Block 3

PRODUCTION AND COST ANALYSIS

Unit 7: Production Function 135

Unit 8: Short Run Cost Analysis 164

Unit 9: Long Run Cost Analysis 189

BLOCK 3 PRODUCTION AND COST
ANALYSIS
Block 3 introduces production and cost analysis and the estimation of production
and cost functions. Production is the process of combining inputs to create output
which the firm sells in the market. The relationship between the production
function and the cost function is analyzed in this block and the implication for
managerial decisions is examined. The block examines cost analysis in the short
and long run. Cost is related to production because if the production function
exhibits increasing returns to scale, the unit cost of production falls, while if the
production function exhibits decreasing returns to scale the unit cost will rise
and so on.
Unit 7 analyzes the production function and its building blocks from a managerial
perspective. The difference between short run and long run is explained from an
economist’s perspective. It is discussed that a profit-maximizing firm will choose
an optimal combination of inputs based on input prices. Estimation of production
function and its managerial uses are also elaborated in this unit.
Unit 8 defines different types of costs including accounting costs & opportunity
costs and short run cost function. Further, certain applications of short run cost
function like break-even analysis and operating leverage are also explained.
Unit 9 explains long run cost function, economies of scale & scope are explained.
Finally, estimation of cost function is presented using the tools of regression
analysis that were developed in Blocks 1 and 2.
 Production Function
UNIT 7 PRODUCTION FUNCTION
Structure

7.0 Objectives
7.1 Introduction
7.2 Production Function
7.3 Production Function with one Variable inputs
7.4 Production Function with two Variable inputs
7.5 The Optimal Combination of inputs
7.6 Returns to Scale
7.7 Functional Forms of Production Function
7.8 Managerial Uses of Production Function
7.9 Let Us Sum Up
7.10 Terminal Questions

7.0 OBJECTIVES
After going through this unit, you should be able to:

 familiarize with the concepts and rules relevant for production decision
analysis;
 understand the economics of production; and
 understand the set of conditions required for efficient production.

7.1 INTRODUCTION
Production process involves the transformation of inputs into output. The
inputs could be land, labour, capital, entrepreneurship etc. and the output
could be goods or services. In a production process managers take four types
of decisions: (a) whether to produce or not? (b) how much output to produce?
(c) what input combination to use? and (d) what type of technology to use?
This Unit deals with the analysis of managers’ decision rules concerning (c)
and (d) above. The analysis of the other two decisions will be covered in
Units 8 and Unit 9 of this block.

In this unit, we shall begin with a general discussion of the concept of

production function. The analysis of this unit mainly focuses on the firms that
produce a single product. Analysis on decisions related to multiproduct firms
is also given briefly. The nature of production when there is only one variable
input is taken up first. We then move on to the problem of finding optimum
135
Production and Cost combination of inputs for producing a particular level of output when there
Analysis are two or more variable inputs. You will also learn about the production
decisions in case of product mix of multiproduct firms. The unit concludes
with various functional forms of production frequently used by economists
and their empirical estimation.

7.2 PRODUCTION FUNCTION

Suppose we want to produce apples. We need land, seedlings, fertilizer,
water, labour, and some machinery. These are called inputs or factors of
production. The output is apples. In general a given output can be produced
with different combinations of inputs. A production function is the functional
relationship between inputs and output. It shows the maximum output which
can be obtained for a given combination of inputs. It expresses the
technological relationship between inputs and output of a product.

In general, we can represent the production function for a firm as:

Q = f (x1, x2, ….,xn)

Where Q is the maximum quantity of output, x1, x2, ….,xn are the quantities
of various inputs, and f stands for functional relationship between inputs and
output. For the sake of clarity, let us restrict our attention to only one product
produced using either one input or two inputs. If there are only two inputs,
capital (K) and labour (L), we write the production function as:

Q = f (L, K)

This function defines the maximum rate of output (Q) obtainable for a given
rate of capital and labour input. It may be noted here that outputs may be
tangible like computers, television sets, etc., or it may be intangible like
education, medical care, etc. Similarly, the inputs may be other than capital
and labour. Also, the principles discussed in this unit apply to situations with
more than two inputs as well.

