Eco Textual Learning Material - Module 3

26 Managerial Economics
Unit 3: Cost and Production Analysis

Notes Structure
3.1. Objectives
3.2. Introduction
3.3. Production Functions
3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors.
3.5. Difference between Returns to a Factor and Returns to Scale
3.6. Isoquants
3.7. Isocost Line or Equal Cost Line
3.8. Marginal Rate of Technical Substitution
3.9. Choices of Input Combination (Optimal Input combination)
3.10. Theory of Cost
3.11. Cost Functions
3.12. Various types of Costs
3.13. Relationship between AC and MC
3.14. Long and Short Run Cost Curves
3.15. Cost and Output Relationship (Cost Function)
3.16. Short Run and Long Run
3.17. Economies / Dis-economies of Scale
3.18. The Theory of firm (Profit Maximization Model)
3.19. Break-even and Shut-down Point
3.20. Managerial Theories of the Firm
3.21. Baumol’s Model
3.22. Marris Model.
3.23. Summary
3.24. Check Your Progress
3.25. Questions and Exercises
3.26. Further Readings
3.1. Objectives
The objective of this chapter is to define and application of the production and cost.
The chapter also focuses on the Production Function, Total Product, Average Product,
Marginal Product; Law of Variable Proportion or Law of Diminishing Returns to Factors,
Returns to a Factor and Returns to Scale, Isocost and Isoquant, Marginal Rate of Technical
Substitution (MRTS), Model of Profit Maximization, Sales Revenue Maximisation Model
by Baumol, Managerial Utility Models, Growth Maximisation Models, Total Cost (TC),
Total Fixed Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average
Variable Cost (AVC), Average Total Cost (ATC) and Marginal Cost (MC), Long and Short
Run Cost Curves, Cost and Output Relationship, Economies / Dis-economies of Scale,
Break-even and Shut-down Point, Baumol’s Model and Marris Model. Graphs are used
consistently for understanding the subject matter easily.
Key Terms
Production, Production Function, Total Product, Average Product, Marginal Product,
Amity Directorate of Distance & Online Education

Managerial Economics 27
Law of Diminishing Returns to Factors, Returns to a Factor, Returns to Scale, Isocost,
Isoquant, Marginal Rate of Technical Substitution (MRTS), Total Cost (TC), Total Fixed
Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost
Notes
(AVC), Average Total Cost (ATC), Marginal Cost (MC), Long and Short Run Cost Curves,
Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even and
Shut-down Point.
3.2. Introduction
Production is basically an activity of transformation which transfers inputs into outputs.
Firms use land, labour, seeds and small amount of capital as inputs to produce output
like corn. Similarly, a flour mill uses inputs like wheat, labour, capital for machinery,
factory building to produce output like wheat flour. So, an input is the goods or services
which produce an output. The firm generally uses many inputs to produce an output.
Output of any firm may be the inputs of other firms, e.g., steel is an output of the steel
producer, but this steel is also an input of automobile or rail coach manufacturing or
refrigeration manufacturing or air-condition manufacturing industries. The transforming
process of inputs into output can be three types: i) change in form (output should be new
form compared to inputs, for example cloth as output and thread as input) ii) change in
space (transportation) and iii) change in time (storage). The transformation process or
production increases the consumer usability of goods and services.
3.3. Production Functions

A production function is the technical relationship between inputs and outputs. A
commodity may be produced by various methods using different combinations of inputs
with given state of technology. Take the e.g. of cloth, it may be produced using cotton or
silk or polymer as raw materials with handloom, power loom or computerized machines.
You can see various types of raw materials and technology options will create several
possible ways of producing the same product. Hence there can be several technically
efficient methods of production. Production function includes all such technically efficient
methods. It can be said that production function is purely a technological relationship
between physical inputs and physical outputs over a given period of time; production is a
function of inputs, their quality and quantity and interrelation, i.e., complementarities and
substitutability. Hence it can be said that production function is:
 Always related to a given time period
 Always related to a certain level of technology
 Depends upon relation between inputs
Production function shows the maximum quantity of the commodity that can be
produced per unit of time for each set of alternatives inputs, and with a given level of
production technology. A given amount of output can be produced by different combinations
of inputs and each of these combinations may be technically efficient. Technical efficiency
is defined as a situation when using more of one input with either the same amount or
more of the other input must increase output.
Normally a production function is written as;
Q = f (x1, x2, …………… x n) …………………………………..…………(i)
Where, Q is maximum quantity of output of a good being produced, and x 1, x 2,………. xn
are the quantities of various inputs used in production. If we replace x 1, x 2,……… x n in (i) by
the factors of production discussed above, the production function may be;
Q = f (L, K, I, R, E) …………………………………………………….. (ii)
Where,
Q =output and the inputs are L, K, I, R, E;
L= labour,

K = capital,
Notes I =land,
R =raw material
E = efficiency parameter
In short run, some inputs like plant, size, and machine equipments cannot be changed,
so a producer trying to increase output in the short run will have to do so by increasing
only the variable inputs. On the contrary in the long run input options are very wide.
On the basis of such characteristics of inputs, production functions are normally divided
into two broad categories :( i) with one variable input or variable proportion production
function (ii) with two variable inputs or constant proportion production function
Production Function with One Variable Input: In short run producers have to
optimize with only one variable input. Let us consider a situation in which there are two
inputs, capital and labour, capital is fixed and labour is variable input. You will notice as
the amount of capital is kept constant and labour is increased to increase output, the ratio
in which these two inputs are used will also change. Therefore any change in output can
be manifested only through a change in labour input only.
Such a production function is also termed as variable proportion production function;
it’s essentially a short term production function in which production is planned with
variable input. The short run production function shows the maximum output a firm can
produce when only one of its inputs can be varied, other inputs remaining fixed. It can be
written as:
Q = f (L, K0)…………………………..………………(iii)
Where, Q is output, L is labour and K0 denotes the fixed capital. This also implies that
it is possible to substitute some of the capital by labour. It is easy to understand that as
units of the variable input are increased, the proportion of use between fixed input and
variable input also changes. Therefore short run production function is governed by law
of variable proportions. To explain the concepts of average and marginal products of
factor inputs consider the production function given in equation (iii), Assuming capital to
be constant and labour to be variable, total product is a function of labour and is given
as:
TPL = f (K0, L)……….………….......................….(iv)
If instead labour is fixed in the short run, the total product of the capital function can
be similarly expressed as:
TPK = f (L0, K) …………………………....……….(v)

Notes
Average Product (AP) is total product per unit of variable input; therefore it can be
expressed as:
APL = TP/L…………………………………………..(vi)
If instead labour is fixed in the short run, average product of the capital function(AP K)
can be similarly expressed as:
APK = TP / K……………………….………………….(vii)
Marginal Product (MP) is defined as addition in total output per unit change in variable
input. Thus marginal product of labour (MPL) would be:
MPL = ∂TP / ∂L ……………………...………….……(viii)
Production Function with Two Variable Inputs: Most simplistic form of production
function with two variable inputs, labour (L) and capital (K), and a single output, Q, is as
follows;
Q = f (L, K) ……………………….…………………(ix)
This production function is constructed based on the assumption that the state of the
technology is given and output can be increased by increasing inputs. When the state of
technology changes, the production function itself changes. Further, it is assumed that
the inputs are utilized in the best possible way, i.e., optimum utilization of inputs. The best
utilization of any particular input combination is a technical, not an economic problem.
Selection of best input combination for the production of a particular output level depends
upon the input and output prices and is subject of economic analysis.
3.4. Law of Variable Proportion or Law of Diminishing Returns to

Factors.
The slope of the total product curve is determined from the law of diminishing returns.
The law of diminishing returns, being empirical in nature, states that with a given state
of technology if the quantity of one factor input increased, by equal increments, the
quantities of other factor inputs remaining fixed, the resulting increment of total product
will first increase and then decrease after a particular point.
The law is also known as diminishing returns to factors. It states that as more and
more one factor of production is employed, other factor remaining the same, its marginal
productivity will diminishing after some time. For example, if we increase labour input and
capital input remaining the same, then the marginal productivity of labour first increased,
reaches maximum and then decreases. The law of diminishing returns to factors is
depending on three assumptions.
i) It is assumed that the state of technology is given.
Notes ii) It is assumed that one factor of production must always be kept constant at
certain level.
iii) This law is not applicable when two inputs are used in a fixed proportion and the
law is applicable only to varying ratios between the two inputs.
3.5. Difference between Returns to a Factor and Returns to Scale

