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Managerial Economics

Cost and Production Analysis

Production Function

Refers to a functional relationship, under given


technology, between physical rates of input and output
of a firm, per unit of time
Q = f( Ld, L, K, M, T, t)
Q = f (L, K)

Inputs based on short run & Long run

Variable input: An input for which the level of usage may


be changed quite readily.
Fixed input: An input for which the level of usage cannot
readily be changed and which must be paid even if no
output is produced.
Quasi-fixed input
An input employed in a fixed amount for any positive level
of output that need not be paid if output is zero

Types of Production Function based on Time


Short Run: defined over as period of time over which
inputs of some factors of production cannot be varied
Q = f (L)
Long Run: defined as a period of time over which all
factors become variable
Q = f (L, K)

Laws of Production
Short run Laws of Production

In short run input output relation are studied with one


variable input, other inputs as constant
With one variable input (Law of Variable Proportions/
Law of Diminishing Marginal Product)
Long run laws of Production
With all variable inputs (Law of Returns to Scale)

Total Product & Average Product

Total Product (TP) refers to total number of units of


output produced per unit of time by every possible
combination of factor inputs.
Average product (AP) refers to total product per unit
of a given variable factor. Thus dividing total
product by quantity of variable factor,
i.e. AP = TP/QVF

Marginal Product

Marginal Product (MP) : Owing to addition of a


unit to a variable factor, all other factors being
held constant, the addition realized in total
product is referred to as marginal product, ie
MP= TPN-TPN-1
Also MP = TP/ QVF
= a small change

Statement of Law of Diminishing Marginal Product


During short period under given state of technology and
with given fixed factors, when units of a variable
factor are increased in order to increase total product,
TP may initially rise at an increasing rate and after a
point it tends to increase at a diminishing rate because
marginal product of variable factor in beginning may
tend to rise but eventually tends to decrease.

Illustration
Consider the Kitchen at Mels hot dogs, a restaurant that sells hot
dogs, French fries and soft drinks. Mels kitchen has one gas
range for cooking hot dogs, one deep fryer for cooking French
fries and one soft drink dispenser. One cook in the kitchen can
prepare 15 meals (consisting of a hot dog, fries and soft drink)
per hour. Two cooks can prepare 35 meals per hour. The marginal
product of the second cook is 20 meals per hour. Adding a third
cook results in 50 meals per hour being produced, so the marginal
product of third cook is 15 (= 50 35) additional meals per hour.

Contd..
Therefore, after the second cook, the marginal product of
additional cooks begins to decline. The fourth cook, for example
can increase the total number of meals to 60 per hour marginal
product of just 10 additional meals. A fifth cook adds only 5 extra
meals per hour, an increase to 65 meals. While the 3rd, 4th and 5th
cooks increase the total number of meals prepared each hour, the
marginal contribution is diminishing because the amount of space
and equipment in kitchen is fixed, (i.e. capital is fixed). Mel
could increase the size of the kitchen or add more cooking
equipment to increase the productivity of all workers.

Law of Variable Proportions OR


Law of Diminishing Returns (DMR)

Law states when more and more units of a variable input


are applied to a given quantity of fixed inputs, the total
quantity may initially increase at an increasing rate and
then at a constant rate but it will eventually increase at
diminishing rates.
Assumptions
Technology is constant
Labor is homogenous
Input prices are given

Production Schedule showing diminishing returns


Units of
Variable Input
(L)

TP

AP

MP

20

20

20

50

25

30

90

30

40

120

30

30

135

27

15

144

24

147

21

148

18.5

148

16.4

10

145

14.5

-1

Stages of Returns

Increasing Returns
Stage I

Decreasing Returns
Stage II

Negative Returns
Stage III

Note regarding Production schedule

Law of DMR becomes evident in the marginal product column.


