UNIT 10 ESTIMATION OF PRODUCTION

AND COST FUNCTIONS

Objectives
After going through this unit, you should be able to:
explain various functional forms of production and costs;
understand empirical determination of these theoretical functions;
identify managerial uses of such empirical estimates.

Structure
10.1 Introduction
10.2 Estimation of Production Function
10.3 Empirical Estimates of Production Function
10.4 Managerial Uses of Production Function
10.5 Cost Function and its Determinants
10.6 Estimation of Cost Function
10.7 Empirical Estimates of Cost Function
10.8 Managerial Uses of Cost Function
10.9 Summary
10.10 Self-Assessment Questions
10.11 Further Readings

10.1 INTRODUCTION
In the process of decision-making, a manager should understand clearly the
relationship between the inputs and output on one hand and output and costs on
the other. The short run production estimates are helpful to production
managers in arriving at the optimal mix of inputs to achieve a particular output
target of a firm. This is referred to as the ‘least cost combination of inputs’ in
production analysis. Also, for a given cost, optimum level of output can be
found if the production function of a firm is known. Estimation of the long run
production function may help a manager in understanding and taking decisions
of long term nature such as capital expenditure.

Estimation of cost curves will help production manager in understanding the

nature and shape of cost curves and taking useful decisions. Both short run
cost function and the long run cost function must be estimated, since both sets
of information will be required for some vital decisions. Knowledge of the
short run cost functions allows the decision makers to judge the optimality of
present output levels and to solve decision problems of production manager.
Knowledge of long run cost functions is important when considering the
expansion or contraction of plant size, and for confirming that the present plant
size is optimal for the output level that is being produced.

In the present Unit, we will discuss different approaches to examination of

production and cost functions, analysis of some empirical estimates of these
functions, and managerial uses of the estimated functions.

1
Production and Estimation of Production
10.2
Cost Analysis ESTIMATION OF PRODUCTION FUNCTION and Cost Functions

The principles of production theory discussed in Unit 7 are fundamental in

understanding economics and provide an important conceptual framework for
analysing managerial problems. However, short run output decisions and long
run planning often require more than just this conceptual framework. That is,
quantitative estimates of the parameters of the production functions are required
for some decisions.

Functional Forms of Production Function

The production function can be estimated by regression techniques (refer to
MS-8, course on “Quantitative Analysis for Managerial Applications” to know
about regression techniques) using historical data (either time-series data, or
cross-section data, or engineering data). For this, one of the first tasks is to
select a functional form, that is, the specific relationship among the relevant
economic variables. We know that the general form of production function is,

Q = f (K,L)

Where, Q = output, K = capital and L = labour.

Although, a variety of functional forms have been used to describe production

relationships, only the Cobb-Douglas production function is discussed here. The
general form of Cobb-Douglas function is expressed as:

Q = AKa Lb

where A, a, and b are the constants that, when estimated, describe the
quantitative relationship between the inputs (K and L) and output (Q).

The marginal products of capital and labour and the rates of the capital and
labour inputs are functions of the constants A, a, and b and. That is,
dQ
MPK = —— = aAKa-1 Lb
dK

dQ
MPL = —— = b AKaLb-1
dK

The sum of the constants (a+b) can be used to determine returns to scale.
That is,

(a+b) > 1 Þ increasing returns to scale,

(a+b) = 1 Þ constant returns to scale, and
(a+b ) < 1 Þ decreasing returns to scale.

Having numerical estimates for the constants of the production function

provides significant information about the production system under study. The
marginal products for each input and returns to scale can all be determined
from the estimated function.

The Cobb-Douglas function does not lend itself directly to estimation by the
regression methods because it is a nonlinear relationship. Technically, an
equation must be a linear function of the parameters in order to use the
ordinary least-squares regression method of estimation. However, a linear
equation can be derived by taking the logarithm of each term. That is,
2
 log Q = log A + a log K + b log L

A linear relationship can be seen by setting,

Y = log Q, A* = log A, X1 = log K, X2 = log L

and rewriting the function as

Y = A* + aX1 + bX2

This function can be estimated directly by the least-squares regression

technique and the estimated parameters used to determine all the important
production relationships. Then the antilogarithm of both sides can be taken,
which transforms the estimated function back to its conventional multiplicative
form. We will not be studying here the details of computing production
function since there are a number of computer programs available for this
purpose. Instead, we will provide in the following section some empirical
estimates of Cobb-Douglas production function and their interpretation in the
process of decision making.

Types of Statistical Analyses

Once a functional form of a production function is chosen the next step is to
select the type of statistical analysis to be used in its estimation. Generally,
there are three types of statistical analyses used for estimation of a production
function. These are: (a) time series analysis, (b) cross-section analysis and
(c) engineering analysis.
a) Time series analysis: The amount of various inputs used in various
periods in the past and the amount of output produced in each period is
called time series data. For example, we may obtain data concerning the
amount of labour, the amount of capital, and the amount of various raw
materials used in the steel industry during each year from 1970 to 2000.
On the basis of such data and information concerning the annual output of
steel during 1970 to 2000, we may estimate the relationship between the
amounts of the inputs and the resulting output, using regression techniques.
Analysis of time series data is appropriate for a single firm that has not
undergone significant changes in technology during the time span analysed.
That is, we cannot use time series data for estimating the production
function of a firm that has gone through significant technological changes.
There are even more problems associated with the estimation a production
function for an industry using time series data. For example, even if all
firms have operated over the same time span, changes in capacity, inputs
and outputs may have proceeded at a different pace for each firm. Thus,
cross section data may be more appropriate.
b) Cross-section analysis: The amount of inputs used and output produced in
various firms or sectors of the industry at a given time is called cross-
section data. For example, we may obtain data concerning the amount of
labour, the amount of capital, and the amount of various raw materials used
in various firms in the steel industry in the year 2000. On the basis of such
data and information concerning the year 2000, output of each firm, we may
use regression techniques to estimate the relationship between the amounts
of the inputs and the resulting output.
c) Engineering analysis: In this analysis we use technical information
supplied by the engineer or the agricultural scientist. This analysis is
undertaken when the above two types do not suffice. The data in this
analysis is collected by experiment or from experience with day-to-day
working of the technical process. There are advantages to be gained from
3
Production approaching
and the measurement of the production function from this angle Estimation of Production
Cost Analysis and Cost Functions
because the range of applicability of the data is known, and, unlike time-
series and cross-section studies, we are not restricted to the narrow range
of actual observations.