The law of diminishing returns factors states that as more and more one factor
of production is employed, other factor remaining the same, its marginal productivity
will start diminishing after some time, e.g., if we increase one factor of production i.e.,
labour and other factor of production i.e., capital remaining the same, then the marginal
productivity of labour first increased, reaches maximum and then decreases. So, returns
to a factor (variable factor) of production is first increasing in the initial level of production
and then decreasing if we increase the amount of that variable factor of production. But,
if we increase more and more of that variable factor then the returns to the variable factor
is negative.
In the very first stage of production, if additional units of labour are employed, the total
output increases more than proportionately; so marginal product rises. In the following
figure, stage I would begin from the origin and continue to a point where APL attains its
maximum value. In this stage, MPL > 0, and MPL > APL. This stage is called as increasing
returns to the variable factor.
In the second stage, the total product increases but less than proportionate to
increase in labour. In this stage, marginal product of labour falls and this stage is called
as diminishing returns to variable factors. Here, MP L > 0 and MPL < APL.
The stage three is a technically inefficient stage of production and a rational producer
will never produce in this stage. Here, MPL < 0 and total product is decreasing.
The law of returns to scale refers to the long run analysis of production. It refers
to the effects of scale relationships which implies that in the long run output can be
increased by changing all factors by the same proportion, or by different proportions. If

the production function is Q0 = f (K, L) and we increase all the factors of production by the
same proportion p. So, the new production function is Q* = f (p.K, p.L).
Notes
If Q* increases in the same proportion as the factors of production, p, then we can say
there are Constant Returns to Scale (CRS).
If Q* increases less than proportionately with an increase in the factors of production,
p, then we can say there are Decreasing Returns to Scale (DRS).
If Q* increases more than proportionately with an increase in the factors of production,
p, then we can say there are Increasing Returns to Scale (IRS).
3.6. Isoquants
An isoquant is the firm’s counterpart of the consumer’s indifference curve. It is a
curve representing the various combinations of two inputs that produce the same amount
of output. It is also known as iso-product curve or equal product curve or production
indifferent curve. It is the collection of inputs in the form of factors of production labour
(L) and capital (K), which yield the same output. For a definite level of output, i.e., for Q 0,
say 1000 units of output or for Q1, say 2000 units of output, the equation of production
function is
Q0 = f (L, K) or Q1 = f (L1 , K1 )
Where, Q0 and Q1 are parameters.

The locus of all the combinations of L and K which satisfy the above equation forms
an isoquant. Since the production function is continuous, an indefinite number of input
Notes combinations will lie on each and every isoquant. The two factors of production are
substitutable and can employ more of one input and less of another input to get the same
level of output. A higher level of output is represented by a higher isoquant. If we assume
that that the marginal productivities of both the factors of production are positive and
decreasing as more of them are used, the isoquant will be downward sloping and convex
to the origin.
Types of Isoquant: Isoquants are various shapes depending on the degree or elasticity
of substitutability of inputs. These are as follows;
i) Linear Isoquant: This type assume perfect substitutability between factors of
production, i.e., a given output can be produced by using only capital or only
labor or by a large number of combinations of capital or labor.

ii) Input-Output Isoquant: It assume strict complementary or zero substitutability
between the factors of production, we get input-output isoquant.
Notes
iii) Kinked Isoquant: This assume limited substitutability of capital and labor.
Since there are only a few processes available for producing any commodity,
substitutability of factors is possible only at kinks. This form is also called activity
analysis isoquant or linear programming isoquant.

iv) Smooth Convex Isoquant: This form assumes continuous substitutability of

capital and labor only over a certain range, beyond which factors can not be
Notes substituted for each other. Such an isoquant appears as a smooth curve convex
to the origin.
An isoquant is a curve showing all combinations of inputs that can be used to produce
a given output. The characteristics of isoquant are as follows.
Isoquants are Downward Sloping: Technological efficiency connotes that an
isoquant must slope downwards from left to right, which implies that using more of one
input to produce the same level of output must imply using less of the other input. Thus
if more of labour is used in the production process, then less of capital must be used to
produce the same level of output. Slope of the isoquant is equal to: K/L, ratio of capital
and labour.

Notes
A higher Isoquant represents a higher output: In the panel I of above figure, if we

consider point A on the curve Q 1 and the point C on Q2, it can follow that C has more of
both labour and capital as compared to A. Thus as per given technology, more of both
factors should produce greater output. However you should learn that it is not necessary
than on a higher isoquant a point will have greater quantity of at least one of the two
inputs as in case of A and B. Hence a greater quantity of any one of the two inputs will
render a higher level of output. In short, using more of both inputs and more of either of
the inputs must increase output given the state of technology. Hence a higher isoquant
Q2 would represent a higher output than isoquant Q 1.
Isoquants do not intersect each other: An isoquant represents the same level
of outputs with different units of two inputs: intersection of two isoquants would signify
single input combinations producing two levels of output. This is explained by Panel II of
above figure. Let A and B be two different points on Q1 and Q2 respectively. Suppose two
isoquants Q1 and Q2 interested each other at point C. At point B and C of isoquant Q 1 the
firm produces the same level output Q1. Again points A and C of isoquant Q 2 denote the
same level of output Q2 any the firm. Thus it follows that at points A and B, the same level
of output should be produced. But from the fig it is clear that point A denotes a higher
level of output than B; this is contradictory, and hence we conclude that isoquants cannot
intersect each other.
Convex to the origin: Given substitutability between factor inputs, as the firm
continues to employ more of one input say labour and less of other say capital, a situation
comes when it becomes difficult to substitute labour for capital. Since labour and capital
are not perfect substitutes, therefore as capital (K) is kept fixed to produce additional
units of outputs only by increasing laour (L), it would require successively increasing
units of labour. This is better understood with the help of the law of the marginal technical
substitution (MRTS). The absolute slope of the isoquant falls as we move down the
isoquant and the declining MRTSlk determining the convexity of an isoquant.
3.7. Isocost Line or Equal Cost Line

The cost equation of the firm is Co = w.L + r.K, where w is the cost of labour, i.e.,
wages and r is the cost of another input capital, i.e., rate of interest. This equation will be
satisfied by different combinations of L and K. the locus of all such combinations is called
the equal cost line or isocost line.

Notes
In the above figure, if the firm spend entire amount of money i.e., C 0 in hiring lanour,
the firm will get OB units of labour which is equal to C 0 / w. On the other hand, if the firm
spends the entire money in purchasing capital, the firm will get OA units of K which is
equal to C0 / r. By joining the two points A and B we get the isocost line C 0. With the given
cost C0 the firm can purchase any combination of labour and / or capital on the line AB.
3.8. Marginal Rate of Technical Substitution

Marginal Rate of Technical Substitution (MRTS) measures the reduction in per unit of
one input, due to unit increase in the other input that is just sufficient to maintain the same
level of output. Thus for the same quantity of output, marginal rate of technical substitution
of labour (L) for capital (K) (MRTSLK) would be willing to give up for an additional unit of
labour. Similarly, marginal rate of technical substitution of capital for labour (MRTS KL)
would be the amount of labour that firm would be willing to give up for an additional unit
of capital.
Consider the isoquant Q1 of above figure, MRTSLK would measure the downward
vertical distance (representing the amount of capital that the producer is willing to sacrifice)
per unit of the horizontal distance (representing additional units of labour).In other words,
MRTS is expressed as the ratio between rates of change in L and K, down the isoquant.

∆Κ
Thus: MRTSLK = –
∆L Notes
MRTS of labour for capital is equal to the slope of the isoquants, it is also equal to the
ratio of the marginal product of one input to the marginal product of other input. Since
output along an isoquant is constant, if ∆K units of labour are substituted for ∆K units
of capital, then the increase in output due to increase in , i.e (x ) should match with the
decrease in output due to decrease in i.e., (-x MP K). In other words:
∆L x MPL = -∆Kx MPK
Or,
MPL / MPK = ∆K- / ∆L
A change in the level of output can be expressed as change in total output (Q) equals
to the sum of change in labour input (∆L) times MP of labour and change in capital input
(∆K) times MP of capital.
In other words:
∆Q = MPL x + MPK x ∆K
However, along a given isoquant, output remains unchanged, ie. ∆Q = 0.
Hence we have
MPL x + MPK x ∆K= 0
Or,
MP L / MPK = - / ∆K- / ∆L
=> MRTS LK = MPL / MPK
So, the marginal rate of technical substitution between two inputs is equal to the ratio
of the marginal physical products of the inputs.
3.9. Choices of Input Combination (Optimal Input combination)

Maximization of Output Subject to the Cost Constraint:
Let us suppose that the production function of the firm is given as Q = f(L,K), given
the factor prices w and r for labor and capital, respectively. The firm is in equilibrium
when it maximizes its output given its total cost outlay. Suppose that the firm decides on
a given cost level Co. With this cost the firm can purchase different combinations of the
two factors of production. All these combinations will lie on the isocost line AB in following
figure. The objective of the firm is to maximize the level of output while remaining on the
given isocost line.
In the figure we see that the firm remains on the isocost line AB and purchase any
combination of the two inputs lying on the line AB. All the points on the isocost line AB
represent equally costly combinations. When the firm is moving from E3 to E1, it can
increase its output, since E1 is on a higher isoquant compared to E3. Similarly, by moving
from E1 to E, the firm can again increase the level of its output further. E is also the
highest possible point that can be attained by a firm while increasing its output at a given
cost constraint that can be attained by a firm while increasing its output at a given cost
constraint of Co. The movement from E to E2 and further to E4 is not desirable by the
firm as by moving to these points the firm decreases its level of output and shift to lower
isoquants. The geometric interpretation of the objective of the firm to maximize output
subject to the cost constraint, is that the firm tries to attain the highest possible isoquant
with the given cost constraint. This happens only when the isoquant is tangent to the
isocost line.

