PRODUCTION AND

COST ANALYSIS

UNIT 3
PRODUCTION
 Syllabus of this Unit AND COST ANALYSIS
 Learning Objectives

a. Production function: Short run production

function, Long run production function,
Cobb-Douglas production function.
b. Optimal use of one variable input and two On completion of this unit, students will be able
variable inputs. to:
c. Learning curve, Empirical estimation of  define production function and distinguish between
short run cost function. short run and long run production function
 explain the properties of Cobb-Douglas production
function
 describe the optimal use of one variable input in the
production
 describe the optimal combination of two variable
inputs in the production
 explain about the learning curve and its uses
 explain the empirical estimation of short run cost
functions
INTRODUCTION

Production refers to the transformation of inputs or

resources into output or goods and services. In other
words, production is process of making goods and services
which can satisfy human wants or desires. The basic
problem faced by firms is how much to produce and how to
use resources or inputs (land, labour, capital, etc.) to
produce output most efficiently.
PRODUCTION FUNCTION
Production function is defined as functional relationship
between physical inputs and physical output of a firm. The
production function is the functional or mathematical or
technical relationship between these inputs (land, labour,
capital, organization and technology) and output.
The production function can be expressed symbolically as
Q = f(Ld, L, K, O, T, R, E, …) … (i)
Q = f(L, K)
TYPES OF PRODUCTION FUNCTION
1. Short Run Production Function: Short run production
function is defined as the production function in which
some inputs are variable and some inputs are fixed.
Q = f(L,K)
2. Long Run Production Function: Long run production
function is defined as the production function in which all
inputs are variable.
Q = f(L, K)
USES/ IMPORTANCE OF PRODUCTION
FUNCTION IN BUSINESS DECISION
Production function shows the technical or mathematical
relationship between physical output and physical inputs. It is
very important in the economic analysis of production and
making business decisions. The uses or importance of
production function can be explained as follows:
1. To determine least cost combination of inputs
2. To determine the value of employing a variable input
3. To take long run production decision
COBB-DOUGLAS PRODUCTION FUNCTION

The power production function was first proposed by Kunt Wicksell

(1851-1926), a leading Swedish economist. Latter, it was tested
empirically by two American originators, C.W. Cobb (a mathematician)
and P.H. Douglas (an economist) in 1928 AD. Therefore, it is known as
the Cobb-Douglas production function.
The Cobb-Douglas production function is given as
Q = A KL … (i)
COBB-DOUGLAS PRODUCTION FUNCTION
CONT.
Properties/ Features of Cobb-Douglas Production Function
Some important properties or features of Cobb-Douglas production
function are as follows:
1. Homogeneous of degree (+)
2. Returns to scale
3. Marginal product of one input depends on quantities of both inputs
4. Marginal rate of technical substitution
5. Measurement of elasticity of factor substitution
6. The efficiency of production
7. Factor intensity
8. Linear form
OPTIMAL INPUT COMBINATION
Isoquant
The term 'isoquant' has been derived from a Greek word 'iso' meaning
equal and a Latin word 'quant' meaning quantity. Isoquant is defined the
locus of different combinations of any two inputs (labour and capital)
yielding the same level of output.
Table 3-1: Isoquant Schedule

Combination Labours Capital Output

s
A 1 11 1000
B 2 7 1000
C 3 4 1000
D 4 2 1000
E 5 1 1000
Figure 3-1: Isoquant Curve

12
A
11
10
9
8
B
Capital
7
6
5
C
4
3
D
2
E
1 IQ = 1000
X
O 1 2 3 4 5
Labour
Figure 3-2: Isoquant Map

Isoquant Map Y
The set of isoquants is called
isoquant map. A higher isoquant
represents higher level of output
and lower isoquant represents a

Capital (K)
lower level of output. Isoquant
map is shown in the Figure 3-2. IQ5 = 5000
IQ4 = 4000
IQ3 = 3000
IQ2 = 2000
IQ1 = 1000

X
O
Labour (L)
OPTIMAL INPUT COMBINATION
CONT.
Properties of Isoquant
The properties or features of isoquant are as follows:
1. Isoquant has negative slope. It slopes downward from left
to right.
2. Isoquant curve is convex to the origin.
3. Isoquants never intersect with each other or do not be
tangent with each other.
4. Higher the isoquant, higher will be output and vice-versa.
5. Isoquant never touch or intersect X and Y-axes.
OPTIMAL INPUT COMBINATION
CONT.
Marginal Rate of Technical Substitution (MRTS)
Marginal rate of technical substitution of labour for capital can
be defined as the number of units of capital which can be
replaced by one unit of labour keeping the level of output
constant. Marginal rate of technical substitution is slope of the
isoquant. The concept of marginal rate of technical substitution
can be easily understood by the help of Table 3-2 and Figure
3-3.
Table 3-2: Marginal Rate of Technical Substitution

