Managerial Economics Chapter 6: Production and Cost Analysis

CHAPTER SIX

PRODUCTION AND COST ANALYSIS

6.1. Theory of Production

Production is a process of converting an input into a more valuable output. The analysis of
demand is mainly used for planning the production process and determining the level of
production. For equilibrium, supply should be equal to demand. Production is an aspect of the
supply side of the market. For clarity let us see the following diagram about how the shoe
production takes place.

Input Process Output

For example: Leather from animal’s skin (Input) dying, cutting, shaping (process) leather shoe
(output).

The inputs could be land, labor, capitals, entrepreneurship etc. and the output could be goods or
services. Production is an important economic activity which satisfies the wants and needs of the
people. Production function brings out the relationship between inputs used and the resulting
output. A firm is an entity that combines and processes resources in order to produce output that
will satisfy the consumer’s needs. The firm has to decide as to how much to produce and how
much input factors (labor and capital) to employ to produce efficiently.

The production theory stresses the efficient use of inputs for producing the desired output. This
can be achieved either by using the minimum input to produce a defined level of output or
producing maximum output for a give input.

What is production theory? Essentially it examines the physical relationships between inputs and
outputs. By physical relationships we mean relationships in terms of the variables in which
inputs and outputs are measured.
 Production is basically an activity of transformation, which connects factor inputs and
output
 Production is an activity that increases consumer usability of goods and services

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Managerial Economics Chapter 6: Production and Cost Analysis

 Managers are concerned with these relationships because they want to optimize the
production process, in terms of efficiency.

6.1.1. Factors of Production

This term refers to inputs or resources. They refer to anything used in the production and
distribution of goods and services. When economists use the term factors of production they
usually classify them into three, or sometimes four, categories: land, labor and capital.
Entrepreneurship is sometimes added as a fourth factor.

a) Land

Land is really a combination of two different factors. First, there is the area of land that is needed
to produce the good. This may be agricultural land, factory area, shop space, warehouse space or
office space. Second, land relates to all-natural resources that are anything that comes from the
surface of the land, underneath it or on top of it. Thus we include minerals, crops, wood, and
even water and air, though it may seem strange to refer to these as land.

b) Labor

Labor is the easiest of the factors to understand, the input of labor being measured in number of
workers, or more precisely, in number of hours worked. Of course, labor is not homogeneous
and manual labor is often divided into unskilled, semi-skilled and skilled categories. Labor also
includes administrative and managerial workers, though some empirical studies have omitted this
important input. In practice we may wish to distinguish between these different categories of
labor, especially if we want to evaluate their different contributions to output, as will be seen.

c) Capital

This term can again be confusing to students. It does not refer to money, or to capital market
instruments; rather it refers to capital goods, that is plant and machinery. Like labor, this is a
highly heterogeneous category, and in practice we might want to distinguish between different
types of capital, again especially if we want to evaluate their different contributions to output.
For example, we may want to classify personal computers, photocopying machines, printers, fax
machines and coffee machines separately.

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Managerial Economics Chapter 6: Production and Cost Analysis

d) Entrepreneurship

Entrepreneurship refers to the ability to identify and exploit market opportunities. It therefore
includes two separate functions. This input is often not considered in economic analysis; it is
really more relevant in long-run situations, and it is notoriously difficult to measure. For one
thing it is difficult to separate entrepreneurship from management; top management should be
concerned with both the functions of entrepreneurship, if they are truly representing the interests
of shareholders.

6.1.2. Production of Functions

A tool of analysis used in explaining the input-output relationship. It describes the technical
relationship between inputs and output in physical terms. In its general form, it holds that
production of a given commodity depends on certain specific inputs.

These represent the relationships between inputs and outputs in symbolic or mathematical form.
In general terms we can say that any production function can be expressed as:
= ( ; ; ; ……; )
Where Q represents output of a product and ; ; ; ……; represents the various inputs.
This function is often expressed as:
= ( , )
Where L represents the labor input and K represents the capital input. This is obviously a
considerable oversimplification since not only can there be more inputs but there can also be
more outputs, with a complex relationship between them.

