MANAGERIAL ECONOMICS

Introduction, Meaning of Production and Production Function- Law of

Variable Proportions- Cost of Production: Various types of cost of
production (internal cost and external cost) Type I Cost of production:
Short run cost of production analysis. Type II cost of production: Long
run cost of production analysis
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) TYPE 1
• 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) TYPE 2
• 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.
TYPE 1 SHORT RUN 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 Product
labour 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.

When a certain proportionate change in both the Labour and Output Proportional Proportional
Capital (TP) change in change in
inputs, K and L, leads to a more than proportionate
labour and output
change in output, it exhibits increasing returns to capital
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.
 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 L β 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-axi
1 2 3 4 s
E 5 02 200 Units 5
Units of Labour

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

same level of output Say 200 units.
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
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
• 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

• Eg - interest, rent, salaries etc

 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
 https://www.youtube.com/watch?v=98DcdXiNu4E&list=TLPQMTUx
MTIwMjDqvXOGSkXvGg&index=2
 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.
IIIUNIT END