MANAGERIAL ECONOMICS AND FINANCIAL ACCOUNTING

UNIT 2 : Introduction to Production function and Cost Analysis

1. What is the Production Function? Explain the relationship between variables and production
function? (or)

Explain the production function with reference to Law of variable proportions and substitutability
Of factors/ Explain the Law of Returns to Scale?/ Law of diminishing returns?

Definition of production function:

Samuelson defines the production function as “the technical relationship which reveals the maximum
amount of output cables of being produced by each and every set of inputs”. It is defined for a given state of
technical knowledge.
Michael R.Baye defines production function as “that function which defines the maximum amount of output
that can be produced with a given set of inputs”.
Concept of Input-output relationship (or) production functions:
The inputs for any product or service are land, labor, capital, organization and technology. In other words,
the production here is the function of these five variable inputs mathematically, this is expressed as

Q = f (L1, L2, C, O, T)

Where Q is the quantity of production, F explains the function, that is , the type of relation between inputs and
outputs,L1,L2,C,O,T refer to land, labor, capital, organization and technology respectively. These inputs have
been taken in conventional terms in reality material also can be include in a set of inputs.

Production functions with one variable input and laws of return:

The laws of return states that when at least one factor of production is fixed when all other factors are varied,
the total output in the initial stage with increasing rate, and after reaching certain level of output the total
output will increase at declining rate. If variable factors Inputs are added further to the fixed factor inputs, the
total output may decline. This law of universal nature and it proved to be true in agriculture and industry also.
The law of returns is also called the law of variable production are the law of diminishing return. Here all the
inputs are proportionately increased this can explained with the following table

No. of Laborers Total product Marginal product Average product Stage

1 5 5 5
2 12 7 6 First Phase
3 18 6 6
1
 4 20 2 5 Second Phase
5 20 0 4
6 18 -2 3
7 14 -4 2 Third Phase

Stage: 1 Law of increasing returns:- The output increases due to increase in the inputs due to following are
the reasons for increasing returns:
1 Right combination of factors of production 4. Availability of external economics
2 Full utilization of productive capacity 5. Improve the technical knowledge
3 Efficient specialization 6. Efficient labor mixture

Stage: 2 Law of constant returns:- Increase in the total output remains constant, due to the following reasons
1. Scarcity of factors 5. Returns exhausted
2. Imperfect substitutability 6. No possibility for further productivity
3. Factors not homogeneous 7. Assumptions of law applicability
4. Wrong combination of factors 8. Lack of extensive knowledge

Stage: 3 Law of decreasing returns: - The total output decline due to the following reasons:
1. Less efficiency and productivity 4. Optimum completed the plant capacity
2. Difficulty in supervision 5. Increase the production cost
3. Lack of co-ordination among factors 6. Outdated technical knowledge

Production functions with two variables and laws of returns:

Let us consider a production process that requires two inputs, capital(C) and labor (L) to produce a given
output (Q) there could be more than two inputs in a real life situation but for a simple analysis we restrict the
number of inputs to two only. In other words the production function based on two inputs can be expressed as

Q = f (C, L)

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2. What are Isoquants and Isocosts?

ISOQUANTS: ‘Iso’ means equal: ‘quant ‘means quantity. Isoquant means that the quantities throughout a
given isoquant are equal. Isoquants are also called Isoproduct curves. An isoquant curve shows various
combinations two input factors such as capital and labor, which yield the same level of output. As an Isoquant
curve represents all such combinations which yield equal quantity of output, any or every combination is a
good combination, for the manufacture. Since he prefer all these combinations equally, an isoquant curve is
also called’ product indifference curve’

FEATURES OF ISOQUANTS:

1. DOWN WORD SLOPING: Isoquants are downward sloping curve because, if one input increases, the
other one reduce. there is no question of increase in both the inputs to yield a given output degree of
substitution is assumed between the factor of production. In other words an isoquant cannot be increasing, as
increase in both the inputs does not yield same level of output. If it is constant, it means that the output
remains constant through the use of one of the factor is increasing which is not true isoquant slop from left to
right.

C E
a
p D
i
t C IQ 20,000 units
a
B A
l

Labor

Fig: Isoquants yielding 20,000 units of production

2. CONVEX TO ORIGIN: Isoquants are convex to the origin. It is because the input factors are not perfect
substitutes one input factor can be substitute by other input factor in a “diminishing marginal rate”. If the
input factor can be substitutes the isoquant would be a falling straight line when the inputs are used in fixed
proportion, and substitution of one input for the other cannot take place, the isoquant will be L shaped.

3. DO NOT INTERSECT: Two isoproducts do not intersect with each other it is because each of these
denotes a particular level of output if the manufacturer wants to operator at a higher level of output; he has to
switch over to another isoquant with a higher level of output vice versa.

