MANAGERIAL ECONOMICS

UNIT 2
PRODUCTION
• In Economics the term production means process by
which a commodity(or commodities) is transformed in
to a different usable commodity.
• In other words, production means transforming
inputs( labour ,machines ,raw materials etc.) into an
output. This kind of production is called manufacturing.
PRODUCTION
• The production process however does not necessarily involve physical
conversion of raw materials in to tangible goods . it also includes the
conversion of intangible inputs to intangible outputs For example ,
production of legal, medical ,social and consultancy services- where
lawyers, doctors, social workers consultants are all engaged in producing
intangible goods.

• An „input` is good or service that goes in to the process of production and

“out put is any good or service that comes out of production process.
PRODUCTION
• The term ‘Production’ in economics refers to the creation of those goods
and services which have exchange value. The process by which man
utilizes or converts the resources of nature, working upon them so as to
make them satisfy the human wants.

• “Production as any activity whether physical or mental, which is directed

to the satisfaction of other people’s wants through exchange.” – Prof. J.
R. Hicks
Production function

Relationship between Input and Output

Meaning
• Production function shows the technological relationship between
quantity of output and the quantity of various inputs used in
production.
PRODUCTION FUNCTION
• Production function is economic sense states the maximum output that can be
produced during a period with a certain quantity of various inputs in the existing
state of technology. In other words, it is the tool of analysis which is used to
explain the input - output relationships. In general, it tells that production of a
commodity depends on the specified inputs. In its specific tem it presents the
quantitative relationship between inputs and output. Inputs are classified as:-
• Q = f( L,K,R,Ld,T,t)
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time

• For our current analysis, let’s reduce the inputs to two, capital (K) and labor (L):
Q = f(L, K)
 Features of production Function

1. Substitutability:

The factors of production or inputs are substitutes of one another which make it possible to vary the total output by changing the quantity of one or a few inputs,

while the quantities of all other inputs are held constant. It is the substitutability of the factors of production that gives rise to the laws of variable proportions.

2. Complementary:

The factors of production are also complementary to one another, that is, the two or more inputs are to be used together as nothing will be produced if the quantity of

either of the inputs used in the production process is zero.

The principles of returns to scale is another manifestation of complementary of inputs as it reveals that the quantity of all inputs are to be increased simultaneously in

order to attain a higher scale of total output.

3. Specificity:

It reveals that the inputs are specific to the production of a particular product. Machines and equipment’s, specialized workers and raw materials are a few examples

of the specificity of factors of production. The specificity may not be complete as factors may be used for production of other commodities too. This reveals that in

the production process none of the factors can be ignored and in some cases ignorance to even slightest extent is not possible if the factors are perfectly specific.

Production involves time; hence, the way the inputs are combined is determined to a large extent by the time period under consideration. The greater the time period,

the greater the freedom the producer has to vary the quantities of various inputs used in the production process.

• In the production function, variation in total output by varying the quantities of all inputs is possible only in the long run whereas the variation in total output by

varying the quantity of single input may be possible even in the short run.
The laws of production
• Production function shows the relationship between a given quantity of
input and its maximum possible output. Given the production function,
the relationship between additional quantities of input and the additional
output can be easily obtained. This kind of relationship yields the law of
production the traditional theory of production studies the marginal
input-output relationship under.
(I) short run: (one variable input)
• In the short run, input-output relations are studied with one variable input, while
other inputs are held constant .The Law of production under these assumptions
are called “the Laws of variable production”
(II) Long run: (all the inputs are variable)
• In the long run input output relations are studied assuming all the input to be
variable. The long-run input output relations are studied under `Laws of Returns
to Scale.
 Production Function

Short Run Production Long Run Production

Return to a factor Return to scale

One variable factor All factors are variable

and other are fixed

Law of variable Law of

return
Assumptions of the production functions
1. Perfect divisibility of both inputs and output;
2. Limited substitution of one factor for the others Constant
technology; and
4. Inelastic supply of fixed factors in the short run
 Short run production Function / Law of variable Proportion:
(Law of Diminishing Returns)
Input – Output relationship with by varying one factor of production.
Law operate under short run
Short run is period where only one input is variable and other is fixed or
constant.
According to Benham
As the proportion of the factor in a combination of factors is increased after
a point, first the marginal and then the average product of that factor will
diminish.
According to Stigler
As equal increment of one input are added, the input of other productive
services being held constant, beyond a certain Point the resulting increment
of product will decrease that the marginal product will diminish.
 Assumption of law of variables Proportion

• State of technology remain unchanged

• One factors is changed other are constant
• Not when factors are to used in fixed proportions

The time period in which some factors of production are fixed while some factors
of production are variable, is known as short period. It explains the technical
relationship between outputs and inputs in the short run. The fixed factor is land
and the variable factor is capital. It is also known as Variable proportions type
production function.
Three stages of law of Variable proportion

• Law of Increasing Return(Production increasing in increasing rate)

• Law of Diminishing return (Production increasing at a diminishing rate)

• Law of Negative return (Production starts to decrease to negative)

