MGT 5103

Business Economics
02/04/2022 [10.45 am -12.45 pm]

Lecture Topic:

Production, Cost & Optimal Usage of Inputs

D. I. J. Samaranayake,
Department of Management Studies, Faculty of Management.
0
 Learning Objectives
By the end of this session you should be able to:
o outline some basic principles of production, in both short- and
long-run time periods
o explain the linkages between production and cost
o assess the relevance of costs to business decision making
o distinguish between the different types of business cost
o explain the relevance of price elasticity of supply to business
o suggest why larger businesses often have a cost advantage
over smaller businesses and why ‘outsourcing’ is becoming
increasingly important.
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What is Production?
Production
An activity of transformation, which
connects factor inputs and outputs.
Ultimately it is creation or addition of
value (increase consumer usability of
goods and services).
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Factors of Production
Land
Capital
Labour
Entrepreneurship
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“Materials and forces which nature
gives freely for man’s aid, in land and
water, in air and light and heat”
- Alfred Marshall

4
 Land
• Land is about natural resources found
within the economy.
• It includes land, fisheries, farms and other
similar natural resources.
• It is usually a limited source (supply fixed).
• Land can be renewable or non-renewable.
• Use of lands for industrial purposes allows
us to improve the production process.
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“A country’s capital is its stock of produced or man
made means of production, consisting of such items as
buildings, factories, machinery, tools, equipment and
inventories of goods in stock”
- Prof. Richard T. Gill

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 Capital
• Capital has been defined as “produced
means of production”.
• Capital can be classified into fixed capital
and working capital.
• Fixed capital are durable-use producer
goods which are used in production again
and again till they wear out.
• Working capital on the other hand are the
single-use producers’ goods. 7
Yes

8
 Labour
• A human factor and it should not be treated
as a saleable commodity like land capital.
• It includes all individuals capable of
working in the economy.
• Labour cannot be separated from the
labourer himself.
• It is a flexible resource.
• It is a perishable factor and not possible to
store it for future use. 9
Entrepreneur

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 Entrepreneurship
• The entrepreneurs bear risk and uncertainty
of the production work.
• Usually have an idea for creating a
valuable good or service and assume the
risk involved with the production process.
• Is to introduce innovations.

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Inputs Process Output

f
12
Short Run
Long Run
13
Short Run
Period of time in which at least one
factor of production is fixed and
cannot be changed. The length of this
time period will depend on the
economic activity under consideration.

14
Short Run
Long Run
15
Long Run
Period of time in which all factors of
production can be varied.

16
 Measuring Changes in Output
• Over time, firms vary the level of output they produce within
any given period. We define some important concepts used to
measure these changes in output.
• Total product (TP): total output a firm produces within a
given period of time.
• Average product (AP): usually measured in relation to a
particular factor of production, such as labour or capital.
𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 𝒐𝒇 𝑳𝒂𝒃𝒐𝒖𝒓 =
𝑻𝒐𝒕𝒂𝒍 𝑳𝒂𝒃𝒐𝒖𝒓 𝑰𝒏𝒑𝒖𝒕
• Marginal product (MP): the change in total product when one
more unit of the factor is used.
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕
𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 𝒐𝒇 𝑳𝒂𝒃𝒐𝒖𝒓 = 𝑪𝒉𝒂𝒏𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑳𝒂𝒃𝒐𝒖𝒓 𝑰𝒏𝒑𝒖𝒕
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Slide 3.18

• This ‘law’ applies to the short-run time period when at

least one factor of production (usually capital) is fixed.
• Increasing returns to the variable factor: output rises
more than in proportion to the variable factor.
• Diminishing returns: output rises less than in
proportion to the variable factor.

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Slide 3.19

Qx=f(L, K)
• Law of diminishing returns: In the short run,
in which at least one factor of production is
fixed, as a firm employs more of the variable
factor, it will eventually experience
diminishing returns to the variable factor.

19
Slide 3.20

§ Total product (TP): This is the total output that

the firm produces over a given period of time as
the number of workers employed is varied.
§ Average product (AP): The average product of
labour represents the output per worker.
§ Marginal product (MP): The marginal product
is the extra output obtained from the employment
of one extra worker.
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Slide 3.21

B Total product
M
15
Average product
A N

Output Q
Output Q

10

5 Marginal product

0
0 56 8 Units of 0 56 8 Units of
labour (L) labour (L)

Total, average and marginal product curves for the variable factor (labour)

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Slide 3.22

• Also called overhead or unavoidable costs.

