Unit 3 Managerial Economics - Production Analysis

Theory of Production
Optimum Efficiency in production or minimizing cost of Production.

To cater this problem, some fundamental questions faced by business managers are

(i) Output response to change in quantity of inputs.

(ii) How technology helps in reducing cost of production.

(iii) How to obtain least cost combination of inputs.

(iv) What happens to rate of return if more plants are installed?

Theory of Production deals with quantitative relationship , Technical and Technological

between inputs ( labour and Capital ) and Output

Some Basic Concept

Production in Manufacturing – transferring inputs ( labour, capital, raw material , time) into
output.

Production in Economics – Process by which resources are transformed into different and
more useful commodity, i.e. some Value Addition is done at different points of time.

Examples

(i)Transporting goods from one place to another

(ii) Storing goods for future consumption.

(iii) Wholesaling , Packaging , Retailing , Assembling all are production

(iv) in some cases inputs and outputs both are intangible.

Input and Output

Input – Anything which the firms buys for use in its production or other process. In economics
input could be any of the labour, Capital, Land Raw Materials , Entrepreneurship, Technology and
Time.

Output - Goods or Service that comes out of Production.

Fixed and Variable Inputs

Fixed Input – in economics inputs whose supply is inelastic in short run but not in long run , hence
all of its users can not buy more of it in short run.

Variable input - in economics inputs whose supply is elastic in short run and long run , hence all of
its users can buy more of it in short and long run .
Short Run and Long run

With reference to time period involved in production process , there are two reference periods Short
Run and Long run.

Short Run – time period in which supply of certain inputs ( plant, building , machinery ) is fixed,
hence production can be increased by increasing amount of variable inputs like labour and material.

Long Run – time period in which supply of all inputs is elastic , hence production can be increased by
increasing amount of both types of inputs . In this time frame , changes in Technology in not
possible.

Very Long Run – A time period where technology of production is also subject to change and
production function also changes.

Meaning and Types of Production Function

Production function is a mathematical relation between input and output.It may take the form of a
schedule or table , a graphed line or curve ,an algebraic equation or mathematical model, which are
inter convertible.

Inputs to a production function may be land and building (LB) , labour (L), Capital C), raw material
(M), technology (T) and time (t).

Q= f ( LB, L, C, M, T , t)

Majorly it is dependency of production on Capital and Labour.

Features of Production Function

Production function presumes the following features.

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 few inputs, while the
quantities of all other inputs are held constant.

Complementarity : 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 quantities of either of
inputs used in the production function is zero.

Specificity: It reveals that the inputs are specific to the production of a particular product. Machines
and equipments, specialized workers and raw materials are a few examples of the specificity.
Production function with two inputs
Production function with two variable inputs K and L is expressed as

Q= f K,L ……………… i

The reason for excluding other inputs are as follows:

Land and building – Constant for the entire economy , but not constant for company or industry,
hence clubbed with Capital.

Raw Material – Bears a constant relation to output at all levels of production. Amount of steel, no.
of tyres , no. of engines per car are fixed, hence left out of production process.

Technology – Remains constant over a period of time.

Hence most of the production function considers only Labour and Capital.

Short Run and Long Run Production function

From equation (i) , we conclude that Quantity will depend on Capital and labour . To increase the
production company will use only Capital , only labour or both will depend on time period ( Short
run , Long run) it takes to increase production .

Short run – Supply of Capital is inelastic , hence only labour can be increased to increase production.

Long run – Supply of Capital and labour both are Elastic , hence both inputs can be increased to
increase Production.

Accordingly there are two production function:

(i) Short run production Function ( Single variable input production function) , Q= f (L)

(ii) Long run production function , Q= f ( K,L)

Cobb Douglas Production Function
The Cobb Douglus production function can be expressed as , in the form of Equation as:

Q=A Ka Lb,

where K= Capital and L=Labour , A ,a and b are parameter and b=(1-a)

The Numerical Values of parameters A, a and b can be estimated by using actual factory data on
production, Capital and labour.