 Measures of production and productivity
• Total product (total output). TP
Total product (total physical product) = the total amount of output produced, in
physical units.
Sum of MP
• Average product (AP) – Total output divided by total units of input, means production per
unit of input.
TQ/Q
Average Product = Total Product/ Units of Variable Factor Input
• Marginal product (MP)
The additional output produced as a result of employing an additional unit of the variable
factor input is called the Marginal Product. Thus, we can say that marginal product is the
addition to Total Product when an extra factor input is used.
TPn -TP n-1
Marginal Product = Change in Output/ Change in Input
law of Variable proportion
Qty of Land Total Average product Marginal
labour product Product

1 200 100 100 100

2 200 210 105 110
3 200 330 110 120
4 299 440 110 110
5 200 520 104 80
6 200 600 100 80
7 200 670 96 70
8 200 720 90 50
9 200 750 83 30
10 200 760 76 10
11 200 740 67 -20
law of Variable proportion - Explanation
Table illustration

• The above table illustrates several important features of a typical production

function .With one variable input.- here both Average Product (AP) and
Marginal Product (MP) first rise ,reach a maximum - then decline. Average
product is the product for one unit of labour. It is arrived at by dividing the
Total Product (TP) by number of workers Marginal product is the additional
product resulting term additional labour. It is found out by dividing the
change in total product by the change in the number of workers. The total
output increases at an increasing rate till the employment of the 4th worker.
The rate of increase in the marginal product reveals this .
Table illustration
• additional labour employed beyond the 4th labour clearly faces the operation of the Law
of Diminishing Returns. The maximum marginal product is 6 after which it continues to fall
, ultimately becoming negative. Thus when more and more units of labour are combined
with other fixed factors the total output increase first at an increasing rate then at a
diminishing rate finally it becomes negative.

• OX axis represents the units of labour and OY axis represents the unit of output. The total
output (TP)curve has a steep rise till the employment of the 4th worker. This shows that
the output increases at an increasing rate till the employment of the 4th labour. TP curve
still goes on increasing but only at a diminishing rate. Finally TP curve shows a downward
trend.
Table illustration
• The Law of Diminishing Returns operation at three stages .At the first stage, total product
increases at an increasing rate .The marginal product at this stage increases at an increasing
rate resulting in greater increases in total product .The average product also increases. This
stage continues up to the point where average product is equal to marginal product .the law of
increasing returns is in operation at this stage

• The Law of increasing Returns operates from the second stage on wards .At the second stage ,
the total product continues to increase but at a diminishing rate . As the marginal product at
this stage starts falling, the average product also declines . The second stage comes to an end
where product become maximum totals and marginal product becomes zero. The marginal
product becomes negative in the third stage. So the total product also declines. The average
product continues to decline in the third stage.
 Long run production function (Law of Returns to scale)

• In the long –run all the factor of production are variable, and an increase in
output is possible by increasing all the inputs. The law of returns of scale explains
how a simultaneous and proportionate Increase in all the inputs affects the total
output

• The time period in which all the factors of production are variable is known as long
period production function. It means that all the factors of production can be
changed in the long period and there exists no difference between the fixed and
variable factors of production.
 Long run production function (Law of Returns to scale)

Increasing Returns to scale

When proportionate increase in all factor of production results in a more than
proportionate increase in output and this results first stage of production which
is known as increasing returns to scale.

Labour Output Proportional Proportion

When a certain proportionate change in both the and (TP) change in al change
Capital labour and in output
inputs, K and L, leads to a more than proportionate capital
change in output, it exhibits increasing returns to
scale. For example, if quantities of both the inputs, K 1+1 10 - -

and L, are successively doubled and the 2+2 22 100 120

corresponding output is more than doubled, the 4+4 50 100 127.2

returns to scale is said to be increasing. 8+8 125 100 150

Increasing Returns to Scale- Diagrammatic Presentation

OA > AB > BC

100 units of output require 3C + 3L

200 units of output require 5C + 5L
300 units of output require 6C + 6L
so that along the expansion path OR, OA > AB > BC.
In this case, the production function is
homogeneous of degree greater than one.
 Long run production function (Law of Returns to scale)

Constant Returns to scale

Firms cannot maintain increasing returns to scale indefinitely after the
first stage; firm enters a stage when total output tends to increase at a
rate which is equal to the rate of increase in inputs. This stage comes in
to operation when the economies of large scale production are
neutralized by the diseconomies of large scale operation.
Proportional
Output change in Proportion
When the change in output is proportional to Labour
(TP) labour and al change
and
capital in output
the change in inputs, it exhibits constant Capital

returns to scale. For example, if quantities of 1+1 10 - -

2+2 20 100 100
both the inputs, K and L, are doubled and
4+4 40 100 100
output is also doubled, then returns to scale
8+8 80 100 100
 Constant Returns to Scale- Diagrammatic Presentation
Figure shows the case of constant returns to scale. Where the distance between the iso quants 100, 200 and 300
along the expansion path OR is the same, i.e., OD = DE = EE It means that if units of both factors, labour and capital,
are doubled, the output is doubled. To treble output, units of both factors are trebled. It follows that

When the change in output is proportional to the change in

inputs, it exhibits constant returns to scale. For example, if
quantities of both the inputs, K and L, are doubled and output
is also doubled, then returns to scale are said to be constant.

