MODULE 2

PRODUCTION AND COST

Production is the process by which inputs are transformed into output. Output can be a
product or a service. In other words it is the creation of utility.

Factors of production

There are four major factors of production these are the primary factors:

1. Land - Land is the free gift of nature in economics. It includes not only the surface area
but also the vegetation air water minerals etc. The reward of land in production is rent.
2. Labor – it is the physical or mental effort put in production for a monetary reward. The
reward of Labor is wages.
3. Capital-It is the produced means of production we’ll stop it can be in the form
of machinery, equipment, building etc. The reward of capital is interest.
4. Entrepreneurship - entrepreneur is the person who combines the services of other
factors and organize production. Burnett shun involves risk and this risk is taken by the
entrepreneur. Therefore the reward of entrepreneurship is profit.

Production function
In simple words production function refers to the functional relationship between inputs and
outputs. Next line in its general form a production function can be written as
Q = f ( L, K, N, T )
Where L - labor, K - capital ,N- natural resources including land, T – Technology .
Thus output is a function of these four factors
Short run production Or variable proportion next line in the short run output can be
increased by increasing the quantities of the variable factors in production. Further in the short
run certain factors like machinery building etc are considered as fixed. Their quantities cannot
be changed in the short. On the other hand labor, raw material etc. Are considered as variable
in the short run production can be increased by increasing the quantities of these variable
factors.
Long run production function or fixed proportion next line in the long run all factors
are variable. It is the period which is sufficient to increase the quantities of all the factors.
Hence output can be increased by increasing the quantities of all the factors in the same
proportion.
Law of variable proportion or returns to a factor or production function with one variable
input
Law of variable proportion describes the changes in output when more and more units of 1
variable factor is employed while keeping the quantities of other factors constant. Since the law
analysis the changes in output when there is a change in the quantities of only one variable input
it is also cold returns to a factor or production function with one variable input this happens in
the short run and hence it is short run production function.
The law states that when more and more units of one variable factor is employed with fixed
quantities of other factors, initially MP increases, then it decreases and finally it becomes negative
in other words, initially the total product increases at an increasing rate, then TP increases at a
decreasing rate and finally it starts declining the law is based on the following assumptions.
1.All units of the variable factor employed are equally efficient
2. Technology remains constant
3.The proportion of inputs can be varied
The low can be explained with a table suppose a farmer has a fixed area of land and land is
considered as the fixed factor labor is the variable factor and the farmer is employing more and
more units of Labor. The changes in TP,MP and AP are given in the following schedule.The law
of variable proportion can also be explained with the help of the following diagram The schedule
and diagram shows three stages while the low operates:

No.of units of Total Marginal Average

Labor Product Product Product

1 8 8 8

2 18 10 9

3 30 12 10 Increasing returns

4 40 10 10

5 45 5 9

6 48 3 8

7 49 1 7

8 49 0 6.1
Decreasing returns
9 45 -4 5

10 40 -5 4 Negative returns
 Stage 1:This is the stage of increasing returns during this stage while MP increases,
TP. increases at an increasing rate.In the table till the employment of the 3rd labor, MP is
increasing. In the diagram, till the point K, that is the point of inflexion, this situation
prevails.First stage continues till MP = AP.During this stage AP is also increasing
Stage 2: This is the stage of diminishing returns. During this stage, MP decreases and
hence TP increases at a diminishing rate. This can be seen in the table with each addition of labor
MP decreases and this continues till the employment of the 8th labor where MP becomes
0. Thus the second stage ends when M P = 0. When MP touches the X axis ( MP=0, TP curve
is at its highest point. In other words, when MP = 0, TP is the maximum.
Stage 3 : This is the stage of negative returns where MP becomes negative and TP
starts declining. In the table the employment of the 9th labor marks the beginning of the third
stage : from this point onwards,TP declines and the TP curve comes down. The MP curve
becomes negative and goes below the X axis.

Relation between MP and DP

1.When MP increases, TP increases at an increasing rate.
2.When MP decreases but remains positive, TP increases at a decreasing rate.
3.When MP becomes negative TP declines
Relation between MP and AP
1.When MP greater than AP, AP increases
2.When MP equals AP, AP is maximum
3.When MP less than AP, AP decreases
Significance of the law
The law has universal applicability. It can be applied to the fields of agriculture, fishing,
mining. It is applicable even to industries.

