UNIT-III

(Production and Cost Analysis)

MODULE-1: COST CONCEPTS

CONTENTS
1.0: Introduction
1.01: Objectives
1.02: Meaning of cost of production
1.03: Money cost
1.04: Explicit and Implicit cost
1.05: Separable and Non-separable cost
1.06: Fixed and Variable cost
1.07: Incremental and Sunk cost
1.08: Replacement and Historical cost
1.09: Relevant and Irrelevant cost
1.10: Private and Social cost
1.11: Summary
1.12: References
1.13: Self Assessment Test
1.0: Introduction:
Cost of production plays an important role in decision making,
given other factors. It is the level of cost relative to revenue that
determines the firm’s overall profitability. In order to maximise
profit the firm try to increase its revenue and lower its cost. While
the external factors determine the level of revenue to a great extent,
the cost can be brought down either by producing the optimum
level output using the least cost combination of inputs or
increasing factor productivities. The firm’s output level is
determined by its cost. Cost of production provides the floor or
base for pricing of a product. A firm which produces with low cost
relative to its rival will have competitive advantage in the market.
As a result no firm ignores its cost analysis.

1.01: Objectives:
The objective of this module is to explain different concepts of
cost. After reading this module, you should be able to understand
the meaning of:

Cost of production
Money cost
Explicit and Implicit Cost
Separable and non-separable cost
Fixed and variable cost
Incremental and sunk cost
Replacement and historical cost
Relevant and irrelevant cost
Private and social cost

1.02: Meaning of cost of production:

In general, the value of inputs used in the production process to
produce a given level of output is called as cost of production. For
example: a business firm employed 10 units of labor and 5 units of
capital and 5 quintals of rawmaterial to produce 100 units of
output. Assume that the price of labor per unit is Rs: 10 the price
of capital per unit is Rs: 20 and the price of rawmaterial per unit is
Rs 500 per quintal. Thus the cost of producing 100 units of output
is Labor cost of Rs 100 + capital cost of Rs 100+ rawmaterial cost
Rs 2500 = Rs.2700. This implies that the physical quantities of
inputs have to be converted into money terms to arrive at cost of
production.

1.03: Money cost:

It is the total expenditure incurred by a business firm towards
producing a volume of output. Business firm may use various
factors of production in the production process to produce output.
We can understand the concept of money cost with the help of
following example.

Rawmaterials worth =Rs 2000

Employed workers and their wages = Rs 400
Interest on capital = Rs.100
Fuel charges Rs 50
Rent towards using building =Rs 100
The money cost of producing given level of output is Rs 2650.

1.04: Explicit and Implicit Cost:

The money cost or total cost of producing given output consists of
explicit and implicit cost. The cost or expenditure incurred by a
firm towards purchased or hired-in factors of production is called
explicit cost or out of pocket cost. On the other hand in addition to
hired-in factors of production, a firm may employ own factors of
production such as own labour (family members), own capital,
own building etc. The payment that a business firm is supposed to
make towards using own factors of production according to market
or opportunity cost is called implicit cost. These costs also known
as book cost or economic cost or implicit cost or imputed cost. We
can understand this cost concept with the help of following
example.
Purchased Rawmaterials worth =Rs 2000
Employed workers (other than family members) and their wages =
Rs 300
Employed workers (family members) and their wages = Rs 100
Interest on borrowed capital = Rs.80
Interest on own capital = Rs.20
Fuel charges Rs 50
Rent towards using own building =Rs 100

In the above example explicit cost items are:

Purchased Rawmaterials worth =Rs 2000
Employed workers (other than family members) and their wages =
Rs 300
Interest on borrowed capital = Rs.80
Fuel charges Rs 50
Total explicit cost is = Rs 2430
The implicit cost items are:
Employed workers (family members) and their wages = Rs 100
Interest on own capital = Rs.20
Rent towards using own building =Rs 100
The total implicit cost is Rs 220.

This classification of cost in to explicit and implicit is useful to

estimate accounting and economic profit. In general accountants’
takes in to consideration accounting cost and they ignore economic
costs. But economists’ takes in to consideration explicit and
implicit costs while calculating profit.

Accounting profit = total revenue – explicit cost

Economic profit = total revenue – (explicit + implicit cost) or
Economic profit = Accounting profit – implicit cost.

ACTIVITY-1
1. Define explicit and implicit costs.
2. What is the difference between accounting and economic profit?

1.05: Separable and non-separable cost:

These costs are also known as direct and indirect costs as well as
traceable and non traceable costs. A direct or traceable cost is one
which can be identified easily on the basis a department or product
or size of the product. For example: rawmwterial cost can be
identified based on product or size of the product. Common are
indirect costs are those that are not traceable department –wise. For
example: the salary of CEO of a business firm, salary of a quality
control engineer, fuel charges, stationery expenses cannot be
traceable.

1.06: Fixed and Variable Cost:

Total cost could be divided into two components such as fixed and
variable costs. In the short-run fixed costs remain constant
irrespective of changes in volume of output. They do not vary as a
result of variations in volume of output. A firm has to incur fixed
costs even when output is zero. There is an inverse relationship
between volume of output and per unit fixed cost. The examples of
fixed costs are: cost incurred on plant and machinery, buildings,
salaries to permanent employees, insurance premium etc. Fixed
costs are also known as over head expenses and supplementary
costs.

Variable costs do change as a result of variations in volume of

output. As output increases variable cost also increases and vice
versa. In the initial stages, as output increases, total variable cost
increases at a decreasing rate. Beyond a level if output increases,
total variable cost increases at an increasing rate. The cost incurred
by business firm towards rawmaterial, wages to workers, fuel
charges and other working expenses are called variable costs.
These costs also called as prime costs and direct costs.

ACTIVITY-1
1. Identify the fixed and variable cost items in your class room.