Economic Efficiency and Technical Efficiency

We say that a firm is technically efficient when it obtains maximum level of
output from any given combination of inputs. The production function
incorporates the technically efficient method of production. A producer
cannot decrease one input and at the same time maintain the output at the
same level without increasing one or more inputs. When economists use
production functions, they assume that the maximum output is obtained from
any given combination of inputs. That is, they assume that production is
technically efficient.

On the other hand, we say a firm is economically efficient, when it produces a

given amount of output at the lowest possible cost for a combination of inputs
136
provided that the prices of inputs are given. Therefore, when only input Production Function
combinations are given, we deal with the problem of technical efficiency;
that is, how to produce maximum output. On the other hand, when input
prices are also given in addition to the combination of inputs, we deal with
the problem of economic efficiency; that is, how to produce a given amount
of output at the lowest possible cost.

One has to be careful while interpreting whether a production process is

efficient or inefficient. Certainly a production process can be called efficient
if another process produces the same level of output using one or more
inputs, other things remaining constant. However, if a production process
uses less of some inputs and more of others, the economically efficient
method of producing a given level of output depends on the prices of inputs.
Even when two production processes are technically efficient, one process
may be economically efficient under one set of input prices, while the other
production process may be economically efficient at other input prices.

Let us take an example to differentiate between technical efficiency and

economic efficiency. An ABC company is producing readymade garments
using cotton fabric in a certain production process. It is found that 10 percent
of fabric is wasted in that process. An engineer suggested that the wastage of
fabric can be eliminated by modifying the present production process. To this
suggestion, an economist reacted differently saying that if the cost of wasted
fabric is less than that of modifying production process then it may not be
economically efficient to modify the production process.

Short Run and Long Run

All inputs can be divided into two categories; i) fixed inputs and ii) variable
inputs. A fixed input is one whose quantity cannot be varied during the time
under consideration. The time period will vary depending on the
circumstances. Although any input may be varied no matter how short the
time interval, the cost involved in augmenting the amount of certain inputs is
enormous; so as to make quick variation impractical. Such inputs are
classified as fixed and include plant and equipment of the firm.

On the other hand, a variable input is one whose amount can be changed
during the relevant period. For example, in the construction business the
number of workers can be increased or decreased on short notice. Many
‘builder’ firms employ workers on a daily wage basis and frequent change in
the number of workers is made depending upon the need. The amount of milk
that goes in the production of butter can be altered quickly and easily and is
thus classified as a variable input in the production process.

Whether or not an input is fixed or variable depends upon the time period
involved. The longer the length of the time period under consideration, the
more likely it is that the input will be variable and not fixed. Economists find
it convenient to distinguish between the short run and the long run. The short
137
Production and Cost run is defined to be that period of time when some of the firm’s inputs are
Analysis fixed. Since it is most difficult to change plant and equipment among all
inputs, the short run is generally accepted as the time interval over which the
firm’s plant and equipment remain fixed. In contrast, the long run is that
period over which all the firms’ inputs are variable. In other words, the firm
has the flexibility to adjust or change its environment.

Production processes of firms generally permit a variation in the proportion

in which inputs are used. In the long run, input proportions can be varied
considerably. For example, at Maruti Udyog Limited, an automobile dye can
be made on conventional machine tools with more labour and less expensive
equipment, or it can be made on numerically controlled machine tools with
less labour and more expensive equipment i.e. the amount of labour and
amount of equipment used can be varied. Later in this unit, this aspect is
considered in more detail. On the other hand, there are very few production
processes in which inputs have to be combined in fixed proportions.
Consider, Ranbaxy or Smith-Kline-Beecham or any other pharmaceutical
firm. In order to produce a drug, the firm may have to use a fixed amount of
aspirin per 10 gm of the drug. Even in this case a certain (although small)
amount of variation in the proportion of aspirin may be permissible. If, on the
other hand, no flexibility in the ratio of inputs is possible, the technology is
described as fixed proportion type. We refer to this extreme case later in this
unit, but as should be apparent, it is extremely rare in practice.

