PRODUCTION AND COST

INTRODUCTION
Up to this you have learnt all about demand,
consumers , their preferences and decision
making.
Now we would learn about producers
preference and their behavior though the
concept of optimum production with efficient
choice of differ factor inputs.

.contd
The basic problem that any firm faces is
duality of paradoxical objectives
Maximum output.
Minimum cost.

In the next sessions we are going to discuss

how can a firm achieve this objective.
What are the resources they may use, how to
combine them , what are the constraints in
optimization of production etc

PRODUCTION
Production is the process of transformation
of inputs into goods and services of utility to
consumers and /or producers.
It is a process of creation of value or wealth
through the production of goods and services
that have economic value to either
consumers or other producers.
The process of adding value may occur
By change in form(input to out put)
Change in place(factory to retailer)
By change in hands(retailer to consumer)

TYPES OF INPUTS

You know what is production..?

What are the inputs.?
What are their characteristics.?
Let us start with technology
Technology is one of the most important input in any
of production process.
Technology determines the type, quantity and
proportion of inputs
It determines the maximum limit of output from a
given combination of inputs.

FIXED AND VARIABLE INPUTS

Typically the production analysis of a firm is
done using two distinct time frames
Short run production
Period of time when the firm cannot vary some of its
inputs
Supply of some inputs are fixed

Long run production

Have sufficient time to vary all inputs including
technology.

.. contd
Based on short run and long run the inputs are
classified in to variable and fixed.
Variable input
Made to vary in short run
Example raw material , unskilled and skilled labor

Fixed input
It cannot be varied in short run
Example land, machine, technology skill set etc.

Each of this input has a unique cost associated

itself

FACTORS OF PRODUCTION
LAND

ORGANIZATION

LABOR
5 FACTORS OF
PRODUCTION

ENTERPRISE

CAPITAL

PRODUCTION FUNCTION
Production function is the technical
relationship between inputs and outputs over
a given period of time
A commodity may be produced by various
methods using different combinations of
inputs with given state of technology.
Exampletextiles(different raw materials,
technology)

Production function includes all such

technically efficient methods.

contd
Production function
Always related to a given time period
Always related to a certain level of technology
Depends upon relation between inputs

Production function shows the maximum

quantity of the commodity that can be
produced/unit of time for each set of
alternative inputs.

MATHEMATICAL EXPRESSION OF
PRODUCTION FUNCTION
Normally a production function is written as
Q = F ( L , K , I , R ,E )
Where Q is the maximum quantity of output

Where L = Labor, K = Capital, I = Land, R= Raw

material, E = Efficiency parameter

TYPES OF PRODUCTION FUNCTION

On the basis of characteristics of inputs
production function normally divided into 2
broad categories
With one variable input or variable production
function.(short run)
With two variable inputs or constant production
function.(long run)

PRODUCTION FUNCTION WITH ONE

VARIABLE INPUT
In the short run producers have to optimize with
only one variable input.
Let us consider a situation in which there are
two inputs
Capital and labor
Capital is the fixed and labor is the variable input.

The amount of capital is kept constant and labor

is increased to increase output.
Any change in output can be manifested only
through a change in labor input only

..contd
This production function also known as variable
proportion production function.
The short run production function shows the
maximum output a firm can produce when only
one of its inputs can be varied other inputs
remaining constant
It can be written as
Q= F ( L , Kc)
Q- Out put
L- labor
Kc Fixed amount of capital

AVERAGE PRODUCT, MARGINAL

PRODUCT, TOTAL PRODUCT
The short run production function is governed
by law of variable proportions.
Concept of average , marginal products, total
product of factor inputs.
Assuming capital to be constant and labor to
be variable. So total product of labor function
is given as
TP L = F (Kc , L)

 If instead labor is fixed in short run, capital is

varied
TP k = F (K, Lc)
AVERAGE PRODUCT (Ap) is total product per
unit of variable input
AP L = TP/L (Capital fixed)
AP k = TP/K (Labor fixed)

MARGINAL PRODUCT
Marginal product (MP) is defined as addition
in total output per unit change in variable
input thus marginal product of labor (MPL)
MPL = TP / L
MPL = d TP / d L

EXPLANATION WITH EXAMPLE

Assume that a manufacturer starts production
with an investment of Rs 10 C in plant and
machinery.
The manufacturer increases units of labor
keeping investment in plant fixed .
LAW OF VARIABLE PROPORTIONS
law of variable proportions states that with
the increase in the quantity of variable factor
its marginal and average product will
eventually decline other inputs remain
unchanged (constant)
SEE THE TABLE..