1.07: Incremental and Sunk cost:

Incremental cost is the change in total cost as a result of producing
additionally a bulk quantity of output. For example: A business
firm produced 100 units of a commodity with total cost Rs 1000.
On the other hand to produce 200 units of output the firm incurred
total cost of Rs 1800. Here the incremental cost is Rs 800. This
increase in total cost is due to change in output by 100 units (bulk
change). Sunk cost is one which is not affected by change in the
level of business activity. It will remain the same whatever the
level of output. The most important example of sunk cost is the
amortization of past expenses i.e. depreciation.

For decision making purpose incremental costs are more

important. Business firms’ always look at incremental costs while
allocating additional load of input in the production process.
Whether to add additional load of input in the production process
or not depends on comparison of incremental costs and
incremental revenues. If incremental costs are less than
incremental revenues, then the business firm will take a decision to
add additional load of inputs or else it may withdraw inputs from
the production process.

1.08: Replacement and Historical Cost:

Historical cost is the cost already incurred by the business firm.
Now the firm cannot avoid or escape. For example: The
expenditure incurred by a firm to buy a machine 5 years back.
Since expenditure already incurred it cannot be avoided. On the
other hand, replacement cost is the expenditure that a business firm
has to incur in order to buy a new or advanced machine to replace
the machine purchased 5 years back. Replacement cost implies the
present price of new machine. For decision making purpose,
managers always takes into consideration replacement costs and
they simply ignore historical costs.

1.09: Relevant and irrelevant costs:

The relevant costs for decision making purpose are those costs
which are incurred as a result of decision under consideration. The
relevant costs are also referred to as incremental costs. Costs that
have been incurred already and costs that will be incurred in the
future regardless of the present decision are irrelevant costs as far
as the present decision problem is concerned.

1.10: Private and social costs:

Private costs are those that accrue directly to the individuals of
firms engaged in relevant activity. External costs, on the other
hand, are passed on to persons i.e. society, not involved in the
activity in any direct way. For example a business firm located on
the banks of a river leaving the effluents in to the river. While the
private cost of leaving the effluents in to the river, to the firm is
zero. On the other hand social cost is definitely positive. Because
the effluents pollute the river water and affects adversely the health
of people located in downstream. These people have to spend
money to cure diseases afflicted through the use of polluted water.
These are called social costs that the society has to incur though it
is in no way involved in the production of commodities which
pollute the environment.

ACTIVITY-3
1. Name the industries which cause positive social cost.

1.11: Summary:
In this module an attempt has been made to understand different
cost concepts that we come across while studying managerial
economics. The value of factors of production employed in the
production process to produce a given volume of output is called
cost of production. Cost of production forms the basis for fixation
of price. In modern times business firms generally concentrating
on cost effective methods and adopting cost reduction policies to
face competition in the market. The different cost concepts
discussed in this module, play an important role in decision
making process with respect arriving at decisions related to output,
price fixation, to add additional quantity of factors of production,
replacement of machinery etc.

1.12: References:
1. P.L.Mehta: Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore: Managerial Economics in a global
economy
3. R.L Varshney and Maheswari: Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

1.13: Self assessment test:

1. Discuss various cost concepts which are helpful to managers’ in
arriving at business decisions.
 UNIT-III
(Production and Cost Analysis)
MODULE- 2: COST OUTPUT RELATIONSHIP-I

CONTENTS

2.0: Objectives
2.01: Total Cost
2.02: Total Fixed Cost
2.03: Total Variable Cost
2.04: Cost Functions and Cost Estimation
2.05: Cost estimation Methods
2.06: Summary
2.07: References
2.08: Self Assessment Test

2.0: OBJECTIVES:
The objective of this module is to discuss the cost output
relationship. After reading this module you should be able to
understand the relationship between output and
Total cost
Total fixed cost
Total variable cost.

2.01: Total cost:

The value of fixed and variable factors of production employed by
the business firm to produce a given level of output is called total
cost. Output is the result of combining together fixed and variable
factors in required proportions. The fixed factors are plant,
machinery, salaries to permanent employees etc. The variable
factors are rawmaterial, fuel, power charges, other working
expenses etc. Therefore, the total cost consists of fixed and
variable costs together. As the volume of output increases the total
cost also increases. In the short run, the shape and position of total
cost curve is influenced by the nature of returns experienced by the
business firm. Where as in the long run the shape and position of
total cost curve is determined by the nature of returns to scale.

2.02: Total Fixed Cost:

The expenditure incurred by a firm towards employing fixed
factors of production is called total fixed cost. In the short run total
fixed will remain constant. The time period (short run) is such that,
it doesn’t allow the managers’ to make adjustment in fixed factors
of production. Regardless of level of output, business firms’ have
to bear these fixed costs in the short run. The basic nature of fixed
costs is that, they do not change as a result of variations in volume
of output. Even at zero level of output, the fixed costs are positive.

2.03: Total Variable Cost:

The expenditure incurred by a business firm towards employing
variable factors of production is called as total variable cost. These
costs vary as a result of variations in volume of output. As output
increases, variable cost also increases and vice versa. In the
beginning, as output increases, total variable cost also increases but
at a decreasing rate. As there is an increase in output further,
variable cost increases at an increasing rate.

We can understand the relationship between output and cost in the

short run with the help of following numerical example:

Output Total Fixed

Cost Total Variable Cost Total Cost
(In ‘000Units) (Rs in
crores) (Rs in crores)
(Rs in crores)
 0 100
---
100
1 100
30
130
2 100
45
145
3 100
55
155
4 100
60
160
5 100
62
162
6 100
78
178
 7 100
105
205
8 100
160
260
9 100
225
325
10 100
300
400

It is clear from the above example that total fixed cost remains
constant regardless of the volume of output produced by a firm. In
the short run business firm by employing Rs 100 crore worth of
fixed factors, can produce any volume of output i.e from 0 (zero)
units to 10 thousand units. In the short run, the fixed nature of
fixed costs acts as an obstacle on the part of business firm. In the
short run if there is sudden increase in the demand for the product,
business firm cannot make adjustment in fixed factors to meet
increased demand. It has to produce an increased quantity with the
same fixed factors. The time period is not long enough to affect
changes in fixed factors of production.