Notes
The necessary condition for the maximization of output given the factor prices is that
the isoquant line must be tangent to one of the isoquants. This means that the slope of
the particular isoquant must be equal to the slope of the isocost line. We know that the
slope of the isoquant is given by the ratio of the marginal productivities, i.e.-(MP L/MP K)
also known as the MRTSL, K and the slope of the isocost line is given as the ratio of the
factor prices, i.e.- w/r. So at the point of tangency we have
MPL /MPK = w/r,
i.e., the ratio of the marginal products is equal to the ratio of the factor prices. The
above condition can also be written in the form:
fL / fK = w / r,
Where, fL is marginal productivity of labour and f K is the marginal productivity of capital.
Rearranging the above equation,
we have
fL / w = fK / r.
Now, fL / w is the amount of output that can be obtained by spending one unit of money
in purchasing the factor labor. Similarly, f K / r is the amount of output that can be attained
by spending one unit of money in purchasing the factor capital.
When these two expressions are equal it means that the firm gets the same amount
of output by spending one unit of money either in labor or in capital. In any case, if the
equality does not hold, e.g; when f L / w > fK / r the firm will get more output in spending
one unit of money on labor than that on capital. Reallocation of the factors of production
continues in this way until a point is reached where total output cannot be increased
further by such reallocation of expenditure between labor and capital. At such a point total
output is maximum.
So, in a nutshell, the necessary condition of output maximization can be mathematically
represented as
MPL / w = MPK / r
An underlying assumption to the fulfillment of the above condition is the isoquants
must be convex to the origin. However, if the isoquants are concave to the origin, the
tangency solution will give us the lowest possible output level. This is because, in the
case of concave isoquants the marginal productivity of the factors of production are
negative. So, obviously, the highest attainable point on a concave isoquant will rise to the
lowest possible output level.

Minimization of cost for a given level of output: Least Cost Conditions:
In the above part, we have seen how output can be maximized for a given cost Notes
constraint. Here we will discuss how the firm minimizes its cost of production for a
particular level of output. The conditions of equilibrium of the firm are formally the same
as in the previous section.
As the level of output is fixed, we will be having only one isoquant and different levels
of cost combinations. For equilibrium, there must be tangency of the given isoquant and
the lowest possible isocost line, the shape of the isoquant being convex to the origin.
However, the problem is conceptually different in the case of cost minimization. The
entrepreneur, in this case wants to produce a given level of output (e.g., a bridge, a
building, or q tons of a particular commodity Q) with the minimum possible cost outlay.
In this case we will have a single isoquant denoted by Qo which represents the desired
level of output, but we have a set of isocost lines denoted by AB, CD and GH in the above
figure.
Lines closer to the origin will show a lower total cost outlay and vice-versa. The isocost
lines are parallel because they are drawn on the assumption of constant prices of the
factors of production. The level of output Q o can be produced by different combinations
of the two factors of production. The locus of all such combinations is an isoquant for the
output level Qo. The problem of the firm is to select a point on the isoquant which is least
costly. The firm can produce at any point such as, E 2, E 1, E, E 3, E 4, etc. If we proceed
from the points E2 or E4 towards the point E we see that the level of cost at E is much
less then the points like E1, E2 , E3 , or E4. Here E is the point which corresponds to the
lowest possible isoquant line. When we move from E2 to E1 we substitute labor for capital.
Such a substitution is possible since total cost is reduced as a result of the substitution.
Similarly, as we move from the point E 4 to point E3 we substitute capital for labor. Once
the point E is reached further substitution is no more possible, as any deviation from
this point implies an increase in the cost of production. Hence at point E, the cost of
production the output level Qo is the minimum.
Points below the point E are desirable because they show lower cost, but are not
attainable for the output level Qo . Points above the E, shows higher costs. Hence the
point E is the least cost point for the output level Q o. The least cost combination is fulfilled
when the given isoquant Qo is tangent to the lowest possible isocost line AB, i.e; the
slope of the isoquant is equal to the slope of the isocost line, i.e; the ratio of the marginal
productivities must be equal to the ratio of the factor prices. This is given as follows:
MPL /MPK = w / r,
which is the same necessary condition, that we had deduced for output maximization
given the cost constraint.

3.10. Theory of Cost

Notes Cost is a sacrifice or foregoing that has occurred or has potential to occur in future,
measured in monetary terms. Cost results in current or future decrease in cash or other
assets, or a current or future increase in liability. Cost is determined by various factors and
each of this has significant implications for cost decisions. An increase in any of these will
affect cost pattern. The most important determinant is price(s) of factor(s) of production,
which are uncontrollable, as they are largely determined by the external environment of
any business. The marginal efficiency and productivity of these factors is strongly related
to their cost, higher the productivity or efficiency, lower will be the cost of the production,
other things remaining the same. Technology is the third important determinant and has
the same relationship with the cost as the efficiency of inputs. Other things remaining the
same, better the technology enhances productivity and reduces the cost of production.
Production and cost analysis constitute the supply side of the market. The production
analysis deals with the supply side in terms of physical units of inputs and output, the cost
analysis is concerned with the supply side in terms of physical units of output and the cost
of production as expressed in nominal terms.
3.11. Cost Functions

Cost functions are derived functions. They are derived from the production function,
which describes the availability of efficient methods of production at any one time.
Economic theory distinguishes between short-run costs and long-run costs. Short-run
costs are the costs over a period during which some factors of production (usually capital
equipment and management) are fixed. The long-run costs are the costs over a period
long enough to permit the change of all factors of production. In the long run all factors
become variable.
Both in the short run and in the long run, total cost is a multivariable function, that is,
a total cost is determined by many factors. Symbolically we may write the long run cost
function as
C= f (X, T, Pf)
And the short – run cost function as
C = f (X, T, Pf, K)
Where C = total costs
X = output
T = technology
Pf = prices of factors
K = fixed factor(s)
Graphically, costs are shown on two-dimensional diagrams. Such curves imply that
cost is a function of output, C = f (X), ceteris paribus. The clause ceteris paribus implies
that all other factors which determine costs are constant. If these factors do change,
their effect on costs is shown graphically by a shift of the cost curve. This is the reason
why determinants of costs, other than output, are called shift factors. Mathematically
there is no difference between the various determinants of costs. The distinction between
movements along the cost curve (when output changes) and shifts of the curve (when the
other determinants change) is convenient only pedagogically, because it allows the use
of two-dimensional diagrams. But it can be misleading when studying the determinants
of costs. It is important to remember that if the cost curve shifts, this does not imply that
the cost function is indeterminate.

