Production, Costs and Revenue

1. To give basic idea about production function.

2. To give basic idea about various costs and revenue
concepts.
Production Cost & Revenue
3. To show the behavior and shapes of short and long
run costs and revenue concepts and the reasons be
hind that.
4. To give basic idea about economies of scales and
scope concepts.
5. To give basic idea about profits maximization.
6. Application of these concepts to practice.
Production, Costs and Revenue
• Production, costs and revenues are related with the supply theory.
• Can we analyze various business organizations through one
theory or do we need many theories. One general framework with
adjustment to suit with various market structures.
• Before deciding the output level, firm has to know two important
issues: How much will it cost to produce and how much revenue will
it generate Price

Cost of production Firm chooses Revenue

Level of output and
fixed the price

Output
 The complete theory of supply

Demand curve
Technology Total cost Marginal Firm Marginal facing the firm
and costs of curves, cost curves, chooses revenue (prices at
hiring short-run short-run level of curve which the firm
factors of and long and long output can sell each
production run run level of output)

Average cost Checks: Whether

curves, short- to produce at all
run and long in short-run:
run whether to close
down in long run

Modeling
Production
The term production refers to more than the physical
transformation of resources. Production involves all the
activities associated with providing goods and services.
Thus the hiring of workers (from unskilled labor to top
management), personnel training, and the organizational
structure used to maximize productivity are all part of the
production process.
Input: any good or service used to produce output.
A technique: a particular method of combining inputs to
make outputs.
Technology: is the list of all known techniques
Technical progress: production of a given output with less
inputs than before or shift in production possibility curve.
The Production Function
- A production function is a descriptive statement that relates
inputs to outputs.
- A technical relationship between physical inputs and outputs.
- It specifies the maximum possible output that can be
produced for a given amount of inputs.
- The minimum quantity of inputs necessary to produce a
given level of output.
- Production functions are determined by the technology
availability to the firm.
The Production Function

Inputs Outputs
Firm
“Black Box”
FOPs

 Inputs - FOPs (Factors of production)

(labour, land, materials, capital,
knowledge, etc)
The Functional Form
Q = f (costs, ...)

This can be separated into :

 Q = f (K, L, La, M, ...)
Q = output, K = capital, L = labour, La = land,
M = materials

Or in its most usual form :

 Q = f (K, L)
 Technical efficiency and economic efficiency in production

Technical efficiency is a method of production which involve

s the minimum amount of a combination of different factors .

Economic efficiency is the use of resources to produce any

given output level at minimum cost .

See page no. in your second text book

Time Duration in Economics
The Short Run (Time period when at least one factor is in fixed
supply. Output can be changed by using variable factor with th
e fixed factor. The length of the short run change firms to firms
and industry to industry.)
Q = f (K - fixed factor, L - variable factor)
The Long Run (No fixed factors or all the factors are variable e
xcept technology.)
The Very Long Run (The time period over which technology mi
ght change.)

Economists analyze production, costs and revenue with respec

t to these short and long run periods.
Fixed and Variable Factors

 in the short run (SR), at least one of the factors

is fixed in supply (“the operating period”)
 can split SR costs into “fixed” and “variable”
 fixed costs are costs which do not vary in the
short-run with the level of output

(e.g. rent, interest payments, capital depreciation..)
 variable costs are costs which do vary in the
short run with the level of output