Initially, MP of variable input [L] rises. TP rises at an increasing rate
[=MP]. AP also rises . This is describes as stage of increasing returns.
When 4th unit of labor is employed MP begins to diminish. Thus the
rate of increase in TP slows down. This is the stage of diminishing
returns.
When AP is maximum, MP=AP
As MP tends to diminish, ultimately becomes zero and negative
thereafter [stage 3]
When MP is zero TP is maximum. Further when MP becomes
negative TP begins to decline in same proportion

Note: short run Law of DMR


The optimizing rule in the context
of a
production function with only one variable input
is to employ that number of units of the input at
which the marginal revenue product equals the
marginal variable cost or marginal factor cost.

Law of Returns to Scale-Long Run

In long run size of firm can be expanded as scale of production


is enhanced as all factors are variable
Returns to Scale refers to degree by which output changes as a
result of given change in the quantity of all inputs in production
Statement of Law:
As a firm in long run increase quantities of all factors
employed, other things being equal, output may rise initially at a
more rapid rate than rate of increase in inputs, then output may
increase in same proportion of input, and ultimately output
increase less proportionately.

Three Phases of returns in long run:

Law of Increasing returns: Percentage increase in input will


lead to greater increase in output
Q/Q > F/F
Reasons: improvements in large scale operations, division of
labor, use of technology, and realization of other internal
economies such as managerial economies.
If there are increasing returns then it is economically
advantageous to have one large firm producing at relatively
low cost rather than to have many small firms at relatively high
cost. This rationalizes the existence of large power companies

Contd..

Law of Constant returns: Percentage increase in input


will lead to same percentage increase in output
Q/Q = F/F
Law of constant returns tends to operate when economies
and diseconomies of scale are exactly in balance over a
range of output.
With constant returns to scale the size of firms operation
does not affect the productivity of its factors.

Contd..

Law of Decreasing Returns: Percentage increase in output is less


than percentage increase in input, Q/Q <F/F
Reasons:
Though all factors inputs are increased proportionately,
organization and management as a factor cannot be increased
in equal proportion
Business risk increases more than proportionately when scale
of production is enhanced
Diseconomies of large scale production set in
Imperfect substitutability of factors causes diseconomies
resulting in a declining marginal output

Economies of Scale

Term Economies refer to cost advantages


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).

Internal economies of scale

As a firm expands its scale of operations, its costs will fall due to
the benefits arising from expansion known as internal economies
of scale. These benefits can be assessed by looking at changes in
average costs at each stage of production as the firm moves into
long run.
By growing, a firm can expect to reduce its average costs and
become more competitive.
How does a firm expand? A firm can increase its scale of
operations in two ways.
Internal growth, also called organic growth
External growth, also called inorganic growth - by merging with
other firms, or by acquiring other firms

Types of Internal Economies


Labor Economies:
Division of labor resulting in greater degree of
specialization
Able to attract efficient labor as it can offer a wide vertical
mobility, better prospects of promotion, etc
Technological Economies:
More mechanized operations: At higher scale of operations
more specialized and productive machinery can be used. For
example using a conveyor belt to unload a small truck may
not be justified, but it greatly increases efficiency in
unloading a train or ship.

Types of Internal Economies


Financial economies:
Fund raising capacity of the firm increases: Large firms can
usually sell bonds and shares more favorably and receive
bank loans at lower interest rates than smaller firms.
Risk bearing Economies:
By diversification of Market
Large firms can also achieve economies of scale or decreasing
costs in advertising and other promotional efforts.

Types of Internal Economies


Marketing Economies
Buying material in bulk at cheaper cost
Selling and promotion costs are lesser
Purchase can be done by experts
Managerial Economies:
More expertise personnel
Purchase economies:
When an organization make a bulk purchase it gets benefits
in the form of discounts

External economies of scale

The lowering of a firm's costs due to external factors. External


economies of scale will increase the productivity of an entire
industry, geographical area or economy. The external factors are
outside the control of a particular company, and encompass
positive externalities that reduce the firm's costs.
External Economies of Scale
Are those shared by a number of businesses in the same
industry in a particular area.
These are advantages gained for the whole industry, not just
for individual businesses.