As the volume of output increases, variable cost also moving in

the same direction. In the beginning, total variable cost is
increasing at a decreasing rate up to the production level of 5000
units. This is due to the increasing returns experienced by the firm
in the production process. Beyond 5000 units, as output increases,
total variable cost is increasing at an increasing rate. This is due to
the diminishing returns experienced by the firm. At zero level of
output, total variable cost is zero. If firm is not producing output i.e
zero output, there is no need for the firm to incur any amount
towards variable cost.

Total cost is the sum of fixed and variable cost at any given level
of output. That is TC = TFC + TVC. Here TC is the total cost, TFC
is the total fixed cost and TVC is the total variable cost. As the
volume of output increases, total cost also moving in the same
direction. In the beginning, total cost is increasing at a decreasing
rate up to the production level of 5000 units. This is due to the
increasing returns experienced by the firm in the production
process. Beyond 5000 units, as output increases, total cost is
increasing at an increasing rate. This is due to the diminishing
returns experienced by the firm. At zero level of output, total cost
is Rs 100 crore. We can understand the cost output relationship
with the help of following diagram.

GRAPH-1
TC

Y TVC

Total cost (TC)

Total Fixed Cost
(TFC)
Total variable TFC
cost(TVC) 100
100

X
0 Quantity

2.04: Cost Functions and cost Estimation:

The important problem of managerial economist is that of
choosing the type of equation or cost function that fits the data
best. There are three types of cost functions a managerial
economist can adopt. They are : (1) Linear (2) quadratic (3) cubic
cost function.
Linear cost function:
Y = a + bX. Here ‘a’ is the fixed cost and ‘b’ is the proportion of
variable cost. ‘X’ is output. bX is the total variable cost. ‘Y’ is the
total cost. The underlying assumption of this function is that, the
firm has fixed costs which must be met irrespective of the quantity
of output produced. In the linear cost function ‘b’ is assumed be
constant and hence total cost is represented by upward sloping
straight line.
Let us assume that the estimated cost function is Y = 5000 + 250
X. Given this function we can estimate cost at different levels of
output as shown below.

Output(X) Total
Cost(Y)
(Units)
(Rs.)

0 5000
1 5250
2 5500
3 5750
4 6000
 5 6250
6 6500

GRAPH-2

Y
Tc
Y= a + bx
TC
TFC Y= 5000+250X

5000 TFC

X
0
Quantity

Quadratic Cost Function:

Y = a + b X +c X2 .

This function indicates that as output (X) increases, total variable

in the beginning increases at a decreasing rate. Beyond a level of
output, Cx2 in the function shows that, total variable cost increases
at an increasing rate. Let us assume that estimated total cost
function as Y = 5000 + 250 X + 1X2. This function indicates, that
the fixed costs of the firm Rs 5000 and whose variable costs are
250X + 1X2. The last variable might arise if the firm’s initial cost
of labour and rawmaterial for producing X units is Rs 250X and
the growing demand for the limited supply of inputs bids up their
prices by the amount X2 as output increases. By substituting the
quantity of output in place of ‘X’ in the above estimated cost
function; we can derive the relationship between output and total
cost.

GRAPH-3 TC
Y
Y=a+bX+CX2
Y = 5000 + 250X + 1X2

TC
TFC
TFC

X
0 Quantity

Managers’ can also use quadratic function as Y = a + b X – c X2.

This function indicates that as the quantity of output increases,
even though the demand for factors of production increases, factor
prices decreases due to elastic supply of factors of production. Let
us assume the estimated demand function as Y = 5000 + 250 X –
0. 1 X2. Given the values of quantity, it is possible to find out the
cost output relationship.

GRAPH- 4

TC
TC Y= a+bX – CX
TFC Y= 5000+250X

5000 TFC

X
0
Quantity

Cubic Cost function:

The form of this cost function is Y = a + b X - c X2 + dx3. This
function indicates that as the volume of output increases, it leads to
increase in the productivity of variable factors of production.
Hence total cost increases but at a decreasing rate. Beyond a point
if output increases, it leads to fall in productivity of variable factors
of production. Hence total cost increases at an increasing rate. Let
us assume the estimated cost function as Y= 18 +30X – 10X2 +X3.
Given the level of output, we can find out cost –output relationship
using the cubic cost function.

GRAPH- 5

TC
Y
Increasing
Decreasing Y=a+bX-Cx2+dx3
productivit
productivity Y = 18+30X-10X2+1X3
y
TC
TFC

TFC
18

0
Quantity

ACTIVITY-1

1. Given the cost function Y= 10 +3X – 6X2 +X3 derive the cost
output relation and show the same with the help of graph.
2. Given the cost function Y= 6000 + 200 X + 0.1 X2, Find the
total cost and total variable cost at output level 400 units and 600
units.

2.05: Cost estimation methods:

Four broad approaches exist for the measurement of actual cost
output relationship. They are:

Accounting method:
This method is used by the cost accountants. In this method the
data is classified in to various categories. By plotting the output
levels and corresponding costs on a graph and joining them by a
line the cost functions are estimated. The cost functions thus found
may be linear or non-linear.

Statistical or Econometric method:

This method adopts statistical techniques to find cost output
relationship. The economic data may relate to past records of the
firm i.e. the time series data or different firms in the same business
at a point of time. i.e. cross section data.

