PRODUCTION AND

COSTS

PRODUCTION FUNCTION

Production function is the name given to the

relationship between the rates of input of productive
services & the rate of output of a product. Thus the
production function expresses the relationship between
the quantity of output & quantities of various inputs
used for production.

Production function can be studied in three ways:

Law of variable proportion: Where quantities of some
factors is kept fixed but the other factors are varied.
Law of Return to Scale: Where quantities of all factors
are varied.
Optimum or best combinations of inputs.

1.
2.
3.

1.

2.

Practical observation of the production function

indicates 2 normal relationships:
When the quantity of a variable input increases while
other inputs remain fixed. It means, there is a direct
relation between variable input & output.
Input & output do not increase in the same proportion.
There may be a phase when output increases faster than
increase in a particular variable input. This is a phase of
increasing returns to the variable input. When input &
output increase in the same proportion, it is a phase of
constant returns.

PRACTICAL IMPORTANCE OF
PRODUCTION FUNCTION

Production function gives us idea of optimum level of the output & the
optimum employment of the variable inputs.

Production function tells management the budget needed for increase in

output.

Production function explains the degree of substitution &

complementarily of different factors of production.

Management should try to produce an upward shift in production which

can definitely improve its financial performance under the given market
productions.

Definitions:
1.
Total physical product: Total quantity of output produced
in physical units by a firm during a period of time.
2.
Marginal product: Change in total product caused as a
result of one additional unit of variable factor employed
in combination with fixed factors is called MARGINAL
PRODUCT.
M.P= T.P. / Variable factor units
3.
Average product: It is the total product that a firm
produces divided by the quantity of a variable factor that
is used to produce it.
A.P. = T.P. / Variable factor units

LAW OF DIMINISHING RETURNS OR

THE LAW OF VARIABLE PROPORTION

As the proportion of one factor in a combination of

factors is increased, after a point, first the marginal &
then the average product of that factor will diminish.(F.
Benham)
An increase in some inputs relative to other fixed inputs
will, in a given state of technology, cause output to
increase; but after a point the extra output resulting from
the same additions of extra inputs will become less &
less.(P.A. Samulson)

Fixed Factor
(say land &
capital)

Variable
Total Product
Factor
(units)
(Labour units)

Average
Product
(units)

Marginal
Product
(units)

15

7.5

10 Returns

30

10

15

50

12.5

20 Constant

70

14.0

20

90

15

20

105

15

15 Diminish-

115

14.3

10 ing

120

13.3

10

124

12.4

11

127

11.5

12

127

10.5

13

118

9.07

-9 Negative
Returns

Increasing

Returns

Returns

Observations of the table:

1.
2.
3.
4.
5.
6.

7.

8.

As long as average product is rising, marginal product would be larger

than the average product.
M.P. is less than A.P., when A.P. is decreasing.
A.P. remains constant when M.P. & A.P. are equal. Also, when A.P. is
maximum M.P. equals A.P.
Total product is maximum when M.P. is zero.
M.P. becomes negative when T.P. falls.
It will be noticed from the table that when 1 to 4 workers are
employed, the marginal product goes on increasing. This is the phase
of Increasing Returns.
When workers 4,5 and 6 are employed we notice that in their case, that
M.P. is 20,20,20. This is the phase when the Law of Constant Returns
is in operation.
From 7 to 11 workers, it is noticed that though T.P. is increasing, the
M.P. goes on decreasing. This is the phase of Diminishing Returns.
This phase may also be called the phase of Diminishing Marginal
Returns. Thus, we observe that the Law of Diminishing Marginal
Returns(M.P.) is in operation in the third phase.

Diagrammatic Illustration of the law of

diminishing returns(variable proportion)

H
T.P.
A.P.
M.P.

Stage
1

Stage
II

Stage
III

T.P. Curve

A.P. Curve
M
M.P. Curve

Units of Variable
Factor (labour)
employed

Three stages of the Law of Variable Proportions or

diminishing returns:

Stage I : Increasing Returns

Stage II : Diminishing Returns
Stage III: Negative Returns

to S
cale
Inc
rea
sin

e
ca l
oS
st
rn

gR

etu
gR

etu
rns

Constant Returns to Scale

n
asi
cre
De

MARGINAL PRODUCT

RETURNS TO SCALE OR LAW OF

RETURNS TO SCALE

SCALE OR PROPORTION

Return to scale

In long run all factors of production become

variable no factor remain fixed. In this period
production of commodity can be increased by
increasing all the factors in the same
proportion. It is a long term concept.

LAW OF INCREASING RETURNS TO SCALE:

If the increase in all factors leads to more than
proportionate increase in output, returns to scale are said
to be increasing. Thus, if all the factors are doubled, &
output increases by more than double, then returns to
scale are increasing. If 10% increase led to 15% increase.

