Production

Function and
Costs
Law of diminishing returns
Family of cost curves
Background
Before this we have already studied
 How producers allocate resources(Production
Possibilities Frontier)
 How individuals allocate resources(Consumer
Behaviour)
 How buyer and seller use their
resources(Demand Supply)
 What is the response of seller and buyer to
change in price or any other factor (Elasticity)
Now we will study how firm manages its cost while
producing
Production Function
It shows the type and amount of output that
results from a particular group of inputs when
those inputs are combined in a certain way.
It describes
Human
effort
1. Required inputs
2. How to combine? Raw
Machinery
3. How much we can material
produce?

Output
Production Function
Mathematically it is represented as

Y = f (Inputs)
Output is function of inputs

We already defined earlier that until we do

not have the magnitude of how input
increase output we can write them as a
function
Production Function
There are several types of input which are part of
production function

 The inputs used are also called factors of

production named as
Land (N), Labor (L), Capital (K) and Organization
(O), and Technology (A)

 So production function is
Y = A f (L, K, N, O)
Factors of Production
 Labour (L):
Physical and mental human effort used to produce
goods and services
Labour are compensated in terms of wage for their
effort.

 Capital (K):
Items such as machinery and equipment which
assist labor in the production of goods and
service, i.e. Computer
Capital acquire costs in terms of interest rate.
Factors of Production
 Land (N):
Productive inputs which are provided by nature
such as coal, fertile soil
Utilization of land for production costs in terms of
rent

 Organization (O):
Organization plays a role of managing other
factors of production
As organization takes risk of production hence it is
compensated in terms of profit.
Technology and Efficiency
 Production function will be efficient if it requires
minimum possible costs. (Less the cost of inputs,
efficient the function will be).

 Technology is the body of knowledge that

exists about production and its process.

 Creative destruction occurs when new

technology and production methods cause
disappearance of old machinery and methods of
production.
CD technology replaced the VHS technology
Example
A person is moving the cement in the bucket to
the second floor for the construction of the wall
Here person is labor, cement is land, bucket is the
capital and the manager of the project is
organization.
So currently the business is using manual
technology, in the automated technology they
could use the wheelbarrow / trolley and a lift to
move the cement to upper floor.
So the total expenditure of the business includes,
wages of the labor, rent for the land / raw
materials, interest rate for the borrowed capital
which used to buy the bucket and profit for the
manager.
Law of Diminishing return
This is production function version of law of
diminishing utility
Just like consumption using more and more of
one factor of production to increase output
leads to less and less benefit of the extra unit of
that input.
i.e. Example of tailor

It explains that when a particular input (#of

tailors) is zero, increasing it (tailors) will
increase the output more than increasing the
input when it (tailors) is already excessively
used.
Role of Law of Diminishing
return
B

Output
This shows diminishing
return in Input
Hence we can see that in
the start when the input
is increasing output (A), A
it becomes cheaper in
terms of total cost

but when input start to

decrease output (B)
(diminishing return
region) then it becomes
expensive # of Input units
Marginal product of input
MP = change in Total output / change in
input TotalOutpu t
MP 
TotalInput s

 For example:
If on a single piece of land some farmers are
hired the production will increase but if more
farmers are hired on the same land again then
a time will come when the cost will increase
because of the wages given to them where as
the production will fall.
It shows that MP rises initially and then falls
Labor Total Calls Total hours Marginal Product
attended worked

1 11 1*8 = 8

2 22 2*8 = 16 (22-11)/(2-1) = 11

3 33 3*8 = 24 11

4 44 4*8 = 32 11

5 55 5*8 = 40 11

6 54 4*8 + 2*4 = 40 -1

7 53 3*8 + 4*4 = 40 -1

8 52 2*8 + 6*4 = 40 -1

9 51 1*8 + 8*4 = 40 -1

10 50 10*4 = 40 -1
Concept of Economic Time Frame
The analysis of production function is generally
carried with reference to time period which are
called “short run” and “long run.”
Short Run: a production time frame in which
some factors of production are variable in
amount and at least one is fixed.
(Hiring part time (overtime) workers to catch high
sale season) (Temporary boost of production)
Long Run: a production time frame in which none
of the input is fixed.
(Opening a new outlet of factory) (permanent
increase output)
Type of Economic Costs
Fixed cost: The cost of one factor of production
which does not change with increase in
production, such as rent of building, wages of
security guards.
Total Fixed Cost: The cost of all fixed factors
which remains same and does not change with
change in production.
Variable costs: The cost of one factor of
production which increases with increase in
production such as fuel cost.
Total variable cost: The cost of all variable
factors of production which increase as
production increases and is zero when production
is zero.
Calculation of costs
Total Cost = Total variable Cost + Total Fixed Cost
TC = TVC + TFC

