MMS Session 4

8/4/2019 MMS Session 4

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SESSION 4

MANAGERIAL ECONOMICS


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PRODUCTION

ANALYSIS


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MEANING OF

PRODUCTION

INPUTS PRODUCTION

PROCESS

OUTPUTS

According to James & Parkinson,

Production is an organized activity of

transforming physical inputs into outputswhich will satisfy the products needs of thesociety.

For Example: Transformation of wood into

furniture.


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PRODUCTIONFUNCTION

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

Q = Output

L = Labor InputK = Capital InputN = Land InputR = Raw MaterialsT = Technology

e = Efficiency

A production function refers to the functionalrelationship, under the given technology,

between physical rates of input & output of afirm, per unit of time.


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Attributes of Production Function


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TYPES OF

PRODUCTIONFUNCTIONOR

LAWS OFPRODUCTION


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(A) Production Function With OneVariable

or Law of Variable Proportions

According to Prof. Benham, The law asthe proportion of one factor in a combination

of factors is increased after a point, theavera e & mar inal roduction of that factor

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

Measurement of Product:Total Product (TP)

Average Product (AP)Marginal Product (MP)


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Units of

variable input(Labor)

Total

Product(TP)

Average

Product(AP)

Marginal

Product(MP)

1 10 10 10

2 30 15 203 60 20 30

4 80 20 20

5 95 19 15

6 108 18 13

7 112 16 4

8 112 14 0

9 108 12 -4-

Short Run Production Schedule with inone Variable


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Three Stages in Production Curves

Units of

O

utpu

t

TP

AP

M

I

Stage I:Increase inthe rate of

Total output.

Stage II:Decrease in

the increasein rate of

Total output.

Stage III:

III

II


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(B) Production FunctionWith

Two Variable or IsoquantsAn isoquant is defined as the locus of variouscombinations of two inputs (labor and capital)

that yield the same level of output.

1 2 3 4 5

1 20 40 50 65 70

2 40 55 70 80 903 50 70 90 100 105

4 65 80 100 110 115

5 70 90 110 115 120

LABOUR

INPUT

CAPITAL INPUT


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U

nitsof

Capital

I

nput

Q2

Q3

Q1

Properties of

Isoquants:

Isoquants

are convex tothe origin.

Isoquantshave a

negativeslope.

ProductionIsoquants

Q1 = 50Q2 = 80

Q3= 115


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(C) Production Function

WithAll Variable or Returns toScaleSTATEMENT OF THIS PRINCIPLE

As a firm in the long run increases the

quantities of all factors employed, the outputmay rise initially at a more rapid rate than the

rate of increase in inputs, then output mayincrease in the same proportion of input, and

ultimately output increases lessproportionately.

THREE STAGES:

Constant Returns to Scale. Increasin Returns to Scale.


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Labor(units)

Capital(units)

TotalOutput

Marginal(units)

Stages

1 2 4 42 4 10 6 Increasing

3 6 19 9 Returns

4 8 29 10

5 10 39 10 Constant

6 12 49 10 Returns

7 14 57 8 Decreasing

STAGES OF RETURNS TOSCALE


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STAGES OF RETURNS TOSCALE

II

I III

Units of Labor &Capital

Total&

Margin

al

Returns

Stage I:Increasing

Returns

Stage II:ConstantReturns

Stage III:Decreasing

Returns


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ECONOMIES OF SCALE

A Common Example : Factory

An investment in machinery is made, andone worker, or unit of production, begins to

work on the machine and produces a certainnumber of goods. If another worker is addedto the machine he or she is able to produce

an additional amount of goods withoutadding significantly to the factory's cost of

operation. The amount of goods producedgrows significantly faster than the plant's

Economies of scale refers to thephenomena of decreased per unit costas the number of units of production

increase.


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TYPES OF

ECONOMIES OFSCALE


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INTERNALECONOMIES

1. Technical EconomiesFor e.g.: ExpensiveMachinery.

2. Managerial EconomieFor e.g.: Special

Departments.

