UNIT-2

Production Function
● Concept of productivity and technology
● Short run and long run production function isoquants
● Least cost combination of inputs
● Producer’s Equilibrium
● Return to scale
● Estimation of production function
Theory of cost
● Cost
● Determinants of cost
● Short and long run theory
● Relationship between cost and production function
In economics, production theory explains the principles in which the
business has to take decisions on how much of each commodity it sells
and how much it produces and also how much of raw material ie., fixed
capital and labor it employs and how much it will use.

It defines the relationships between the prices of the commodities and

productive factors on one hand and the quantities of these commodities
and productive factors that are produced on the other hand.
Concept
Production is a process of combining various inputs to produce an
output for consumption. It is the act of creating output in the form of a
commodity or a service which contributes to the utility of individuals.

In other words, it is a process in which the inputs are converted into

outputs
Function
The Production function signifies a technical relationship between the physical inputs and
physical outputs of the firm, for a given state of the technology.

Q = f (a, b, c, . . . . . . z)

Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the
output for a firm.

If labor (L) and capital (K) are only the input factors, the production function reduces to −

Q = f(L, K)

Production Function describes the technological relationship between inputs and outputs. It is
a tool that analysis the qualitative input – output relationship and also represents the
technology of a firm or the economy as a whole.
During short period, production can be increased
through:

a) Greater application of fixed factors

b) Greater application of variable factors
c) Greater application of all the factors of
production
d) None of these
● Production function shows the ___________relationship
between physical inputs and physical output.
The production function is differently defined in the short run and in the long run.
This distinction is extremely relevant in microeconomics. The distinction is based
on the nature of factor inputs.

Those inputs that vary directly with the output are called variable factors. These are
the factors that can be changed. Variable factors exist in both, the short run and the
long run. Examples of variable factors include daily-wage labour, raw materials, etc
On the other hand, those factors that cannot be varied or changed as the output changes
are called fixed factors. These factors are normally characteristic of the short run or
short period of time only. Fixed factors do not exist in the long run.

Consequently, we can define two production functions: short-run and long-run. The
short-run production function defines the relationship between one variable factor
(keeping all other factors fixed) and the output. The law of returns to a factor explains
such a production function.
For example, consider that a firm has 20 units of labour and 6 acres of land and it
initially uses one unit of labour only (variable factor) on its land (fixed factor). So, the
land-labour ratio is 6:1. Now, if the firm chooses to employ 2 units of labour, then the
land-labour ratio becomes 3:1 (6:2).

The long-run production function is different in concept from the short run production
function. Here, all factors are varied in the same proportion. The law that is used to
explain this is called the law of returns to scale. It measures by how much proportion the
output changes when inputs are changed proportionately.
Production Function with Two Variable Inputs:
A production function with two variable inputs can be represented by a tool known as isoquants.

An Isoquant is a combination of two terms, namely, iso and quant. The meaning of ‘lso’ is equal. The
meaning of ‘Quant’ is quantity. Therefore, isoquant means equal quantity or equal product. Isoquants are
defined as the curves which represent the different combination of inputs producing a particular quantity
of output. Any point on the isoquant corresponds to the same level of output.

Assumptions of Isoquants:
1. There are only two inputs, labour and capital to produce a commodity.

2. The two inputs (L, K) can be substituted for one another at a diminishing rate, up to a certain limit.

3. Production function is continuous.

4. Factors of production are divisible

The isoquant illustrates all possible combinations of the two inputs (say labour and
capital) capable of producing equal or a given level of output. Isoquants are also
known as iso product curves or equal product curves or production indifference
curves
Isoquants
Isoquants are a geometric representation of the production function.
The same level of output can be produced by various combinations of
factor inputs. The locus of all possible combinations is called the
‘Isoquant’.
Characteristics/ Properties of Isoquant
1. An isoquant slopes downward to the right.
2. A Higher isoquant represent a higher output
3. An isoquant is convex to origin.
4. Two isoquants do not intersect.
Types of Isoquants-The production isoquant may assume various shapes depending
on the degree of substitutability of factors.

