ME15 - Unit 3

Managerial
Economics
UM16MB501
Unit 3 : Cost, Profit & Production Analysis
PES University
Accounting Vs Economic Cost
• Economic cost is a more comprehensive idea that accounting costs. Accounting
costs only include what economists call "explicit costs." These are the amounts
that a firm actually pays out to other people in the process of producing their
product. So, if you open a business selling cosmetics from your home, the
accounting costs would include things like the price of the cosmetics, the
money you spend on advertising, if any, and the amount that it costs you to go
around selling your product.
• Economic costs include "implicit costs," which are the same as opportunity
costs. In the example mentioned above, the economic costs of starting this
business would also include the value of whatever else you could have been
doing with your time. Economic costs would also include, then, the wages that
you could have been getting if you had gone to work instead of opening this
business.
• Economic Cost = Accounting Cost + Opportunity Cost
PES University - MBA - Managerial Economics (UM15MB501) 2

Difference Between Accounting & Economic Cost
Accounting Cost Economic Cost
1. Take into account only explicit costs 1. Are a sum of explicit and implicit costs
2. Appear on the financial statements of a firm 2. Are not taken into account on paper but they
are relevant for decision making
3. Are backward-looking 3. Are forward-looking
4. Are objectively verifiable as they show the 4. Are not usually objectively verifiable as they
firm’s position to outsiders and are used to make are estimates of the cost of alternatives
tax payments sacrificed.
Although economists and accountants define profits and losses similarly, economic profits
and accounting profits often differ (Unc.edu). The difference between the two (as shown
above) is the opportunity cost. It is possible to make an ‘accounting profit’ while making an
'economic loss' at the same time. This is possible because economists include the costs of
lost opportunities (i.e. the salary that you would have received if you had not quit your
job to start a new business).
3
PES University - MBA - Managerial Economics (UM15MB501)
Other types of Cost
• Historic costs are simply the costs that are paid at the time of purchase
of a fixed asset. For example, the historic cost of machinery purchased in
the past is always going to be equal to the cost of the machinery that you
paid at that time. (Boddunan.com).
• Sunk costs are monies that have been spent and cannot be recovered.
They should not be taken into account when making financial decision
and they must never affect your future decisions! (Mcafee, R, et al.
pg 1) For example, if you spent £100,000 on constructing a self-made
assembly line that failed to work, this should not affect your decision in
terms of trying to save this money from other operations. You should act
as if you never lost this money.

Other types of cost
• Fixed Costs (FC). The costs which don’t vary with changing output. Fixed costs
might include the cost of building a factory, insurance and legal bills. Even if
your output changes or you don’t produce anything, your fixed costs stays the
same. In the above example, fixed costs are always £1,000.
• Variable Costs (VC). Costs which depend on the output produced. For
example, if you produce more cars, you have to use more raw materials such as
metal. This is a variable cost.
• Semi-Variable Cost. Labour might be a semi-variable cost. If you produce
more cars, you need to employ more workers; this is a variable cost. However,
even if you didn’t produce any cars, you may still need some workers to look
after empty factory.
• Total Costs = Total Fixed Cost + Total Variable Costs
• TC = TFC + TVC

Other types of costs
• Average Total Cost (AC) = Total Cost / Q (Output is quantity produced or ‘Q’)
• Average Variable Cost (AVC) = Total Variable Cost / Q
• Average Fixed Cost (AFC) = Total Fixed / Q
• AC = AFC + AVC
• Marginal Cost (MC)- In economics, marginal cost is the change in the total
cost that arises when the quantity produced is incremented by one unit. That
is, it is the cost of producing one more unit of a good is. In general terms,
marginal cost at each level of production includes any additional costs
required to produce the next unit. Change in Total Costs / Change in Output

Total Cost Curves Average Cost Curves

Calculate TC, AFC, AVC, AC, MC & Plot the graphs.
Q TFC TVC TC AFC AVC AC MC

0 500 0 500 - - - -
1 500 50 550 500 50 550 50
2 500 80 580 250 40 290 30
3 500 105 605 166.7 35 201.7 25
4 500 129 629 125 32.3 157.3 24
5 500 150 650 100 30 130 21
6 500 180 680 83.33 30 113.3 30
7 500 225 725 71.43 32.1 103.6 45
8 500 280 780 62.5 35 97.5 55
9 500 360 860 55.56 40 95.56 80
10 500 450 950 50 45 95 90
11 500 545 1045 45.45 49.5 95 95
12 500 655 1155 41.67 54.6 96.25 110
13 500 800 1300 38.46 61.5 100 145
14 500 1020 1520 35.71 72.9 108.6 220
15 - MBA500
PES University 1350
- Managerial Economics (UM15MB501) 1850 33.33 90 123.3 330
8
Production Optimization for lowest Cost
• At the Point A, the lowest point on AC curve, we
observe that AC=MC. This is the Least Cost point.
• This condition is called Optimization condition
for Lowest cost production.
• Qoptimum shows the level of production at which
the AC will be the lowest.
• Qoptimum can be found by two methods
1. AC = MC to find Qoptimum
2. Find first derivative of AC and equate it to Zero to
find Qoptimum
• Validation is done by taking second derivate of

AC, and check if it is greater that Zero.