100 units of output require 1 (2C + 2L) = 2C + 2L

200 units of output require 2(2C + 2L) = 4C + 4L
300 units of output require 3(2C + 2L) = 6C + 6L
 Long run production function (Law of Returns to scale)
Diminishing Returns to Scale
In this stage, a proportionate increase in all the input result only less
than proportionate increase in output. This is because of the
diseconomies of large scale production. When the firm grows further,
the problem of management arise which result inefficiency and it will
affect the position of output.
Labour Output Proportional Proportion
When a certain proportionate change in inputs, K and and (TP) change in al change
Capital labour and in output
L, leads to a less than proportionate change in output. capital
For example, when inputs are doubled and output is
1+1 10 - -
less than doubled, then decreasing returns to scale is
2+2 18 100 80
in operation.
4+4 30 100 66.6
8+8 45 100 50
 Constant Returns to Scale- Diagrammatic Presentation
Figure shows the case of decreasing returns where to get equal increases in output, larger
proportionate increases in both labour and capital are required. It follows that

100 units of output require 2C + 2L

200 units of output require 5C + 5L
300 units of output require 9C + 9L
so that along the expansion path OR, OG < GH < HK.
Difference between Short run and Long run
 Cobb-Douglas Production Function

As we know, a production function explains the functional relationship between inputs

(or factors of production) and the final physical output. Let us begin with a simple form a
production function first
Q = f(L, K)
The above mathematical equation tells us that Q (output) is a function of two inputs
(assumption). These inputs are L (amount of labour) and K (hours of capital). Basing
our understanding of the function above, we can now define a more specific production
function – the Cobb Douglas Production Function.
Q = A Lβ Kα
Here, Q is the output and L and K represent units of labour and capital respectively. A is a
positive constant (also called the technology coefficient). α and β are constants lying
between 0 and 1.
The production function shows at one (1%) percentage change in labour, capital remaining
constant, is associated with 0.75% change in output. Similarly One percentage change in
capital, labour remaining constant, is associated with a 20%change in output. Returns to
scale are constant. That is if factors of production are increased, each by 10 percentages
then the output also increases by 10 percentages
Iso Quants

The term Iso-quant or Iso-product is composed of two words,

Iso = equal, quant =quantity or product = output.
Isoquants are the curves which represent the different
combinations of inputs producing a particular quantity of output.
Any combinations on the iso quant represents the same level of
output.
Isoquant indicates various combinations of two factors of
production which give the same level of output per unit of time.
“Iso-product curve shows the different input combinations that
will produce a given output.” Samuelson
ASSUMPTIONS

• Two Factors of Production

• Divisible Factor
• Constant Technique
• Possibility of Technical Substitution- production
function is of ‘variable proportion’ type rather than
fixed proportion.
• Efficient Combinations - Under the given Technique,
factors of production can be used with maximum
efficiency
 Iso quant graphical representation

Factor Unit of labour Unit of Output

Combination capital

A 1 12 200 Units 12

Units of Capital
B 2 08 200 Units 8
5

C 3 05 200 Units 3 Iso

2 quant
curve
D 4 03 200 units
X-
1 2 3 axis
E 5 02 200 Units 4 5
Units of Labour

Each of the factor combinations A,B,C,D and E represents the

same level of output Say 200 units.
Marginal rare of technical substitution(MRTS)

• The Principles of marginal rate of technical substitution is

based on the production function where two factors can be
substituted in Variable proportions in such a way as to
produce a constant level of output.
• Marginal rate of technical substitution indicates the rate at
which factors can be substituted at the margin without any
change in the level of output.
Properties of Iso quant
1. Iso-Product Curves Slope Downward from Left to Right
❖ When we increase labour, we have to decrease capital to
produce a given level of output.
2. Isoquants are Convex to the Origin
☻ Due to MRTS (Marginal Rate of Technical Substitution)
☻ MRTS = ∆L/∆C
Like indifference curves, isoquants are convex to the origin. In
order to understand this fact, we have to understand the concept of
diminishing marginal rate of technical substitution (MRTS),
because convexity of an isoquant implies that the MRTS
diminishes along the isoquant. The marginal rate of technical
substitution between L and K is defined as the quantity of K which
can be given up in exchange for an additional unit of L. It can also
be defined as the slope of an isoquant.
3. Two Iso-Product Curves Never Cut Each Other
• If two isoquant curves intersect each other – a single
combination of two factors produces two levels of output.
4. Higher Iso-Product Curves Represent Higher Level of
Output
• IQ1 represents an output level of 100 units whereas IQ2
represents 200 units of output.
5. Isoquants Need Not be Parallel to Each Other
• The rate of substitution in different isoquant schedules
need not be necessarily equal.
6. No Isoquant can Touch Either Axis
• If an isoquant touches X-axis, then the product is being
produced with the help of labour alone without using capital at
all.
7. Each Isoquant is Oval-Shaped
► The firm will produce only in those segments of the isoquants which are convex to the origin and
lie between the ridge lines – economic regions of production
► Up dotted portion, more capital and in the lower dotted portion more labour- uneconomic
regions of production
Indifference curve
• An Indifference curve (IC) is the locus of all those combination
of two goods which give the same level of satisfaction to the
consumer.
 INDIFFERENCE CURVES
24
22 A(1, 22)
20
INDIFFERENCE SCHEDULE 18
Combination Apples 16 ,1 4)
(2
Oranges 14 B
A 1 22 0 )
, 1
B 2 14 12 (3

)
,8
10 C

D( 4
C 3 10

)7
8

5,
D 4 8
Oranges

E(
6
E 5 7 4 IC1
2
0 Apples
1 2 3 4
 Iso Quant and indifference cureve – Difference
Sl. Isoquant curve Indifference Curve
N
o.
Producer Goods Consumer goods
1. Isoquant curves related with production theory. There are related with demand theory.

