Unit-III Managerial

Economics
For- MBA First Year
By- Atul Raghuvanshi
What is Production?
• Production means- Rising of Crops or Making of a
Physical Good in Factories?
• When a farmer produces Wheat in the farms?
Or
• When Cadbury produces chocolates?
“Man does not produce physical
(material) goods; but when it is said that
he produces material goods, in fact, he
only creates the utility.”
-Alfred Marshall
The word "production” is used to imply
creation or increasing the utility of a
good so that its value is increased.
• Production means an increase in the value of a
commodity."-Nicholson

• "Production is any activity which adds to the value of

a nation's supply of goods and services.” -M. J. Ulmer

• "Production may be defined as the process by which

inputs may be transformed into output" -Robert Awh
Difference between Consumption
and Production-
• Production and consumption are considered to be
altogether contrary and different activities.

• Consumption is the use of utility whereas

Production is creation of utility.
Methods of Creation of Utility-
• Form Utility
• Place Utility
• Time Utility
• Service Utility
• Possession Utility
• Knowledge Utility
Factors of Production-

“The sources of services which enter into the

process of production are called factors of
production. The factors are broadly classified
as land, labour, capital, organisation and
enterprise.”
-M.J. Ulmer
Factors of production are neither two
nor four but millions.
Production Process
Production Theory-
• Production theory is an application of
Constrained Optimization Technique.

• Means- The firm tries either to minimize cost of

production at a given level of output or maximize
the output achievable with a given level of cost.
Production Theory-

Maximize
Output Costs

Minimize
 Inputs of Production

Fixed Variable
Inputs Inputs
 Fixed Vs. Variable Inputs
• Fixed Inputs are those • Variable Inputs are those
that cannot be quickly that can be changed
changed during the time easily and on very short
period under notice (e.g., most raw
consideration except, materials and unskilled
perhaps at a very great labour).
expense, (e.g., a firms’
plant).
 Production Decisions
• What are objectives of a Producer/Business Owner?
Maximizing Profits
Expanding Market Share
Improving Product Quality
Reducing Costs
 Production Decisions
• Important questions for a Producer/Business
Owner-

What ratio should the firm combine inputs to

produce outputs?

How much output should the firm produce?

 Production Decisions
• The answer to the question would be-

As much as it
As much as the
Or takes to maximize
firm can sell?
its profits?
 Production Decisions
• The answer to the question would be-

As much as it
takes to maximize
its profits?
 Production Decisions
• How the producer/owner, at given state of
technology, combines various inputs to
produce a definite amount of output in an
economically efficient manner?
 Steps in Production Decisions