Survivorship method:
This method is based on the rationale that over time competition
tends to eliminate firms of inefficient size and that only the firms
with efficient size will survive and these will have lower average
cost. In this method firms in the industry are classified in to size
groups. Growth of firms in each size is examined. The size –group
whose share in the industry grows the most during a specified time
period is considered the most efficient size. For example if the
share of small firms in the industry moved upwards at the cost of
the share of large firms, it implies that the optimum size of a firm
in the present case is the small sized one.

Engineering Method:
In this method, the cost functions are estimated with the help of
physical relationships such as weight of the finished product and
the weight of rawmaterials used. Then these rawmaterials are
converted into money terms to arrive at an estimate of cost.

2.06: Summary:
In this module an attempt has been made to discuss and understand
cost output relationship. The expenditure incurred by a firm on
various inputs to produce a given level of output is called total
cost. Total cost consists of total fixed cost and total variable cost.
In the short-run total fixed cost will remain constant. On the other
hand, total variable cost depends on the nature of returns
experienced by the business firm. In the beginning, as the volume
of output increases, total variable cost increases at a decreasing
rate. Beyond a level of output, total variable cost increases at an
increasing rate. In the short-run the shape of the total cost curve is
influenced by the nature of total variable cost. Economists
generally use mathematical cost functions i.e. linear, quadratic,
cubic, to identify the nature of cost output relationship.

2.07: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore : Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

2.08: Self assessment test:

1. Discuss the relationship between cost and output in the short run
with the help of total cost function.
2. Explain mathematical cost functions.
 UNIT-III
(Production and Cost Analysis)
MODULE- 3: COST OUTPUT RELATIONSHIP –II

CONTENTS

3.0: Objectives
3.01: Average fixed cost and output
3.02: Average Variable Cost and Output
3.03: Average cost and output
3.04: Marginal Cost and Output
3.05: Relationship between AC and MC
3.06: Long run Average Cost and Output
3.07: Cost functions and Estimation of TC,AFC,AVC,
AC, MC.
3.08: Cost Forecasting
3.09: Summary
3.10: References
3.11: Self assessment test.

3.0: Objectives:

The objective of this module is to discuss average cost and output

relationship in the short run and long run. After reading this
module you should be able to understand the relationship between:

Average fixed cost and output

Average variable cost and output
Average cost and output in the short run
Long run average cost and output.
3.01: Average Fixed Cost (AFC) and Output (Q):

Business firm can arrive at average fixed cost i.e. fixed cost per
unit, by dividing total fixed cost with the level of output.

TFC
AFC = -----.
Q

If the TFC is Rs 1000 and the level of output is 100 units, then
AFC is Rs.10. The basic feature of AFC is that it decreases
continuously as the volume of output increases. This is due to the
fact that TFC remains constant in the short-run .

Y
GRAPH-1
AFC

AFC

X
Quantity

3.02: Average Variable Cost (AVC) and Output (Q):

We can arrive at average fixed cost by dividing total variable cost

(TVC) with the level of output.

TVC
 AVC = -----
-
Q

If the total variable cost of producing 100 units of output is Rs

2000, then the AVC is Rs 20. The basic feature of AVC is that, in
the beginning, it decreases as the level of output increases. But
after certain level of output, it increases due to diminishing returns
experienced by the business firm.

GRAPH-2

AVC
AVC

X
0
Quantity

3.03: Average Cost (AC) and Output (Q):

We can arrive at average cost by adding together AFC and AVC at

any given level of output. For example to produce 100 units of
output, the AFC is Rs 10 and the AVC is Rs 20. So that AC is Rs
30. In the beginning as output increases AC decreases. Beyond a
level of output as output increases AC decreases.
GRAPH-3

AC
AC

0 Quantity

3.04: Marginal Cost (MC):

The change in total cost as a result of an additional one unit

increase in output is called marginal cost. In the short marginal
cost depends on AVC. We can calculate marginal cost as:

MCn =
TCn - TCn -1.

Here MCn is the marginal cost of nth unit of output. TCn is the
total cost of ‘n’ units of output. TCn -1 is the total cost of n-1 units
of output. For example TCn is Rs 100 where as TCn-1 is Rs 87.
MCn is Rs 13. In the beginning, as output increases MC decreases.
After certain level of output, MC increases. Marginal cost i.e. the
cost of producing an additional unit plays an important role in
decision making by business firms.
 Y
GRAPH-4
MC

MC

X
Quantity

3.05: Relationship between AC and MC:

As the volume of output increases AC and MC decrease. But the

rate of fall in MC is more than the rate of fall in AC. On the other
hand as AC increases MC also increases. But the rate of increase in
MC is more than the rate of increase in AC. According to
numerical example given in the next page, as output increases from
1 unit to 5units AC decreased from Rs130 to Rs 32.40. On the
other hand MC decreased from Rs.30 to Rs.2. When out increased
from 8 units to 10 units, AC increased from Rs 32.50 to Rs 40.
Where as MC increased from Rs 55 to 75.

GRAPH-5

MC AC
We can understand the relationship between output and AFC,AVC,
AC,MC with the following example.

Output TFC TVC TCs

AFC AVC AC
MC

0 100 --- 100

Infinite nil infinite --
-
1 100 30 130
100.0 30.0 130.0
30
2 100 45 145
50.0 22.5 72.50
15
3 100 55 155
33.3 18.33 51.63
10
 4 100 60 160
25.0 15.0 40.00
5
5 100 62 162
20.0 12.40 32.40
2
6 100 78 178
16.66 13.0 29.66
16
7 100 105 205
14.30 15.0 29.30
27
8 100 160 260
12.50 20.0 32.50
55
9 100 225 325
11.10 25.0 36.10
65
10 100 300 400
10.0 30.0 40.0
75

3.06: Long run Average Cost (LAC) and Output (Q):

In the long run a business firm can make perfect adjustment in its
production capacity through introducing changes in fixed factors of
production along with variable factors of production. The shape of
long run average cost curve depends on the nature of economies of
scale experienced by the business firm. The derivation of LAC
curve is shown below.