Inputs are commonly classified as fixed inputs or variable inputs. Fixed inputs are those inputs
whose quantity cannot readily be changed when market conditions indicate that an immediate
adjustment in output is required. In fact, no input is ever absolutely fixed but may be fixed
during an immediate requirement. For example, if the demand for Beer rises suddenly in a week,
the brewery factories cannot plant additional machinery overnight and respond to the increased
demand. Buildings, land and machineries are examples of fixed inputs because their quantity
cannot be manipulated easily in a short period of time. Variable inputs are those inputs whose
quantity can be altered almost instantaneously in response to desired changes in output. That is,
their quantities can easily be diminished when the market demand for the product decreases and

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Managerial Economics Chapter 6: Production and Cost Analysis

vice versa. The best example of variable input is unskilled labour. Not all labor may be easily
varied however, since salaried staff may have long-term contracts, making it difficult to reduce
this input.

6.1.3. Period of Production

a) The Short Run
This is again a term that has a different interpretation in economics from other aspects of
business, including finance. In finance the short run or short term refers to a period of a year or
less. In economics this is not such a useful definition because it does not permit so many
generalizations, bearing in mind the large differences between firms in terms of their business
environments. It is therefore more useful to define the short run as being the period during which
at least one factor input is fixed while other inputs are variable. In practice this will vary from
firm to firm and industry to industry according to the circumstances. It also means that a firm
might have several short-run time frames as more and more factors become variable. This tends
to be ignored in analysis since the same general principles apply to any short-run situation, as
long as at least one factor is fixed. Sometimes economists refer to the ‘very short run’, defined as
being the period during which all factors are fixed. Although output cannot be varied under such
circumstances, different amounts can be supplied onto the market depending on inventory levels.

b) The Long Run

This is the converse of the short run, meaning that it is the period during which all factors are
variable. It may seem initially that this circularity is a problem and is not getting us anywhere,
but we will see that these definitions permit some very useful analysis. Some economists also
refer to the ‘very long run’, which they define as being the period during which technology can
also change. However, this is not a frequently used term, perhaps because technology is
changing more quickly now; most economists assume that technology is changeable in the long
run but not in the short run.

Thus, the production manager’s responsibility is that of identifying the right combination of
inputs for the decided quantity of output. As a manager, he has to know the price of the input
factors and the budget allocation of the organization. The major objective of any business
organization is maximizing the output with minimum cost. To achieve the maximum output the
firm has to utilize the input factors efficiently. In the long run, without increasing the fixed

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factors it is not possible to achieve the goal. Therefore, it is necessary to understand the
relationship between the input and output in any production process in the short and long run.

6.1.4. Measures of Productivity

There is some measure of productivity. These are total product (TP), marginal product (MP) and
average product (AP). The total product (TP) is the total amount of output resulting from the use
of different quantities of inputs. If we assume labor (L) to be the variable input assuming
(capital, etc., held constant) then marginal product of labor (MPL) is defined as the change in
total product (TP) per unit change in variable input, say labor (L).

= =

Where, ΔTP stands for change in total production, ΔL stands for change in labor input.

Average Product (AP): Average product of an input is the level of output that each unit of input
produces, on the average. It tells us the mean contribution of each variable input to the total
product. Mathematically, it is the ratio of total output to the number of the variable input. The
average product of labour (APL), for instance, is given by:

Similarly, average product of labor may be defined as Where, TP stands for total production.
APL stands for average product for labor.

Example 6.1

Assume that capital is fixed at 1 unit, while L increases. Table 6.1 shows that the total product
reaches a maximum of 27 when 6 units of labor are used. The MP of labor for the 2 nd unit of
labor is 6. It then increases to 7 and ultimately becomes negative. Average product of labor also
first increases and then falls. The production function expressed in tabular form is as follows.

Generally, the relationship between MPL and APL can be stated as follows.
 When is increasing, > .
 When is at its maximum, = .
 When is decreasing, < .

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Managerial Economics Chapter 6: Production and Cost Analysis

Table 6.1: TP, MP and AP

We can also express the relationship between Total product, average product and marginal
product curves through graph as shown in Figure 6.1.

6.1.5. The Law of Diminishing Returns/ Law of Variable Proportions

In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a
person preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the
later stages. There is a limit to the extent to which one factor of production can be substituted for
another. The total production increases up to an extent and it gets saturated or there won’t be any
change in the output due to the addition of the input factor and further it leads to negative impact
on the output. That means the marginal production declines up to an extent and it reaches zero
and becomes negative. The point at which the MP becomes zero is the maximum output of the
firm with the given set of input factors.