1.Production Technology

2.Consumer & Cost Constraints

3.Input Choices
 Production Function
• Is an equation that expresses the relationship
between the quantities of productive factors
(such as labour and capital) used and the amount
of product obtained.
• It tells amount of product that can be obtained
from every combination of factors, assuming that
the most efficient available methods of
production are used.
 Production Function
• In a general mathematical form, a production function
can be expressed as: Q= f(LB, L, K, M, t)
• Q = output/quantity
• LB = Land & Buildings.
• L = Labour.
• K = capital.
• M = raw material.
• t= time.
 Production Function
• It can also be expressed as: Q= f(X1, X2, X3, X4…
Xn)
• Q = output/quantity produced during a given period of
time
• (X1, X2, X3, X4…Xn)= Quantities of Various Inputs
used in production
 What does Production Function
answer?
• What is the marginal productivity of a particular factor
of Production?
• What is the cheapest combination of productive factors
that can be used to produce a given output?
 Nature of Production Function-
•Represents a purely technical relationship in
physical quantities between the inputs of factors
and the output of the products.
•It has no reference to money price. The price
factor is left out altogether.
•The output is the result of a joint use of the
factors of production.
 Nature of Production Function-
• The physical productivity of one factor can be
measured only in the context of this factor being
used in conjunction with other factors.
• The nature or the quantity of the various factors and
the manner in which they are combined will depend
on the state of technical knowledge.
• For instance, labour productivity will depend on the
quality of labour as determined by their education
and training.
 Assumptions of Production
Function-
• Production function is related to a specific time period.
• The state of technology is fixed during this period of
time.
• The factors of production are divisible into the most
viable units.
• There are only two factors of production, labour and
capital.
• Inelastic supply of factors in the short-run period.
 Limitations of Production
Function-
• Restricts itself to the case of two inputs and one
output.
• Assumes a smooth and continuous curve, which is not
possible in the real world, as there are always
discontinuities in production.
• Assumes technology as fixed, which is not possible in
the real world.
• Assumes a perfectly competitive market, which is rare
in the real world.
 Output Elasticity
• The elasticity of production, also called output
elasticity, is the percentage change in the production of
a good by a firm, divided the percentage change in an
input used for the production of that good, for
example, labor or capital.
• The elasticity of production shows
the responsiveness of the output when there is a
change in one input.
 Output Elasticity
• It is defined as de proportional change in the product, divided
the proportional change in the quantity of an input.
• For example, if a factory employs 10 people, and produces
100 chairs per day. If the number of people employed in the
factory increases to 12, that is, a 20% increase, and the
number of chairs produced per day increases to 110 (that is, a
10% increase), the elasticity of production is:
• ΔQ/Q / ΔL/L = 10/100 / 2/10 = 0.1 / 0.2 = 0.5
 Types of Production Function-
• Short Run Production • Long Run Production
Function Function
1. Linear Function 1. Cobb-Douglas
2. Quadratic Production Production Function
Function
3. Cubic Production
Function
4. Power Function
Linear Production Function
• The Linear Homogeneous Production Function implies
that with the proportionate change in all the factors of
production, the output also increases in the same
proportion.
• Such as, if the input factors are doubled the output also
gets doubled. This is also known as constant returns to
a scale.
• nP = f(nK, nL)
Linear Production Function
• nP = f(nK, nL)
• Where, n = number of times
• nP = number of times the output is increased
• nK= number of times the capital is increased
• nL = number of times the labor is increased
Linear Production Function
• Thus, with the increase in labor and capital by
“n” times the output also increases in the same
proportion. The concept of linear homogeneous
production function

• Total Product, Y = a + bX
Quadratic Production Function
• The production function may be quadratic, taking the
following form-
• Y = a + bX – cX2
• where the dependent variable, Y, represents total
output and the independent variable, X, denotes input.
The small letters are parameters; their probable values,
of course, are determined by a statistical analysis of
the data.
Quadratic Production Function
• The production function may be quadratic, taking the
following form-
• Y = a + bX – cX2
• where the dependent variable, Y, represents total
output and the independent variable, X, denotes input.
The small letters are parameters; their probable values,
of course, are determined by a statistical analysis of
the data.
Quadratic Production Function
(i) The minus sign in the last term denotes diminishing
marginal returns.
(ii) The equation allows for decreasing marginal product
but not for both increasing and decreasing marginal
products.
(iii) The elasticity of production is not constant at all
points along the curve as in a power function, but
declines with input magnitude.
Quadratic Production Function
(iv) The equation never allows for an increasing
marginal product.
(v) When X = O, Y = a. This means that there is some
output even when no variable input is applied.
(vi) The quadratic equation has only one bend as
compared with a linear equation which has no bends.
Quadratic Production Function
(iv) The equation never allows for an increasing
marginal product.
(v) When X = O, Y = a. This means that there is some
output even when no variable input is applied.
(vi) The quadratic equation has only one bend as
compared with a linear equation which has no bends.
Cubic Production Function
• The cubic production function takes the
following form –
Y= a + bx + cX2 – dX3
Cubic Production Function
• It allows for both increasing and decreasing
marginal productivity.
• The elasticity of production varies at each point
along the curve.
• Marginal productivity decreases at an increasing
rate in the later stages.
Cobb Douglas Production Function
• The Cobb-Douglas production function is based
on the empirical study of the American
manufacturing industry made by Paul H. Douglas
and C.W. Cobb.
• A linear homogeneous production function which
takes into account two inputs, labour and capital,
for the entire output of the manufacturing
industry.
Cobb Douglas Production Function
• Q = ALa Cβ
• where Q is output.
• L and С are inputs of labour and capital
respectively.
• A, a and β are positive parameters
Cobb Douglas Production Function
• The equation tells that-