Output Satisfaction
2.
It shows the various combination of two inputs on an equal It shows the various combinations of two commodities.
output
3. Isoquant curve show constant levels of output which can be These curves show the constant level of satisfaction
measured. which cannot be measured.
4.
It represents combination of two factors. It represents combination of two good / commodity.
5. It provide economic and uneconomic information region of It provides no any information about economic and
production. uneconomic region of consumption of goods.
6.
Its slope influenced by the technical possibility of Its slope influenced depends upon Marginal Rate of
substitution between production Substitution between commodities consumed by the
consumer.
ISOCOST
LEAST COST COMBINATION
Definition: Technological progress shifts the production
function by allowing the firm to:
1. Produce more output from a given combination of
inputs, or
2. Produce the same output with fewer inputs.

53
 Three categories:
1. Neutral technological progress
2. Labor-saving technological progress
3. Capital-saving technological progress

54
Definition: Neutral technological progress shifts the
isoquant inwards, but leaves the MRTSL,K unchanged
along any ray from the origin

 In other words, for any given capital-labor ratio, the

MRTSL,K remains unaffected.

55
K Example: Neutral technological progress

Q = 100 before

K/L
L
56
K Example: Neutral technological progress

Q = 100 before

Q = 100 after

K/L
L
57
K Example: Neutral technological progress

Q = 100 before

Q = 100 after

MRTS remains same

K/L
L
58
Definition: Labor-saving technological progress results
in a decrease in the MRTSL,K along any ray from the origin

59
 Example: Labor Saving Technological Progress
K

Q = 100 before

K/L
L 60
 Example: Labor Saving Technological Progress
K

Q = 100 before

Q = 100 after

K/L
L 61
 Example: Labor Saving Technological Progress
K

Q = 100 before

Q = 100 after

MRTS gets smaller

K/L
L 62
Definition: Capital-saving technological progress results
in an increase in the MRTSL,K along any ray from the
origin

63
 Example: Capital-saving technological progress
K

Q = 100 before

K/L
L 64
 Example: Capital-saving technological progress
K

Q = 100 before

Q = 100 after

K/L
L 65
 Example: Capital-saving technological progress
K

Q = 100 before

Q = 100 after

MRTS gets larger

K/L
L 66
Example: Technological Progress

Before: Q = 500 (L + 3K)

MRTSL,K = MPL = 500 = 1

MPK 1500 3

After: Q = 1000 (0.5L + 3K)

MRTSL,K = MPL = 500 = 1

MPK 3000 6

Since MRTSL,K has decreased, technological progress is labor-

saving
67
1. Production function is analogous to utility function and is
analyzed by many of the same tools.

2. One of the main differences is that the production function

is much easier to infer/measure than the utility function.
Both engineering and econometric techniques can be
used to do so.

68
3. Technological progress shifts the production function by
allowing the firm to achieve more output from a given
combination of inputs (or the same output with fewer
inputs).

4. Returns to scale is a long run concept: It refers to the

percentage change in output when all inputs are
increased a given percentage.

5. The production function is cardinal, not ordinal

69
Cost

• Meaning
• Cost, a key concept in economics, is the monetary expenses
incurred by organizations for various purposes such as,
acquiring resources, producing goods and service, advertising,
and hiring workers.
• In other words, cost can be defined as monetary expenses that
are incurred by organization for a specified thing or activity
TYPES OF COST
On the basis of Nature of Cost

On the basis of Expenses

On the basis of Control

Types of Cost
On the basis of functions and
/Classifications of
operations cost
Cost

On the basis of Behaviour of cost

On the basis of relavance and

decision making

Other tyepes of Cost

 On the basis
of Nature of
Cost

Fixed Cost Variable Cost Semi variable Total Cost

cost
• Fixed Cost: It is the Cost of fixed inputs used in the production. These cost do not vary
with the changes in volume of production Eg - interest, rent, salaries etc
• Variable cost: It is the cost of Variable inputs used in the production. These cost
changes in according to the volume of production. Variable costs by contrast change in
relation to the activity of a business such as sales or production.
• Semi variable Cost: It refers to cost which are partly fixed and partly variable. These
type of costs do not affect the level of production but vary with change in production
facilities Eg – Administrative cost, maintenance Cost, depreciation cost.
• Total Cost: It refers to the total cost of production. it is the cost refers to the total
expenses incurred in reaching a particular level of output
• TC = TFC + TVC
• Marginal Cost: It refers to the cost of producing one extra unit of a product. Marginal
cost at each level of production includes any additional costs required to produce the
next unit.
• MCn = TCn – TCn-1
• i.e the marginal cost of the unit of output is the total cost of producing n units minus
the total cost of producing n-1 (i.e …one less in the total) units of output
 On the basis of
Expenses

