Mefa Unit 2

MANAGERIAL ECONOMICS UNIT-III
UNIT - III
PRODUCTION FUNCTION
Introduction: The production function expresses a functional relationship between

physical inputs and physical outputs of a firm at any particular time period. The output
is thus a function of inputs. Mathematically production function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors
such as land, labour, capital and organization. Here output is the function of inputs.
Hence output becomes the dependent variable and inputs are the independent
variables.
The above function does not state by how much the output of “Q” changes as a
consequence of change of variable inputs. In order to express the quantitative
relationship between inputs and output, Production function has been expressed in a
precise mathematical equation i.e.
Y= a+b(x)
Which shows that there is a constant relationship between applications of input (the
only factor input ‘X’ in this case) and the amount of output (y) produced.
Importance
1. When inputs are specified in physical units, production function helps to estimate
the level of production.
2. It becomes is equates when different combinations of inputs yield the same level
of output.
3. It indicates the manner in which the firm can substitute on input for another
without altering the total output.
4. When price is taken into consideration, the production function helps to select
the least combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable
proportions’ and ‘law of returns to scale’. Law of variable propositions explains
the pattern of output in the short-run as the units of variable inputs are
increased to increase the output. On the other hand law of returns to scale
K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.
explains the pattern of output in the long run as all the units of inputs are
increased.
6. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum
quantities of various inputs that are required to produce a given quantity of
output.
Production function can be fitted the particular firm or industry or for the economy as
whole. Production function will change with an improvement in technology.
Assumptions
Production function has the following assumptions.
1. The production function is related to a particular period of time.

2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Cobb-Douglas production function
Production function of the linear homogenous type is invested by Junt wicksell and first
tested by C. W. Cobb and P. H. Dougles in 1928. This famous statistical production
function is known as Cobb-Douglas production function. Originally the function is
applied on the empirical study of the American manufacturing industry. Cabb – Douglas
production function takes the following mathematical form.
Y= (AKX L1-x)
Where Y=output
K=Capital
L= Labour
A, ∞=positive constant

Assumptions
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and
labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a
linear function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and
‘quent’ implies quantity. Isoquant therefore, means equal quantity. A family of iso-
product curves or isoquants or production difference curves can represent a production
function with two variable inputs, which are substitutable for one another within limits.
Iqoquants are the curves, which represent the different combinations of inputs
producing a particular quantity of output. Any combination on the isoquant represents
the some level of output.
For a given output level firm’s production become,
Q= f (L, K)
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus an isoquant shows all possible combinations of two inputs, which are capable of
producing equal or a given level of output. Since each combination yields same output,
the producer becomes indifferent towards these combinations.

Assumptions
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two
inputs.
4. The technology is given over a period.
An isoquant may be explained with the help of an arithmetical example.
Combinations Labour (units) Capital (Units) Output (quintals)

A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’
quintals of a product all other combinations in the table are assumed to yield the same
given output of a product say ‘50’ quintals by employing any one of the alternative
combinations of the two factors labour and capital. If we plot all these combinations on
a paper and join them, we will get continues and smooth curve called Iso-product curve
as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which
shows all the alternative combinations A, B, C, D, E which can produce 50 quintals of a
product.
Producer’s Equilibrium Or Least cost combination
The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as
the consumer is in equilibrium when be secures maximum satisfaction, in the same
manner, the producer is in equilibrium when he secures maximum output, with the
least cost combination of factors of production.
The optimum position of the producer can be found with the help of iso-product curve.
The Iso-product curve or equal product curve or production indifference curve shows
different combinations of two factors of production, which yield the same output. This is
illustrated as follows.
Let us suppose. The producer can produces the given output of paddy say 100 quintals
by employing any one of the following alternative combinations of the two factors
labour and capital computation of least cost combination of two inputs.
L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost

Units Units Output Cost of cost of
labour capital
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168
50 8 100 150 32 182
It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost
the producer Rs. 20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting
cost would be Rs. 172/-. Substituting 10 more units of ‘L’ for 12 units of ‘K’ further
reduces cost pf Rs. 154/-/ However, it will not be profitable to continue this substitution
process further at the existing prices since the rate of substitution is diminishing
rapidly. In the above table the least cost combination is 30 units of ‘L’ used with 16
units of ‘K’ when the cost would be minimum at Rs. 154/-. So this is they stage “the
producer is in equilibrium”.
LAW OF PRODUCTION
Production analysis in economics theory considers two types of input-output

relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions

ii) Law of returns to scale
I. Law of variable proportions
The law of variable proportions which is a new name given to old classical concept of
“Law of diminishing returns has played a vital role in the modern economics theory.
Assume that a firms production function consists of fixed quantities of all inputs (land,
equipment, etc.) except labour which is a variable input when the firm expands output
by employing more and more labour it alters the proportion between fixed and the
variable inputs. The law can be stated as follows:
“When total output or production of a commodity is increased by adding units of a

variable input while the quantities of other inputs are held constant, the increase in
total production becomes after some point, smaller and smaller”.
“If equal increments of one input are added, the inputs of other production services
being held constant, beyond a certain point the resulting increments of product will
decrease i.e. the marginal product will diminish”. (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point,
first the marginal and then the average product of that factor will diminish”. (F.
Benham)
The law of variable proportions refers to the behaviour of output as the quantity of one
Factor is increased Keeping the quantity of other factors fixed and further it states that
the marginal product and average product will eventually do cline. This law states three
types of productivity an input factor – Total, average and marginal physical
productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in

technology, the average and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant.
This law does not apply to those cases where the factors must be used in
rigidly fixed proportions.
iii) All units of the variable factors are homogenous.
Three stages of law
The behaviors of the Output when the varying quantity of one factor is combines with a
fixed quantity of the other can be divided in to three district stages. The three stages
can be better understood by following the table.
Fixed factor Variable factor Total product Average Marginal

(Labour) Product Product
1 1 100 100 - Stage
1 2 220 120 120 I
1 3 270 90 50
1 4 300 75 30 Stage
1 5 320 64 20 II
1 6 330 55 10
1 7 330 47 0 Stage
1 8 320 40 -10 III
Above table reveals that both average product and marginal product increase in the
beginning and then decline of the two marginal products drops of faster than average
product. Total product is maximum when the farmer employs 6 th worker, nothing is
produced by the 7th worker and its marginal productivity is zero, whereas marginal
product of 8th worker is ‘-10’, by just creating credits 8 th worker not only fails to make a
positive contribution but leads to a fall in the total output.
Production function with one variable input and the remaining fixed inputs is illustrated
as below

From the above graph the law of variable proportions operates in three stages. In the
first stage, total product increases at an increasing rate. The marginal product in this
stage increases at an increasing rate resulting in a greater increase 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 diminishing returns starts operating from the second stage
awards. At the second stage total product increases only at a diminishing rate. The
average product also declines. The second stage comes to an end where total product
becomes maximum 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.
We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than
“ A. P; When ‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A.
P.’ starts falling, ‘M. P.’ falls faster than ‘ A. P.’.
Thus, the total product, marginal product and average product pass through three
phases, viz., increasing diminishing and negative returns stage. The law of variable
proportion is nothing but the combination of the law of increasing and demising returns.
II. Law of Returns of Scale
The law of returns to scale explains the behavior of the total output in response to
change in the scale of the firm, i.e., in response to a simultaneous to changes in the
scale of the firm, i.e., in response to a simultaneous and proportional increase in all the
inputs. More precisely, the Law of returns to scale explains how a simultaneous and
proportionate increase in all the inputs affects the total output at its various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed

factors can not be changed and all factors cannot be changed. On the other hand in the
long-term all factors can be changed as made variable. When we study the changes in
output when all factors or inputs are changed, we study returns to scale. An increase in
the scale means that all inputs or factors are increased in the same proportion. In
variable proportions, the cooperating factors may be increased or decreased and one
faster (Ex. Land in agriculture (or) machinery in industry) remains constant so that the
changes in proportion among the factors result in certain changes in output. In returns
to scale all the necessary factors or production are increased or decreased to the same
extent so that whatever the scale of production, the proportion among the factors
remains the same.
When a firm expands, its scale increases all its inputs proportionally, then technically
there are three possibilities. (i) The total output may increase proportionately (ii) The
total output may increase more than proportionately and (iii) The total output may
increase less than proportionately. If increase in the total output is proportional to the
increase in input, it means constant returns to scale. If increase in the output is
greater than the proportional increase in the inputs, it means increasing return to scale.
If increase in the output is less than proportional increase in the inputs, it means
diminishing returns to scale.
Let us now explain the laws of returns to scale with the help of isoquants for a two-
input and single output production system.
ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a firm. When a firm
expands its size of production by increasing all the factors, it secures certain
advantages known as economies of production. Marshall has classified these economies
of large-scale production into internal economies and external economies.
Internal economies are those, which are opened to a single factory or a single firm
independently of the action of other firms. They result from an increase in the scale of

output of a firm and cannot be achieved unless output increases. Hence internal
economies depend solely upon the size of the firm and are different for different firms.
External economies are those benefits, which are shared in by a number of firms or
industries when the scale of production in an industry or groups of industries increases.
Hence external economies benefit all firms within the industry as the size of the
industry expands.
Causes of internal economies

Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization.
1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a
fixed minimum size. For instance, if a worker works half the time, he may be paid half
the salary. But he cannot be chopped into half and asked to produce half the current
output. Thus as output increases the indivisible factors which were being used below
capacity can be utilized to their full capacity thereby reducing costs. Such indivisibilities
arise in the case of labour, machines, marketing, finance and research.
2. Specialization.
Division of labour, which leads to specialization, is another cause of internal economies.

Specialization refers to the limitation of activities within a particular field of production.
Specialization may be in labour, capital, machinery and place. For example, the
production process may be split into four departments relation to manufacturing,
assembling, packing and marketing under the charge of separate managers who may
work under the overall charge of the general manger and coordinate the activities of
the for departments. Thus specialization will lead to greater productive efficiency and to
reduction in costs.
Internal Economies
Internal economies may be of the following types.
A). Technical Economies.
Technical economies arise to a firm from the use of better machines and superior
techniques of production. As a result, production increases and per unit cost of
production falls. A large firm, which employs costly and superior plant and equipment,
enjoys a technical superiority over a small firm. Another technical economy lies in the
mechanical advantage of using large machines. The cost of operating large machines is
less than that of operating mall machine. More over a larger firm is able to reduce it’s
per unit cost of production by linking the various processes of production. Technical
economies may also be associated when the large firm is able to utilize all its waste
materials for the development of by-products industry. Scope for specialization is also
available in a large firm. This increases the productive capacity of the firm and reduces
the unit cost of production.
B). Managerial Economies
These economies arise due to better and more elaborate management, which only the
large size firms can afford. There may be a separate head for manufacturing,
assembling, packing, marketing, general administration etc. Each department is under
the charge of an expert. Hence the appointment of experts, division of administration
into several departments, functional specialization and scientific co-ordination of various
works make the management of the firm most efficient.
C). Marketing Economies
The large firm reaps marketing or commercial economies in buying its requirements
and in selling its final products. The large firm generally has a separate marketing
department. It can buy and sell on behalf of the firm, when the market trends are more
favorable. In the matter of buying they could enjoy advantages like preferential
treatment, transport concessions, cheap credit, prompt delivery and fine relation with
dealers. Similarly it sells its products more effectively for a higher margin of profit.
D). Financial Economies
The large firm is able to secure the necessary finances either for block capital purposes
or for working capital needs more easily and cheaply. It can barrow from the public,
banks and other financial institutions at relatively cheaper rates. It is in this way that a
large firm reaps financial economies.
E). Risk bearing Economies
The large firm produces many commodities and serves wider areas. It is, therefore,
able to absorb any shock for its existence. For example, during business depression,
the prices fall for every firm. There is also a possibility for market fluctuations in a
particular product of the firm. Under such circumstances the risk-bearing economies or
survival economies help the bigger firm to survive business crisis.
F). Economies of Research
A large firm possesses larger resources and can establish it’s own research laboratory
and employ trained research workers. The firm may even invent new production
techniques for increasing its output and reducing cost.
G). Economies of welfare
A large firm can provide better working conditions in-and out-side the factory. Facilities
like subsidized canteens, crèches for the infants, recreation room, cheap houses,
educational and medical facilities tend to increase the productive efficiency of the
workers, which helps in raising production and reducing costs.
External Economies.
Business firm enjoys a number of external economies, which are discussed below:
A). Economies of Concentration
When an industry is concentrated in a particular area, all the member firms reap some
common economies like skilled labour, improved means of transport and
communications, banking and financial services, supply of power and benefits from
subsidiaries. All these facilities tend to lower the unit cost of production of all the firms
in the industry.
B). Economies of Information
The industry can set up an information centre which may publish a journal and pass on
information regarding the availability of raw materials, modern machines, export
potentialities and provide other information needed by the firms. It will benefit all firms
and reduction in their costs.
C). Economies of Welfare