Returns to scale or fixed proportion or long run production function

in the long run all the factors are variable. Therefore output can be increased by increasing g the
quantities of all the factors in the same proportion. Thus the long run production function
describes the changes in output when all the inputs are varied at the same proportion when all
the inputs are varied at the same proportion, initially the producer gets increasing returns to scale,
then constant returns to scale and finally decreasing returns to scale. Increasing returns to scale
means that output increases at a greater proportion than the increase in inputs. That is when there
is a 10% increase in inputs output increases more than 10%. When there is a constant returns to
scale former output increases at the same proportion of the increase in inputs. A 10% increase
in inputs leads to a 10% increase in output. Decreasing returns to scale means output increases
at a lesser proportion.

Assumptions of the long run production function:

1.All units of the inputs used are homogeneous.
2.Technology remains constant.
Economies of scale
Economies of scale means advantages of large scale production which help in reducing the
average cost of production.
The economies of scale can be broadly classified into
1.Internal economies
2.External economies
Internal economies depend on the size of the firm these advantages emerge within the firm
itself as it scale of production increases.
The firm enjoys these internal economies itself the different types of internal economies
are labor economies – division of Labor which increases efficiency of Labor
Technical economies – S firm expands it can use the latest technology and machinery which
increases efficiency and reduces cost of production
Managerial economies-When there is large scale production specialist managers can be
appointed in different departments and this increases overall efficiency
Marketing economies-When a firm purchases a large quantity of raw materials it can get
the raw materials at a cheaper rate. Similarly large scale marketing will reduce average
marketing expenses.
Financial economies-when firms easily get funds at the lower rate of interest there is
financial economies.
External economies
External economies mean gains available to all the firms in an industry from the growth of that
industry will stop these advantages rice due to localization of the industry the important types of
external economies are
One economies of localization: when number of firms in the industry are located in one place,
there are mutual advantages in the form of availability of skilled hilabor, provision of better
transport facilities etc
Economies of information in an industry research work can be done jointly
Economies of byproduct: the availability of waste material in large quantity from the industry
may help the starting up of firms in the area which produce byproducts by using this waste
materials.
Diseconomies of Scale
Producers equilibrium and isoquant analysis
The equilibrium of a producer can be explained with the help of isoquants and isocost lines.
Isoquant
An isoquant is a curve which shows various combinations of two inputs which give equal
quantity of output. That is an isoquant represents equal quantity of output. Isoquants are also
called Iso product curves or equal product curves. The construction of an isoquant can be
explained with the help of the following schedule.

Combinations of Units of Labor (L) Units of Capital (K) Output of Cloth

Labor and capital
(meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100
In the above schedule labor and capital are taken as the two inputs; all the given combinations
of Labor and capital produce the same level of output here cloth. The graphical representation
of the table gives an isoquant.
Properties of an isoquant
The important features or properties of isoquants are the following
1.Isoquants are negatively sloped. An Isoquant represents a particular level of output. To keep
the output constant, when the quantity of one factor input is increased, the quantity of the other
inputs has to be decreased. Therefore, isoquants are negatively sloped.
2.Isoquants are convex to the origin. This is because along the isoquant marginal rate of
technical substitution of Labor for capital goes on decreasing. MRTS is the rate at which one
input is replaced by the employment of additional units of the other factor. In other words it
means how much of capital is replaced by the employment of an additional unit of Labor.This
is the slope of the isoquant. Slope of the isoquant is ΔK/Δ L.
That is, MRTSLk =ΔK/ΔL.
From the diagram, it can be understood that Δ K, the amount of capital replaced by
one additional unit of Labor is going on decreasing.

3.Two isoquants never intersect. Each isoquant represents a particular level of output. When
two isoquants intersect, the intersecting point will be common and it can be two different
levels of output. Logically this is not correct.
4.Higher isoquant represents higher levels of output. A set of isoquants in a single diagram is
called an isoquant map. In isoquant map, higher isoquant represents higher levels of output as
shown in the diagram.