.contd

The law of variable proportions is also called

as law of diminishing marginal returns

LAW OF VARIABLE PROPORTIONS

LABOR (L)
(000 UNITS)

TOTAL
PRODUCT (TP)
(000 TONNES)

MARGINAL
PRODUCT (MP)
d TP /d L

AVERAGE
PRODUCT
(TP/L)

STAGES

20

20

50

30

25

INCREASING

90

40

30

RETURNS

120

30

30

140

20

28

DIMINISHING

150

10

25

RETURNS

150

21.5

130

-20

16.25

NEGATIVE

100

-30

11.1

RETURNS

LAW OF VARIABLE PROPORTIONS

160
140
120
100

OUTPUT

80
TOTAL PRODUCT

60

MARGINAL PRODUCT
AVERAGE PORODUCT

40

20
0
1

-20
-40

LABOR

GRAPH - INFERENCE
With small increase in units of labor, capital
being constant, extra units of labor manifests
through an increase in output.
After a certain point where there are too
many workers with fixed capital.
So the part of the workforce becomes
ineffective and the marginal products of
labor starts falling.
This law is based on the assumption that
each unit of labor is homogenous (i.e. each
worker has same skills)

TOTAL ,MARGINAL AND AVERAGE

PRODUCT CURVE
B

C
X AXIS LABOR
Y AXIS TOTAL OUTPUT
TP
MP
AP

PANEL A

A
STAGE I

A*
PANEL B

STAGE II

B*

STAGE III

GRAPH INFERENCE
PANEL A explains the behavior of TP
PANEL B exhibits the nature of AP and MP curves.
With successive change in the variable input labor.
Point A inflexion of TP curve
Point A* on the MP curve in PANEL B it corresponds to
Point A.
Point A*- It is the point where MP attains its highest
and starts falling thereafter.
Point B on TP curve is where AP is equal to MP
After point B* in PANEL B the AP starts falling.
Point C- TP is maximum after it falls
Point C* - where MP cuts x axis

STAGES IN GRAPH
STAGE I Increasing returns to the variable
factor
This is first stage
In this additional units of labor are employed the total
out put increases. So marginal product rises.
In this MP > 0 and MP > AP

STAGE II Diminishing returns to the variable

factor
It is second stage
Total output increases but less than proportionate to
increase in labor
This stage marginal product falls and this is known as
law of diminishing returns to the variable factor.
Both AP and MP are positive but declining
Here MP > 0 but AP is falling MP < AP where TP is
increasing at diminishing.

..contd
STAGE III Negative returns to variable factor
This is third stage
Which MP < 0 and TP is falling
Technically this is inefficient stage of production
A rational firm never operate in this stage.

PRODUCTION FUNCTION WITH TWO

VARIABLE INPUTS
So far we dealt with production functions
with one variable input short run
Let us move a head to long run in which all
the inputs are variable.
Thus the firm has the opportunity to select
the combinations of inputs and maximizes
returns.
We restrict ourselves to most simplistic form
of production function with 2 variable inputs
and a single out put

ISOQUANT
ISOQUANT (iso- equal quant- quantity) is the
locus of all technically efficient combinations
for producing a given level of output.
ISOQUANT are similar to concept of
indifference curve/iso utility curve.
ISO QUANT
It is the different combinations of two inputs that
corresponds to the same output.

It is also referred to as ISOPRODUCT curve.

EXPLANATION
Taking the production function
Q = F ( L , K)

With a fixing level of out put Q at some

quantity we have an implicit relationship
between units labor( L ) and capital (K)
Qc = F ( L , K )

It is possible to produce the same amount of

output by using different combination of
input.

EXAMPLE
Firm produces 150 thousand tones of out put,
with investment of Rs 40 C and 600 labor
units.
The manufacturer wants to know which
different combinations of this inputs can be
used to produce 150 thousand tones of out
put
see the table..

INPUT COMBINATIONS
POINT

CAPITAL (Rs CRORE)

LABOR (000 UNITS)

40

28

18

12

10

GRAPH ISOQUANT
A

X AXIS LABOR
Y AXIS CAPITAL

B
C

D
Q1

GRAPH - INFERENCE
The curve in graph shows the locus of
different combinations of labor and capital
that produce 150 thousand tones of out put.
Locus of points
A at curve Q1 shows Rs 40 c and 600 Labor units
give the 150 Thousands tones of output.
like that all points B , C,D,E (combinations) may
infer that the level of output remains the same at
all points on the same isoquant.