Average variable cost (AVC): is the variable cost

per unit of output.
AVC = TVC / Q
Average Fixed Cost: is the fixed cost per unit of
output.
AFC = TFC / Q
Calculation of costs
Average Total Cost (ATC):
ATC = (TVC + TFC) / Q
Marginal Cost: The change in total cost when
one or more unit of output is produced.
MC = change in TC/ change in quantity of
output
MC TC
Q

It is the cost incurred on an additional unit of

output. As it is opposite to Marginal product,
hence its curve will be opposite too, it will fall
initially and then rise
Costing of the call center
 Company has to pay 100 rupee per computer
120 rupee per table and 50 rupee per
telephone
 Other than labor cost is (100*5 + 120*5 +
50*5) = 1350
 50 rupee per labor per day

 Company also receives 75 rupees per call

attended
 Total
Average
Lab Calls Total hours Total Average Average
Revenu Total cost
or attend worked revenue
e
Product cost
ed

11 * 75 11/1 = 1400/ 11 =
1 11 1*8 = 8 75 1400
= 825 11 127.3
2 22 2*8 = 16 1650 75 11 1450 65.9

3 33 3*8 = 24 2475 75 11 1500 45.4

4 44 4*8 = 32 3300 75 11 1550 35.22

5 55 5*8 = 40 4125 75 11 1600 29.1

4*8 + 2*4
6 54 4050 75 9 1650 30.5
= 40
3*8 + 4*4
7 53 3975 75 7.5 1700 32.1
= 40
2*8 + 6*4
8 52 3900 75 6.5 1750 33.6
= 40
1*8 + 8*4
9 51 3825 75 5.6 1800 35.3
= 40
10 50 10*4 = 40 3750 75 5 1850 37
Law of Diminishing returns and Costs
We have seen Max. Output
already increase in Output
inputs have higher Costs
benefit at start but
lower at the end
So costs are
opposite to benefit,
there will be low
cost at the start
and high at the end
Hence for profit
maximization,
output Min. Cost
maximization is
also cost # of Input units
minimization are
two methods
Calculation of costs
Q TFC TVC TC AFC AVC ATC MC

0 80 0

1 60

2 110

3 150

4 200

5 260

6 330
Q TFC TVC TC AFC AVC ATC MC

0 80 0 80 - - - -

1 80 60 140 80 60 140 60

2 80 110 190 40 55 95 50

3 80 150 230 26.6 50 76.6 40

4 80 200 280 20 50 70 50

5 80 260 340 16 52 68 50

6 80 330 410 13.3 55 70 70

Family of cost curves

Costs
Relationship of AFC, AVC,
ATC and MC
 ATC and AVC is falling when MC is below it.
 ATC and AVC rises when MC is above.
 ATC and AVC is minimum when it is equal to MC.
 AFC is always falling
 The gap between AVC and ATC is higher at start
but smaller at the end
 ATC and AVC is U shaped curves
Long Run Costs:
In long run there are no fixed costs, as all costs
become variable.
The fixed cost are zero because in the long run
none of the factor remains constant all of them
are changing so they become fixed cost

For example:
Interest rates change in long run, rent of
building might increase in long run increasing
fixed cost.
 Stages of Long run cost:
 When increasing size of production (Output) in long
run causes the per unit cost(Average cost) of
production to fall then its called Economies of
Scale.
(while expanding company is buying larger stock of
inputs from wholesale so input costs are falling)
 Diseconomies of Scale occur when increasing size
of production in long run causes the per unit cost to
rise.
(While expanding they need new managers new
infrastructure which increase cost more than output)
 Constant Returns to Scale occur when increasing
output does not affect cost, it remains constant.
(While expanding the cost and output are increase at
Accounting vs. Economic profit:
Explicit costs: payments to acquire factors of
production. It is actually transfer of payment from
the pocket of owner
Implicit cost: the best forgone alternative
(opportunity cost of using their own resources).
if the owner is using its own property then he will
add the rent of property which he could have earned
if he had rented out (second best option)
Accounting Profit is total revenue - explicit cost.
Economic Profit is total revenue – (explicit + implicit
cost)
As owners costs are recovered even when economic
profit is zero hence it is also called normal profit.
Illustration
 The concept of economic profit shows the
aspect that the manager will only keep the
business working if he sees that he is at least
covering the opportunity cost. So if the
economic profit is negative then the rational
manager will quit the business and work at the
second best job.
 And it the economic profit is positive then other
people will start to think that this business is a
good investment option hence more manager
will start the business.
Conclusion
 The numerical showed that when Marginal cost is
equal to Average total cost then the total costs
are ATC is minimum so profit is maximum
possible
 The knowledge of these cost curves can help firm
managers to decide about whether to increase
output or to decrease.

Profit of firm = Revenue - Cost

 The MC = TAC show the minimum cost , hence it
will be the point which is firms best performance
considering its costs to maximise its profit, now
we will study in next chapter how does price
changes can effect profit.
Case Study Question
QTY TFC TVC TC AFC AVC ATC MC

0 20
1 8
2 15
3 13.67
4 6
5 7
6 62
7 51