PRODUCTION

FUNCTION
 PRODUCTION FUNCTION
Production is a transformation of physical
inputs into physical output. The out put is
thus a function of inputs.

The production function is a technological

relationship between the inputs, called the
factors of production and the outputs.
Economy’s factors of the production are the
quality of land (LD), Labour (L), capital (K),
and entrepreneurship (E), that the economy
possesses and uses in the production.

Besides these, technology (T) effects the

production. Since Land – Natural resource is fixed,
it ceases to be factor in explaining the changes in
output. Thus the economy’s production function
may expressed as follows:
 Y= f ( L, K. T)
or
Y = f [x1, x2,x3,……….Xn; T]
Y=Real GDP/ Quantity of production
Where f= functional Relationship
x1, x2,x3,……….Xn indicates the quantity used as factors.
T = at given Technology.
No prudent economy would
employ an extra unit of any
input, unless its output
increase.

Here also Low of diminishing

retune will apply, not only to
the production of goods but
also to the goods and
services.
 Production Function

Q= f (L , L, K, M, T)
Q= output in physical units of good x
∞
Ld = Land units employed in the production of Q
L = Labour units employed in the production of Q
K = Capital units employed in the production of Q
M= Managerial units employed in the production of Q
T = Technology employed in the production of Q
f = Unspecified function
Fi = Peripheral derivatives of Q with respect to ith
function.
It should be noted that above function gives
the maximum possible output that can be
produced from given amount of various
outputs OR alternatively the minimum
quantity of inputs necessary to produce
given level of output.

This is a general production function. A

special production function may not have all
these input or may have some inputs in
disaggregated terms.
Production function can be expressed and
analyzed through TABLE, GRAPH &
EQUATION.
This means the Marginal Physical Production
(MPP) of Each factor declines as more and
more of that is used in production, the
other factors remains constant.
Figure shows the output as a function of the labour,
Keeping other factor constant. Such can be drown
for other factors Also Up to point A slop Convex
then Between A-B concave and
after B downward Out
sloping curve . put
This is because MPP of variable (Y) B
first rises, then falls, hits zero, A

and turns negative thereafter

o
Labour
 Assumptions:
1. P F like demand function must be
considered with reference to a particular
period of time
2. P F of a firm is determined by6 the state
of technology.
3. Firm uses the best and efficient methods.
4. Factors are divisible into viable units.

Production Function can be represented by the

Tables, Mathes equations, Simple total average
and Marginal Production curves. It can also be
represented by input - output tables.
 COST CURVES:
In production process, There are three types of
cost considered:
1. Total Cost Curves: This represents the total cost of
production. It is divided into Total Fixed Cost (TFC) and Total
Variable cost (TVC)
2. Average Cost: TC/ Total no. of units produce. It is a cost
per unit of commodity Produced. It is divided into Average
Fixed Cost (AFC) and Average Variable Cost (AVC).
3. Marginal Cost: Marginal cost is the additional
made to the total cost as a result of producing an
extra unit of output.
NO. of Total Average Cost Marginal cost
units Cost (AC) (MC)
‘(TC)
1 10 10.00 10
2 20 10.00 10
3 25 8.34 5
4 28 7.04 3
5 30 6.04 2
6 52 8.06 22
7 85 12.14 33
8 110 13.74 55
9 220 24-44 110
10 400 40.00 180
Total cost rising but at a diminishing rate. TC is rising
upwards from left to right
Y Y MC

TC

AC
Total cost

AC & MC
0 z 0
Units of Output z
Units of Output

T C = Total Cost Ac = TC/Q; AC is sum of AFC+ AVC

MC= TC/ TQ

AC curve is “U” shaped ,

MC curve is “U” shaped
MC curve insects the AC curve at the lowest point of AC
curve
 Break Even Analysis
It is very useful technique of profit planning and control
Profit maximization, main objective of any firm/co. Profit
can not be lest to chance or luck. Proper technique is
very important for profit earning. Two main techniques
for profit planning and control
(a) The Break- Even Analysis
(b) The Ratio Analysis
Break Even analysis revels the relationship between the
volume of cost of production on one hand and revenue &
Profit obtain from Sales on other.
Break Even analysis indicates at what level cost & revenue
are in equilibrium. Here BE Point is very Important.
 Break Even Point:-
At the Break Even point TR =Total
expenses: It is point of zero profit. At
this point firms TC=TR. Produces less
to this firm would incurs losses: If it
produces & sales more than BE Point it
makes profit.
The figure shows effects of changes in
output on COST, RVENUE, & PROFIT.
TC & TR curves --- Linear
 Y TR

