MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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Unit II
Production Function, Law of variable proportion, Law of supply, Elasticity of supply, Measurement of
elasticity, Significance and use of the concept of elasticity, Costs of Production, Private Costs & Social
Costs, Accounting and Economic Costs, Short Run and Long Run Cost, Economies of Scales, Cost
estimation, Methods of Cost Estimation and Cost Forecasting, Cost reduction and Cost Control.

THEORY OF PRODUCTION

PRODUCTION FUNCTION:
The functional relationship between inputs and outputs is known as production function. . It shows
level of output for any specific combination of inputs. Inputs refer to the factor services which are used
in production i.e. land, labour, capital and enterprise. Output refers to the volume of goods produced.
Algebraically, it may be expressed in the form of an equation as
Q = f (L,M,N,K,T)
Where Q stands for the output of a good per unit of time, L for labor, M for management (or
organization), N for land (or natural resources), K for capital and T for given technology, and f refers to
the functional relationship.
Cobb-Douglas Production Function : If we only Few other basic variations of Production
take two inputs, labor and capital, the production function may have following forms:
function assumes the form
Q=2L+15K
Linear
Q = f(L, K)
Q=3L+7K+50
Linear + constant
One of the most popular production functions in Q=35L+12K+7LK
Linear + Interaction
use is Cobb-Douglas Production Function. The form
general form of the CobbDouglas production Q=3.5L2+22K2+17LK+15
Quadratic
+
function for the two-input case may be written
interaction + constant
Q=AKL
Q=15K2.5L0.75
Power
Where A, and are known parameters and K and
L represent the explanatory variables capital and
labor, respectively. It is further assumed that 0
(, ) 1.
RETURNS TO SCALE AND RETURNS TO A FACTOR
In studying production functions, two important relations between inputs and outputs are of interest.
One is the relation between output and the variation in all inputs taken together. This is known as the
returns to scale characteristic of a production system.
A second important relation in any production system is that between output and variation in only one
of the inputs employed. This is known as the returns to a factor. It signals the relation between the
quantity of an individual input (or factor of production) employed and the level of output produced.
FIXED AND VARIABLE FACTOR OF PRODUCTION:
FIXED FACTORS are the factors of production that cannot be changed in the short run. This does not
mean that they cannot be changed at all; they can be changed in the long run. In practice these factors
tend to involve that aspect of land that relates to area of land, and capital equipment.
The cost of fixed factor of production which cannot be changed in short run is known as fixed costs.
Fixed costs remain the same in short run for varying output; firms must pay these even if they shut
down. Examples include the costs of leasing or purchasing capital equipment; the rental costs of
buildings; the annual business rate charged by local authorities; the costs of employing full-time
contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed
capital (due solely to age) and also the costs of business insurance.
VARIABLE FACTORS are the converse of the fixed factors, meaning that they are inputs that can be
varied in both short and long run. In practice this applies mainly to that part of land that relates to raw
materials and to labor.
The costs of variable factor of production which can be changed in short run as well as in long run
and these are known as variable costs. Examples include labor and material costs. Note that long
term contractual staff does not come under this category.

By Pashupati Nath Verma

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

SHORT RUN AND LONG RUN PRODUCTION FUNCTION

The production function as determined by technical conditions of production is of two types: it may be
rigid or flexible. The former relates to the short run and the latter to the long run.
SHORT RUN PRODUCTION FUNCTION
In the short run it is not possible to alter all factors of production and therefore, at least one
or few factor of production is fixed while some other may be fixed; in short run output can be
increased by adding more variable factors (and keeping some other factor of production fix); but up
to some extent after that it starts decreasing. This empirical phenomenon is known as The Law of
Variable Proportion. For example, if we employing more workers and buying in more raw materials
and does not increase machine-capacity initially productivity will go up but later its starts decreasing.
LONG RUN PRODUCTION FUNCTION
In the long run all inputs are variable. Production can be increased by changing one or more of the
inputs. Thus, in the long run, it is possible for a firm to change all inputs up or down in accordance with
its scale of production. This long run production phenomenon is known as returns to scale. The
returns to scale are constant when output increases in the same proportion as the increase in the
quantities of inputs. The returns to scale are increasing when the increased in output is more than
proportional to the increase in inputs. They are decreasing if the increase in output is less than
proportional to the increase in inputs.
SCALE OF PRODUCTION: This term scale of production or organization relates to the amount of fixed
factors that a firm has. It follows therefore that a firm cannot change its scale in the short run. A firms
scale determines its capacity; this can be defined in various ways, but the simplest is that it refers to the
maximum output that a firm can produce in the short run.

TOTAL, MARGINAL & AVERAGE PRODUCT

TOTAL PRODUCT is the output from a production system. It can be derived from the production
function Q = f (L,M,N,K,T). Thus, Total product is the overall output that results from employing a
specific quantity of resources in a given production system. When the total product concept is used to
investigate the relation between output and variation in only one input in a production function, it is
called Total Product of Variable Input. By holding the quantity of an input constant and changing
the quantity used of the other input, we can derive the total product (TP) of the variable input.
For Example, following Table represents Total Product for different combination of two factor
production system (one being Labor and other is Capital)

Total Product Table

Shaded Column represent Total product of
Capital is kept fixed at 3 in this
column).