GRAPH ISOQUANTS
X AXIS LABOR
Y AXIS CAPITAL

C
B
A

Q2

Q1
Qo

CHARACTERISTICS OF ISOQUANTS
Down ward sloping
Slope downwards from left to right
Using more of input to produce the same level of
output must imply using less of other input
slope = -(K / L)

A higher isoquant represent a higher output.

Iso quants do not intersect.
Convex to the origin.

MARGINAL RATE OF SUBSTITUTION

MRTS

MRTS measures the reduction in one input

due to unit increase in the other input that is
just sufficient to maintain the same level of
out put

..contd
For the same quantity of output , MRTS of
labor ( L ) for capital (k) = MRTS LK
MRTS LK would be the amount of capital that
the firm would be willing to give up for an
additional unit of labor.
It is similarly for MRTS KL.
MRTS LK is expressed in
MRTS LK = - ( K / L)

..CONTD
MRTS of labor for capital is equal to the slope of
the isoquant.
MRTS also equal to the ratio of the a marginal
product of one input to the marginal product of
other input.
Let see how
Since output along isoquant is constant
If units of labor( L) is substituted for units of capital
( K) then the increase in output due to increase in
labor ( L) should match with decrease in output due
to decrease in capital ( K)

..CONTD
SO
L X MP L = - (K X MP K )

MP L / MP K = - (K/ L)

MRTS LK = - ( K / L) = MP L / MP K

TYPES OF ISOQUANTS
LINEAR ISO QUANT
Two inputs are perfect substitutes
Qc = F ( L , K ) = K + L
Where , are constant
In this case MP L = d Q / d L , MP K = d Q / d K
MP L = , MP K =
Therefore MRTS LK = /
ISOQUANTS in this case is down ward sloping
straight lines

GRAPH LINEAR ISOQUANT

X AXIS LABOR
Y AXIS - CAPITAL

Q1

Q2

Q3

contd
RIGHT ANGLED ISO QUANT
In this the inputs are perfect
complements.(assumption)
Non substitutability between the two factors
This isoquant is right angled
Production function
Q = MIN (L / , K / )
Where , fixed coefficient.

GRAPH RIGHT ANGLED ISOQUANT

Q3

Q2

Q1

X AXIS LABOR
Y AXIS - CAPITAL

ISOCOST LINES
The concept of ISOCOST line is similar to
budget line.
ISOCOST line is the budget line of a producer
in terms of two inputs.
ISOCOST line is the locus of points of all the
different combinations of labor and capital
that firm can employ given the total cost and
prices of inputs

contd
ISOCOST lines expressed as

C =wL + r K
Where price of labor is wage = w
The price of the capital is interest = r
The total cost is C

The total cost C of the firm is fixed and the input

prices are given the ISOCOST line gives various
combinations of labor and capital
Usually the ISOCOST line is linear with slope
equal to ratio of the factor prices. ..*

..contd
See the graph
The intercept of the ISOCOST line on the capital
axis is the maximum amount of capital employed
when labor is not used in the production process
is given by C / r
Similarly the intercept in labor axis is given by
C/w
SO therefore
Slope = (K / L) = {(C/r)/(C/w)} = w/r *

GRAPH- ISOCOST LINE

X AXIS LABOR
Y AXIS - CAPITAL

A2
A

A1

B1

B2

GRAPH- ISOCOST MAP

X AXIS LABOR
Y AXIS - CAPITAL

A2
A

A1

B2

B1

GRAPH - INFERENCE
The set of parallel ISOCOST lines is called
ISOCOST map.
Line AB basic ISOCOST line.
AB1 shows a rise in W more of labor can
acquired.
AB 2 shows a fall in W.
Same as for BA2 and BA1

PRODUCERS EQUILIBRIUM
A firm may maximize its profits at given
production function.
When producers faced with several technically
efficient combinations the decision is taken on
basis of economic efficiency.
Producers use the combinations which minimize
the cost of production.
The producers must determine the combinations
of inputs that produces the output at minimum
cost.
Assume that producers act rationally that
means choosing which combination gives
minimize cost and maximum output.

..contd
For minimum cost we need ISOCOST line and
maximum output we need ISOQUANTS.
Combining the ISOQUANTS and ISOCOST lines
will help to understand the producers
equilibrium.

