MANAGERIAL ECONOMICS

CHAPTER SIX
PRODUCTION AND COST ANALYSIS

By: Teklebirhan A. (Asst. Prof)

E-mail: [email protected]

1 AAU , 2024
Objectives
2

Define theory of production and theory of cost

Describe the concept of Economies and Diseconomies of scale
Solve Economies of scope problems
 6.1. Theory of Production
3

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 example: Leather from animal’s skin (Input) dying, cutting,
shaping (process) leather shoe (output).
 Cont…..
4

Production is an important economic activity which satisfies the

wants and needs of the people.
Production Theory 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.
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.
 Cont…..
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Managers are concerned with these relationships because they

want to optimize the production process, in terms of efficiency.
 6.1.1. Factors of Production
6

This term refers to inputs or resources.

They refer to anything used in the production and distribution of
goods and services.
Economists use the term factors of production they usually classify
them into three, or sometimes four, categories:
 Land
 Labour
 Capital
 Entrepreneurship
 6.1.2. Production Functions
7

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.
It is a tool of analysis used in explaining the input-output
relationship.
These represent the relationships between inputs and outputs in
symbolic or mathematical form.
 Cont…..
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In general terms we can say that any production function can be
expressed as:
= ( ; ; ; ……; )
Where 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.
 Cont…..
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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.
 Cont…..
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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 vice versa.
The best example of variable input is unskilled labour.
 6.1.3. Period of Production
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a) The Short Run

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.
 Cont…..
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b) The Long Run

It is the period during which all factors are variable.

 Conclusion
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.
 Cont…..
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To achieve the maximum output (objective of the firm) the firm
has to utilize the input factors efficiently.
In the long run, without increasing the fixed 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
14

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).

= =
 Cont…..
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Average Product (AP) 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.

 Generally, the relationship between and can be stated as

follows
 When is increasing, >
 When is at its maximum, =
 When is decreasing, <
 Cont…..
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 6.1.5. The Law of Diminishing Returns/
law of variable proportions
17

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.
 For example, if additional workers are hired to work with a
constant amount of capital equipment, output will eventually rise
by smaller and smaller amounts as more workers are hired.
 6.1.6. Stages of Production
18

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.
 Cont…..
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Stage I:
 The stage goes from the origin where TP=0 to the point where is
maximum.
 This stage is not an efficient region of production though the MP of
variable input is positive.
It is a range of Increasing Marginal Product.
 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).
 It is also known as an Extensive stage, b/c the variable inputs are
under-employed & the fixed inputs are under-utilized
 Cont…..
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 Cont…..
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Stage II:
It is the stage of production ranges from maximum to
= 0 (TP reaches its maximum level).
It is the stage of diminishing marginal returns because TP
increase at decreasing rate.
The reason for decreasing average and marginal products is due to
the scarcity of the fixed factor.
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).
 Cont…..
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In this stage, there is proper utilization & employment of resources.

Stage III:
This ranges from = 0 to through the –ve part of .
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.
So, this stage of production is known as Intensive margin.
 Cont…..
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The cause of negative marginal returns is the fact that the volume
of the variable inputs is quite excessive relative to the fixed input
This stage implies that labor is over employed and capital is over
utilized.

Where the rational producer will produce?

 Cont…..
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 Cont…..
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To understand a production function with two variable inputs

(Long run production), it is necessarily known the concept Iso-
quant/Iso-product curve.
The Iso-quant curve show the various combinations of two
variable inputs resulting in the same level of output.
In other words, an isoquant is a curve along which the maximum
achievable rate of production is constant.
Various iso-quant curves presented in a graph is called as iso-
quant map.
 Cont…..
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Characteristics of Isoquants
a) Isoquants are normally negatively sloped: because when one factor
increases, the other factor decreases.
b) An isoquant laying above and to the right of another represents a
higher level of output.
c) Two isoquants cannot intersect each other or tangent to one
another.
d) No isoquants can touch either axis
e) Each isoquant is normally drawn convex to the origin (indicate the
MRTS is diminishing)
 Cont…..
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Iso-cost: different combination of inputs that can be purchased at

a given expenditure level.
 Cont…..
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Optimal input combination: The points of tangency between

iso-quant and iso-cost curves depict optimal input combination at
different activity levels
 6.1.7. Cobb Douglas Production Function
29

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.
 Cont…..
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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
31

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, and all these costs
are included in the cost of production.
Costs are important for both profit and non-profit sectors.
 6.2.1. The Economic Cost concepts
32

Since different decisions are affected by different types of costs, a

manager needs to understand which decision should consider
which 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
So, we need to discuss the various possible cost concepts in detail.
 Cont…..
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 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.
The cost of the next best alternative is Opportunity cost.
 Not recorded in the books of account however it should be
considered in decision making
 It should be used as a break-even cost
 Cont…..
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 Fixed costs and Variable costs

Fixed costs are defined as the costs that remain constant
concerning the output change
 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.
 They only exist if output is produced
 Cont…..
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 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/payment. They are
known as implicitly costs or book costs.
 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.
 Cont…..
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 Total costs, Average costs, and Marginal costs

The sum total of all the costs: fixed variable explicit and implicit
for the entire output is known as 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.

= − =
 Cont….

 What type of note you have got from the above diagram?
37
 Cont…..
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 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.
 Cont…..
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 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.
 Include both fixed and variable costs
In contrast, long-run cost is the cost that varies with output when
all the factor inputs change.
 Include only variable costs – because all inputs are variable.
 Cont…..
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 Accounting Costs and Economic Costs

Accounting/Explicit 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
Economic cost of producing a commodity considers the monetary
value of all inputs (purchased and non-purchased).
 Calculating economic costs will be difficult since there are no
direct monetary expenses for non-purchased inputs.-so we
estimate using opportunity costs
 Therefore, economic cost is the sum of implicit and explicit cost.
 6.2.2. Determinants of cost
41

The cost of production depends on various input factors used by

the organization and it differs from firm to firm.
Thus, the determinants are
 Price of Factors of Production (+ve)
 Productivity of factors of production (-ve)
 Technological Advancement (-ve)
 Output
 6.2.3. Short-run cost of production with
output
42

 Total Costs in the Short Run

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 (TFC) and
 Total variable cost (TVC).
Thus,
= +
 Cont…..
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 Cont…..
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 Cont…..
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 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.
 Cont…..
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 Cont…..
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 Cont…..
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 Marginal Costs 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:

=
 Cont…..
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 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.
 Cont…..
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 6.3. Economies and Diseconomies of
scale
51

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.
Diseconomies of Scale: Arises due to managerial problems.
 Cont…..
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 Cont…..
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Factors Causing Economies of Scale:

a) Internal Factors: b) External Factors:

 Labor economies:  Better repair and maintenance
 Technical economies: facilities:
 Managerial economies:  Research and Development:
 Marketing economies:  Training and Development:
 Vertical integration  Economies of location:
 Financial economies:  Economies of Information
 Economies of risk spreading: Technology:
 Economies of scale in purchase:  Economies of by-products:
 Cont…..
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Factors Causing Diseconomies of Scale:

Labor union:
Poor team work:
Lack of co-ordination:
Difficulty in fund raising:
Difficulty in decision making:
Scarcity of Resources:
Increased risk:
 6.4. Economies of Scope
55

Economies of scope: producing variety to get cost advantage. In

retail business it is commonly used.
That is, the more different but similar goods you produce, the
lower the total cost to produce each one.
 Cont…..
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