Chapter Three Chapter Three Production and Cost Analysis Production and Cost Analysis

ME for MBA 7/26/2014
CHAPTER THREE
Production and Cost Analysis
3.1 Theory of Production

3.2 Theory of Costs
3.1 Theory of Production

The theory of production is the basis for the theory
of cost as the theory of consumer behavior was for
the theory of demand.
The theory of production examines the physical
relationships between inputs and output.
For example, the number of workers, tons of
steel, barrels of oil, megawatts of electricity,
hectares of land, number of drilling machines,
and number of automobiles produced.
produced.
Managers are concerned with these relationships
because they want to optimize the production
process, in terms of efficiency, as there might be
different combinations (techniques) to produce
certain level of output.
1
Basic concepts and definitions

Production – the process of transforming
inputs into output (a consumable form).
Production function – shows the maximum
amount of a good that can be produced
using alternative combinations of inputs.
Q = f(L,K)
Resources / Inputs / Factors of production –
they refer to anything used in the production
and distribution of goods and services.
These are: Labor, Land, Capital,
Entrepreneurship.
Fixed factors - inputs that cannot be

changed in the short run, but can be changed
in the long run. For example, Land & capital
Variable factors – they are inputs that can be
varied in both the short run and long run.
For example, raw materials and labor.
Short run - the period during which at least
one input is fixed and the others are
variable.
Long run – a period of time long enough for
all inputs to be varied.
2
Scale of production – it refers to a firm’s

capacity.
capacity. It is the maximum output that a
firm can produce in the short run when
some inputs are fixed.
This implies that a firm cannot change its
scale in the short run.
run.
Efficiency
Technical efficiency (production
production) – this
production
implies that a firm is producing the
maximum possible output from given
quantities of inputs.
Economic efficiency (production + cost
cost)
– this involves producing a given output
at least cost.
Production in the short run

Lets consider a two-factor situation,
involving labor and capital, where capital is
fixed.
The marginal product of labor (MPL) is the
additional output resulting from using one
more unit of labor, while holding the capital
input constant, and vise versa.
Consider a Cobb–Douglas function, .

The MPL = = slope of Q.
The coefficient ‘b’ is the elasticity of
output with respect to labor while ‘c’ is
for capital.
3
Derivation of the short run MPL & APL

Consider the following short run production
function:
We can show the impact of rising labor,

given a fixed level of capital, on TP (Q),
MPL and APL with the following table.
4
Graphically,
In the above graph:

When the variable input (L) is very low, the
underutilized.. Thus, additional
fixed input(K) is underutilized
worker could increase productivity.
At this stage the TP increases at an increasing
rate; hence the MP increases.
However, as more workers are employed, the
over--utilized
fixed factor (K) becomes over utilized..
AS a result, the TP increases, but at a
decreasing rate; hence MP starts decreasing.
This effect becomes more serious as even more
workers are added.
5
The fixed factor becomes so over-

over-utilized and
workers so crowded that total output starts to
fall; the marginal product now becomes
negative.
The Law of Diminishing Returns/Law of
Variable Proportion – states that when
additional units of a variable factor (in this case
labor) is combined with a fixed amount of
another factor (in this case capital) the additions
to total output, in other words the marginal
product, will eventually decline.
The relationship between TPL, MPL & APL

Consider point G, H & J on the graph above.
At point G, the MPL (slope of TP) is at
maximum. The TP curve changes from convex
to concave shape to the horizontal axis.
The slope of a line from the origin to the TP
curve, which is a measure of APL (TP/L), is
maximum at point H. At this point, APL and
equal..
MPL are equal
The TP curve reaches maximum at point J; this
means that the slope (MPL)is 0.
Stage II is a rational stage of production.
6
Production in the Long-

Long-run
Isoquant - is a curve that shows various
combinations of inputs that yield the same
total quantity of output.
Properties of Isoquant:
Isoquant: analogous with the
curves..
properties of Indifference curves
MRTSLK - the MRTS of L for K is a
measure of the rate at which L is substituted
for K, while maintaining total output
constant.
It measures the amount of K sacrificed for
each additional unit of L used ( ).
7
When the firm moves from point B to C, the

gain of output from using more L should be
equal to the loss from using less K, i.e.,
This is the slope of an Isoquant, which is the

same as the marginal rate of technical
substitution of L for K.
Degree of homogeneity and returns to scale