T
FI
R O TC
BEP
Cost Revenue, Price (Rs)

P
E T
N
Variable cost

FC
L
o
s
Fixed Cost
s

0 Q X

Units of output

The figure shows effects of changes in

output on COST, RVENUE, & PROFIT.
 Use of B E Chart for
following:

1. Break even production Volume

2. Profit Appropriation for given level
of output
3. Choice of optimum level of output
4. Impact of the rate of Change in
sales on costs and profits.
Consumer
Behavior
 Price Concept:
• Price denotes the exchange value of
unit of a good Expressed in terms of
money.
• No unique price for any good – there
are multiple price.
– Price of what?
– Price of whom?
– Price Where?
– Price When?
• Price of well defined Product varies
over the types of buyer.
• Price of good or service also depends
up on the place it is received, for
that, there is a transport cost
• Price while purchasing on credit
• Price on down payment transaction.
 Price of Determinants
• Price of product = Demand and supply of that
product.

• Three Situation:
(a) Change in demand, Supply constant
(b) Change in supply, demand Constant
(c) Change in Demand and supply – Uni
Directional
(d) Change in Demand and supply – Opposite
Direction
 Price Discrimination
• Three broad forms- referred as degree.

(1) First Degree Price Discrimination:

Different prices to each of its customers firm

would charge each consumer the maximum rice
that customer willingly to pay. This maximum
price called as customer’s RESERVATION PRICE.
This is called first degree price discrimination.
First profit maximizing output at the point at
which Marginal Revenue = Marginal Cost.
(2) Second Degree Price Discrimination
Practice of charging different prices per unit for
different quantities of the same good or services
i.e. quantity discounts are an examples of second
degree price discrimination.

(3) Third Degree Price Discrimination

Practice of dividing consumers into two or more
groups with separate demand curves and charging
different prices to each group.
- Student Groups – Less price or discounts
- Senior citizen – Less price or discount
- Normal Group – Market price only.
 Consumer Behaviour
• How can a consumer with a limited income, decide which
goods and services to buy?
• Consumer behavior is best understood in three distinct
step:
(1) Consumer Preferences: to fins way to describe the
reason people might prefer one good to another. We will
study that.
(2) Budget constraint: Limited income- as such prices of
goods and services – Restriction in buying goods.
(3) Consumer choices: Given their preferences and limited
income consumer choose to buy combination of goods
that maximize their satisfaction
These three steps of basics of consumer theory. When
number of goods and services are available, consumer will
see its ability and prices.
 Some basic assumption about
preferences:
• Three basic assumptions about
people’s preferences:
(1) Completeness: Consumer compares the basket and
select the compete basket or both basket are OK, he will
remain indifferent by ignoring cost.

(2) Transitivity: preferences are transitive – means that if

consumer preference basket A to B and B to C Basket then
consumer also prefers A to C
(3) More is better than less: Goods are assumed to be
desirable – be good so, consumer always prefer more of
any good to less. More is always better even if just a litter
better. Some good like air pollution, may be undesirable,
and consumer will always prefer less.
 Pricing
Methods:

Demand Strategy
Come. Based
Cost Based
Based
Based

Dual
Cost Going Sealed Pricing Price Price
Full Marginal
Plus Rate Rate Price PenetrationSkimming
Cost Cost
Discrimination
 Govt. Intervention and Pricing.

Government
Intervention

Direct Indirect

Price of
Price Pegging taxes Subsidies
Floors/ Ceiling.

Partial /
All Out put Sales Profile Real Estate
Dual Pricing

Specific Ad - Val Orem

 Change in demand, supply Constant.
A = increase in D
B = increase in D

s1
S1
P1

P1

P2 P2
D1
D1

D2 D2

O Q2 Q1 O Q2
Q1

Change in supply , demand Constant.