The law states that as more and more of one factor input is employed, assuming all other input
quantities held constant, a point will eventually be reached where additional quantities of the
varying input will yield diminishing marginal contributions to total product.

The law of variable proportions states that as successive units of a variable input(say, labour) are
added to a fixed input (say, capital or land), beyond some point the extra, or marginal, product
that can be attributed to each additional unit of the variable resource will decline.

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6.1.6. Stages of production

We are not in a position to determine the specific number of the variable input (labour) that the
firm should employ because this depends on several other factors than the productivity of labour.
However, it is possible to determine the ranges over which the variable input (labour) be
employed. To this end, economists have defined three stages of short run production.

Stage I: This stage of production covers the range of variable input levels over which the
average product (APL) continues to increase. It goes from the origin to the point where the APL
is maximum, which is the equality of MPL and APL (up to L2 level of labour employment in
figure 6.1). This stage is not an efficient region of production though the MP of variable input is
positive. The reason is that the variable input (the number of workers) is too small to efficiently
run the fixed input so that the fixed input is under-utilized (not efficiently utilized).

Figure 6.1: Stages of Production

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Managerial Economics Chapter 6: Production and Cost Analysis

Stage II: It ranges from the point where APL is at its maximum (MPL=APL) to the point where
MPL is zero (from L2 to L3 in figure 6.1). Here, as the labour input increases by one unit, output
still increases but at a decreasing rate. Due to this, the second stage of production is termed as the
stage of diminishing marginal returns. The reason for decreasing average and marginal products
is due to the scarcity of the fixed factor. That is, once the optimum capital-labour combination is
achieved, employment of additional unit of the variable input will cause the output to increase at
a slower rate. As a result, the marginal product diminishes. This stage is the efficient region of
production. Additional inputs are contributing positively to the total product and MP of
successive units of variable input is declining (indicating that the fixed input is being optimally
used). Hence, the efficient region of production is where the marginal product of the variable
input is declining but positive.

Stage III: In this stage, an increase in the variable input is accompanied by decline in the total
product. Thus, the total product curve slopes downwards, and the marginal product of labour
becomes negative. This stage is also known as the stage of negative marginal returns to the
variable input. The cause of negative marginal returns is the fact that the volume of the variable
inputs is quite excessive relative to the fixed input; the fixed input is over-utilized. Obviously, a
rational firm should not operate in stage III because additional units of variable input are
contributing negatively to the total product (MP of the variable input is negative). In figure 6.1,
this stage is indicated by the employment of labour beyond L3.

In economics, the production function with one variable input is illustrated with the well-known
law of variable proportions. It shows the input-output relationship or production function with
one factor variable while other factors of production are kept constant. To understand a
production function with two variable inputs (Long run production), it is necessarily known the
concept iso-quant or iso-product curve.

Iso-Quants
To understand the production function with two variable inputs, iso-quant curve is used. These
curves show the various combinations of two variable inputs resulting in the same level of
output. The shape of an Iso-quant reflects the ease with which a producer can substitute among
inputs while maintaining the same level of output. From the graph we can understand that the
iso-quant curve indicates various combinations of capital and labor usage to produce 100 units of

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Managerial Economics Chapter 6: Production and Cost Analysis

motor pumps. The points a, b or any point in the curve indicates the same quantum of
production. If the production increases to 200 or 300 units definitely the input usage will also
increase therefore the new iso-quant curve for 200 units (Q1) is shifted upwards. Various iso-
quant curves presented in a graph is called as iso-quant map.

Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

Figure 6.2: isoquant curve

The above graph explains clearly that the iso quant curve for 100 units of motor consist of ‘n’
number of input combinations to produce the same quantity. For example, at ‘a’ to produce 100
units of motors the firm uses OC amount of capital and OL amount of labor i.e., more capital and
less labor forces. At ’b’ OC1 amount of capital and OL1 labor force is used to produce the same
that means more labor and less capital.

Optimal input combination: The points of tangency between iso-quant and iso-cost curves depict
optimal input combination at different activity levels.

Figure 6.3: Iso-quant curve and Iso-cost curve

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Managerial Economics Chapter 6: Production and Cost Analysis

6.1.7. Cobb Douglas Production Function

This is a function that defines the maximum amount of output that can be produced with a given
level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labor (L) and capital (K). The general equilibrium for the production function
is
= ( , )

There are various functional forms available to describe production. In general Cobb-Douglas
production function (Quadratic equation) is widely used.

