shutdown point is a level of operations at which a company experiences

no benefit for continuing operations and therefore decides to shut down
temporarily—or in some cases permanently. At the shutdown point, there
is no economic benefit to continuing production
A shutdown arises when price or average revenue (AR) falls below
average variable cost (AVC) at the profit-maximizing output level.
Continued production will incur additional variable costs but will not
generate enough revenue to cover them. At the same time, the firm will
still have fixed costs to pay, further increasing the losses.
Shutdown point is defined as that point where the market price of the
product is equal to the AVC in the short run.

In summary, the shutdown point has the following characteristics:

1. It is the output and price point where a firm is able to just

cover its total variable cost.
2. The average variable cost (AVC) is at its minimum point.

3. It is where the marginal cost (MC) curve intercepts the

average variable cost (AVC) curve.
 4. The firm is indifferent between shutting down and continuing
production where losses equal to the total fixed costs are
incurred regardless of either decision.
Break Even Point

It is a method used to study the relationship between TC and TR. The

break-even point is the point at which total cost and total revenue are
equal, meaning there is no loss or gain for your small business.

BEP is the point where TC equals to TR. No profit, no loss (zero profit)

BEP: TC = TR
Profit / Loss = TR – TC
Profit / Loss = (P x Q) – (TFC + TVC)
BEP = TFC / P – AVC
NOTE:

1.) At BEP, it is zero profit

2.) When no of units sold is lesser than BEP, it is loss

When no of units sold is greater than BEP, it is profit

Observations:

TC > TR, it is Loss

TC < TR, it is Profit
TC = TR, No Profit , No Loss ( BEP )

PV Ratio (Profit Volume Ratio) is the ratio of contribution to sales.

P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S

or, P/V Ratio = Fixed Cost + Profit/Sales i.e. F + P/S

Using PV Ratio, we can find BEP

BEP = TFC/ PV Ratio OR TFC * S / S – V

Margin of Safety (MOS)

• MOS is the sales beyond break – even point. Margin of safety is how much
output or sales level can fall before a business reach its BEP.
• Margin of Safety = Excess of Sales – BEP

Advantages of BEP

• To know the cost revenue relationship

• To plan future business expansion
• To plan future production
• To target sale
• It helps in managerial decision making