Revenues
• Total Revenue= TR = Sales = Topline
• TR = TC + Total Profit
• TR = SP * Quantity Sold
• Selling Price = SP = Average Revenue = AR = (TR/Q)

Problem Set 1
1. Compute the Optimum level of production for
2. Compute and Validate the Optimum production level for
3. Calculate the Total Revenue of the company if 25 units were produced
and sold using cost plus pricing strategy of 10% margins. The
company pays Rs 20000 rent, Rs 10000 Salary. Each product requires
2 units of raw material A costing Rs 3 each and 3 units of Raw material
B costing Rs 10 each.
4. A factory which produces plastic chairs has a machine with a
production capacity of 1000 units /month. The company pays Rs 5000
monthly rent, Rs 10000 alary per month for supervisor, Rs 10 per unit

Contd…
Chair produced for laborers. 2 Laborers are needed to produce each chair.
The machine consumes 500 units of electricity and its consumption is
proportionate to the production level. Electricity cost is Rs 10 per unit.
Raw material A – 1 kilo per unit is Rs 50000 for 10 kilos. Raw material B: 2
units per chair each costing Rs 500. Direct overhead cost of 10% on total
variable cost is applicable. The company wants to determine its Selling
price of the chairs which should include 30% profit margin. The
production schedule is given below Month Production Level
Jan 80%
Feb 50%
Mar 100%
Apr 90%
Difference between Long run and Short run
• The main difference between long run and short run costs is that there are no
fixed factors in the long run; there are both fixed and variable factors in the
short run .
• In the long run the general price level, contractual wages, and expectations
adjust fully to the state of the economy. In the short run these variables do not
always adjust due to the condensed time period.
• In order to be successful a firm must set realistic long run cost expectations.
How the short run costs are handled determines whether the firm will meet its
future production and financial goals.
• In the long run, firms change production levels in response to
(expected) economic profits or losses, and the land, labor, capital
goods and entrepreneurship vary to reach associated long-run average cost. All
production in real time occurs in the short run.

Long Run Costs
In the simplified case of plant capacity as the only fixed factor, a generic firm can make these changes in the
long run: enter an industry in response to (expected) profits, leave an industry in response to losses, increase
its plant in response to profits, decrease its plant in response to losses.
• The long run is associated with the long-run average cost (LRAC) curve in microeconomic models along
which a firm would minimize its average cost (cost per unit) for each respective long-run quantity of output.
• Long-run marginal cost (LRMC) is the added cost of providing an additional unit
of service or commodity from changing capacity level to reach the lowest cost associated with that extra
output.
• The concept of long-run cost is also used in determining whether the long-run expected to induce the firm to
remain in the industry or shut down production there.
• In long-run equilibrium of an industry in which perfect competition prevails, the LRMC = LRAC at the
minimum LRAC and associated output. The shape of the long-run marginal and average costs curves is
determined by returns to scale.
• The long run is a planning and implementation stage. Here a firm may decide that it needs to produce on a
larger scale by building a new plant or adding a production line. The firm may decide that new technology
should be incorporated into its production process. The firm thus considers all its long-run production
options and selects the optimal combination of inputs and technology for its long-run purposes. The optimal
combination of inputs is the least-cost combination of inputs for desired level of output when all inputs are
variable. Once the decisions are made and implemented and production begins, the firm is operating in the
short run with fixed and variable inputs.
Why Long-Run Average Cost Curve is of U-Shape?
It is generally believed by economists that the long-

run average cost curve is normally U shaped, that is,
the long-run average cost curve first declines as
output is increased and then beyond a certain point it
rises.
Firm first enjoys internal economies of scale leading

to reduction in LAC and then beyond a certain point
(Q) it suffers internal diseconomies of scale leading to
increase in costs.
Shape of the long-run average cost curve depends

upon the returns to scale. Since in the long run all
inputs including the capital equipment can be altered,
the relevant concept governing the shape of this long-
run average cost curve is that of returns to scale.
Contd…
The main reasons for the economies of scale leading to initial Long term cost reduction
• First, as the firm increases its scale of operations, it becomes possible to use more
specialized and efficient form of all factors, especially capital equipment and
machinery. For producing higher levels of output, there is generally available a more
efficient machinery which when employed to produce a large output yields a lower cost
per unit of output.
• Secondly, when the scale of operations is increased and the amount of labour and other
factors becomes larger, introduction of a great degree of division of labour or
specialisation becomes possible and as a result the long-run cost per unit declines.
• Thus, whereas the short-run decreases in cost (the downward sloping segment of the
short-run average cost curve) occur due to the fact that the ratio of the variable input
comes nearer to the optimum proportion, decreases in the long-run average cost
(downward segment of the long-run average cost curve) take place due to the use of
more efficient forms of machinery and other factors and to the introduction of a greater
degree of division of labour in the productive process.