Meterial Cost Labour Cost Overhead Cost

Cost
• Material Cost: It refers to the cost of procurement and use of
any raw materials used for production
• Labour Cost: It refers to the payments made to permanent
and temporary workers for their service
• Overhead Cost: It refers to the costs which are semi variables
and vary with the level of production like administrative cost,
Cost of indirect material and labour, indirect expenses
 On the basis of
Control

Controllable Uncontrollable
Cost Cost
• Controllable cost: It refers to costs which can be influenced or
controlled by the actions of the organization members. Also known as
managed costs,
• Variable costs such as direct materials, direct labor, and variable
overhead that are usually considered controllable by the department
manager. Further, a certain portion of fixed costs can also be
controllable.
• Uncontrollable cost: It refers to costs which cannot be controlled by the
actions of the organizations members. An expense that cannot be
unilaterally changed by an individual, department or business. Example
of an uncontrollable cost within a business context might include an
employee's rate of pay that they cannot change themselves or the rent
that a landlord charges for use of the company’s premises
 On the basis of
Functions and
operations Cost

Preliminary Cost Cost of Cost of marketig Cost of research

Production and Selling and
development
• Preliminary Cost: Costs incurred before the commencement
of the aactual business Eg- Rent, Interest, Product trial cost,
underwriting cost etc.
• Cost of production: Cost of material, labour, Overheads
• Cost of Marketing and selling: Costs incurred for marketing
activities and sales promotion, Advertising, Distribution
channels etc.
• Cost of research and development: Cost spent for
innovation, new products research, Improved products
research, advance production facilities research etc.
 Behavioural
Cost

Direct Cost Expliciting or

Indirect Cost Accounting Cost Implicit or
Economic Cost
• Direct cost - Direct costs are those cost that are directly related to
production of the goods and easily traceable Ex: wages paid, salary paid
labor, material…etc
• Indirect cost - Indirect costs are those costs which cannot be directly
assigned to a single product. The costs which are not directly accountable to
specific cost object or not directly related to production Ex: insurance,
maintenance, telecom, .etc
• Explicit Cost: Explicit costs are normal business costs that appear in the
general ledger and directly affect a company's profitability. ... Examples of
explicit costs include wages, lease payments, utilities, raw materials, and
other direct costs
• Implicit Cost: An implicit cost is any cost that has already occurred but not
necessarily shown or reported as a separate expense. It represents an
opportunity cost that arises when a company uses internal resources toward
a project without any explicit compensation for the utilization of resources.
 On the basis of
relevance to the
decision making

Oppurtnity Replacement
cost Sunk Cost Cost Real Cost Social Cost
• Opportunity Cost; Cost incurred for loosing next best alternative.
Opportunity costs represent the potential benefits an individual,
investor, or business misses out on when choosing one alternative
over another.
• The cost incurred on the next best alternative that is forgone to
acquire or produce a particular good is known as opportunity cost.
• Sunk Cost: COST that a company has already spent or invested in a
particular project, etc. and that it cannot get back: sunk costs that
cannot be recovered if market conditions turn out to be worse than
expected
• Replacement Cost: It is cost of replacing an asset, Plant, machinery
and other equipment's etc. A replacement cost is an amount that it
would cost to replace an asset of a company at the same or equal
value.
• Let's look at a replacement costs example. If a company bought a
machine for $1,000 five years ago, and the value of the asset today,
less depreciation, is $300 dollars, then the book value of the asset is
$300. However, the cost to replace that machine at current market
prices may be $1,500.
• Real Cost: Real cost implies an accumulation of various kinds of
costs to attain the total costs. The cost of producing a goods or
service, including the cost of all the resources used and the cost
of not employing those resources in alternative uses.
• Social Cost; It refers to the cost of hardship and scarifies that a
society has to bear due to operation of business activities. Eg-
unemployment, retirement benefits, housing, education or family
circumstances etc.
 Other types of
Cost

Historical Cost Normal Cost Differential

Cost Abnormal Cost Cost Incremental
Cost
• Historical cost: It refers to the actual cost acquiring an asset or
producing the product or service. Historical cost is the original
cost of an asset, as recorded in an entity's accounting records.
Many of the transactions recorded in an organization's
accounting records are stated at their historical cost
• Historical cost is the original cost of an asset, as recorded in an
entity's accounting records. For example, the historical cost of
an office building was $10 million when it was purchased 20
years ago, but its current market value is three times that
figure.
• Normal Cost: It is the cost which normally incurred in
achieving a certain level of output under certain conditions.
• Abnormal Cost; It is the cost which is not normally incurred at a
given level of output under normal conditions. It is a irregular
cost which would not exist in ideal conditions.
• (Example: destruction due to fire; lockout; shut down of machinery etc.)
• Differential Cost: It is the change in cost due to change in level
of production.
• Incremental Cost: It is the additional cost in relation to a change
in the level or nature of business activity. Historical cost is the
original cost of an asset, as recorded in an entity's accounting
records. Many of the transactions recorded in an organization's
accounting records are stated at their historical cost
Other types of cost
Accounting Costs – this is the monetary outlay for producing a
certain good. Accounting costs will include your variable and
fixed costs you have to pay.
• Accounting costs are those for which the entrepreneur pays
direct cash for procuring resources for production. These
include costs of the price paid for raw materials and
machines, wages paid to workers, electricity charges, the
cost incurred in hiring or purchasing a building or plot, etc.
Accounting costs are treated as expenses. Chartered
accountants record them in financial statements
 Economic cost