Isocost line
To explain the producers equilibrium the second tool required is isocost lines.
Isocost line:
An isocost line shows various combinations of Labor and capital or two inputs that can be
purchased for a given expenditure of the firm. In other words it shows various combinations of
Labor and capital that a firm can purchase at the same cost and at given prices of the inputs. A
price line or an isocost line is shown in the diagram.
If Y is the total money in the hands of the firm and if PK is the price of capital then Y/PK is the
amount of capital that can be purchased by the firm with its income Y. Similarly if PL is the
price of labour and Y, the total money income of the firm, then the firm can purchase Y/PL Of
Labor with its income Y.

A price line AB is shown in the diagram. The slope of the price line is OA/OB. When the money
resources of the firm increases, with fixed prices of inputs, the priceline PL shifts upwards
parallelly.

Producers’ equilibrium or least cost combination

A producer will be in equilibrium when he is able to produce a given quantity of output with
least cost. He gets maximum profit when he produces maximum output with a given amount of
inputs we stop in other words, least cost combination of inputs is that combination which cost
least to the firm in producing a certain quantity of output. It is attained at that point where the
isoquant is tangent to the isocost line. This is shown in the diagram.
 In the diagram producer is in equilibrium at point where the highest possible isoquant is
tangent to the isocost line. He is able to produce the maximum output with the available
resources. In other words, output Q2 is produced with the least cost. Point E is the producer's
equilibrium point.
Expansion path
Expansion path is a line connecting optimal input combinations of a firm. As the scale of
production expands, a firm moves to a higher level of Equilibrium. By joining the least cost input
combinations at every level of output, we can obtain the expansion path of the firm. We can obtain
the expansion path by joining the points of tangency between isoquants and isocost lines of a firm
an expansion part is shown in the diagram.
Technical progress and its implications
When there is a change in technical progress the production function will change there will
be an upward shift in the production function which means that more output is produced with
the same level of inputs or the same output is produced with lesser quantities of inputs.
Technical progress may be embodied and disembodied. It is embodied or investment specific
when new machinery or capital is used in the production process. It is disembodied or investment
neutral when output increases without any increase in investment but by an innovation through
research.
There are three types of technological progress
1.Neutral technical progress: when changing the marginal product of Labor and capital are
same due to the technical progress it is called neutral technical progress. In this case there
will be a parallel downward shifting of the isoquant. In other words there is an equal
reduction in both the inputs in the production of a certain quantity of output.
2.Labor augmenting technical progress: it means the marginal product of labor increases
faster than the marginal product of capital. Here the new isoquant becomes more steeper.
3. Capital augmenting technical progress: it means the marginal product of capital increases
faster than the marginal product of Labor. In this case the new Iso quant becomes more flatter.

Cobb- Douglas production function

Cobb - Douglas production function explains the technological relationship between the
amounts of two inputs, capital and labor and the output that can be produced by these inputs.
Charles Cobb and Paul Douglas in the 1930s empirically tested the contribution of capital and
labor in the production of output. In its most standard form the function is written as