Q = the maximum rate of output for a given rate of capital (K) and labor (L).

6.2. Theory of Cost

A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output is
the one that maximizes total profit that is the difference between total revenue and total cost.
Entrepreneurs pay for the factors of production- Wages for labor, price for raw material, rent for
building hired, and interest for borrowed money. All these costs are included in the cost of
production.

The theory of cost, together with the principles of demand, supply and production, constitute
three the basic areas of managerial economics. Few significant resources allocation decisions are
made without a thorough analysis of costs. For profit –maximizing firm, the decision to add
comparing additional revenues to additional cost makes a new product associated with that new
product decision on capital investment also (new machinery or warehouse) made by comparing
the rate of return on the investment with the opportunity cost of the funds used to make the
capital acquisitions. Costs are also important in the non-profit sectors. For example, to obtain
funding for a new dam, a government agency must demonstrate that the value of the benefits of
the dam such as flood control and water supply, exceeds the cost of the project.

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Managerial Economics Chapter 6: Production and Cost Analysis

6.2.1. The Economic Cost Concepts

There are various reverent cost concepts. Cost is understood differently for different purposes the
definition of cost thus varies from decision to decision. Cost may include the price to be paid for
a good, its transportation storage, and handling expenses besides other miscellaneous outflows.
Since different decisions are affected by different types of costs, a manager needs to understand
which decision should consider which cost, that is must identify the relevant cost. A cost that
may be relevant for one particular type of decision is very likely to be meaningless for arriving at
one other decision. Relevant cost is defined as the cost that actually affects a given business
decision and should therefore be considered in the decision-making process. In order to ascertain
the relevant cost to be considered for a particular situation we need to discuss the various
possible cost concepts in detail.

Actual costs and Opportunity Cost

Costs that are actually incurred in acquiring or producing a good or service are known as actual
costs. Since these costs are real cash outflows and are generally recorded in the account books,
they are also called acquisition or account costs. Any process of production requires input factors
to be used for producing an output. Each process of production requires input factors to be used
for producing an output.

Each factor of production has its land price it is rent for labor it is wage for capital it is interest
and so on all these costs form the actual costs. Cash outflows in the form of the expenditure
/payments made by the firm to the supplies of factors of production are only recorded by the
account in the account books of the firm.

Since opportunity cost is a notional concept it is not recorded in the books of account however it
should be considered in decision making. It should be used as a break-even cost. A firm should
continue to be in business only till the time it can generate more profits than what it would have
made in an alternative business, in case of two alternatives or the next best alternative in case of
many alternatives. Examples of opportunity cost

 a consumer who pays Ten birr for dinner may have to give up going to a theater
 a manager who hires an additional secretary may have to forgo hiring an additional clerk

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Fixed costs and Variable costs

Costs of different kinds behave differently from the output. Some remain fixed over a range of
output while other varies with the output. Fixed costs are defined as the costs that remain
constant concerning the output. They might exist even if no output is produced. On the other
hand, costs that vary with the changes in output are known as variable costs. The rent of the
building and factory intersect on borrowed capital cost of plant and machinery etc. are all fixed
costs while the costs of raw material wages, etc. are all variable costs in other words costs of
fixed assets are all fixed costs and those of current assets are variable costs.

However, some costs cannot be so easily distinguished into fixed or variable costs they are fixed
to some extent and variable thereafter. Such costs are known as semi-variable costs. They neither
remain constant nor vary with the changes in output at all times.

Explicit costs and implicit costs

Explicit costs are out-of-pocket costs for which a cash payment is made. However, some costs
don’t involve a cash outlay. They are known as implicitly costs or book costs. Sometimes the full
opportunity cost of a business decision is not accounted for because of failure to include implicit
cost while the payment for raw material utilities wage etc. constitutes explicit costs depreciation
and salary of owner-manager etc. are implicit costs if a building is owned by a firm then the rent
that would have been received had it been rented would become the implicit cost. However, if
the building was taken on rent by the firm then the rent would be an explicit cost is implicitly
cost while if it is hired or rented then it is an explicit cost. Thus, ownership differentiates
between the two types of costs.

Since implicit costs do not involve cash payment, they are often ignored by firms, especially the
smaller ones. However, it must be recognized for efficient decision-making that both explicit and
implicit costs need to be considered. The implicit costs can be measured using the opportunity
costs concept. Failure to consider the implicit costs may lead to wrong decisions and
overestimation of profits.

