UNIT III:

time. These inputs do not change as output

changes.

PRODUCTION AND Variable inputs are those that can easily be

increased or decreased in a short period of
time. These inputs increase or decrease as
COST ANALYSIS output changes.

Factors of Production
Production Analysis
Factors of production is an economic term that
Definition of Production describes the inputs used in the production of
goods or services to make an economic profit.
According to Bates and Parkinson, “Production
is the organized activity of transforming
resources into finished products in the form of
goods and services; and the objective of
production is to satisfy the demand of such
transformed resources”.
1. Land: Refers to all natural resources
that exist without man’s intervention.
The payment for land is called rent.
Production is the process of making or 2. Labor: Refers to human inputs such as
manufacturing goods and products from raw manpower skills. The payment for labor
materials or components. In short, it is the is called wages and salaries.
process in which the inputs are converted into 3. Capital: Refers to man-made factor of
outputs. production used to create another
product. The payment for capital is
called interest.
Theory of Production 4. Entrepreneurship: Factor of production
that integrates land, labor, and capital.
It is an effort to explain the principles by which An entrepreneur is an individual who
a business firm decides how much of each makes the decisions regarding
commodity that it sells it will produce, and how production and utilizing the other
much of each kind of labor, raw material, fixed factors of production. The payment for
capital good, etc., that it employs will be used. capital is called profit.

Factor Payments
Production Function
The two types of production functions are the
Short-run and Long-run Production.

Production function can be expressed as:

q=f(L,K)
Where: q – firm production function; L-Labor; K-
Capital

Types of Production Law of Diminishing Returns

1. Short Run Production: Describes the
relationship between output and inputs The Law of Diminishing Returns states that
when at least one input is fixed, such as adding an additional factor of production
output varies based on the amount of results in smaller increases in output. After
labor used. The law of Diminishing some optimal level of capacity utilization, the
Returns is used to explain the concept addition of any larger amounts of a factor of
of short run production. production will inevitably yield decreased per-
unit incremental returns.
2. Long Run Production: Long run refers to
a flexible time frame where all inputs
can be adjusted for optimal production Other terms used for Law of Diminishing
efficiency. It involves decisions on Returns are the “Law of Diminishing Marginal
resource allocation, plant size, and scale returns”, “Principle of Diminishing Marginal
of operations, exploring factors like Productivity“, and the “Law of Variable
economies of scale and producer proportions
equilibrium. The Law of Return to Scale
is used to explain the concept of long-
run production.

Stages law of Diminishing Returns

Inputs of Production
1. Increasing Marginal Returns: Total
Inputs in production can be described as either product increases at a growing rate,
Fixed or Variable. with both marginal and average
Fixed inputs are those that cannot easily be products rising. This continues until
increased or decreased in a short period of average product equals marginal
 product. The law of increasing returns increase in input, it means constant
applies in this stage.

returns to scale.
2. Decreasing Marginal Returns: Total
product increases at a diminishing rate,
and average product starts to decline. 3. Diminishing Returns to Scale: If increase
This stage ends when total product in the output is less than proportional
reaches its maximum, and marginal increase in the inputs, it means
product becomes zero. diminishing returns to scale.

3.Negative Marginal Returns: Marginal

Isoquants
product becomes negative, causing An isoquant is a curve that represents all the
total product to decline. Average combinations of two inputs (usually labor and
product continues to decrease. capital) that produce the same level of output.
The term is derived from “iso,” meaning equal,
and “quant,” referring to quantity. Isoquants
are similar to indifference curves in consumer
theory but are applied to production.

Isocost
An isocost line graphically represents all
possible combinations of inputs that can be
purchased for a given total cost. The term ‘iso’
comes from Greek, meaning ‘equal’, so an
Isocost line shows combinations of inputs that
have an equal cost.

Mathematically, the equation for an isocost

Line can be expressed as: C = wL + rK,
where:

Law of Return on Sale C is the total cost (constant)

It is an economic principle that describes how W is the wage rate or the cost per unit of labor
the output of production changes as the
L is the quantity of labor
quantity of input varies. It also refers to how
the output of a production process changes as R is the rental rate or the cost per unit of
all inputs are increased proportionally. It helps capital
understand the efficiency of production in the
long run. K is the quantity of capital

Categories of Return to Scale

1. Increasing Return to Scale: If increase in
the output is greater than the
proportional increase in the inputs, it
means increasing return to scale.