Suppose A=50 , a=0.5 , b=0.5 then Specific form of Cobb Douglas Equation

Q=50 K0.5 L0.5

For K=1 and L= 10 Q=158

For K=2 and L=5 Q=158

For K=5 and L=2 Q=158

For K=10 and L=1 Q=158

Hence we can find the resulting output, by varying the numerical values of K and L which can be
plotted on graph. Important to note here that four combination of K and L , are producing the same
amount of output , when joined by a line , produces a curve known as Isoquant Curve ( A very
important tool to analyze input and output relationship).

Short Run laws of Production: One variable input

In short run, input output relations are studied with one variable input (labour), other inputs held
constant. These are known as La s of Va ia le p opo tio s o la s of etu s to a a ia le i put .

The Law of Diminishing return

It states that when more and more units of a variable input are used with a given quantity of fixed
input , the total output may initially increase at increasing rate and then at constant rate but it will
eventually increase at diminishing rate.

i.e. marginal increase in total output decreases eventually , when additional units of a variable factor
are used , given quantity of fixed factors.

Assumptions

1. Only labour is variable , Capital is Constant.

2. Labour is homogenous.

3. No change Technology and Input prices.

Long Run laws of Production: Two variable input
• Relationship between input and output , when both the inputs Capital and Labour are
variable. In long run, demand for both inputs are elastic and hence more quantity of both
can be arranged, as e result scale of production increases.

• The technological relationship between changing scale of inputs and output is explained
under laws of return to scale.

• This law can be explained through Isoquant curve and production function.

INDIFFERENCE CURVE
Definition : An Indifference curve (IC) is the locus of points each representing a different
combination of two substitute goods, which yield the same utility or level of satisfaction to the
consumer. Therefore he is indifferent between any two combinations of two goods when it comes to
making a choice between them .

Thus consumer is indifferent towards all the combinations lying on the same indifference curve. In
other words, consumer gives equal preference to all such combinations.

INDIFFERENCE CURVES

24
22 A(1, 22)
20
INDIFFERENCE SCHEDULE 18
(Table Showing Different
16
Combinations giving Equal
Satisfaction) 14
Combinatio Apples Oranges
12
n 10
A 1 22 8
6
B 2 14
Oranges

4
C 3 10 2 Apples
D 4 8 0
E 5 7 1 2 3 4 5 6

Something more about Indifference Curve

1. Indifference curve below ( U1) the one mentioned in prior slide (U) will give us less utility ,
and above (U2) , will give us more utility.

2. U1< U and U < U2

3. An Indifference curve is formed by substituting one good for another . The MRS is the rate at
which one commodity can be substituted for another , the level of satisfaction remaining the
same.
MARGINAL RATE OF SUBSTITUTION (MRS)

The marginal rate of substitution of X for Y (MRSxy) is defined as the amount of Y, the consumer is
just willing to give up to get one more unit of X and maintain the same level of satisfaction.

MRSxy = Decrease in the Consumption of Y / Increase in the Consumption of X = (-) ∆Y / ∆X

DIMINISHING MARGINAL RATE OF SUBSTITUTION

Combination Apples Oranges MRS

A 1 22 ---

B 2 14 8:1

C 3 10 4:1

D 4 8 2:1

E 5 7 1:1

As the consumer increases the consumption of apples, then for getting every additional unit of
apples, he will give up less and less of oranges, that is, 8:1, 4:1, 2:1, 1:1 respectively This is the Law
of Diminishing MRS.

LAW OF DIMINISHING MRS

24 A
22
20
MRS = -O/A = 8:1
18
16
MRS = 4:1
14
MRS is measured by 12 MRS = 2:1
the slope of the 10
indifference curve 8
6
Oranges

4 IC1

2
Apples
0
1 2 3 4 5
Why MRS Decreases
Marginal Utility (MU) of a commodity increases , as its quantity decrease and vive versa.

Since goods are not perfect substitute , the subjective value attached to the additional quantity (
Subjective MU) of a commodity decreases fast in relation to the other commodity whose total
quantity is decreasing.

Therefore when the quantity of one commodity (X) increases and that of other (Y) decreases, the
subjective MU of Y increases and that of (X) decreases.

Hence consumer become increasingly unwilling to sacrifice more units of Y for one unit of X.

PROPERTIES OF IC
1. An Indifference curve has Negative slope i.e. it slope downwards from left to right.

(i) The two commodities can be substituted.

(ii) If quantity of one commodity decreases , quantity of other commodity must

increase for same level of Satisfaction.