Types of External Economies

Economies of Localization: When a number of firms


are located in one place all of them derive mutual
advantages through training of skilled labor, provision
of better facilities, etc. As businesses grow within an
area, specialist skills begin to develop. Skilled labour in
the area local colleges may begin to run specialist
courses.
Economies of Information: In large industry research
work is done jointly

Diseconomies of Scale
It occurs primarily because as the scale of operations
increases it becomes even more difficult to mange the firm
effectively and coordinate the various operations and
divisions of the firm.
The number of meetings, paperwork and telephone bills
increase more than proportionately to the increase in scale of
operation and it becomes increasingly difficult for top
management to ensure that their directives and guidelines are
properly carried out by their subordinates.
Thus efficiency decreases and costs per unit tend to rise.

Types
of
diseconomy
scale

Example
of

Communication

As firm grows there are 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
As a business grows control of activities gets harder
and
control As the firm gets bigger and new parts of the business are set up
problems
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

Diseconomies of scale

Difficulties of management
Difficulties of coordination
Difficulties of Management
Increased Risks
Labor Diseconomies
Scarcity of Factor Supplies
Marketing Diseconomies

Illustration

Consider a dairy farm. Milk production is a function of land, cows,


equipment and feed. A dairy farm with 50 cows will use an input mix
weighted toward labor and not equipment (i.e. cows are milked by hand). If
all inputs were doubled a farm with 100 cows could double its milk
production. The same will be true for the farm with 200 cows, and so forth.
In this case, there are constant returns to scale.
Large dairy farms however have the option of using milking machines. If a
large farm continues milking cows by hand regardless of the size of the
farm constant returns would continue to apply. However when the farm
moves from 5o to 1000 cows, it switches its technology toward the use of
machines and in the process is able to reduce its average cost of production
from Rs 10 to 7 per litre. In this case there are economies of scale.

Economies of scope

Cost savings when different goods/services are produced under one roof
Scope economies are cost advantages that stem from producing multiple
outputs
Big scope economies explain the popularity of multi-product firms.
Economies of scope exist when joint cost of producing two or more goods
is less than the separate costs of producing the goods. In case of two goods
X& Y ,
C(X,Y) < C(X) + C(Y)

Contd..

Economies of scope arise when inputs can be jointly


used to produce more than one product
It can also be in terms of administrative and
marketing resources
Eg: Commercial banks use the same assets to
provide variety of financial services, an oil well
produces both crude oil and natural gas

The Learning Curve

Learning economies are distinct from economies of


scale
Learning leads to lower costs, higher quality and more
effective pricing and marketing
Over a time when a firm accumulates its business
experience
it
may
tend
to
improve
its
production/organization methods with improved
knowledge and experience of management and labor
used in the production process. The firms learning
experience would pay in terms of cost reduction.
33

What is Learning curve??

In long run, these tends to the downward shifts in the


average cost curves of the firm on account of learning on
experience effect that improves productive efficiency of
the firm in its operations over time.
LER= [1 ACt1/ACt0] x 100

The Learning Curve


AC

AC1

AC2

Quantity
Q

2Q

35

Learning Curve Strategy

Expand output rapidly to benefit from the


learning curve and achieve a cost advantage
May lead to losses in the short term but
ensure long term profitability

36

Sum on Learning Curve Concept


Suppose a firm develops a new PC model in
1995 with an average costs of Rs. 30,000 per
unit. In 1996, however its average costs declined
to Rs. 24,000 when other things being given and
output is doubled. This may be simply attributed
to learning effect. What is the learning effect rate
[LER] in this case:

Cost Concepts

Fixed & Variable cost


Explicit & Implicit cost
Accounting & Economic Cost
Real cost
Private & Social Cost
Replacement cost
Historic & Future cost
Production and Selling cost

Social Costs

Social costs of a firm are those that the society in general


has to bear because of the firms activities . Social costs are
external cost from firms perspective and social costs from
society's point of view
These costs are arise due to the functioning of the firm but
are not explicitly borne by the firms
Social cost includes
Cost of resources for which the firm is not required to
pay a price i.e. atmosphere, rivers, lakes, etc
Cost in the form of disutility created through air, water
pollution, etc.