GRAPH-6

SAC1 SAC
SAC3

R LAC Curve
According to the above graph, SAC1, SAC2, SAC3 are short run
average cost curves, which represent cost of production or the state
of technology in that short period. A firm can produce OQ1 level
of output with Q1M average cost in short period -1. If there is
increase in the demand for the product, with SAC1 technology the
average cost of producing OQ2 is Q2S. If the firm operates in the
long run, it can adopt new technology represented by SAC2. With
SAC2, firm can produce OQ2 output with average cost Q2N. This
is less than Q2S. Firm can expand its output to OQ3 at which the
average cost is Q3T. If the firm produces OQ4, with SAC2
technology, the average cost is Q4R. By going advanced
technology such as SAC3, it can produce OQ4 with OH average
cost. The thick line which touches all the short run average cost
curves is known as long run average cost curve (LAC curve). The
minimum point of LAC curve is touching the minimum point of
SAC2 at point T. This indicates that in the long run a business firm
can produce OQ3 volume of output with the minimum average
cost Q3T. Since OQ3 level of output corresponds to minimum
average cost in the long run, it ( OQ3) is called as optimum output.
A firm which produces output corresponds to minimum average
cost in the long run is called as an ‘optimum firm’ or most efficient
firm. LAC curve also known as planning curve or envelope curve.

3.07: Cost functions and Estimation of AFC, AVC, AC, and

MC:

Linear cost function:

Y = a+ b X. In this function Y is the total cost, ‘a’ is the total fixed

cost and b X is the total variable cost.

a
AFC = ----
X

bX
AVC = ----- = b
X

a bX
AC = --- + -----
X X

NOTE-1

AC = +b

MC = = b
Given the estimated cost function Y = 100 + 20X, at 100 units of
output
Y i.e total cost = Rs 2100, TFC = Rs 100, TVC = Rs 2000
AFC = Rs 1, AVC =20, MC = Rs 20, AC = Rs 21

Quadratic cost function

Y = a + bX + C X2

AC = = + +

= + b + CX

AFC =

AVC = b + CX

MC = = b+2CX

Given the estimated cost function Y = 5000 + 250X + 1 X2, at 100

units of output

Y = Rs 40,000
AFC = Rs 50
AVC = Rs 350
AC = Rs 400
MC = Rs 450

Cubic cost function:

Y = a +bX – C X2 + dX3

AC = = + - +
AFC =

AVC = b – CX + dX2

MC = = b-2cx+3dx2

Given the cost function Y=18+30X-10X2+x3, at 100 units of

output

Y = Rs 903018
AC = Rs 9030.18
AFC = Rs 0.18
AVC = Rs 9030
MC = Rs 31970

Cost Forecasting
Based on the estimated cost functions, we can forecast the TC, AC,
AFC, and MC at different levels of output
Given the linear cost function
Y = 100+20X, it is possible to forecast Y at different levels of
output.
For example

Output(X) (Units) Total Cost

(Rs)
100 2100
200 4100
300 6100
400 8100
500
10100
In the same way using quadratic and cubic cost functions, it is
possible to forecast total cost, AFC, AVC, AC and MC at different
levels of output.

ACTIVITY-1

1. Given the estimated cost function Y = 6000 + 200 X – 0. 2 X2,

estimate the TC, AFC, AVC, MC at the level of output 200 units
and 300 units. Observe, is there any change in average cost
structure as a result of increase in output.

3.09: Summary:
In this module an attempt has been made to discuss the cost output
relationship in terms of AC, AFC,AVC, MC AND LAC. As output
increases, AFC decreases continuously. AFC curve is a rectangular
hyperbola. As output increases, in the beginning AVC decreases.
Beyond a level of output AVC increases. AC also decreases in the
beginning. Later on it takes an upward movement. MC also
decreases in the beginning and later on it increases. AVC, AC, MC
curves are ‘U’ shaped. LAC curve shows the nature of average cost
in the long run. It is possible to have an idea about optimum firm
with the help of LAC curve. Managers’ generally use different cost
functions based on data availability, to estimate cost output
relationship and to forecast the cost of production corresponding to
different level of planned output.

3.10: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore : Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

3.11: Self assessment test:

1. Discuss the relationship between output and AFC, AVC, AC,
MC in the short run.
 UNIT-III
(Production and Cost Analysis)

MODULE – 4: PRODUCTION ANALYSIS

CONTENTS
4.0: Introduction
4.01: Objectives
4.02: Meaning of production function
4.03: Short run production analysis
4.04: Long run production analysis
4.05: Choice of optimum input combination
4.06: Summary
4.07: References
4.08: Self Assessment Test

4.0: Introduction:
Production analysis relates physical output to physical units of
factors of production. In the production process various inputs are
transformed in to some form of output. In production analysis, we
study the least cost combination of factor inputs, factor
productivities and returns to scale. Managers’, while employing
resources in the production process, concerned with economic
efficiency of production which refers to minimization of cost for a
given output level. The efficiency of production process is
determined by the proportion in which various inputs are used, the
absolute level of each input and productivity of each input.

4.01: Objectives:
The objective of this module is to discuss the input – output
relationship in physical terms. After reading this module you will
be in a position to understand the:

Meaning of production function

Short run production function
Least cost input combination

4.02: Meaning of production Function:

The functional relationship between physical input and output is
called as production function. Production function expresses the
technological or engineering relationship between output of a
product and inputs employed in its production. In other words, the
relationship between the amount of various inputs used in the
production process and the level of output is called production
function. It represents the technology involved in the production
process. With the help of production function, it is possible to find
out number of units of factors of production required to produce a
given volume of output. In the same way it is possible to find out
the quantity of output that a business firm can produce by
employing given quantity of factors of production. Production
function describes only efficient levels of output; that is the output
associated with each combination of inputs is the maximum output
possible, given the existing level of technology. Production
function changes as the technology changes.