2. Indifference curve is always convex to the origin.

Convexity implies two things

(i) Two commodities are imperfect substitute for one another , else IC would have been
a straight line.

(ii) MRS decreases , as consumer moves along IC Curve.

3. Two Indifference curves can neither intersect nor be tangent with one another . Because if it
happens it yields two impossible conclusion

( i) same combination yields , two different level of satisaction.

(iii) Two different combination ( b and c ) yields the same satisfaction.

 4. Higher indifference curve represents higher satisfaction.

PROPERTIES OF IC
5. Indifference curve touches neither X-axis nor Y-
axis.

X
12
10 A(0, 10)
8
6
IC1
Oranges

4
2 Apples
0
1 2 3 4 5
Isoquant curve
Iso- Equal and Quant- Quantity, it means equal Quantity. Also k o as P odu tio i diffe e e
u e o E ual P odu t Cu e .

Iso ua t u e is defi ed as lo us of poi ts , ep ese ti g a ious o i atio of t o i puts Capital

and Labour- yielding the same output.

It is same as Indifference Curve, with following two distinction.

(i) there are two producers goods ( Labour and Capital) , as compared to two consumer goods in
Indifference curve.

(ii) it measures output , whereas indifference curve measures Satisfaction.

Isoquant Curves are drawn on following assumptions

(i) only two inputs capital and Labour are required to produce a commodity.

(ii) Both L and K and product X are perfectly divisible.

(iii) The two inputs can substitute each other , but at a diminishing rate as they are imperfect
substitute of each other.

(iv) The technology of production is given.

Properties of ISOQUANT Curves

1. An Isoquant curve has Negative slope i.e. it slope downwards from left to right.

(i) The two inputs can be substituted for each other.

(ii) If quantity of one input decreases , quantity of other input must increase for same level of
output .

2. Isoquant curve is always convex to the origin.

Convexity implies two things

(i) Two inputs are imperfect substitute for one another , else IQ would have been a straight
line.

(ii) MRTS ( Marginal rate of Technical Substitution ) decreases , as consumer moves along IC
Curve.

MRTS = Slope of Isoquant Curve = Rate at which marginal unit of labour can substitute marginal unit
of capital.

3. Two Iso Quant curves can neither intersect nor be tangent with one another . Because if it
happens it yields two impossible conclusion
( i) same combination of inputs yields , two different level of Output.

(ii) Two different combination ( b and c ) yields the same Output.

4. Upper Isoquant Curve represents higher level of output.

5. Iso quant curve never touches X or Y Axis.

Forms of IsoQuant Curve

The Shape of an IsoQuant Curve depends on the degree of substitutability between the factors in
production function.

Linear Isoquant – Given Quantity of a product can be produced by using only labour or only capital
or both, hence it implies a Perfect substitutability between the two inputs K and L and, MRTS
between K and L remains constant through out.

Mathematically Q= f (K,L) Then Q= aK + bL

L Shaped IsoQuant - Given Quantity of a product can be produced by using one and only one
combination of labour and Capital, hence it implies a Perfect Complementarily between the two
inputs K and L. The output can be increased by increasing both the inputs Proportionately.

Mathematically Q = f (K,L) Then Q= Min ( aK, bL)

Kinked Isoquant or Linear Programming IsoQuant – Same Quantity of a product can be produced
by using Different combination of labour and Capital, when these different combinations are joined
we get Kinked IsoQuant Curve. It is so because one can find different techniques of production to
produce a given quantity of output , consuming different combination of inputs Capital and Labour.
Laws of Return to Scale
The Laws of return to scale explain the behaviour of output in response to a proportional and
simultaneous change in inputs (Expansion of Scale of Production).

There could be three possibilities w.r.t expansion of scale of production

(i) Total output may increase more than proportionately (increasing return to Scale)

(ii) Total output may increase proportionately (Constant return to Scale)

(iii) Total output may increase less than proportionately (Decreasing return to Scale)

Increasing return to Scale

When inputs K and L , are increased at a certain proportion and output increases more than
proportionately , it exhibits increasing return to scale. In diagram when inputs are increased by
100% , output increases by more than 100% and so on.