Contd
Why does LAC Rise Eventually? Diseconomies of Scale
• In the view of Chamberlin and his followers is that when the firm has reached a size large
enough to allow the utilisation of almost all the possibilities of division of labour and the
employment of more efficient machinery, further increases in the size of the plant will
entail higher long-run unit cost because of the difficulties of management. When the scale
of operations exceeds a certain limit, the management may not be as efficient as when the
scale of operations is relatively small. After a certain sufficiently large size these
inefficiencies of management more than offset the economies of scale and thereby bring
about an increase in the long-run average cost and make the LAC curve upward-sloping
after a point.
• The second view considers the entrepreneur to be a fixed indivisible factor. In this view,
though all other factors can be increased, the entrepreneur cannot be. The entrepreneur
and his functions of decision-making and ultimate control are indivisible and cannot be
increased.Therefore, when a point is reached where the abilities of the fixed and indivisible
entrepreneur are best utilised, further increases in the scale of operations by increasing
other inputs cause the cost per unit of output to rise. In other words, there is a certain
optimum proportion between an entrepreneur and other inputs and when that optimum
proportion is reached, further increases in the other inputs to the fixed entrepreneur
means the proportion between the inputs is moved away from the optimum and, therefore,
these results in the rise in the long-run average cost.

Profits
• Total Profit = Total Revenue – Total Cost i.e., π = TR - TC
• Economic Profit or Pure Profits = Total Revenue - (Explicit costs + Implicit costs)
• Economic Profit (Or Loss) - The difference between the revenue received from the sale
of an output and the opportunity cost of the inputs used. This can be used as another
name for "economic value added" (EVA).
• In calculating economic profit, opportunity costs are deducted from revenues earned.
Opportunity costs are the alternative returns foregone by using the chosen inputs. As a
result, you can have a significant accounting profit with little to no economic profit.
• For example, say you invest $100,000 to start a business, and in that year you earn
$120,000 in profits. Your accounting profit would be $20,000. However, say that same
year you could have earned an income of $45,000 had you been employed. Therefore,
you have an economic loss of $25,000 (120,000 - 100,000 - 45,000).

Clark’s Dynamic theory
• According to J.B. Clark, the profits arises in a Dynamic Economy and not static economy.
• He says that in a static world, where the size of the population, the amount of capital,
the quantity and quality of human wants, the methods of production, technical
knowledge, the organization of business, etc., remain the same, profits tend to
disappear under the force of competition.
• Profits represent the difference between selling price and cost. It is a surplus above
costs. But if competition works in a frictionless manner, the surplus will vanish.
Wherever there is a surplus, production will increase, bringing down the price. That is
how the surplus will disappear.
• In the static condition each factor protects what it manufactures, and since expenditure
and selling cost are always equivalent, there can be no profits outside wages for the
schedule work of management. In a stationary state, everything is known and
knowable. There is no risk and no uncertainty, and hence no profits.

Clark’s Dynamic theory Contd…
• But we are not living in a stationary state. Ours is a dynamic world and some
changes are constantly taking place. The clever entrepreneur foresees these
changes. He is a pioneer. Somehow by invention or otherwise, he lowers the
cost and makes profits.
• The changing world offers limitless opportunities to the far-sighted, daring and
clever entrepreneurs to make profits by turning the facts of the situation in
their favor. It is only because the world is dynamic that it is possible for them to
keep the lead and reap the profits. In a static slate, profits will disappear, and
the entrepreneurs will only earn wages of management.
• Entrepreneurs try to earn Pure profits in a Dynamic condition. Pure Profits
exists only in Short Run. In long run due to dynamic nature of conditions
Profits Normalise.
Hawley’s Risk Theory
• F. B. Hawley offered his "risk theory of profit" in 1893.
• According to Hawley, risk in business arose from product obsolescence, a sudden fall in
prices, superior substitutes, natural calamities or scarcity of certain crucial materials.
• Risk taking was an inevitable component of dynamic production and those who took risk in
business had a right to a separate reward known as "profit". According to Hawley, profit is
the price paid by society for assuming business risk. A businessman would not take a risk
without expecting compensation in excess of actuarial value i.e., a premium on calculable
risk. The reason that expected profit must be more than actuarial risk is the assumption
that risk gives rise to dis-utilities of various kinds. Therefore, assuming risk gives the
entrepreneur a claim to a reward in excess of the actuarial value of the risk.
• Hawley stated that profit was composed of two parts: one part represents compensation for
average loss incidental to the various causes of risk and the other part represents an
inducement to suffer the consequences of being exposed to the risk. Hawley believed that
profits arose from factor ownership as long as the ownership included risk. If the
entrepreneur avoided risk by insuring against it, he ceased to be an entrepreneur and
should not receive profits. According to Hawley profit arose out of uninsured risk. The
uncertainty ends with sale of the entrepreneur's product. Profit thus is a residue. Hawley's
theory is also known as the "residual theory of profit"