3.12. Various types of Costs
In economic analysis, the following types of costs are considered in studying costs Notes
data of a firm:
 Total Cost (TC)
 Total Fixed Cost (TFC)
 Total Variable Cost (TVC)
 Average Fixed Cost (AFC)
 Average Variable Cost (AVC)
 Average Total Cost (ATC). and
 Marginal Cost (MC)
Total Cost (TC)

Total cost is the aggregate of expenditures incurred by the firm in producing a given
level of output. Total cost is measured in relation to the production function by multiplying
factors of prices with their quantities.
If the production functions is: Q = f (a, b, c….n), then total cost is TC = f (Q) which
means total cost varies with output.
For measuring the total cost of a given level of output, thus, we have to aggregate the
product of factors quantities multiplied by their respective prices.
Conceptually, total cost includes all kinds of money costs, explicit as well as implicit.
Thus, normal profit is included in total cost. Normal profit is an implicit cost. It is a normal
reward made to the entrepreneur for his organizational services. It is just a minimum
payment essential to retain the entrepreneur in a given line of production. If this normal
return is not realized by the entrepreneur in the long run, he will stop his present business
and will shift his resources to some other industry.
Now, an entrepreneur himself being the paymaster, he cannot pay himself, so he
treats normal profit as implicit costs and adds to the total cost.
In the short run, total costs may be bifurcated into total fixed cost and total variable
cost. Thus, total cost may be viewed as the sum of total fixed cost and total variable cost
at each level of output. Symbolically, TC=TFC + TVC.
Total Fixed Cost (TFC)

Total fixed cost corresponds to fixed inputs in the short run production function. It
is obtained by summing up the product of quantities of the fixed factors multiplied by
their respective unit prices. TFC remains the same at all levels of output in the short
run. Suppose a small furniture shop proprietor starts his business by hiring a shop at a
monthly rent of Rs. 1,000 borrowing Rs. 50,000 from a bank at an interest rate of 10% and
buys capital equipment worth Rs. 2,000. Then his monthly total cost is estimated to be:
Rs. 1,000 + Rs. 2,000 + Rs.500 = Rs. 3,500

(Rent) (Equipment cost) (Monthly interest on th loan)
Total Variable Cost (TVC)

Corresponding to variable inputs in the short-run production is the total variable cost.
It is obtained by summing up the product of quantities of input multiplied by their prices.
Again, TVC = F (Q) which means, total variable cost is an increasing function of output.
Suppose, if a shop proprietor starts with the production of chairs and he employs a
carpenter on a wage of Rs. 200 per chair. He buys wood worth Rs. 2,000 rexine sheets
worth Rs. 1,500, spends Rs. 400 for other requirements to produce 3 chairs. Then this
total variable cost for producing 3 chairs is measured as Rs. 2,000 (wood price) + Rs.
1500 (rexine cost) + Rs. 400 (allied cost) + Rs. 600 (labour charges) = Rs. 4,500.
Notes Average Fixed Cost (AFC)
Average fixed cost is total fixed cost divided by total units of output.
AFC = TFC / Q
Where,
Q stands for the number of units of the product.
Thus, average fixed costs are the fixed cost per unit of output.
In the above example, thus, when TFC = Rs. 3,500 and Q = 3.
Therefore AFC = 3,500 /3 = Rs. 1,166.67
Average Variable Cost (AVC)

Average variable cost is total variable cost divided by total units of output.
AVC = TVC / Q where, AVC means average variable cost.
Thus, average variable cost is variable cost per unit of output. In the above example,
TVC = Rs. 4,500 for Q = 3,
Therefore AVC = 4,500 / 3 = Rs. 1,500
Average Total Cost (ATC)

Average Total Cost or average cost is total cost divided by total units of output.
Thus:
ATC or AC = TC / Q
In the short run, since
TC = TFC + TVC
ATC = TC / Q = TFC + TVC / Q = (TFC / Q) + (TVC / Q)
Since = TFC / Q = AFC and TVC /Q = AVC,
Therefore ATC = AFC + AVC.
Hence, average total cost can be computed simply by adding average fixed cost and
average variable cost at each level of output. To take the above example, thus
ATC = Rs. 1,166.67 + Rs. 1,500 = Rs. 2,666.67 pr chair.
Marginal Cost (MC)

The marginal cost is also per unit cost of production. It is the addition made to the total
cost by producing one more unit of output. Symbolically, MC n = TC n –TC n – 1, that is, the
marginal cost of the nth 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.
Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000 while that for 3
chairs (i.e. n – 1 is Rs. 8,000. Marginal cost of producing the 4th chair, therefore, works
out as under:
MC4 = TC4 – TC3 = Rs. 10,000 – Rs. 8,000 = Rs. 2,000.
Marginal cost is the cost of producing an extra unit of output. In other words, marginal
cost may be defined as the change in total cost associated with a one unit change in
output. It is also an “extra – unit cost” or incremental cost, as it measures the amount by
which total cost increases when output is expanded by one unit. It can also be calculated
by dividing the change in total cost by the one unit change in output.
Symbolically, thus, MC = ∆TC / ∆1Q where, ∆ denote change in output assumed to
change by 1 unit only.
Therefore, output change is denoted by ∆1.
It must be remembered that marginal cost is the cost of producing an additional unit Notes
of output and not of average product. It indicates the change in total cost of producing an
additional unit.
3.13. Relationship between (Average Cost) AC and (Marginal Cost)

MC
Economists have observed a unique relationship between the two as follows:
 When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at
the minimum point of ATC curve.
 When AC is falling, MC is also falling initially, after a point MC may start rising but
AC continues to fall. However AC is greater that MC (AC > MC). Hence ultimately
at a point both costs will be equal. Thus, when MC and AC are failing, MC curve
lies below the AC curve.
 Once MC as equal to AC, then the output increases AC will start rising and MC
continues to rise further but now MC will be greater than AC. Therefore, when
both the costs are rising, MC curve will always lie above the AC curve.
The above stated relationship is easy to see through geometry of AC and MC curves,
as shown in following figure.
It can be seen that
 Initially, both MC and AC curve are sloping downward; MC curve lies below AC.
 When AC curve is rising, after the point of intersection, MC curve is above it.
 It follow thus when MC is less than AC, it exerts a downward pull on the AC
curve. When MC us more than AC it exerts an upward pull on the AC curve.
Consequently, MC must equal AC, while AC is at the minimum. Hence, MC curve
intersects at the lowest point of AC curve. It may be recalled that MC curve also
intersects the lowest point of AVC curve. Thus, it is a significant mathematical
property of MC curve that it always cuts both the AVC and ATC curve at their
minimum points.
In the following figure, the MC curve crosses the AC curve at point P. At this point, for
OQ level of output the average cost of PQ which is minimum.

It should be noted that no such relationship can ever be traced between the MC curve
and the AFC curve simply because by definition, the MC curve is independent. Further,
Notes the area underlying the MC curve is equal to the total variable cost of the given output.
In fact, the point on each average cost curve measures the average cost but the area
underlying them denote total costs as under:
 Total, area underlying the AFC curve measures the total fixed cost.
 The area underlying the AVC curve measures the total variable cost.
 The area underlying the MC curve measures the total variable cost.
 The area underlying the ATC curve measures the total cost.
Finally, the MC curve is important because it is the cost concept relevant to rational
decision making. It has greater significance in determining the equilibrium of the firm. In
fact, the increasing MC due to diminishing returns sets a limit to the expansion of a firm
during the period. Further, it is the MC curve which acts on the supply curve of the firm.
From the above discussion of cost behavior we may conclude that short run average
cost curves (AVS, ATC and MC curves) are U shaped, except then AFC curve, which is
an asymptotic and downward sloping curve.
3.14. Long and Short Run Cost Curves

In the long run, all inputs (factors of production) are variable and firms can enter or
exit any industry or market. Consequently, a firm’s output and costs are unconstrained in
the sense that the firm can produce any output level it chooses by employing the needed
quantities of inputs (such as labor and capital) and incurring the total costs of producing
that output level.
The Long Run Average Cost (LRAC) curve of a firm shows the minimum or lowest
average total cost at which a firm can produce any given level of output in the long run
(when all inputs are variable).
In the long run, a firm will use the level of capital (or other inputs that are fixed in the
short run) that can produce a given level of output at the lowest possible average cost.
Consequently, the LRAC curve is the envelope of the short run average total cost (SR
ATC) curves, where each SR ATC curve is defined by a specific quantity of capital (or
other fixed input).