Labor

(TPL)

(as

AVERAGE PRODUCT of a
factor, APX, is the total product
unit of factor input usage and

per
is

determined by dividing the

product of factor input X by
total amount of factor input X

total
the
used,

holding all other inputs constant. Average product of X is expressed as

AP X =

TP X
X

MARGINAL PRODUCT of a factor, MPX, is the change in output associated with a one unit change in
the factor input X, holding all other inputs constant. Marginal product of X is expressed as

MP X =

Q
=TP X TP X 1
X

Where Q is the change in output resulting from change X in the some variable input factor X.
We use following mathematical expression to represent Marginal product of X if production function is a
continuous function

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-II

Q
X

Page3

MP X =

Marginal product of Labor and Average Product of Labor can be easily calculated as follows: A
hypothetical production schedule is worked out to explain TPL, APL, MPL

Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor = labor.

Labor
Input(Workers).L
0
1
2
3
4
5
6
7
8

Total product of
Labor (TPL)
0
7
17
29
40
49
54
52
48

Average product of
Labor (APL)
0
7/1=7
17/2=8.5
29/3=9.67
40/4=10
49/5=9.8
54/6=9
52/7=7.43
48/8=6

Marginal product of
Labor (MPL)
7-0=7
17-7=10
29-17=12
40-29=11
49-40=9
54-49=5
52-54=-2
48-54=-4

LAW OF VARIABLE PROPORTION

The law can be states that As the quantity of different units of only one factor input is
increased to a given quantity of fixed factors, beyond a particular point, the marginal,
average and total output eventually decline.

The law of variable proportions is the new name for

the famous Law of Diminishing Returns of
classical economists. This law is stated by various
economists in the following manner According to
Prof. Benham, As the proportion of one factor
in a combination of factors is increased, after
a point, first the marginal and then the
average product of that factor will diminish.

The same idea has been expressed by Prof. Marshall

in the following words:
An increase in the quantity of a variable
factor added to fixed factors, at the end
results in a less than proportionate increase
in the amount of product, given technical
conditions.

APL
Stage I

Stage II

Stage III

MPL

ASSUMPTIONS OF THE LAW

1. Only one variable factor unit is to be varied while all other factors should be kept constant.
2. Different units of a variable factor are homogeneous.
3. Techniques of production remain constant.
4. The law will hold good only for a short and a given period.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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5. There are possibilities for varying the proportion of factor inputs.

THE THREE STAGES OF PRODUCTION:

Law of Variable proportion identifies three important Stages of Production:
Stage I of Production: It runs from zero unit of variable unit (here in this case labor) to level where
APL reaches to its maximum.
Stage II of Production: It follows stage I to the where level where MP L reaches to zero.
Stage III of Production: It starts from the end of stage II and continue to follow. In this MP L becomes
negative..
STAGE I: STAGE OF INCREASING RETURNS
Stage I ends where the average product reaches its highest (maximum) point. During this stage, the
total product, the average product and the marginal product are increasing. It is notable that the
marginal product in this stage increases but in a later part it starts declining. Though marginal product
starts declining, it is greater than the average product so that the average product continues to rise.
STAGE II: STAGE OF DECREASING RETURNS
Stage II ends at the point where the marginal product is zero. In the second stage, the total product
continues to increase but at a diminishing rate. The marginal product and the average product are
declining but are positive. At the end of the second stage, the total product is maximum and the
marginal product is zero.
STAGE III: STAGE OF NEGATIVE RETURNS
In this stage the marginal product becomes negative. The total product and the average product are
declining.
Product
ion
Stage
Total
Product
(TP)

Stage I
(Underutilization of
Fixed Capacity)
Increases at and
increasing rate.

Margin
al
Product
(MP)
Averag
e
Product
(AP)

Increases and reaches

its maximum and starts
diminishing.
Increases (but slower
than MP).

Stage II
(Optimum utilization of Fixed
Capacity)
Increases at a diminishing rate, Reaches
it maximum, with diminish rate
becomes constant and then starts to
decline
Keep on diminishing and becomes zero

Stage III
(Overutilization of
Fixed Capacity)
Keeps on declining.

Starts diminishing

Continues to but
must always be
greater than zero.

Keeps on declining
and becomes
negative.

RETURNS TO SCALE

If all inputs are changed simultaneously, (possible only in the long-run) i.e., say increased
proportionately, and then the concept of returns to scale has to be used to understand the behaviour of
output. The behaviour of output is studied when all factors of production are changed in the same
direction and proportion. Returns to scale are classified as follows:
INCREASING RETURNS TO SCALE: If the increase in all factors leads to a more than proportionate
increase in output, it is called increasing returns to scale. For example, if all the inputs are increased by
5%, the output increases by more than 5% i.e. by 10%. In this case the marginal product will be rising.
CONSTANT RETURNS TO SCALE: If we increase all the factors (i.e. scale) in a given proportion, the
output will increase in the same proportion i.e. a 5% increase in all the factors will result in an equal
proportion of 5% increase in the output. Here the marginal product is constant.
DECREASING RETURNS TO SCALE: If the increase in all factors leads to a less than proportionate
increase in output, it is called decreasing returns to scale i.e. if all the factors are increased by 5%, the
output will increase by less than 5% i.e. by 3%. In this phase marginal product will be decreasing.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

LAW OF VARIABLE PROPORTIONS Vs. RETURN TO SCALE

Laws of returns
1. Short run Production function
2. Only one factor is varied and all other
factors are kept constant
3. Factor proportions are changed
4. Law does not apply when the factors must
be used in fixed proportions to produce a
product.
5. Increasing returns are due to the
indivisibility of factors and specialization of
labor.
6. Diminishing returns are due to non-optimal
factor proportion and imperfect elasticity of
substitution of factors.