Schumpeter’s Innovation Theory
• American economist Joseph Schumpeter has singled out for special treatment
the par; played by innovations. The daring and the dynamic entrepreneurs
continue to hit at one innovation or another, keeping their business ahead of
others and thus making handsome profits.
• According to Schumpeter, the principal function of the entrepreneur is to make
innovations and profits are a reward for successful innovations. To Schumpeter,
the principle function of the entrepreneur is to make innovations and profits
are a reward for performing this important function.
• Schumpeter has given the term ‘innovation’ very wide meaning. Discovery of a
new material or a new technique of production resulting in a lowering of the
cost of production or improving the quality of the product is an innovation. Any
new measure or new policy initiated by the entrepreneur comes under
innovation in the sense in which Schumpeter uses the term.

Schumpeter’s Innovation Theory contd…
• Innovations may be of two types:
• Those which change the production function and reduce the cost of production, and
• Those innovations which stimulate the demand for the product, i.e., which change
the demand or utility function.
• In the first type are included the introduction of new machinery,
improved production techniques or processes, exploitation of a new
source of raw material or a new and better organisational pattern for
the firm.
• The second type of innovations are those which are calculated to
increase the demand for the product by introducing a new product or a
new variety of an old product, new and more effective mode of
advertisement, discovery of new markets, etc.
Schumpeter’s Innovation Theory contd…
• Success of any of these innovations brings a handsome increase in
profits. Profits increase because either the cost of production is lowered
or the product fetches a higher price. It may be pointed out, however,
that profits owing to innovations are only temporary and tend to be
competed away. Sooner the innovations come to be innovations the
rivals, they cease to be innovations or lose their novelty.

Profit Planning
• Profit planning is the process of developing a plan of operation that makes it possible to
determine how to arrange the operational budget so that the maximum amount of profit can be
generated. There are several common uses for this process, with many of them focusing on the
wise use of available resources. Along with the many benefits of this type of planning process,
there are also a few limitations.
• The actual process of profit planning involves looking at several key factors relevant to
operational expenses. Putting together effective profit plans or budgets requires looking closely
at such expenses as labor, raw materials, facilities maintenance and upkeep, and the cost of sales
and marketing efforts.
• By looking closely at each of these areas, it is possible to determine what is required to perform
the tasks efficiently, generate the most units for sale, and thus increase the chances of earning
decent profits during the period under consideration. Understanding the costs related to
production and sales generation also makes it possible to assess current market conditions and
design a price model that allows the products to be competitive in the marketplace, but still earn
an equitable amount of profit on each unit sold.
Profit Maximization
• Profit maximization is the short run or long run process by which a firm
determines the price and output level that returns the greatest profit.
• Two Methods of finding Profit Maximization
1. Total Revenue & Cost perspective
2. Marginal Revenue & Cost perspective
Total Revenue & Cost perspective

To obtain the profit maximizing output quantity, we start by recognizing that
profit is equal to total revenue (TR) minus total cost (TC). Given a table of
costs and revenues at each quantity, we can either compute equations or plot
the data directly on a graph. The profit-maximizing output is the one at which
this difference reaches its maximum

The Profit-Maximizing Decision
(Marginal Revenue & Cost Perspective)
The firm uses MR and MC to decide how much to produce.

• • Suppose increasing output by one unit will bring in more additional revenues
than it costs to produce. That is, MR > MC. Then it makes sense to produce the
unit, because doing so will create more added benefit than added cost.
• • On the other hand, suppose your last unit cost more to produce than it
brought in additional revenue. Then MR < MC. And it makes sense to cut back
your production (not produce that unit after all), because the last unit created
more added cost than added benefit.
• • So the only point at which you’re satisfied is where MR = MC. This is the
general rule for profit maximization, which we’ll use with any firm, whether a
perfect competitor, monopolist, or anything in between.

Profit Maximization contd…
A firm can maximise profits if it produces at
an output where
Marginal revenue (MR) = Marginal cost (MC)
In the diagram, If the firm produces less than
Q1, MR is greater than MC. Therefore, for this
extra output, the firm is gaining more
revenue than it is paying in costs. Total
revenue will increase. Close to Q1, MR is only
just greater than MC, therefore, there is only
a small increase in profit. But, profit is still
rising. However, after Q1, the marginal cost
of the output is greater than the marginal
revenue. This means the firm will see a fall in
its profit level.

How Do We Calculate Profit Maximization?
• The calculation for profit maximization is: the number of units (Q) is
obtained by equating MR and MC that is MR = MC
• Validation is to take Second Derivative of MR or MC and it must be

Lesser than 0.