• Output depends directly on L and C, and that

part of output which cannot be explained by
L and С is explained by A which is the
‘residual’, often called technical change.
Cobb Douglas Production Function
• The production function solved by Cobb-
Douglas had
• 1/4 contribution of capital to the increase in
manufacturing industry and
• 3/4 of labour so that the C-D production
function is-
Cobb Douglas Production Function
• Q = AL3/4 C1/4
• which shows constant returns to scale because the
total of the values of L and С is equal to one: (3/4
+ 1/4), i.e.,(a + β = 1)
• The coefficient of labourer in the C-D function
measures the percentage increase in Q that would
result from a 1 per cent increase in L, while
holding С as constant.
Cobb Douglas Production Function
• Similarly, В is the percentage increase in Q that
would result from a 1 per cent increase in C, while
holding L as constant.
Limitations of Cobb Douglas Production
Function-
• Considers only two inputs, labour and capital,
and neglects some important inputs, like raw
materials, which are used in production.
• It is, therefore, not possible to generalize this
function to more than two inputs.
 Consumption • Utility
Factors of • Returns/Product
Production/Input
 If Factors of
If Consumption
Production/Inputs
Increases
increase

Utility starts Returns/Product

decreasing start decreasing
Law of Diminishing
Returns
Law of Diminishing Returns/Diminishing Marginal
Returns/Diminishing Marginal Productivity
• The law of diminishing returns is rooted back in
the 18th century.
• The origin of the law of diminishing returns was
developed primarily within the agricultural
industry.
• Early observation was that at a certain point, that
the quality of the land kept increasing, but so did
the cost of produce.
Law of Diminishing Returns/Diminishing Marginal
Returns/Diminishing Marginal Productivity
• Diminishing Returns are the decrease
in marginal (incremental) output(MP) of
a production process as the amount/quantity of a
single factor of production is incrementally
increased, holding all other factors of production
equal.
Law of Diminishing Returns/Diminishing Marginal
Returns/Diminishing Marginal Productivity
• In productive processes, increasing a factor of
production by one unit, while holding all other
production factors constant, will at some point
return a lower unit of output per incremental unit
of input.
Law of Diminishing Returns/Diminishing Marginal
Returns/Diminishing Marginal Productivity
• The law of diminishing returns does not cause a
decrease in overall production capabilities, rather
it defines a point on a production curve whereby
producing an additional unit of output will result
in a loss and is known as negative returns.
Law of Returns to Scale
Difference between Short Run & Long
Run
Short Run Long Run

• Firms can only control prices, • Factors of Production and

means only prices are highly Costs both are variable.
variable. • Long run production function
• Short run production connotes the time period, in
function alludes to the time which all the factors of
period, in which at least one production are variable.
factor of production is fixed.
Law of Returns to Scale
• The law of returns to scale examines the relationship
between output and the scale of inputs in the long run
when all the inputs are increased in the same
proportion.