Returns to scale
1. Long run Production function
2. All the factors are varied
3. Factor proportions are not changed. The
Scale changes.
4. Law does apply when the factors must be
used in fixed proportions to produce a
product.
5. Increasing returns to scale are due to
economies of scale.
6. Diminishing returns to scale are due to
diseconomies of scale.

ISOQUANTS
Isoquants are a geometric representation of the
production function for the same level of output
that can be produced by various combinations
of factor inputs. The locus of all such possible
combinations is called the Isoquant.
CHARACTERISTICS OF ISOQUANT
An isoquant slopes downward to the right.
An isoquant is convex to origin.
An isoquant is smooth and continuous.
Two isoquants do not intersect

SUPPLY ANALYSIS

Supply is the willingness and ability of producers to

Supply
make a specific quantity of output available to
consumers at a particular price over a given period of
Curve
time.
LAW OF SUPPLY: The law of supply establishes a direct
relationship between price and supply. Firms will supply
less at lower prices and more at higher prices. Other
things remaining the same, as the price of commodity
rises, its supply expands and as the price falls, its supply
contracts.
SUPPLY SCHEDULE AND SUPPLY CURVE
A supply schedule is a statement of the various
quantities of a given commodity offered for sale at
various prices per unit of time. With the help of the
supply schedule, a supply curve can be drawn.
FACTORS AFFECTING THE SUPPLY:
Price of Commodity: Higher the price of a commodity,
larger is the quantity supplied and vice-versa.
Technological Changes: Improved techniques reduce
the cost of production and increase the supply and vice
versa.
Input Prices: A fall in prices of factors of production will
increase the supply of the commodity and vice-versa.
Goal of the firm: If the goal is profit maximization, more quantity will be supplied at higher price. If
the firms goal is sales maximization more commodities will be supplied at same price. If its aim is to
minimize risk, less will be supplied.
Price of Related Goods: If price of a substitute goods increase, supply of the commodity concerned
will fall. If price of a complementary good increases, supply of the commodity concerned also increases.
Expectation about future prices: If there is an expectation of increase in price of the commodity in
future, supply will be less at present and vice-versa.
Government Policy: Imposition of taxes reduces supply and subsidy increases supply.
Number of firm: The larger the number of firms, greater in the market supply and vice-versa.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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CHANGE IN SUPPLY VS. SHIFT IN SUPPLY

CHANGE IN QUANTITY SUPPLY

When supply changes due to change in price of
commodity. It is called movement along supply
curve.
a)
a) Extension in supply: - When supply increases
due to increase in supply.
b)
b) Contraction in supply: - When supply decreases
due to decrease in supply, is called contraction in
supply.

CHANGE IN SUPPLY/SHIFT OF SUPPLY CURVE:

It occurs due to change in other factors affecting
supply like Technology, No. of Firms, etc.
Increase in supply: When more quantity is
supplied at same price.
Decrease in supply: When less quantity is
supplied on the same price is called Decrease in
supply.

SUPPLY

By Pashupati Nath Verma

Price Elasticity

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

of Supply

Percentage
Change
in QuantitySupplied
Percentage
Change
inPrice
Q / Q
Symbolical
ly,eS
P / P
law ofof supply
us that
supplied will respond to a change in price. The concept of The
elasticity
supplytells
explains
thequantity
rate of
change in supply as a result of change in price. It is measured by the formula mentioned below
Priceelasticityof supply

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

There
1.
2.
3.
4.
5.

TYPES OF ELASTICITY OF SUPPLY

are five types of elasticity of supply.
Perfectly elastic supply ( eS=)
Relatively elastic supply( eS>1)
Unitary elastic supply ( eS=1)
Relatively inelastic supply( eS<1)
Perfectly inelastic supply( eS=0)

MEASUREMENT OF ELASTICITY OF SUPPLY

1. Percentage Method
2. Graphical Method
3. Mathematical Method
4. Total outlay Method
5. Arc method

WHAT FACTORS AFFECT THE ELASTICITY OF SUPPLY?

