Unit 4 Eco

Managerial Economics
(MBA132N)
Dr. Tapas Das
MISSION VISION CORE VALUES

CHRIST is a nurturing ground for an individual’s Excellence and Service Faith in God | Moral Uprightness
holistic development to make effective contribution Love of Fellow Beings
to the society in a dynamic environment Social Responsibility | Pursuit of Excellence
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Deemed to be University
Unit 4
Analyses of Production, Costs and Revenues

- (5 hrs)
Production functions, Law of Variable proportions,

returns to scale and economies of scale. Producers
surplus- Costs, Isoquants, Least cost combination
types of costs, Short run costs and long run cost,
Revenue Analysis –TR, AR and MR, and break even
analysis, (case study)
Excellence and Service

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Production
✓ Production is the process that creates or adds

value or utility.
✓ It is the process in which inputs are converted
into outputs.
✓ The word production in Economics is not
merely confined to effecting physical
transformation in the matter, it is creation or
addition of value. Therefore, production in
economics also covers the rendering of services
such as transporting, financing, marketing.

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Production
✓ The three elements of the production system are-
inputs, the production process and outputs.
✓ The four different but interrelated production

decisions taken by managers are:
▪ Whether or not to actually produce or shut down
▪ How much to produce
▪ What input combination to use and
▪ What type of technology to use.

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Production Function
✓ Production function means the functional relationship between inputs
and outputs in the process of production.
✓ It is a technical relation which connects factors or inputs used in the

production function and the level of outputs
✓ Q = f (Land, Labour, Capital, Organization, Technology, etc)

• Land- Natural resources such as surface, minerals, air, sea, rivers etc.
• Labour- Mental or physical effort done by man
• Capital- Man made goods used in the production process
• Organisation- Entrepreneur or coordinator of all other factors of
production

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Short Run vs. Long Run

✓ The short run is defined as the period of time
when the plant size is fixed. Plant size is fixed,
labor is variable
✓The long run is defined as the time period

necessary to change the plant size. Both Plant size
and labor are variable
✓Duration of the long/short run depends on the

production process…

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Total Product
✓Total Product- Represents the relationship
between the number of workers (L) and the TOTAL
number of units of output produced (Q) holding all
other factors of production (the plant size)
constant.
✓TP/Q = f(L)
❖ Examples
• For a coffee shop, output would be measured in
“number of coffee cups a day”
• For a steel mill, output would be measured in “tons of
steel produced a day”

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Average Product

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Marginal Product

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Average and Marginal Product

✓ For most productions processes as we add more
workers, additions to output increase at the
beginning but eventually decrease (could
become negative).
✓For this, we use a function with both increasing

and decreasing (eventually negative) MP
✓The most common production function has

increasing slope at the beginning. Eventually,
slope decrease and slope may become negative
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Production Function with two variable inputs
✓ In the long run, all inputs are variable.

✓When analysing production with more than one variable
input, it is not possible simply to use average and marginal
product curves because theses curves are derived holding
the use of only one of the input to vary.
✓In the case of two variable input changing the use of one
input is likely to cause a shift in the marginal and average
product curves of the other input.
✓So we use the concept of equal-product curve or isoquant
curve or production- indifference curves.

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Production Function with two variable inputs
✓ Isoquants show combinations of two inputs that can

produce the same level of output.
✓In other words, Production isoquant shows the various
combination of two inputs that the firm can use to produce
a specific level of output.
✓Firms will only use combinations of two inputs that are in
the economic region of production, which is defined by the
portion of each isoquant that is negatively sloped.
✓Q=5L+2K
Let Q= 100: L= 10, K= 25; L=12 K=20: L=14 K=15

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Long-run Production Function

THE PRODUCTION FUNCTIONS ARE
BASED ON CERTAIN ASSUMPTIONS.
❖ Perfect divisibility of both inputs and

outputs
❖Limited substitution of one factor for
another
❖Constant technology
❖Inelastic supply of fixed factors in the short
run
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What is MRTS?
• The slope of an isoquant is called MRTS of labor for
capital. The slope measures the degree of substitutability
of the factors or in other words it means that within limits,
labor and capital can be substituted for each other.
• MRTS is defined as the amount of capital that the firm is
willing to give up in exchange for labor, so that output level
remains constant.
Factor Combination Units of Labour Units of Capital MRTS of L for K
A 1 12
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1

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Features or Properties of Isoquant

1. The Isoquants are always downward sloping meaning
that if a firm wants to use more of labor then it must use
less of capital to produce the same level of output or to
remain on the same Isoquant.
2. The isoquants never intersect each other.
3. The Isoquants are convex to the origin due to
diminishing Marginal Rate of Technical Substitution
(MRTS)
4. A higher isoquant refers to a larger output, while a lower
isoquant refers to a smaller output.
5. Ridge Lines.

