Chapter V

Cost Analysis

Dr. GOPALAKRISHNA B.V.

Faculty of MBA,
SDM, Mangalore
 Introduction
• In technical sense, production is the
transformation of resources into
commodities over time and space.
• In simply, production is the act of converting
or transforming input into output.
• A firm is a business unit which undertakes the
activity of transforming inputs into
outputs of goods and services.
• In the production process, a firm combines
various inputs in different quantities and
proportions to produce different levels of
outputs.
 The concept of production
function
• The term ‘production function’ refers
to the relationship between the inputs
and the outputs produced by them.
• The terms factors of production and
resources are used inter changeably
with the term ‘inputs’
• The study of the production function is
directed towards the maximum output
which can be achieved with a given set
of resources or inputs with given state
of technology
 Production Function

Production
Inputs
Function Output
(L, K)
q = f(L, K) q
 Production Function
•A production function expresses the
relationship between a combination of inputs
(factors of production) and outputs (quantity
of goods and services).
• Production is a process in which the physical
inputs are transformed into physical output.
• The output is thus the function of inputs.
• Production function can be algebraically
expressed in an equation in which the output
is the dependent variable and inputs are
independent variables
 Algebrical expression
Q = f (a, b, c, d …..n)
• Q = stands fro the rate of output of
given commodity.
• A, b, c, d ….n are different factors
and services
• f = functional relationship
 Production function depends on
1. Quantities of resources (raw-materials,
labourers, capital, machinery etc).
2. State of technology is given.
3. Possible processes.
4. Size of the firms.
5. Nature of firms organization and
6. Relative price of inputs and the manner
in which the inputs are combined.
 Production function

In economic theory, there are three

types of production function, they
are –
1. Production function with one variable
input
2. Production function with two variable
input
3. Production function with all variable
input
• Production function with one variable
inputs are also called as law of variable
proportions.
• This law occupies an important place in
economic theory.
• The law states a technical physical
relationship between the fixed and
variable factors of production in the
short run.
• Here it is assumed that only one factor
of production is a variable factor (labour)
while other factor are assumed to
remain fixed (land)
 Assumptions of the law
1. The state of technology is assumed to be
given and unchanged.
2. Only one factor is varied (labour) and all
other factors remain unchanged (land,
capital, equipment and raw-material etc).
3. The fixed factor and the variable factor are
combined together in various proportions in
the process of production.
4. The units of the variable factors are
homogeneous.
5. The law operates in the short-run.
 Table 5.1 Returns to Labour
Units of Total Product Marginal Average
Labour (quintals) Product Products
(quintals) (quintals)

1 80 80 80
2 170 90 85
3 270 100 90
4 368 98 92
5 430 62 86
6 480 50 80
7 504 24 72
8 504 00 63
9 495 -9 55
10 480 -15 48
Average and Marginal
Product Curves
TP
Total Product

AP max &
AP = MP
MP max
L
Point of diminishing
AP
marginal returns
MP Point of diminishing
average returns
AP
MP
L’ L” L
 Production with
One Variable Input (Labor)
Outpu
Observations:
t
Left of E: MP > AP & AP is increasing
per
Right of E: MP < AP & AP is decreasing
Month
E: MP = AP & AP is at its maximum
30
Marginal Product

E Average Product
20

10

0 1 2 3 4 5 6 7 8 9 10 Labor per Month

Total Product Marginal Average Stages
Product Product
-First increases at -Increases -Increases First
increasing rate -Reaches a -Continues Stage
-Then the rate of maximum and increases
increase changes then starts
from increase to diminishing
diminishing rate
Continues to - Continues - Reaches a Second
increase at diminishing maximum stage
diminishing rate AP = MP

Diminishes - Is negative - Continues Third

diminishing Stage
Three Stages of Production in the
Short-Run
60 Stage I Stage II Stage III

50
40
30
20
10
0
15
0 2 4 6 8 10
10

0
0 2 4 6 8 10
-5
Three stages of the law of variable
proportion
Stage I
• Total product will increases at an increasing rate.
• Average and marginal product also increase but
marginal product rises at a faster rate than average
product.