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4. DO NOT TOUCH AXES: The Isoquants touch neither X-axis nor Y-axis as both inputs are required to
produce a given product.

C
A
P IQ3 = 40,000 units
I
IQ2= 30,000 units
T
A IQ1 = 20,000 units
l

LABOUR

Fig:5.3(a) Isoquants where input factors are perfect substitutes

C
A
P
I IQ3 = 40,000 units
T
A
IQ2= 30,000 units
l

IQ1 = 20,000 units

LABOUR

Fig: 5.3(b) Isoquants where input factors are not perfect substitutes

C
A
P IQ3 = 40,000 units
I
T
IQ2= 30,000 units
A
l
IQ3 = 20,000 units

LABOUR

Fig: 5.3 (c)Isoquants each showing different volumes of output

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ISOCOST:

Isocost refer to that cost curve that represents the combinations of inputs that will cost the
producer the same amount of money. In other words each isocost denotes a particular level of total cost for a
given Level of production. If the level of production changes the total cost changes and thus isocost curve
moves upwards and vice versa.

IC 3 = 2 lakh

IC 2 = 1.5lakh

IC 1 = 1 lakh

CAPITAL

LABOUR

Figure 5.4 three down word sloping straight line cost curves(assuming that the input price are fixed, no
quality discount are available) each costing Rs 1.0 lakh, is 1.5 lakh, and 2.0 lakh for the out put level of
20,000,30,000 and 40,000 units( the total cost as represent by each cost curve is calculated by multiplying the
quantity of each input factor with in input price) Isocosts farther from the origin, for given input costs, are
associated with higher cost any change in input prices changes the slope of isocost lines.

LEAST COST COMBINATION OF INPUTS:

Where the slope of isoquant is equal to that of isocost, there lies the lowest point of cost of production. This
can be observed by the isocosts on isoproduct curves. The points of tangency P, Q, R on each of the isoquants
curves represents the least cost combination of inputs, yielding maximum level of output. The subsituition of
one input for the another continues until the producer reaches the point of P, Q, R where the inputs are equal
to the ratio between the prices of inputs. Thus at the point of equilibrium lies the expansion Path. The
expansion path refers to the line representing the least cost combinations of inputs P, Q, R for different levels
of output. Expansion path indicates how the production can be expanded along this path, if the factor prices
are given.

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 Fig: 5.4 Isoquants each representing different levels of total cost

3. Explain briefly Cobb-Douglas production function.( Regular 2016)

CONCEPT OF COBB-DOUGLAS PRODUCTION FUNCTION:-

Cob and Douglas put forth a production function relating output in American
manufacturing industries from 1899 to 1922 to labor and capital inputs they used the following formula
P=b Lᵃ C ¹- ͣ
Where P is total output
L= the index of employment of labor in manufacturing
C= index of fixed capital in manufacturing
The exponents a and 1-a are the elasticity’s of production these measure the percentage response of output to
percentage changes in labor and capital respectively
The function estimated for the USA by cob and Douglas is
P=1.01 L0.75 C 0.25
R²=0.9409
The production function shows the one present change in labor input, capital reaming the same, is associated
with 0.75 present changes in output. Similarly, one present change in capital, labor remaining the same, is
associated with 0.25 present changes in output. The coefficient determination (R²) means that 94% of the
variations on the dependent variable (P) we accounted for by the variations in the independent variables (L
and C). It indicates constant return to the scale which means that there are no economics (or) diseconomies of
large scale of production.

4. What is Leontief Production function?

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Concept of Leontief Production function :In economics, the Leontief production function or fixed
proportions production function is a production function that implies the factors of production will be used
in fixed (technologically pre-determined) proportions, as there is no substitutability between factors. It was
named after Wassily Leontief and represents a limiting case of the constant elasticity of
substitution production function.
For the simple case of a good that is produced with two inputs, the function is of the form
where q is the quantity of output produced, z1 and z2 are the utilized quantities of input 1 and input 2
respectively, and a and b are technologically determined constants.
Example: Suppose that the intermediate goods "tires" and "steering wheels" are used in the production of
automobiles (for simplicity of the example, to the exclusion of anything else). Then in the above
formula q refers to the number of automobiles produced, z1 refers to the number of tires used, and z2 refers to
the number of steering wheels used. Assuming each car is produced with 4 tires and 1 steering wheel, the
Leontief production function is
Number of cars = Min {¼ times the number of tires, 1 times the number of steering wheels}

5. What is Economics to Scale? Discuses the various types of Organizational Economics? ( or )

Explain the internal and external economics of large scale.