Linear Isoquant-This type assumes perfect substitutability of factors of production. A given

commodity may be produced by using only capital or only labour or by an infinite
combination of K and L.

Input-Output Isoquant-This assumes strict complementarity, that is zero substitutability of

the factors of production. There is only one method of production for any one commodity.
The isoquant takes the shape of a right angle. This type of isoquant is called “Leontief
Isoquant”.

Kinked Isoquant-This assumes limited substitutability of K and L. Generally, there are few
processes for producing any one commodity. Substitutability of factors is possible only at the
kinks. It is also called “activity analysis-isoquant” or “linear-programming isoquant” because it
is basically used in linear programming.
Least-Cost Combination

The problem of least-cost combination of factors refers to a firm getting the largest volume
of output from a given cost outlay on factors when they are combined in an optimum
manner.

In the theory of production, a producer will be in equilibrium when, given the cost-price
function, he maximizes his profits on the basis of the least-cost combination of factor. For
this he will choose that combination of factors which maximizes his cost of production.
This will be the optimum combination for him.
The firm cannot choose and neither combination beyond line AB nor will
it chooses any combination below this line. AB is known as the factor
price line or cost outlay line or iso-cost line.
It is an iso-cost line because it represents various combinations of
inputs that may be purchased for the given amount of money allotted.
The slope of AB shows the price ratio of capital and labour, i.e., By
combining the isoquants and the factor-price line, we can find out the
optimum combination of factors. Fig. illustrates this point.
Define-
ONE WORD ANSWER-

1) In context of production function,Factor ratio

is- _____________ .
2) Which factor alone can we changed in short
period?
Total Product, Marginal Product, Average Product

● Total Product refers to the total amount of goods and services produced in a given period

of time within a given input.

● Marginal Product is the quantity of total goods and services when an additional unit of the

variable factor is used.

● Average Product refers to the total product per unit of variable factors or input.
 Law of Variable Proportions
This law exhibits the short-run production functions in which one factor varies while the others
are fixed.

Also, when you obtain extra output on applying an extra unit of the input, then this output is
either equal to or less than the output that you obtain from the previous unit.

The Law of Variable Proportions concerns itself with the way the output changes when you
increase the number of units of a variable factor. Hence, it refers to the effect of the changing
factor-ratio on the output.
 Returns to Scale
In the long run all factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity of all factors of production.

Returns to scale are of the following three types:

1. Increasing Returns to scale.

2. Constant Returns to Scale

3. Diminishing Returns to Scale

Marginal Rate of Substitution
MRS is defined as the units of one input factor that can be substituted for a single unit of
the other input factor. So MRS of x2 for one unit of x1 is −
=
Number of unit of replaced resource (x2) / Number of unit of added resource (x1)
Price Ratio (PR) =
Cost per unit of added resource / Cost per unit of replaced resource
=
Price of x1 / Price of x2
Therefore the least cost combination of two inputs can be obtained by equating MRS
with inverse price ratio.
x2 * P 2 = x 1 * P 1
 COST
THEORY OF COSTS- Every Business has two side: Income and Expenditure.
The Expenditure side of business constitutes Cost and Income side constitutes the
Revenue. The analysis of cost is important in the study of Managerial Economics
because it provides a basis for two important decisions made by Managers-

a) Whether to produce or not; and

b) How much to produce when a decision is taken to produce

Some of the cost concepts that are frequently used in the
Managerial decision making process, may be classified as
follows :
1) Actual Cost and Opportunity Cost:-

Suppose we pay Rs. 100 per day to a worker when we employ for 10 days, then
the cost of labour is Rs 1000. This is the cost actually incurred by the firm in the
process of production. It is otherwise known as Accounting Cost or Acquisition
Cost or Outlays Cost.
Consider a firm that owns a building and the firm do not pay rent for its use. If the
building was rented to others, the firm could have earned rent. The foregone rent
is an opportunity cost of utilizing the office space and should be included as part of
the cost of business. Sometimes this opportunity cost, are called as alternative
cost.
2) Explicit Cost and Implicit Cost:-
● Actual payment to other Parties
● a firm pays Rs 150 per day to a worker, and engages 10 workers for l0 days,
and then the explicit cost will be Rs 15,000 incurred by the firm. Other types
of explicit costs include renting a building, amount & rent on advertising etc.
a manager who runs his own business foregone the salary that could have been
earned by working for someone else.