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Economic Region of Production

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Special Cases
✓ Perfect Substitutes : In case when labor and capital are
perfect substitutes, MRTS is constant and the isoquants
are straight lines. It means the rate at which capital and
labor can be substituted for each other is same no matter
whatever the level of inputs are being used.
✓ Perfect Complements : When the isoquants are L-

shaped, only one combination of labor and capital can be
used to produce a given output. Additional output cannot
be obtained unless more capital and labor are added in
specific proportions. Adding more capital alone or labor
alone does not increase output. This implies that the
methods of production are limited. In this case the
production function will be of fixed proportions.
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Iso-cost Line
➢ Iso-cost line is a line that shows the different
possible combinations of two inputs, which a
producer can buy that yields him the same cost
irrespective of the combination he chooses given
his budget and the prices of factor inputs.
➢ Anywhere on the iso-cost line a producer is
spending his entire budget either on capital or on
labor or the combination of both.
➢ C = wL + rK, where w is the wage rate per unit of
labour and r is the rental per unit of capita.

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Producer’s Equilibrium

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Returns to Scale
• Increasing returns to scale : a production function
for which any given proportional change in all
inputs leads to a more than proportional change
in output.
• Constant returns to scale : a production function
for which a proportional change in all inputs
causes output to change by the same proportion.
• Decreasing returns to scale : a production
function for which a proportional change in all
inputs causes a less than proportional change in
output.

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Expansion Path

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Types of Cost
✓ Opportunity Cost
Opportunity cost is concerned with the cost of forgone
opportunities/alternatives. In other words, it is the return from the second
best use of the firms resources which the firms forgoes in order to avail of
the return from the best use of the resources. It can also be said as the
comparison between the policy that was chosen and the policy that was
rejected.
If a firm owns a land, there is no cost of using the land (ie., the rent) in the
firms account. But the firm has an opportunity cost of using the land, which
is equal to the rent forgone by not letting the land out on rent.
✓ Incremental Cost
Incremental costs are addition to costs resulting from a change in the nature of
level of business activity. As the costs can be avoided by not bringing any
variation in the activity in the activity, they are also called as "Avoidable Costs"
or "Escapable Costs". More ever incremental costs resulting from a
contemplated change is the Future, they are also called as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the
product line.
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Types of Cost
✓ Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are
generally not taken into consideration in decision - making as they do not vary with the changes in the
future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable
costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is amortization of past
expenses, like depreciation
✓ Explicit Cost
Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs are
recorded in the books of accounts. Explicit costs are important for calculating the profit and loss
accounts and guide in economic decision-making. Explicit costs are also called as "Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc

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Types of Cost
✓ Implicit Cost
Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not recognised
by the accounting system and are not recorded in the books of accounts but are very important in
certain decisions. They are also called as the earnings of those employed resources which belong to
the owner himself. Implicit costs are also called as "Imputed costs".
Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity
capital etc.
✓ DIRECT COSTS
• A price that can be completely attributed to the production of specific goods or services. Direct costs
refer to materials, labor and expenses related to the production of a product. For example, the cost of
meat in a hamburger can be attributed directly to the cost of manufacturing that product, as could the
cost of packaging materials and preservatives. These are considered variable costs that are
inconsistent and change amounts often
✓ Indirect Costs
Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, a
product, a process or a department. Like the direct costs indirect costs, do not vary ie., they may or may
not be variable in nature. However, the nature of indirect costs depend upon the costing under
consideration. Indirect costs are both the fixed and the variable type as they may or may not vary as a
result of the proposed changes in the production process etc. Indirect costs are also called as Non-
traceable costs.
Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs and
the costs of machinery, labour etc.
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Types of Cost
✓ AVOIDABLE COST
Avoidable costs are expenses that can be avoided if a decision is made
to alter the course of a project or business. For example, a
manufacturer with many product lines can drop one of the lines,
thereby eliminating associated expenses such as labor and materials.
Corporations looking for methods to reduce or eliminate expenses often
analyze avoidable costs associated with underperforming or non-
profitable product lines.
✓ UNAVOIDABLE COSTS
These are those costs which an entity has to incur if the entity wants to
stay in business. Unavoidable costs cannot be eliminated even if a
product line is discontinued or a decision is made to buy products
instead of producing them internally. Examples of such costs include
rent and tax