Limitations of Different Types of Statistical Analysis

Each of the methods discussed above has certain limitations.
1. Both time-series and cross-section analysis are restricted to a relatively
narrow range of observed values. Extrapolation of the production function
outside that range may be seriously misleading. For example, in a given
case, marginal productivity might decrease rapidly above 85% capacity
utilization; the production function derived for values in the 70%-85%
capacity utilization range would not show this.
2. Another limitation of time series analysis is the assumption that all observed
values of the variables pertains to one and the same production function. In
other words, a constant technology is assumed. In reality, most firms or
industries, however, find better, faster, and/or cheaper ways of producing
their output. As their technology changes, they are actually creating new
production functions. One way of coping with such technological changes is
to make it one of the independent variables.
3. Theoretically, the production function includes only efficient (least-cost)
combinations of inputs. If measurements were to conform to this concept,
any year in which the production was less than nominal would have to be
excluded from the data. It is very difficult to find a time-series data, which
satisfy technical efficiency criteria as a normal case.
4. Engineering data may overcome the limitations of time series data but mostly
they concentrate on manufacturing activities. Engineering data do not tell us
anything about the firm’s marketing or financial activities, even though these
activities may directly affect production.
5. In addition, there are both conceptual and statistical problems in measuring
data on inputs and outputs.

It may be possible to measure output directly in physical units such as tons of

coal, steel etc. In case more than one product is being produced, one may
compute the weighted average of output, the weights being given by the cost of
manufacturing these products. In a highly diversified manufacturing unit, there
may be no alternative but to use the series of output values, corrected for
changes in the price of products. One has also to choose between ‘gross
value’ and ‘net value’. It seems better to use “net value added” concept
instead of output concept in estimating production function, particularly where
raw-material intensity is high.

The data on labour is mostly available in the form of “number of workers

employed” or “hours of labour employed”. The ‘number of workers’ data
should not be used because, it may not reflect underemployment of labour, and
they may be occupied, but not productively employed. Even if we use ‘man
hours’ data, it should be adjusted for efficiency factor. It is also not advisable
that labour should be measured in monetary terms as given by expenditure on
wages, bonus, etc.

The data on capital input has always posed serious problems. Net investment
i.e. a change in the value of capital stock, is considered most appropriate.
Nevertheless, there are problems of measuring depreciation in fixed capital,
changes in quality of fixed capital, changes in inventory valuation, changes in
composition and productivity of working capital, etc.
4
Finally, when one attempts an econometric estimate of a production function,
one has to overcome the standard problem of multi-collinearity among inputs,
autocorrelation, homoscadasticity, etc.

10.3 EMPIRICAL ESTIMATES OF PRODUCTION

FUNCTION
Consider the following Cobb-Douglas production function with parameters
A=1.01, a = 0.25 and b=0.75,

Q = 1.01K0.25 L0.75

The above production function can be used to estimate the required capital and
labour for various levels of output. For example, the capital and labour
required for an output level of 100 units will be given by

100 = 1.01K0.25 L0.75

Þ 99 = K0.25 L0.75

By substituting any value of L (or K) in this equation, we can obtain the

associated value of K (or L). For example, if L=50, the value of K will be
given by

99 = K0.25 (50)0.75

Þ log 99 = 0.75 log 50 + 0.25 log K

Þ 1.9956 = 0.75 (1.6990) + 0.25 log K

1
Þ log K = —— (1.9956 – 1.2743) = 2.8852
0.25

Þ K = antilog 2.8852 = 768

Similarly, for any given value of K we can find out the corresponding value of
L.

As explained in Unit 7, an isoquant for any given output level or an isoquant

map for a given set of output levels can be derived from an estimated
production function.

Consider the following Cobb-Douglas production function with parameters

A=200, a = 0.50 and b = 0.50,

Q = 200K0.50 L0.50

For different combinations of inputs (L and K), we can construct an associated

maximum rate of output as given in Table 10.1 For example, if two units of
labour and 9 units of capital are used, maximum production is 600 units of
output. If K=10 and L=10 the output rate will be 2000. The following three
important relationships are shown by the data in this production Table.
1. Table 10.1 indicates that there are a variety of ways to produce a particular
rate of output. For example, 490 units of output can be produced with any
one of the following combinations of inputs.