Problem Set 1
1. A monopolist has the cost function TC(y) = 200y + 15y2 and faces the price
2
function given by p = 1200-10y.What output maximizes its profit? What is

the profit-maximizing price? What is its maximum profit?
2. Maximize and validate π = -100+ 160Q-10Q2 Find the Maximum profits
that is generated.
3. TC = 16000 + 500Q-1.5Q2+0.004Q3 and P=1700-7Q, then find the profit
maximization production level.
4. Find the profit maximization production level TC = 10+0.5Q2 and TR =
100Q-2Q2
5. Find the profit maximization production level TC = 10000+100Q+2Q2 and
TR = 600Q-3Q2 using the equation Tπ = TR-TC
Break Even point
Break Even point is that level of
production/sales at which the
company is in no loss no profit level.
It is the point at which the total cost
of production is equal to the total
revenue. It is a point which
determines the operating profits or
loss. Production & Sales below the
BEP will generate operating loss
while beyond the BEP will generate
operating profits

Break-Even Quantity
• Break even Quantity is defined as that level of production at which the
Total Revenue is equal to the Total Cost of production. It is the quantity
at which the there is no profit or no loss. This is the minimum quantity
that need to be produced and sold in order to be in a no loss no profit
situation. Quantity in excess of BEQ will generate profits and any
quantity less than BEQ will generate loss.
TFC
• Break Even Quantity = BEQ =
SP−AVC
TFC
• Break Even Quantity = BEQ =
Contribution per unit

Contribution
• Contribution can be defined as the excess of sales
over the variable cost. It is the difference between the
total revenue and the total variable cost. At the BEP
the total contribution is equal to the total fixed cost.
• Contribution = Sales - Total Variable Cost
• Contribution = Total Fixed Cost + Profit
• Contribution per unit can be defined as the excess of

Selling price over the Average variable cost. It is the
difference between the Selling Price and the Average
variable cost.
• Contribution per unit = SP - AVC (i.e, Selling Price -
Average Variable Cost )

Shutdown Point
• A point of operations where a firm is indifferent between continuing
operations and shutting down temporarily. The shutdown point is the
combination of output and price where a firm earns just
enough revenue to cover its total variable costs.
• If a firm is operating at its shutdown point, it is usually operating at a
loss. The concept is that if a firm can produce revenue greater or equal
to its total variable costs, it can use the additional revenue to pay down
its fixed costs.
• This assumes that fixed costs will still be incurred when a firm shuts
down, such as lease contracts or other lengthy obligations. In other
words, when a firm can earn a positive contribution margin, it should
remain in operations, despite an overall loss.

What happens to BEP when TR slope changes?
• With TC remaining unchanged. When the
SP increases, the Slop of the TR gets
steeper and the BEQ becomes decreases,
When the SP decreases the slope of the TR
becomes flatter and the BEQ increases. In
the Figure we can observe that the BEQ
changes from Q1, to Q2 to Q3 when the SP
decreases reducing the slop of TR.
• Angle of Incidence is the angle formed
between the Total Revenue and the Total
Cost Curve in a Break even Analysis chart.
The angle of incidence is a measure of the
Quickness of the Break even. Bigger the
Angle of Incidence faster is the breakeven
and Vice versa.

Margin of Safety (MOS)
• Margin of safety is defined as the
difference between the actual sales and the
break even sales. Margin of safety provides
us information on how safe we are in the
operating profit zone from the current
sales. Margin of safety can be increased
either by increasing the selling price or by
increasing the quantity of goods sold.
Higher the MOS higher is the profit and
vice versa. Negative MOS indicates
operating loss.
• MOS = Actual Sales - Break-Even Sales
Actual Sales−Breakeven Sales
• MOS Ratio = ×
Actual Sales
100

Various Formulae
TFC
• Break Even Quantity = BEQ = SP−AVC
TFC
• Break Even Quantity = BEQ = Contribution per unit
• Break Even Sales = BEQ × Selling Price
TFC
• Break Even Sales = P/VRatio
TFC
• Break Even Sales = Contribution per unit × SP
TFC
• Break Even as a Percentage of Capacity = Total Contribution

• Contribution = Sales - Total Variable Cost (where sales is TR, total revenue)
• Contribution = Total Fixed Cost + Profit
• Contribution per unit = SP - AVC (i.e, Selling Price - Average Variable Cost )
Contribution Contribution/ unit

• Contribution Ratio Or P/V Ratio = Or
Sales Selling Price
TR−TVC SP−AVC
• Contribution Ratio Or P/V Ratio = Or
TR SP
Change in Profit Or Change in Contribution

• Contribution Ratio Or P/V Ratio =
Change in Sales
• MOS = Margin of Safety = Actual Sales - Break-Even Sales

Actual Sales−Breakeven Sales
• MOS Ratio = × 100
Actual Sales
• Profit = MOS × P/V Ratio
TFC+Target Profits TFC+Target Profits Target Profit
• Target Sales (units) = Or Or BEQ +
Contribution per unit SP−AVC SP−AVC
TFC+Target Profits
• Target Sales (value)= P/V Ratio