Social costs

The relevance of social costs lies in the social costs benefit


analysis of the overall impact of a firms operation on the
society as a whole and in working out the social cost of
private gains.
The concept of social cost in the corporate sector has given
rise to Corporate Social Responsibility (CSR).

Private costs

Private costs are those which are incurred by a firm.


Such costs are internalized costs that are
incorporated in the firms total cost of production
Thus the total cost of a firms commercial activity =
Private costs (internal ) + Social costs (external)

Replacement Cost

Replacement costs refer to the current price or cost of


buying or replacing any input at present.
Every machine or equipment has a certain life in terms
of its economic and technological utility. With expiry
of its economic life the equipment must be replaced.
Hence when an expenditure does not result in an
increase in total assets, it is known as replacement
cost a such as buying a new machine to replace the
old one.

Historic & Future Cost

Historic costs are incurred at the time of purchase of assets.


They are also regarded as sunk costs as they cannot be
retrieved from the business without loss.
It is the amount paid in the past which is no longer relevant
in decision making.
Costs that firm incurs by launching a portal which cannot
be recovered once the firm subsequently decides to
discontinue the portal.
Future costs include profit forecasting, capital expenditure
program, etc.

Production & Selling cost

Productions costs are the costs related to the level of


output.
Selling costs are incurred on making the output
available to the consumer.

Total Cost functions in the short run

Total cost (TC) is the full cost of producing any


given level of output.
Total cost is divided into two parts, fixed cost and
variable cost.
Total fixed cost (TFC) does not vary with the level
of output.
Total variable cost (TVC) varies directly with
output.
TC = TFC + TVC

Total Cost functions in the short run

Cost output relationship can be studied in short as well as long run


TFC remains constant at all levels so it is a straight line parallel to X
axis
TVC is an inverse S shaped upward sloping curve starting from origin.
The shape is determined by the law of Diminishing marginal returns.
According to this law as more & more units of variable factor are
added productivity initially increases at an increasing rate. This leads to
fall in per unit cost in the beginning, as we increase the variable factor,
other factors fixed, productivity of the input falls, so TVC curve is
steeper on the upper side
TC varies in same proportion as TVC since TFC is fixed.

Short-Run Cost Curves


Total cost & Average cost curves
TC

MC

TVC

TFC

Cost

Cost

ATC
AVC

AFC
Output

Average cost functions in the short run

AFC decreases as output increases. Since total fixed


costs remain same, AFC steeply initially spreading
overhead over more units and then gently
AVC is U shaped first decreases and then increases
as output increases, this can also be explained with
law of diminishing returns
ATC or AC is U shaped. The logic is when AFC &
AVC fall, AC falls. AVC soon reaches a minimum
and starts rising while AFC continues to fall

Relationship between AC & MC

When AC is minimum , MC is equal to AC


When AC is falling, MC curve lies below it
When AC curve is rising, after the point of
intersection MC curve lies above it
MC decreases initially but then increases as
output is increased
When AC is minimum, AC = MC

Shifts in Short-Run Cost Curves


A change in the price of any variable input
used by the firm will shift its ATC and MC
curves -- upward for a price increase and
downward for a price decrease.

AC,MC
MC1
MC0
ATC1
ATC0

Output

Cost schedule in short run for firm


Q

TFC

TVC

TC

AFC

AVC

AC

MC

100

100

100

25

125

100

25

125

25

100

40

140

50

20

70

15

100

50

150

33.3

16.6

50

10

100

60

160

25

15

40

10

100

80

180

20

16

36

20

100

110

210

16.3

18.3

35

30

100

150

250

14.2

21.4

35.7

40

100

300

400

12.5

37.5

50

150

100

500

600

11.1

55.6

66.7

200

Find out TC,AC and MC from the following table. Fixed


cost i.e., FC=300 RS
No. of units produced

Variable cost in Rs.