5
Production and10.1:
Table Output Table for different Combinations of Inputs for the Production Estimation of Production
Cost Analysis and Cost Functions
Function Q = 200K0.50 L0.50

Rate of labour input (L)

1 2 3 4 5 6 7 8 9 10
1 200 283 346 400 447 490 529 566 600 632
Rate of capital input (K)

2 283 400 490 566 632 693 748 800 849 894
3 346 490 600 693 775 849 917 980 1039 1095
4 400 566 693 800 894 980 1058 1131 1200 1265
5 447 632 775 894 1000 1095 1183 1265 1342 1414
6 490 693 849 980 1095 1200 1296 1386 1470 1549
7 529 748 917 1058 1183 1296 1400 1497 1587 1673
8 566 800 980 1131 1265 1386 1497 1600 1697 1789
9 600 849 1039 1200 1342 1470 1587 1697 1800 1897
10 632 894 1095 1265 1414 1549 1673 1789 1897 2000

Combination of inputs Output

K L
6 1 490
3 2 490
2 3 490
1 6 490

This shows that there is substitutability between the factors of production.

That means the production manager can use either the input combination
(k=6 and L=1) or (k=3 and L=2) or (k=2 and L=3) or (k=1 and L=6) to
produce the same amount of output (490 units). The concept of substitution
is important because it means that managers can change the input mix of
capital and labour in response to changes in the relative prices of these inputs.
2. In the equation given that a = 0.50 and b = 0.50. The sum of these
constants is 1 (0.50+0.50=1). This indicates that there are constant returns
to scale (a+b=1). This means that a 1% increase in all inputs would result
in a 1% increase in output. For example, in Table 10.1 maximum production
with four units of capital and one unit of labour is 400. Doubling the input
rates to K=8 and L=2 results in the rate of output doubling to Q=800. In
Table 10.1, production is characterized by constant returns to scale. This
means that if both input rates increase by the same factor (for example,
both input rates double), the rate of output also will double. In other
production functions, output may increase more or less than in proportion to
changes in inputs.
3. In contrast to the concept of returns to scale, when output changes because
of changes in one input while the other remains constant, the changes in the
output rates are referred to as returns to a factor. In Table 10.1, if the rate
of one input is held constant while the other is increased, output increases
but the successive increments become smaller. For example, from Table
10.1 it can be seen that if the rate of capital is held constant at K=2 and
labour is increased from L=1 to L=6, the successive increases in output are
117, 90, 76, 67, and 60. As discussed in Unit 7, this relationship is known
6 as diminishing marginal returns.
We will consider another empirical estimate of Cobb-Douglas production
function given as:

Q = 10.2K 0.194 L0.878

Here, the returns to scale are increasing because a+b=1.072 is greater than 1.
The marginal product functions for capital and labour are

MPK = aAKa-1Lb = 0.194(10.2)K(0.194-1)L0.878 = 0.194(10.2)K-0.806L0.878

and
MPL = b AKaLb-1 = 0.878(10.2)K0.194L(0.878-1) = 0.878(10.2)K0.194L-0.122

Based on the above MPK and MPL equations we can calculate marginal
products of capital and labour for a given input combination. For example,
suppose we are given that the input combination K=20 and L=30. Substituting
these values for the constants A, a, and b gives the following marginal
products:

MPK = 0.194(10.2)(20)-0.806(30)0.878 = 3.50

and
MPL = 0.878(10.2)(20)0.194 (30)-0.122 = 10.58

We can interpret the above marginal products of capital and labour as follows.
One unit change in capital with labour held constant at 30 would result in 3.50
unit change in output, and one unit change in labour with capital held constant
at 20 would be associated with a 10.58 unit change in output.

Empirical estimates of production functions for industries such as sugar, textiles,

cement etc., are available in the Indian context. We will briefly discuss some
of these empirical estimates here.

There are many empirical studies of production functions in different countries.

John R. Moroney made one comprehensive study of a number of
manufacturing industries in U.S.A. He estimated the production function:

Q = AKa L1b L2g

Where, K = value of capital

L1 = production worker-hours
L2 = non-production worker-hours

A summary of the estimated values of the production elasticities (a, b, and g)

and R2, the coefficient of determination, for each industry is shown in Table
10.2.

From Table 10.2 it can be observed that R2 values are very high (more than
0.951) for all the functions. This means that more than 95% of the variation in
output is explained by variation in the three inputs. A test of significance was
made for each estimated parameter, a, b, and g, using the standard t-test.
Those estimated production elasticities that are statistically significant at the
0.05 levels are indicated with an asterix (*). The sum of the estimated
production elasticities (a+b+g) provides a point estimate of returns to scale in
each industry. Although, the sum exceeds unity in 14 of the 17 industries, it is
statistically significant only in the following industries: food and beverages,
apparel, furniture, printing, chemicals, and fabricated metals. Thus, only in
those six industries there are increasing returns to scale. For example, in the
fabricated metals industry, a 1% increase in all inputs is estimated to result in a
1.027% increase in output. 7
Production and Table 10.2: Estimated production Elasticities for 17 Industries Estimation of Production
Cost Analysis and Cost Functions