(e.g. raw materials, heating and lighting, waged
labour...)
In studying production functions, there are two types of
relations between inputs and outputs that are of
interest for managerial decision making.
1. Returns to scale
Relation between output and the variation in all
inputs taken together.
This plays an important role in managerial decisions.
They affect the optimal scale, or size of a firm and its production
facilities.
They also affect the nature of competition in an industry and
thus are important in determining the profitability of investment
in a particular economic sector.
2. Returns to a factor
The relation between output and variation in only one of the
inputs employed.
The terms factor productivity and returns to a factor are
used to denote this relation between the quantity of an
individual input (or factor of production) employed and the
output produced.
Factor productivity provides the basis for efficient resource
employment in a production system.
TOTAL, AVERAGE, AND MARGINAL PRODUCT
Total Product (TP): The total output that results from
employing a specific quantity of resources in a production
system. Generally this TP will rise as more units of labor are
employed with fixed volume of capital. But the trend of this curve
has different rates of increases: first it increases at an increasing
rate, then at a decreasing rate and finally it will decline. The
explanation for this behavior can be explained through the
concept of marginal product.
Marginal Product (MP): The change in output associated
with a unit change in one input factor, holding other inputs
constant.
MP = d(TP)/dQ or ATP/AQ
This curve first goes up due to workers specialization and spare
capacity in fixed factor and then goes down due to full utilization
of the fixed factor.
Average Product (AP)
Total product divided by the units of inputs employed.
AP = TP/L
This curve first goes up then goes down
Relationship between AP and MP: AP goes up then MP above it
and AP goes down then MP below it. This relationship can be
explained through principle of diminishing returns.
Principle of Diminishing Returns: More units of a variable factor
(L) are combined with a given number of fixed factors (K) there
comes a point where the returns to the variable factor begin to
decline.
Total Product, Marginal Product, and Average
Product of Factor X, Holding Y=2
Input Total Product Marginal Prod: Average Prod:
Quantity of the Input of Input X of Input X
(X) (Q) (MPx= A Q/ A X) (Apx = Q/X)
1 15 15 15
2 31 16 15.5
3 48 17 16
4 59 11 14.8
5 68 9 13.6
6 72 4 12
7 73 1 10.4
8 72 -1 9
9 70 -2 7.8
10 67 -3 6.7
 Total, Average, and Marginal Product for
Input X: Given Y=2

80 TPx
60
Output Q

40
20
0
1 2 3 4 5 6 7 8 9 10
Input x
 20
Average and Marginal Products
15

10
Output Q

APx

0
1 2 3 4 5 6 7 8 9 10
-5 MPx

Input X
The Law of diminishing returns
As the quantity of a variable input increases,
with the quantities of all other factors being held
constant, the resulting increases in output
eventually decrease.
Holding all factors constant except one, the law
of diminishing returns says that, beyond some
level of the variable input, further increases
in the variable input lead to a steadily
decreasing marginal product of that output.
Cost Analysis
Cost Analysis plays a central role in managerial economics because
virtually every managerial decision requires a comparison between costs
and benefits.

There are number of other cost concepts.

Relevant cost and Opportunity cost
Accounting cost and economic cost
Explicit vs implicit costs
Marginal cost or Incremental Cost
Sunk cost (while leaving industry you can not recover this costs) and
fixed cost
Short and long-run costs
Short-run Costs
Short-run Total Costs
Total Cost: TC (fixed and variable costs in production)
Total Fixed Cost: TFC (Cost which does not change with output
and it is the overhead or capital costs. The curve is a horizontal
or flatter)
Total Variable Cost: TVC (Cost which change with output: labor
and raw materials). This curve is the inverse shape of TP curve
.First it increases at decreasing rate (additional unit of labour ad
d more value to production) and then increases at increasing rat
e (additional unit of labour add more to cost rather to production
).
TC = TFC + TVC, TFC = TC - TVC, TVC = TC - TFC
Short-run Average Total Costs
TC/Q = TFC/Q + TVC/Q
ATC = AFC + AVC
AFC (falls as output increases and it is continually down-ward sl
opping. It is the fixed costs per unit of output produced).

AVC (first falls and then rise and it is the inverse shape of AP cur
ve: AP rises then AVC falls AP falls then AVC rises due to chang
es in labor productivity.