3. Financial EconomiesFor e.g.: Advance Loans.

4. CommercialEconomies

For e.g.: Discounts &

Concessions.

Related toIndividual

Firm.


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EXTERNALECONOMIES

Related toAll Firms

inan

Industry.

1. Economies ofConcentration

like skilled labor,

better transport &communications.

2. Economies of

Information like publication of

journals regarding rawmaterials, modernmachines etc.

3. Economies of Welfare

like housing & others ecial facilities to


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COST

ANALYSIS


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MEANING OF COST

Cost is an amount that hasto be paid or given up in

order to get something. It isthe summation of all costsincurred by a business firmin its production process.

An economist analyzeCost in terms of real costof production of a particular

product.


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COST CONCEPTS


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MONEYCOST:(or NominalCost) Money Cost means the total money

expenses incurred by a business firmon the various items entered into the

production of particular product. It isalso called as nominal cost.

For example: Payments for raw materials

purchased. Wages & salaries to managerial staff

and laborers. Ex enses on ower & li ht,


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REAL

COST:Real Cost refers to the physical

quantities of various factors used inproducing a commodity. It signifies

the aggregate of real productiveresources absorbed in the production

of a commodity.

For example:Real Cost of a table is composed of acarpenters labor, two cubic feet ofwood, a dozen of nails, half a bottle of

aint, de reciation of car enters


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OPPORTUNITY

COST:(or Alternative cost)

Opportunity cost is the cost of agiven economic resource is the

foregone benefits from the next bestalternative use of that resource.

Importance:

Determination of relative prices ofgoods.

Determination of normal


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ACTUAL COST:

(Outlay or Acquisition orAbsolute Cost)

Actual cost refers to the actualfinancial expenditure of the firm &

recorded in the firms books ofaccounts.

For Example: Payment of wages, interest. Cost of raw materials. Cost of machineries etc.

Economic Profit = Actual Cost


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EXPLICITCOST:(or Paid outcost)

Explicit cost refers to the actualmoney outlay or out of pocket

expenditure of the firm to, buy or

hire the productive resources itneeds in the process of

production.

For Example: Cost of raw materials. Wages & Salaries. Insurance Premium. Rent of business or factory


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IMPLICITCOST:(or Imputedcost)

Implicit cost are the opportunitycosts of the use of factors which a

firm does not buy or hire but

already owns.

For Example: Wages of labor rendered by

entrepreneur himself. Use of his own capital in his firm. Rent of land belonging to himthat is used in his production.

Economic cost = Explicit cost +


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INCREMENTALCOST:(Avoidable orEscapable Cost)

Incremental cost are the addedcosts resulting from a change inthe nature and level of business

activity. It can be avoided by notbringing any change in the

activities.

For Example: Change in product or outputlevel. Adding or replacing a machine. Chan in distribution channels.

IC = C = C2 C1


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SUNK COST:(Non-avoidable or Non-

escapable Cost)

Sunk cost are the costs that arenot altered by varying the nature

or the level of business activityand cannot be recovered.

For Example:

Depreciationof Machines.Incremental costs are important

whereas sunk costs forirrelevant for decision-making.


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REPLACEMENTCOST:

Replacement cost states the costthat the business firm would have

to incur if it wants to replace or

acquire the same assets now.

HISTORICALCOST:

Historical or original cost of anasset states the cost of plant,

equipment and materials at theprice paid by business firm

originally for them.


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DIRECT COST:(Traceable or

Assignable Costs)Direct costs are the ones thathave direct relationship with a

unit of operation like a product, a

process or a department of thefirm. These costs are directly anddefinitely identifiable. It includesdirect material, direct labor and

direct expenses.

For example:

Cost of raw materials required for


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INDIRECT COST:(Non-traceable or Non-assignable or

Common Costs)Indirect cost are those costs which

cannot de easily and definitelytraced to a product, a process or a

department of the firm. It includesindirect material, indirect labor

and indirect expenses.