Industry a b g a+b+g R2
Food and beverages 0.555* 0.438* 0.076* 1.070* 0.987
Textiles 0.121 0.549* 0.335* 1.004 0.991
Apparel 0.128 .0437* 0.477* 1.041* 0.982
Lumber 0.392* 0.504* 0.145 1.041 0.951
Furniture 0.205 0.802* 0.103 1.109* 0.966
Paper and Pulp 0.421* 0.367 0.197* 0.984 0.990
Printing 0.459* 0.045* 0.574* 1.079* 0.989
Chemicals 0.200* 0.553* 0.336* 1.090* 0.970
Petroleum 0.308* 0.546* 0.093 0.947 0.983
Rubber and Plastics 0.481* 1.033* -0.458 1.056 0.991
Leather 0.076 0.441* 0.523 1.040 0.990
Stone and Clay 0.632* 0.032 0.366* 1.029 0.961
Primary Metals 0.371* 0.077 0.509* 0.958 0.969
Fabricated Metals 0.151* 0.512* 0.365* 1.027* 0.995
Non-electrical machinery 0.404* 0.228 0.389* 1.020 0.980
Electrical Machinery 0.368* 0.429* 0.229* 1.026 0.983
Transportation Equipment 0.234* 0.749* 0.041 1.023 0.972

Source: J.R. Moroney, “Cobb-Douglas Production Functions and Returns to

Scale in U.S. Manufacturing Industry,” Western Economic Journal 6
(December): 39-51, 1967.
Activity 1

1. Observe the following Cobb-Douglas production function:

Q = 50K0.4L 0.7

For this production function system, are returns to scale decreasing, constant,
or increasing? Explain.
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2. Use the data from Table 10.1 to answer the following questions:
a) If the rate of capital input is fixed at four and if output sells for Rs. 10
per unit, determine the total, average, and marginal product functions and
the marginal revenue product function for labour and complete the
following Table.
8
L TPL AP L MP L MRP L
1 400 — —
2 166
3 1270
4 200
5 940
6 980
7 78
8 141.4
9
10 1265 650

b) Using the data from the above-completed table, if the wage rate is
Rs. 675 per unit, how much labour should be employed?
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c) If the rate of labour is fixed at 2 and the price of output is Rs. 10 per
unit, determine the total, average, and marginal, product functions for
capital and the marginal revenue product of capital in the following Table.

C TPL AP L MP L MRP L
1 283.0 — —
2 117
3 490
4
5 126.4
6
7 55
8
9 49
10 894 450

d) Using the data from the above-completed table, if the price of capital is
Rs. 600 per unit, how much capital should be employed?
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9
Production and
3. The production function for ABC company is Estimation of Production
Cost Analysis and Cost Functions
Q=50K0.4 L0.6
Where Q is the total output, L is the quantity of labour employed, and K is
the quantity of capital.
a) Calculate TP, AP, and MP for 10, 15, and 20 units of labour employed if
capital is fixed at 30 units.
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b) To which stage of production do these quantities of labour correspond?
Why?
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10.4 MANAGERIAL USES OF PRODUCTION

FUNCTION
There are several managerial uses of the production function. It can be used
to compute the least-cost combination of inputs for a given output or to choose
the input combination that yields the maximum level of output with a given level
of cost. There are several feasible combinations of input factors and it is
highly useful for decision-makers to find out the most appropriate among them.
The production function is useful in deciding on the additional value of
employing a variable input in the production process. So long as the marginal
revenue productivity of a variable factor exceeds it price, it may be worthwhile
to increase its use. The additional use of an input factor should be stopped
when its marginal revenue productivity just equals its price. Production
functions also aid long-run decision-making. If returns to scale are increasing,
it will be worthwhile to increase production through a proportionate increase in
all factors of production, provided, there is enough demand for the product. On
the other hand, if returns to scale are decreasing, it may not be worthwhile to
increase the production through a proportionate increase in all factors of
production, even if there is enough demand for the product. However, it may
in the discretion of the producer to increase or decrease production in the
presence of constant returns to scale, if there is enough demand for the
product.
Activity 2

1. Can you list some more managerial uses of production function other than
those given in section 10.4?
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10 .....................................................................................................................
10.5 COST FUNCTION AND ITS DETERMINANTS
Cost function expresses the relationship between cost and its determinants such
as the size of plant, level of output, input prices, technology, managerial
efficiency, etc. In a mathematical form, it can be expressed as,

C = f (S, O, P, T, E…..)

Where, C = cost (it can be unit cost or total cost)

S = plant size
O = output level
P = prices of inputs used in production
T = nature of technology
E = managerial efficiency

Determinants of Cost Function

The cost of production depends on many factors and these factors vary from
one firm to another firm in the same industry or from one industry to another
industry. The main determinants of a cost function are:
a) plant size
b) output level
c) prices of inputs used in production,
d) nature of technology
e) managerial efficiency

We will discuss briefly the influence of each of these factors on cost.

a) Plant size: Plant size is an important variable in determining cost. The
scale of operations or plant size and the unit cost are inversely related in the
sense that as the former increases, unit cost decreases, and vice versa.
Such a relationship gives downward slope of cost function depending upon
the different sizes of plants taken into account. Such a cost function gives
primarily engineering estimates of cost.
b) Output level: Output level and total cost are positively related, as the total
cost increases with increase in output and total cost decreases with
decrease in output. This is because increased production requires increased
use of raw materials, labour, etc., and if the increase is substantial, even
fixed inputs like plant and equipment, and managerial staff may have to be
increased.
c) Price of inputs: Changes in input prices also influence cost, depending on
the relative usage of the inputs and relative changes in their prices. This is
because more money will have to be paid to those inputs whose prices have
increased and there will be no simultaneous reduction in the costs from any
other source. Therefore, the cost of production varies directly with the
prices of production.
d) Technology: Technology is a significant factor in determining cost. By
definition, improvement in technology increases production leading to increase
in productivity and decrease in production cost. Therefore, cost varies
inversely with technological progress. Technology is often quantified as
capital-output ratio. Improved technology is generally found to have higher
capital-output ratio.
e) Managerial efficiency: This is another factor influencing the cost of
production. More the managerial efficiency less the cost of production. It
is difficult to measure managerial efficiency quantitatively. However, a 11
Production change
and in cost at two points of time may explain how organisational or Estimation of Production
Cost Analysis and Cost Functions
managerial changes within the firm have brought about cost efficiency,
provided it is possible to exclude the effect of other factors.