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Managerial Economics Chapter 6: Production and Cost Analysis

Total costs, Average costs, and Marginal costs

The sum total of all the costs: fixed, variables, explicit, and implicit for the entire output is
known as a total cost. Average cost is the cost per unit of output and is computed by dividing the
total cost by the number of units produced. Marginal cost is the change in total cost due to the
production of one additional unit of output.

Let the cost of producing 10 units be birr 5000 and that for 11 units be birr 5050. In this case, the
average cost of each unit is birr 500 and the marginal cost of producing the eleventh unit is birr
50. However, since it is not possible to have small divisible units of output the incremental cost
concept is preferred over the marginal cost concept. Incremental cost is the change in total cost
due to the production of additional output. Mathematically marginal cost is:

= −

Where and are the total costs of reproducing n and n-1 units output

Historical costs and Replacement costs

The historical cost is a past cost that was incurred at the time of the acquisition of that asset. On
the other hand, replacement cost is the current cost of purchasing that asset. Depending upon the
nature of the commodity or asset, the replacement cost will be more than or less than the
historical cost. For assets that appreciate with time the replacement cost will be more than the
historical cost. The opposite holds time the replacement cost will be more than the historical
cost. The opposite holds goods for depreciating assets for volatile assets that is assets with large
price variations the replacement costs will be quite different from the historical costs.

Short-run costs and Long-run costs

Before we discuss costs in the short run and long run it would be worthwhile to define short run
and long run. The short run is a period during which one or more inputs of the firm are fixed,
however, in the long run, all the factors inputs are variable. The fixed factors in the case of a
short run are the plant and equipment thus in the short run the decisions of a firm are contained
by prior financial commitments and capital expenditure. No such restriction exists in the long

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run. The actual duration of a short run is affected by the economic life of the firm’s assets the
time required to install new assets and the associated degree of specialization in the assets.

Corresponding to these periods there are short-run costs and long-run costs. A short-run cost is a
cost that varies with the output when plant and equipment remain the same. In contrast, long-run
cost is the cost that varies with output when all the factor inputs change. while decisions relating
to production with a given plant size use short-run costs for analysis those convening increasing
plant size require an analysis of long-run cost curves.

Accounting Costs and Economic Costs

Some cost concepts are used by accountants for record-keeping financial analysis and control
and auditing purposes, while others are used by managers for decision-making costs that are
recorded in the books of account and are used for accounting. On the other hand, costs that help
in managerial decision-making for achieving the economic objectives of a firm are called
economic costs.

Accounting cost is the monetary value of all purchased inputs used in production; it ignores the
cost of non-purchased (self-owned) inputs. It considers only direct expenses such as
wages/salaries, cost of raw materials, depreciation allowances, interest on borrowed funds, and
utility expenses (electricity, water, telephone, etc.). These costs are said to be explicit costs.

In the real world economy, entrepreneurs may use some resources that may not have direct
monetary expense since the entrepreneur can own these inputs himself or herself. The economic
cost of producing a commodity considers the monetary value of all inputs (purchased and
nonpurchased). Calculating economic costs will be difficult since there are no direct monetary
expenses for non-purchased inputs. The monetary value of these inputs is obtained by estimating
their opportunity costs in monetary terms. The estimated monetary cost for nonpurchased inputs
is known as implicit cost. For example, if Mr. X quits a job that pays him Birr 10, 000.00 per
month to run a firm he has established, then the opportunity cost of his labour is taken to be Birr
10,000.00 per month (the salary he has forgone to run his own business). Therefore, economic
cost is given by the sum of implicit cost and explicit cost.

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6.2.2. Determinants of cost

Many factors determine the cost behavior. The cost of production of goods and services depends
on various input factors used by the organization and it differs from firm to firm. In the following
discussion, we shall attempt to arrive at some general determinants of costs.

Price of Factors of Production

Total cost comprises the cost of factors of production and the cost of raw material. When the
price of any one or more factors of production increases, while everything else is kept constant
the total cost of production increases. The nature of this increase will vary from case to case. It
will depend upon the extent to which the factors of production can be substituted for one another.
If the factor inputs are readily substitutable the firm can replace a costly input with a relatively
cheaper input. In this case, the increase in cost will not be as large as it would have been if the
substitution was not possible. Thus, the cost of production varies directly with the prices of the
factor inputs.

