Production and

Cost Analysis

Submitted By: Submitted To:

Alfonso, Marvin Mrs. Lucia Wong Lazo
Mirandilla, Klaryz
Lopez, Jose Miguel
 Production and Cost Analysis: Production Function with 2 Variable Inputs

 Production Function
o Relates physical output of a production process to physical inputs or factors of
production. It is a mathematical function that relates the maximum amount of
output that can be obtained from a given number of inputs – generally capital and
labor. The production function, therefore, describes a boundary or frontier
representing the limit of output obtainable from each feasible combination of
inputs.
o Firms use the production function to determine how much output they should
produce given the price of a good, and what combination of inputs they should
use to produce given the price of capital and labor. When firms are deciding how
much to produce they typically find that at high levels of production, their
marginal costs begin increasing. This is also known as diminishing returns to
scale – increasing the quantity of inputs creates a less-than-proportional increase
in the quantity of output. If it weren’t for diminishing returns to scale, supply
could expand without limits without increasing the price of a good.

Notes to Remember:

 The production function describes a boundary or frontier representing the limit of output
obtainable from each feasible combination of inputs.
 Firms use the production function to determine how much output they should produce
given the price of a good, and what combination of inputs they should use to produce
given the price of capital and labor.
 The production function also gives information about increasing or decreasing returns to
scale and the marginal products of labor and capital.
 Isoquants - represents all those factor combinations which are capable of producing the
same level of output.
o Iso = Equal or Same

Key Terms:

 Production Function: Relates physical output of a production process to physical inputs

or factors of production.
 Marginal Cost: The increase in cost that accompanies a unit increase in output; the
partial derivative of the cost function with respect to output. Additional cost associated
with producing one more unit of output.
 Output: Production; quantity produced, created, or completed.

The following table will be discussed:

Analyzation of the Graphs:

 Isoquants cannot be fluctuating; must be constant (in quantity).

 Each combination can be only one isoquant.
 “More Labor added, less the capital is being utilized but not affecting the constant yield
on the long run.”
o Supported by: (1) Law of Diminishing Marginal Utility; (2) Marginal Rate of
Technical Substitution.
Law of Diminishing Marginal Utility

 The Law Of Diminishing Marginal Utility states that all else equal as consumption
increases the marginal utility derived from each additional unit declines. Marginal utility
is derived as the change in utility as an additional unit is consumed. Utility is an
economic term used to represent satisfaction or happiness. Marginal utility is the
incremental increase in utility that results from consumption of one additional unit.
 Marginal utility may decrease into negative utility, as it may become entirely unfavorable
to consume another unit of any product. Therefore, the first unit of consumption for any
product is typically highest, with every unit of consumption to follow holding less and
less utility. Consumers handle the law of diminishing marginal utility by consuming
numerous quantities of numerous goods.
o Example:
 An individual can purchase a slice of pizza for $2; she is quite hungry and
decides to buy five slices of pizza. After doing so, the individual consumes
the first slice of pizza and gains a certain positive utility from eating the
food. Because the individual was hungry and this is the first food she
consumed, the first slice of pizza has a high benefit. Upon consuming the
second slice of pizza, the individual’s appetite is becoming satisfied. She
wasn't as hungry as before, so the second slice of pizza had a smaller
benefit and enjoyment as the first. The third slice, as before, holds even
less utility as the individual is now not hungry anymore.

Marginal Rate of Technical Substitution

 An economic theory that illustrates the rate at which one factor must decrease so that the
same level of productivity can be maintained when another factor is increased.
 The MRTS reflects the give-and-take between factors, such as capital and labor, that
allow a firm to maintain a constant output. MRTS differs from the marginal rate of
substitution (MRS) because MRTS is focused on producer equilibrium and MRS is
focused on consumer equilibrium.

Key Points:

 The marginal rate of technical substitution shows the rate at which you can substitute one
input, such as labor, for another input, such as capital, without changing the level of
resulting output.
 The isoquant, or curve on a graph, shows all of the various combinations of the two
inputs that result in the same amount of output.
Analyzation:

 Panel I – No substitution
 Panel 2 – Perfect Substitution
 Panel 3 – Imperfect Substitution

Example of an Isoquant Map (A group of Isoquants)

 THE OPTIMAL COMBINATION OF INPUTS

What is the optimal input combination?