Factor Units of Units of MRTS of L for

Combinations Labour Capital K (MRTSL, K) =

A 1 11 -
B 2 7 4
C 3 4 3
D 4 2 2
E 5 1 1
Figure 3-3: Marginal Rate of Technical Substitution

In Figure 3-3, the

Y
downward slopping curve IQ
represents isoquant. The
12
slope of the isoquant is the 11
A
marginal rate of technical 10
substitution (MRTS). It is 9 K
8
continuously decreasing B

Capital
7
from point A to B, B to C, C 6
L
K
to D and D to E. 5
C
4
L
3 K
Slope of the Isoquant 2 L K
D
E
= MRTSL, K= = 1 L IQ = 1000
X
O 1 2 3 4 5
Labour
OPTIMAL INPUT COMBINATION
CONT.
Isocost Line
Isocost line is defined as the locus of various combinations of
any two inputs which the producer can get for a certain
amount of money at a given prices of the factors or inputs.
Total outlay (C) = Expenditure on labour + Expenditure
on capital
C = w.L + r.K … (i)
Table 3-3: Isocost Schedule

Combination
Labour Capital Total Cost Outlay = wL+ rK
s

A 0 40 Rs. 2000 = 100 × 0 + 50 × 40

B 5 30 Rs. 2000 = 100 × 5 + 50 × 30
C 10 20 Rs. 2000 = 100 × 10 + 50 × 20
D 15 10 Rs. 2000 = 100 × 15 + 50 × 10
E 20 0 Rs. 2000 = 100 × 20 + 50 × 0
Figure 3-4: Isocost line

50

40 A

Capital (K)
B
30
C
20
D
10
E
X
O 5 10 15 20 25
Labour (L)
OPTIMAL INPUT COMBINATION
CONT.
Slope of Isocost Line
The slope of the isocost line represents the ratio of the price of
a unit of labour to the price of a unit of capital. The slope of
isocost line can be obtained through cost equation. We know
that
C = wL + rK … (i)
or, K=K-L … (ii)
Equation (ii) is in the form of y = mx + c, hence
Slope of the isocost line (m) =
OPTIMUM USE OR EMPLOYMENT
OF ONE VARIABLE INPUT
The optimum employment of one variable input is the short-
run production phenomenon. It explains how much labour
input should be used by a firm in order to maximize profit.
The rational answer is that the firm should employ an
additional unit of labour as long as marginal revenue from
the sale of output produced exceeds the marginal cost of
hiring it.
OPTIMUM USE OR EMPLOYMENT
OF ONE VARIABLE INPUT CONT.
Assumptions
 The firm uses only one input, i.e. labour.
 The objective of the firm is to maximize profit.
 The firm produces only one commodity X.
 There is existence of perfect competition in the product as well as

labour market.
 Price of the product is fixed or constant.
 There is no change in the state of technology.
 The economy operates in full employment in the long run.

On the basis of above assumptions, the equilibrium condition of the firm

can be expressed as
DL = SL
OPTIMUM USE OR EMPLOYMENT
OF ONE VARIABLE INPUT CONT.
1. Demand for Labour (DL): The marginal revenue productivity of labour
(MRPL) curve is the demand curve for labour. MRPL is the change in total
revenue due to employment of an additional unit of labour.
MRPL= PX  MPL
2. Supply for Labour (SL): Marginal cost of labour is the wages paid to
each additional unit of labour. Therefore, marginal cost of labour (MC L)
equals to wage rate (w).
MCL =w
The profit maximizing firm will hire labour where MCL equals to marginal
revenue productivity of labour (MRPL).
MRPL = MCL
or, MRPL =w
The optimal employment of labour Figure 3-5: Optimum Use of One
can also be explained by the help Variable Input
of
Figure 3-5.
Y

Wage
w SL (MCL)

MRPL (DL)/
VMPL

X
O L1 L L2
Units of Labour
OPTIMUM USE OR EMPLOYMENT OF
TWO VARIABLE INPUTS (PRODUCER'S
EQUILIBRIUM)
It is assumed that a rational firm or producer always seeks to
maximize profit. For profit maximization, the firm seeks to
minimize cost of production for producing a given quantity of
output or maximize output for the given level of cost outlay.
The choice of particular combination of factors or inputs
depends upon the technical possibilities of production and
prices of factors of production or inputs used for the
production of the particular product.
OPTIMUM USE OR EMPLOYMENT OF TWO
VARIABLE INPUTS (PRODUCER'S
EQUILIBRIUM) CONT.
Assumptions
The concepts of optimum use of two variable inputs are based on the
following assumptions:
 The producer is rational, i.e. he/she seeks to maximize profit.