10.6 ESTIMATION OF COST FUNCTION

Several methods exist for the measurement of the actual cost-output relation for
a particular firm or a group of firms, but the three broad approaches -
accounting, engineering and econometric - are the most important and
commonly used.

Accounting Method
This method is used by the cost accountants. In this method, the cost-output
relationship is estimated by classifying the total cost into fixed, variable and
semi-variable costs. These components are then estimated separately. The
average variable cost, the semi-variable cost which is fixed over a certain
range of output, and fixed costs are determined on the basis of inspection and
experience. The total cost, the average cost and the marginal cost for each
level of output can then be obtained through a simple arithmetic procedure.

Although, the accounting method appears to be quite simple, it is a bit

cumbersome as one has to maintain a detailed breakdown of costs over a
period to arrive at good estimates of actual cost-output relationship. One must
have experience with a wide range of fluctuations in output rate to come up
with accurate estimates.

Engineering Method
The engineering method of cost estimation is based directly on the physical
relationship of inputs to output, and uses the price of inputs to determine costs.
This method of estimating real world cost function rests clearly on the
knowledge that the shape of any cost function is dependent on: (a) the
production function and (b) the price of inputs.

We have seen earlier in this Unit while discussing the estimation of production
function that for a given the production function and input prices, the optimum
input combination for a given output level can be determined. The resultant cost
curve can then be formulated by multiplying each input in the least cost
combination by its price, to develop the cost function. This method is called
engineering method as the estimates of least cost combinations are provided by
engineers.

The assumption made while using this method is that both the technology and
factor prices are constant. This method may not always give the correct
estimate of costs as the technology and factor prices do change substantially
over a period of time. Therefore, this method is more relevant for the short
run. Also, this method may be useful if good historical data is difficult to
obtain. But this method requires a sound understanding of engineering and a
detailed sampling of the different processes under controlled conditions, which
may not always be possible.

Econometric Method
This method is also some times called statistical method and is widely used for
estimating cost functions. Under this method, the historical data on cost and
output are used to estimate the cost-output relationship. The basic technique
of regression is used for this purpose. The data could be a time series data of
12
a firm in the industry or of all firms in the industry or a cross-section data for
a particular year from various firms in the industry.

Depending on the kind of data used, we can estimate short run or long run
cost functions. For instance, if time series data of a firm whose output
capacity has not changed much during the sample period is used, the cost
function will be short run. On the other hand, if cross-section data of many
firms with varying sizes, or the time series data of the industry as a whole is
used, the estimated cost function will be the long run one.

The procedure for estimation of cost function involves three steps. First, the
determinants of cost are identified. Second, the functional form of the cost
function is specified. Third, the functional form is chosen and then the basic
technique of regression is applied to estimate the chosen functional form.

Functional Forms of Cost Function

The following are the three common functional forms of cost function in terms
of total cost function (TC).
a) Linear cost function: TC = a1 + b1Q
b) Quadratic cost function: TC = a2 + b2Q + c2Q 2
c) Cubic cost function: TC = a3 + b3Q + c 3Q2 +d3Q 3

Where, a1, a2, a3, b1, b2, b3, c2, c3, d3 are constants.

When all the determinants of cost are chosen and the data collection is
complete, the alternative functional forms can be estimated by using regression
software package on a computer. The most appropriate form of the cost
function for decision-making is then chosen on the basis of the principles of
economic theory and statistical inference.

Once the constants in the total cost function are estimated using regression
technique, the average cost (AC) and marginal cost (MC) functions for chosen
forms of cost function will be calculated. The TC, AC and MC cost functions
for different functional forms of total cost function and their typical graphical
presentation and interpretation are explained below.
a) Linear cost function
TC = a1 + b1Q
AC = (TC)/Q = (a1/Q) + b1

d(TC)
MC = ——— = b1
dQ

The typical TC, AC, and MC curves that are based on a linear cost function
are shown in Figure 10.1. These cost functions have the following properties:
TC is a linear function, where AC declines initially and then becomes quite flat
approaching the value of MC as output increases and MC is constant at b1.
b) Quadratic cost function
TC = a2 + b2Q + c2Q 2

AC = (TC/Q) = (a2/Q) + b2 + c2Q

d(TC)
MC = ——— = b2 + 2c2Q
dQ 13
Production
Theand
typicalTC, AC, and MC curves that are based on a quadratic cost Estimation of Production
Cost Analysis and Cost Functions
function are shown in Figure 10.2. These cost functions have the following
properties: TC increases at an increasing rate; MC is a linearly increasing
function of output; and AC is a U shaped curve.
c) Cubic cost function
TC = a3 + b3Q + c 3Q 2 +d3Q3

AC = (TC/Q) = (a3/Q) + b3 + c3Q + d3Q2

d(TC)
MC = ——— = b3 + 2c3Q + 3d3Q2
dQ
The typical TC, AC, and MC curves that are based on a cubic cost function
are shown in Figure 10.3. These cost functions have the following properties:
TC first increases at a decreasing rate up to output rate Q1 in the Figure 10.3
and then increases at an increasing rate; and both AC and MC cost functions
are U shaped functions.
The linear total cost function would give a constant marginal cost and a
monotonically falling average cost curve. The quadratic function could yield a
U-shaped average cost curve but it would imply a monotonically rising marginal
cost curve. The cubic cost function is consistent both with a U-shaped
average cost curve and a U-shaped marginal cost curve. Thus, to check the
validity of the theoretical cost-output relationship, one should hypothesize a cubic
cost function.