Productivity of factors of production

The productivity of a factor of production may be defined as the unit contribution of that factor
to the output. Productivity, in a sense, is a measure of the efficiency of the input factor. A factor
with higher productivity will be able to produce a larger output when other things remain the
same. In other words, the same output can be produced by using smaller quantities of the factor
inputs which have higher productivity. Naturally, the cost of production in such cases will
decrease. Thus, the cost of production varies inversely with the productivity of factor inputs.

Technological Advancement

Technological advancement improves the efficiency or productivity of a factor or production.

The cost of production is inversely related to technological advancements

Output

Output is the most important determinant of cost. A lager output requires more of the factor
inputs and the raw material. Ceteris paribus, larger quantities of raw material and factors of
production would mean higher costs of production. The two components of total cost fixed cost

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and variable cost behave differently with the output. As their names indicate fixed costs remain
constant over a range of output while variable costs vary with output. However, this distinction
between fixed cost and variable cost holds good only in the short run as in the long run all costs
are variable. We thus need to study the cost-output relationship separately for the short and long
run.

6.2.3. Short-run cost of production with output

Total Costs in the Short Run

There are three concepts concerning total cost in the short period: Total Fixed Cost, Total
Variable Cost, and Total Cost. Fixed cost is the cost which is incurred for fixed factors. Fixed
costs consist of the salary of the permanent staff, interest on borrowed capital, rent of the factory
buildings, depreciation of machinery, expenses for maintenance of buildings, property tax and
license fees etc.

Variable cost is a cost that is incurred for variable factors. The main types of variable costs are
expenditures incurred for raw materials, wages and salaries paid to casual workers, operating
expenses like electricity, and taxes such as excise duties, which depend upon the output
produced.

The total cost of production is the sum of all fixed and variable costs. Corresponding to fixed and
variable factors in the short-run, total cost is divided into two parts:

 Total fixed cost and

 Total variable cost.

1) Total Fixed Cost (TFC): Total fixed cost refers to the total cost incurred by the firm for the
use of all fixed factors. This cost is independent of output, i.e., it does not change with a change
in quantity of output. Fixed cost is also known as overhead cost. Even if the firm produces only
one unit of output, the fixed cost is incurred. Even if nothing is produced for some time in the
short run, fixed costs are incurred. That is why the fixed cost is often known as ‘unavoidable
cost’. For example, a shopkeeper has to pay rent for the shop, no matter what the output or sale is
during the month.

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2) Total Variable Cost (TVC): Total variable cost refers to the total cost incurred by a firm for
the use of the variable factors. These costs vary directly with changes in the volume of output,
rising as more is produced and falling as less is produced. That is why the variable cost is also
known as ‘avoidable cost’. For instance, if you want to produce more shirts, you have to buy
more raw materials like yarn and hire more workers.

3) Total Cost: Total cost is the cost incurred on all types of inputs – fixed as well as variable
inputs incurred in producing a given amount of output. The total cost (TC) for the short run is
given by

= +

Since total cost has total variable cost as one of the components which varies with change in
output, the total cost will also change positively with change in output. Also, since total fixed
cost, by definition, remains constant, the changes in total cost are entirely due to changes in total
variable cost.

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TFC curve: As Table 6.2 shows, total fixed cost remains constant at Birr 60 for the entire range
of output from 0 to 6 units. It does not change with a change in output. The TFC curve is a
straight line parallel to the horizontal axis, indicating the same amount of fixed cost at every
level of output. Note that, in Figure 6.4, the TFC curve starts from point A on the Y-axis,
indicating that the total fixed cost is incurred even if the output is zero.

TVC curve: Total variable cost changes with a change in output. Initially, it increases at a
decreasing rate as total output increases (up to 3 units), and subsequently, it increases at an
increasing rate with increases in output (from the 4th unit onwards). The TVC curve is a
positively sloping curve, showing that, as output increases, total variable cost also increases. But
the rate of increase of TVC is not the same throughout. The TVC curve is concave downward, up
to the OQ level of output, indicating that the total variable cost increases at a decreasing rate, and
subsequently (beyond the OQ level of output) it is concave upward, indicating that total variable
cost increases at an increasing rate. Also note that the TVC curve starts from the origin, which
shows that when output is zero, total variable cost is also zero.