Activity 1

1. What is a production function? How does a long run production

function differ from a short run production function?

2. When can we say that a firm is: (a) technically efficient, (b)
economically efficient? Is it necessary that a technically efficient firm
is also economically efficient?

7.3 PRODUCTION FUNCTION WITH ONE

VARIABLE INPUT

Consider the simplest two input production process - where one input with a
fixed quantity and the other input with its variable quantity. Suppose that the
fixed input is the service of machine tools, the variable input is labour, and
the output is a metal part. The production function in this case can be
represented as:

Q = f (K, L)

Where Q is output of metal parts, K is service of five machine tools (fixed

input), and L is labour (variable input). The variable input can be combined
with the fixed input to produce different levels of output.
138
Total, Average, and Marginal Products Production Function

The production function given above shows us the maximum total product
(TP) that can be obtained using different combinations of quantities of inputs.
Suppose the metal parts company decides to know the output level for
different input levels of labour using fixed five machine tools. Table 7.1
explains the total output for different levels of variable input. In this
example, the TP rises with increase in labour up to a point (six workers),
becomes constant between sixth and seventh workers, and then declines.

Table 7.1: Total, Average and Marginal Products of labour

(with fixed capital at five machine tools)

Number of Total output (TP) Marginal product Average product

workers (L) (thousands per year) (Q) (MP L = ∆Q/∆L) (APL = Q/L)
0 0 — —
1 10 10 10
2 28 18 14
3 54 26 18
4 76 22 19
5 90 14 18
6 96 6 16
7 96 0 13.5
8 92 –4 11.5

Two other important concepts are the average product (AP) and the marginal
product (MP) of an input. The AP of an input is the TP divided by the
amount of input used to produce this amount of output. Thus AP is the
output-input ratio for each level of variable input usage. The MP of an input
is the addition to TP resulting from the addition of one unit of input, when the
amounts of other inputs are constant. In our example of machine parts
production process, the AP of labour is the TP divided by the number of
workers.
APL = Q/L
As shown in Table 7.1, the APL first rises, reaches maximum at 19, and then
declines thereafter. Similarly, the MP of labour is the additional output
attributable to using one additional worker with use of other input (service of
five machine tools) fixed.
MP L = ∆Q/∆L

Where ∆ means ‘the change in’. For example, from Table 7.1 for MP4
th
(marginal product of 4 worker) ∆ Q = 76–54 = 22 and ∆ L = 4–3 =1.
Therefore, MP4 = (22/1) = 22. Note that although the MP first increases with
addition of workers, it declines later and for the addition of 8th worker it
becomes negative (–4).
139
Production and Cost Figure 7.1: Relationship between TP, MP, and AP curves and the three
Analysis stages of production

The graphical presentation of total, average, and marginal products for our
example of machine parts production process is shown in Figure 7.1.

Relationship between TP, MP and AP Curves

Examine Table 7.1 and its graphical presentation in Figure 7.1. We can
establish the following relationship between TP, MP, and AP curves.

1a) If MP > 0, TP will be rising as L increases. The TP curve begins at the

origin, increases at an increasing rate over the range 0 to 3, and then
increases at a decreasing rate. The MP reaches a maximum at 3, which
corresponds to an inflection point (x) on the TP curve. At the inflection
point, the TP curve changes from increasing at an increasing rate to
increasing at decreasing rate.

140
b) If MP = 0, TP will be constant as L increases. The TP is constant Production Function
between workers 6 and 7.

c) If MP < 0, TP will be declining as L increases. The TP declines beyond

7. Also, the TP curve reaches a maximum when MP = 0 and then starts
declining when MP < 0.

2. MP intersects AP (MP = AP) at the maximum point on the AP curve.

This occurs at labour input rate 4.5. Also, observe that whenever MP
>AP, the AP is rising (upto number of workers 4.5) — it makes no
difference whether MP is rising or falling. When MP < AP (from
number of workers 4.5), the AP is falling. Therefore, the intersection
must occur at the maximum point of AP. It is important to understand
why. The key is that AP increases as long as the MP is greater than AP.
And AP decreases as long as MP is less than AP. Since AP is positively
or negatively sloped depending on whether MP is above or below AP, it
follows that MP=AP at the highest point on the AP curve.