A homogenous function has a form:
The function is said to be homogenous of degree

n and it indicates the type of returns to scale.
Ex.
Ex. 1: Cobb-Douglas production function
Q = f(L, K) = ALaKb
Q* = f(tL
f(tL,
tL, tK) tL)a(tK)
tK) = A(tL
A(tL) tK)b = AtaLatbKb
Q* = ta+bALaKb = ta+bQ
Degree of homogeneity:
homogeneity: a+b
Returns to scale:
scale: IRS if a+b >1.
DRS if a+b <1.
CRS if a+b = 1.
EX.
EX. 2:
8
Optimal combination of inputs

Isocost line – shows the different
combination of inputs that can be employed
given a certain level of cost outlay and prices
of the factors.
The slope is:

The objective of the firm is to minimize cost
required to produce certain level of output.
This occurs at the point where the isoquant is
tangent to the lowest possible isocost line.
At this point the slopes are equal.
EX:: w = $400,
EX 400, r = $500.
500.
9
It can be seen from the graph that the

minimum cost to produce 80 units of an
output is $4000,
4000, shown by point C.
Other combination, for example point B,
costs more than $4000.
4000.
Application..
Application
A firm has the following short run
production function:
Where Q is output per week and L is number

of workers employed
employed..
1. When does the law of diminishing returns
take effect?
2. Calculate the range of values for labor over
which stages I, II and III occur.
10
Application..
Application
A bottling plant employs three different
types of labor: unskilled manual workers,
technicians and supervisors. It has estimated
that the marginal product of the last manual
worker is 200 units per week, the marginal
product of the last technician is 275 units
per week and the marginal product of the
last supervisor is 300 units per week. The
workers earn £300, £400 and £500 per
week respectively.
1. Is the firm using the optimal combination of
inputs?
2. If not, advise the firm on how to reallocate
its resources.
Application..
Application
A firm has estimated that it has the
following production function:
Labor costs £60 and capital costs £75. It wants

to maximize output subject to the cost
constraint of £1,500.
1. What amounts of labor and capital should
be used?
2. What is the total output from the above
combination?
11
3.2 Theory of Costs

Managers must have a good understanding of
cost relationships if they are to maximize the
value of the firm and profit.
There are many different definitions and
concepts of cost.
Accounting (explicit) vs.
vs. economic (explicit +
implicit) costs.
costs.
Historical vs.
vs. current/replacement costs
Costs in historical terms, at the time they
were incurred.
Current costs refer to the amount that
would be paid for an item under present
market condition.
Sunk vs.
vs. incremental costs
Sunk costs are costs that do not vary
according to different decisions.
Incremental costs refer to changes in costs
caused by a particular decision.
Short-
Short-run vs.
vs. long-
long-run costs
decision--making:
Relevant costs for decision
economic costs (not accounting costs),
current costs (not historical) &
incremental costs (not sunk costs).
costs).
Depreciation should be based on
replacement value, not on historical cost.
cost.
12
Derivation of Short-
Short-run costs
The short-
short-run cost function is derived from
the short-
short-run production function.
function.
In the short-
short-run, we have both fixed and
variable factors and, hence, fixed and
variable costs.
costs.
There is first increasing returns and then
decreasing returns in the short run as we add
more variable factor(s) on fixed factor(s).
factor(s).
this::
Due to this
1. The marginal cost is U-shaped - MC initially
falls as output rises because of increasing
returns and then it begins to rise because
of diminishing returns.
13
This implies that MC is inversely related to