 It is an input combination which maximizes output given the costs faced by the firm.

While all the input combinations are technically efficient, the final decision to employ a
particular input combination is purely an economic decision and rests on cost (expenditure).
Thus, the production manager can make either of the following two input choice decisions:

1. Choose the input combination that yields the maximum level of output with a given level of
expenditure.

2. Choose the input combination that leads to the lowest cost of producing a given level of
output.

Thus, the decision is to minimize cost subject to an output constraint or maximize the output
subject to a cost constraint.

RETURNS TO SCALE

Returns to Scale

 It is the quantitative change in output of a firm or industry resulting from a proportionate

increase in all inputs.

How output responds in the long run to changes in the scale of the firm?

 Clearly, there are 3 possibilities.

1. If output increases by more than an increase in inputs, then the situation is one of
increasing returns to scale (IRS). O > I

2. If output increases by less than the increase in inputs, then it is a case of decreasing
returns to scale (DRS). O < I

3. Lastly, output may increase by exactly the same proportion as inputs. This is a case
of constant returns to scale (CRS). O = I

EXAMPLE: A box with dimensions 4*4*4 has a capacity of 64 times a box with dimensions
1*1*1, even though the former uses only 16 times more wood than the smaller box. 3 Isoquants
can also be used to depict returns to scale (Figure) Panel A shows constant returns to scale. Three
isoquants with output levels 50,100 and 150 are drawn. In the figure, successive isoquants are
equidistant from one another along the ray 0Z. Panel B shows increasing returns to scale, where
the distance between 2 isoquants becomes less and less i.e. in order to double output from 50 to
100, input increase is less than double. The explanation for panel C, which exhibits decreasing
returns to scale, is analogous. There is no universal answer to which industries will show what
kind of returns to scale. Some industries like public utilities (Telecom and Electricity generation)
show increasing returns over large ranges of output, whereas other industries exhibit constant or
even decreasing returns to scale over the relevant output range. Therefore, whether an industry
has constant, increasing or decreasing returns to scale is largely an empirical issue.

The Empirical Production Function

1. Linear Homogeneous Production Function

 When all the inputs are increased in the same proportion, the production function is
said to be homogeneous. The degree of production function is equal to one. This is
known as linear homogeneous production function. In order to estimate the
production function, it is necessary to express the function in explicit functional form.
Mathematically, this form of production function is expressed as nQ = f (nL, nK)
 This production function also implies constant returns to scale. That is if L and К are
increased by n-fold, the output Q also increases by n-fold. This form of production
function is a well behaved production function. Which makes the task of the
entrepreneur quite simple and convenient? He requires only Finding out just one
optimum factor proportions.
 So long as relative factor prices remain constant, he has not to make any fresh
decision regarding factor proportions to be used, as he expands his level of
 production. Moreover, this feature of the same optimum factor proportions is also
very useful in input- output analysis, In India, farm management studies have
emphasised the constant return to scale and homogeneous production function.
2. Cobb-Douglas Production Function
 Charles W. Cobb and Paul H. Douglas studied the relationship of inputs and outputs
and formed an empirical production function, popularly known as Cobb-Douglas
production function. Originally, C-D production function applied not to the
production process of an individual firm but to the whole of the manufacturing
production.
 The Cobb-Douglas production function is expressed by: Q = A(L^α)(K^β)
o where Q is output and L and A’ are inputs of labour and
capital respectively. A, α and β are positive parameters
where α > 0, β > 0. The equation tells that output depends
directly on L and K and that part of output which cannot be
explained by L and К is explained by A which is the
‘residual’, often called technical change.
 The marginal products of labour and capital are the functions of the parameters A, α
and β and the ratios of labour and capital inputs. That is,
o MPL =∂Q/∂L = αA[(L^(α-1)](K^β)
o MPK = ∂Q/∂K = βA[(L^α)](K^β-1)
o The two parameters a and P taken together measure the
degree of the homogeneity of the function.
o In other words, this function characterises the returns to
scale thus:
o α + β >1: Increasing returns to scale
o α + β =1: Constant returns to scale
o α +β <1: Decreasing returns to scale.
 Although the С-D production function is a multiplicative type and is non-linear in its
general form, it can be transferred into linear function by taking it in its logarithmic
form. That is why, this function is also known as log linear function, which is

Log Q = log A + a log L + p log K

 It is easier to compute С-D function when expressed in log linear form.