This relationship between MP and AP is not unique to economics. Consider a

cricket batsman, say Sachin Tendulkar, who is averaging 50 runs in 10
innings. In his next innings he scores a 100. His marginal score is 100 and his
average will now be above 50. More precisely, it is 54 i.e. (50 * 10 + 100)/
(10+1) = 600/11. This means when the marginal score is above the average,
the average must increase. In case he had scored zero, his marginal score
would be below the average, and his average would fall to 45.5 i.e. 500/11
is 45.45. Only if he had scored 50 would the average remain constant, and
the marginal score would be equal to the average.

The Law of Diminishing Marginal Returns

The slope of the MP curve in Figure 7.1 illustrates an important principle, the
law of diminishing marginal returns. As the number of units of the variable
input increases, the other inputs held constant (fixed), there exists a point
beyond which the MP of the variable input declines. Table 7.1 illustrates this
law. Observe that MP was increasing up to the addition of 4th worker (input);
beyond this the MP decreases. What this law says is that MP may rise or stay
constant for some time, but as we keep increasing the units of variable input,
MP should start falling. It may keep falling and turn negative, or may stay
positive all the time. Consider another example for clarity. Single application
of fertilizers may increase the output by 50%, a second application by another
30% and the third by 20% and so on. However, if you were to apply fertilizer
five to six times in a year, the output may drop to zero.

Three things should be noted concerning the law of diminishing marginal

returns.

1. This law is an empirical generalization, not a deduction from physical

or biological laws.
141
Production and Cost 2. It is assumed that technology remains fixed. The law of diminishing
Analysis
marginal returns cannot predict the effect of an additional unit of
input when technology is allowed to change.

3. It is assumed that there is at least one input whose quantity is being

held constant (fixed). In other words, the law of diminishing marginal
returns does not apply to cases where all inputs are variable.

Stages of Production
Based on the behaviour of MP and AP, economists have classified production
into three stages:
Stage 1: MP > 0, AP rising. Thus, MP > AP.

Stage 2: MP > 0, but AP is falling. MP < AP but TP is increasing (because

MP >0).

Stage 3: MP < 0. In this case TP is falling.

These results are illustrated in Figure 7.1. No profit-maximizing producer

would produce in stages I or III. In stage I, by adding one more unit of
labour, the producer can increase the AP of all units. Thus, it would be
unwise on the part of the producer to stop the production in this stage. As for
stage III, it does not pay the producer to be in this region because by reducing
the labour input the total output can be increased and the cost of a unit of
labour can be saved.

Thus, the economically meaningful range is given by stage II. In Figure 7.1
at the point of inflection (x), we saw earlier that MP is maximized. At point y,
since AP is maximized, we have AP = MP. At point z, TP reaches a
maximum. Thus, MP = 0 at this point. If the variable input is free then the
optimum level of output is at point z where TP is maximized. However, in
practice no input will be freely available. The producer has to pay a price for
it. Suppose the producer pays Rs. 200 per worker per day and the price of a
unit of output (say one apple) is Rs. 10. In this case the producer will keep on
hiring additional workers as long as

(Price of a unit of output) * (marginal product of labour) > (price of a unit of

labour)

That is, marginal revenue of product (MRP) of labour >PL

On a similar analogy,

(price of a unit of output) * (marginal product of capital) > (price of a unit of

capital)

That is, marginal revenue of product (MRP) of capital > PK

142
The left side denotes the increase in revenue and the right side denotes the Production Function
increase in the cost of adding one more unit of labour. As long as the
increment to revenues exceeds the increment to costs, the profit of the
producer will increase. As we increase the units of labour, we see that MP
diminishes. We assume that the prices of inputs and output do not change. In
this case, as MP declines, revenues will start falling, and a point will come
when the increase in revenue equals the increase in cost. At this point the
producer will stop adding more units of input. With further addition, since
MP declines, the additional revenues would be less than the additional costs,
and the profit of the producer would decline.