MP, given that the price of labor/wage (PL) is
constant.
2. The AVC curve is also U-shaped – it is
inversely proportional to average product.
3. The AFC – continuously decreases as

output increases.
4. The ATC – this is also U-shaped because it
is the sum of AVC and AFC.
At low levels of output, ATC falls because
both AVC and AFC are falling.
After point H” the AVC starts rising, but the
ATC continuous to fall as the fall in AFC is
higher than the rise in AVC.
However, the ATC starts rising after point J”
since the rise in AVC more than offsets the
fall in AFC.
14
Optimal level of variable input
We can determine the optimal level of

variable input given the cost function
For example, given Q = f(L, Kf), then C =
TFC + wL.
wL. Thus,
max.
max. π = TR – TC = TR – TFC – wL w.r.t.
L.
∂ (TR − TFC − TVC ) ∂TR ∂TVC
=0 ⇒ =
∂L ∂L ∂L
⇒ MRPL = MEL
The Long-
Long-Run Cost Function
Long run marginal cost(LRMC) measures the change in
long run costs associated with a change in output.
Long run average cost(LRAC) measures the average per-
unit cost of production when all inputs are variable.
In general, the LRAC is u-shaped.
◦ When LRAC is declining we say that the firm is
experiencing economies of scale.
Economies of scale implies that per-unit costs are falling.
◦ When LRAC is increasing we say that the firm is
experiencing diseconomies of scale.
Diseconomies of scale implies that per-unit costs are rising.
15
Application of various cost concepts in

Decision making
TC: useful in breakeven analysis and in
determining whether a firm is making profit
or loss
ATC: used for calculating profit to be
obtained from per unit of output produced
MC: useful in deciding whether a firm can
expand its output further or not of a
particular enterprise
Long-run cost: useful in making decision
about investment for expanding firm size in
the future
The LR Relationship Between Production

and Cost
The long run cost structure of a firm is
related to the firm’s long run production
process.
The firm’s long run production process is
described by the concept of returns to
scale.
Studies show that a firm’s long-run
production function may exhibit at first
increasing returns, then constant returns,
and finally decreasing returns to scale.
16
When a firm experiences increasing returns

to scale
◦ A proportional increase in all inputs increases
output by a greater percentage than costs.
◦ Costs increase at a decreasing rate
When a firm experiences constant returns to
scale
output by the same percentage as costs.
◦ Costs increase at a constant rate
When a firm experiences decreasing returns to
scale
output by a smaller percentage than costs.
◦ Costs increase at an increasing rate
The LR Relationship Between Production and Cost
This graph
illustrates the
relationship
between the
long-run
production
function and the
long-run cost
function.
17
Economies and diseconomies of scale

Could be internal (controllable) or external
(uncontrollable).
(uncontrollable).
Internal economies:
economies:
Technical – specialization & indivisibilities.
indivisibilities.
Managerial – more specialized managers.
managers.
Marketing – obtaining bulk discounts.
discounts.
Financial – more & cheaper sources of finance.
finance.
Internal diseconomies:
diseconomies:
Technical – motivation, productivity, strikes.
strikes.
Managerial – communications break down.
down.
Marketing -large dd may drive up inputs price.
price.
Transportation – larger market.
market.
Economies and diseconomies of scope

Whereas economies of scale relate to cost
reductions caused by increasing scale,
economies of scope occur when changing the
mix of operations has cost benefits.
benefits. There
are two main causes of this:
1. The products may use common processing
facilities; for example, different car models
being produced at the same plant.
2. There may be cost complementarities,
especially when there are joint products or
by-products.
18
Economies of scope could be measured by:

by:
C (Q1 ) + C (Q2 ) − C (Q1 + C2 )
s=
C (Q1 + C2 )
s > 0, economies of scope.

scope.
s < 0, diseconomies of scope.
scope.
The learning curve

This results from learning by doing which
leads to higher knowledge and experience
which in turn reduces unit costs overtime.
overtime.
The learning curve, which shows the r/ship
b/n unit cost and cumulative output, QC, is
downward sloping.
sloping.
Mathematically, U = a(Qc)b, where b<0 b<0. Or
logU = a + blogQC
19
Optimal combination of inputs in the