TC curve: Since total cost is the sum of total fixed cost and total variable cost, it is calculated in
Table 6.2 by adding figures from column 2 and column 3 at different levels of output. The total
cost varies directly with output because of increases in variable costs with increases in output.
The TC curve has been obtained by adding up vertically the TFC curve and the TVC curve.
Since a constant fixed cost is added to the total variable cost, the shape of the TC curve is the
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Managerial Economics Chapter 6: Production and Cost Analysis

same as that of the TVC curve. Note that the TC curve originates not from 0, but from A
because, at zero level of output, total cost equals fixed cost. The vertical distance between the
TVC and TC curves equals the amount of the total fixed cost.

Average Costs in the Short Run

Average cost is simply the total cost divided by the number of units produced. Corresponding to
the three types of total costs in the short run, there are three types of average costs. Average
Fixed Cost, Average Variable Cost, and Average Total Cost.

Average Fixed Cost (AFC): Average fixed cost is the per-unit cost of the fixed factors. It is
obtained by dividing the fixed cost by the total units of output.

Where Q represents the total units of output produced.

Average Variable Cost (AVC): Average variable cost is the per-unit cost of the variable factors
of production. It is obtained by dividing the total variable cost by the total units of output.

Average Cost (AC) or Average Total Cost (ATC): Average total cost or simply average cost is
the per-unit cost of both fixed and variable factors of production. It is obtained by dividing total
cost by the total units of output.

+
= = + = +

The following schedule (based on Table 6.3), together with the corresponding average cost
curves, explains various types of average costs in the short run.

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Managerial Economics Chapter 6: Production and Cost Analysis

AFC Curve

It slopes downward throughout its length, from left to right, showing a continuous fall in average
fixed cost with increases in output. For very small outputs, the average fixed cost is high, and for
large outputs it is low. The curve approaches the X-axis but never touches it because the average
fixed cost cannot be zero since total fixed cost is positive. Similarly, the AFC curve never
touches the Y-axis because total fixed cost has a positive value even at very low levels of output.

AVC Curve

The behavior of the average variable cost is derived from the behavior of the total variable cost.
The AVC curve slopes downward, up to output OQ2 (the optimum capacity level of output),
showing decreases in average variable cost, and it slopes upward beyond output OQ2, indicating
increases in average variable cost. In other words, the AVC curve is U-shaped. It is minimum at
A, corresponding to optimum capacity level of output, OQ2.

Why is the AVC Curve U-shaped? The U-shape of the AVC curve follows directly from the law
of variable proportions. The average variable cost falls up to the optimum capacity level of
output due to increasing returns, and it increases thereafter due to diminishing returns to the
variable factor.

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Managerial Economics Chapter 6: Production and Cost Analysis

ATC Curve

Geometrically, the ATC Curve (or AC curve) can be obtained by adding the AFC and AVC
curves. An ATC curve is the vertical summation of the AFC and AVC curves. Therefore, at each
level of output, the ATC curve lies above the AVC curve at a distance equal to the value (height)
of the AFC curve.

Marginal Cost in the Short Run

Marginal cost is the addition to total cost as one more unit of output is produced. In other words,
marginal cost is the addition to the total cost of producing n units instead of n – 1 unit.

= −
Since the marginal cost is the change in total cost as a result of the change in output by one unit,
it can be written as:

Where, ΔTC is the change in total cost, and ΔQ is the change in the quantity of output

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Managerial Economics Chapter 6: Production and Cost Analysis

Long-run cost output relationship

In the long run, costs fall as output increases due to economies of scale, consequently, the
average cost AC of production falls. Some firms experience diseconomies of scale if the average
cost begins to increase. This fall and rise derive a U-shaped or boat-shaped average cost curve in
the long run which is denoted as LAC. The minimum point of the curve is said to be the
optimum output in the long run. It is explained graphically in the chart given below.

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Managerial Economics Chapter 6: Production and Cost Analysis

In the long run all factors are variable and the average cost may fall or increase to A, B
respectively but all these costs are above the long run cost average cost. LAC is the lower
envelope of all the short run average cost curves because it contains them all. At point ‘E’ the
SAC1 and SMC1 intersects each other, in case the organization increases its output from OM to
OM1 they have to spend OC1 amount. In case the organization purchases one more machine
(increase in fixed cost) then they will get a new set of cost curves SAC2, and SMC2. But the new
average cost curve reduces the cost of production from OC1 to OC2. That means they can save
the difference of C1C2 which is nothing but AB. Therefore, in the long run due to business
expansion a firm can reduce their cost of production. During their business life they will meet
many combinations of optimum production and minimum cost in different short periods. In the
long run due to law of diminishing returns the long run average cost curve LAC also slopes like
boat shape.