Problem set 1
1. The fixed cost of a factory is Rs 15000 per year. The variable cost per unit of
the product is Rs 3 per unit and selling price being Rs 5 per unit. Find out the
break even quantity and Breakeven sales.
2. What quantity of goods must be sold in order to generate a profit of Rs 5.5
Lacs, provided the total fixed cost of production is Rs 6.5 Lacs, Variable cost
per unit is Rs 450 and the Price of the product is Rs 670.
3. A business unit is selling 3000 units per annum, He charges Rs 30 per unit to
the customers and incurs a fixed cost of Rs 20000 per annum. If the variable
cost is Rs 20 per unit, how much should he sell in order to recover his fixed
costs over BEQ?
4. If the Break-even sales is Rs 3,55,000 and at Breakeven 14,200 units of
product were sold, What is the Selling Price of the Product?

Problem set 2
1. Calculate the Average Cost of producing one unit in a factory producing 25000 units
per year, paying Rs 45000 factory rent per month, manager salary of Rs 55000 per
month, Wages of Rs 100 per employee per working day. There is one Labour and 20
working days in a month. The raw materials cost Rs 40 for A and Rs 55 for B. each
unit of production requires 3:4 ratio of A:B raw materials. There are additional
advertising costs of Rs 250000 p.a. If the company decided to adopt the Cost plus
concept of pricing, with 15% profit margins what should be the selling price? Also
determine the Break even Quantity.
2. What is the profit generated by a company with Rs 4.75 Lac sales, having a Rental
cost of Rs 55000, Administrative costs of Rs 76000 and the P/V ratio of 4% ?
3. Find the Break-even point and contribution per unit if the total fixed cost of
production is Rs 48000 and the selling price of the product is Rs 50 and an additional
Rs 35 is spent in producing each unit.
4. X.co Ltd has a overall P/V ratio of 40%. The marginal cost of Product A is estimated
to be Rs 30/- Determine the selling price of the product A.

Production Analysis
• Economic production is an activity carried out under the control and
responsibility of an institutional unit that uses inputs of labour (L),
capital (K), and goods and services to produce outputs of goods or
services.
• Various Factors of Production are
1. Land
2. Man / Labour
3. Machine / Plant & Equipment
4. Materials
5. Money

Production process
Production theory is the study of production, or the
economic process of converting inputs into outputs.
Production is a process of combining various material

inputs and immaterial inputs (plans, know-how) in order
to make something for consumption (the output). It is the
act of creating output, a good or service which
has value and contributes to the utility of individuals.
Theory of production, in economics, an effort to explain the principles by which a business firm decides how
much of each commodity that it sells (its “outputs” or “products”) it will produce, and how much of each kind
of labour, raw material, fixed capital good, etc., that it employs (its “inputs” or “factors of production”) it will
use. The theory involves some of the most fundamental principles of economics. These include the
relationship between the prices of commodities and the prices (or wages or rents) of the productive factors
used to produce them and also the relationships between the prices of commodities and productive factors,
on the one hand, and the quantities of these commodities and productive factors that are produced or used,
on the other.
Production Function
• Production function is a mathematical relationship between the amount
of output that is manufactured when different mix of inputs like (Labour,
Land, Capital, Materials, Money) is added to the production assuming
the latest technology is used in the production
Qp = f (Ld, L, K, Mc, Mt, T, t)
Qp = Quantity Produced Ld= Land L=Labour K=Capital Mc = Machine
Mt = Materials T= Technology and t=time
Even though all above factors determined the Quantity produced, Labour
(L) and Capital (K) are the two most important factors used for
Production analysis, and other factors ca be represented by these two
factors.
Cobb-Douglas Production Function
Thus taking two Factors Labour (L) and Capital (K) we can define the production
function as given by Cobb-Douglas through their empirical study as below
Qp = f (L, K) ; keeping Technology, Land & Building Constant.
where:
• Y = total production (the real value of all goods produced in a year)
• L = labor input (the total number of person-hours worked in a year)
• K = capital input (the real value of all machinery, equipment, and buildings)
• A = total factor productivity
• α and β are the output elasticities of capital and labor, respectively. These values are
constants determined by available technology.

Types of Production Functions
• Short Run Production function : Also called single variable input
production function. Here either Capital (K) or Labour (L) is constant
and the other is varying.
• Long Run Production function : Hers both Capital (K) and Labour (L)
varies. Cobb-Douglas production function is the best example for the
Long run production function.

Iso-Quant Curves
• Isoquant is also called as equal product
curve or production indifference curve or
constant product curve. Isoquant indicates
various combinations of two factors of
production which give the same level of
output per unit of time. The significance of
factors of productive resources is that, any
two factors are substitutable e.g. labour is
substitutable for capital and vice versa. No
two factors are perfect substitutes. This
indicates that one factor can be used a
little more and other factor a little less,
without changing the level of output.