• Economic cost is the gains and losses in money, time and

resources of one course of action compared to another. The
comparison includes the gains and losses precluded by taking
a course of action, as the those of the course taken itself.
Explicit cost and Implicit cost

• Explicit Cost is the cost which is actually incurred by the organization,

during production. On the other hand, Implicit Cost, are just opposite
to the explicit cost, as the organization does not directly incur them,
but they are implied in nature which does not involve a cash payment.
The former is an out of pocket cost, while the latter is an opportunity
cost.
 Cost of
Production
• The amount spent on the use of factor and non factor inputs,
inputs is called cost of production.

• The relation between output and cost is cost function. Cost

functions are derived functions. These are derived from the
production function. Enables the firm to determine its profit
maximizing or loss minimizing output. Helps a firm in deciding
whether it is profitable for it to continue production. Aids in
estimating its profit – both per unit as well as total.
Theory Of Cost
• Traditional Theory
▫
Short Run • Modern Theory
 Total Cost ▫
Short Run
▫
Total Fixed Cost ▫
Long Run
▫
Total Variable Cost
 Average Cost
▫
Average Fixed Cost
▫
Average Variable Cost
 Marginal Cost
▫
Long Run
▫
Long run Total Cost
▫
Long Run Average Cost
▫
Long Run Marginal Cost
Type I Cost of production: Short run cost of production
analysis

•In the short-run the firm cannot change or modify fixed

factors such as plant, equipment and scale of its
organization. In the short-run output can be increased
or decreased by changing the variable inputs like
labour, raw material, etc
 15

Short-Run Costs to the Firm

• Total Costs
▫
The sum of total fixed costs and total
variable costs
• Fixed Costs
▫
Costs that do not vary with output
• Variable Costs
▫
Costs that vary with the rate of production
Total costs (TC) = TFC + TVC
 16

Short-Run Costs to the Firm

• Average Total Costs (ATC)

Total costs (TC)

Average total costs (ATC) =
Output (Q)
 AVERAGE COST

They are of three types.


AVERAGE FIXED COST: It is the per-unit cost of the fixed factors.
AFC=TFC/Q.


AVERAGE VARIABLE COST: It is the per-unit cost of the variable factors.
AVC=TVC/Q.


AVERAGE TOTAL COST:
* It is the total cost divided by the number of units produced.
* Sum of average fixed cost and average variable cost.

ATC=TC/Q AC=AFC+AVC.
 20

Cost of Production: An Example

 22

Cost of Production: An Example

Type II cost of production: Long run cost of production analysis

• The long run refers to that time period for a firm where it can vary all
the factors of production. Thus, the long run consists of variable
inputs only, and the concept of fixed inputs does not arise. The firm
can increase the size of the plant in the long run.
Long Run Total Costs

• Long run total cost refers to the minimum cost of production. It is the
least cost of producing a given level of output.
• Thus, it can be less than or equal to the short run average costs at
different levels of output but never greater.
• In graphically deriving the LTC curve, the minimum points of the STC
curves at different levels of output are joined. The locus of all these
points gives us the LTC curve.
Long Run Average Cost Curve

• The long-run average cost curve shows the cost of producing each
quantity in the long run, when the firm can choose its level of
fixed costs and thus choose which short-run average costs it desires.
• Long run average cost (LAC) can be defined as the average of the LTC
curve or the cost per unit of output in the long run. It can be
calculated by the division of LTC by the quantity of output.
Graphically, LAC can be derived from the Short run Average Cost (SAC)
curves.
Long Run Average Cost Curve

As you can see in the figure above, the long run average cost curve is
drawn tangential to all SACs. In other words, every point on the long
run average cost curve is a tangent point on some SAC. Hence,
whenever a firm desires to produce a certain output, it operates on
the corresponding SAC.

From the Fig above, you can observe that to produce an output OM,
the corresponding point on the long run average cost curve is ‘G’. Also,
the corresponding SAC is SAC2.

Therefore, the firm operates on SAC2 at point G. Similarly, the firm

chooses different SACs based on its output requirement. It is also
possible for the firm to produce the output OM with SAC3.