• Do not vary with output.
• Include rent paid on the premises, rates, interest
payments on loans and hire purchase repayments.
• In the short run, at least one factor of production is
fixed.

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Slide 3.23

• Also called running costs, direct costs or

avoidable costs.
• Do vary with output.
• Include raw materials, wages of the operative
staff and the cost of fuel. When no output is
produced, no variable costs are incurred.
• In the long run, all the factors of production are
variable, and so all costs are variable.
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Slide 3.24

• The total cost of producing a particular

level of output.
• Total cost can be divided into total fixed
cost (TFC) and total variable cost (TVC)
so that:
TC = TFC + TVC
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Slide 3.25

• Average total cost is the cost per unit and is

obtained by dividing total cost by the number of
units produced. Average total cost (ATC)
comprises average fixed cost and average variable
cost so that:

• Average fixed cost is given by AFC = TFC/Q

• Average variable cost is given by AVC = TVC/Q
25
Slide 3.26

• Marginal cost is the change in the total cost as

a result of a change in the output of one unit.
!"#$%& '$ () ∆()
• 𝑀𝐶 = =
)"#$%& '$ *+,-+, ∆/

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Slide 3.27

Average and 45
marginal cost (£)
40
MC
• These are short-run cost curves.
35
The average fixed cost declines
continuously as output increases. 30

• The average variable cost and 25 ATC

average total cost curves are U- 20 AVC
shaped with the vertical distance
15
between the two representing the
average fixed cost. 10

• The marginal cost (MC) curve is also 5

AFC
U-shaped and cuts the AVC and ATC
0 1 2 3 4 5 6 7 8 9 10
curves at their minimum points. Output
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Slide 3.28

• Fixed costs: do not change with output

• Variable costs: do change with output
• Total costs: TC = TFC + TVC

• Average total cost: ATC = AFC + AVC

• Marginal cost: addition to total cost from
producing last unit of output
MCn = TCn - TCn-1
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Slide 3.29

MC
Product

Costs
AVC

AP
MP

0 Quantity of the 0
variable factor Q1 Q2 Output
L1 L2

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Slide 3.30

• In the long run all the factors of production are

variable.
• The long-run average cost (LRAC) curve is the
outer envelope to all the short-run average cost
curves.
• LRAC represents the lowest cost of producing
different levels of output when all factors can be
varied.
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Slide 3.31

The long-run average cost (LRAC) curve as the outer ‘envelope’ to a family of short-run
average cost (SRAC) curves

SRAC1 (K1)

SRAC2 (K2)
SRAC3 (K3)
C1
Cost (£)

AC
LR
C2

0 Q1 Q∗ Output

Economies of scale Diseconomies of scale

31
Slide 3.32

• Refers to the fall in the long-run average cost

curve as the output increases.
• Technical economies: relate to the increase in
size of the plant or production unit.
• Non-technical economies: relate to the increase
in size of the enterprise as a whole.

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Slide 3.33

• Specialisation.
• Indivisibility of large-scale processes (i.e. more
efficient, large-scale processes cannot be
reproduced at a smaller scale).
• ‘Engineers’ rule’ – area increases as the square
but volume (capacity) as the cube.
• Dovetailing of linked processes (i.e. lowest
common multiple is a large output).
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Slide 3.34

Advantages include: Disadvantages include:

• Increased productivity • Increased boredom
• Increased standard of living • Lack of variety
• Increased range of products • Worker interdependence
available. • Limited market size.

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Slide 3.35

Type of Factor inputs: Factor inputs: Output

process L (men) K (machines) X (units)

A Small-scale
1 1 1
process
B Medium-scale
100 100 1,000
process
C Large-scale
1,000 1,000 20,000
process

Indivisibility:
the physical inability, or economic inappropriateness, of running a machine or
some other piece of equipment at below its optimal operational capacity.
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Slide 3.36

• Area of larger motor vehicles, ships, planes,

containers etc. increases as the square.
• Material costs therefore increase as the square.
• Volume of larger motor vehicles, ships, planes,
containers etc. increases as the cube.
• Output (capacity) therefore increases as the
cube, so that material costs per unit of output fall
with size.
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Slide 3.37

• Final product depends on three processes – A, B and C

• Specialist machine needed for each process
• 3 units per hour, machine for Process A
• 4 units per hour, machine for Process B
• 5 units per hour, machine for Process C
• Lowest Common Multiple (LCM) is 60, i.e. the lowest
level of output where no waste/spare capacity exists
(20 x A, 15 x B and 12 x C)

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Slide 3.38

• Financial economies: Larger enterprises can raise financial

capital more cheaply (lower interest rates, access to share
and rights issues via Stock Exchange listings, etc.)
• Administrative, marketing and other functional economies
• Distributive economies: More efficient distributional and
supply-chain operations become feasible with greater size
• Purchasing economies: Bulk buying discounts are available
for larger enterprises.