Iso-Cost Curves
It is a locus of all combinations of two (or more) inputs which the
producer can buy using his fixed outlay at fixed input prices.”
We shall now draw the isocost line on the basis of an imaginary
example.
Let us assume that a firm has a sum of $500 to spend on two factors,
labor and capital. Further, let us assume that a unit of labor costs $10
and a unit of capital (machine) costs $100. With the total outlay of
$500, the firm could hire 50 units of labor and no capital, or it could hire
5 units of capital and no labor; or some combination of labor and capital
in between. OM in the diagram represents 50 workers and ON
represent 5 machines.
If we connect the two points N and M, we get the isocost line. Thus, an
isocost line gives all combinations of labor and capital at equal cost.
The isocost line will shift when the prices of factors change, the outlay
remaining the same. Likewise, the isocost line will shift to the right if the
outlay of the firm increases. Hiring more of both inputs will cost more.
When the total outlay is $600, the isocost line is N1M1. N2M2 is the
isocost line when the outlay is $700.

Law of Variable Proportions
• Law of variable proportions occupies an important place in economic theory.
This law examines the production function with one factor variable, keeping
the quantities of other factors fixed. In other words, it refers to the input-
output relation when output is increased by varying the quantity of one input.
• When the quantity of one factor is varied, keeping the quantity of other factors
constant, the proportion between the variable factor and the fixed factor is
altered; the ratio of employment of the variable factor to that of the fixed factor
goes on increasing as the quantity of the variable factor is increased.
• Since under this law we study the effects on output of variation in factor
proportions, this is also known as the law of variable proportions. Thus law of
variable proportions is the new name for the famous ”Law of Diminishing
Returns” of classical economics. This law has played a vital role in the history
of economic thought and occupies an equally important place in modern
economic theory. This law has been supported by the empirical evidence about
the real world.

Total Product→ It is the total of output, resulting from efforts of all factors
of production. TP= P*Q
Average Product →It is the total product per unit of the variable factor.
APL=TP/L
Marginal Product →It is addition made to the Total Product as a result of

production of one more unit of output. MPL= d/dL (TP)
This law has Three stages
1.Increasing Returns .
2. Diminishing Returns.
3. Negative Returns.
STAGE 1 - Increasing Returns:

In this stage, Average Product increases, Marginal Product
increases and also Total Product. TP increases at more
proportionate rate . TP increases from 10 to 25 units. This stage
is known as increasing returns. This stage of increasing output
by increasing labour does not last for a long time. This
continues upto 3rdunits. The point F onwards TP increases at a
diminishing rate. In the first stage, marginal product curve of a
variable factor rises in a part and then falls. The average
product curve rises throughout and remains below the MP
curve. MP reaches maximum in this stage.
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STAGE 2 - Diminishing Returns:
This is the most important stage in the production function. In stage 2, the total production
continues to increase at a diminishing rate until it reaches its maximum point where the 2nd stage
ends. In this stage both the marginal product (MP) and average product of the variable factor are
diminishing but are positive. When TP reaches the maximum, MP is zero.MP intersects the X axis
in this stage.
As more and more variable factors are used on fixed factor, marginal and average product begins
to decrease. Factors of production are indivisible. Economically this is the most viable area of
production.
STAGE 3 - Negative Returns:

In the 3rd stage, the TP decreases. The TP, curve slopes downward (From point H onward). The
MP curve falls to zero at point L2 and then is negative. When we increases the labour even after
MP becomes zero, then MP becomes negative and it goes below the X axis. This is the most
unviable region. In our table from 8th unit onwards, this stage starts.
Any sensible producer will stop the production in the second stage where AP and MP begins to
decrease, but MP has not become negative. The producer will employ the variable factor (say
labor) up to the point where the marginal product of the labor equals to the wage rate.

Law of returns to scale
The law of returns to scale describes the relationship between outputs and scale of inputs in the
long-run when all the inputs are increased in the same proportion. In the words of Prof. Roger
Miller, “Returns to scale refer to the relationship between changes in output and proportionate
changes in all factors of production. To meet a long-run change in demand, the firm increases its
scale of production by using more space, more machines and labourers in the factory’.
Assumptions: This law assumes that:

(1) All factors (inputs) are variable but enterprise is fixed.
(2) A worker works with given tools and implements.
(3) Technological changes are absent.
(4) There is perfect competition.
(5) The product is measured in quantities.
Given these assumptions, when all inputs are increased in unchanged proportions and the scale of
production is expanded, the effect on output shows three stages: increasing returns to scale,
constant returns to scale and diminishing returns to scale.
Increasing Returns to Scale
During this stage, the firm enjoys various internal and external economies such as dimensional economies,
economies flowing from indivisibility, economies of specialization, technical economies, managerial
economies and marketing economies. Due to these economies, the firm realizes increasing returns to scale.
Marshall explains increasing returns in terms of “increased efficiency” of labor and capital in the improved
organization with the expanding scale of output and employment factor unit. It is referred to as the economy
of organization in the earlier stages of production.
Constant Returns to Scale