Reason behind Increasing Return to Scale

(i) Technical and Managerial Indivisibilities

Productivity of Inputs which can not be divided into parts to suit small scale production ( like half
part of turbine, 1/3 rd of harvestor, half of manager time ), increases exponentially , resulting into
increased return to scale.

(ii) Higher degree of Specialization

The cumulative effect of employing higher degree of Specialization of both labour and machinary is
possible only with increase in scale of production.
Constant Return to Scale
When inputs K and L , are increased at a certain proportion and output increases in the same
proportion , it exhibits constant return to scale. In diagram when inputs are increased by 100% ,
output increases equally by 100% and so on.

Reason Behind Constant Return to Scale

Limits of Economies of Scale

When economies of Scale reach their limit ( factors of production are perfectly divisible) and
diseconomies are yet to begin , return to sclae becomes constant.

Decreasing return to Scale

When inputs K and L , are increased at a certain proportion and output increases less
proportionately , it exhibits decreasing return to scale. In diagram when inputs are increased by
100% , output increases by 80% and so on.

Reason Behind Decreasing Return to Scale

Diseconomies of Scale

Managerial efficiency decreases.

Limitedness or exhaustibility of natural resources.

 Unit 3 : Managerial Economics - Cost Analysis
COST
Cost refers to a ou t of expe diture i urred o , or attri uta le to a give thi g “

Cost determination helps in :

1) Planning and organizing purchases

2) Controlling inventory of materials

3) Reducing cost of lab hour.

4) Minimizing overhead expenses

5) Achieving lower cost per unit

6) Increasing profit margin

Elements of cost
Cost is made up of Prime cost and Overheads :

Prime cost - Direct (material cost/direct wages /direct expenses )

Overheads - Indirect (material cost/indirect wages/indirect expenses)

Prime cost

Direct materials – Cost related with a product, plant , customer or a project . E.g. raw materials /
freight / taxes etc.

Direct wages -It includes wages of direct laborers in production /wages of foreman.

Direct expenses are expenses which can be linked with cost object or a cost center e.g. portable
crane of engine / cost of special moulds / hiring of tool for a job / fees paid to consultants / cost of
patents and royalties.

Overheads

Indirect materials are those materials which cannot be identified or traced with a finished products
E.g. oil , grease , cleaning materials , nails etc.

Indirect wages. It includes wages of indirect laborers like inspectors /cleaners / mechanics / store
keepers / time keepers / fringe benefits to employees .

Indirect expenses - rent , taxes, insurance , canteen expenses , dispensary , hospital , power, lighting
, depreciation , repairs and maintenance
Overheads can be further classified under the following :

Factory or manufacturing overheads

Indirect expenses which are incurred in factory or in producing goods and are concerned with
running of factory e.g rent of factory building , repairs of plant and machinery , depreciation of
machinery.

Office and administrative overheads

These are indirect expenses incurred for administration of business e.g rent and taxes of office
building , staff salaries , postage and stationery , bank charges etc.

Selling and distribution overheads

Selling overheads includes expenses incurred for promoting sales and for retention of customers in
business e.g. advertising expenses , salaries and commissions , market research expenses .

Distribution overheads includes expenses incurred from the time the product is completed until it
reaches its destination e.g warehouse expenses , freight charges
Classification of cost on basis of Function
(I) Manufacturing / Production cost

It includes all cost starting from raw material to packaging.

Includes direct material +direct wages+ direct expenses+ Factory overheads (indirect material
+indirect wages +indirect expenses)

(2) Administrative cost

Consists of all cost related to operations such as salaries of staff, office expenses , rent of factory ,
cost of depreciation , other general administrative expenses

(3) Selling and distribution cost

Costs which start when the product is ready for dispatch till it is made available to customer . They
are salaries and incentives of sales staff /rent /depreciation cost and insurance cost of sales office
/expenses of advertisements /cost of freight / packing / shipping / export duty / maintenance of
delivery vans.

(4) Research and development cost

Research cost is cost of searching for new products , new manufacturing processes , improvement
of existing products , processes and equipment

Development cost is related to activities concerned with putting the results of research on a
commercial basis
Cost Analysis
There are broadly two Categories in which cost can be analyzed

(i) Cost Concepts for accounting purpose

(ii) Cost Concepts for Analytical Purpose

Cost Concept for Accounting Purpose

Cost analysis under two heads (i) Accounting Cost Concepts and (ii) Analytical Cost concepts , is only
a matter of business Activities.