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 Slide 3.39

• The more substantial the

economies of scale the steeper the
fall in the LRAC curve,
• The cost gradient measures the
steepness of the fall in LRAC up £ Q1 = MES
to MES. Q2 = ½MES
• It is expressed over the range of
the LRAC from ½ MES to MES
LRAC
or from 1/3 MES to MES.
• For example: the cost gradient for
an industry is expressed as 20% C2
from ½ MES to MES. LRAC′
C1
• This means that at output Q2, firm
will have average costs C2 which
is 20% higher than C1 which has Q2 Q1 Output
0
an output Q1 that is twice as large
Economies of scale
as Q2.
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Slide 3.40

• The steeper is the gradient of LRAC up to

MES, the greater is the cost disadvantage of
producing at a level of output below Q1 (MES)
in the long run.
• Two key issues for the organisation:
• The level of output at which MES occurs
• The steepness of LRAC up to MES.

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 Diseconomies of Scale
• If a firm attempts to produce beyond the MES
(Q1), then average costs will begin to rise and
we have the ‘U’-shaped LRAC curve.
• Diseconomies of scale and are usually
attributed to managerial problems in handling
output growth efficiently.

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Slide 3.42

• Internal – relate to the growth in size of the

organisation itself, whether a growth in the
production unit (technical economies) or in the
enterprise (non-technical economies).
• External – relate to the growth in size of the
industry or sector of which the organisation is a
part, e.g. growth of ready made garments
industry
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Slide 3.43

• Reduction in average costs through changing the mix of

production.
• Sources include selecting a product mix that:
• Can use joint inputs (e.g. common management,
marketing etc.)
• Involves products that are complements in production
(cars and trucks, teaching and research)
• Involves by-products that can be used constructively
(e.g. heat from one production process used as energy
in another).
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Slide 3.44

1,00
0

900
Cost/unit, C

800

700

600

500 Learning curve

400

300

200 0 1 2 4 8 12 16
Cumulative output, Q

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Slide 3.45

• Here it is cumulative output that matters, not

annual output.
• A smaller firm producing, say, 50,000 units in
total over 10 years (i.e. 5,000 units a year) is
likely to have gained more experience as regards
how to reduce costs than a larger firm
producing, say, 30,000 units in its first year.

45
Slide 3.46

• Short-run – continue to produce only if revenue

at least covers all the running costs [i.e. price
(AR) greater than or equal to AVC].
• Long-run – continue to produce only if revenue
at least covers all the costs of production,
including ‘normal profit’ [i.e. price (AR) greater
than or equal to ATC].

46
Slide 3.47

• A measure of responsiveness of quantity

supplied of X to a change in its own price

% change in quantity supplied of X

PES =
% change in price of X

47
Slide 3.48

• Mobility of the factors of production

• The time period under consideration
• Momentary period
• Short-run period
• Long-run period
• The existence of spare capacity
• The availability of stocks
• The willingness of the supplier to take risks
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Slide 3.49

• PES will be greater (more elastic)

• The more mobile are factors of production
• The longer the time period
• The less risk-averse the producer
• The fewer the natural constraints on
production

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Slide 3.50

S0
Price S1
S2

P1

P0

0 q0 q1 q2 Quantity

The figure illustrates momentary, short- and long-run supply curves. The long-run supply
curve S2 is more elastic than the short-run supply curve S1, over the price range P0 to P1.
The momentary supply curve S0 is perfectly inelastic.
50
Slide 3.51

• Firms continually review where to locate

different elements of the value chain in order to
minimize costs.
• The idea of Relative Unit Labour Costs
(RULCs) is important here .

51
Slide 3.52

Relative Labour Cost

RULC = x Relative Exchange Rate
Relative Labour Productivity

• There are considerable differences between

countries, at least as regards relative labour
costs, as indicated in the following table.

52
Slide 3.53

Country Total labour costs ($ per hour)

India 0.9
China 1.4
Mexico 4.0
Brazil 8.3
Greece 19.6
US 32.3
UK 35.8
Ireland 44.8
Germany 48.2
Euro Area 43.3
East Asia (except Japan) 13.3
Source: adapted from US Bureau of Labor Statistics (2010)

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Thank you!

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