In the short run, because at least one factor of production is fixed, output can
be increased only by adding more variable factors. Hence we consider both fixed and
variable costs. Fixed costs are business expenses that do not vary directly with the level
Notes
of output i.e. they are treated as independent of the level of production.
Examples of fixed costs include the rental costs of buildings; the costs of leasing or
purchasing capital equipment such as plant and machinery; the annual business rate
charged by local authorities; the costs of full-time contracted salaried staff; the costs of
meeting interest payments on loans; the depreciation of fixed capital (due solely to age)
and also the costs of business insurance.
Fixed costs are the overhead costs of a business. They are important in markets
where the fixed costs are high but the variable costs associated with making a small
increase in output are relatively low. We will come back to this when we consider
economies of scale.
 Total fixed costs (TFC) remain constant as output increases,
 Average fixed cost (AFC) = total fixed costs divided by output
Average fixed costs must fall continuously as output increases because total
fixed costs are being spread over a higher level of production. In industries where the
ratio of fixed to variable costs is extremely high, there is great scope for a business to
exploit lower fixed costs per unit if it can produce at a big enough size. Consider the new
Sony portable play station. The fixed costs of developing the product are enormous, but
these costs can be divided by millions of individual units sold across the world. A change
in fixed costs has no effect on marginal costs. Marginal costs relate only to variable
costs!
3.15. Cost and Output Relationship (Cost Function)

Cost- output functional relationship is expressed by the cost function. Thus:
C = f (Q),
Where,
C = total cost,
Q = output Quantity
The cost function of the firm gives the functional relationship between total cost and
total output. The same level of output can be produced with the help of different cost
combinations. The cost function gives the least cost combinations for the production of
different levels of output.
Notes
3.16. Short Run and Long Run
The short run is a period during which one of the factors of production is considered
to be constant (assuming that there are only two factors of production labour and capital)
and the other is variable. Usually it is assumed that capital is the fixed factor in the short
run.
All costs are variable in the long run since factors of production, size of plant, machinery
and technology are all variable. This in turn implies radical changes in the cost structure
of the firm. The long run cost function is often referred to as the ‘planning cost function’
and the long run average cost (LAC) curve is known as the ‘planning curve’. As all cost
are variable, only the average cost curve is relevant to the firm’s decision-making process
in the long run. The long run consists of many short runs, e.g., a week consists of seven
days and a month consists of four weeks and so on. So, the long run cost curve is the
composite of many short run cost curves.
3.17. Economies / Dis-economies of Scale

The LAC curve is the mirror image of the returns to the scale in the long run. It is
apparent that since returns to the scale are based on the internal economies and the
diseconomies of scale, the long run average cost curve traces these economies of scale.
As a matter of fact increasing returns to scale can be largely traced to the economies
which become available to a firm when it expands its scale of operations. As a result of
these economies, the firm enjoys a number of cost advantages and return in terms of
total output. Thus, economies of scale explain the falling segment of the LAC curve. This
shows that the decline average cost of output in the long run is due to economies of large
scale enjoyed by the firm. Increasing LAC is attributed to the diseconomies of scale after
a certain point of further expansion.
In short economies and diseconomies of large scale play a significant role in determining
the shape of the LAC curve. Again the structure of an industry is also affected by the cost
consideration which is conditioned by the economies and diseconomies of scale. Of the
many determinants of the number and size of firms in an industry , the, cost consideration
and relevant economies and diseconomies are a significant determining factor.
Increasing average costs in the long run, attributed to the growing diseconomies of
scale, set a limit to the further expansion of the firm.
Economies and diseconomies of scale reflect upon the behavior of LAC curve.
Analytically speaking the downward slope of the LAC curve may be attributed to the
internal economies of scale. Similarly, the upward slope of the LAC curve is caused by
the internal diseconomies of scale. And the horizontal slope of the LAC curve may be
explained in terms of the balance between internal economies and diseconomies.

Notes
In short, the internal economies and diseconomies have their significance in

determining the shape of the LAC curve of a firm. However, the shift in the LAC curve
may be attributed to the external economies and diseconomies. External economies
reflect in reducing the overall cost function of the firm. Thus, a downward shift in the LAC
may be caused by external economies as shown in following Figure.
In above figure, ABCD is the LAC curve. Its AB portion – the downward slope – is
subject to the internal economies. Its BC portion – the horizontal slope – is due to the
balance between economies and diseconomies. Its CD portion – the upward slope – is
subject to internal diseconomies.
In following figure, the original LAC 1 curve shifts downward as LAC 2 on account of
external economies.
Similarly, an upward shift in the LAC curve may be attributed to the external
diseconomies, as shown in following figure.

Notes
In above figure, the original LAC1 curve shifts up as LAC 2 owning to the external
diseconomies.
3.18. The Theory of firm (Profit Maximization Model)

Economists have been using the model of profit maximization for a long time. The
‘theory of firm’ has been developed on the basis of the assumption that rational firms
pursue the objective of profit maximization, subject to the technical and market constraints.
The basic propositions of the theory of firm may be summed up as:
(a) Firm is a unit which transforms valued inputs into outputs of a higher value, given
the state of technology.
(b) The firm strives towards the achievement of its goal- usually profit
maximization.
(c) The market conditions (like competition, monopoly, etc.) for a firm to operate are
given.
(d) While choosing between alternatives, the firm prefers the alternative which helps
it to consistently achieve profit maximization.
(e) The primary concern of the theory of firm is to analyze changes in the price and
quantity of inputs and outputs.
Taking these as central points, the theory of firm has been carried to varying degrees of
elaboration and refinement. Before taking it up in detail, let us note the basic assumptions
on which this theory rests.
Assumptions of the Model:

1. The firm has a single goal , viz., to maximize profit( Motivational assumption)
2. The firm acts rationally to pursue its goal. Rationality implies perfect knowledge of all
relevant variables at the time of decision-making.
3. The firm is a single ownership one, i.e; run by its owner, called the entrepreneur.
The Model: The term ‘profit maximization’ is usually taken to mean the generation of
largest absolute amount of profits over the time period being analyzed. This then leads us
to defining the term ‘time period’. Economists have suggested two broad time period: the
short-run and long-run; consequently, there is short-run and long-run profit maximization.

The short run is defined as a period where adjustments to changed conditions are only
partial, e.g.; if defined for the product for a firm increases, in the short run it can meet
the increased demand through changes in man-hours and intensive use of existing
Notes
machinery, but it cannot increase its production capacity. On the other hand, long-run is a
period where adjustment to changed circumstances is complete. For example, the above
mentioned firm can meet the increased demand in the long-run by making changes in
its production capacity or by setting up an additional plant, besides changes in man-
hours and intensive use of its existing machinery. Thus, in the short-run there are certain
constraints (physical or financial) on expansion. As time passes, these constraints can
gradually be overcome. And, when all the constraints are overcome, the long-run is
reached. No calendar time can be specified for short-run or long-run. It depends upon
the nature of production. For example, a furniture workshop can increase its capacity
and make complete adjustments within a matter of months, while a firm manufacturing
automobile may take years to do so. The long-run will, therefore, be a matter of months
in case of furniture workshop and a matter of years for an automobile firm.
Relationship between Short-run and Long-run Profit Maximization: We know
that the long-run consists of a number of short-run periods. But, it implies that if the firm
maximizes profit in the short-run, it must be found to maximize in the long-run also. It
depends upon the two following conditions;
1. Assumption of independence of periods. Is each short-run period considered in
isolation, in the sense that a short-run period has no effect which link this period
to the next period?
2. Assumption of period-linkages- Each short-run period is linked to the next short-
run period.
Under the assumption of independence of periods, the short-run and long-run profit
maximization is consistent. On the other hand, with the assumption of period-linkages,
the profit maximization in the two periods may conflict. For example, a firm which
dominates the market may decide to restrict supplies in order to change higher price
to maximize profits. This would, in the long-run, attract rival firms into the industry, thus
forcing a reduction in the price and profits of the dominant firm. Had the firm not attended
to maximize profits in the short-run the rival would not possible have been attracted to the
industry, thus allowing the dominant firm to achieve long-run profit maximization. Here the
short-run profit maximization policy results in the defeat of long-run profit maximization.
Several instances may be cited where a conflict between the profit maximization in the
two periods may exist, like:
(a) Higher profits in the short-run may in the long-run induce workers to demand
higher wages.
(b) Maximization of profits in the short-run may give an impression of being
exploitative, thus inviting legal or government intervention which would affect
long run profits adversely.
(c A firm trying to build up its reputation by charging low prices and supplying quality
products in the short run would be able to make long run profits.
It may however be noted that the assumptions of independence of period are not found
tenable in practice. On the other hand the period linkage are considerably affected by the
condition of uncertainty since the dependence of one period on the other involves future
reactions, there remains an element of uncertainty. The extent of uncertainty increases
the further we go into the future. This perhaps is the reason why firm prefer short run
profit maximization to the long run. There is however a major problem if the firms prefer
long run rather than short run profit maximization. In such cases almost any decision can
be defended on the basis that it aims at long run profit maximization, e.g. extravagancy in
the reception facilities may be defended on the grounds of improving firms’ public image
which would contribute to long run profits.