 The producer uses two inputs: labour and capital.

 The price of both inputs (labour and capital) is fixed or constant.

 All units of inputs are homogeneous.

 The total cost or money outlay is given.

 There is existence of perfect competition in the factor market.

 There exists isoquant map in case of output maximization and family

of isocost line in case of cost minimization.

OPTIMUM USE OR EMPLOYMENT OF TWO
VARIABLE INPUTS (PRODUCER'S
EQUILIBRIUM) CONT.

Conditions for Equilibrium or Optimum Use of Inputs

The following two conditions must be fulfilled in order to achieve optimal use of
inputs:
1. First order condition (Necessary condition): Isoquant must be tangent
to the isocost line. In other words, the slope of isoquant should be equal to
slope of isocost line.
Slope of Isoquant = Slope of IsocostLine
=
2. Second order condition (Sufficient condition): Isoquant must be convex
to the origin at the point of tangency.
There are two cases or approaches of explaining optimum use of inputs which
are as follows:
Figure 3-6: Maximization of output for the given
1. Maximization of output cost outlay
for the given cost
outlay : A rational firm or Y
producer seeks to maximize
output at the given cost
outlay. This case or A
approach of optimal use of

Capital
M
two variables inputs or
equilibrium of the firm can
E IQ3
be explained by the help of K1
Figure 3-6. IQ2
N IQ
1

X
O L1 B
Units of Labour
2. Minimization of cost for the
Figure 3-7: Minimization of cost for the given level
given level of output (Cost
of output
minimization subject to
output constraint): A rational Y
firm or producer seeks to
minimise cost at the given level A3
of output. This case or approach
of optimal use of two variable

Units of Capital
A2
M
inputs or equilibrium of the firm
can be explained by the help of A1
Figure 3-7. E
K1
N
IQ

X
O L1 B1 B2 B3
Units of Labour
Concept of Expansion Path

Expansion path is defined Figure 3-8: Derivation of Expansion Path

as the line joining tangent
points of isoquants and Y

isocosts with input prices

A3
held constant and which
shows optimal combination A2

Units of Capital
P (Expansion Path)
of inputs. It is shown in
A1
Figure 3-8. E3
E2
E1 IQ3

IQ2
IQ1

X
O B1 B2 B3
Units of Labour
LEARNING CURVE
Learning curve is defined as the curve that shows the decline in
average cost of production with rise in cumulative total output
overtime. As firms gain experience in the production of a commodity or
service, their average cost of production declines.
The learning curve can be expressed algebraically as follows:
C = a Qb … (i)
Taking log on both sides of the equation (i), we get
Log C = Log (a. Qb)
or, Log C = Log a + Log Qb
 Log C = Log a + b LogQ … (ii)
Figure 3-9: Learning Curve

LEARNING CURVE CONT. 500

Average Cost
400
The equation (ii) can be
300
empirically estimated by using
historical data on average 200
cost and cumulative output.
100 LC
The concept of learning curve
X
can be explained by the help O
100 200 300
of Figure 3-9:
Cumulative Total Output
LEARNING CURVE CONT.
Significance of Learning Curve in Business Decision Making
The significance or importance or uses of learning curve are as follows:
i. It helps to make pricing decisions and production strategies.
ii. It helps managers to improve their ability in forecasting production
cost based on projected cumulative output.
iii. It helps to determine long-run competitive strategy.
iv. It helps to choose production techniques.
EMPIRICAL ESTIMATION OF
SHORT RUN COST FUNCTION
Empirical estimation means estimation of economic variable
based on experiment or real data. Empirical estimates of
cost functions are essential for many managerial decision
purposes.
The most common method of estimating short run cost
function is regression analysis whereby total variable cost
are regressed against output and other few other variables,
such as input prices and operating conditions, during the
time period when size of the plant is fixed.
EMPIRICAL ESTIMATION OF
SHORT RUN COST FUNCTION
CONT.