100

500

200

640

300

720

400

740

500

800

600

900

Complete the following table


units

TFC

20

TVC

TC
30

45

70

95

150

220

MC

AC

Sum
Suppose Marutis total cost of producing 5 cars
is 10.5 lakhs and its total cost of producing 6
cars is 12 lakhs, what is average cost of
producing six cars? What is marginal cost of
sixth car?

Long Run Cost behavior


LAC is derived as a tangent to various SAC curves appropriate
to different levels of output. Also referred to as envelope curve
LAC curve is less U shaped or rather dish- shaped. This means
in the beginning it gradually slopes downwards and after
reaching a certain point it gradually begins to slope upwards
This behavior of LAC is attributed to the operation of laws of
returns to scale. Internal Economies causes LAC curve to fall. It
remains constant when economies equal diseconomies. Net
diseconomies causes LAC to rise

Diagram for Economies and Diseconomies of


Scale

Types of Long run Cost Curves

Empirically it has been found that those industries where economies


of scale are numerous as well as deep and diseconomies take
considerable time to emerge LAC curve tends to decrease over long
range of output and thereafter it tends to remain constant over a
period of time
In petroleum refineries, railways, steel plants etc have confirmed to
this L shape (gradual)
In some cases LAC curve has a rapid downward slope up to a
certain range of output and thereafter curve becomes flat due to
adoption of scientific methods in business such as financial controls,
use of computers, delegation of decision making ie L shape (rapid)

L-shaped Cost Curve

In reality, cost curves are closer to L-shaped curves that to Ushaped curves
Returns to scale vary considerably across firms and industries.
Other things being equal, the greater the returns to scale, the
larger the firms in an industry are likely to be. Because
manufacturing involves large investments in capital equipment,
manufacturing industries are more likely to have increasing
returns to scale than service oriented industries. Services are
more labour intensive

58

Fixed Costs

Certain inputs in the production process may not fall


below a minimum
Increasing the volume of production yields
economies of scale in the short run
In the long run, economies of scale are obtained
through choice of technology

59

Short Run & Long Run Economies of Scale

Short run economies of scale through better capacity


utilization
Long run economies of scale can be achieved

by switching to high fixed cost technology


Outsourcing and nowadays firms also adopt global sourcing
and try to attain international economies of scale
or pursuing diversification as a growth strategy which can be
organic or inorganic. Generally firms pursue inorganic growth
strategies to be on higher growth trajectory (path). This is the
reason why firms pursue M&As (Mergers & Acquisitions)
60

Why Firms Diversify

To grow i.e. achieve economies of scale


To more fully utilize existing resources and
capabilities.
To escape from undesirable or unattractive industry
environments.
To make use of surplus cash flows.

Diversification as a growth strategy

Diversification strategies are used to expand firms' operations


by adding markets, products (related or unrelated), services, or
stages of production (value chain) or within the sector
(concentric) or across different sectors (conglomerate)
Types of Diversification:
Product diversification
Market development
Horizontal value chain
Vertical - value chain
Concentric, and
Conglomerate

Organic strategies

Refer to internal growth strategies that focus on growth by


the process of asset replication, exploitation of technology,
better customer relationship, innovation of new technology
and products to fill gaps in the market place.
It is a gradual growth process spread over a few years
Apple Inc. is probably an excellent example of Organic
Growth.
organic growth strategies are business development
techniques that grow a company via increased output and
larger sales volume.

Inorganic growth strategies

Refer to external growth by takeovers, mergers and


acquisitions, Joint ventures, strategic alliance. It is fast and
allows immediate utilization of acquired assets. It is less
risky as it does not result in expansion in capacity.
Microsoft, on the other hand is a clear case of In-Organic
growth as it has successfully completed more than 100
acquisitions since 1986.
Eg: Skype communication, Hotmail

Concentric Diversification

When in concentric diversification new product or service


is provided with the help of existing or similar technology
it is called technology-related concentric diversification.
For example, Mother dairy has added 'curd and Lassi to its
range of milk products.
In marketing-related concentric diversification, the new
product or service is sold through the existing distribution
system. For instance, a bank may start providing mutual
fund services to its customers.