Spare production capacity: If there is plenty of spare capacity then a business can increase
output without a rise in costs and supply will be elastic in response to a change in demand. The

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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supply of goods and services is most elastic during a recession, when there is plenty of spare
labour and capital resources.
Stocks of finished products and components: If stocks of raw materials and finished
products are at a high level then a firm is able to respond to a change in demand - supply will be
elastic. Conversely when stocks are low, dwindling supplies force prices higher because of
scarcity
The ease and cost of factor substitution/mobility: If both capital and labour
are occupationally mobile then the elasticity of supply for a product is higher than if capital
and labour cannot easily be switched. E.g. a printing press which can switch easily between
printing magazines and greetings cards. Or falling prices of cocoa encourage farmers to switch
into rubber production
Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural markets
the momentary supply is fixed and is determined mainly by planting decisions made months
before, and also climatic conditions, which affect the production yield. In contrast the supply of
milk is price elastic because of a short time span from cows producing milk and products
reaching the market place.
Spare production capacity: If there is plenty of spare capacity then a business can increase
output without a rise in costs and supply will be elastic in response to a change in demand. The
supply of goods and services is most elastic during a recession, when there is plenty of spare
labor and capital resources.
Stocks of finished products and components: If stocks of raw materials and finished
products are at a high level then a firm is able to respond to a change in demand - supply will be
elastic. Conversely when stocks are low, dwindling supplies force prices higher because of
scarcity
The ease and cost of factor substitution/mobility: If both capital and labor
are occupationally mobile then the elasticity of supply for a product is higher than if capital
and labor cannot easily be switched. E.g. a printing press which can switch easily between
printing magazines and greetings cards. Or falling prices of cocoa encourage farmers to switch
into rubber production
Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural markets
the momentary supply is fixed and is determined mainly by planting decisions made months
before, and also climatic conditions, which affect the production yield. In contrast the supply of
milk is price elastic because of a short time span from cows producing milk and products
reaching the market place.

SIGNIFICANCE OF ELASTICITY OF SUPPLY

1. The elasticity of supply of a good is a major factor in
determining as to how much of its price will alter when there is
a change in the conditions of demand. Let us explain this with
the help of supply of and demand for sugarcane as shown in
figure. In figure , DD is the demand curve and SS is the supply
curve. OP is the price. If demand for sugar increases to D 1S1 in
the short-run it is inelastic, for its supply can be expanded only
by adding labor, fertilizers etc. therefore, the supply increases
only by a small amount (MM1). However, in the long period
more land can be put under sugarcane. Supply is, therefore
more elastic and is represented by the curve S 1S1. The long-run
price falls to OP2 and quantity increases to OM2.
2. The elasticity of supply is significant in determining the extent
of taxation. Where the supply of a good is inelastic the government can impose a tax on the producer
without having a great effect on the amount of the goods offered for sale. For example, a man owns a
mineral well for which a maximum rent of $100 can be got. The owner gives it on rent for $1000 per
month. Suppose the government levies a tax of $500 a year on this mineral well. This means that the
owner will have to pay the tax from out of his own pocket, since he cannot get it from the user. If the
tax amount is increased to $1000, the owner of the mineral well will stop letting it on rent because the
net income from the mineral well becomes zero.
3. Inelastic supply of many hard and soft commodities making prices more volatile.
4. Elasticity of supply of labour is a factor explaining wage differentials i.e. migrant workers can
help to relieve shortages of labour and improve the elasticity of supply.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

By Pashupati Nath Verma

MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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COST

COST
OF
PRODUCTION:

ANALYSIS

When an entrepreneur decides

to

produce
a
commodity,
he
uses in production.

has to pay the price for inputs which he

When

he

employs labour, he pays wages to

buys raw materials, fuel and power, rent
the factory building and so on.

them and pays money when

for

production

The term cost of production means expenses incurred in

of a commodity. This refers to the total amount of

production of a

money spent on the

commodity.
The

the

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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determinants of cost of production are: the size of plant, the level of production, the nature of
technology used, the quantity of inputs used, managerial and labour efficiency. Thus the cost of
production of a commodity is the aggregate of prices paid for the factors of production used in
producing a commodity.
COST FUNCTION
Time factor is very important in cost theory. The short-run costs are the costs over a period during
which some factors of production are fixed. The long-run costs are the costs over a period long enough
to permit changes in all factors of production. Both in the short-run and in the long-run, cost is a
multivariate function, i.e., it is determined by many factors simultaneously, symbolically, the long run
cost function is given as:
C=f(X,T,Pf)
And the shot-run-run cost function is:
C=f(X,T,Pf,K)
Where C = Total Cost
X = Output
T = Technology
Pf = Prices of factors
K = Fixed factor (s)
Graphically, the cost function is generally shown on a two-dimensional diagram by taking C= f(x),
ceteris paribus, If other factors (i.e.T,Pf) to change, then the cost curve will shift.
DETERMINANTS OF COSTS
Factors determining the cost are
1. Size of plant: There is an inverse relationship between size of plant and cost. As size of plant
increases, cost falls and vice versa.
2. Level of Output: There is a direct relationship between output level and cost. More the level of
output, more is the cost ( i. e., total cost) and vice Versa.
3. Price of Inputs: There is a direct relationship between price of inputs and cost. As the price of
inputs rises, cost ruses and vice versa.
4. State of technology: More modern and upgraded the technology implies lesser cost and vice
versa.
5. Management and administrative efficiency: Efficiency and cost are inversely related. More
the efficiency in management and administration better will be the product and less will be the
cost. Cost will case of inefficiencies in management and administration.
NEED AND SIGNIFICANCE OF COST IN MANAGERIAL DECISION-MAKING
The solution of various economic problems needs cost figures different from what are available in the
balance sheets, income-statements, etc. of the firm. The accounting cost figures serve the legal,
financial and tax needs of the firm but are not directly very helpful for managerial decisions. For which
the management needs costs in terms of their source, period, rate of change with respect to output,
the degree of their controllability etc.
It must be pointed out that all types of costs do not matter much rather future costs matter most in
managerial decision-making. The other costs are relevant only if the management is to continue with
its past or present policies in future too, and if the environment in which the firm operates remains
unchanged. Further, only those costs which are affected by the decision of the management need be
analyzed; while expenses that remain unchanged should be ignored in the Decision-making process.
Cost of production provides the floor to pricing. It provides a basis for managerial decision with respect
to the price the firm must quote to its prospective customers; in deciding whether to accept a particular
order or not; whether to abandon an old or establish a new product line; whether or not to increase the
volume of specific outputs; to use idle capacity or rent facilities to outsiders; and whether to make a
particular product or buy it. There are no straight and simple rules for such decisions and it is necessary
to study production and cost analysis thoroughly to arrive at these decisions. The costs which firms
incur are payments to various factors of production and hence they indicate incomes of these factors
also. An understanding of cost thus helps to understand the distribution of factor incomes as well.
Since determinants of cost vary from situation to situation and enterprise to enterprise, it is not
possible to state any general set of determinants of costs. Each management must, therefore, have to
identify for itself the various determinants relevant to that particular situation. However a few
determinants, which seem important in modern business, are plant size, utilization of the plant,
technology, prices of the various inputs, size of lot, stability of production level, management and
labour-efficiency.
Making of effective and right decisions depends much on the proper calculation of costs. If different
types of costs are not properly understood, the managerial decisions are bound to be wrong and
misleading.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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VARIOUS COST CONCEPTS FOR CLASSIFYING THE COSTS:

Cost concepts differ because of differences in view point. Different combinations of cost ingredients are
important for various kinds of management problems. Disparities occur form deletions, from additions
from recombination which do not appear anywhere in the accounting records. Different cost concepts
explained in our study are
1. Actual cost and opportunity costs
2. Past and future costs
3. Incremental costs and sunk costs
4. Explicit and Implicit costs
5. Private, External and social costs

6. Short run and long run costs

7. Total, Average and Marginal Costs

ACTUAL COSTS AND OPPORTUNITY COSTS
Actual costs mean the actual expenditure incurred for producing a good or service. These costs are
the costs that are generally recorded in account books. These costs are also commonly called Absolute Costs

or Outlay Costs.
For example: Actual wages paid, cost of materials purchased.
The concept of opportunity cost is very important in modern economic analysis. The opportunity
costs are the return from the next best use of the firms resources, which the firm forfeits. It avails its
return from the best use of the resources.
For example, a farmer who is producing wheat can also produce potatoes with the same factors.
Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes which he
gives up which again can be a given money value.
PAST AND FUTURE COSTS
Past costs are actual costs which were incurred on the past and they are documented essentially for
record keeping activity. These costs can be observed and evaluated. Past costs serve as the basis for
projecting future cost but if they are regarded high, management can indulge in checks to find out the
factors responsible without being able to do anything about reducing them.
Future costs are those costs that are likely to be incurred in future periods. Since the future is
uncertain, these costs have to be estimated and cannot be expected to absolute correct figures. Future
costs can be well planned, if the future costs are considered too high, management can either plan to
reduce them or find out ways to meet them.
Management needs to estimate future costs for a various managerial uses where future cost are
relevant such as appraisal, capital expenditure, introduction of new products, estimation of future profit
and loss statement, cost control decisions, and expansion programs.
INCREMENTAL AND SUNK COSTS
Incremental costs are defined as the change in overall costs that result from particular decision
being made. Change in product line, change in output level, change in distribution channels are some
examples of incremental costs. Incremental costs may include both fixed and variable costs. In the
short period, incremental cost will consist of variable costcosts of additional labor, additional raw
materials, power, fuel etc.
Sunk cost is the one which is not altered by a change in the level or nature of business activity. It
will remain the same irrespective of activity level. Sunk costs are the expenditures that have been
made in the past or must be paid in the future as a part of contractual agreement. These costs are
irrelevant for decision making as they do not vary with the changes contemplated for future by the
management.
EXPLICIT COSTS AND IMPLICIT COSTS
Explicit costs are those expenses which are actually paid by the firm. These costs appear in the
accounting records of the firm. On the other hand, implicit costs are theoretical costs in the sense
that they go unrecognized by the accounting system. These costs may be defined as the earnings
of those employed resources which belong to the owner himself. These implicit costs are not included
by the accountant of the firm in its accounting statements. However, these costs are considered
relevant by economists while calculating the economic profits of the firm.
ACCOUNTING COST AND ECONOMIC COST
Accounting costs or explicit costs are the payments made by the entrepreneur to the suppliers of
various productive factors. The accounting costs are only those costs, which are directly paid out or
accounted for by the producer i.e. wages to the laborers employed, prices for the raw materials
purchased, fuel and power used, rent for the building hired for the production work, the rate of interest
on the borrowed capital and the taxes paid.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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The economic cost includes not only the explicit cost but also the implicit cost. The money rewards for
the own services of the entrepreneur and the factors owned by himself and employed in production are
known as implicit costs or imputed costs. The normal return on money capital and rent of the land and
buildings belonging to him and used in production constitute implicit cost. Thus,
Economic cost = Explicit cost + Implicit cost.
It may be pointed out that the firm will earn economic profits only if it is making revenue in excess of
economic cost.
Economic profit = Total Revenue Economic Costs.
PRIVATE, EXTERNAL AND SOCIAL COSTS
Sometimes, there is a discrepancy between the cost incurred by a firm and the cost that must be
incurred by the society as a whole. For example, a factory may dispose of its untreated waste into a
river or a lake. Such a method of waste disposal may minimize the private cost but it does impose a
cost to the society in the form of polluted waterways. A cost that is not borne by the firm, but is
incurred by others in society is called an external cost. The true cost to the society must include all
costs regardless of who bears them. Thus, the social cost is the sum of private and external cost. This is
Social cost = Private Cost + External Cost
Or
External Cost = Social Cost- Private Cost
SHORT RUN AND LONG RUN COSTS
Economist usually distinguishes between short run and long run costs on the basis of functional or
operational time period in production activity.
The short run costs are operating costs associated with the change in output. In the short run, the
production function contains a set of fixed factor input and a set of variable inputs. Short run costs vary
in relation to the variation in the variable input component only.
The long run costs are the operating costs associated with the changing scale of output and the
alteration in the size of plant. In the long run production function all the factor inputs are variable. Their
costs are the long run costs.
TOTAL COST, AVERAGE COST AND MARGINAL COST
Total cost includes all cash payments made to hired factors of production and all cash charges imputed
for the use of the owners factors of production in acquiring or producing a good or service. Thus total
cost of a firm is the sum total of the explicit plus implicit expenditures incurred for producing a given
level of output. For example, a shoe makers cost will include the amount he spends on leather, thread,
rent for his workshop, wages, interest on borrowed capital and salaries of employees etc. and the
amount he charges for his services and his own funds invested in the business.
Average cost is the cost per unit of output. At a given level of output, say, it can be calculated as
Average Cost=Total Cost/Total Quantity produced or AC n=TCn/n
Marginal cost is the extra cost of producing one additional unit. At a given level of output, say n,
Marginal Cost canbe calculated as
Marginal Cost=Total Cost at current level- Total Cost at previous level, MC n=TCn-TCn-1
140
120
100
80
60
40
20
0
0