Properties of C-D Production Function

The C-D production function has the following properties:

1. There are constant returns to scale.

2. Elasticity of substitution is equal to one.
3. A and p represent the labour and capital shares of output respectively.
 4. A and p are also elasticities of output with respect to labour and capital respectively.
5. If one of the inputs is zero, output will also be zero.
6. The expansion path generated by C-D function is linear and it passes through the origin.
7. The marginal product of labour is equal to the increase in output when the labour input is
increased by one unit.
8. The average product of labour is equal to the ratio between output and labour input.
9. The ratio α /β measures factor intensity. The higher this ratio, the more labour intensive is
the technique and the lower is this ratio and the more capital intensive is the technique of
production.

Importance of C-D Production Function

The C-D production function possesses the following merits:

1. It suits to the nature of all industries.

2. It is convenient in international and inter-industry comparisons.
3. It is the most commonly used function in the field of econometrics.
4. It can be fitted to time series analysis and cross section analysis.
5. The function can be generalised in the case of ‘n’ factors of production.
6. The unknown parameters a and p in the function can be easily computed.
7. It becomes linear function in logarithm.
8. It is more popular in empirical research.

Limitations of C-D Production Function

It has the following limitations:

1. The function includes only two factors and neglects other inputs.
2. The function assumes constant returns to scale.
3. There is the problem of measurement of capital which takes only the quantity of capital
available for production.
4. The function assumes perfect competition in the factor market which is unrealistic.
5. It does not fit to all industries.
6. It is based on the substitutability of factors and neglects complementarity of factors.
7. The parameters cannot give proper and correct economic implication.

3. Constant Elasticity of Substitution Production Function:

The CES production function is otherwise known as Homohighplagic production function.

Ar-row, Chenery, Minhas and Solow have developed the Constant Elasticity of Substitution
(CES) func­tion. This function consists of three variables Q, К and L, and three parameters A, a
and 0. It may be expressed in the form:

Q = A [α C-ϴ+ (1- α) L -ϴ]-1/ϴ

where Q is the total output, К is capital, and L is labour. A is the efficiency parameter indicating
the state of technology and organisational aspects of production. It shows that with technological
and/or organi-sational changes, the efficiency parameter leads to a shift in the production
function, a (alpha) is the distribution parameter or capital intensity factor coefficient concerned
with the relative factor shares in the total output, and 0 (theta) is the substitution parameter which
determines the elasticity of substitu­tion. And A > 0; 0 < α <1; ϴ > -1.

In the CES production function, the elasticity substitution is constant and not necessarily equal to
unity.

Mukherji has generated the CES function by introducing more than two inputs.

Properties of CES Production Function:

1. The value of elasticity of substitution depends upon the value of substitution parameter.
2. The marginal products of labour and capital are always positive if we assume constant
returns to scale.
3. The marginal product of an input will increase when other factor inputs increase.
4. When the elasticity substitution is less than unity the function does reach a finite
maximum as one factor increases while other is held constant.
5. The marginal product curves are sloping downward.
6. The estimation of the elasticity of substitution parameter requires the assumption of
perfect com-petition.

Merits of C.E.S. Production Function:

1. CES production function is more general.

2. CES covers all types of returns.
3. CES function takes account of a number of parameters.
4. CES function takes account of raw material among its inputs.
5. CES function is very easy for estimation.
6. CES function is free from unrealistic assumptions.

Limitations of CES Production Function:

1. The generated function suffers from the drawback that elasticity of substitution between
any parts of inputs in the same which does not appear to be realistic.
2. In estimating parameters of CES production function, we may encounter a large number
of problems like choice of exogenous variables, estimation procedure and the problem of
multicollinearities.
3. Any attempt to remove the problem of multicollinearities would magnify the errors in
measure-ment of variables.
 4. Serious doubts have been raised about the possibility of identifying the production
function under technological change.