Stage II
• Total product continues to increase but at a diminishing
rate
• Marginal product is diminishing and becomes equal to
zero
• Average product starts diminishing

Stage III
• Total product starts declining
• Marginal product becomes negative
• Average product continues to decline.
 Table 5.2 Behaviour of TP, MP and AP
during three stages of production
Different Total Product Marginal Product Average
Stages (TP) (MP) Product (AP)

Increases, reaches
Stage I Increases at an its maximum and Increases and
increasing rate then declines till MR reaches its
= AP maximum
Increases at a It diminishing and
Stage II diminishing becomes equal to Starts declining
rate till it zero
reaches
maximum

Stage III Starts Become negative Continues to

declining decline
 2. Production Function with two
variable inputs
• To understand a production function
with two variable inputs, it is necessary
to understand iso-quant curve.
• An iso-quant is also known as iso-
product curve, which are similar to
indifference curves analysis.
• These curve shows the various
combinations of two variable inputs
resulting in the same level of output
 Iso-quant curve

• The Iso-quants are thus contour lines

which are trace the loci of equal
outputs.
• Iso-quant represents those
combinations of inputs which will be
capable of producing an equal
quantity of output
Table 5.3 Labour and capital
inputs in relation to output

Labour Capital Output

(units) (units) (units)
1 5 10
2 3 10
3 2 10
4 1 10
5 0 10
 y

Iso-quant Curve
A
, Capital

C
D

0 x
Labour
 Iso-quants map

Capital 3

2
Q3

1 Q2
Q1
1 2 3 4 5
Labor
 Properties of Isoquants

• Isoquants slope downwards from

left to right
• No two iso-quant can intersect each
other
• Iso-quants curve are convex to the
origin

7-23
 Properties of Iso-quants
1. Iso-quants slope downward from
left to right
When the quantity of on factor (labour)
increased, the quantity of other capital
must be reduced so as to keep output
constant on a given iso-quant.
2. No two iso-quants can interest
each other
Iso-quant curve never cut each other as
higher and lower curves show different
levels of satisfaction.
 Properties of Iso-quants
3. Iso-quants curve are convex to the Origin
• Iso-quant curve as similar to indifference curves
are convex to the origin and they cannot be
concave to the Origin.
• The marginal rate of technical substitution are
normally convex to the origin and it cannot be
concave.
• If the iso-quants were concave to the origin –
marginal rate of technical substitution increased
as more and more units of labour are substituted
for capital
Isoquant Curve

7-26
Figure 7.10: Properties of Isoquant

7-27
 Marginal Rate of Technical
Substitution (MRTS)
• The Marginal Rate of Technical
Substitution (MRTS) production theory is
similar to the concept of Marginal Rate
of Substitution of Indifference curve
analysis.
• MRTS - indicates the rate at which factors
can be substituted at the margin without
altering the level of output
• MRTS of labour for capital - defined as one
number of units of capital which can be
replaced by one unit of labour, the level of
output remaining unchanged..
 Marginal Rate of Technical
Substitution (MRTS)
• The MRTS of factor X (labour) for a unit
of factor Y (capital).
• Each input combinations A, B, C, D & E
yields the same level of output.

increase in capital ∆K
− MRTS = =
increase in labor ∆L

Slope of Isoquant
 Table: 5.4 Marginal Rate of Technical
Substitution
Factor Units of Units of MRTS of
Combination Labour (L) Capital (K) L for K

A 1 12 -

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1
Figure: 5.1 MRTS
 Law of Returns to Scale
• In the long run all factors of production are
variable – no factor is fixed – all the factors
treated as variable factors.
• Accordingly, the scale of production can be
changed by changing the quantity of all
factors of production.
• It all factors of production is doubled, the total
output will also be doubled.
• According to this law, when all factor units are
increased, total product generally increases
at an increasing rate, later at a constant rate
and finally decreasing rate.
 Returns to Scale