ATC (first falls and then rise mainly due to AVC curve)

AFC = ATC - AVC, AVC = ATC - AFC

Marginal Cost is the increase in total cost when output is
increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again rises.
The main reasons for this behaviour is production techniques
(at low level of output – simple techniques then costs go up
Output increases – sophisticated techniques then economies
of scales. Output further increases – diseconomies of scales
such as Organizational problems – cost go up).
Generally MC, AVC and ATC show some relationship.
If MC < AVC then AVC falls
If MC = AVC then AVC is at minimum
If MC > AVC then AVC rises
Same relationship holds between MC and ATC
Short-Run Cost Relationships

Q TC TFC TVC ATC AFC AVC MC

1 120 100 20 120 100 20 20
2 138 100 38 69 50 19 18
3 151 100 51 50.3 33.3 17 13
4 162 100 62 40.5 25 15.5 11
5 175 100 75 35 20 15 13
6 190 100 90 31.7 16.7 15 15
7 210 100 110 30 14.3 15.7 20
8 234 100 134 29.3 12.5 16.8 24
9 263 100 163 29.2 11.1 18.1 29
10 300 100 163
200 30 10 20 37
Short Run Cost Curves
$ per time
period Increasing Decreasing
productivity productivity
of variable of variable
factors factors Fixed
Total cost cost = OF

Variable
F cost
Total
Fixed Variable
cost cost

O Q1 Q2 Q3
Output per time period (units)
Total Costs
 Short Run Cost Curves

Cost MC

ATC
AVC

AFC
O Q2
Q1 Q3 Output
Profit maximising output Q1
MR
Bringing FC and VC together
Cost (£)

ATC
AVC

TFC

AFC
0 q1 Quantity (no. of units)
ATC and MC
Cost (£)

MC

ATC

0 q* Quantity (no. of units)

The Relationship between Average and
Marginal Curves
• AC is falling when MC is less than AC, and rising
when MC is greater than AC (AC is declining
whenever MC is below AC, and rising whenever MC
above).

• AC is at minimum at the output level at which AC and

MC cross (MC cuts the minimum point of AC).
Short-run Optimality
Full or optimum capacity = firm produces at minimum level of s
hort-run average cost curve and at this point all the inputs are
employed to their optimum efficiency.
If the firm faces long U shape (Saucer) cost curve, the range of
the minimum points are called load factor or normal capacity uti
lization.
If firm producing a point right to this then it’s average costs is ri
sing.
If firm is producing left to this point then firm has a reserve cap
acity; firm is not fully utilizing its factors of production.
Self-study Exercise 1: Identify the main
fixed and variable costs need to
operate within the following
industries...
 Newspaper business
 Jewellery retailing
 Electronic components manufacture
 Electricity generation
 Software development
 Cellular telecommunications
 Hotel management
Long-Run Cost Curves
In the long run all the factors are variable and accordingly firm
can change it’s scale of the operation. However firms can not
change all the variables together. Therefore, long-run is going to
be a series of short run periods.
During this period firms will change the scale of production (the
amount firm is able to produce in relation to its size) which will
affect for productive efficiency in three ways:
1) Constant returns to scale
2) Increasing returns to scale
3) Decreasing returns to scale
LR Average Costs

 in the long run, quantities of all inputs can be

varied (“the planning horizon”)
 this means that there are no fixed costs in the
long run
 and so the LRAC curve is different from the
SRAC we’ve considered so far…. It is more
enlarge U (saucer) shaped one. It is the
envelope of the short-run cost curves.
 The Long Run Average Cost Curve
LRAC

LRMC
cost (£)

SRAC1
c1 SRAC5
SRAC4
SRAC2
c2 SRAC3
c*

0 q1 q2 q* q4 q5

The relationships between LRAC and LRMC same units

li of output
ke in short-run.
 Economies and diseconomies of scale
There are economies of scale (increasing returns to scale)
when long-run average cost decreases as output rises or
volume of output rises more quickly than the volume of inputs.
There are constant returns to scale when long-run average
cost are constant as output rises or volume of output increases
in the same proportion to the volume of inputs .
There are diseconomies of scale (decreasing returns to scale)
When long-run average cost increase as output rises or volume
of output rise less quickly than the volume of inputs.
These are explained by the presence of both internal and
external economies and diseconomies of scale in production.
Returns to Scale
Increasing Constant Decreasing
returns to returns to returns to
scale scale scale
Cost (£)

LRMC
LRAC
LRAC

LRMC

0 q1 q2 Quantity (no. of units)