Q = A Lα Kβ
Where Q = total output, L = Labor, K = Capital, A= Total factor productivity, ,α and β are the
output elasticities of Labor and Capital respectively.
Total factor productivity A can be interpreted as A= Q / Lα K β
The value of A depends on technology. Higher the value of A, higher would be the level of output
Q.
Output elasticity measures the responsiveness of output to a change in quantities of either labor
or capital used in production. Cobb Douglas production function is a homogeneous production
function.
If α + β = 1, it is the case of constant returns to scale. Then Cobb Douglas production function
is linearly homogeneous.
If α + β > 1, it is the case of increasing returns to scale. In this case output increases at a greater
proportion than the increase in inputs.
If α+β <1, it is the case of decreasing returns to scale. Here output increases at a lesser proportion
than the increase in inputs.
Cost of production
Cost is the expenditure incurred by a firm in the production of a commodity. To produce a
commodity a firm needs raw materials, labor, building etc. the expenses of these items are
termed as cost.
Cost concepts
Explicit and implicit cost
Explicit cost is the expenses actually met by the producer while producing the commodity. These
are the payments incurred by the producer for outsiders who supply raw materials labor electricity
etc these items are recorded in the books of account of a firm.
On the other hand implicit cost is the cost of the factor services supplied by the organization
itself next sentence sometimes a firm will be running in a building which is owned by the
producer himself hence an expense like rent does not arise.
Real cost
This is the actual pain and suffering involved in the production of a commodity
Accounting cost
Accounting cost is the money cost that can be recorded in the books of account. This is same
as explicit cost
Social cost
social cost is the sum of private cost and external cost private cost is the cost incurred by the
producer in the production of a commodity these are the expenses of the producer in hiring factor
services however when a commodity is produced, it may cause damages to the environment in
the form of air pollution water pollution etc these are the external cost and it is met by the society
Replacement cost
Replacement cost is the cost incurred when an asset depreciates and it is replaced with the new
asset
Sunk cost
Sunk cost is the cost which has already been incurred and cannot be recovered it is totally
irretrievable
Short run and long run
Short run is a period in which a firm can increase its output only by employing more of the
variable factors such as labor and raw materials. In the short run fixed factors such as building
machinery etc remains to see
On the other hand, in the long run all factors are variable. Hence the size of plant and building
can be increased. Thus output can be increased by increasing the quantities of all the all the
factors.
Short run Costs
In the short run certain factors are fixed and certain other factors are variable. A firm incurs
fixed cost and variable cost.
Total Fixed cost ( TFC )
It is the cost which does not vary with the level of output. In other words, it has to be met even
at zero level output. Eg: Rent of factory building, interest payment etc. Since fixed cost remains
the same in the short period, TFC curve is a horizontal straight line parallel to the quantity axis.

OUTPUT
TFC Curve
Total Variable Cost ( TVC)

Variable cost is the cost that vary with the level of output. That is, when output is zero variable
cost is also zero and as output increases variable cost also increases. Cost of raw materials, wages
of workers, transportation cost, fuel charges etc. are examples of variable cost.

Total Cost (TC)

Total cost is the sum of total fixed cost and total variable cost.

TC = TFC + TVC
 TC curve has the same shape of the TVC curve. But it starts from the starting point of the TFC
curve because at zero level of output TC equals TFC. TC and TFC curves are parallel.

Average fixed cost ( AFC)- It is the fixed cost per unit of output. AFC is obtained by dividing
TFC by the number of units of output ( Q ) produced AFC = TFC/Q

Graphically AFC curve is a rectangular hyperbola. As output increases AFC decreases and hence
AFC curve is downward sloping.

Average variable cost (AVC) - It is the variable cost per unit of output. AVC is obtained by
dividing TVC by the number of units of output (Q) . AVC = TVC/Q . AVC curve is U shaped in
the initial stages of production. When in the initial stages of production, TVC increases at a
decreasing rate, AVC falls. But later TVC increases at an increasing rate and hence AVC rises.
Therefore AVC curve is U shaped.
Average Cost (AC) - AC is the cost per unit of output produced. It is obtained by dividing TC
by the number of units of output ( Q ) produced . AC = TC/Q = TFC/ Q + TVC/Q =AFC + AVC.
Thus AC is the sum of AFC and AVC. The basic reason for U shape of AC is the law of variable
proportion.

Marginal cost (MC) - MC is the addition to total cost when one more unit of output (Q) is
produced.
MC = ΔTC/ΔQ or dTC / dQ
or MCn= TC n– TC n-1

Graphically MC curve is also U shaped. When TVC increases at a decreasing rate, MC falls.
Later when TVC increases at an increasing rate,MC rises.
The relation between MC and AVC or MC and AC

The following are the relation between MC and AVC.

1.When MC < AVC, AVC decreases.
2. When MC=AVC, AVC is the minimum.
3. When MC > AVC, AVC increases.
The same relations exist between MC and AC .

Long run cost

Long run is a period which is sufficient to increase the quantities of all the factors such as
building, machinery, labor, raw materials etc. Hence all the factors are variable in the long run
and therefore there is no fixed cost.

Long run total cost ( LTC )

It is the minimum cost at which a given level of output can be produced in the long run.
LTC is inverse S shape and the reason is returns to scale.