• This law applies only in the long run when no factor is

fixed, and all factors are increased in the same
proportion to boost production.
Three stages of Law of Returns to Scale
• Increasing Returns to Scale
• Diminishing Returns to Scale
• Constant Returns to Scale
Increasing Returns to Scale
• Increasing returns to scale or diminishing
cost refers to a situation when all factors of
production are increased, output increases at
a higher rate.
• Means if all inputs are doubled, output will
also increase at the faster rate than double.
Increasing Returns to Scale
Diminishing Returns to Scale
• Diminishing returns or increasing costs refer to
that production situation, where if all the factors of
production are increased in a given proportion,
output increases in a smaller proportion.
• Means, if inputs are doubled, output will be less
than doubled.
• If 20 percent increase in labour and capital is
followed by 10 percent increase in output, then it is
an instance of diminishing returns to scale.
Diminishing Returns to Scale
Cost
 Fixed Cost Vs. Variable Cost
Fixed Cost Variable Cost
• Costs for expenses that • Variable costs are for
remain constant for a expenses that change
specific period, such as rent constantly, such as
or loan payments. taxes, labor, and operational
• Fixed costs are generally expenses.
easier to plan, manage, and • Variasble costs are not
budget. easier to track, plan,
• Fixed Costs are time related. manage, and budget.
• Variable Costs are volume
related.
Cost-Output Relationship in the Short
Run

How can we By making

make
change in
changes to
the the variable
production? inputs
Cost-Output Relationship in the Short
Run

Machinery, Land & Buildings are

mostly fixed in the short-run.
Cost-Output Relationship in the Short Run
• Short-run is a period not sufficient enough to
expand the quantity of fixed inputs.
• Total Cost (TC) in the short-run is composed of
two elements – Total Fixed Cost (TFC) and Total
Variable Cost (TVC).
• TFC remains the same throughout the period and
is not influenced by the level of activity.
Cost-Output Relationship in the Short Run
• The firm will continue to incur these costs even if
the firm is temporarily shut down.
• Even though TFC remains the same, fixed cost
per unit varies with changes in the level of output.
• TVC increases with increase in the level of
activity, and decreases with decrease in the level
of activity.
• If the firm is shut down, there are no variable
costs.
Cost-Output Relationship in the Short Run
So in the short-run an increase in TC implies
an increase in TVC only. Thus:

TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
TC = TFC when the output is zero.
TC Curve is also upward
rising. When no
production, TC=TFC TVC Curve is
upward rising
TVC=0 when
no production

TFC does not

change with
increase in
output
Average cost & Marginal Cost
• Average Cost- Average cost is not actual cost, It is
obtained by dividing the total cost by the total output.
• AC= Total Cost/Units Produced
• Marginal cost- The cost incurred on producing one
additional unit of commodity is known as marginal
cost. Thus it shown a change in total cost when one
more or less unit is produced.
• MC= TCn – TC(n-1 )
Short Run Average cost & Marginal Cost
Short Run Average cost & Marginal Cost
• Average Fixed Cost (AFC): Average fixed cost is obtained
by dividing the TFC by the number of units produced.
• AFC = TFC/Q where, ‘Q’ refers quantity of production.
• Since TFC is constant for any level of activity, fixed cost
per unit goes on diminishing as output goes on
increasing.
• The AFC curve is downward sloping towards the right
throughout its length, with a steep fall at the beginning.
Short Run Average cost & Marginal Cost
Short Run Average cost & Marginal Cost
• Average Variable Cost (AVC): Average Variable Cost
is obtained by dividing the TVC by the number of
units produced.
• Therefore: AVC = TVC / Q
• Due to the operation of the Law of Variable
Proportions AVC curve slopes downwards till it
reaches a certain level of output and then begins to
rise upwards.
Short Run Average cost & Marginal Cost
Short Run Average cost & Marginal Cost
• Average Total Cost (ATC): Average Total Cost or simply
Average Cost is obtained by dividing the TC by the
number of units produced.
• Thus: ATC = TC / Q
• The ATC curve is very much influenced by the AFC and
AVC curves.
Short Run Average cost & Marginal Cost
In the beginning both AFC curve and AVC curve decline
and therefore ATC curve also declines.
The AFC curve continues the trend throughout, though
at a diminishing rate.
AVC curve continues the trend till it reaches a certain
level and thereafter it starts rising slowly.
Short Run Average cost & Marginal Cost
• Since this rise initially is at a rate lower than the rate of
decline in the AFC curve,
the ATC curve continues to decline for some more time and
reaches the lowest point,
which obviously is further than the lowest point of the AVC
curve.
• Thereafter the ATC curve starts rising because the rate of rise
in the AVC curve is greater than the rate of decline in the AFC
curve.
Short Run Average cost & Marginal Cost
• Marginal Cost (MC): Marginal Cost is the increase in TC as a
result of an increase in output by one unit.
• It is the cost of producing an additional unit of output.
• MC is based on the Law of Variable Proportions. A downward
trend in MC curve shows decreasing marginal cost (i.e.
increasing marginal productivity) of the variable input.
• Similarly an upward trend in MC curve shows increasing
marginal cost (i.e. decreasing marginal productivity). MC
curve intersects both AVC and ATC curves at their lowest
points.
Short Run Average cost & Marginal Cost
Cost-Output Relationship in the Long Run
• In the long run the size of an industry can be expanded to
meet the increased demand for products
-as such in the long run all the factors of production can be
varied according to the need.
• Hence, long run costs are those which vary with output
when all the input factors including plant and equipment
vary.
• Costs fall as output increases due to economies of scale,
consequently the average cost AC of production falls.
Cost-Output Relationship in the Long Run
• Some firms experience diseconomies of scale if the
average cost begins to increase.
• This fall and rise derives a U shaped or boat shaped
average cost curve in the long run which is denoted as
LAC.
Cost-Output Relationship in the Long Run
Cost-Output Relationship in the Long Run
Cost-Output Relationship in the Long Run
• Long term average cost (LAC) is the envelope of all short term average
cost curves (SACs). That is why LAC is also known as the envelope curve.