Figure 10.1: Cost Curves Based on Linear Cost Function

TC = a1 + b1Q
TC

Output (Q)
Cost per Unit of Output

AC

MC

14 OOutput (Q)
 Figure 10.2: Cost Curves Based on Quadratic Cost Function

TC
TC = a2 + b2Q + c2Q2

Output (Q)

MC = b2 + 2c2Q
Cost per Unit of Output

AC = (a2/Q) + b2 + c2Q

b2

An example of using estimated cost function:

Using (Q)
Output the output-cost data of a chemical firm, the following total cost function
was estimated using quadratic function:
TC = 1016 – 3.36Q + 0.021Q2
a) Determine average and marginal cost functions.
b) Determine the output rate that will minimize average cost and the per unit
cost at that rate of output.
c) The firm proposed a new plant to produce nitrogen. The current market
price of this fertilizer is Rs 5.50 per unit of output and is expected to remain
at that level for the foreseeable future. Should the plant be built?
i) The average cost function is
AC = (TC/Q) = (a2/Q) + b2 + c2Q = (1016/Q) – 3.36 + 0.021Q
and the marginal cost function is 15
Production and Figure 10.3: Cost Curves Based on Cubic Cost Function Estimation of Production
Cost Analysis and Cost Functions

TC = a3 + b3Q + c3Q2
TC

Output (Q)
Cost per Unit of Output

MC = b3 + 2c3Q + 3d3Q2

AC = (a3/Q) + b3 + c3Q + d3Q2

Output (Q)

d(TC)
MC = ——— = b2 + 2c2Q = –3.36 + 2(0.021)Q = –3.36 + 0.042Q
dQ
ii) The output rate that results in minimum per unit cost is found by taking
the first derivative of the average cost function, setting it equal to zero,
and solving for Q.
d(AC) a2 1016
——— = —— + c2 = – ——— + 0.021 = 0
dQ Q2 Q2

1016
——— = 0.021; 0.021Q2 = 1016; Q2 = 48381; Q = 220
Q2
16
 To find the cost at this rate of output, substitute 220 for Q in AC equation
and solve it.

AC = (1016/Q) – 3.36 + 0.021Q = (1016/220) – 3.36 + (0.021 * 220)

Rs. 5.88 per unit of output.

iii) Because the lowest possible cost is Rs. 5.88 per unit, which is Rs. 0.38
above the market price (Rs. 5.50), the plant should not be constructed.

Short Run and Long Run Cost Function Estimation

The same sorts of regression techniques can be used to estimate short run cost
functions and long run cost functions. However, it is very difficult to find
cases where the scale of a firm has changed but technology and other relevant
factors have remained constant. Thus, it is hard to use time series data to
estimate long run cost functions. Generally, regression analysis based on cross
section data has been used instead. Specially, a sample of firms of various
sizes is chosen, and a firm's TC is regressed on its output, as well as other
independent variables, such as regional differences in wage rates or other input
prices.

Figure 10.4: Typical Long Run Average Cost Curve

Long run average cost curve

AC

Output (Q)

Many studies of long run cost functions that have been carried out found that
there are very significant economies of scale at low output levels, but that
these economies of scale tend to diminish as output increases, and that the long
run average cost function eventually becomes close to horizontal axis at high
output levels. Therefore, in contrast to the U-shaped curve in Figure 9.4
shown in Unit 9, which is often postulated in micro economic theory, the long
run average cost curve tends to be L-shaped, as shown in Figure 10.4.

Problems in Estimation of Cost Function

We confront certain problems while attempting to derive empirical cost
functions from economic data. Some of these problems are briefly discussed
below.
17
Production andcollecting
1. In cost and output data we must be certain that they are Estimation of Production
Cost Analysis and Cost Functions
properly paired. That is, the cost data applicable to the corresponding data
on output.
2. We must also try to obtain data on cost and output during a time period
when the output has been produced at relatively even rate. If for
example, a month is chosen as the relevant time period over which the
variables are measured, it would not be desirable to have wide weekly
fluctuations in the rate of output. The monthly data in such a case
would represent an average output rate that could disguise the true cost-
output relationship. Not only should the output rate be uniform, but it
also should be a rate to which the firm is fully adjusted. Furthermore,
there should be no disruptions in the output due to external factors such
as power failures, delays in receiving necessary supplies, etc. To
generate the data necessary for a meaningful statistical analysis, the
observations must include a wide range of rates of output. Observing
cost-output data for the last 24 months, when the rate of output was the
same each month, would provide little information concerning the
appropriate cost function.
3. The cost data is normally collected and recorded by accountants for their
own purposes and in a manner that it makes the information less than
perfect from the perspective of economic analysis. While collecting
historical data on cost, care must be taken to ensure that all explicit as
well as implicit costs have been properly taken into account, and that all
the costs are properly identified by time period in which they were
incurred.
4. For situations in which more than one product is being produced with given
productive factors, it may not be possible to separate costs according to
output in a meaningful way. One simple approach of allocating costs
among various products is based on the relative proportion of each product
in the total output. However, this may not always accurately reflect the
cost appropriate to each output.
5. Since prices change over time, any money value cost would therefore relate
partly to output changes and partly to price changes. In order to estimate
the cost-output relationship, the impact of price change on cost needs to be
eliminated by deflating the cost data by price indices. Wages and equipment
price indices are readily available and frequently used to ‘deflate’ the money
cost.
6. Finally, there is a problem of choosing the functional form of equation or
curve that would fit the data best. The usefulness of any cost function for
practical application depends, to a large extent, on appropriateness of the
functional form chosen. There are three functional forms of cost functions,
which are popular, viz., linear, quadratic and cubic. The choice of a
particular function depends upon the correspondence of the economic
properties of the data to the mathematical properties of the alternative
hypotheses of total cost function.