S2
S1

S1
S2
P2
P1

P2 P1
D1 D1

Q1 Q2 Q2 Q1
A= increase in supply B= decrease in supply
Change in demand & supply: unidirectional S4
B = decrease in both
A= Increase in both S3
S2
s1
S1
P4
S2 P1
P4
D1
P2
P1
D4
P2 D2
D D2 D3
1

0 Q Q Q 0 Q4 Q3 Q2 Q1
Q1

Change in demand & supply: Opposite

2 3 4

directional
S
4 S
3 S1
S
P4 2
S2
P1
P3

P2 S
1 P2 D1
P3
D
2 D2
P1
P4 D
3
D4
D
1 Q Q Q
0 Q Q Q 0
3 1 2 4 1 2

A= Increase in D Decrease in S B= Increase in S Decrease in D

 Cost Concepts
1. ECONOMIC COST
2. EXPLICIT AND IMPLICIT COSTS
3. OPPORTUNITY COST
4. NORMAL PROFIT
5. HISTORICAL & REPLACEMENT COST
6. INCREMENTAL & SUNK COSTS
7. FIXED AND VARIABLE COSTS
8. SEPARABLE &COMMOM COSTS
9. PRIVATE & SOCIAL COSTS
10. TOTAL, AVERAGE & MARGINAL
11. LONG RUN & SHORT RUN
1 Economic Cost : The economic cost that a firm
incurs in the production of a good refer to the
payments it must make to all resource ( factors of
production) employed by it in the production of good.
2 Explicit & implicit cost: Explicit cost stands for the
payment that must be made to the hired factors hired
from outside the control of the firm. Implicit costs is a
non cash cost, refers to the payment made to the self
owned resources used in the production.
3 Opportunity Cost : -- Opportunity cost is a loss of the
reward in the next best use of that source. It should
be noted that the ‘reward’ includes both monetary as
well as non monetary and the true opportunity cost of
a factor may not be exactly known but may be possible
to impute.
4 Normal profit : Normal profit is a economic jargon.
The normal profit is a component implicit cost.
5 Historical & Replacement Cost :- The cost incurred
at the time the asset was acquired. While replacement
Stands for the cost which must be incurred if the asset
is to be purchased today. The two concept differs due to
price variations over time.
6 Incremental and Sunk cost : - Incremental costs are
the costs which vary with the decision . In contrast ,
Sunk costs are the costs which are in varience with the
decision. The cost of the time of faculty, administrator,
clerk cum peon, and the amount spent on electricity
bill, chalk, .etc. will be the incremental costs and the
cost of the class room and black board would be the
sunk cost
7 Fixed and Variable costs : - In the short run, some
cost which do not vary as output varies, while there
are which move up and down as output increases and
decreases. The former are called the fixed costs and the
later the variable costs.
8 Separable and Common costs :-- Costs are also
classified on the basis of their traceability. The costs
which can be attributed to a product, a department, or
a process are the separable costs, and the rest are non
separable or common costs.
9. Private and Social Costs : -- Private costs refer to the
costs incurred by an individual firm while Social costs
stands for the costs incurred by the society as a whole. The
former is the sum total of explicit and implicit costs that a
firm incurs in the production of a good.
10. Total, Average & Marginal costs : - Total cost (TC) is
the sum of total of explicit and implicit costs. The average
cost concept is of relevance for estimating profit margin per
unit of sales Total costs concepts is useful for breakeven
and profit analysis. The average cost concept is of
relevance for estimating profit margin per unit. The
marginal cost concept is of significance in deciding the
optimum level of output.
11. Long Run & Short Run Costs :-- Long and short run
costs are related to long and short production functions.
The former refers to costs when all factors of production
are subject to change, while the latter stands for costs
when at least one of the factors of production is fixed. In
the long run all costs are variable costs while in the short
run, some costs are fixed and some are variable.
 COST FUNCTION
Cost incurs by Firm for production of goods & services
depends on two things:
(a) Firm’s Production Function
(b) Market’s Input’s Supply Functions

Cost Function: C = f (Q, E1, P1,) f1,f3>0>f2

Where:
C= Total (production) cost
Q= Total output
E1 = Efficiencies of inputs
P1 = Prices of input

An increase in price and other things remains same – would

lead to an increase in the cost of production.