6.3. Economies and Diseconomies of scale

The economies and diseconomies of scale are a phenomenon relating to the long run cost and
output relationship. The long run average cost first decreases with an increase in output, reaches
a minimum point and then finally increases beyond a certain plant size. In the first part when the
long run average cost decreases with an increase in plant size economies of scale are said to
exist. Diseconomies of scale arise when the long run average cost increases with the increase in
plant size. At the optimal plant size, economics of scale equal the diseconomies of scale.

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Managerial Economics Chapter 6: Production and Cost Analysis

When we say that there are economics of scale it does not mean that there are advantages in all
the aspects. Normally it shows that there are advantages in a majority of factors.

Economies of scale: means a fall in average cost of production due to growth in the size of the
industry within which a firm operates. Economies of scale exist when long-run average costs
decline as output is increased.

Factors Causing Economies of Scale:

There are various factors influencing the economies of scale of an organization. They are
generally classified into two categories Internal factors and External factors.

a) Internal Factors:
 Labor economies: if the labor force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labor productivity.
 Technical economies: with the use of advanced technology they can produce large
quantities with quality which reduces their cost of production.
 Managerial economies: the managerial skills of an organization will be advantageous to
achieve economies of scale in various business activities.
 Marketing economies: use of various marketing strategies will help in achieving
economies of scale.
 Vertical integration: if there is vertical integration then there will be efficient use of raw
material due to internal factor flow.
 Financial economies: the firm’s financial soundness and past record of financial
transactions will help them to get financial facilities easily.
 Economies of risk spreading: having variety of products and diversification will help
them to spread their risk and reduce losses.
 Economies of scale in purchase: when the organization purchases raw material in bulk
reduces the transportation cost and maintains uniform quality.
b) External Factors:
 Better repair and maintenance facilities: When the machinery and equipment are repaired
and maintained, then the production process never gets affected.

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Managerial Economics Chapter 6: Production and Cost Analysis

 Research and Development: research facilities will provide opportunities to introduce

new products and process methods.
 Training and Development: continuous training and development of skills in the
managerial, production level will achieve economies of scale.
 Economies of location: the plant location plays a major role in cutting down the cost of
materials, transport and other expenses.
 Economies of Information Technology: advanced Information technology provides
timely accurate information for better decision making and for better services.
 Economies of by-products: Organizations can increase the economies of scale by
minimizing waste and can be environmental responsible by using the by- products of the
organization.

Diseconomies of Scale: Arises due to managerial problems. If the size of the business becomes
too large, then it becomes difficult for management to control the organizational activities
therefore diseconomies of scale arise. Diseconomies of scale exist when long run average cost
rises as output is increased.

Factors Causing Diseconomies of Scale:

 Labor union: continuous labor problem and dissatisfaction can lead to diseconomies of
scale.
 Poor team work: Poor performance of the team leads to diseconomies of scale.
 Lack of co-ordination: lack of coordination among the work force has a major role to
play in causing diseconomies of scale.
 Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.
 Difficulty in decision making: the managerial inability, delay in decision making is also a
factor that determines the economies of scale.
 Scarcity of Resources: raw material availability determines the purchase and price.
Therefore, there is a possibility of facing diseconomies in firms.
 Increased risk: growing risk factors can cause diseconomies of scale in an organization. It
is essential to reduce the same.

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Managerial Economics Chapter 6: Production and Cost Analysis

6.4. Economies of scope

Economies of scope: producing variety to get cost advantage. In retail business it is commonly
used. Product diversification within the same scale of plant will help them to achieve success. It
is an economic concept that the unit cost to produce a product will decline as the variety of
products increases. That is, the more different but similar goods you produce, the lower the total
cost to produce each one.

Example: let’s say that you are a shoe manufacturer, you produce men’s and women’s sneakers.
Adding a children’s lines of sneakers would increase economies of scope because you can use
the same production, equipment, suppliers, storage and distribution channel to make a new line
of products. That will further reduce the cost of production on all your shoes.

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