Production analysis basically is concerned with the analysis in which the resources such as land, labor, and capital are employed to produce a firm’s final product. To produce these goods the basic inputs are classified into two divisions −
Inputs those change or are variable in the short run or long run are variable inputs.
Inputs that remain constant in the short term are fixed inputs.
Cost function is defined as the relationship between the cost of the product and the output. Following is the formula for the same −
C = F [Q]
Cost function is divided into namely two types −
Short Run Cost
Short run cost is an analysis in which few factors are constant which won’t change during the period of analysis. The output can be changed ie., increased or decreased in the short run by changing the variable factors.
Following are the basic three types of short run cost −
Long Run Cost
Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of production is as low as possible.
Long run cost = Long run variable cost
In the long run, firms don’t have the liberty to reach equilibrium between supply and demand by altering the levels of production. They can only expand or reduce the production capacity as per the profits. In the long run, a firm can choose any amount of fixed costs it wants to make short run decisions.
Law of Variable Proportions
The law of variable proportions has following three different phases −
- Returns to a Factor
- Returns to a Scale
Returns to a Factor
Increasing Returns to a Factor
Increasing returns to a factor refers to the situation in which total output tends to increase at an increasing rate when more of variable factor is mixed with the fixed factor of production. In such a case, marginal product of the variable factor must be increasing. Inversely, marginal price of production must be diminishing.
Constant Returns to a Factor
Constant returns to a factor refers to the stage when increasing the application of the variable factor does not result in increasing the marginal product of the factor – rather, marginal product of the factor tends to stabilize. Accordingly, total output increases only at a constant rate.
Diminishing Returns to a Factor
Diminishing returns to a factor refers to a situation in which the total output tends to increase at a diminishing rate when more of the variable factor is combined with the fixed factor of production. In such a situation, marginal product of the variable must be diminishing. Inversely the marginal cost of production must be increasing.
Returns to a Scale
If all inputs are changed simultaneously or proportionately, then the concept of returns to scale has to be used to understand the behavior of output. The behavior of output is studied when all the factors of production are changed in the same direction and proportion. Returns to scale are classified as follows −
- Increasing returns to scale− If output increases more than proportionate to the increase in all inputs.
- Constant returns to scale− If all inputs are increased by some proportion, output will also increase by the same proportion.
- Decreasing returns to scale− If increase in output is less than proportionate to the increase in all inputs.
For example − If all factors of production are doubled and output increases by more than two times, then the situation is of increasing returns to scale. On the other hand, if output does not double even after a 100 per cent increase in input factors, we have diminishing returns to scale.
The general production function is Q = F (L, K)