Average Costs

10

12

Marginal Costs

FIXED & VARIABLE COSTS

All the costs faced by companies/ business organizations can be categorized into two main types:
1. Fixed costs
2. Variable costs
Fixed costs are expenses that have to be paid by a company, independent of any business activity. It
is one of the two components of the total cost of goods or service, along with variable cost.

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Examples include rent, buildings, machinery, etc.

Variable costs are corporate expenses that vary in direct proportion to the quantity of output. Unlike
fixed costs, which remain constant regardless of output, variable costs are a direct function of
production volume, rising whenever production expands and falling whenever it contracts.
Examples of common variable costs include raw materials, packaging, and labor directly involved in a
company's manufacturing process.

SHORT-RUN COST-OUTPUT RELATIONSHIP

Once the firm has invested resources into the factors such as capital, equipment, building, top
management personnel, and other fixed assets, their amounts cannot be changed easily. Thus in the
short-run there are certain resources whose amount cannot be changed when the desired rate of
output changes, those are called fixed factors.
There are other resources whose quantity used can be changed
almost instantly with the output change and they are called variable
factors. Since certain factors do not change with the change in
output, the cost to the firm of these resources is also fixed; hence
fixed cost does not vary with output. Thus, the larger the
quantity produced, the lower will be the fixed cost per unit
and marginal fixed cost will always be zero.
On the other hand, those factors whose quantity can be changed in
the short-run is known as variable cost. Thus,
TOTAL COST: The total cost of a business is the sum of its total
variable costs (TVC) and total fixed cost (TFC).
TC=TFC+TVC
It should be noted that total fixed cost is the same irrespective of
the level of output. Therefore a change in total cost is influenced by
the change in variable cost only.
AVERAGE FIXED COST (AFC):The average fixed cost is the fixed cost per unit of output. It is obtained
by dividing the total fixed cost by the number of units of the
commodity produced.
AFC = TFC / Q
Where AFC = Average fixed Cost
TFC = Total Fixed cost
Q = number of units of output produced
AVERAGE VARIABLE COST (AVC): Average variable cost is the
variable cost per unit of output. It is the total variable cost divided
by the number of units of output produced.
AVC = TVC / Q
Where AVC = Average Variable Cost
TVC = Total Variable Cost
Q = number of units of output produced
Average variable cost curve is U Shaped. As the output increases,
the AVC will fall up to normal capacity output due to the operation
of increasing returns. But beyond the normal capacity output, the
AVC will rise due to the operation of diminishing returns.
AVERAGE TOTAL COST OR AVERAGE COST (SHORT RUN PER UNIT COST): Average total cost is
simply called average cost which is the total cost divided by the number of units of output produced.
ATC = TC / Q
Where ATC = Average Total Cost
TC = Total Cost
Q = number of units of output produced
Average cost is the sum of average fixed cost and average variable cost.
ATC = AFC+AVC
RELATIONSHIP BETWEEN MARGINAL COST AND AVERAGE COST:
There is a unique relationship between AC (ATC as well AVC) and MC that is described as below:
1. When AC is lowest MC is equal to AC. Thus MC intersects AC at its lowest point.
2. When AC is falling, MC is always below AC. In fact, it is the MC that pulls down AC along with its.
The point to note here is that MC may be rising, but will remain below AC.
3. When AC is rising, MC must be above AC.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