Variable Elasticity Substitution Production Function:

 Recently attempts have been made by Bruno, Knox Lovell and Revankar to get a new
production function. The resulting production function is the generalisation of CES
which possesses the desirable properties of variable elasticity substitution.
 Lu and Fletcher have filled a logarithmic relationship containing the wage rate (W) as
well as the capital-labour ratio (K/L) to explain value added per unit of labour.

L = a + b log W + с log K/L

 Where: V = Value added; W = Wage rate; K = Capital; L = Labour

 a, b and с are the parameters to be estimated.
 The elasticity of substitution (σ) is

σ = b/1-c (1+WL/rk)

where, WL and rk are the shares of labour and capital respectively.

Properties of VES Production Function:

1. VES satisfies the requirements of a neo-classical production function

2. ES function includes the fixed co-efficient models.
3. VES production function is more general.
Innovation and Global Competitiveness

Innovation

 Translating an idea or invention into a good or service that creates value or for
which customers will pay. To be called an innovation, an idea must be
replicable at an economical cost and must satisfy a specific need.

Global Competitiveness

 The ability of something to compete with a trend.

 The ability of a country to achieve sustained high rates of growth in gross
domestic product (GDP) per capita.

Product Life Cycle

 Products, like people, have life cycles. The product life cycle is broken into
four stages: introduction, growth, maturity, and decline. This concept is used
by management and by marketing professionals as a factor in deciding when it
is appropriate to increase advertising, reduce prices, expand to new markets,
or redesign packaging.
o Introductory Stage - This stage of the cycle could be the
most expensive for a company launching a new product.
The size of the market for the product is small, which
means sales are low, although they will be increasing. On
the other hand, the cost of things like research and
development, consumer testing, and the marketing needed
to launch the product can be very high, especially if it’s a
competitive sector.
o Growth Stage – The growth stage is typically characterized
by a strong growth in sales and profits, and because the
company can start to benefit from economies of scale in
 production, the profit margins, as well as the overall
amount of profit, will increase. This makes it possible for
businesses to invest more money in the promotional
activity to maximize the potential of this growth stage.
o Maturity Stage – During the maturity stage, the product is
established and the aim for the manufacturer is now to
maintain the market share they have built up. This is
probably the most competitive time for most products and
businesses need to invest wisely in any marketing they
undertake. They also need to consider any product
modifications or improvements to the production process
which might give them a competitive advantage.
o Decline Stage – Eventually, the market for a product will
start to shrink, and this is what’s known as the decline
stage. This shrinkage could be due to the market becoming
saturated (i.e. all the customers who will buy the product
have already purchased it), or because the consumers are
switching to a different type of product. While this decline
may be inevitable, it may still be possible for companies to
make some profit by switching to less-expensive
production methods and cheaper markets.
 JIT Production System

 In manufacturing, speed to market and costs of production can make or break a

company. Just in time (JIT) manufacturing is a workflow methodology aimed at
reducing flow times within production systems, as well as response times from
suppliers and to customers. JIT manufacturing helps organizations control variability
in their processes, allowing them to increase productivity while lowering costs. JIT
manufacturing is very similar to Lean manufacturing, and the terms are often used
synonymously.
 A management strategy that aligns raw-material orders from suppliers directly with
production schedules.
 Benefits of Just in Time Manufacturing
When done well, adopting a Lean manufacturing or just in time
manufacturing system can have a drastic impact on an
organization’s productivity, risk management, and operating costs.
Here are just a few of the quantitative benefits experienced by
manufacturers worldwide:
o Reduction in inventory
o Reduction in labor costs
o Reduction in space needed to operate
o Reduction in WIP (work in process)
o Increase in production
o Improvements in product quality (lower rates of defects)
o Reduction of throughput time
o Reduction of standard hours
o Increase in number of shipments

Competitive Benchmarking

 Process of comparing your company against a number of competitors using a set

collection of metrics. This is used to measure the performance of a company and
compare it to others over time.

Computer-Aided Designs and Manufacturing (CAD/CAM)

 Using computers or softwares to automate a design/manufacturing process.

 Used by architects, manufacturers, engineers, drafters, artists, and others to create
precision drawings or technical illustrations.