Minimum efficient
scale (MES)
 The long- run average cost curve
Average
(i.e. per Increasing Decreasing
unit) cost of
returns to returns to
production
scale scale

Constant returns to
scale
Decreasing Increasing
cost Constant cost cost
production production production

O q1 q2 Output expansion
over the long run
 Increasing returns to scale
• Read the given handout part

• Internal economies of scale – economies internal to the firm

resulting from a more efficient utilization of resources. This can
be technical or non-technical: labour, investment indivisibilities,
large scale procurement, R &D,capital, diversification, promotion,
transport and distribution, by-products, specialization, flexible
manufacturing large scale necessary to take advantage, reserve
capacity, end of learning period.
• External economies of scale – economies brought about by the
growth or conentration of the industry: existence of good labour
force, existence of network of suppliers, existence of social
economic and environmental infrastructure.
Decreasing returns to scale

(Internal diseconomies of scale - management, labour, other

inputs, External diseconomies of scale – geography of
concentration, range of business, time of the business).

Solution to the decreasing returns to scale

1) Relocation of operation
2) Contracting-out
3) Reorganization of management structures
4) Lay-off the workers
5) Productivity increase by new technology and HR programmes.
Minimum Efficient Scale (MES)
The point at which the long run average cost curve first
becomes horizontal (flatter) and it is the technical optimum
scale of production. It gives a firm a strong competitive
advantage in the market place over higher cost producers.
Beyond this MES, firms do not have additional economies of
scales.
Expanding scale firms can further enjoy MES status. Then
managerial problems and other diseconomies are going to
emerge.
Economies of Scope
This exist where several different outputs draw on a common
resources and it is a diversification in a same or different
production and marketing lines. This diversification leads to
cost savings. Generally economies of scale and scope reinforce
each other to minimize cost.
The Degree of Economies of Scope (DES)
DES = {[TC(An) + TC(Bn)] –TC (An + Bn)}/[TC (An+Bn)]
TC(An) = Total cost of producing An units of product A separately
TC(Bn) = Total cost of producing Bn units of product B separately
TC (An+Bn) = Total cost of producing A and B jointly
DES < 0 Negative ES. It is better to produce separately
DES >0 Positive ES. More economical to produce jointly.
Generally economies of scale and economies of scope are reinforcing
each other to reduce costs.
Sources of Economies of Scale and
Scope
Economies of Scale

Real Economies Pecuniary Economies

Production Selling/ Managerial Other

Marketing
Bulk buy raw materials
Labour Specialisation/team-working Lower cost of finance
Capital Decentralisation Lower cost of advertising
Inventory Mechanisation Lower transport rates
Lower R & D costs
Advertising
Transport
Large-scale promotion
Storage
Exclusive dealers
R & D efficiencies
By-product production
Experience curves
source : adapted from Koutsoyiannis (1979)
X-inefficiency
The situation of wastage of firm’s resources and its costs high
er than necessary level. This can happen due to managerial or
technological or any other factor. This firm can not exist market
in long-run. Most of the public sector institutions have this prob
lem. But generally in the long-run in competitive markets, firms
can not survive if they have X-inefficiency problem: full efficient
firms only survive. We can measure it as actual cost point - ME
S = (q1a-q1b) =ab
C
LRAC
a
b

0 q1 q
The Learning Effect (Accumulative productive
experience)
Firm accumulate its business experience over the years which improve its
production and organizational methods which ultimately reduces the cost of
production. -learning by doing approach-
At managerial level the learning effects occurs
• Perfection and precision reached due to constant practice of managerial
decision making.
• Finding more efficient production and business procedure.
• Knowing better ways to use tools and equipments.
• Familiarization with the production activities which helps to give good
instructions to subordinates.
Cost per unit
• Right placement of right people.
• Better co-ordination and control.
• Good integration of works. LRAC
• Better TQM
• Better project management and scheduling Cumulative output
Learning Effect Rate (LER)
LER = [ 1- (ACt1/ACt0)] *100
ACt1 = Average cost in initial period (t0) increment
ACt0 = Average cost in next period (t1) increment
ACt1/ACt0 = Experience factor
This measures percentage decrease in additional cost with
respect to a 100 per cent increase in output at each time.

