SESSION 4

Click to edit Master subtitle style MANAGERIAL ECONOMICS

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PRODUCTION ANALYSIS

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MEANING OF PRODUCTION
According to James & Parkinson, Production is an organized activity of transforming physical inputs into outputs which will satisfy the products needs of the society. For Example: Transformation of wood into INPUTS furniture. PRODUCTI OUTPUT
ON PROCESS S

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PRODUCTION FUNCTION
A production function refers to the functional relationship, under the given technology, between physical rates of input & output of a firm, per unit of time.
where Q = Output L = Labor Input K = Capital Input N = Land Input R = Raw Materials T = Technology e= 4/21/12 Efficiency

Q = f (L, K, N, R, T,e)

Attributes of Production Function

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TYPES OF PRODUCTION FUNCTION OR LAWS OF PRODUCTION

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(A)

Under this law of variable proportion, it is assumed that only one factor of production is variable while other factors remains constant.

Production Function With One Variable or Law of Variable Proportions

Measurement of Product:
Total Product (TP) Average Product (AP) Marginal Product (MP)

According to Prof. Benham, The law as the proportion of one factor in a combination of factors is increased after a point, the 4/21/12 average & marginal production of that factor

Units of variable input (Labor) 1 2 3 4 5 6 7 8 9

Short Run Production Schedule with in one Variable

Total Product (TP) 10 30 60 80 95 108 112 112 108 Average Product (AP) 10 15 20 20 19 18 16 14 12 Marginal Product (MP) 10 20 30 20 15 13 4 0 -4

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Three Stages in Production Curves

II

I
O u t p u t

III

Stage I: Increase in the rate of Total output.

T P

A P
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Stage II: Decrease in the increase in rate of Total output. Stage III:

Units of

An isoquant is defined as the locus of various combinations of two inputs (labor and capital) that yield the same level of output. LABOUR CAPITAL INPUT INPUT

Production Function With Two Variable or Isoquants

(B)

1 2 3 4 5 4/21/12

1 20 40 50 65 70

2 40 55 70 80 90

3 50 70 90 100 110

4 65 80 100 110 115

5 70 90 105 115 120

Properties of Isoquants:
Units of Capital Input

Production Isoquants
Q1 = 50 Q2 = 80 Q3 = 115

Isoquants are convex to the origin.

Isoquants have a negative slope.

Q 1 Units of Labour Input

Q 3 Q 2

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 As a firm in the long run increases the quantities of all factors employed, the output may rise initially at a more rapid rate than the rate of increase in inputs, then output may increase in the same proportion of input, and ultimately output increases less proportionately. THREE STAGES:
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Production Function With All Variable or Returns to STATEMENT OF THIS PRINCIPLE Scale
(C)

Constant Returns to Scale. Increasing Returns to Scale.

STAGES OF RETURNS TO SCALE

Labor Capital Total Marginal (units) (units) Output (units) 1 2 3 4 5 6 7
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Stages

2 4 6 8 10 12 14

4 10 19 29 39 49 57

4 6 9 10 10 10 8

Increasing Returns Constant Returns Decreasing

STAGES OF RETURNS TO SCALE

Stage I: Increasing Returns Stage II: Constant Returns Stage III: Decreasing Returns
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Total & Marginal Returns

II

III

Units of Labor & Capital

ECONOMIES OF SCALE
Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase.

A Common Example : Factory

An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced 4/21/12 grows significantly faster than the plant's

TYPES OF ECONOMIES OF SCALE

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INTERNAL ECONOMIES

1. Technical Economies For e.g.: Expensive Machinery.

2.

Managerial Economies For e.g.: Special Departments. Related to Individual Firm. 3. Financial Economies For e.g.: Advance Loans. 4. Commercial Economies For e.g.: Discounts & Concessions.

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EXTERNAL ECONOMIES

1.

Economies of Concentration like skilled labor, better transport & communications. Economies of Information like publication of journals regarding raw materials, modern machines etc. Economies of Welfare like housing & other special facilities to

2. Related to All Firms in an Industry.

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3.

COST ANALYSIS

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MEANING OF COST
Cost is an amount that has to be paid or given up in order to get something. It is Click to edit Master the summation of all subtitle style costs incurred by a business firm in its production process. An economist analyze Cost in terms of real cost of production of a particular 4/21/12 product.

COST CONCEPTS

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MONEY COST:

(or Nominal Money Cost means the total money Cost) expenses incurred by a business firm on the various items entered into the production of particular product. It is also called as nominal cost.

For example:

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Payments for raw materials purchased. Wages & salaries to managerial staff and laborers. Expenses on power & light,

REAL COST:
Real Cost refers to the physical quantities of various factors used in producing a commodity. It signifies the aggregate of real productive resources absorbed in the production of a commodity.

For example:

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Real Cost of a table is composed of a carpenters labor, two cubic feet of wood, a dozen of nails, half a bottle of paint, depreciation of carpenters

OPPORTUNITY COST:

(or Alternative cost) Opportunity cost is the cost of a given economic resource is the foregone benefits from the next best alternative use of that resource.