GRAPH - PRODUCERS EQUILIBRIUM

X AXIS LABOR
Y AXIS CAPITAL

CONDITION FOR
PRODUCE
REQUILIBRIUM
SLOPE OF ISOCOST
LINE = ISOQUANT
CURVE

K*

Q3
D
Q2
Qo
L*

GRAPH - INFERENCE
Point E is producer equilibrium.
At this point the firm would employ L* and K*
units of labor and capital respectively.
Q2 amount of output can also be considered to
be the maximum output that can be produced at
a given cost.
Any amount of output above AB is not feasible
Below AB is feasible but not desirable because
the firms aims to maximize output so like to use
entire funds.

contd
Point C and D are also on the ISOCOST line
But C and D are on Q1 which is lower than
Q2.
So point C , D, E shows the combinations of
inputs L and K which come for the same cost
but give different output.
Thus E is preferred to C and D which is on the
highest possible ISOQUANT.

PRODUCERS EQUILIBRIUM- FOR GIVEN

LEVEL OF OUT PUT(CONSTANT)
X AXIS LABOR
Y AXIS - CAPITAL

A2
R

A1
K

CONDITION FOR
PRODUCE
REQUILIBRIUM
SLOPE OF ISOCOST
LINE = ISOQUANT
CURVE

S
Q
O

B1

B2

GRAPH - INFERENCE
In this the firm already decided the level of
output at ISOQUANT Q.
So we have a single ISOQUANT line.
Q out put can be produced with three
combinations of two inputs shown by points
R , S , E. which are on different ISOCOST line.
Given the assumption of rationality the firm
will take the combination which minimize its
cost for given out put.
So the firm choose point E ( OL AND OK of
inputs) on AB as equilibrium.

EXPANSION PATH
Expansion path is the line formed by joining
the tangency points between various isocost
lines and the corresponding highest
attainable isoquants.
It is also defined as the locus of equilibrium
points of the isoquant with lowest possible
isocost line

EXPANSION PATH LONG RUN GRAPH

X AXIS LABOR
Y AXIS - CAPITAL

E2
E

K*
E1
Q1
O

L*

GRAPH - INFERENCE
Expansion path is a long run concept and
each point on the expansion path represents
a combination of inputs that minimizes cost.
The arrow from the origin shows all the cost
minimizing input combinations for various
levels of out put the firm could produce in the
long run.
Long run expansion path E1 E E2

CONTD
Is the expansion path always linear . No.
The slope of the expansion path depends on the
ratio of the input prices.
When production function is homogenous then
the slope of expansion path is linear.
If production function not homogenous then
expansion path is not linear.

RETURNS TO SCALE
Returns to scale refer to the degree by which
the level of out put changes in response to a
given change in all the inputs in a production
system.
Types of returns to scale
Constant return to scale
Decreasing return to scale
Increasing return to scale.

..contd
Constant return
If a proportional increase in all inputs yields an equal
proportional increase in output.
Example = if labor and capital are doubled then
output also doubled.

Decreasing return
If a proportional increase in all inputs yields a less
than proportional increase in output.
Example = if labor and capital are doubled then
output is less than doubled.

Increasing return
If a proportional increase in all inputs yields an more
than proportional increase in output.
Example = if labor and capital are doubled then
output is more than doubled.

GRAPHS RETURN TO SCALE

CONSTANT
50 100 200
B C
A

DECREASING
50 125

90
INCREASING

50

150

400

PRODUCTION FUNCTION

Cob-Douglas Production Function

Type of Empirical production function.
Proposed by WICKSELL
Tested against statistical evidence by CHARLES
W.COBB & PAUL H.DOUGLAS.
Equation is

Q AL K
b

Q = Total Output
L = Units of Labor.
K = Units of Capital.
A = a constant
B = a parameter

1b

COB-DOUGLAS FUNCTION PROPERTIES

Both L and K should be positive for Q to exist.
b + (1-b) =1. It assumes only constant returns
to scale. It does not support Increasing or
Decreasing returns to scale.
Cob-Douglas equation rewritten

Q AL K

= Wage share / Total Income.

= Capital share / Total Income.

PROPERTIES CONTD
If (+) = 1, it is Constant return to scale.
If (+) > 1, it is increasing returns to scale.
If (+) < 1, it is decreasing returns to scale.

Q AL K
b

1b

LIMITATIONS OF COB-DOUGLAS
It cannot show marginal product of an input
passing the 3 stages of Production.
It assumes Constant return to scale. Certain
Production function cannot be increased in
the same proportion.
Difficulty in measurement of various inputs.
It assumes there is a fixed relation of raw
materials and output.

CES CONSTANT ELASTICITY OF

SUBSTITUTION PRODUCTION FUNCTION

X KC

(1 K ) L

X = Output, C = Capital, L = Labour

= Efficiency parameter (scale effect)
K = Capital intensity factor coefficient
K-1 = Labour intensity factor coefficient
= Degree of returns to scale.
= Substitution parameter.