Determination of profit maximizing output and price

Notes The approach of the traditional economic theory is that the firm compares the cost and
revenue implication of different output levels and fix up the output level that maximizes
the absolute difference between the two. Let TR and TC be the total revenue and total
cost at a given level of output X .then profit (π) at that level of output would be,
π = TR-TC
For π to attain the maximum value, the firm shall produce that level of output where
the following two marginal conditions are satisfied:
which implies that the slope of MR curve is less than the slope of MC curve.
An output level (X) which satisfies both the above conditions would be the profit-
maximizing level of output.
Since profit (ð) is the difference between total revenue (TR) and total cost (TC), the
profit-maximizing output will occur when the gap between TR and TC is maximum. In
Fig. 3.1, TR and TC curves represent the total cost and total revenue for different output
levels. The gap between TR and TC is maximum at output Oq* where the slopes of the
two curves are equal. Since slopes of total cost and total revenue curves are marginal
cost (MC) and marginal revenue (MR) respectively, it implies that profit is maximized at
that output level where MR=MC.
Limitations: The traditional theory suggests a number of reasons as to why do a firm
want to maximize profits. All these reasons essentially fall into the following categories:

1. Traditional economic theory assumes that the firm is owner-managed, and
therefore maximizing profit would imply maximizing the income of the owner.
Owner would like to have adequate return for his activity as an entrepreneur.
Notes
Maximizing-profits for a given amount of effort will, therefore, be quite a rational
behavior for him.
2. The very survival of the firm depends upon the entrepreneur’s ability to maximize
profits in the long run. The goal of profit maximization is, in fact, forced upon
him by the impact of the competing firms. By maximizing profits the firm can
accumulate financial assets which allow it to grow faster than those firms which
pursue goals other than profit maximization – share of the latter gradually shrinks
and such firms eventually get eliminated. In case of monopoly situation, where
there are no rivals to force him to maximize profits, he would like to pursue this
goal to achieve the maximum return for his efforts.
3. Firm may pursue goals other than profit-maximization, but they can achieve
these ‘subsidiary’ goals much easier if they aim for profit-maximization.
These justifications of profit-maximization have been subjected to severe criticism
and certain alternative goals have been suggested by economists. Some of the main
points of criticism are the following:
1. In the context of real business situation the assumption of profit-maximization
is of doubtful validity. There is no reason to believe that all businessmen pursue
the same goal. They may aim at sales maximization, expansion of market share,
etc.
2. The assumption of traditional theory that firms are owner-managed is not valid in
the modern business world where firm is a complex organization run by salaried
managers whose interests may, and often do, differ from those of the shareholders
who want maximum profits.
3. In the absence of usually incomplete information all the business decisions may
not be optimal. This lack of information may be of two types: a) Since business
decisions always, directly or indirectly, relate to the future, and since future is
always uncertain, the businessman’s decisions may not always be what he wants
them to be. b) Further, the lack of information also results from the failure or
inability of the firm to collect the adequate information and to use the information
it already possesses. Former results due to expensiveness of collection of
information, and the latter due to the difference in what the business firm collects
and what it actually needs.
4. The modern business firm divides itself into separate departments, each having
a considerable degree of autonomy in its operations. Under these conditions it
is not possible for those at the top of the firm to ensure that decisions taken in
particular departments or functions fit in with the overall policy of the firm and
whether these decisions lead to the overall optima for the whole firm. It will be
more appropriate to say that given the organization of the modern firm and its
problems, firms are often too complex for any individual or group to be able to
see them as a whole.
5. One cannot say that in non-competitive situations the firms that do not maximize
profits will be driven out of business; and that, under such a situation a profit-
earning firm need not quickly adjust to changes in the economic environment. It is
also not true that these adjustments will be done in the direction which economic
theory has predicted. For example, if there is a large group of firms, demand for
whose products remains at a very high level for a long period of time, any firm
in this group, however inefficient, will be able to survive. It has been found that
where profits are easy to come the keen quest for profits will be abandoned in
many cases. Such a situation was there in advanced countries during the long
period of inflation and full employment after World War II. Further, the firms might
enter into open or tacit agreement to avoid some kinds of competition, especially
price competition. These agreement are found quite often in markets like those
for automobiles, aircrafts, detergents and chemicals. Thus, while the assumption
Notes of profit maximization has served economics well for many years, it is clear that
it needs supplementing by other assumptions.
6. It has been observed in the modern business world that the emerging dominant
market structure is oligopoly, where a few large firms dominate the market. The
small firms often have to follow these large firms in fixing the price. Under such
circumstances how can these small firms (which are generally in majority) are
expected to pursue the goal of profit-maximizations?
7. Lack of predictive power of managers, and they generally being risk-averse,
results in firms settling with less-than-maximum profit as their goal. Firms are
prevented to maximize profits also because they generally suffer from lack of
proper intra-firm communication.
Literature criticizing profit-maximization hypothesis is extensive and much of it is
of considerable economic and philosophical subtlety. However, the attack on profit-
maximizing hypothesis is threefold:
a) Firms cannot have profit maximization as their goal as they lack the necessary
information and ability to do so.
b) Even if the firms could, they do not want to pursue profit-maximizations. There
are multiplicity of goals a modern firm pursues and profit-maximizations may be
only one of them; and,
c) Firms do not maximize profits but face some bind of minimum profit constraint.
The management has discretion in setting goals subject to minimum profit
constraint.
Some alternatives suggested

Economists have suggested the following alternatives to the goal of profit-
maximization:
1. Papandreou argues that organizational objectives grow out of interaction among
the various participants in the organization.
2. Baumol argues that firms seek to maximize sales (i.e., total revenue) subject to
a profit constraint.
3. Rothschild suggests that the primary motive of enterprise is long-run survival.
Decisions, therefore, aim to maximize the security of the organization. Feller has
similarly argued that firms are interested in safety margins.
4. Scitovsky argues that the entrepreneur chooses between greater profit and more
leisure.
5. Cooper suggests that businesses (mainly banks) attempt to maintain liquidity
sufficient to assure the firm’s financial position and retention of control.
6. The other objectives suggested include the maintenance of the firm’s share of
the market, payment of good wages and the welfare of employees, growth of
firm, excellence of a product, and the maintenance of good public relations.
These alternatives emphasize goals other than profits, though most of them do not
exclude profit as a constraint within which firms pursue these goals. Some empirical
studies point out that firms have a profit goal but that they do not attempt to maximize
profits. But in defense of the goal of profit maximization, one may say that from the
array of alternative goals suggested to dispense with the profit motive, no single goal
has gained wide acceptance. It would be more appropriate to say that these alternative
goals are not so much intended to replace the profit maximization hypothesis as to deny
its primary importance. Business goals are probably multiple. Moreover, though profits
enter into the calculations of every business, it is more difficult to sustain the views that

firms do maximize profits. In a complex environment, where information is lacking and
uncertainties prevail maximization of profits is generally unattainable.
Notes
It may, therefore, be safe to conclude that there is no universally acceptable objective
for business policy and, therefore, it is impossible to point out a single, simple, obvious
criterion of business efficiency. Each business must define its own objectives, which
may have to satisfy the needs of those groups whose co-operation makes the continued
existence of business possible; the shareholders, management, employees and
customers. Businesses have multiple goals and the needs of survival, goodwill, security
or growth commonly call for some sacrifice of short-term profits. In short, though profit is
not the only goal of the business, it is an extremely important one.
3.19. Break-even and Shut-down Point

Breakeven point is the point where total cost just equals to the total revenue; it is the no
profit no loss point. It is an important application of cost analysis. It examines the relation
between total revenue, total cost and total profits of a firm at different levels of output. This
analysis is about determining profit at various projected levels of sales, identifying the
breakeven point, and making a managerial decision regarding the relationship between
likely sales and the breakeven point. ‘Break-even analysis’ is used synonymously with
Cost Volume Profit Analysis, though many are of opinion that finding the breakeven point
is just the first step in any planning decision. There are several approaches of breakeven
analysis, but here we would explain graphical method only. Total revenue and total cost
measured in the vertical axis and output is measured in the horizontal axis. Here, total
cost (TC) is total fixed cost (TFC) plus total variable cost (TVC); i.e., TC = TFC +TVC.
Total revenue (TR) is 45o line, which starts from origin, where output (Q) is zero and TR
is also zero. In the following figure, at point E, the total revenue is equal to total cost, i.e.,
TR=TC, that means no loss no profit case. In this case, the total output is OQe units. So,
the breakeven point is E and Breakeven amount of output is OQe units.
The fixed cost is that cost which is occurs irrespective of output, which means the firm
has to bear this TFC even when the production is stopped. To get normal profit or zero
profit, the firm has to cover TC (TFC + TVC). But if the firm is not able to cover this TC
then also the firm will continue to produce up to the level where the loss amount is equal
to TFC. Because, the firm is identical in both the cases, i.e., if stopped production then
the maximum amount of loss is TFC or if they produce then also they can bear the same
amount of loss (equal to TFC). So, in the following figure, the shut-down point is S and
shut-down output is OQs.