For example: Cost of factory premises. Salary of a manager whosupervises more than onede artment.


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PRIVATECOST:

Private costs are those which areactually incurred or provided for byan individual or a business firm for

its business activities.

For example:

Private costs a consumer faceswhen driving a car:

The private costs of driving a carincludes the cost of fuel and oil,

its maintenance, depreciation, and


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SOCIALCOST:

Social cost are the total costs to thesociety on account of production ofcommodity. It includes both privatecosts & any other external costs to

the society.

For example:

The social costs include all theseprivate costs:(fuel, oil, maintenance, insurance,depreciation, and operator's driving

time) and also the cost experienced


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URGENT

COST: Urgent costs are those costs whichmust be incurred in order to

continue operations of the businessfirm. For example : cost of raw

material and labor if production is totake place.

POSTPONABLE

COST: Postponable cost are those costswhich can be postponed for time

being. For example : maintenance

of building and replacing of old


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SHORT-RUNCOST:

Short run cost is that cost that varieswith output when plant andequipment remains the same. Whiledecisions relating to production with

a given plant size use short run costsfor analysis.

LONG-RUNCOST:

Long run cost is that cost whichvaries with output when all the

factor inputs change. While decisionsrelating to the expansion or

increasing plant size, requires long


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FIXED COST:(Constant or

Supplementary Costs)

Fixed Cost are theamount spent by

the firm in fixedinputs in the shortrun & which are

remain constant. It

includes:

Rent for building.Insurance

premiums. Outp

COS

T

Fixedcost


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VARIABLE COST:(or Prime Costs)

Variable Cost arethose costs that

are incurred onvariable factors &vary directly with

the level of output.

It includes:

Prices of rawmaterials.

Wages of labor. Outp

COS

T

Variablecost


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TOTALCOST:

Outp

COS

T

TC

TV

C

TF

C

TC = TFC +TVC

TC increases , Outputincreases.

TVC increases , Output

increases.

Total Cost is theaggregate ofexpenditures

incurred by thefirm in producing agiven level of

output.


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AVERAGECOST:

Average Cost isthe cost per unit ofoutput produced

by a firm.

Outp

COS

T

A

C

AVC

AFCAC or ATC = AFC+ AVC

AC =TC

Q


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MARGINALCOST:

Marginal Cost isthe additional costto the total cost of

a firm byproducing onemore unit of the

product.

Outp

COS

T

MC

MC =

TC

QFirstly MC declines,and afterwardsincreases.


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COST FUNCTION

(COST OUTPUTRELATIONSHIP)

Cost Function expresses the relationship

between cost & its determinants like:C = f (S,O,P,T,

..) Size of plant. Output level. Prices of inputs. Technology. ManagerialEfficiency.


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SHORT-RUN COST OUTPUTRELATIONSHIPUnits ofoutput TFC TVC TC AFC AVC ATC MC

01000 0

1000

101000 400

1400 100 40 140 40

201000 700

1700 50 35 85 30

301000 930

1930 33.3 31 64.3 23

401000

1100

2100 25 27.552.5 17

50

100

0

140

0

240

0 20 28 48 30

It includes:

Total

Cost &Output,

Fixed

Cost &Output,

Variable

Cost &


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Short-Run CostCurves:

Outp

COST

MC

ATC

AVC

AFC

Output

COST TF

C

TCTVC


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LONG-RUN COST OUTPUTRELATIONSHIP

The long run cost output relationship isestablished with the help of long run cost

cures. It is a flatter U-shaped curve.

LAC = LTCQ

Thesecostsareincurredbyabusiness

firmoveraperiodoftimeduringwhichallfactorsofproductionarevariable.It

basicallyconsistsofperspectiveplanningfortheexpansionofthefirm.


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Long-Run CostCurves:

COST

LMC

LAC

COST

LAC

SAC

MMS Session 4

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