Increasing Returns Constant Returns Decreasing Returns

1. Increasing Returns to Scale
 increasing returns to scale or diminishing cost
refers to a situation when all factors of production
are increased, output increases at a higher rate.
 It means if all inputs are doubled output will also
increase at the faster rate than double.
 This increase is due to many reasons like division
of labour, specialisation and other external
economies of scale.
2. Constant Returns to Scale
• Constant returns to scale or constant cost
refers to the production situation in which
output increases exactly in the same
proportion in which factors of production are
increase.
• In simple terms, if factors of production are
doubled output will also be doubled.
• In this case internal & external economies
are exactly equal to internal economies &
external diseconomies
• This is also known as Homogeneous
Production Function or Cobb-Douglas Linear
homogeneous production function
3. Diminishing Returns to Scale
 DRS or increasing costs refers to that
production situation, where if all the
factors of production are increased in
a given proportion, output increases
in a smaller proportion.
 It means, if inputs are doubled,
output will be less than double
Figure 7.17: Returns to
Scale

7-37
 Least Cost Combination of Inputs
 It is also known as producer’s equilibrium or
choice of optimal factor combination.
 Producer’s equilibrium occurs when he earns
maximum profit with optimal combination of
factors.
 A profit maximisation producer faces two
choices of optimal combination of factors
(inputs)
1. To minimise its cost for a given output
2. To maximise its output for a given cost.
 Thus least cost combination – refers to a firm
producing the largest volume of output from a
given cost and producing a given level of
output with the minimum cost.
 Economies of Scale
• Prof Stigler – economies of scale are also known
as returns to scale.
• As the scale of production is increased, upto a
certain point, one gets economies of scale.
• It is a common experience of every producer that
costs can be reduced by increased production.
That is why the producers are more keen on
expanding the size/scale of production.
• Economies of scale have been classified by
Marshall into – internal and external economies.
 Economies of Scale

Economies of Scale

Internal Economies External Economies

 Internal Economies
• Internal economies - are those economies production
which accrue to the firm when it expands the output, so
that the cost of production would come down
considerably and place the firm in a better position to
compete in the market effectively.
• Economies arise purely due to endogenous factors
relating to efficiency of the entrepreneur or his
managerial talents the marketing strategy adopted.
• Basically, internal economies are those which are special
to each firm. These solely depend on the size of firm and
will be different for different firms.
 Internal Economies (checks this)
• For example, one firm will enjoy the
advantage of good management other may
specialisation in the techniques of
production.
• According to Cairncross – internal
economies are those which are open to a
single factory or a single firm independently
of the action of other firms.
• Prof Koutsoyannis has divided the internal
economies into two parts.
 Internal Economies