3.20. Managerial Theories of the Firm

Notes The main argument of managerial theories is that in modern large firms, ownership and
control are divorced. Managers, therefore, have a primary role in the effective control of
the firm. The firm, then, seems to behave so as to maximize managerial objectives rather
than shareholder’s profits. Like the traditional theory of firm the managerial theories are
also optimizing theories, though what is maximized differs: in the theory of firm it is the
profit maximization, while in the managerial theories it is the maximization of managerial
utility. Different managerial theories of the firm view managerial utility as a function of
different combinations of variable like, salary, status, power, growth and job security.
Managerial theories may be broadly classified into three categories:
1. Sales Revenue Maximization Model by Baumol,
2. Managerial Utility Models, and
3. Growth Maximization Models.
3.21. Baumol’s Model

Baumol pointed out that the oligopolistic firms aim is to maximize their sales revenue
not profit maximization. According to him, the reasons behind this are as follows:
 Financial institutions judge the health of a firm largely in terms of the rate of
growth of its sales revenue.
 Salaries of top management are correlated more closely to the firm’s sales than
with its profits.
 Growing sales help in keeping a healthy personnel policy, thus keeping employees
happy by giving them higher salaries and better terms.
 Managers prefer the steady performance with satisfactory profits than spectacular
profit-maximization projects. This is so because if the managers declare their
aim as spectacular profit maximization but, for obvious reasons, cannot give the
spectacular profit year after year, they shall be penalized for the non-achievement
of the goal.
 Large and growing sales by maintaining or increasing the market share of the
firm increases the competitive power of the firm.
Assumptions: The firms while pursuing the goal of sales maximization cannot
completely ignore the shareholders. The goal of the firm is, thus, the maximization of
sales revenue subject to a minimum profit constraint. The profit constraint is determined
by the expectation of the shareholders and to enable it to raise new capital at a future
date. The assumptions are follows.
1. Goal of the firm is sales maximization subject to minimum profit constraint.
2. Advertisement is a major instrument of the firm as non-price competition is the
typical form of competition in oligopolistic markets.
3. Production costs are independent of advertisement.
4. Advertisement will always result in creating favourable conditions for the
product.
5. Price of the product is assumed as constant.
The Single-Period model: According to Baumol, it is only after the profit constraint has
been satisfied that profits became subordinate to sales in the firm’s hierarchy of goals. In
the following figure, the profit constraint is shown by a line π. Obviously, sales maximiser
will keep on selling till the MR remains positive. So, the sales maximiser’s level of output
would be OQ1 where MR (dTR / dQ) equal to zero. If the minimum profit constraint (π0)
is above the level of profits where MR=0 (at point K 1), the sales revenue maximiser is
‘constraint’ to stop at OQ 3 output where minimum profit constraint π0 is met. On the other

hand, if minimum profit constraint is π (which is less than the profits where MR=0) then
the sales revenue maximiser will face no ‘profit constraint’ and would, therefore, produce
OQ1 output. Thus, if the minimum profit constraint is less than the maximum profit, the
Notes
sales maximiser will produce a greater output than the profit maximiser.
TC
Implications of Baumol’s Model: If both the profit maximiser and a constrained

sales maximiser face the same demand curve, the later will charge a lower price to sell
the extra output (Q3 – Q1). A sales maximiser will spend more on advertisement than does
a profit-maximiser firm. Baumol assumes that advertisement does not affect the product’s
price but it does lead to increased output sold. It is also assumed that advertisement will
always lead to a rise in TR; MR will never become negative. This is shown in the following
figure. Since, advertisement will always increase TC; the management will increase
advertisement until prevented by the profit constraint (π0).

3.22. Marris Model

Notes Marris tried to improve upon Baumol’s model. He offered a variation of Baumol’s model
that stressed the maximization of growth subject to the security of management’s position.
Marris’ hypothesis is that executive actions are limited by the need for management to
protect itself from dismissal or takeover raids in the event of failure. Like Williamson,
Marris’ approach is also based on the fact that ownership and control of the firm is in the
hands of two different sets of people. He, like Williamson, also suggested that manager
have a utility function in which salary, status, power, prestige and security are important
variables. Owners of the firm (i.e.; shareholders) are, however, more concerned about
profits, market share, output etc. In other words, goals of the managers and shareholders
differ from each other. The utility function of managers (Um) and that of the owners (Uo)
may, therefore, be defined as:
Um = f (salaries, power, status, job security)
And, Uo = f (profits, market share, output, capital, public esteem).
In contrast to Williamson, Robin Marris believes that most of the variables entering
into the utility function of managers and owners are strongly correlated with a single
variable: the size of the firm. He, therefore, postulates that the managers would be mainly
concerned about the rate of the growth of size. However, various measures of size exist,
like capital, output, revenue, and market share. Marris defines size in terms of corporate
capital, which is measured as the “sum total of the book value of assets, inventory and
short-term assets including cash revenue.” Further, it may be noted that managers aim
to maximize rate of growth of size rather than absolute size, as the managers generally
wish to stay in the concern and grow rather than move from a smaller size firm to a bigger
size firm. Moreover, maximizing the rate of growth of size also satisfies the owners, while
absolute size may not. Thus, the attraction of the growth rate of size stems from the fact
that not only it has a positive effect upon the prospects of promotion of the managers, but
it also keeps the shareholders satisfied.
Marris recognizes that the drive for the rate of growth of size is not, however, without
constraints. He lists mainly two constraints to the achievement of maximization of the rate
of growth:
(a) Marris adopts Penrose’s thesis of the existence of a sure limit on the rate of
managerial expansion. In other words, the capacity of the managerial team in fact
determines the upper limits to the growth of the firm. There is a high possibility
that management would lose control over a rapidly growing firm. There is a limit to
output increase by hiring new managers due to their lack of experience. And the
time-lag involved in their acquiring the specific corporate culture and developing
coordination with the existing managerial team. The ability of manager to find and
successfully launch new products to take the place of old ones is also subject to
a limit. Similarly, the research and development department cannot be expected
to produce expanding flow of products continuously. All these factors are strong
enough to set a limit to the rate of growth of size of the firm.
(b) The second constraint on the rate of the growth stems from the voluntary slowing
down process by the management itself. This slowing down process comes from
the desire of the management for job-security. The management which holds
high the consideration of job security would grow in such a way that it remains
safe on the financial side. For example, in case management aims to achieve
growth at any cost, it should not hesitate to borrow large sum of money from the
capital market for investment purpose. But increased rate of borrowing may give
out an impression of following a less prudent financial policy, thus inviting take-
over bid by another firm. This would definitely be real danger to the job-secure
motivation of the managers. Obviously, there is definite disutility of risk and the
managers would like to seek the job security through the adoption of a cautious
and prudent financial policy which would consist of: non-involvement in risky
investments; financing growth mainly from the profit levels being generated by
the present set of products. The ratio of external to internal finance is not allowed
to grow significantly.
Notes
To judge the prudent of a financial policy, Marris proposes the concept of financial
constraint (a) which is mainly determined by the risk attitude of the top management. A
risk-loving management would prefer a high value of a, while a risk-averting management
would prefer a low value of a. Marris defines ‘a’ as the weighted average of the following
three security ratios:
Liquidity Ratio (a1) = Liquid Assets/Total Assets;
Leverage Ratio (a2) = Value of Debts/Total Assets;
Profit-Retention Ratio (a3) = Retained Profits/Total Profits.
Low liquidity ratio implies the possibility of insolvency of the firm. High liquidity, of
course increases the security, but a too high liquidity ratio has an adverse impact on
rate of growth. To ensure security the management has, therefore to choose a level of a1
which is neither too high nor too low. The leverage ratio relates to the extent of reliance on
borrowing for expansion purposes. A high and growing leverage ratio would invite takeover
bids and increase the rate of failure, while a too low leverage ratio would retard growth.
Retained profits are perhaps the most important financial source for the growth of capital.
But, a high level of retained profits is perhaps the most important financial source for the
growth of the capital. But a high level of retained profits cannot keep the shareholders
happy and a too high a3 would mean that management is taking a risk of displeasing the
shareholders. As is obvious from the discussion above, value of the financial constraint
(a) would increase if either a2 or a3 are increased or a1 is reduced. That is, liquidity ratio
and profit-retention ratio are positively related. Marris further postulates that there is a
negative relationship between job-security and the financial constraint: job security of
managers is reduced if a is increased and job security increases if a is reduced. Thus,
financial security constraint determines the level of job security and therefore limits the
rate of growth of the capital supply and thereby the rate of growth of size of firm.
Model: Merris argues that the managers would aim to have a balanced growth, in the
sense that growth in demand (stemming mainly from new products) would be matched
by growth in capital (making available the investible funds for launching and producing
these products). That is, the managers would want to maximize balance growth rate (g),
which is equal to the growth rate of demand for the product (gd) and growth rate of capital
supply (gc): Max. g = gd= gc
By this process the managers achieve maximization of their own utility as well as that
of the shareholders. In case the management wants to expand too rapidly (by undertaking
highly risky projects, resorting to heavy borrowing for expansion, etc.), it runs the risk
of job security. On the other hand, if it wants to expand too slowly (due to lack of
initiative in finding new market and products, keeping excessive reserves by high profit-
retention ratio but shying away from new investment projects), it would be considered as
an inefficient management, again impairing job-security.
The first step to achieve balanced growth rate would be to identify the factors that go
in to determining gd and gc. According to Marris, these determinants can be expressed
in terms of two variables:
1. Diversification rate(d);
2. Average profit margin (m).
Both these variables can be however determined only after the management has
decided about its financial policy, a. The diversification rate can be chosen either by
changes in style of the existing products or by expanding the range of products. Given the
price of the product and the production cost, the average profit margin would be affected
by the levels of advertising and R&D. Higher the expenditure on advertisement (A) as
well as R&D, lower would be average profit margin (m). Thus, the Marris’ firm has three
policy variables: a, d and m.