An industry is in a better position to provide welfare facilities to the workers. It may get
land at concessional rates and procure special facilities from the local bodies for setting
up housing colonies for the workers. It may also establish public health care units,
educational institutions both general and technical so that a continuous supply of skilled
labour is available to the industry. This will help the efficiency of the workers.
D). Economies of Disintegration
The firms in an industry may also reap the economies of specialization. When an
industry expands, it becomes possible to spilt up some of the processes which are
taken over by specialist firms. For example, in the cotton textile industry, some firms
may specialize in manufacturing thread, others in printing, still others in dyeing, some
in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the firms
specializing in different fields increases and the unit cost of production falls.
Thus internal economies depend upon the size of the firm and external economies
depend upon the size of the industry.
DISECONOMIES OF LARGE SCALE PRODUCTION
Internal and external diseconomies are the limits to large-scale production. It is

possible that expansion of a firm’s output may lead to rise in costs and thus result
diseconomies instead of economies. When a firm expands beyond proper limits, it is
beyond the capacity of the manager to manage it efficiently. This is an example of an
internal diseconomy. In the same manner, the expansion of an industry may result in
diseconomies, which may be called external diseconomies. Employment of additional
factors of production becomes less efficient and they are obtained at a higher cost. It is
in this way that external diseconomies result as an industry expands.
The major diseconomies of large-scale production are discussed below:
Internal Diseconomies
A). Financial Diseconomies
For expanding business, the entrepreneur needs finance. But finance may not be easily
available in the required amount at the appropriate time. Lack of finance retards the
production plans thereby increasing costs of the firm
B). Managerial diseconomies
There are difficulties of large-scale management. Supervision becomes a difficult job.

Workers do not work efficiently, wastages arise, decision-making becomes difficult,
coordination between workers and management disappears and production costs
increase.
C). Marketing Diseconomies
As business is expanded, prices of the factors of production will rise. The cost will
therefore rise. Raw materials may not be available in sufficient quantities due to their
scarcities. Additional output may depress the price in the market. The demand for the
products may fall as a result of changes in tastes and preferences of the people. Hence
cost will exceed the revenue.
D). Technical Diseconomies
There is a limit to the division of labour and splitting down of production p0rocesses.
The firm may fail to operate its plant to its maximum capacity. As a result cost per unit
increases. Internal diseconomies follow.
E). Diseconomies of Risk-taking
As the scale of production of a firm expands risks also increase with it. Wrong decision
by the management may adversely affect production. In large firms are affected by any
disaster, natural or human, the economy will be put to strains.
External Diseconomies
When many firm get located at a particular place, the costs of transportation increases
due to congestion. The firms have to face considerable delays in getting raw materials
and sending finished products to the marketing centers. The localization of industries
may lead to scarcity of raw material, shortage of various factors of production like
labour and capital, shortage of power, finance and equipments. All such external
diseconomies tend to raise cost per unit.

COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends
upon its ability to earn sustained profits. Profits are the difference between selling price
and cost of production. In general the selling price is not within the control of a firm but
many costs are under its control. The firm should therefore aim at controlling and
minimizing cost. Since every business decision involves cost consideration, it is
necessary to understand the meaning of various concepts for clear business thinking
and application of right kind of costs.
COST CONCEPTS
A managerial economist must have a clear understanding of the different cost concepts
for clear business thinking and proper application. The several alternative bases of
classifying cost and the relevance of each for different kinds of problems are to be
studied. The various relevant concepts of cost are:
1. Opportunity costs and outlay costs
Out lay cost also known as actual costs obsolete costs are those expends which are
actually incurred by the firm these are the payments made for labour, material, plant,
building, machinery traveling, transporting etc., These are all those expense item
appearing in the books of account, hence based on accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best
alternative, has the present option is undertaken. This cost is often measured by
assessing the alternative, which has to be scarified if the particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very
important in capital expenditure budgeting. This concept is very important in capital
expenditure budgeting. The concept is also useful for taking short-run decisions
opportunity cost is the cost concept to use when the supply of inputs is strictly limited
and when there is an alternative. If there is no alternative, Opportunity cost is zero.
The opportunity cost of any action is therefore measured by the value of the most
favorable alternative course, which had to be foregoing if that action is taken.
2. Explicit and implicit costs

Explicit costs are those expenses that involve cash payments. These are the actual or
business costs that appear in the books of accounts. These costs include payment of
wages and salaries, payment for raw-materials, interest on borrowed capital funds, rent
on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself.
These costs are not actually incurred but would have been incurred in the absence of
employment of self – owned factors. The two normal implicit costs are depreciation,
interest on capital etc. A decision maker must consider implicit costs too to find out
appropriate profitability of alternatives.
3. Historical and Replacement costs
Historical cost is the original cost of an asset. Historical cost valuation shows the cost of
an asset as the original price paid for the asset acquired in the past. Historical valuation
is the basis for financial accounts.
A replacement cost is the price that would have to be paid currently to replace the
same asset. During periods of substantial change in the price level, historical valuation
gives a poor projection of the future cost intended for managerial decision. A
replacement cost is a relevant cost concept when financial statements have to be
adjusted for inflation.
4. Short – run and long – run costs
Short-run is a period during which the physical capacity of the firm remains fixed. Any
increase in output during this period is possible only by using the existing physical
capacity more extensively. So short run cost is that which varies with output when the
plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including
plant and capital equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and books costs
Out-of pocket costs also known as explicit costs are those costs that involve current
cash payment. Book costs also called implicit costs do not require current cash
payments. Depreciation, unpaid interest, salary of the owner is examples of back costs.