• LAC is always less than SAC. That is why all SAC curves are located above
LAC.

• LAC indicates the minimum cost of production and optimum size of the
firm (Law of constant returns).

• LAC curve only touches the SAC curves and does not cuts them.
Cost-Output Relationship in the Long Run
• Long term average cost (LAC) is the envelope of all short term average
cost curves (SACs). That is why LAC is also known as the envelope curve.

• LAC is always less than SAC. That is why all SAC curves are located above
LAC.

• LAC indicates the minimum cost of production and optimum size of the
firm (Law of constant returns).

• LAC curve only touches the SAC curves and does not cuts them.
Cost-Output Relationship in the Long Run
• In the short run, the SAC curve is U-shaped because
the laws of returns operate but in the long run, LAC is
also U-shaped because
-the Laws of Returns to scale operate namely the law of
increasing return to scale, the Law of Constant Returns
to scale and the Law of Diminishing Returns to scale.
Cost-Output Relationship in the Long Run
• As the level of output is expanded or the scale of
operation is increased by the large firm they will enjoy
economies of scale but if these firms produce beyond
their installed capacity then they might get
diseconomies of scale.
• Economies of scale bring down the fall in unit cost and
diseconomies result in rising in it.
Total Revenue
• The total revenue is the total amount a
vendor/business can collect from the sale of
commodities or services to the customer.
• The price of the commodities can be expressed as P ×
Q, which means the cost price of the commodities
multiplied by the amount sold.
• Therefore, total revenue (TR) is defined as the market
cost price of the commodity (p) multiplied by the
enterprise's output (q).
Total Revenue
Thus,
TR = p × q
Where,
TR-Total Revenue,
P-Price,
Q-Quantity.
Average Revenue
• The average revenue represents the revenue initiated
per unit of output sold.
• The average revenue contributes greatly to the profit
of any enterprise. In calculating profit per unit, the
average (total) cost is subtracted from the average
revenue.
Average Revenue
• It is usually more profitable for an enterprise to
manufacture the greatest amount of output.
• AR = TR/q = p × q/q = p
-Where,
• AR-Average Revenue,
• TR-Total Revenue,
• P-Price
• Q-Quantity.