Importance:
Determination of relative prices of goods. Determination of normal

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ACTUAL COST:

(Outlay or Acquisition or Absolute Cost) Actual cost refers to the actual financial expenditure of the firm & recorded in the firms books of accounts. For Example: Payment of wages, interest. Cost of raw materials. Cost of machineries etc. Economic Profit = Actual Cost 4/21/12

EXPLICIT COST:

(or Paid out Explicit cost refers to the actual cost) money outlay or out of pocket expenditure of the firm to, buy or hire the productive resources it needs in the process of production. For Example: Cost of raw materials. Wages & Salaries. Insurance Premium. Rent of business or factory

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IMPLICIT COST:

(or Imputed Implicit cost are the opportunity cost) costs of the use of factors which a firm does not buy or hire but already owns. For Example: Wages of labor rendered by entrepreneur himself. Use of his own capital in his firm. Rent of land belonging to him that is used in his Economic cost = Explicit production. cost +

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INCREMENTAL COST:

(Avoidable or Incremental cost are the added Escapable Cost) costs resulting from a change in the nature and level of business activity. It can be avoided by not bringing any change in the activities.

For Example:

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Change in product or output level. Adding or replacing a machine. IC = C = C2 Changing distribution channels. C1

SUNK COST:

(Non-avoidable or Nonescapable Cost) Sunk cost are the costs that are not altered by varying the nature or the level of business activity and cannot be recovered. For Example:

Depreciation of Machines.
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Incremental costs are important whereas sunk costs for irrelevant for decision-making.

REPLACEMENT COST:
Replacement cost states the cost that the business firm would have to incur if it wants to replace or acquire the same assets now.

HISTORICAL COST:

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Historical or original cost of an asset states the cost of plant, equipment and materials at the price paid by business firm originally for them.

DIRECT COST:

(Traceable or Assignable Costs) Direct costs are the ones that have direct relationship with a unit of operation like a product, a process or a department of the firm. These costs are directly and definitely identifiable. It includes direct material, direct labor and direct expenses.

For example:

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Cost of raw materials required for

INDIRECT COST:

(Non-traceable or Non-assignable or Common Costs) Indirect cost are those costs which cannot de easily and definitely traced to a product, a process or a department of the firm. It includes indirect material, indirect labor and indirect expenses. For example: Cost of factory premises. Salary of a manager supervises more than department.

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who one

PRIVATE COST:
Private costs are those which are actually incurred or provided for by an individual or a business firm for its business activities. For example: Private costs a consumer faces when driving a car: The private costs of driving a car includes the cost of fuel and oil, its maintenance, depreciation, and

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SOCIAL COST:

Social cost are the total costs to the society on account of production of commodity. It includes both private costs & any other external costs to the society.

For example: The social costs include all these private costs: (fuel, oil, maintenance, insurance, depreciation, and operator's driving time) and also the cost experienced

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URGENT COST:

POSTPONABLE COST:

Urgent costs are those costs which must be incurred in order to continue operations of the business firm. For example : cost of raw material and labor if production is to take place. Postponable cost are those costs which can be postponed for time being. For example : maintenance of building and replacing of old

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SHORT-RUN COST: Short run cost is that cost that varies

LONG-RUN COST:

with output when plant and equipment remains the same. While decisions relating to production with a given plant size use short run costs for analysis.

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Long run cost is that cost which varies with output when all the factor inputs change. While decisions relating to the expansion or increasing plant size, requires long

FIXED COST:
Fixed Cost are the amount spent by the firm in fixed inputs in the short run & which are remain constant. It includes: Rent for building. Insurance premiums. 4/21/12

(Constant or Supplementary Costs)

C O S T

Fixed cost

Outp

VARIABLE COST:
(or Prime Costs) Variable Cost are those costs that are incurred on variable factors & vary directly with the level of output. It includes: Prices of raw materials. Wages of labor. 4/21/12

C O S T

Variable cost

Outp

TOTAL COST:
Total Cost is the aggregate of expenditures incurred by the firm in producing a given level of TC = TFC + output. TVC TC increases , Output increases. TVC increases , Output 4/21/12 increases.

T C

TV C

C O S T

TF C

Outp

AVERAGE COST:
Average Cost is the cost per unit of output produced by a firm. AC = TC Q AC or ATC = AFC + AVC
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A C
C O S T

AV C AFC

Outp

MARGINAL COST:
Marginal Cost is the additional cost to the total cost of a firm by producing one more unit of the product. MC = TC Firstly MC declines, Q and afterwards 4/21/12 increases.

MC
C O S T

Outp

COST FUNCTION
(COST OUTPUT RELATIONSHIP)
Cost Function expresses the relationship between cost & its determinants like: C = f (S,O,P,T, ..) Size of plant. Output level. Prices of inputs. Technology. Managerial 4/21/12 Efficiency.
Click to edit Master subtitle style

Click to edit Master subtitle style

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SHORT-RUN COST OUTPUT RELATIONSHIP

It includes: Units of Total Cost & Output,

Fixed Cost & Output,

Variable Cost 4/21/12 &

output TFC TVC TC AFC AVC ATC 100 100 0 0 0 0 100 140 10 0 400 0 100 40 140 100 170 20 0 700 0 50 35 85 100 193 30 0 930 0 33.3 31 64.3 100 110 210 40 0 0 0 25 27.552.5 100 140 240 50 0 0 0 20 28 48

MC

40 30 23 17 30

Short-Run Cost Curves:

TC TV C M C AT C AV C

C O S T

TF C

C O S T

AF C
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Outp ut

Outp

These costs are incurred by a business firm over a period of time during which all factors of production are variable. It basically consists of perspective planning for the expansion of the firm. LAC = LTC Q

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The long run cost output relationship is established with the help of long run cost cures. It is a flatter U-shaped curve.

LONG-RUN COST OUTPUT RELATIONSHIP

Long-Run Cost Curves:

LM C LAC C O S T SA C C O S T LA C

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Outp ut

Outp