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Cost Function- Short Run

C = C(Q)
✓Total fixed cost occur only in the short run. Total Fixed
cost as the name implies is the cost of the firm's fixed
resources, Fixed cost remains the same in the short run
regardless of how many units of output are produced. We
can say that fixed cost of a firm is that part of total cost
which does not vary with changes in output per period of
time. Fixed cost is to be incurred even if the output of the
firm is zero
✓For example, the firm's resources which remain fixed in
the short run are building, machinery and even staff
employed on contract for work over a particular period.

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✓Total variable cost Total variable cost is

linked with the level of output. When output
is zero, variable cost is zero. When output
increases, variable cost also increases and
it decreases with the decrease in output.
✓ For example, wages paid to the labor

engaged in production, prices of raw
material which a firm. incurs on the
production of output are variable costs.

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✓ Total cost is the sum of fixed cost and

variable cost incurred at each level of
output. Total cost of production of a firm
equals its fixed cost plus its:
Formula:
TC = TFC + TVC
Where:
TC = Total cost.
TFC = Total fixed cost.
TVC = Total variable cost.
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Average Fixed Cost (AFC):

✓ Average fixed cost refers to fixed cost per
unit of output. Average fixed Cost is found
out by dividing the total fixed cost by the
corresponding output
AFC = TFC
Output (Q)
✓ For instance, if the total fixed cost of a

shoes factory is $5,000 and it produces 500
pairs of shoes, then the average fixed cost
is equal to $10 per unit.
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✓Average variable cost refers to the variable

expenses per unit of output Average variable cost
is obtained by dividing the total variable cost by
the total output.
✓ For instance, the total variable cost for

producing 100 meters of cloth is $800, the
average variable cost will be $8 per meter.
✓ Formula:
AVC = TVC
(Q)
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✓ Marginal cost is the addition made to the total cost by

the production of an additional unit of output. Marginal
Cost is governed only by variable cost which changes
with changes in output. Marginal cost.
✓ It is the total cost of producing t units instead of t-1
units, where t is any given number. For example, if we
are producing 5 units at a cost of ` 200 and now suppose
the 6th unit is produced and the total cost is ` 250, then
the marginal cost is ` 250 - 200 i.e., ` 50.
✓ Formula:
Marginal Cost = Change in Total Cost = ΔTC
Change in Output Δq
MCn= TCn – TCn-1

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Cost Relation-Long Run

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Managerial Economics

Dr. Tapas Das

MISSION VISION CORE VALUES

Analyses of Production, Costs and Revenues

Production functions, Law of Variable proportions,

Excellence and Service

✓ Production is the process that creates or adds

Excellence and Service

✓ The four different but interrelated production

Excellence and Service

✓ It is a technical relation which connects factors or inputs used in the

✓ Q = f (Land, Labour, Capital, Organization, Technology, etc)

Excellence and Service

Excellence and Service

Short Run vs. Long Run

✓The long run is defined as the time period

✓Duration of the long/short run depends on the

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Average and Marginal Product

✓For this, we use a function with both increasing

✓The most common production function has

Excellence and Service

Excellence and Service

Excellence and Service

Production Function with two variable inputs

✓ In the long run, all inputs are variable.

Excellence and Service

Production Function with two variable inputs

✓ Isoquants show combinations of two inputs that can

Excellence and Service

Long-run Production Function

❖ Perfect divisibility of both inputs and

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Features or Properties of Isoquant

Excellence and Service

Economic Region of Production

Excellence and Service

✓ Perfect Complements : When the isoquants are L-

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Excellence and Service

Cost Function- Short Run

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Excellence and Service

✓Total variable cost Total variable cost is

✓ For example, wages paid to the labor

Excellence and Service

Excellence and Service

✓ Total cost is the sum of fixed cost and