For working examples see Mithani.D.M (2000),

Managerial Economics, Theory and Applications,
Himalaya Publishing House, Page 280-1
Self-study Exercise 2: What are the
potential sources of economies of scale
and scope in the following industries/Or
in your firm/organization?

1) Consumer finance
2) Pharmaceuticals
3) Printing
4) Road construction
5) Recorded music industry
6) Shoe manufacture & retail
7) Training and education provision
Profits Maximization
Total Revenue - Total Costs = Profits
TR - TC = Profits
d(TR)/dQ - d(TC)/dQ = Marginal profits
MR = MC, Profits maximizing condition or rule
Marginal revenue = Marginal cost

Profits maximising output decision:

MR > MC Q should goes up
MR = MC Q profit maximising output
MR < MC Q should goes down

Profits maximising output and revenue maximising output are

two different concepts (see next table).
 Profit maximization & the Revenue maximization

P Qd PQd TC 
(per unit) (TR) (TFC+ TVC) (TR-TC)
- 0 0 10 -10

21 1 21 25 -4

20 2 40 36 4

19 3 57 44 13

18 4 72 51 21

17 5 85 59 26

16 6 96 69 27

15 7 105 81 24

14 8 112 95 17

13 9 117 111 6

12 10 120 129 -9
Marginal Cost is the increase in total cost when output is
increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again rises.

MC MC

0
Q
Marginal revenue is the increase in total revenue when output is
increased by 1 unit. Its behaviour depends on the firm’s demand
curve . Generally it is a downward for most market structures
except perfect competition (horizontal).
Perfect Competition
P P Other Markets

MR/D/P

0 0 Q
Q AR =D
MR
Profits Maximization in Short
Run

MC

ATC
AVC

AFC
O Q1 Q2 Q3
MR > MC MC < MR
Profits maximising output Q1 MR
Comparative Static Analysis

MC
MC 1
MR MC
MC 2

MR
Q
0 Q1 Q Q2
Comparative Static Analysis

MC

MR MC

MR2
MR
MR1
Q
0 Q1 Q Q2
See figure a (TR, TC and profits curves)
1) Break even points Q1 and Q4 (TR = TC).
2) Loss making area below Q1 and above Q4 (TC>TR).
3) Profits making area between Q1 - Q4 (TR>TC).
4) Maximum profits in Q2 (highest difference between TC and TR).
See figure b (MC, AC, AR and MR curves)
These two figures are interrelated:
1) Break even points Q1 and Q4 (AC=AR).
2) In loss making area below Q1 and above Q4 (AC > AR).
3) Profits making area between Q1 and Q4 (AR > AC).
4) Maximum profits in Q2 (MR =MC, Moving to right from Q1 MR>MC
. Moving to left from Q4 MR>MC, Moving right to Q2 MR<MC. Theref
ore the best point is Q2).
Figure a

Figure b
Normal Profits

At a breakeven point firm makes zero profits. But economists n

ame it as a normal profits based on the opportunity cost concep
t.

Abnormal Profits (Super normal profits)

Surplus above the normal profits. Between Q1 and Q4

Shut-Down Price

Below the normal profits firm does not get full cost recovery. Th
erefore, they will decide to shut-down the business.
 The Shut-down Position in Short-run
Price and Cost

SRAC
SRMC SRAVC

Abnormal profits D5 = MR5

P5

D4 = MR4
Normal profits P4
P3 D3 = MR3

Shut-down price P2 D2 =MR2

P1 D1 =MR1

Q2 Q3
0 Q1 Q4 Q5 Output
Exercise
Usage of profits maximizing model to loss making firm - Baldwin’s
fashion Ltd
This firm make profits till very recent but now in loss and consideri
ng closing down. Your advice to regain the profits and to remain i
n the industry.
Solutions:
1) Decreasing variable costs
2) Decreasing fixed costs
3) Increasing the level of demand
4) Combinations of all these