Implicit cost represents the values of foregone opportunities but do not involve an
actual cost payment.
3) Accounting Cost and Economic Cost :-
● Accounting costs are the actual or outlay costs. These costs point out how
much expenditure has already been incurred on a particular process or on
production as such. These costs generally relate to the past

● Concerned with opportunity cost along with explicit cost. Since the only cost
that matter for business decision are future costs. It is the economic costs that
are used for decision making.
4-Sunk Cost and Incremental cost :-
● The money already paid for machinery, equipment, inventory and future rental
payment on a warehouse that must be paid a part of a long term lease
agreement are Sunk costs.

● Incremental costs refer to total additional cost of implementing a managerial

decision. Change in product line, change in output level, adding or replacing a
machine, changing distribution channels etc
5 Relevant costs and Irrelevant costs :-
The relevant costs for decision making purposes are those costs which are
incurred as a result of decision under consideration. The relevant costs are also
referred to as the incremental costs.

They are there main categories of relevant or incremental costs.

They are 1) The present period explicit costs

2) The opportunity costs implicitly involved in the decision

On the other hand, costs that have been incurred already and the costs that will be
incurred in future, regardless of the present decision are irrelevant costs as far as
the current decision problem is concerned.
6-Fixed cost and Variable cost :
Fixed costs are that part of the total cost of the firm which does not change with
output. Expenditures on depreciation, Rent of land and buildings, property taxes
and interest payment on Bonds are examples of fixed costs. For given a capacity
fixed costs remain the same irrespective of actual output.

Variable costs on the other hand change with changes in output. Examples of
variable costs are wages and expenses on raw materials.
Cost Determinants

The cost of production of goods and services depends on various input factors used by the
organization and it differs from firm to firm.

The major cost determinants are:

1. Level of output: The cost of production varies according to the quantum of output. If the size of
production is large then the cost of production will also be more.
2. Price of input factors: A rise in the cost of input factors will increase the total cost of production.
3. Productivities of factors of production: When the productivity of the input factors is high then the
cost of production will fall.
4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.
5. Output stability: The overall cost of production is low when the output is stable over a period of time.
6. Lot size: Larger the size of production per batch then the cost of production
will come down because the organizations enjoy economies of scale.

7. Laws of returns: The cost of production will increase if the law of

diminishing returns applies in the firm.

8. Levels of capacity utilization: Higher the capacity utilization, lower the cost
of production

9. Time period: In the long run cost of production will be stable.

10. Technology: When the organization follows advanced technology in their
process then the cost of production will be low.

11. Experience: over a period of time the experience in production process will
help the firm to reduce cost of production.

12. Process of range of products: Higher the range of products produced, lower
the cost of production.

13. Supply chain and logistics: Better the logistics and supply chain, lower the
cost of production.

14. Government incentives: If the government provides incentives on input factors

then the cost of production will be low.
Determinants Of Short –Run Cost Fixed cost:

Some inputs are used over a period of time for producing more than one batch of
goods. The costs incurred in these are called fixed cost. For example amount
spent on purchase of equipment, machinery, land and building.

Variable cost: When output has increased the firm spends more on these items.
For example the money spent on labour wages, raw material and electricity usage.
Variable costs vary according to the output. In the long run all costs become
variable.
Total cost: The market value of all resources used to produce a good or service.

Total Fixed cost: Cost of production remains constant whatever the level of output.

Total Variable cost: Cost of production varies with output. Average cost: Total cost
divided by the level of output.

Average variable cost: Variable cost divided by the level of output.

Average fixed cost: Total fixed cost divided by the level of output. Marginal cost:
Cost of producing an extra unit of output.