But the book costs are taken into account in determining the level dividend payable
during a period. Both book costs and out-of-pocket costs are considered for all
decisions. Book cost is the cost of self-owned factors of production.
6. Fixed and variable costs
Fixed cost is that cost which remains constant for a certain level to output. It is not
affected by the changes in the volume of production. But fixed cost per unit decrease,
when the production is increased. Fixed cost includes salaries, Rent, Administrative
expenses and depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total
output results in an increase in total variable costs and decrease in total output results
in a proportionate decline in the total variables costs. The variable cost per unit will be
constant. Ex: Raw materials, labour, direct expenses, etc.
7. Post and Future costs
Post costs also called historical costs are the actual cost incurred and recorded in the
book of account these costs are useful only for valuation and not for decision making.
Future costs are costs that are expected to be incurred in the futures. They are not
actual costs. They are the costs forecasted or estimated with rational methods. Future
cost estimate is useful for decision making because decision are meant for future.
8. Traceable and common costs
Traceable costs otherwise called direct cost, is one, which can be identified with a
products process or product. Raw material, labour involved in production is examples of
traceable cost.
Common costs are the ones that common are attributed to a particular process or
product. They are incurred collectively for different processes or different types of
products. It cannot be directly identified with any particular process or type of product.
9. Avoidable and unavoidable costs
Avoidable costs are the costs, which can be reduced if the business activities of a
concern are curtailed. For example, if some workers can be retrenched with a drop in a
product – line, or volume or production the wages of the retrenched workers are
escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction
in this cost even if reduction in business activity is made. For example cost of the ideal
machine capacity is unavoidable cost.
10. Controllable and uncontrollable costs
Controllable costs are ones, which can be regulated by the executive who is in change
of it. The concept of controllability of cost varies with levels of management. Direct
expenses like material, labour etc. are controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to
various processes or products in some proportion. This cost varies with the variation in
the basis of allocation and is independent of the actions of the executive of that
department. These apportioned costs are called uncontrollable costs.
11. Incremental and sunk costs
Incremental cost also known as different cost is the additional cost due to a change in
the level or nature of business activity. The change may be caused by adding a new
product, adding new machinery, replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred
in the past. This cost is the result of past decision, and cannot be changed by future
decisions. Investments in fixed assets are examples of sunk costs.
12. Total, average and marginal costs
Total cost is the total cash payment made for the input needed for production. It may
be explicit or implicit. It is the sum total of the fixed and variable costs. Average cost is
the cost per unit of output. If is obtained by dividing the total cost (TC) by the total
quantity produced (Q)
TC
Average cost = ------
Q

Marginal cost is the additional cost incurred to produce and additional unit of output or
it is the cost of the marginal unit produced.
13. Accounting and Economics costs
Accounting costs are the costs recorded for the purpose of preparing the balance sheet
and profit and ton statements to meet the legal, financial and tax purpose of the
company. The accounting concept is a historical concept and records what has
happened in the post.
Economics concept considers future costs and future revenues, which help future
planning, and choice, while the accountant describes what has happened, the
economics aims at projecting what will happen.
COST-OUTPUT RELATIONSHIP
A proper understanding of the nature and behavior of costs is a must for regulation and
control of cost of production. The cost of production depends on money forces and an
understanding of the functional relationship of cost to various forces will help us to take
various decisions. Output is an important factor, which influences the cost.
The cost-output relationship plays an important role in determining the optimum level
of production. Knowledge of the cost-output relation helps the manager in cost control,
profit prediction, pricing, promotion etc. The relation between cost and its determinants
is technically described as the cost function.
C= f (S, O, P, T ….)
Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology
Considering the period the cost function can be classified as (a) short-run cost function
and (b) long-run cost function. In economics theory, the short-run is defined as that
period during which the physical capacity of the firm is fixed and the output can be

increased only by using the existing capacity allows to bring changes in output by
physical capacity of the firm.
(a) Cost-Output Relation in the short-run
The cost concepts made use of in the cost behavior are total cost, Average cost, and
marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total
cost is the summation of fixed and variable costs.
TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant, building,
equipment etc, remains fixed. But the total variable cost i.e., the cost of labour, raw
materials etc., Vary with the variation in output. Average cost is the total cost per unit.
It can be found out as follows.
TC
AC= Q
Q
The total of average fixed cost (TFC/Q) keep coming down as the production is
increased and average variable cost (TVC/Q) will remain constant at any level of
output.
Marginal cost is the addition to the total cost due to the production of an additional unit
of product. It can be arrived at by dividing the change in total cost by the change in
total output.
In the short-run there will not be any change in total fixed cost. Hence change in total
cost implies change in total variable cost only.