Concentric Diversification

When a firm diversifies into some business which is


related with its present business in terms of marketing,
technology, or both, it is called concentric
diversification.
Firms generally pursue concentric diversification to
utilize the existing leverage or expertise that they have
within the sector and to become most dominant player of
that sector
Automobile companies, Real estate players, firms in the
IT sector generally pursue concentric diversification

Conglomerate Diversification

Conglomerate diversification occurs when there is no


relationship between the new and old lines of
business; the new and old businesses are unrelated.
a conglomerate is a multi-industry company.
Conglomerates are often large and multinational.
Several Indian companies have adopted this strategy,
Reliance, Sahara, Essar group, ITC, Godrej, are
examples of conglomerates

Conglomerate diversification

Firms pursue this strategy for several reasons:

Continue to grow after a core business has matured or


started to decline.
To reduce cyclical fluctuations in sales revenues and
cash flows.

Problems with conglomerate or unrelated


diversification:

Managers often lack expertise or knowledge about their


firms businesses.

Diversification: Vertical

Vertical integration occurs when firms undertake


operations at different stages of value chain.
In vertical integration new products or services are
added which are complementary to the present product
line or service. New products fulfill the firms own
requirements by either supplying inputs or by serving
as a customer for its output.
In vertical integration the firm moves backward or
forward from the present product or service.

Backward Integration

When a firm diversifies closer to the sources of raw


materials in the stages of production, it is following a
backward vertical integration strategy.
For example, a Car manufacturer may start producing
tire tubes;
Reliance Industries Ltd. Has been able to grow
largely through backward integration. It started
business with textiles and went for backward
integration to produce PFY and PSF critical raw
materials for textiles

Forward Integration

Forward integration means the firm entering into the


business of distributing or selling its present products.
It
refers
to
moving
upwards
in
the
production/distribution process towards the ultimate
consumer.
The firm sets up its own retail outlets for the sale of its
own products.
For example, many companies like Bata, Bombay
Dyeing, Raymonds and Reliance have set up their own
retail outlets to sell their fabrics.

Example of Vertical Integration

Oil companies, both multinational (such as Exxon


Mobil, Royal Dutch Shell, or BP) often adopt a
vertically integrated structure. This means that they
are active along the entire supply chain from
locating crude oil deposits, drilling and extracting
crude, transporting it around the world, refining it
into petroleum products such as petrol/gasoline, to
distributing the fuel to company-owned retail
stations, for sale to consumers.

Diversification: Horizontal

Horizontal integration or diversification involves the


firm moving into operations at the same stage of
production. In terms of value chain terminology, a
horizontal integration keeps the firm at the same level
of value chain.
Most commonly seen in Banking sector through
mergers & acquisitions
Advantage is to achieve economies of scale and scope

Minimizing costs internationally


International economies of scale

Firms must constantly explore sources of cheaper


inputs and overseas production in order to remain
competitive. This process can be regarded as
organization's international economies of scale. This
can be achieved in five basic areas: product
development, purchasing, production, demand
management and order fulfillment.

Global sourcing

Strategic procurement concept with an international


focus.
A cross-border search is conducted for suitable
suppliers that meet specific quality, time and price
requirements
Global sourcing is defined as the process of
identifying, developing, and utilizing the best source
of supply for the enterprise, regardless of location

Global sourcing

Most companies report a 10% to 35% cost savings by sourcing


from low-cost-country suppliers
These days, the likes of Big Bazaar, Ebony, Shoppers Stop,
Westside are looking to source merchandise at the lowest rates
globally.
Future Groups Pantaloon Retail India has just set up global
sourcing offices in Hong Kong and Mainland China the first
overseas sourcing operation by any domestic retail chain.
India's biggest carmaker Maruti Udyog Ltd is toying with the
idea of sourcing components from the global market as part of
its strategy to become more cost competitive.

Thank you

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