1) Accounting/Actual cost ( Explicit)and Opportunity Cost (Implicit)

Cost acquired by firm in acquiring various inputs from outside suppliers . It shows actual transfer of
money i o pa s ooks of a ou ts su h as a ate ial, sala ies a d ages, fuel a d po e ,
rent of building . These are also known as explicit cost.

There can be implicit cost also . This is cost which would have been incurred in some other activity
other than business / production e.g. if a owner of a firm has invested sum of money in some bank /
insurance plan instead of investing in business activity then he would have earned some interest on
the investment done which is known as implicit cost .

IMPLICT COST IS ALSO INCLUDED BY ECONOMIST WHILE CALCULATING COST OF PRODUCTION

2) Economic cost

This cost includes not only the accounting /explicit cost but also the implicit cost .

Economic cost = Explicit cost + implicit cost

Economic profit = Total Revenue – Economic cost

Whe a e o o ist sa s that the fi is just o e i g the ost it ea s fi is o e i g e pli it ,

implicit cost and is also earning normal profits (profits earned by firm which are sufficient to retain
firm in its present line of business).

3) Opportunity cost

It is concerned with cost of foregone opportunity . It involves a comparison between a project that
was chosen and project that was rejected . It is also related to concept of scarcity of resources . If
the resources are unlimited then there can be no opportunity cost .

4) Out of Pocket and Book Cost

Expenditures involving cash payment or cash transfers are known as Out of Pocket cost ( All explicit
cost) , but actual business cost that do not involve cash payments , but a provision is therefore made
in the books of account and considered while finalizing profit and loss account.
Cost Concept for Analytical Purpose
Variable cost - Cost which tends to vary with volume .

E.g. direct material cost, direct lab our , direct expenses, power and fuel.

Fixed cost -Cost which remains unaffected by changes in volume of output. E.g. rent of factory ,
salaries of works manager , depreciation of machinery and building.

Total, Average and Marginal cost

Total Cost = Fixed Cost + Variable Cost

Avg. cost = total cost / no. of units produced

Marginal Cost – Change in Total Cost due to increase in output by one unit

Marginal cost = change in total cost / change in output

- If avg. cost is rising then marginal cost > avg. cost

- If avg. cost is constant marginal cost = avg. cost

- If avg. cost is falling then marginal cost < avg. cost

Replacement Cost and Historical Cost :

- Replacement cost is the price which would have to be paid currently for replacing the old
Assets , whereas Historical cost is the cost incurred in past on acquisition of productive
assets.

Short Run and Long Run Cost

- Short run Cost – It has Short run implications in Production Process, such cost can not be
used again and again , short run cost varies with variation in output , hence it is treated as
Variable Cost.

- Long Run Cost – Long run implications in Production Process, such cost is used over a long
range of output , incurred on fixed factors like plant , building , Machinery ( Change in Size
and Kind of Plant) . Hence it is treated as fixed cost.

Incremental cost and sunk cost : Incremental cost is the additional cost incurred due to change in
level or nature of activity and Sunk cost is that which once incurred , can not be altered , increased
or decreased , by varying the rate of output , nor can they be recovered , when there is a change in
market conditions or business decision.

Shutdown and Abandonment cost – Shutdown cost are those which would be incurred in event of
temporary discontinuation of business and which would have been saved if operations continued.
Abandonment cost are cost of retiring a fixed asset from use for e.g. a second hand plant installed
during a war may not be useful in a peace time
Graphical Representation of TFC, TVC and TC
 Cost Output Relations
Theory of cost deals with, behaviour of cost in relation to a change in output. Basic principal of cost
behaviour is that the total cost increases with increase in output.

Importance from managerial point of view is not the absolute increase in the total cost , but the
direction of change in the Average cost (AC), and the marginal cost (MC).

The Direction of Change in AC and MC , Whether they increases , decreases or remain constant –
depends on nature of cost function.

Short run Cost Output Relation

The Cost Output relations are determined by the Cost Function and are exhibited through cost
curves. Given the data cost functions may take a variety of forms , Linear , Quadratic and cubic.