Cost – output relations
Units of Total Total Total Average Average Average Marginal

Output fixed variable cost variable fixed cost cost cost
Q cost cost TC=(TFC cost AFC=(TFC AC=(TC/Q) MC
TFC TVC + TVC) AVC=(TVC / Q)
/ Q)
0 60 - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42
The above table represents the cost-output relation. The table is prepared on the basis
of the law of diminishing marginal returns. The fixed cost Rs. 60 May include rent of
factory building, interest on capital, salaries of permanently employed staff, insurance
etc. The table shows that fixed cost is same at all levels of output but the average fixed
cost, i.e., the fixed cost per unit, falls continuously as the output increases. The
expenditure on the variable factors (TVC) is at different rate. If more and more units
are produced with a given physical capacity the AVC will fall initially, as per the table
declining up to 3rd unit, and being constant up to 4th unit and then rising. It implies that
variable factors produce more efficiently near a firm’s optimum capacity than at any
other levels of output.
And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’
starts rising from the 5th unit onwards whereas the ‘AC’ starts rising from the 6 th unit
only so long as ‘AVC’ declines ‘AC’ also will decline. ‘AFC’ continues to fall with an
increase in Output. When the rise in ‘AVC’ is more than the decline in ‘AFC’, the total
cost again begin to rise. Thus there will be a stage where the ‘AVC’, the total cost again
begin to rise thus there will be a stage where the ‘AVC’ may have started rising, yet the
‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and
diminishing returns or diminishing cost in the second stage and followed by diminishing
returns or increasing cost in the third stage.

The short-run cost-output relationship can be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an account of its
spread over more and more units Output. But AVC curve (i.e. variable cost per unit)
first falls and then rises due to the operation of the law of variable proportions. The
behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In
the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline.
But after a certain point ‘AVC’ starts rising. If the rise in variable cost is less than the
decline in fixed cost, ATC will still continue to decline otherwise AC begins to rise. Thus
the lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’
curve are U-shaped. The lowest point in ‘ATC’ curve indicates the least-cost
combination of inputs. Where the total average cost is the minimum and where the
“MC’ curve intersects ‘AC’ curve, It is not be the maximum output level rather it is the
point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:
1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

b. Cost-output Relationship in the long-run
Long run is a period, during which all inputs are variable including the one, which are
fixes in the short-run. In the long run a firm can change its output according to its
demand. Over a long period, the size of the plant can be changed, unwanted buildings
can be sold staff can be increased or reduced. The long run enables the firms to expand
and scale of their operation by bringing or purchasing larger quantities of all the inputs.
Thus in the long run all factors become variable.
The long-run cost-output relations therefore imply the relationship between the total
cost and the total output. In the long-run cost-output relationship is influenced by the
law of returns to scale.
In the long run a firm has a number of alternatives in regards to the scale of
operations. For each scale of production or plant size, the firm has an appropriate
short-run average cost curves. The short-run average cost (SAC) curve applies to only
one plant whereas the long-run average cost (LAC) curve takes in to consideration
many plants.
The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above
figure it is assumed that technologically there are only three sizes of plants – small,
medium and large, ‘SAC’, for the small size, ‘SAC2’ for the medium size plant and
‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output, it will
choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for
medium size plant. It does not mean that the OQ production is not possible with small

plant. Rather it implies that cost of production will be more with small plant compared
to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of production will be
more with medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve
drawn will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches
each ‘SAC’ curve at one point, and thus it is known as envelope curve. It is also known
as planning curve as it serves as guide to the entrepreneur in his planning to expand
the production in future. With the help of ‘LAC’ the firm determines the size of plant
which yields the lowest average cost of producing a given volume of output it
anticipates.
BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP
is the point at which total revenue is equal to total cost. It is the point of no profit, no
loss. In its broad determine the probable profit at any level of production.
Assumptions
1. All costs are classified into two – fixed and variable.

2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the
volume of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold
stock.
9. There is only one product or in the case of multiple products. Sales mix remains
constant.

Merits
1. Information provided by the Break Even Chart can be understood more easily
then those contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It
reveals how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct
material, direct labour, fixed and variable overheads.
Demerits
1. Break-even chart presents only cost volume profits. It ignores other

considerations such as capital amount, marketing aspects and effect of
government policy etc., which are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight
lines. In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm
may increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of
multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in
BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally
there may be opening stock.
10.When production increases variable cost per unit may not remain constant but
may reduce on account of bulk buying etc.
11.The assumption of static nature of business and economic activities is a well-
known defect of BEP.