LONG-RUN COST-OUTPUT RELATIONSHIP

The long-run is a period of time during which the firm can vary all its inputs. None of the factors is fixed
and all can be varied to expand output.
It is a period of time sufficiently long to permit the changes in plant like: the capital equipment,
machinery, land etc., in order to expand or contract output.
The long-run cost of production is the least possible cost of production of producing any given level of
output when all inputs are variable including the size of the plant. In the long-run there is no fixed
factor of production and hence there is no fixed cost.
If Q=f(L,K)
TC=L.PL+K.PK
Given factor prices and a specific production function one can draw an expansion path which gives the
least costs associated with various levels of output which in fact yields the long-run total cost
schedule/curve. LTC is an increasing function of output. The rates of change in these two variables are
not known unless the qualitative relationship is quantified. If one recalls the concepts of returns to scale
and assumes fixed factor prices, one could see three things: Increasing Rate of Return, Constant
Rate of Return and Decreasing Rate of Return.

Point of Inflection Point of Kink

Long Run Total Cost (LTC)

Diseconomies of Scale
Long Run Average Cost (LAC)
Economies of Scale
Long Run Marginal Cost (LMC)

RELATIONSHIP BETWEEN MARGINAL COST AND AVERAGE COST:

The relationship between LAC and LMC follow from that of LTC curve. Both LAC and LMC are U-shaped.
Further the following relationships hold good:
(a) At the point of inflection on LTC curve (A), LMC takes the minimum value (at K).

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(b) At the point of Kink of LTC curve (B)where the slope of the straight line from origin to the LTC
curve is the minimumLAC assumes the minimum value (at K1).
(c) LAC is the least (at K1) when LMC=LAC.
(d) LAC curve is falling when LMC < LAC.
(e) LAC curve is rising when LMC > LAC.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

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LONG-RUN AVERAGE COST CURVE IS DERIVED FROM SHORT-RUN COST CURVES

In the following diagram SRAC A, SRACB and SRACC refer to the short run cost curve corresponding to the
different scales of operations. In the following situations the firm will be producing the desired output at
the lowest cost, for example, OQ1 output is produced at PM1 in the scale of operations represented by
the curve SRACA. OQ2 will be produced on SRACB and so on.
However, it is imperative that only in the long-run the scale of operations can be altered; in the shortrun, in it will be fixed and the average cost of output above or below the optimum level will necessarily
rise along the short-run cost curve in question whether it will be SRAC A, SRACB and SRACC and so on.
Thus to optimize its cost a production system it must run along the lowest point of each of the SRAC
curve in the long run resulting in a long run average cost (LRAC) Curve.

Cost per Unit output

Cost per Unit output

IMPORTANT FEATURES OF LONG RUN AC

1.

CURVES

LRAC Curve

Tangent
curve

Different SAC
represent

curves
different
operational capacities
plants in the short run.
curve is locus of all

of
these

different
LAC
points of

tangency.
The SAC curve can never cut a
LAC
curve
Output per time period (Units)
Output
per
time
period
(Units)
though they are tangential to each other. This implies that for any
given level of
output, no SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the
ling run. Thus, LAC curve is tangential to various SAC curves.
2. Envelope curve
It is known as Envelope curve because it envelopes a group of SAC curves appropriate to different
levels of output.
3. Flatter U-shaped or dish-shaped curve.
The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and much flatter
in nature. LAC gradually falls and rises due to economies and diseconomies of scale.
4. Planning curve.
The LAC cure is described as the Planning Curve of the firm because it represents the least cost of
producing each possible level of output. This helps in producing optimum level of output at the
minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant. Optimum
scale plant is that size where the minimum point of SAC is tangent to the minimum point of LAC.
5. Minimum point of LAC curve should be always lower than the minimum point of SAC
curve.
This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The LAC curve
will touch the optimum plant SAC curve at its minimum point.
A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at which
SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In the diagram,
OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At OM2 output LAC =
SAC.

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LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of the
optimum scale. But at these points of tangency, neither LAC, nor SAC is least. SAC curves are either
rising or falling indicating a higher cost.