Thus, profit maximization implies that a producer with no control over prices
will increase the use of an input until—

Value of marginal product (MP) = Price of a unit of variable input

Activity 2
1. Fill in the blanks of the following table.
Capital Labour TP APL MPL

1 0 0
1 1 2 2
1 2 5 3
1 3 3 4
1 4 12 3
1 5 14
1 6 2½ 1
1 15¾ 2¼
1 8 11
1 9 1 –2

2. State clearly the relation between APLand MPL.

3. Why is the marginal product of labour likely to increase and then decline
in the short-run?

4. Faced with constantly changing conditions, why would a firm ever keep
any factors fixed? What determines whether a factor is fixed or variable?

5. Suppose a chair manufacturer is producing in the short run where

equipment is fixed. The manufacturer knows that as the number of
labourers used in the production process increases from 1 to 7, the 143
Production and Cost number of chairs produced changes as follows: 10, 17, 22, 25, 26, 25, and
Analysis 23.

a) Calculate the marginal and average product of labour for this

production function.

b) Does this production function exhibit increasing returns to labour or

decreasing returns to labour or both? Explain.
c) Explain intuitively what might cause the marginal product of labour
to become negative?

6. Why a profit-maximizing producer would produce in stage-II and not in

stage-I or III? Explain.

7.4 PRODUCTION FUNCTION WITH TWO

VARIABLE INPUTS
Now we turn to the case of production where two inputs (say capital and labour)
are variable. Although, we restrict our analysis to two variable inputs, all of
the results hold for more than two also. We are restricting our analysis to two
variable inputs because it simply allows us the scope for graphical analysis.
When analyzing production with more than one variable input, we cannot simply
use sets of AP and MP curves like those discussed in section 7.3, because these
curves were derived holding the use of all other inputs fixed and letting the use
of only one input vary. If we change the level of fixed input, the TP, AP and MP
curves would shift. In the case of two variable inputs, changing the use of one
input would cause a shift in the MP and AP curves of the other input. For
example, an increase in capital would probably result in an increase in the MP of
labour over a wide range of labour use.

Production Isoquants

In Greek the word ‘iso’ means ‘equal’ or ‘same’. A production isoquant (equal
output curve) is the locus of all those combinations of two inputs which
yields a given level of output. With two variable inputs, capital and labour, the
isoquant gives the different combinations of capital and labour, that produces the
same level of output. For example, 5 units of output can be produced using
either 15 units of capital (K) or 2 units of labour (L) or K=10 and L=3 or K=5
and L=5 or K=3 and L=7. These four combinations of capital and labour are four
points on the isoquant associated with 5 units of output as shown in Figure 7.2.
And if we assume that capital and labour are continuously divisible, there would
be many more combinations on this isoquant.

Now let us assume that capital, labour, and output are continuously divisible in
order to set forth the typically assumed characteristics of isoquants. Figure 7.3
illustrates three such isoquants. Isoquant I shows all the combinations of capital
144
and labour that will produce 10 units of output. According to this isoquant, it is Production Function

possible to obtain this output if K0 units of capital and L0 units of labour inputs
are used.

Figure 7.2: Production Isoquant: This isoquant shows various

combinations of capital and labour inputs that can produce
5 units of output.

Figure 7.3: Isoquant Map: These isoquants shows various combinations

of capital and labour inputs that can produce 10, 15, and 20
units of output.

Alternately, this output can also be obtained if K1 units of capital and L1 units
of labour inputs or K2 units of capital and L2 units of labour are used.
145
Production and Cost Similarly, isoquant II shows the various combinations of capital and labour
Analysis
that can be used to produce 15 units of output. Isoquant III shows all
combinations that can produce 20 units of output. Each capital- labour
combination can be on only one isoquant. That is, isoquants cannot intersect.
These isoquants are only three of an infinite number of isoquants that could
be drawn. A group of isoquants is called an isoquant map. In an isoquant
map, all isoquants lying above and to the right of a given isoquant indicate
higher levels of output. Thus, in Figure 7.3 isoquant II indicates a higher
level of output than isoquant I, and isoquant III indicates a higher level of
output than isoquant II.

