Production and Costs

Anand Venkatesh
IRMA
Production
• The process of transforming inputs to outputs
• E.g: Transforming wheat seeds combined with soil, labour, fertilizer,
sunlight, water, etc into wheat crop
• Technology: The set of all feasible input output bundles
• Technique: A single input-output combination lying in the technology
set
• Labour vs capital intensive technique
Production Function
• The mathematical relationship between input(s) and the maximum
output that can be produced by these input(s)
• Most popular production function is the Cobb-Douglas Production
Function
• Where
• A is the technology parameter (can be normalized to one)
• K and L are Labour and Capital (two inputs)
• Output is a weighted geometric mean of Labour and capital where weights are and for
labour and capital respectively,
Isoquant
• A graphical device showing combinations of inputs that produce a
fixed level of output assuming efficient production
• Let the inputs be labour and fertilizer and the output be the wheat
crop.
• Assume the output level is 100 kg of wheat
• The following combinations of wheat and fertilizer can efficiently
produce 100 kg of wheat
• 5 workers and 1 tons of fertilizer
• 3 workers and 3 tons of fertilizer
• 7 workers and 0.5 ton of fertilizer
Isoquant for the Cobb-Douglas
Production Function
Cobb-Doublas Isoquant
Y=100, A=1
60

50

𝛼=𝛽=0.5
Here Y fixed at 100

40
Labour

30

20

10

0
0 10 20 30 40 50 60

Capital
 Isoquant

Isoquant
3.5

2.5

1.5

0.5

0
2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5
How Much to Produce?
• Assume the following input prices
• Wage rate of Rs. 100 per worker
• Price of Rs. 200 per kg of fertilizer
• Also let the total budget with farmer be Rs. 1000
• Isocost line: Combinations of inputs such that the budget of Rs. 1000
is completely exhausted
• 100L+200F=1000
Isocost Line
Isocost Line
6

0
0 2 4 6 8 10 12
The Producer’s Optimum
Isocost Line
6

Q=300
3
Q=200

Q=100
2

0
0 2 4 6 8 10 12
• The farmer will choose that combination of labour and fertilizer which
will maximize his output while being within his budget constraint.
• This happens at that input combination where the isocost line is
tangent to the isoquant.
• This is the equilibrium of the farmer.
• What will happen when
• The budget of the farmer increases?
• The price of fertilizer falls to say Rs. 100 per kg.
Production in Short Run
• Short Run: A period where at least one factor is fixed and at least one is variable
• Long Run: A period wherein all factors of production are variable
• E.G. Consider a farmer who is using land and fertilizer.
• Land is in fixed supply, say 5 acres
• Output can be increased only by increasing the variable input, viz., fertilizer
• Total Product: The total output using the fixed and variable inputs
• TP(n)= Total Product of n units of the variable inputs
• Marginal Product: Additional to the Total Product by using one more unit of the
variable input
• MP(n)= TP(n)-TP(n-1)
An Example
Fertilizer Output Marginal Product Stage of production
0 0- -
1 150 50Stage 1: Increasing Returns Land =5
acres
2 210 60Stage 1: Increasing Returns
3 260 50Stage 1: Increasing Returns
4 300 40Stage 2: Diminishing Returns
5 330 30Stage 2: Diminishing Returns
6 350 20Stage 2: Diminishing Returns
7 360 10Stage 2: Diminishing Returns
8 365 5Stage 2: Diminishing Returns
9 360 -5Stage 3: Negative Returns
10 350 -10 Stage 3: Negative Returns
Total Product Curve
Total Product
400

350

300

250

200

150

100

50

0
0 2 4 6 8 10 12
Accountant vs Economist’s view of a
Firm
Production and Costs
Total Production Curve
Total Cost Curve
Costs of a Firm
• Fixed Costs: Those costs which do not vary with output
• Variable Costs: Those costs which vary with output
• Average cost: Cost of the typical (per unit) output: TC/Output
• Mariginal cost: Cost of producing an extra unit of output:
• MC(nth unit)=TC(n units)-TC(n-1 units)
Total Cost Curve
Average and
Marginal Cost
Curves
• When MC is below AC, AC is falling
• When MC is above AC, AC is rising
• MC cuts AC at its lowest point i.e
• MC=Min AC
Long-Run Vs Short-Run Costs
• Short run is a period when at least one factor is fixed and at least one factor is
variable
• As we move from short run to long run more and more factors become variable
• Hence more costs become variable
• Eg. In the short run, number or size of factories is fixed. To increase output, the
firm can only hire more labour
• In the long run it is variable . Firm can open new plants or shut its existing
plants.
• In long run all costs are variable
• If long run AC declines as output increases, we have economies of scale
otherwise diseconomies of scale
Example
• Suppose we start a samosa business
• A thela can optimally serve 100 samosas
per day, although it is feasible to serve
higher or lower numbers using the same.
• We have yet to start our business and are
planning the number of thelas to buy
• Assume for simplicity that the choices are
between 1,2, or 3 thelas.
• We are confident of serving 200 samosas
per day
Possible Plant (Thela) Sizes
 The LRAC Curve
SRAC3
SRAC1
Cost per Samosa SRAC2

LAC

25

15

100
200 Qty of Samosa
Deriving the LRAC Curve as Envelope of SAC
Curves

Minimum
Efficient Scale
Long-Run Average Cost Curve

Minimum
Efficient
Scale
Economies and Diseconomies of
Scale
• Economies of scale come from
• Risk Bearing
• Financial
• Managerial
• Technical
• Marketing
• Purchase
• Diseconomies of Scale
• 3 Cs and 1 M
• Communication
• Control
• Co-ordination
• Motivation
• May have to pay more for inputs
• New and more expensive inputs
Efficient Scale and Market
Concentration
• Efficient Scale is the output level corresponding to minimum long-run AC
• Efficient scale is the output level at which we stop getting economies of scale
• Suppose price of a Samosa gets close to say, Rs. 22
• Those who operate closer to the efficient scale (lowest LRAC) can continue to be in
production while those with higher costs will exit the samosa market
• Compare the minimum efficient scale to market size
• Suppose the market size of samosas is 40000 per day in our city
• Thus, efficient scale is a small fraction of total market
• Hence likely to have many producers of samosas
• Suppose market size were just 400 samosas per day
• One cost-efficient producer will get close to half the market
• If market size is 195 samosas, there will be just one samosa producer
Summary of Key Costs