The cost function can be expressed as

C = f(Q, X1, X2, X3, … , Xn) … (i)
The equations of the S-shaped cost curves:
TVC = a(Q) + bQ2 + cQ3… (ii)
AVC = a + bQ + cQ2 … (iii)
MC = a + 2bQ + 3cQ2 … (iv)
If TVC is linear,
TVC = a + bQ … (v)
AVC = + b … (vi)
MC =b … (vii)
Figure 3-10: Empirical Estimation of Short Run Cost Function
Y Y
Figure (I) Figure (II)
TVC TVC'
TVC

TVC

TVC
Range of output
a observations

O X O X
Output Output
Y Y
Figure (III) Figure (IV)

MC
AVC and MC

AVC and MC
AVC

AVC
b MC

O X O X
Q' Q''
Output Output
EMPIRICAL ESTIMATION OF
SHORT RUN COST FUNCTION
CONT.

Shape of Short-Run Cost Function

Three different specifications of cost functions are: cubic,
quadratic and linear. Each represents a possible shape of the
cost curves. The economist, after collecting and adjusting
the data, will use one of these specifications to measure the
relationship between cost and output. Other statistical
functions could be employed (e.g.; the Cobb-Douglas
production function), but the three shapes are the ones most
frequently encountered in statistical studies, that is, cubic,
quadratic or linear.
EXERCISE 1
The demand curve for labour in the market is w = 120 – 2L and supply curve
of labour is w = 3L. Determine equilibrium level of employment and wage.
SOLUTION
Given,
Demand curve for labour (DL): w = 120 – 2L
Supply curve for labour (SL): w = 3L
We know that equilibrium level of employment is determined at the point
where demand for labour and supply of labour become equal. Thus,
DL = SL
or, 120 – 2L = 3L
or, –5L = –120
 L = = 24
Wage rate (w) = 3L
= 3 × 24
= Rs. 72
Hence, equilibrium level of employment is 24 and wage rate is Rs. 72.
EXERCISE 2
Let us suppose, a firm produces quantities of a commodity Q per day and the
number of labour to be used is Q = 60L – 2L2. The firm sells the commodity
at price Rs. 50 per unit so that its marginal revenue is Rs. 50. The wage rate
of labour is Rs. 200 per day. How much labour should the firm hire in order to
maximize
SOLUTION profit? = 50 × (60 – 4L)
Given, = 3,000 – 200L
Production function (Q) = 60L – 2L2 For equilibrium labour,
Price of the product (P) = Rs. 50 MRPL = w
Marginal revenue (MR) = Rs. 50 or, 3,000 – 200L = 200
Wage rate of labour (w) = Rs. 200 or, –200L = 200 – 3,000
We known that  L = = 14
MRP­L = MR . MPL … (i) Thus, the firm should hire 14 units
MPL= = of labour for profit maximization.
= 60 – 2
= 60 – 4L
Then,
MRPL = MR × MPL
EXERCISE 5
The production function of a firm is given by Q = 20K0.5L0.5. Suppose, the
quantity of capital is fixed at 100. If the wage rate is Rs. 20 and price of
output is 3 per unit, determine the optimal use of labour input.
SOLUTION = 10
Given = 10
Production function: Q = When K = 100
20K0.5L0.5 = 10
Wage rate (w) = Rs. 20 =
Price of output (P) = Rs. 3 We know that
Quantity of capital (K) = 100 MRPL = Price of output × MPL
We know that = P × MPL
MPL = =3×=
=
= 20 K0.5
= 20 × K0.5 × 0.5 × L0.5 –
1

= 10 K0.5 L–0.5
For optimal use of labour,
MRPL = Wage rate
or, MRPL = W
or, = 20
or, =
or, = 15
or, L = 152
 L = 225 units
Hence, optimal quantity of labour is 225 units.
EXERCISE 8
Consider the following information and estimate the cost when output is 42
units. [2018 Semester]
Observations 1 2 3 4 5 6 7 8
Output ('000 units) 10 13 16 20 25 27 30 35
Variable cost (Rs in 22 25 29 33 38 40 45 49
millions)
SOLUTION
The required linear cost function:
C = a + bQ
or, Y = a + bX …(i)
where,
Y = Variable cost
X = Output
a and b are constants.
The normal equations are
Y = na + bX …(ii)
XY = aX + bX2 …(iii)
Y X X2 XY
22 10 100 220
25 13 169 325
29 16 256 464
33 20 400 660
38 25 625 950
40 27 729 1080
45 30 900 1350
49 35 1225 1715
Y = 281 X = 176 X2 = 4404 XY = 6764