However, this will lead to a higher cost of production as compared to

SAC2. On the other hand, to produce a higher output OV, the firm
requires SAC3. If the firm uses SAC2 for the same, then it results in
higher unit similarity.
Economies of scale
• Economies of Scale refer to the cost advantage experienced by a firm
when it increases its level of output.
• The advantage arises due to the inverse relationship between per-unit
fixed cost and the quantity produced. The greater the quantity of output
produced, the lower the per-unit fixed cost.
• Economies of scale also result in a fall in average variable costs (average
non-fixed costs) with an increase in output. This is brought about by
operational efficiencies and synergies as a result of an increase in the
scale of production.
Economies of scale
Effects of Economies of Scale on Production Costs

• It reduces the per-unit fixed cost. As a result of increased production,

the fixed cost gets spread over more output than before.

• It reduces per-unit variable costs. This occurs as the expanded scale of

production increases the efficiency of the production process.
 Types of Economies of Scale

1. Internal Economies of Scale

This refers to economies that are unique to a firm. For instance, a firm may hold a patent over a mass

production machine, which allows it to lower its average cost of production more than other firms in the

industry.

2. External Economies of Scale

These refer to economies of scale enjoyed by an entire industry. For instance, suppose the government wants

to increase steel production. In order to do so, the government announces that all steel producers who employ

more than 10,000 workers will be given a 20% tax break. Thus, firms employing less than 10,000 workers

can potentially lower their average cost of production by employing more workers. This is an example of an

external economy of scale – one that affects an entire industry or sector of the economy.
Internal economics

• Technical Economies of Scale

• Marketing Economies of Scale

• Financial Economies of Scale

• Managerial Economies of Scale

• Commercial Economies of Scale

Internal Economics
a. Technical economies of scale:

Occur when organizations invest in the expensive and advanced technology. This helps in lowering and controlling the

costs of production of organizations. These economies are enjoyed because of the technical efficiency gained by the

organizations. The advanced technology enables an organization to produce a large number of goods in short time.

Thus, production costs per unit falls leading to economies of scale.

b. Marketing economies of scale:

Occur when large organizations spread their marketing budget over the large output. The marketing economies of

scale are achieved in case of bulk buying, branding, and advertising. For instance, large organizations enjoy benefits

on advertising costs as they cover larger audience. On the other hand, small organizations pay equal advertising

expenses as large organizations, but do not enjoy such benefits on advertising costs.
Internal Economics
c. Financial economies of scale:
Take place when large organizations borrow money at lower rate of interest.
Generally, banks prefer to grant loans to those organizations that have
strong foothold in the market and have good repaying capacity.
d. Managerial economies of scale:
Occur when large organizations employ specialized workers for performing
different tasks. These workers are experts in their fields and use their
knowledge and experience to maximize the profits of the organization. For
instance, in an organization, accounts and research department are created
and managed by experienced individuals, SO that all costs and profits of the
organization can be estimated properly.
Internal Economics

e. Commercial economies:

Refer to economies in which organizations enjoy benefits of buying raw

materials and selling of finished goods at lower cost. Large
organizations buy raw materials in bulk; therefore, enjoy benefits in
transportation charges, easy credit from banks, and prompt delivery of
products to customers.
External economies of Scale
• As businesses grow within an area, specialist skills begin to develop.
• Skilled labour in the area – local colleges may begin to run specialist
courses.
• Being close to other similar businesses who can work together with
each other.
• Having specialist supplies and support services nearby.
• Reputation
External economies of Scale
1. Economies of Localization:

When a no. of firms are located in one place, all of them derive mutual
advantage through the training of skilled labour, provision of better
transport facilities, etc.. Moreover, when there is an increasing
concentration of firms, arrangement can be made for repairs and
maintenance and special services required by the industries. The cost of
production is thereby reduces.
External economies of Scale
2. Economies of Information or Technical & Market Intelligence:
An economy of information and market intelligence action program is
concerned with improving the flow of tropical timber from producers and
consumers. It is designed to assist member countries in understanding and
growing markets for tropical timber and other tropical forest goods and
services. The program includes work on timber trade and market data,
market access, forest certification, ecosystem services, forest law
enforcement and the marketing of tropical timber and non-timber
products, among other things.
External economies of Scale

3. Economies of Vertical Disintegration:

The growth of industry will make it possible to split up production and

some subsidiary fob can be done more efficiently by specialized firms.
In textile industry, the color manufacturing process may be taken up by
specialized chemical firms and the mills can get better products at low
costs.
External economies of Scale

4. Economies of By-products: Large firms can make a more economical use

of their raw materials. A large firm can avoid waste of its raw material,
which it can economically use of manufacturing certain by-products.
For example, in a sugar factory belt, sugarcane pulp can be used by the
paper mill in producing paper.
Diseconomies of Scale

• Any increase in output leads to a rise in average costs. This is an

example of diseconomies of scale – a rise in average costs due to an
increase In output
• Diseconomies of scale occur when the cost per unit increases with
an increase in quantity produced. This means that any attempt by
the firm to increase its output will transcend to a corresponding
increase in the unit cost associated with the unit increase in output.
Diseconomies of Scale
• Internal Diseconomies of Scale
When a firm expands its production scale beyond a certain
level, it suffers certain disadvantages.

