Relationship between production and cost in economics

relationship between production and cost in economics

production relationships and prices of the inputs determine the cost functions and the answers to engage in production of economic goods. In some cases the. On the supply side of the product market are the economic (or business) firms. Note: Studying the relationship between costs and inputs without regard to the. Total, Average, and Marginal Cost Calculations. Once we know a firm's production behavior, and we know what each factor of production costs, we can derive.

Different interpretations are, however, required for crosssection and time series studies. To estimate the parameters, restrictions must be imposed on the joint distribution function of u0u1, and u2.

If there is no correlation between u0 and u1 and between u0 and u2 then a simple extension of the usual method of least squares will provide suitable estimates, but the empirical evidence suggests that there are in fact significant correlations between technical and economic efficiency Walters An alternative way of analyzing the production process is to estimate the cost function, which describes cost as determined by the level of output and the prices of inputs when the firm uses the most efficient technique.

Most empirical studies of cost have been concerned with measuring the variation of C and X, and not with estimating the effect of factor prices on C. It is clear, however, that if factor prices do change, there is an opportunity to measure the coefficients of the production function by regressing cost on factor prices and output Nerlove Cost functions, although apparently more useful than production functions because of the availability of accounting data, are often more intractable, owing to the difficulties of defining and measuring cost.

The cost function reflects not only the technological conditions of production but also competitive conditions in factor markets. If, for example, the business is faced with a rising supply curve of labor, the parameters of that supply curve will enter as determinants of the cost function. In addition, one does not escape the simultaneous equations difficulty referred to above.

The production function or cost function of the firm can be measured by observing the firm as it reacts to different stimuli— such as changes in relative factor and output prices. A time series of observations will produce variations in output, inputs, and cost from which production and cost functions can be traced. These observations will usually generate the short-run production and cost relationships—very short-run for monthly observations—and what may be called an intermediate-run production function for annual observations.

The main difficulty with this type of study is that it samples a dynamic adjustment process—a mixture of factor price movements, technological change, and exogenous shocks. One cannot be sure that one has identified the static production function or cost function. Most time series studies of firms have been cast in the form of cost functions. Accounting data are adjusted for changes in factor prices.

The difficulties with accounting data are that a the unit period the financial year is longer than the short period of economic theory, and b the valuation of stocks, capital, and depreciation is usually conventional and based on the requirements of tax law. Studies vary according to their success in dealing with these problems. The general result is, however, reasonably clear: There is no striking evidence of sharply rising marginal cost.

Close scrutiny of these results reveals that some can be explained by the fact that output levels were cyclically low relative to the size of the plant. There does remain, however, evidence of excess capacity in certain industries. To avoid the problems of technological and other changes over time, researchers frequently use observations on a number of firms for a particular year—a cross-section sample.

relationship between production and cost in economics

Variations in inputs and outputs from one firm to another provide the raw material for crosssection estimates. Differences in the sizes of firms are so large and have normally persisted for so long that the cross-section results are usually interpreted as long-run relationships.

Production and Cost Analysis |

The main difficulty with cross-section analysis, however, is that in a competitive market there is no separate and quantitatively different stimulus for each firm. The success of cross-section studies of households in measuring Engel curves is due to the fact that each household has a different income, which generates different expenditure patterns.

But this is not the case with businesses in a competitive industry. Any observed differences in factor inputs are caused by differences in production functions or accidentsand the observations do not identify a particular production function. Similarly, the cost function in a perfectly competitive cross section shows that average costs, as measured by price, are constant over the sample.

If one measured costs by deducting entrepreneurial rewards, one would find only how these rewards per unit of output varied over the population of firms; nothing can be deduced about the variation in cost as a representative firm expands its output. Constant cost curves in cross sections may be evidence of competition rather than of constant returns to scale.

This criticism does not apply to studies of firms in isolated factor or goods markets or to instances where there are imperfections in factor markets and output markets or where the level or price of output is controlled exogenously by a government agency. In these cases, there is some opportunity for measuring the production and cost functions Nerlove When the production relationship is measured directly, i. But in measuring marginal productivity conditions and cost functions, the parameters of the supply curve of factors must be known before one can calculate the production function or cost function parameters.

With international or, in some cases, interregional cross sections it is sometimes reasonable to specify both separate factor or goods markets and competitive conditions in each; in these circumstances a cross section may give observations which are suitable for estimating production functions.

The general result from cross-section cost studies has been that average cost declines rapidly for small outputs and is more or less constant for large outputs.

There is no evidence that large firms incur high costs. For a competitive industry the above interpretation would suggest that small firms probably produce specialized products which command a high price, whereas the large and medium-size firms produce similar commodities which must sell at more or less the same price.

For public utilities, certain monopolistic industries, and railways, however, the predominant result—declining cost curves—does indicate economies of scale; but in view of the regulations imposed by governments and sometimes the noncompetitive nature of factor markets, the result must often be interpreted with caution.

For studies of production functions from cross sections of firms except public utilitiesthe results tend to be that a the order of the homogeneous production function is close to unity and b the share of wages is not very different from the value predicted by the production function i.

There are, however, many exceptions to these generalizations.

relationship between production and cost in economics

First, least squares estimates may give seriously biased results because of the simultaneous equations form of the underlying model. Second, to identify the production coefficients, one must avoid measuring some combination of the marginal productivity conditions or the condition that all revenue is exhausted.

In very few studies have simultaneous identification methods been used with suitable safeguards. The function so measured describes how production relationships vary not with the size of firms but with the size of industries.

Production and Cost Analysis

Large industries may be composed of small firms, and small industries may consist of one or two giant firms. Therefore we can say that along any expansion path the demand for any factor of production will depend on the level of output to be produced. So, if L and K are the amounts of the factors of production and Q is the level of output then it can be said that L and K are functions of Q.

Since, w and r are constant C is only a function of Q. This function is called the total cost functions of the firm. The function shows that the total cost of the firm depends on the output to be produced.

relationship between production and cost in economics

The costs function is deduced from the expansion path of the firm. The cost function derived from the expansion path of the firm represents the cost function in its long run nature as in this case we have assumed that both the factors of production are variable.

Overt the range of rising marginal product marginal; cost if falling. When marginal product is a maximum, marginal; cost is a minimum.

Over the rang4e of rising average product, average variable cost is falling.

relationship between production and cost in economics

When average product is a maximum, average variable cost is a minimum. Over the range of diminishing marginal product, marginal cost is rising. And over the range of diminishing marginal product, average variable cost is rising. Addison-Wesley, Economics,Cost Revenue Analysis and Market Price determination analysis is based on the demand and supply forces.


These in turn depend on the revenue and the cost of production respectively. Thus cost and revenue analysis is indispensable. This analysis exhibit only the profits or losses earned by the firm but also helps in output determination and production planning.

Money, Real and Opportunity Costs. Fixed Cost and Variable Costs. Explicit Costs and Implicit Costs. Accounting costs and Economic Costs. Past Cost and Future Cost. And others Money, Real and Opportunity Costs Money costs mean the aggregate money expenditure incurred by a firm on the various items entering into the production of a commodity.