Cost theory analysis

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Production and Cost Theory

Prepared byMd. Nasful Huda Prince

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Objectives of this presentation

To study about Production theory

To study about production efficiency

To study about Cost theory

To relate the cost with production To study to achieve maximum profit for an

organization To study to take decision which will result

maximum financial benefit for the organization

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Outline of Presentation

1. Production

2. Short-run Production and Cost

3. Long-run Production and Cost

4. Cost Estimation Technique

5. Conclusion

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1. Production

Definition

Input OutputValue added

Transformation

Production processes increase the ability of inputs (or resources) to satisfy wants by:

a. Change in physical characteristicsb. Change in locationc. Change in timed. Change in ownership

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1.1. Production

Production Function

Q = f (L,K,Technology,………….)

Cobb-Douglas production function

Q = .

Where, Q represents output,

K represents Capital

and L represents Labor

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1.2. Time and Production

Generally, four time periods are used in the analysis of production, they are:

Market Period Short-run Long-run The very Long-run

Most of the economists consider either Long-run or short-run.

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2. Short-run Production and Cost2.1. Production in the Short-run

Production function can be represented as

Q = f(L,K)

Here, Bar sign upon K indicates that K is fixed.

So the Production function can be represented as

Q = f(L)

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2.1. Production in the Short-run

Common Terminology: Total Product: Sum of total output (Q). Average Product: AP = = Marginal Product:

MP = = Technical Efficiency:

TE = Economic Efficiency:

EE=

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2.1. Production in the Short-run

Fig 1a: Graphical Representation of Total Product

Fig 1b: Graphical Representation of Average and Marginal Product

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2.2. Sort-run Cost

Some common Terms about cost: Opportunity Cost Implicit and Explicit Cost Total Cost (TC) Total Fixed Cost (TFC) Total Variable Cost (TVC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Marginal Cost (MC) Average Total Cost (ATC) Total Revenue (TR) Marginal Revenue (MR)

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2.2. Short-run Cost

Fig 2a: Graphical Representation of Total Cost Curve

Fig 2b: Graphical Representation of AFC, AVC, AC and MC

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2.2. Short-run Cost

Calculation of various cost figure (assuming data)

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3. Long-run Production and Cost

Long-run Production function can be represented as

Q = f(L,K)

Where, both the inputs are variable but technology is

same.

Cobb-Douglas production function can also be used to explain this Production Function.

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3.1. Isoquant

Fig 3: Graphical Representation of Isoquant

The characteristic of Isoquant is that, it is downward sloping.

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3.1. Isoquant

Fig 4a: Isoquant when inputs are perfect substitutes

Fig 4b: Isoquant when inputs are perfect complements

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3.2. Marginal Rate of Technical Substitution (MRTS)

MRTS can be defined using following equation

MRTS = - .

It is possible to relate MRTS with Marginal Product by using following equation

MRTS = - .=

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3.3. Isocost Curve

Fig 5: Graphical Representation of Isocost

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3.3. Isocost Curve

Fig 6: Shift of Isocost Curve

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3.4. Output Maximization

Fig 7: Ouput Maximization for a given level of Cost

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3.5. Expansion Path

Fig 8: Graphical representation of Expansion Path

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3.6. Returns to Scale

Consider a production function as following form

Q = f (L,K)

Now if the input will change the variation of out can be represented as

zQ = f (cL,cK)

Here, c & z are the proportionate change of input and output

Now, If z>c, Increasing Returns to Scale

If z<c, Decreasing Returns to Scale

If z=c, Constant Returns to Scale

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3.7. Economies of Scope (SC)

If Joint production cost of two product is C(X,Y) and C(X) & C(Y) are the individual production cost of product X & Y the economies of scope will exist if

C(X,Y) < C(X) + C(Y)

The Degree to which SC exist is

SC= .

Diseconomies of scope will exist if

C(X,Y) > C(X) + C(Y)

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3.8. Long-run Average and Marginal Cost Curve

Fig 9a: Long-run Average and Marginal Cost Curve

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3.9. Long-run Average and Marginal Cost Curve

Fig 9b: Long-run Average Cost as the Planning Horizon

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4. Cost Estimation Technique

If we consider a Total Cost Function as following

TC = .

Average Total Cost can be calculated in this way

ATC = .

Marginal Cost can be calculated in this way

MC = .

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5. Conclusion

Analysis of production and cost is very important for an organization.

A good manager will concentrate on technical and economic efficiency.

Study of production and cost will help a manager to take decision for maximizing organization profit.

At last it can be concluded in this way that, study and improvement of our knowledge about discussed topics help us to fulfill our presentation objectives.

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THANK YOU ALL