Marris also points out that there can be a conflict between managers’ objective of
maximizing growth and stockholders’ objective of maximizing profits. Therefore, if the
Notes growth maximizing solution does not generate sufficient profits, growth rate will have to
be reduced to increase dividend to meet shareholders’ expectations.
In brief in Marris model the management, whose actions are limited by the motivation
to protect itself from dismissal or take over bids, takes to the following course:
1. The management must walk on a knife-edge between debt/assets ratio high
enough to stimulate growth but not low enough to suggest financial imprudence.
2. The management must also maintain a low liquidity ratio, i.e; liquid asset/total assets.
But this ratio must not be so low that it endangers paying all obligations on time.
3. The management must try to keep a high retention ratio, viz., retained earnings/
total profits. But this ratio should not be so high that shareholders are not paid
satisfactory dividend.
3.23. Summary
The theory of cost is a fundamental concern of managerial economics. The best
measure of resource cost is the value of that resource in its highest-valued alternative
use. The cost of a long-lived asset during the production period is the difference in the
value of that asset between the beginning and end of the period. The cost function relates
cost to specify rates of output. The basis for the cost function is the production function
and the price of the inputs. In the short run, the rate of one input is fixed. The cost
associated with that input is called fixed cost. In the long run, all costs are variable. The
long-run average cost curve is the envelope of a series of short run average cost curves.
The long run cost functions are used for planning the optimal scale of plant size.
Chec k Your Progress

1. If a change in all inputs leads to a proportional change in the output, it is a case of
(a) Increasing returns to scale, (b) Increasing returns to scale,
(c) Diminishing returns to scale, (d) Variable returns to scale
2. Isoquants are
(a) Equal cost lines, (b) Equal product lines,
(c) Equal revenue lines, (d) Equal total utility lines
3. When average product is highest
(a) Total product is maximum, (b) Total product is maximum,
(c) Marginal product is zero,
(d) Marginal product is equal to average product
4. If marginal product is negative, it means that the
(a) Total product is at maximum,
(b) Average product is at maximum,
(c) Average product is falling, (d) Total product is increasing
5. Which of the following curves is called envelope curve?
(a) Long run total cost curve,
(b) Long run average total cost curve,
(c) Long run marginal cost curve,
(d) Long run average variable cost curve

Questions and Exercises
1. Explain the concept of Production Function with the help of a two-input and one- Notes
output case.
2. What is the law of diminishing return as applied to any production system?
3. Define returns to scale. What is the significance of increasing, decreasing and
constant returns to scale?
4. What are Isoquants? Describe the characteristics of Isoquants.
5. What is Isocost Line? How do they help in finding the least cost combination of
inputs?
6. Define and explain expansion path.
7. The various possible combinations of two inputs, labour and capital, which can
produce 100 units of output are given as below:
L 2 3 4 5 6
K 20 15 12 10 9
If the prevailing prices of labour and capital are Rs. 15 per unit and Rs. 12 per
unit, find out the least cost combination of these inputs.
8. “The behaviour of costs is determined by several factors.” Comment.
9. Explain the short-run cost-output relationship with the help of a hypothetical
example. How do the different costs behave with the changes in output?
10. Long-run cost-output relationship is an envelope of the family of short-run cost
curves. Give your comment.
11. Explain economies and diseconomies of scale. Are these short-run and long-run
phenomena?
12. Discuss in details the factors that cause economies and diseconomies of scale.
Fundamental Questions
1. What is production?
2. What are factors of production?
3. What are the difference between short run and long run?
4. What are the inputs and outputs?
5. What is cost?
6. How do we define total, average and marginal product of labour?
7. What is Marginal Rate of Technical Substitution (MRTS)?
8. What is Law of Variable Proportion?
9. What are economies of scale?
10. What are the basic features of profit maximization model?
11. Why long run average cost curve is the envelope of short run average cost
curves?
12. Why marginal cost curve passes through the minimum point of average cost
curve?
Further Readings
 Hirschey, Economics for Managers, Cengage Learning
 Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning

 Froeb, Managerial Economics: A Problem Solving Approach, Cengage Learning

Notes  Mankiw, Economics: Principles and Applications, Cengage Learning
 Gupta, G.S. 2006, Managerial Economics, 2nd Edition,Tata McGraw Hill
 Peterson, H.C and Lewis, W.C. 2005, Managerial Economics, 4th Edition, Prentice
Hall of India
 R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics
Macmillan.
 Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
 Koutsoyiannis,A. Modern Economics, Third Edition.
 Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and
Review, 6th Edition, Tata McGraw Hill.
 Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.

Eco Textual Learning Material - Module 3

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Eco Textual Learning Material - Module 3

Uploaded by

Copyright:

Available Formats

26 Managerial Economics

Unit 3: Cost and Production Analysis

Amity Directorate of Distance & Online Education

3.3. Production Functions

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

3.4. Law of Variable Proportion or Law of Diminishing Returns to

3.5. Difference between Returns to a Factor and Returns to Scale

Amity Directorate of Distance & Online Education

Where, Q0 and Q1 are parameters.

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

iv) Smooth Convex Isoquant: This form assumes continuous substitutability of

Amity Directorate of Distance & Online Education

A higher Isoquant represents a higher output: In the panel I of above figure, if we

3.7. Isocost Line or Equal Cost Line

Amity Directorate of Distance & Online Education

3.8. Marginal Rate of Technical Substitution

Amity Directorate of Distance & Online Education

3.9. Choices of Input Combination (Optimal Input combination)

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

3.10. Theory of Cost

3.11. Cost Functions

Amity Directorate of Distance & Online Education

Total Cost (TC)

Total Fixed Cost (TFC)

Rs. 1,000 + Rs. 2,000 + Rs.500 = Rs. 3,500

Total Variable Cost (TVC)

Average Variable Cost (AVC)

Average Total Cost (ATC)

Marginal Cost (MC)

3.13. Relationship between (Average Cost) AC and (Marginal Cost)

Amity Directorate of Distance & Online Education

3.14. Long and Short Run Cost Curves

Amity Directorate of Distance & Online Education

3.15. Cost and Output Relationship (Cost Function)

3.17. Economies / Dis-economies of Scale

Amity Directorate of Distance & Online Education

In short, the internal economies and diseconomies have their significance in

Amity Directorate of Distance & Online Education

3.18. The Theory of firm (Profit Maximization Model)

Assumptions of the Model:

Amity Directorate of Distance & Online Education

Amity Directorate of Distance & Online Education

Determination of profit maximizing output and price

Amity Directorate of Distance & Online Education

Some alternatives suggested

Amity Directorate of Distance & Online Education

3.19. Break-even and Shut-down Point

Amity Directorate of Distance & Online Education

3.20. Managerial Theories of the Firm

3.21. Baumol’s Model

Amity Directorate of Distance & Online Education

Implications of Baumol’s Model: If both the profit maximiser and a constrained

Amity Directorate of Distance & Online Education

3.22. Marris Model

Amity Directorate of Distance & Online Education

Chec k Your Progress

Amity Directorate of Distance & Online Education