Long--run
Long
Given Q = f(L, K),
Optimal use of L & K:
Comes from:
from: max.
max. π=TR–
=TR–TC=TR–
TC=TR–rK–
rK–wL
w.r.t. L & K.
∂ (TR − TC ) ∂ (TR − TC )
=0 & =0
∂L ∂K
⇒ MRPL = MEL & ⇒ MRPK = MEK

MPL MEL
⇒ =
MPK MEK
Cost--Volume-
Cost Volume-profit analysis
CVP analysis – examines r/ps
r/ps b/n costs, revenues
and profit and volume of output.
output.
CVP is normally based on the assumption that both

TC & TR functions are linear.
linear.
20
TR = PQ
TC = F + mQ
Breakeven quantity:
quantity: TR = TC
PQ = F + mQ
QBE = F/(P – m)
Where F is fixed cost, p is price and m is the AVC.
Profit contribution:
contribution: ΠC = ∆ in Π / ∆ in Q
ΠC = P – m
Each unit the firm produces contributes P – m birr
to profit (or to the recovery of fixed cost).
cost).
Degree of Operating Leverage (DOL):(DOL): elasticity of
profit w.r.t. output.
output. DOL = % ∆ in Π / % ∆ in Q
Π = PQ-
PQ-mQ-
mQ-F
Π = Q(P-
Q(P-m) – F
DOL = (P – m) x Q/[(P–
Q/[(P–m)Q – F)]
= [(P-
[(P-m)Q]/[(P-
m)Q]/[(P-m)Q – F]
= [(P-
[(P-m)Q]/[(P-
m)Q]/[(P-m)Q – (P-
(P-m)QBE]
= [(P-
[(P-m)Q]/[(P-
m)Q]/[(P-m)(Q – QBE)]
= Q/(Q-
Q/(Q-QBE)
DOL is larger for points closer to the BEO.
BEO.
Example:
Example: A firm may have fixed costs of £10,000
per month and variable costs of £12 per unit; the
market price may be £20.
Profit contribution (ΠΠC) = 20 - 12 = £8
BEO = 10,000/8 = 1,250 units per month:
If the firm produces 1,251 units, Π=£8; if it
produces 1,252 units, Π =£16.
21
Thus the firm is contributing £8 to profit for every

unit it produces above break-even output.
If the firm produces no output it makes a loss of
£10,000 (its fixed costs); if it produces 1 unit it
makes a loss of £9,992.Thus the firm is contributing
£8 to fixed costs for every unit it produces below
break-even output.
If the firm is producing 1,500 units per month, the
DOL is calculated as follows:
C = 10,000 + 12Q and R = 20Q
Π = 8Q – 10,000 = £2,000 at output of 1,500 units.
DOL = 8 * 1,500/2,000 = 6
The interpretation of this result is that a 1 per cent
increase in output will increase profit by 6 per cent.
22

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ME for MBA 7/26/2014

3.1 Theory of Production

3.1 Theory of Production

Basic concepts and definitions

Fixed factors - inputs that cannot be

Scale of production – it refers to a firm’s

Production in the short run

Consider a Cobb–Douglas function, .

Derivation of the short run MPL & APL

We can show the impact of rising labor,

In the above graph:

The fixed factor becomes so over-

The relationship between TPL, MPL & APL

Production in the Long-

When the firm moves from point B to C, the

This is the slope of an Isoquant, which is the

Degree of homogeneity and returns to scale

The function is said to be homogenous of degree

Optimal combination of inputs

The slope is:

It can be seen from the graph that the

Where Q is output per week and L is number

Labor costs £60 and capital costs £75. It wants

3.2 Theory of Costs

This implies that MC is inversely related to

3. The AFC – continuously decreases as

Optimal level of variable input

We can determine the optimal level of

Application of various cost concepts in

The LR Relationship Between Production

When a firm experiences increasing returns

The LR Relationship Between Production and Cost

Economies and diseconomies of scale

Economies and diseconomies of scope

Economies of scope could be measured by:

s > 0, economies of scope.

The learning curve

Optimal combination of inputs in the

⇒ MRPL = MEL & ⇒ MRPK = MEK

CVP is normally based on the assumption that both

Thus the firm is contributing £8 to profit for every

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