Long run average cost (LAC )

LAC is the cost per unit of output in the long run. It is derived from short run average cost
curves SACs. In the short run,one plant size is suitable for producing one particular level of
output. For the next level of output another plant size is suitable and hence a large number of
SACs can be drawn. From each SAC curve one point is taken. Joining these points we get the
LAC curve. Hence LAC curve is an envelope of sac curves and it will be flatter when compared
to the SAC curves.
For convenience, we assume that only five plant sizes are available to produce a commodity. So
there are five SAC curves shown in the diagram.

In the figure SAC1 is suitable to produce up to q1 level of output. Even though more output
can be produced with same plant size, cost will be higher. Therefore, it will shift to SAC2.
It is suitable to produce up to q2 level of output. By joining the various points of SACs we get
LAC curve. LAC is also U shaped.
Long run marginal cost (LMC)

LMC is the addition to total cost when one more unit of output is produced in the long run.
LMC curve is also U shaped because of different returns to scales in the long run.
Revenue
Revenue is the income from the sale of output
Total revenue (TR) - It is the total receipts from the sale of a given quantity of output. It is
obtained by multiplying quantity sold (Q )by price per unit ( P).
TR = P *Q
Average revenue AR – It is the revenue per unit of output sold. AR is obtained by dividing TR
by the number of units of output sold (Q).
AR = TR/Q = P *Q/ Q =P
Marginal revenue ( MR) - It is the addition to total revenue by selling one more unit of output.
 MR = dTR /dQ or
MRq=TRq - TRQ q-1
Shut down point - Suppose the price of a product is less than AC. It is still beneficial for the firm
to continue production till price is greater than AVC. Once the price equals AVC, it may stop
production. Therefore Price = AVC is the shutdown point of the firm. That is the minimum point
of the AVC curve.

Suppose price is P1, the firm will supply a quantity Q1 where price equals marginal cost. Since
this price is greater than AC, the firm is getting a profit. When price falls to P2, it is less than AC
and hence there is a loss BC. But still it is beneficial for the firm to produce in the short run
because when it produces Q2 level of output, the firm is able to cover its variable cost Q2V and
a part of the fixed cost VB. Hence the loss will be BC only. If it stops production loss per unit
will be VC. Once the price reaches P3 it may stop production at Q3 because the firm is able to
cover its variable cost only .It is the shutdown point.

Break- even analysis

Break-even analysis is a method used to analyze the relation between total cost, total revenue
and profit of an organization at different levels of output. Break- even analysis is used as an
important tool of managerial decision making.
Break-even point can be identified through this analysis. Break - even point is the point at which
total revenue of a firm equals total cost. It is the point at which there is no profit or loss for the
firm.
Graphical method to construct break-even chart

In the figure output is marked along the X axis and TR and TC on the Y axis.
At point E, the TR curve intersects the TC curve and E is the break- even point where the firm
produces Qb level of output. The gap between the TR curve and the TC curve beyond Qb level
of output shows profit and the gap below E or Qb level of output shows loss. At the break even
point E, there is no loss and there is no profit.

Algebraic method of calculating break- even level of output

Break-even point is the point where total revenue equals total cost. Break -even output Qb is
calculated using the formula

TFC
Qb =
P−AVC

where TFC is the Total Fixed Cost, P is the price and AVC is the Average Variable Cost . P-AVC
is known as the Contribution Margin per unit of output sold.

P V ratio or Profit Volume Ratio

PV ratio is the ratio of contribution to sales.
P V ratio = contribution /sales.
Since contribution = Sales (S)- Variable cost(V)

𝑆𝑎𝑙𝑒𝑠−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑆−𝑉

P V ratio = =
𝑆𝑎𝑙𝑒𝑠 𝑆

This ratio can also be shown in the form of percentage by multiplying by 100
Thus if selling price of a product is ₹20 and variable cost is ₹15 per unit, then
P V ratio = 20 -15 / 20 *100 equals 5 /20 *100 is equal to 25%.
Margin of safety
Margin of safety is the sales beyond break- even point. It is calculated as the difference between
total sales and the break even sales.
Margin of safety =Sales - Break- Even sales

Uses of break-even analysis

1. It helps in the determination of selling price which will give the desired profits.
2. It helps in the fixation of sales volume to get a desired level of revenue
3. It helps in making interfirm comparison of profitability.
4. It helps in determination of costs, revenue and profit at various levels of output.
5. It helps in managerial decision making.