2. Constant returns to Scale: If increase in

the total output is proportional to the
 include the negative effects on others.
Social costs add these external effects
Relationship of Isocost and Isoquants to private costs.
An isocost line helps to determine the
combination of input for a defined amount of
cost while an isoquant curve helps us to 6. Sunk Costs: Money already spent that
determine the combination of input to produce cannot be recovered. These should not
the same amount of output affect future decisions since they don’t
change regardless of outcomes.

Optimal input Combination

7. Incremental Costs: Extra costs incurred
to produce one more unit of a product.
These help businesses assess if
producing additional units is efficient
and profitable.

Cost-output Relationship
The costs and output are related. The cost of
production depends upon several factors such
as volume of production, relation between the
costs and output, prices and productivity of the
inputs such as land, labor, capital and so forth,
and the time scale.

Cost Analysis
The cost-output relationship significantly differs
in the short run and in the long run. It is
Definition of Cost because, in the short run, the costs can be
classified into fixed costs and variable costs.
Cost is the monetary value spent by a The cost-output relationship in the short run is
company to produce products and operating governed by certain restrictions in terms of
the business. It is the value of everything a fixed costs
person or company gives up to produce a good
service, including both explicit expenses and
implicit costs
Short-run costs Analysis
The short-run for a firm is the time horizon
Types of Costs when one input is held constant, To analyze the
short-run costs, it is essential to fix the level of
1. Accounting Costs: These are the actual capital and study the changes in the quantity
payments a business makes, like rent, of labor hired.
salaries, materials, and bills. They are
out-of-pocket expenses and are
recorded in financial statements.
Examples include standard costs,
Types of Short-run costs
activity-based costs (ABC), lean costs, 1. Total Fixed Costs (TFC): Costs that do
and marginal costs. not vary with output. Examples of these
costs are depreciation of buildings and
machinery, salaries of top management,
2. Economic Costs: These include rent expenses on leased plant, and
accounting costs plus the value of interest payments on borrowed capital.
sacrifices made when choosing one
option over another (opportunity costs).
They cover both explicit costs (actual 2. Total Variable Costs (TVC): Costs that
payments) and implicit costs (non- vary with output. Examples of these
monetary sacrifices). costs are payment for raw materials,
wages, tax payments, operating
expenses (light, fuel, and water).
3. Production Costs: These are all the
expenses involved in making a product
or offering a service, including 3. Total Costs (TC): Sum of total fixed costs
materials, wages, maintenance, and and total variable costs. TC =
shipping. They are divided into direct FC + VC
costs (e.g., raw materials) and indirect
costs (e.g., factory upkeep).
4. Average Fixed Costs (AFC): Average
fixed cost (AFC) is the fixed cost per unit
4. Opportunity Costs: This is the value of and is calculated by dividing the total
what you give up to get something else. fixed cost by the number of
It’s the next best use of resources that output/quantities produced.
is sacrificed when a decision is made. AFC = FC/Q

5. Private Costs: These are costs paid by 5. Average Variable Costs (AVC): Average
individuals or businesses, such as labor, variable cost (AVC) refers to the per unit
materials, and machinery. They don’t
 variable cost of production. It is
calculated by dividing TVC by total
output/quantities produced. Long run Marginal Cost (LMC)
AVC = VC/Q
The long run marginal cost is an addition to the
long run total cost when an additional unit of a
commodity is produced. It is calculated as the
6. Average Total Costs (ATC): Average total short run marginal cost is calculated. Long run
cost (ATC) refers to the per unit total marginal cost curve is also U-shaped but the
cost of production. It is calculated by fall and rise in the marginal cost curve is not
dividing TC by total quantity produced. sharp but it is gradual.
ATC = TC/Q

7. Marginal Costs (MC): Marginal cost is

the change in total production cost that
comes from making or producing one
additional unit. Marginal Costs changes
in total costs divided by the change in
output produced (Q). It is also the
additional cost incurred from producing
an additional unit of output.
MC= ΔTC/ΔQ

Long-run costs Analysis

Long period gives sufficient time to business
managers to change even the scale of Why is the LAC is U- shaped?
production. All the factors of production are
variable. All the costs are variable costs and In the short run SAC curve is U-shaped because
there is no fixed cost. The supply of goods can the laws of return operate but in the long run
be adjusted to their demands because scale of LAC is also U-shaped because the laws of
production and factors of production can be return of scale operate, namely, law of
changed. In the long run we can study the long increasing returns to scale, law of constant
run average cost curve and long run marginal returns to scale and the law of diminishing
cost curve. returns to scale. As the level of output is
expanded or scale of operation is increased by
the large firm, they will enjoy economies of
scale but if these firms produce beyond their
installed capacity, then they might get
diseconomies of scale. Economies of scale
bring down the fall in unit cost and
diseconomies results into rise in it.