ECONOMIES OF SCALES: The economics of scale result because of increase in the scale of production.
Alfred marshal divides the economics of scale into two groups: internal (or) external.

INTERNAL ECONOMICS: Internal economics refer to the economics in production costs which accrue to
the firm alone when it expands its output. The internal economics occur as a result of increase in the scale of
production. The internal economics may be of the following type:-

 MANAGERIAL ECONOMICS:-

As the firm expands, the firms need qualified managerial personnel to handle each of its functions,
marketing, finance, production, human resource s and other in a professional way. Functional specialization
ensures minimum. Wastage and lower the cost of production in long-run

 COMMERCIAL ECONOMICS:-

The transactions of buying and selling raw materials and other operating supplies such as spares and so
on will be rapid and the volume of each transaction also grows as the firm grows. There could be cheaper
saving in the procurement, transportation and storage costs. This will lead to lower costs and increased profits.

 FINANCIAL ECONOMICS:-

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 There could be cheaper credit facilities from the financial institutions to meet the capital expenditure (or)
working capital requirement. a large firm has large assets to give security to the financial institutions which
can consider reducing the rate of interest on the loans.

 TECHNICAL ECONOMICS:-

Increase in the scale of production follows when there is sophisticated technology available and the firm is
in position to hire qualified technical manpower to make use of it. There would be substantial savings in the
hiring of man power due to large investments in the technology. This lowers the cost per unit substantially.

 MARKETING ECONOMICS:-

As the firm grows larger and larger, it can afford to maintain a full fledged marketing department
independently to handle the issues related to design of customer surveys, advertising materials, promotion
campaign, handling of sales and marketing staff, renting of hoardings, launching a new product and so on.

 RISK-BEARING ECONOMIES:-

As there is growth in size of the firm, there is increase in the risk also. Sharing the risk with the insurance
companies is the first priority for any firm. The firm can insure its machinery and other asserts against the
hazards of fire, theft and other risks.

 INDIVISIBILITIESB AND AUTOMATED MACHINERY:-

To manufacture goods, a plant of certain minimum capacity is required whether the firm would like to
produce and sell and the full capacity (or) not.

 ECONOMICS OF LARGE DIMENSION:-

Large-scale production is require to take advantage of bigger size plant and equipment. For example, the cost
of a 1, 00,000 units capacity plant will not be double that of 50,000 units capacity plant.

 ECONOMICS OF RESEARCH AND DEVELOPMENT:-

Large organizations such as Dr.Reddy’s labs Hindustan lever spend heavily on research and development and
bring out several innovative products. Only such firms with a strong R&D base can hope with competition
globally.

EXTERNAL ECONOMIES:-

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External economies refer to all firms in the industry, because of growth of the industry as a whole (or)
because of growth of ancillary industries external economies benefits all the firms in the industry as the
industry expands. This will lead to lowering the cost if production and there by increasing the profitability
the external economies can be grouped under three types:

1) ECONOMIES OF CONCENTRATION:-

Because of all firms are located at one place, it is likely that there is better infrastructure in terms of approach
roads ,transportation facilitates such as rail way lines and so on, banking and communication facilities,
availability of skilled labor and such factors.

2) ECONOMIES OF R&D:-

All the firms can pool resources together to finance research and development activities and thus share the
benefits of research. There could be a common facility to share journals, newspapers and other valuable
reference materials of common interest.

3) ECONOMIES OF WELFARE:-

There could be common facilities such as canteen, industrial housing, community halls, schools and
colleagues, employment ‘bureau’, hospitals and so on, which can be used by common by the employees in the
whole industry.

6. Explain the various cost concepts with suitable Examples (or)

Explain the concepts of cost and explain their contribution to managerial decisions.
CONCEPT AND NATURE OF COST: Cost refers to the expenditure incurred to produce a particular
product or service. All costs involve a sacrifice of some kind or other to acquire some benefits for example, if
I want to eat food, I should prepare to sacrifice money.

Cost may be monetary or non monetary, tangible or intangible, determined subjectively or objectively.
Social costs such as pollution , noise or traffic congestion add another dimension to the cost concept. The
people in the neighborhood face the social cost by bearing with the smoke generated by the factory, adverse
health effects, and the resultant clean up cost. It is not uncommon to find psychic costs such as frustration or
dissatisfaction resulting from the stress and strain of the modern industry from activity.

The cost of product normally includes the cost of raw materials, labor and other expresses. This cost is
known as total cost (TC).this is compared with total revenue (TR) realized on the sale of the products
manufactured. The difference between the total revenue and total cost in termed as profit (TR-TC=profit).

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 Hence, the understanding of the meaning of various cost concepts is essential for clean business thinking.
They facilitate clear understanding of the management problem, and also of the concept of cost that is
reverent for it. They provide familiarity with the nature of each type of business and its financial records. It
is true that the managerial economist develops a sense of ingenuity and boldness with the knowledge of cost
analysis.