The following points highlight the three main types of cost functions. The types are:

1. Linear Cost Function 2. Quadratic Cost Function 3. Cubic Cost Function.

Short run Cost Output Relation – Linear Function

1. Linear Cost Function:

A linear cost function may be expressed as follows:

TC = k + ƒ Q

he e TC is total ost, k is total fi ed ost a d hi h is a o sta t a d ƒ Q is a ia le ost

which is a function of output.

It may alternatively be expressed as:

TC = Y = a + bQ.

It is depicted in Fig. 15.2. The cost function here is derived from the basis of following
(implicit) assumptions:
(i) When output is zero, total cost is equal to total fixed cost. Moreover, the shorter the short run,
the more certain is the manager that fixed costs are sunk (historical) costs by definition. If total fixed
cost remains constant at all levels of output up to capacity, any increase in total cost is traceable to
change in total variable cost.

To be more specific, if factor prices remain constant over the relevant range of output, a doubling of
inputs would lead to an exactly doubling of output. In other words, there would be constant returns
to the variable factor.

(ii) We assume away the operation of the Law of Diminishing Returns. The linear cost function in Fig.
15.2 reflects the short run cost condition of the firm. In the short run, capacity (or plant size) is fixed.
So the firm can vary its level of rate of output up to capacity (i.e., with the existing plant).

(iii) Average (total) cost declines with an expansion of output.

Average cost may be expressed as:

AC = Y/Q where Y is total cost and Q is output.

MC ∆Y/∆Q =

If-the cost function is continuous, marginal cost may be expressed as

MC = d (TC)/ dQ

In both the situations, MC = b and MC is constant and is a linear cost equation. Such a constant MC
curve appears as horizontal line parallel to the output axis as in Fig. 15.3.

Short run Cost Output Relation – Non Linear Function

Short run Cost Output Relation – Quadratic Function
• If there is diminishing return to the variable factor the cost function becomes quadratic.
There is a point beyond which TPP is not proportionate. Therefore, the marginal physical
product of the variable factor will diminish.

• And if TPP actually falls MPP will be negative. In other words, there is a point beyond which
additional increases in output cannot be made. So costs rise beyond this point, but output
cannot. Such cost function is illustrated in Fig. 15.4.

• We have noted that if the cost function is linear, the equation used in preparing the total
cost curve in Fig. 15.2 is sufficient. But the quadratic cost function has one bend – one bend
less than the highest exponent of Q.

• Total cost is equal to fixed cost when Q — 0, i.e., when no output is being produced.
However, as Q increases, fixed cost remains unchanged. Therefore, increases in total costs
are traceable to changes in variable cost.

• It is to be highlighted that the major difference between the linear and quadratic cost
functions is the area of diminishing returns to the variable factors). If the cost function is
linear, variable cost increases at a constant rate.

• It is quite reasonable to assume that linear cost functions exist regardless of the current
level of operating capacity at which the firm is producing. Rather, the truth is that as output
reaches the physical capacity limitations of existing plant and equipment in the short run,
variable costs rise because of the operation of the Law of Diminishing Returns (or variable
proportions).

• Most economists agree that linear cost functions are valid over the relevant range of output
for the firm. Over this range of output, o statisti all sig ifi a t i p o e e t o the li ea
h pothesis is a hie ed the i lusio of se o d o highe deg ee te s i output ;
o eo e , supple e ta tests, su h as the e a i atio of i e e tal ost atios, ,
usually confirm the linea h pothesis.
Short run Cost Output Relation – Cubic Function
In traditional economics, we must make use of the cubic cost function as illustrated in Fig. 15.5. Such
a cost function is not of much empirical use. It does not provide statistically significant improve-
ments over the linear or quadratic cost function. Moreover, it is very difficult to calculate, interpret
and apply, to test statistical hypothesis regarding cost behaviour in manufacturing concerns.

The cubic cost function is based on three implicit assumptions:

1. When Q = 0, total cost is equal to total fixed cost.

2. Total fixed cost remains constant at levels of output up to capacity (as in the previous two cases).

3. With an output expansion there is an initial stage of increasing return to the variable factor;
thereafter a point is reached (the inflection point) at which there is constant return to the variable
factor; finally, there is diminishing return to the variable factor. In short, the cubic cost curve has two
bends, one bend less than the highest exponent of Q.
 Law of Diminishing Returns through Cost Function
Through Production Function

When more and more units of variable inputs are applied, other inputs held constant, the returns
from marginal units of the variable input may initially increase , but decreases eventually.