During this stage, the economies accrued during the first stage start vanishing and diseconomies arise.
Diseconomies refers to the limiting factors for the firm’s expansion. Emergence of diseconomies is a natural
process when a firm expands beyond certain stage. In the stage II, the economies and diseconomies of scale
are exactly in balance over a particular range of output. When a firm is at constant returns to scale, an
increase in all inputs leads to a proportionate increase in output but to an extent. A production function
showing constant returns to scale is often called ‘linear and homogeneous’ or ‘homogeneous of the first
degree.’ For example, the Cobb-Douglas production function is a linear and homogeneous production
function.
Diminishing Returns to Scale

In figure 1, the stage III represents diminishing returns or decreasing returns. This situation arises when a
firm expands its operation even after the point of constant returns. Decreasing returns mean that increase in
the total output is not proportionate according to the increase in the input. Because of this, the marginal
output starts decreasing (see table 1). Important factors that determine diminishing returns are managerial
inefficiency and technical constraints. PES University - MBA - Managerial Economics (UM15MB501) 54
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Economies of Scale
• These occur when mass producing a good results in lower average cost.
Economies of scale occur within an firm (internal) or within an industry
(external).
• Average costs fall per unit – Average costs per unit = total costs /
quantity produced
• Internal Economies of Scale - As a business grows in scale, its costs
will fall due to internal economies of scale. An ability to produce units of
output more cheaply.
• External Economies of Scale - Are those shared by a number of
businesses in the same industry in a particular area.

Below are types of internal economy of scale
• Production / Technical Economies : Larger firms can use computers / technology to replace
workers on a production line, Mass production lowers cost per unit, Large scale producers can
employ techniques that are unable to be used by a small scale producer, Able to transport bulk
materials.
• Purchasing / Marketing Economies : Advertising costs can be spread across products, Large
businesses can employ specialist staff, Bulk buying - if you buy more unit cost falls
• Financial Economies : Larger firms have better lending terms and lower rates of interest, Easier
for large firms to raise capital, Risk is spread over more products, Greater potential finance from
retained profits, Administration costs can be divided amongst more products
• Managerial Economies : More specialised management can be employed, this increases the
efficiency of the business decreasing the costs
• Risk-bearing Economies : Large firms are more likely to take risks with new products as they
have more products to spread the risk over

External Economies of Scale
• These are advantages gained for the whole industry, not just for
individual businesses.
• For Example:
• As businesses grow within an area, specialist skills begin to develop.
• Skilled labour in the area – local colleges may begin to run specialist courses.
• Being close to other similar businesses who can work together with each other.
• Having specialist supplies and support services nearby.
• Reputation

Diseconomies of Scale
• Occur when firms become too large or inefficient. Average costs per unit start to rise. Below are the types of
diseconomy of scale and some examples
• Communication : When firms grow there can be problems with communication, As the number of people in
the firm increases it is hard to get the messages to the right people at the right time, In larger businesses it is
often difficult for all staff to know what is happening
• Coordination and control problems : As a business grows control of activities gets harder, As the firm gets
bigger and new parts of the business are set up it is increasingly likely people will be working in different
ways and this leads to problems with monitoring
• Motivation : As businesses grow it is harder to make everyone feel as though they belong, Less contact
between senior managers and employees so employees can feel less involved, Smaller businesses often have
a better team environment which is lost when they grow
• Economies of Scale & Monopolies : Economies of scale can lead to the development of monopolies as
larger businesses are able to exploit lower unit costs and therefore make more profits
• Minimum efficient scale: Where an increase in the scale of production gives no benefits to a reduction in
unit costs, This is the point where production is sufficient for internal economies of scale to be fully
exploited, Minimum efficient scale is seen as the lowest point on the long run average cost curve, The MES
depends on a number of factors including: Ratio of fixed to variable costs If a natural monopoly exists
• Minimum efficient plant size - Where an increase in the scale of production of an individual plant within
the industry doesn’t result in any unit cost benefits 59

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Managerial

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Q TFC TVC TC AFC AVC AC MC

• Validation is done by taking second derivate of

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It is generally believed by economists that the long-

Firm first enjoys internal economies of scale leading

Shape of the long-run average cost curve depends

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Total Revenue & Cost perspective

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The firm uses MR and MC to decide how much to produce.

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• Validation is to take Second Derivative of MR or MC and it must be

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function given by p = 1200-10y.What output maximizes its profit? What is

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• Contribution per unit can be defined as the excess of

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• Break Even Sales = BEQ × Selling Price

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Contribution Contribution/ unit

Change in Profit Or Change in Contribution

• MOS = Margin of Safety = Actual Sales - Break-Even Sales

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Production is a process of combining various material

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Marginal Product →It is addition made to the Total Product as a result of

STAGE 1 - Increasing Returns:

STAGE 3 - Negative Returns:

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Assumptions: This law assumes that:

Constant Returns to Scale

Diminishing Returns to Scale

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