1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known as
fixed expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be
noted that fixed changes are fixed only within a certain range of plant capacity. The
concept of fixed overhead is most useful in formulating a price fixing policy. Fixed
cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of
production of sales are called variable expenses. Eg. Electric power and fuel, packing
materials consumable stores. It should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies and
measuring the profitability of different proposals. Contribution is a sure test to
decide whether a product is worthwhile to be continued among different products.
Contribution = Sales – Variable cost

Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales.
It can be expressed in absolute sales amount or in percentage. It indicates the
extent to which the sales can be reduced without resulting in loss. A large margin of
safety indicates the soundness of the business. The formula for the margin of safety
is:
Profit
Present sales – Break even sales or P . V . ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.

5. Angle of incidence: This is the angle between sales line and total cost line at the
Break-even point. It indicates the profit earning capacity of the concern. Large angle
of incidence indicates a high rate of profit; a small angle indicates a low rate of
earnings. To improve this angle, contribution should be increased either by raising
the selling price and/or by reducing variable cost. It also indicates as to what extent
the output and sales price can be changed to attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios
for studying the profitability of business. The ratio of contribution to sales is the P/V
ratio. It may be expressed in percentage. Therefore, every organization tries to
improve the P. V. ratio of each product by reducing the variable cost per unit or by
increasing the selling price per unit. The concept of P. V. ratio helps in determining
break even-point, a desired amount of profit etc.
Contribution
The formula is, Sales X 100
7. Break – Even- Point: If we divide the term into three words, then it does not
require further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It
is a point of no profit, no loss. This is also a minimum point of no profit, no loss.
This is also a minimum point of production where total costs are recovered. If
sales go up beyond the Break Even Point, organization makes a profit. If they
come down, a loss is incurred.
Fixed Expenses
1. Break Even point (Units) = Contribution per unit
Fixed expenses
2. Break Even point (In Rupees) = Contribution X sales


Mefa Unit 2

Uploaded by

Copyright:

Available Formats

Mefa Unit 2

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Mefa Unit 2

Uploaded by

Copyright:

Available Formats

MANAGERIAL ECONOMICS UNIT-III

Introduction: The production function expresses a functional relationship between

1. The production function is related to a particular period of time.

Cobb-Douglas production function

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

It has the following assumptions

For a given output level firm’s production become,

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

An isoquant may be explained with the help of an arithmetical example.

Combinations Labour (units) Capital (Units) Output (quintals)

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

Producer’s Equilibrium Or Least cost combination

L K Q L&LP (3Rs.) KXKP(4Rs.) Total cost

Production analysis in economics theory considers two types of input-output

i) Law of variable proportions

I. Law of variable proportions

“When total output or production of a commodity is increased by adding units of a

i) The state of technology remains constant. If there is any improvement in

Three stages of law

Fixed factor Variable factor Total product Average Marginal

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

II. Law of Returns of Scale

The concept of variable proportions is a short-run phenomenon as in these period fixed

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

Causes of internal economies

Division of labour, which leads to specialization, is another cause of internal economies.

Internal economies may be of the following types.

A). Technical Economies.

B). Managerial Economies

C). Marketing Economies

D). Financial Economies

E). Risk bearing Economies

F). Economies of Research

G). Economies of welfare

A). Economies of Concentration

B). Economies of Information

C). Economies of Welfare

D). Economies of Disintegration

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is

The major diseconomies of large-scale production are discussed below:

A). Financial Diseconomies

B). Managerial diseconomies

There are difficulties of large-scale management. Supervision becomes a difficult job.

C). Marketing Diseconomies

D). Technical Diseconomies

E). Diseconomies of Risk-taking

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

1. Opportunity costs and outlay costs

2. Explicit and implicit costs

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

4. Short – run and long – run costs

5. Out-of pocket and books costs

K.INTHIYAZ M.B.A., NET, (Ph. D), Assistant Professor& HOD-MBA, SSITS.

6. Fixed and variable costs

7. Post and Future costs

8. Traceable and common costs

9. Avoidable and unavoidable costs