Through Cost Function

When more and more units of variable inputs are applied , other inputs held constant , the marginal
cost initially decreases ( law of increasing returns operates in initial stages of production) , but
increases eventually ( law of Diminishing Returns comes into picture).

Behaviour of AC and MC

In initial stage of production, both AFC and AVC are declining, because of internal economies,. Since
AC=AFC + AVC , hence AC is also declining. Because of operation of law of increasing returns in initial
stages.

but beyond a certain output ( 9 unit) , AFC continues to fall , AVC starts increasing, because of faster
increase in TVC , consequently rate of fall in AC decreases. AC reaches its minimum at 10 unit , and
increases beyond it.

Downward trend in MC shows increasing marginal productivity,

While Upward trend in MC shows , decreasing marginal productivity

 Long Run Cost Output Relation
• 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 u e.

• To d a o LAC u e e ha e to sta t ith a u e of SAC u es. I the a o e figu e it

is assumed that technologically there are only three sizes of plants – small, medium and
la ge, SAC , fo the s all size, SAC fo the ediu size pla t a d SAC fo the la ge size
pla t. If the fi a ts to p odu e OP u its of output, it ill hoose the s allest pla t. Fo
a output e o d OQ the fi ills opti u fo ediu size pla t. It does ot ea 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.

• Fo a output OR the fi ill hoose the la gest pla t as the ost of p odu tio ill e
more with medium plant. Thus the firm has a se ies of SAC u es. The LCA u e d a
ill e ta ge tial to the e ti e fa il of SAC u es i.e. the LAC u e tou hes ea h 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 fi dete i es the size of pla t hi h ields the lo est a e age
cost of producing a given volume of output it anticipates.
 Estimation of Revenue, Average and Marginal Revenue
Revenue Types : Total, Average and Marginal Revenue!

The term revenue refers to the income obtained by a firm through the sale of goods at different
p i es. I the o ds of Doole , the e e ue of a fi is its sales, e eipts o i o e .

The revenue concepts are concerned with Total Revenue, Average Revenue and Marginal Revenue.

Total Revenue:

The income earned by a seller or producer after selling the output is called the total revenue. In fact,
total revenue is the multiple of price and output. The behavior of total revenue depends on the
market where the firm produces or sells.

Total e e ue is the su of all sales, e eipts o i o e of a fi . Doole

Total e e ue a e defi ed as the p odu t of pla ed sales output a d e pe ted selli g p i e.

Clower and Due

Total e e ue at a output is e ual to p i e pe u it ultiplied ua tit sold. Sto ie a d

Hague
2. Average Revenue:

Average revenue refers to the revenue obtained by the seller by selling the per unit commodity. It is
obtained by dividing the total revenue by total output.

The a e age e e ue u e sho s that the p i e of the fi s p odu t is the sa e at ea h le el of

output. Sto ie a d Hague

3. Marginal Revenue:

Marginal revenue is the net revenue obtained by selling an additional unit of the commodity.
Ma gi al e e ue is the ha ge i total e e ue hi h esults f o the sale of o e o e o o e less
u it of output. Fe guso . Thus, a gi al e e ue is the additio ade to the total revenue by
selling one more unit of the good. In algebraic terms, marginal revenue is the net addition to the
total revenue by selling n units of a commodity instead of n – 1.

In Next fig. three concepts of revenue have been explained. The units of output have been shown on
horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue, average revenue
and marginal revenue curves respectively.

In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. F o poi t K to K
total e e ue is o sta t. But at poi t K total e e ue is a i u a d egi s to fall. It ea s e e
by selling more units total revenue is falling. In such a situation, marginal revenue becomes negative.
Similarly, in the figure 1 (B) average revenue curves are sloping downward. It means average
revenue falls as more and more units are sold.

In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It signifies the fact that MR
with the sale of every additional unit tends to diminish. Moreover, it is also clear from the fig. that
when both AR and MR are falling, MR is less than AR. MR can be zero, positive or negative but AR is
always positive.