Real Economies Pecuniary Economies

 Types of Internal Economies

1. Technical Economies – Technical

economies are those which accrue to a
firm from the use of better machines and
techniques of production. As a result,
production increases and cost per unit of
production decreases.
• Technical economies are 5 kinds –
1. Economies of increased dimensions
2. Economies of linked processes
3. Economies of the use of by-products
4. Economies in power
5. Economies of increased specialisation
1. Economies of increased dimensions
• Certain technical economies may arise on
account of increased dimensions.
• For example, a double decker bus is more
economical than a single decker.
• One driver and one conductor may needed.
Whether it is a double decker or a single
decker bus.
2. Economies of linked processes
• A big firm can also enjoy the economies of
linked process.
• A big firm carries all productive activities,
these linked activities save time and transport
cost to the firm.
3. Economies of the use of by
products
• A large firm is in a better position to utilise the
by products efficiently and attempt to produce
another new product.
• For example large sugar factory uses molasses
– producing alcohol
4. Economies in power
• Large size machines without continuous
running are often more economical than small
sized machines
• Big boiler consumes more/less the same
power of small boiler
5. Economies of increase Specialisation
• A large firm can dived the work into various sub-
processes.
• Division of labour and specialisation become possible.
• For example, only a well established big school can have
specialised teachers.
2. Marketing Economies
• When the scale of production of a firm is increased it
enjoys numerous selling or marketing economies.
• Advertisement economies, opening up of show rooms,
appointment of sole distributors, Research &
Development (R & D)
3. Financial Economies
• The credit requirements of the big
firms can be meet from banks and
other financial institutions easily.
• A large firm is able to mobilise
much credit at cheaper rates.
1. Investors have more confidence in
investing money – large firms.
2. Shares and debentures of a large firm
can easily sold in the stock market.
4. Managerial Economics
• On the managerial side also
economies can be achieved.
• When output increases, specialists
can be more fully employed.
• A large firm can divide its big
departments into various sub-
departments and each department
such as finance, marketing, legal,
administration , sales etc.
5. Economies of Research
• A large sized firm can spend more money
on its research activities.
• Spend hug sum money in order to innovate
new varieties of products or improve the
quality of the existing products.
• In cases of innovation it will become an
asset of the firm.
• New innovations/new methods of
producing a product may help to reduce its
average cost.
6. Risk bearing Economies
• The big firms always involved risk-bearing.
• A big firm produces a large number of
items and of different varieties so that the
loss in one can be counter balanced by the
gain in another.
7. Economies of Transport and Storage
• A firm producing on large scale enjoys the
economies of transport and storage.
• A big firm can have its own means of
transportation to carry finished as well as –
raw-material from one place to another.
• Moreover big firms also enjoy the
economies of storage facilities.
• The big firm also has its own storage and
godown facilities.
 External Economies
• External economies refers to all those
benefits which accrue to all the firms
operating in a given industry.
• External economies can be enjoyed by
all the firms in the industry irrespective
of their size.
• The emergence of external economies is
due to localisation.
• According to Cairncross – “External
economies are those benefits which are
shared in by a number of firms/industries
when the scale of production in any
industry increases”.
 External Economies…….
• He divided the external economies
into the following parts as –
1. Economies of Concentration
2. Economies of Information
3. Economies of Disintegration
4. Economies of Localisation
5. Economies of By-products
1. Economies of Concentration
• As the number of firms in an area increases
each firm enjoys some benefits like,
transport and communication, availability of
raw-materials, research and invention etc.
• Financial assistance from banks and non-
bank institutions easily accrue to firm.
• Therefore, concentration of industries lead
to economies of concentration.
2. Economies of Information
• When the number of firms in an industry
expands they become mutually
dependent on each other – they do not
feel the need of independent research on
individual basis.
• Many scientific and trade journal are
published – these journals provide
information to all the firms which relates
to new markets, sources of raw-materials,
latest techniques of production etc.
3. Economies of Disintegration
• As an industry develops, all the firms engaged in it
decided to divide and sub-divide the process of
production among themselves.
• Each firm specialises in its own process.
• For example – cotton Textile Industry – some firms
may specialise in manufacturing thread, some
others in producing dhoties, some in knitting
baniqus some in weaving sarees etc.
• The disintegration may be horizontal or vertical.
Both will help the industry in avoiding duplication
and saving time materials.
4. Economies of Location
• The localisation of an industry means the
concentration of firms producing identical
product in a particular area.
• For example railway is an industry – where
parcel agency, post and telegraph department
– post office, state electricity department
installers power transformer and transport
companies.
• As a result, all the firms get these facilities at
low prices, consequently the average cost of
production in the industry declines.
5. Economies of By-Products
• The growth and expansion of an
industry would enable the firms to
reduce their cost of production by
making use of waste materials.
• The waste material of one firm may be
available and useable in the other firms.
• Thus, wastes are converted into by
products.
• The selling firms reduce their costs of
production by realising something for
their wastes.