Managerial Economics Cost and Production Analysis

Production Function

Refers to a functional relationship, under given technology, between physical rates of input and output of a firm, per unit of time Q = f( Ld, L, K, M, T, t) Q = f (L, K)

Types of Production Function based on Time

Short Run: defined over as period of time over which inputs of some factors of production cannot be varied Q = f (L) Long Run: defined as a period of time over which all factors become variable Q = f (L, K)

Laws of Production
Short run Laws of Production

In short run input output relation are studied with one variable input, other inputs as constant With one variable input (Law of Variable Proportions/ Law of Diminishing Returns) With all variable inputs (Law of Returns to Scale)

Long run laws of Production

Concepts of Product

Total Product (TP) refers to total number of units of output produced per unit of time by all factor inputs. Average product (AP) refers to total product per unit of a given variable factor. Thus dividing total product by quantity of variable factor, ie AP = TP/QVF

Contd..

Marginal Product (MP: Owing to addition of a unit to a variable factor, all other factors being held constant, the addition realized in total product is referred to as marginal product, ie MP= TPN-TPN-1 Also MP = TP/ QVF = a small change In terms of calculus, dTP/dQVF where d = a unit change measured by derivative of related variable

Statement of Law of Variable Proportion using concept of MP (Short Run) During short period under given state of technology and with given fixed factors, when units of a variable factor are increased in order to increase total product, TP may initially rise at an increasing rate and after a point it tends to increase at a decreasing rate because marginal product of variable factor in beginning may tend to rise but eventually tends to diminish

Law of Variable Proportions OR Law of Diminishing Returns (DMR)

Law states when more and more units of a variable input are applied to a given quantity of fixed inputs, the total quantity may initially increase at an increasing rate and then at a constant rate but it will eventually increase at diminishing rates. Assumptions Technology is constant Labor is homogenous Input prices are given

Units of Variable Input (L) 1 2 3 4 5 6 7 8 9 10

Production Schedule showing diminishing returns

TP AP MP 20 50 90 120 135 144 147 148 148 145 20 25 30 30 27 24 21 18.5 16.4 14.5 20 30 40 30 15 9 3 1 0 -1

Stages of Returns

Increasing Returns Stage I

Decreasing Returns Stage II

Negative Returns Stage III

Note regarding Production schedule

Law of DMR becomes evident in the marginal product column. Initially, MP of variable input [L] rises. TP rises aat an increasing rate [=MP]. AP also rises . This is describes as stage of increasing returns. When 4th unit of labor is employed MP begins to diminish. Thus the rate of increase in TP slows down. This is the stage of diminishing returns. When AP is maximum, MP=AP As MP tends to diminish, ultimately becomes zero and negative thereafter [stage 3] When MP is zero TP is maximum. Further when MP becomes negative TP begins to decline in same proportion

Law of Returns to Scale-Long Run

In long run size of firm can be expanded as scale of production is enhanced as all factors are variable Returns to Scale refers to degree by which output changes as a result of given change in the quantity of all inputs in production Statement of Law: As a firm in long run increase quantities of all factors employed, other things being equal, output may rise initially at a more rapid rate than rate of increase in inputs, then output may increase in same proportion of input, and ultimately output increase less proportionately.

Three Phases of returns in long run:

Law of Increasing returns: Percentage increase in input will lead to greater increase in output Q/Q > F/F Reasons : improvements in large scale operations, division of labor, use of technology, and realization of other internal economies such as managerial economies

Contd..

Law of Constant returns: Percentage increase in input will lead to same percentage increase in output Q/Q = F/F Law of constant returns tends to operate when economies and diseconomies of scale are exactly in balance over a range of output

Contd..

Law of Decreasing Returns: Percentage increase in output is less than percentage increase in input Q/Q <F/F Reasons:

Though all factors inputs are increased proportionately, organization and management as a factor cannot be increased in equal proportion Business risk increases more than proportionately when scale of production is enhanced Diseconomies of large scale production set in Imperfect substitutability of factors causes diseconomies resulting in a declining marginal output

Economies &Diseconomies of Scale

Term Economies refer to cost advantages Economies of Scale

External: those which are available to all firms in an industry Internal: those which are available to a particular firm when its size expands and give it advantage over other firms engaged in the industry

Types of Internal Economies

Labor Economies: Division of labor resulting in greater degree of specialization Able to attract efficient labor as it can offer a wide vertical mobility, better prospects of promotion, etc Technical Economies: More mechanized operations Long run continuation of process Financial economies: Fund raising capacity increases

Contd..

Marketing Economies Buying material in bulk at cheaper cost Selling and promotion costs are lesser Purchase can be done by experts Managerial Economies: More expertise personnel Risk bearing Economies: By diversification of Output By diversification of Market

Types of External Economies

Economies of Localization: When a no of firms are located in one place all of them derive mutual advantages through training of skilled labor, provision of better facilities,etc Economies of Information: In large industry research work is done jointly

Diseconomies of scale

Difficulties of management Difficulties of coordination Difficulties of Management Increased Risks Labor Diseconomies Scarcity of Factor Supplies Marketing Diseconomies

Economies of scope

This refers to reduction in a firms unit cost by producing two or more goods or services jointly rather than separately Average total cost of production decreases as a result of increasing the number of different goods produced.