TYPES OF COSTS:

FIXED VS VARIABLE COSTS:-Variable costs are differentiated from fixed costs based on the degree of
their variability in relation to the rate of output. The distinction between fixed and variable costs is based on
an assumption that time has a significant role to play in decision making given more time, all the costs are
variable.

Fixed costs are those costs that are fixed in the short run. Whether production is taken up or not, we have to
incur certain expenses such as rent for factor and offline buildings, insurance, telephone, electricity and so on.
Even if the production is stopped temporarily for a short period, we continue to spend on these fixed cost. In
other words, total fixed cost or fixed or constant in the short run. Fixed cost per unit changes with volume of
production, the less in the fixed cost per unit and vice versa.

Variable costs are those costs that vary with the volume of production. Variable costs comprise the cost of
raw materials, wages paid to the labor and so on. These costs are incurred only when there is production. If
the production is temporarily suspended, there will not be any variable cost. In other words, the more the
production, the more are the variable cost and vice versa.

OPPORTUNITY COST:-

Opportunity costs can be distinguished from outlay costs based on the nature of sacrifice. Opportunity costs
refer to earnings/profits that are foregone from alternative ventures by using given limited facilities for a
particular purpose. They represent the only the sacrificed alternatives. So they are never recovered in the
books of account. However, there costs must be considered for decision making.

Opportunity cost refer to the next best alternative foregone for the cost. We have scarce resources and all
these have alternative uses. Where there is an opportunity to reinvest the resource. In other words, if there are
no alternatives, there are no opportunity costs it is necessary that should always consider the cost of the next
best alternative foregone before committing funds on a given option. In other words, the benefits from the
present opinion should be more than the benefits of the best alternative variability with output.

EXPLICIT VS. IMPLICIT COSTS:-

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The cost of using resources in production involve both explicit cost(also called out-of- pocket costs) and
other non-cash costs called implicit costs.

Explicit cost involve payment of cash the rent for the landlord, wages for the labors, interest paid on the
funds borrowed, taxes and duties paid to the government and so on, are the explicit costs

Implicit costs are also called imputed costs. Implicit costs do not involve payment of cash and they are not
actually incurred. They would have been incurred had the owner not been in possession of the facilities.
Hence, these are only national costs. Examples, of implicit costs are: interest on own capital, savings in terms
of salary due to own supervision, rent of own premises and so forth.

Both implicit and explicitly costs are important for decision-making. If ignored they lead to over-estimation of
profits, which is not desirable.

OUT OF POCKET COST:

This destination is based on traceability and variability with output. Out of pocket costs are those costs that
involves on immediate outflow of cash. These are spent at day-to-day life of the business, such as purchase of
raw materials or payment of salaries, utility expenses, rent of the premises occupied, interest on loans and so
on. Out-of-pocket costs are also called “explicitly costs” because they are incurred in reality.

7. Describe Break-Even Point with the help of diagram? Or Cost Volume Profit Analysis.

BREAK EVEN ANALYSIS:-

Break even analysis refer to analysis of the breakeven point (BEP). The BEP is defined as a no- profit or no-
loss point. Why is it necessary to determine the BEP when there is neither profit nor loss? It is important
because it denotes the minimum volume of production to be undertaking to avoid losses. In other words, it
points out how much minimum is to be produced to see the profits. It is a technique for profit planning and
control, and therefore is considered a variable managerial tool.
Break-even analysis is defined as analysis of costs and their possible impact on revenue and volume of firm.
Hence, it is also called the cost-volume-profit analysis. A firm is said to attain the BEP when its total revenue
is equal to total cost(TR=TC).
Total cost comprises fixed cost and variable costs. The significant variables on which the BEP is based are
fixed costs, variable costs and total revenue

“Key terms used in break even analysis is followed in the notes”

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BEA is a subset of CVP analysis which is used by management to help understand the relationships between
cost, sales volume and profit. This techniques focuses on how much selling prices, sales volume, variable
costs, fixed costs and the mix of product sold affects profit.

LIMITATIONS of BEA:

 BEP is based on fixed cost, variable cost and total revenue. A change in one variable will affect the BEP
 Total cost and total revenue lines are not always straight as shown in the figure.
 It is based on fixed cost concept and hence holds good only on short run
 All costs cannot be classified into fixed costs and variable costs.

SIGNIFICANCE of BEA:

 To calculate sales required to earn a particular desired level of profit.

 To compare the efficiency of the different terms.
 To decide whether to add particular product to the existing product line or drop one from it
 To ascertain the profit on a particular level of sales volume or a given capacity of production

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