The accounting and engineering methods are more appropriate than the
econometric method for estimating the cost function at the firm level, while the
econometric method is more suitable for estimating the cost function at the
industry or national level. There has been a growing application of the
econometric method at the macro level and there are good prospects for its use
even at the micro level. However, it must be understood that the three
approaches discussed above are not competitive, but are rather complementary
to each other. They supplement each other. The choice of a method therefore
depends upon the purpose of study, time and expense considerations.

18
10.7 EMPIRICAL ESTIMATES OF COST FUNCTION
A number of studies using time series and cross-section data have been
conducted to estimate short run and long run cost behaviour of various
industries. Table 10.3 lists a number of well-known studies estimating short run
average and marginal cost curves. These and many other studies point one
conclusion: in the short run a linear total variable cost function with constant
marginal cost is the relationship that appears to describe best the actual cost
conditions over the “normal” range of production. U-shaped average cost
(AC) and marginal cost (MC) curves have been found, but are less prevalent
than one might expect.

Table 10.3: Numer of well-known studies estimating short run average and marginal
cost curves

Name Type of Industry Findings

Dean (1936) Furniture Constant MC which failed to
rise
Dean (1941) Leather belts No significant increases in
MC
Dean (1941) Hosiery Constant MC which failed to
rise
Dean (1942) Department store Declining or constant MC,
depending on the department
within the store
Ezekiel and Wylie Steel Declining MC but large
(1941) variation
Hall and Hitch (1939) Manufacturing Majority have decreasing MC
Johnston (1960) Electricity, multi “Direct” cost is a linear
product function food function of output, and MC is
processing constant
Johnston (1960) Electricity Average total cost falls, then
flattens, tending toward
constant MC up to capacity
Mansfield and Wein Railways Constant MC
(1958)
Yntema (1940) Steel Constant MC

Source: A.A. Walters, “Production and Cost Functions: An Econometric

Survey”, Econometrica, January-February 1963, PP.49-54

Table 10.4 lists a number of well known, long run average cost studies. In
some industries, such as light manufacturing (of baking products), economies of
size are relatively unimportant and diseconomies set in rather quickly, implying
that a small plant has cost advantages over a large plant. In other industries,
such as meat packing or the production of household appliances, the long run
average cost curve is found to be flat over an extended range of output, there
by indicating that a variety of different plant sizes are all more or less equally
efficient. In some other industries such as electricity or metal (aluminum and
steel) production, substantial economies of size are found, thereby implying that
a large plant is most efficient. Rarely are substantial diseconomies of size
found in empirical studies, perhaps because of firms recognising that production
beyond a certain range leads to sharply rising costs. Therefore, they avoid
such situations if all possible by building additional plants.
19
Production and Table 10.4: Number of well known, long run average cost studies Estimation of Production
Cost Analysis and Cost Functions

Name Type of Industry Findings

Alpert (1959) Metal Economies of scale up to
some level of output per
month; constant returns to
scale and horizontal LRAC
thereafter
Bain (1956) Manufacturing Small economies of scale for
multi-plant firms
Gribbin (1953) Gas (Great Britain) LRAC of production declines
as output rises
Holton (1956) Retailing LRAC L-shaped
Johnston (1960) Life Assurance LRAC declines
Johnston (1960) Road passenger transport LRAC either falling or
(Great Britain) constant
Johnston (1960) Electricity (Great Britain) LRAC of production declines
as output rises
Lomax (1951) Gas (Great Britain) LRAC of production declines
as output rises
Lomax (1952) Electricity (Great Britain) LRAC of production declines
as output rises
Moore (1959) Manufacturing Economies of scale prevail
quite generally
Nerlove (1961) Electricity (U.S.) LRAC (excluding transmission
costs) declines and then shows
signs of increasing
Gupta (1968)* Manufacturing (India) L-shaped in 18 industries,
U-shaped in 5 industries, and
linear in 6 industries

Source: A.A. Walters, “Production and Cost Functions: An Econometric

Survey”, Econometrica, January-February 1963, PP.49-54.