Examples: Economies of scope

McDonalds can produce both hamburgers and French fries at a lower average cost than what it would cost two separate firms to produce the same goods. This is because McDonalds hamburgers and French fries share the use of food storage, preparation facilities, and so forth during production. Another example is a company such as Proctor & Gamble, which produces hundreds of products from razors to toothpaste. They can afford to hire expensive graphic designers and marketing experts who will use their skills across the product lines. Because the costs are spread out, this lowers the average total cost of production for each product.

Cost Analysis-Cost Concepts

Explicit costs are direct contractual monetary payments incurred through market transactions Implicit Costs are opportunity costs of use of factors which a firm does not buy or hire but already owns Economic and Accounting Cost Money and Real Cost Fixed and Variable Costs

Types of Production Costs for Cost Analysis in Short Run

Total cost (TC) is the full cost of producing any given level of output. Total cost is divided into two parts, fixed cost and variable cost. Total fixed cost (TFC) does not vary with the level of output. Total variable cost (TVC) varies directly with output. TC = TFC + TVC Average total cost (ATC) is TC divided by the level of output. Average total cost can be separated into average fixed cost (AFC) and average variable cost (AVC). ATC = AFC + AVC AFC = TFC/Q AVC = TVC/Q Marginal cost (MC) is the increase in total cost resulting from increasing the level of output by one unit. MC = TCn- TCn-1

Short-Run Cost Curves

TC

MC

TVC ATC AVC

t so C

TFC

t so C

AFC Output

Short Run cost Schedule of Firm

Cost output relation ship can be studied in short as well as long run Cost Schedule is statement of variations in cost resulting from variations in output level TFC remains constant at all levels TVC varies with output and does not change in same proportion TC varies in same proportion as TVC

Cost Behavior in short Run

AFC decreases as output increases. Since total fixed costs remain same, AFC continuously declined cos spreading overhead over more units AVC first decreases and then increases as output increases ATC decreases initially, remains constant for a while but then goes on increasing as output increases MC decreases initially but then increases as output is increased When AC is minimum, AC = MC

Relationship between AC & MC

When AC is minimum , MC is equal to AC When AC is falling, MC curve lies below it When AC curve is rising, after the point of intersection MC curve lies above it

Shifts in Short-Run Cost Curves

A change in the price of any variable input used by the firm will shift its ATC and MC curves -- upward for a price increase and downward for a price decrease.
MC1 MC0 ATC1 ATC0

AC,MC

Output

Cost schedule in short run for firm

Q 0 1 2 3 4 5 6 7 8 9 TFC 100 100 100 100 100 100 100 100 100 100 TVC 0 25 40 50 60 80 110 150 300 500 TC 100 125 140 150 160 180 210 250 400 600 AFC 100 50 33.3 25 20 16.3 14.2 12.5 11.1 AVC 25 20 16.6 15 16 18.3 21.4 37.5 55.6 AC 125 70 50 40 36 35 35.7 50 66.7 MC 25 15 10 10 20 30 40 150 200

Long Run Cost behavior

LAC is derived as a tangent to various SAC curves appropriate to different levels of output. Also referred to as envelope curve LAC curve is less U shaped or rather dish- shaped. This means in the beginning it gradually slopes downwards and after reaching a certain point it gradually begins to slope upwards This behavior of LAC is attributed to the operation of laws of returns to scale. Internal Economies causes LAC curve to fall. It remains constant when economies equal diseconomies. Net diseconomies causes LAC to rise

Diagram for Economies and Diseconomies of Scale

Types of Long run Cost Curves

Empirically it has been found that those industries where economies of scale are numerous as well as deep and diseconomies take considerable time to emerge LAC curve tends to decrease over long range of output and thereafter it tends to remain constant over a period of time In petroleum refineries, railways, steel plants etc have confirmed to this L shape (gradual) In some cases LAC curve has a rapid downward slope up to a certain range of output and thereafter curve becomes flat due to adoption of scientific methods in business such as financial controls, use of computers, delegation of decision making ie L shape (rapid)

What is Learning curve??

Over a time when a firm accumulates its business experience it may tend to improve its production/organization methods with improved knowledge and experience of management and labor used in the production process. The firms learning experience would pay in terms of cost reduction. In long run, these tends to the downward shifts in the average cost curves of the firm on account of learning on experience effect that improves productive efficiency of the firm in its operations over time. LER= [1 ACt1/ACt0] x 100

Sum on Learning Curve Concept

Suppose a firm develops a new PC model in 1995 with an average costs of Rs. 30,000 per unit. In 1996, however its average costs declined to Rs. 24,000 when other things being given and output is doubled. This may be simply attributed to learning effect. What is the learning effect rate [LER] in this case:

Find out TC and AC from the following table. Fixed cost ie FC=300 RS No. of units produced Variable cost in Rs. 100 200 300 400 500 600 500 640 720 740 800 900

Complete the following table

units 1 2 3 4 5 6 TFC 20 TVC TC 30 45 70 95 150 220 MC AC

Sum
Suppose Marutis total cost of producing 5 cars is 10.5 lakhs and its total cost of producing 6 cars is 12 lakhs, what is average cost of producing six cars? What is marginal cost of sixth car?

Thank You