In general we can represent the production function for a firm as Q

= f (K, L,). Where Q is the total output, K is the fixed capital; L is
the variable capital including labour. In the production function Q
is the dependent variable and K, L are the independent variables.
From the above relationship, it is easy to infer that for a given
value of Q, alternative combinations of K and L can be used since
labour and capital are substitutes to a limited extent. This implies
that, a minimum amount of K and L is absolutely essential for the
production of a commodity.

4.03: Short run production analysis:

A business firm cannot make perfect adjustment in fixed factors of
production in the short-run. This time period doesn’t allow the
firm to change fixed factors. It has to continue the production with
the given K even in the presence of upward movement in demand.
This is a basic constraint under which the firm has to conduct
production operations. Firm can increase the output, to meet
increased demand, by employing more of variable factors on the
given fixed factor. In beginning, as the quantity of variable factors
increases, the marginal productivity of variable factors also
increases. Therefore the total product increases at an increasing
rate. This is called the stage of increasing returns i.e. stage-1. After
stage-1, if the firm employs additional units of variable factors,
marginal product of variable factors diminishes. As result the total
output increases at a decreasing rate. This is called as the law of
diminishing returns i.e. stage -2. Beyond this stage if the firm
employs variable factors, the marginal product of variable factors
will become negative, due to lack of support from given fixed
factors. Therefore the firm experiences negative returns in the
production process i.e.stage-3. We can understand these three
stages with the help of following example.
 Quantity of L Total Product
Average Product Marginal Product
(Units)
(Units) (Units)
1 3
3 3
2 7
3.5 4
3 12
4.0 5
4 16
4.0 4
5 18
3.6 2
6 18
3.0 0
7 14
2.0 -4

GRAPH-1
M
Y

Total Product
Average product
Marginal Product
Stage Stage II
In the above graph, TPL is the total product of labour, APL is the
average product of labour and MPL is the marginal product of
labour curve. At point M, TPL reaches to maximum. When total
product is the maximum at 6 units of employment of variable
factors, the marginal product becomes zero. Corresponding to
point M on TPL, MPL curve is cutting the horizontal axis. Beyond
6 units of employment of variable factors, MPL is negative.

ACTIVITY -1
1. Spell out the meaning of production function.
2. How many stages are there in the short run production analysis?
What are they?
4.04: Long Run Production Analysis
Long run is a time period where perfect adjustment in all the
factors of production is possible. We can understand input –output
relationship in the long run with the help of isoquant (IQ) or
isoproduct curves.

In the long run a business firm can combine together capital and
labour in different proportions to produce the same level of output.
By joining together the corresponding points of combinations of
capital and labour which yield the same level of output to business
firm, we can derive isoquant.

Isoquant schedule:
Labour
Capital
Output
(Units)
(Units)
(Units)
 1
6
100
2
4.5
100
3
4.0
100
4
3.7
100
5
3.5
100

According to the above example, a business firm can employ 1 unit

of labour + 6 units of capital or any other combination as shown in
numerical example, to produce 100 units of output. By plotting the
above data on a graph paper and joining together corresponding
points, we can derive isoquant.

GRAPH-2
Y

6 A
Isoquant is convex to the origin. All points on an isoquant
represent the same level of output, though each and every point
related to a specific quantity of capital and labour. As the
employment of labour increases, the business firm is reducing the
employment of capital, to produce same level of output. But the
fact is that, as employment of labour increases every time by one
unit, the business firm would like to reduce capital in smaller
quantities for every successive additional unit increase in labour .
This is called the Diminishing Marginal Rate of Technical
Substitution of labour for capital. This is equal to the slope of
isoquant. The slope of isoquant = MRTSLK.
Though the business firm can employ any combination of inputs to
produce 100 units of output, there exists difference in cost of
employing these combinations. The aim of the business firm is to
employ that combination of inputs which minimizes cost to
produce 100 units of output. To identify least cost combination of
inputs, in addition to isoquant, we have to understand the isocost or
factor price line.

Factor price line:

Each and every point on factor price line indicates the different
quantities of capital and labour a business can employ actually in
the production process, given the prices of capital & labour and the
volume of investment at its disposal. Let us assume that the price
of capital Rs 20, price of labour Rs 20 and the volume of
investment at the disposal of firm is Rs 130. Based on this
information we can construct isocost schedule as shown below.

Quantity of labour
Quantity of capital
(Units)
( Units)
 0. 0
6. 50
0. 5
6.00
1. 0
5. 50
1. 5
5 .00
2. 0
4. 50
2. 5
4. 00
3. 0
3. 50
3. 5
3 .00
4. 0
3. 50
-
-
-
-
 -
-
6. 5
0. 0

Business firm can employ any one of the combinations shown

above. The cost of employing any combination is Rs 130. By
plotting the above shown information on a graph paper, and
joining together the corresponding points, we can derive the
isocost line.

GRAPH-3

6.5
Iso cost time
Units of Capital

Units of labour
The slope of isocost line represents the relative factor price ratio
i.e. the ratio between price of labour to price of capital (PL /PK). In
other words also we can say that the slope of isocost indicates the
ratio between wage rate to rate of profit (w /r).

4.05: The choice of optimum input combination:

The combination of factor inputs that produces maximum output
with least cost is called optimum input combination or least cost
input combination. A business firm can identify this combination
at a point where MRTSLK = PL / PK. This is possible at a point
where isocost is tangent to isoquant.