n=8 b = 1.09
Putting values of the table in equation Putting the values of a and b in
(ii) equation (i), we get
and (iii), we get, Y = 11.05 + 1.09X
281 = 8a + 176b …(iv) When, X = 42,
6764 = 176a + 4404b … Y = 11.05 + 1.09 × 42
(v) = 56.83
Solving equation (iv) and (v) we get, Hence, variable cost at 42 unit of
a = 11.05 output is 56.83 units.
EXERCISE 9
A company has following production function: Q = 100 K0.5L0.5. This firm has
operated in efficient condition by using 100 units of capital and 25 units of
labour.
a. Find the marginal productivity of capital and marginal productivity of
labour.
b. If rental price of capital is Rs. 20 per unit, what is wage rate?
c. Suppose that the rental price of capital is expected to increase Rs. 25,
while wage rate remains unchanged under the terms of contract, what
input rate of capital will be used when firm run under the efficient
SOLUTION
condition?
Given, [2014, Semester]
Production function: Q = 100 K0.5L0.5
L = 25
K = 100
a. We know that, =100  K0.5
Marginal productivity of capital = 100 K0.5 0.5  L0.51
MPK = = 50
= = 50
= 100 L0.5 = 50
= 100 L0.5 0.5  K0.51 = 100 units
= 50
= 50
= 50
= 25 units

Marginal productivity of labour

MPL =
=
b. Given, New rental price of capital (r) =
Rental price of capital (r) = Rs. Rs. 25
20 Wage rate (w) = Rs. 80,
We know that, L = 25
= Then,
or, = =
 w = = Rs. 80 or, =
or, =
or, =
 K = = 25 = 80 units
Hence, MPK = 25, MPL = 100
w = Rs. 80, K = 80 units.

c. Given,
EXERCISE 13
Let, the production function realized by the Noodle factory is Q = 100, wage
rate = Rs. 50, rate of interest = Rs = 40, P = Rs 2 per unit.
a. Compute productivities of two inputs.
b. (i) Show how to determine the amount of labour and capital that the firm
should use in order-to minimize cost of producing 1118 units of output,
(ii) What is the profit and minimum cost? (iii) What will be the minimum
cost and optimal employment of labor and capital at output 2236 units?
c. (i) What will be the optimal employment of labour and capital in order to
maximize output under given total cost outlays Rs 1,000?
(ii) What is the level of output and profit? (iii) What will be the level of
output and optimal employment of labor and capital when total cost
outlay increases to Rs. 2,000? [2016 Semester]
SOLUTION
a. Given
Production function: Q = 100 = 100 K1/2L1/2
Wage rate (w) = Rs. 50
Rate of interest (r) = Rs. 40
Price per unit (P) = Rs. 2
We know that,
MPK =
= = 50 = 50
Similarly
MPL =
= = 50 = 50
b. or, 1118 = 100 K
i. For equilibrium or, K = = 12.5 units
= Then, L = = 10 units
or, = Hence, the cost minimizing units
or, = of labour and capital are 10 units
or, L= and 12.5 units respectively.

Putting value of L in the given

production function or equation,
Q = 100
or, Q = 100 K
ii. Minimum cost (C) = wL + rK
= 50  10 + 40  12.5 = Rs. 1000
Q = 100
= 100
= 100 
= 1118
We know that,
Profit () = TR – TC
= (P  Q)  (C)
= (2  1118)  1000
= Rs. 1236
iii. Given
Output (Q) = 2236
We know that,
Q = 100
or, 2236 = 100
or, K = = = 25 units
Then, L = = = 20 units
Minimum cost (C) = wL + rK
= 50  20 + 40  25
= 1000 + 1000
= Rs. 2000
Hence, Optimum employment of labour and capital are 20 units and 25
units respectively and minimum cost is Rs 2000.
c.
i. Given
Cost Outlay (C) = Rs. 1000
We know that,
C = wL + rK
or, 1000 = 50 + 40  K
or, 1000 = 40 K + 40 K
or, 80 K = 1000
 K = = 12.5
Then,
L = = = 10
Hence, optimal employment of labour and capital are 10 units and
12.5 units respectively.
ii. Level of output (Q) = 100 iii. Total cost (C) = Rs. 2000
= 100  We know that
= 1118 C = wL + rK
Profit () =PQC or, 2000 = 50 + 40  K
= 2  1118  (wL + rK) or, 2000 = 40K + 40 K
= 2236  (5 10 + 40  or, 80 K = 2000
12.5)  K = = 25 units
= 2236  (500 + 500) L = = = 20
= 2236  1000 Level of Output (Q) = 100
= Rs. 1236 = 100
= 2236
Hence, optimal employment of
labour and capital are 20 units and
25 units respectively and level of
output 2236.
Thank You