• External Diseconomies of Scale

External factors beyond the control of a company increases its
total costs, as output in the rest of the industry increases. The
increase in costs can be associated with market prices
increasing for some or all of the factors of production.
Internal Diseconomies of Scale
• Managerial inefficiency: As a firm grows and levels of hierarchy increase
the efficiency and effectiveness of communication breaks down and
management-employee relation becomes impersonal. This means
supervision would be relaxed and this leads to increasing inefficiency and
therefore increasing average costs.
• Labour inefficiency: With larger firms, it is harder to satisfy and motivate
workers. This means they do not give of their best, and again as the firm
grows average output falls, and average costs increase. Workers become so
crowded that space needed for each worker to work efficiently becomes
minimal. Over-specialization and division of labour creates over-
dependence. This situation can be detrimental to the firm if one worker
should be absent.
External Diseconomies of Scale
1) Breakdown of relationships with suppliers and buyers: When the
firm is small, there is often a direct relationship between owner managers
and customers or suppliers. As the firm grows, these relationships are hard
to maintain as the owner manager finds his time is taken up with
administration or problem solving.
2) Competition for labour: More firms means increased demand for
labour, making the best workers harder to recruit and keep.
3) Increasing employment costs: More firms means increased demand
pushing up the price of labour-wages
4) Traffic congestion: The firm grows, suppliers move in, the area
becomes an industrial centre, the roads are clogged with vehicles making
deliveries late.
 What is an externality?
An externality is the external effects associated with the production
and consumption of goods and services.

Externalities occur when producing or consuming a good cause an

impact on third parties not directly related to the transaction.

This can be further classified as positive or negative.

For example, just driving into a city centre, will cause external costs
of more pollution and congestion to those living in the city.
Introduction
• One type of market failure: externalities.

• Externality: the uncompensated impact of

one person’s actions on the well-being of a bystander
• Negative externality:
the effect on bystanders is adverse
• Positive externality:
the effect on bystanders is beneficial
Externalities and Market Inefficiency Examples of
Negative Externalities
● Automobile exhaust(pollution)
● Cigarette smoking
● Barking dogs (loud pets)
● Loud stereos in an apartment building
● Traffic congestion
● talking on cell phone while driving makes the roads less safe for
others
 Examples of Positive Externalities
●Immunizations
●Infrastructure development
●Restored historic buildings
●Research into new technologies
●Individual education(lower crime rates, better
government)
Solutions to Externalities

1. Defining property rights

The stricter definition of property rights can limit the influence of economic activities on unrelated

parties. However, it is not always a viable option since the ownership of particular things such as air

or water cannot be unambiguously assigned to a particular agent.

2. Taxes

A government may impose taxes on goods or services that create externalities. The taxes would

discourage activities that impose costs on unrelated parties.

3. Subsidies

A government can also provide subsidies to stimulate certain activities. The subsidies are commonly

used to increase the consumption of goods with positive externalities.

The Market for Aluminum...
When OP level of price and OQ
Price of
level of output the demand and
Aluminum
supply curve is intersected that
is the point the company is on Supply
market equilibrium (private cost)

P Equilibrium

Demand
(private value)

0 QMARKET Quantity of
Aluminum
Positive externalities diagram
This diagram highlights what happens in order for a
positive externality to arise.

P1, Q1 represent the private benefit. (demand is equal to

supply)
This would be the benefits received by the individual or
organisation providing the product or service.

However as a positive externality relates to the benefits

society receives, Q2 is where the social cost is equal
to the social benefit.

D=PMB (this stands for the demand, the

private benefit)
SMB (stands for the social benefit)
S=PMC=SMC (stands for supply is equal to the private cost which is
equal to the social cost)
 Negative externality diagram

This diagram highlights what happens

Welfare loss
in order for a negative externality to
arise.

P1, Q1 represent the private marginal

benefit. (demand is equal to supply)

SMC (stands for Social Marginal Cost)

S = PMC (stands for Supply = Private Marginal Cost)
D = PMB (stands for Demand = Marginal Private Benefit)
Consumer Surplus & Producer surplus
Definition of Consumer Surplus
This is the difference between what the consumer pays and what he would have
been willing to pay.
For example: If you would be willing to pay £50 for a ticket to see the F. A. Cup
final, but you can buy a ticket for £40. In this case, your consumer surplus is £10.
Definition of producer surplus
This is the difference between the price a firm receives and the price it would be
willing to sell it at.
If a firm would sell a good at £4, but the market price is £7, the producer surplus
is £3.
BREAKEVEN ANALYSIS
USES
Case study

Firms in India are losing productivity because of Facebook. Office staff are spending
too long on the social networking site. According to The Associated Chambers of
Commerce and Industry (Assocham) employees use Orkut, Facebook, Myspace, and
Linkedin for "romancing" and other purposes. On average, employees spend an hour
a day on sites like Facebook. This reduces productivity by 12.5%. Nearly half of
office employees accessed Facebook during work time. Some 83% saw nothing
wrong in surfing at work during office hours. In September 2009 Portsmouth City
Council in England banned staff from accessing Facebook on its computers when it
was discovered that they spent, on average, 400 hours on the site every month.
Questions

1. What is meant by productivity?

2. Analyse the impact on a fall in productivity on costs.
3. Analyse the possible consequences for businesses in India of banning
access to Facebook and other social networking sites.
4. Do you think access should be denied?