GRAPH-4
Y

6.5

R
Units of Capital

4.5

0 2 6.5

Units of labour
In the above graph at point R isocost line is tangent to isoquant.
Therefore the combination of labour and capital that firm would
like to employ to produce 100 units of output (2 units of labour + 4
. 5 units of capital. See the isoquant schedule) is same as the
combination of labour and capital that firm can actually employ
with Rs 130 total investment ( 2 units of labour + 4 . 5 units of
capital. See the isocost schedule). If the firm employs any other
combination of labour and capital to produce 100 units of output,
its cost on labour and capital will be more than Rs 130. Thus the
combination of 2 units of labour + 4. 5 units of capital is the least
cost combination or optimum combination. This is also called as
optimization of production.

ACTIVITY-2
1. Define isoquant.
2. Define isocost.
3. What is least cost input combination?
4.06: Summary:
Production function represents the relationship between physical
input and output. With the help of production function it is
possible to find out the quantity of capital and labour required to
produce a given level of output. Production function is generally
expressed as Q = f ( K,L). In the short run, beyond a level of
output, firm experiences diminishing returns in the production
process due to the given fixed factors of production. In the long
run, firm can make perfect adjustment in all the factors of
production. Therefore, firm can produce optimum output i.e. the
maximum possible output with minimum cost in the long run.

4.07: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore: Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

4.08: Self Assessment Test:

1. What is production function? Discuss the input- output
relationship in the short run.
2. Explain the process of identification of optimum input
combination with the help of isoquant and isocost line.
 UNIT-III
(Production and Cost Analysis)
MODULE- 5: Returns to Scale and Linear
Programming in Production

CONTENTS
5.0: Objectives
5.01: Meaning of Returns to Scale
5.02: Types of Returns to Scale
5.03: Linear programming and production analysis
5.04: Types of production functions.
5.05: Summary
5.06: References
5.07: Self Assessment Test

5.0: Objectives:
The objective of this module is to discuss the concepts of returns to
scale, linear programming in production and types of production
functions used for estimation. After reading this module you
should be able to understand the :
Different types of returns to scale
Linear programming and production analysis
Estimation of production function

5.01: Meaning of Returns to Scale:

The proportionate change in output as a result of given
proportionate change in input is called returns to scale. This is
simply the input elasticity of output. We can define returns to scale
in terms of a ratio between percentage change in output to
percentage change in input as shown below.

Proportionate change in output

Returns to scale= -------------------------------------------
Proportionate change in input

5.02: Types of Returns to scale:

There are three different types of returns to scale. They are (1)
Increasing returns to scale (2) constant returns to scale (3)
decreasing returns to scale. Now we shall discuss these three types
of returns to scale.

Increasing Returns to Scale:

If the proportionate change in output is more than the proportionate
change in input, it is called as increasing returns to scale. If the
firm experiences increasing returns to scale, then one percent
increase in input causes more than one percent increase in output.
In the same way 100 percent increase in input leads to more than
100 percent increase in output. For example: A firm employed 5
units of labour &10 units of capital and produced 100 units of
output. Suppose the same firm doubled the input use i.e it
employed 10 units of labour & 20 units of capital,and could
produce 300 units of output. The increase in input is 100 percent
where as the increase in output is more than hundred percent.
Under these conditions if the firm doubles the employment, output
gets more than doubled.

GRAPH-1

B
Capital

20
A
10
In the above graph OR is the scale line. It indicates that, every
time, the increase in inputs is 100 percent. But increase in out is
more than 100 percent i.e increased from 100 units to 300 units.
On scale line OA = AB.

Constant Returns to Scale:

If the proportionate change in output is equal to the proportionate
change in input, it is called as constant returns to scale. If the firm
experiences constant returns to scale, then one percent increase in
input causes exactly one percent increase in output. In the same
way 100 percent increase in input leads to 100 percent increase in
output. For example: A firm employed 5 units of labour &10 units
of capital and produced 100 units of output. Suppose the same firm
doubled the input use i.e it employed 10 units of labour & 20 units
of capital, and could produce 200 units of output. The increase in
input is 100 percent and also the increase in output is 100 percent.
Under these conditions if the firm doubles the employment, output
also gets doubled.

GRAPH-2

Y
R

Capital
20
IQ2=20
A
10
IQ1=100 un

0 5 10
Labour

In the above graph OR is the scale line. It indicates that, every

time, the increase in inputs is 100 percent. But increase in out is
also 100 percent i.e increased from 100 units to 200 units. On
scale line OA = AB.

Decreasing Returns to Scale:

If the proportionate change in output is less than the proportionate
change in input, it is called as decreasing returns to scale. If the
firm experiences decreasing returns to scale, then one percent
increase in input causes less than one percent increase in output. In
the same way 100 percent increase in input leads to less than 100
percent increase in output. For example: A firm employed 5 units
of labour &10 units of capital and produced 100 units of output.
Suppose the same firm doubled the input use i.e it employed 10
units of labour & 20 units of capital, and could produce 180 units
of output. The increase in input is 100 percent and where as the
increase in output is less than 100i.e 80 percent. Under these
conditions if the firm doubles the employment, output gets less
than doubled.

GRAPH-3

Y
R

B
Capital

20
IQ2=180 units
A
10
IQ1=100 units

X
5 10
Labour
In the above graph OR is the scale line. It indicates that, every
time, the increase in inputs is 100 percent. But increase in out is
less than 100 percent i.e increased from 100 units to 180 units. On
scale line OA = AB.

We can understand the concept of returns to scale with the help of

marginal productivities. In case of increasing returns to scale, the
marginal productivity of factors of production increases. In case of
constant returns to scale the marginal productivity of factors of
production remains constant. In case of decreasing returns to scale,
the marginal productivity of factors of production decreases.

GRAPH-4

Y
Marginal productivity of
factors of productions

B C
Returns to scale
curve
A
D

X
Quantity of factors of
production
In the above graph, we measured the quantity of factors of
production on horizontal axis and marginal productivity on vertical
axis. From point A to B on returns to scale line represents
increasing returns to scale. From point B to C represents constant
returns to scale. From point C to D represents decreasing returns to
scale.