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ECONOMIES OF SCALE

Economies mean advantages. Scale refers to the size of unit. Economies of Scale refers to the cost
advantages due to the larger size of production. As the volume of production increases, the overhead
cost will come down. The bulk purchase of inputs will give a better bargaining power to the producer
which will reduce the average variable cost too. All these advantages are due to the large scale
production and these advantages are called economies of scale.
During Economies of scale output grows proportionately faster than the use of inputs. With prices
remaining constant, this leads to lower costs per unit. Thus, the primary reason for scale economies, in
the long run, is the increasing returns to scale in the firms long run production function.
There are two types of economies of scale
a) Internal economies of scale; b) External economies of scale
A) INTERNAL ECONOMIES OF SCALE
Internal economies of scale are the advantages enjoyed within the production unit. These economies
are enjoyed by a single firm independently of the action of the other firms. For instance, one firm may
enjoy the advantage of good management; another may have the advantage of more up-to-date
machinery. There are five kinds of internal economies. They are
1. Technical Economies: As the size of the firm is large, the availability of capital is more. Due to this,
a firm can introduce up to- date technologies; thereby the increase in the productivity becomes
possible. It is also possible to conduct research and development which will help to increase the quality
of the product.
2. Financial Economies: It is possible for big firms to float shares in the market for capital formation.
Small firms have to borrow capital whereas large firms can buy capital.
3. Managerial Economies: Division of labor is the result of large scale production. Right person can
be employed in the right department only if there is division of labor. This will help a manager to fix
responsibility to each department and thereby the productivity can be increased and the total
production can be maximized.
4. Labor Economies: Large Scale production paves the way for division of labor. This is also known as
specialization of labor. The specialization will increase the quality and ability of the labor. As a result,
the productivity of the firm increases.
5. Marketing Economies: In production, the first buyer is the producer who buys the raw materials.
As the size is large, the quantity bought is larger. This gives the producer a better bargaining power.
Also he can enjoy credit facilities. All these are possible because of large scale production. Buying is the
first function in marketing.
6. Economies of survival: A large firm can have many products. Even if one product fails in the
market, the loss incurred in that product can be managed by the profit earned from the other products.
B) EXTERNAL ECONOMIES OF SCALE
When many firms expand in a particular area i.e., when the industry grows they enjoy a number of
advantages which are known as external economies of scale. This is not the advantage enjoyed by a
single firm but by all the firms in the industry due to the structural growth.
They are
a) Increased transport facilities
b) Banking facilities
c) Development of townships
d) Information and communication development
All these facilities are available to all firms in an industrial region.

DISECONOMIES OF SCALE

The diseconomies are the disadvantages arising to a firm or a group of firms due to large scale
production after reaching optimum level of operation.
Internal Diseconomies of Scale
If a firm continues to grow and expand beyond the optimum capacity, the economies of scale disappear
and diseconomies will start operating. For instance, if the size of a firm increases, after a point the
difficulty of management arises to that particular firm which will increase the average cost of
production of that firm. This is known as internal diseconomies of scale.
External Diseconomies of Scale
Beyond a certain stage, too much concentration and localization of industries will create diseconomies
in production which will be common for all firms in a locality. For instance, the expansion of an industry
in a particular area leads to high rents and high costs. These are the external diseconomies as this
affects all the firms in the industry located in that particular region.

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MGT 105: MANAGERIAL ECONOMICS: UNIT-II

By Pashupati Nath Verma

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COST ESTIMATION AND FORECASTING

The estimation of cost can be classified in two broad categories:

1. Short Run Cost Estimation
2. Long Run Cost Estimation
SHORT RUN COST ESTIMATION: Purpose of the short run cost estimation helps in knowing the
behavior of Marginal Cost, which helps us in determining output and prices. Short run cost estimation
frequently employed the time series technique with data for a specific plant/firm over time to study
short run cost functions.
LONG RUN COST ESTIMATION: Long run Cost estimation helps us in determining most efficient size
of the plant. Long run cost estimation generally uses cross section analysis; in which, observation are
recorded in a particular time period for a number of plants of various sizes.
METHODS OF COST ESTIMATION: Four broad approaches for estimating costs are: Accounting
Method, Statistical or Econometric Method, Survivorship Method, Engineering Method
Accounting Method: Method classifies the data in to various categories (viz: fixed, variable and semivariable) and observation for these categories are taken for various level of outputs starting from
minimum to maximum. By plotting the output levels and the corresponding costs on a graph and
joining them by lines the costs are estimated,
Statistical or Econometric Method: In this method costs functions are estimated by using time
series data of the firm (in case of short run estimation) or uses cross section data of various firms (in
case of long term estimation) and costs functions are estimated by using methods of regression
analysis ( Econometric Method).
Survivorship Method: Method is based on rational that over the time only efficient size firm will
survive i.e. in general firm with lower average costs will survive. In this method firms are categorized
into size group, growth of each size group examined and finally size group whose share in the industry
grows more during the specified time period is considered to most efficient size group.
Engineering Method: under this approach, the cost function is estimated with the help of physical
relationship between input and output converted in to the money terms. Method is useful in case of no
historical data is available but requires sound knowledge of engineering and production process.
Once the cost function estimated cost forecast can be made easily.

COST REDUCTION AND COST CONTROL.

Cost reduction may be defined as the real and permanent reduction in the unit costs of goods
manufactured or services rendered without impairing their suitability for the intended use while Cost
control is defined as the regulation by executive action of the costs of operating an undertaking.
Cost reduction
1. Cost reduction represents achievement in
the reducing cost.
2. Cost reduction intermittent process.
3. Cost reduction involves innovation to
reduce cost.
4. Cost reduction can be applied to every
aspect of business.
5. Cost reduction is a corrective function.
6. Cost reduction focuses on present and
future costs.
7. Cost reduction recognizes no condition as
permanent to reduce costs.
8. Tools:
Brain
Storming,
Technological
Changes

Cost control
1. It represents keeping costs under control to
a targeted level.
2. It is as Continuous process.
3. It involves standardization to maintain cost.
4. It is limited to the aspects where costs can
be standardized.
5. It is preventive function.
6. It focuses on past and present costs.
7. It seeks to attain lowest possible costs
under prevailing condition.
8. Tools: Budgetary Control, Standard Costing,
Costs Ratios

By Pashupati Nath Verma