Law of constant return to

scale

Constant return to scale occurs when a given

% increase in all factors input causes equal
percentage increase in output. If 10%
increase in input led to 10% increase in
output. It is a stage when fixed factor is used
at optimum level. example-computer systems
in IT industry and employee working over
them.

Law of diminishing return to

scale

Law of Diminishing return refers to a situation

in which total output tends to increase at the
diminishing rate when more variable are
combined with fixed factors .It is diminishing
because we are employing more variable
factors than required for a certain production.

Cost concept

The cost of production is the money spent by

a business to produce a product. A firm
always try to cover up the cost and generate
normal profit, a firm want to minimize cost
and increase profit. Manager try to produce
goods at a optimum level and they use the
least cost combination of factors of
production.eg :Raw material,labour,capital
etc.

COST CONCEPTS
TYPES OF COSTS:
1.
ACCOUNTING COSTS: actual cost

They are the costs of production of a firm.

These costs are paid by the producer & are also known as
entrepreneurs costs.

These are explicit costs & they enter the accounts books of the firms.

These costs include i)wages to labor ii)interest on borrowed capital

iii) rent paid to owners of land which is borrowed by the firm iv)cost
of raw materials v)replacement & repairing charges of machinery
vi)depreciation of capital goods vii)normal profits of the
manufacturer

Costs may be classified as:

a)Production costs including material costs, wages cost & interest
cost.
b)Selling cost are the cost such as advertisement, promotion.
c)Other costs,including insurance charges, taxes etc.

2.

ECONOMIC COSTS:

Those payments which must be received by resource

owners in order to ensure that they will continue to
supply the resources for production.
Explicit costs,include costs & normal profits together
form the total costs of a firm or
Economic Cost =Explicit Costs+ Implicit Costs+Normal
Profits

3. OPPORTUNITY COSTS

Economists define the cost of production of a particular product as the

value of the foregone alternative products, that resource used in its
production could have produced.
Opportunity lost of not being able to produce some other product.
For eg:10 employee were engaged in production of 5 units of fan that
is product x,they could have produced 5 units of cooler that is product
y.
The cost of not producing 5 units of cooler , is the opportunity cost.

. EXPLICIT & IMPLICIT COSTS:

A) Explicit Costs:
Money payment, which is a firm makes to those outsiderswho supply
labor services, raw materials, transport services, electricity etc. are called
explicit costs.
B) Implicit Costs:

The costs of self owned resources which are employed by the firm are nonexpenditure or implicit costs like the salary of the entrepreneurs own
investment, rent on own land used by the firm.

To the firm the implicit cost are the money-payments which the self-owned &
employed resources could have earned in their next best alternative use.
c)
Normal Profits as a cost:
Explicit costs, implicit costs & normal profits together form the full costs of a
firm (economic costs).
d)
Economic( or Pure) Profits:

By profits the accountant means total revenue minus explicit costs. But to
the economist profits means total revenue minus all costs.

When an economist says that a firm is just covering its costs, he means that all
explicit & implicit costs are being covered & that the entrepreneur is
therefore, receiving a return just large enough to keep him in his present job.

OTHER PRODUCTION COSTS:

i) Fixed Costs & variable costs(F.C. & V.C.):
Distinction between F.C. & V.C. is relevant in the short period only.
F.C.+V.C. = T.C. (Total Cost)
ii) Avoidable & Unavoidable costs:
Costs which can be avoided due to contraction of the firm are called
avoidable costs & costs which cannot be avoided because of
contraction are unavoidable costs.
iii) Incremental & Sunk Costs:
Costs which increase because of expansion of a firm are called incremental
Costs e.g change in product, replacement of machine, and the costs which
have to be borne whether there is expansion or not are called Sunk
costs.eg:depriciation,rent and all past cost.

v) Historical & replacement costs:

Cost of purchase of a capital asset, when it was
initially purchased, say in 1994 the machine price
was 10000 this is the historical cost of the asset.In
year 2004 price is 12000 this is the replacement
cost. Now firm will have to pay 2000 extra to
replace machine.

Direct and indirect cost

Such type of cost which directly influence or

involve in production are called direct cost
example :purchase of raw material,wages of
labors, machine on the other hand indirect
cost are the supervisor payment for
supervising the activities such as idle time.
lubricants for machines, Security guard,
management salary, research and
development.

Private cost and social cost

Private Cost can be calculated as if a company say
manufacturing unit established its plant at two places it
will increase its private cost as they are incurred by firm
itself ,but that firm will generate pollution as black
smoke, which will be inhaled by the peoples of the
society .Therefore it is seen that company also maintain
social accounting that what it has done for the society.
The expenditure done for that are social cost.
eg are: Birla cement factory in Baikunth(chattisgarh)made
garden, hospital and schools their for the peoples living
their.