ACTIVITY-1
1. Define the concept of returns to scale.
2. Explain the nature of marginal products under different types of
returns to scale.

5.03: Linear programming and production analysis:

Linear programming is a mathematical technique for solving
constrained optimization and minimization problems, when there
are many constraints and the objective function to be optimized, as
well as constraints faced are linear i.e. represented by straight
lines. The usefulness of linear programming arises because firms
and other organizations face many constraints in achieving their
goals of profit maximization or cost minimization or other
objectives. For example: The optimization problem of a business
firm is maximization of output subject to given cost constraint. In
order to maximize output, the firm should produce at the point
where isocost is tangent to its isoquant.

One of the basic assumptions of linear programming is that a

particular commodity can be produced with only a limited number
of input combinations. Each of these input combinations or ratios
is called a production process or activity and can be represented by
a straight line ray from the origin in input space. For example a
particular commodity can be produced with three different
processes, each utilizing a particular combination of labour (L) and
capital(K).These are : process 1 with K/L =2. Process 2with K/L=
1, and process 3 with K/L = ½. Each of these processes is
represented by the ray from the origin with slope equal to the
particular K/L ratio used.

GRAPH- 5

Y
Process 1
(K/L = 2)

12
Process 2
10 (K/L =1)
8
Process 3
(K/L = ½
Capital

2
In the above graph process 1 uses 2 units of capital for each unit of
labour used, process 2 uses 1 unit of capital for each unit of labour
and process 3 uses ½ unit of capital for each unit of labour. By
joining points of equal output on the rays or processes, we define
isoquant for the particular level of output of the commodity. The
process of derivation of isoquants is shown in the following graph.

GRAPH-6
Y

Process 1

Process
6
Process 3
Capital

3
X
3 4 6
Labour
In the above graph, the isoquants are straight line segments and
have kinks. Point A on process 1 shows that 100 units of output
can be produced by using 3 units of labour and 6 units of capital.
Point B on process 2 shows that 100 units of output can be
produced with 4 units of labour and 4 units of capital. Point C on
process 3 shows that 100 units of output can be produced with 6
units of labour and 3 units of capital. By joining, points A,B, C we
get the isoquant for 100 units of output. Further, since we have
constant returns to scale, the isoquant for twice as much output i.e
200 units is determined by using twice as much of each input with
each process. This defines the isoquant for 200Q with kinks at
points D( 6L,12K), E( 8L,8K), and F( 12L,6K).

If the firm faced only one constraint, such as isocost line whose
level is determined by volume of investment and the prices of
factors of production. Assume the isocost line of firm is GH as
shown below.

GRAPH-7

Process 1

12 D Proce
Feasible Region and Optimal Solution
With isocost line GH the feasible region is shaded triangle OJN
and the optimal solution is at point E where the firm uses 8L and
8K and produces 200 units of output.

GRAPH-8

Y
Process 1

16 G
Process 2
D
12
E Process 3
J F
8

6 N
Capital

H
X
6 8 12 16
ACTIVITY-2

1. Identify feasible set of inputs with linear programming

technique.

5.04: Types of production functions:

Several types of mathematical functions are commonly employed
in the measurement of production function. But in applied research
four types have had the widest use. These are:

Linear Function:
A linear production function would take the form Y= a + b X. Here
Y is the total product. X is the input.

Y a bX
Average product = --- = ---- + -----
X X X
 a
= ----- + b
X

Power function:
The production function most commonly used in empirical
estimation is the power function of the form:

A power function expresses output Y, as a function of input X in

the form:
Y = aXb.

The exponents are the elasticities of output. Power function as it is

can not be used for estimation. It is to be written in the log linear
form as:

Log Y = log a + b log X. The best example of power function is

the cobb-douglas production function of the form:

Q = A Ka Lb. Where Q is the output, K is the capital and L is the

labour. ‘a’ and ‘b’ are the parameters to be estimated empirically.
This production function is often referred to as cobb –douglas
production function. In this production function the exponents ‘a’
and ‘b’ represents output elasticity of capital and labour
respectively. The sum exponents ‘a’+ ‘b’ = 1. The sum of
exponents represents returns to scale. If ‘a’+ ‘b’ = 1 it represents
constant returns to scale. If ‘a’+ ‘b’ is more than 1, it represents
increasing returns to scale. If ‘a’+ ‘b’ is less than 1, it represents
decreasing returns to scale.

Quadratic production function:

Y= a + b X – c X2. In this function Y is the total output, and X is
the input. a, b, c are the parameters.
The minus sign in the last term denotes diminishing marginal
returns. The equation allows for diminishing marginal product but
not for increasing and decreasing marginal products. The elasticity
of output is not constant at all points along the curve as in power
function but declines with input magnitude.

Cubic production function

Y= a + b X + c X2 - d X3.
It allows for increasing and decreasing marginal productivity. The
elasticity of output varies at each point along the curve. Marginal
productivity decreases at an increasing rate in the later stages.

ACTIVITY-3
1. Bring out the main features of power function.

5.05: Summary:
In this module we discussed at length the types of returns to scale,
linear programming in production and types of production
functions used in the estimation of input output relationship. The
ratio between the proportionate changes in output to proportionate
change input is called returns to scale. Thus it is the degree of
responsiveness in output as a result of given percentage change in
input. Linear programming technique is used to find out solution to
optimization problem. In the production analysis, the optimization
problem is maximization of output with minimum cost. Using
linear programming technique we can find out optimum input
combination to produce given level of maximum output. Business
firms’ and researchers can adopt different types of production
function to estimate input output relationship.

5.06: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore: Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics

5.07: Self Assessment Test:

1. Discuss different types of returns to scale.
2. Discuss the importance of linear programming in production
analysis.
3. Spell out different types of production functions used to estimate
input out relationship.