* Vinod K Gupta, “Cost Functions, Concentration, and Barriers to Entry

in Twenty-nine Manufacturing Industries of India”, Journal of Industrial
Economics, November 1, 1968, 59-60.
Activity 3

1. Pradeep Company’s total variable function is as follows:

TVC = 50Q – 10Q2 + Q3
Where Q is the number of units of output produced.
a) What is the output level where marginal cost is a minimum?
b) What is the output level where average variable cost is a minimum?
c) What is the value of average variable cost and marginal cost at the
output specified in the answer to part (b)?
.................................................................................................................
.................................................................................................................
.................................................................................................................
.................................................................................................................
20
2. How would you reconcile the findings of Yntena with those of Ezekiel and Wylie?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
3. How would you explain the findings of Johnston (Electricity) in short run
and long run?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
4. Production is related to costs. In fact, cost function can be derived from
estimated production function. In view of empirical determination of
production function, can you think of some limitations of statistical analysis
relating to cost function?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
5. Despite the above limitations listed by you, an estimated cost function is
useful to a manager. Can you think of some points to support this
contention?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
6. Some empirical studies have suggested that the marginal cost function is
approximately horizontal, but conventional cost theory suggests that the
marginal cost curve is U-shaped. Provide an explanation for this apparent
inconsistency.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
7. The ABC Manufacturing Company’s short-run average cost function in the
year 2000 is AC = 3 +4Q
Where AC is the firm’s average cost (in Rs. per unit of the product), and
Q is the output rate.
a) Obtain the firm's short-run total cost function.
b) Does the firm have any fixed costs? Explain.
c) If the price of the firm’s product is Rs. 3 per unit, is the firm making
profits or losses? Explain.
d) Derive the firm's marginal cost function.
................................................................................................................
................................................................................................................
................................................................................................................
................................................................................................................ 21
Production and Estimation of Production
10.8 MANAGERIAL USES OF COST FUNCTION
Cost Analysis and Cost Functions

In Unit 9 we have already discussed some of the uses and applications of cost
analysis in the production process of managerial decision-making. The estimated
cost function can help managers to take meaningful decisions with regard to:
1. determination of optimum plant size,
2. determination of optimum output for a given plant, and
3. determination of a firm’s supply curve.

The optimum plant size, as discussed earlier, is defined in terms of minimum

costs per unit of output. In other words, an optimum plant is given by that
value of K (plant size) for which the average cost is minimum. If the long run
total cost curve is a cubic function, the resultant long run average cost curve
will be a conventional U-shaped curve. The plant level at which the long run
average cost is minimum will be of optimum size.

For a given plant, the optimum output level will be achieved at a point where
the average cost is the least. This condition can be easily verified from the
short run total cost function.

The level of output that a firm would like to supply to the market will depend
on the price that can charge for its product. In other words, a firm’s supply is
a positive function of the product price. To get the firm’s supply schedule, one
needs to know the firm's cost function and its objectives.
Activity 4

1. Can you list some more managerial uses of cost function other than given in
section 10.9?
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................

10.9 SUMMARY
Decision-making often requires a quantitative estimate of the parameters of
production function. With quantitative estimates of the parameters of a
production function on hand we can determine the marginal product of each
input and economies of scale. Although, there are many different forms of
production function we have discussed here only Cobb-Douglas production
function. For this function the returns to scale are constant, increasing, or
decreasing depending on whether the sum of the estimated parameters is equal
to one (=1), greater than one (>1), or less than one (<1), respectively.

We have also discussed three forms of cost functions viz. linear cost function,
quadratic cost function, and cubic cost function and their empirical estimates.
Though, empirical estimates of both production functions and cost functions
have a lot of use for managerial decision making there are conceptual and
statistical problems in estimating such functions. But we understand that it will
be sufficient for the manager if he knows how to interpret the estimates
based on empirical research in his/her decision making process.

22
10.10 SELF-ASSESSMENT QUESTIONS
1. Discuss the managerial uses of production function?
2. What care should be taken while collecting the data for estimation of a
production function?
3. Explain the determinants of cost function?
4. Explain the econometric method of estimating cost function? Why is this
method is more popular than the other two methods (accounting and
engineering) estimation costs?
5. What are the common problems you encounter while attempting to derive
empirical cost functions from economic data?
6. The total cost function for a manufacturing firm is estimated as
C = 128 +6Q +2Q2
Determine the optimum level of output Q to be produced?
7. Suppose that for a XYZ corporation’s total cost function is as follows
TC = 300 + 3Q + 0.02Q2
Where TC is the total cost, Q is the output.
a) What is the corresponding fixed cost function, average fixed cost
function, and variable cost function, average variable cost function?
b) Calculate the average total cost function and marginal cost function.
8. Based on a consulting economist’s report, the total and marginal cost
functions for an ABC company are
TC = 200 + 5Q – 0.04Q2 + 0.001Q3
MC = 5 – 0.08Q + 0.003Q2
The president of the company decides that knowing only these equations is
inadequate for decision making. You have been directed to do the following.
a) Determine the level of fixed cost (if any) and equations for average total
cost, average variable cost, and average fixed cost.
b) Determine the rate of output that results in minimum average variable cost.
c) If fixed costs increase to Rs. 500, what output rate will result in
minimum average variable cost?
9. Given the total cost function for Laxmi Enterprices Co.
TC = 100Q – 3 Q2 + 0.1Q3
a) Determine the average cost function and the rate of output that will
minimize average cost.
b) Determine the marginal cost function and the rate of output that will
minimize marginal cost.

10.11 FURTHER READINGS

1. Craig Peterson and W. Cris Lewis, (1994). Managerial Economics
(Chapter 6 and 7), Macmillian Publishing Company, USA.
2. Maddala, G.S., and Ellen Miller, (1989). Micro Economics: Theory and
Applications (Chapter 6 and 7), McGraw-Hill, New York.
3. Mote, V.L., Samuel Paul, and G.S. Gupta, (1977). Managerial Economics:
Concepts and Cases (Chapter 3), Tata McGraw-Hill, New Delhi.
4. Ravindra H. Dholakia and Ajay N. Oza, (1996). Micro Economics for
Management Students (Chapter 8 and 9), Oxford University Press, Delhi.
23