In general, isoquants are determined in the following way. First, a rate of

output, say Q0, is specified. Hence the production function can be written as

Q0 = f (K,L)

Those combinations of K and L that satisfy this equation define the isoquant
for output rate Q0.

Marginal Rate of Technical Substitution

As we have seen above, generally there are a number of ways (combinations

of inputs) that a particular output can be produced. The rate, at which one
input can be substituted for another input, if output remains constant, is
called the marginal rate of technical substitution (MRTS). It is defined
in case of two inputs, capital and labour, as the amount of capital that can be
replaced by an extra unit of labour, without affecting total output.

∆
MRTSL for K =
∆

It is customary to define the MRTS as a positive number, since ∆K/∆L, the

slope of the isoquant, is negative. Over the relevant range of production the
MRTS diminishes. That is, more and more labour is substituted for capital
while holding output constant, the absolute value of ∆K/∆L decreases. For
example, let us assume that 10 pairs of shoes can be produced using either 8
units of capital and 2 units of labour or 4 units each of capital and of labour
or 2 units of capital and 8 units of labour. From Figure 7.4 the MRTS of
labour for capital between points a and b is equal to ∆K/∆L= (4–8) / (4–2) =
–4/2 = –2 or | 2 |. Between points b and c, the MRTS is equal to –2/4 = –½ or
| ½ |. The MRTS has decreased because capital and labour are not perfect
substitutes for each other. Therefore, as more of labour is added, less of
capital can be used (in exchange for another unit of labour) while keeping the
output level constant.

146
 Figure 7.4: Marginal Rate of Technical Substitution Production Function

There is a simple relationship between MRTS of labour for capital and the
marginal product MPK and MPL of capital and labour respectively. Since
along an isoquant, the level of output remains the same, if ∆L units of labour
are substituted for ∆K units of capital, the increase in output due to ∆L units
of labour (namely, ∆L* MPL) should match the decrease in output due to a
decrease of ∆K units of capital (namely, ∆K * MPk). In other words, along an
isoquant,

∆ L * MPL = ∆ K * MPK

Which is equal to
∆
=
∆

However, as we have seen earlier ∆K/∆L is equal to MRTSL for K, and

hence, we get the following expression for MRTS of L for K as the ratio of
the corresponding marginal products.

MRTSL For K =

There are vast differences among inputs in how readily they can be
substituted for one another. For example, in some extreme production
process, one input can perfectly be substituted for another; whereas in some
other extreme production process no substitution is possible. On the other
hand, in most of the production processes what we see is imperfect
substitution of inputs. These three general shapes that an isoquant might
have are shown in Figure 7.5. In panel I, the isoquants are right angles
implying that the two inputs a and b must be used in fixed proportion and
147
Production and Cost they are not at all substitutable. For instance, there is no substitution possible
Analysis between the tyres and a battery in an automobile production process. The
MRTS in all such cases would, therefore, be zero. The other extreme case
would be where the inputs a and b are perfect substitutes as shown in
panel II. The isoquants in this category will be a straight line with constant
slope or MRTS. A good example of this type would be natural gas and fuel
oil, which are close substitutes in energy production. The most common
situation is presented in panel III. The inputs are imperfect substitutes in this
case and the rate at which input a can be given up in return for one more
unit of input b keeping the output constant diminishes as the amount of input
b increases.

Figure 7.5: Three General Types of Shapes of Isoquants

The Economic Region of Production

Isoquants may also have positively sloped segments, or bend back upon
themselves, as shown in Figure 7.6. Above OA and below OB, the slope of
the isoquants is positive, which implies that increase in both capital and
labour are required to maintain a certain output rate. If this is the case, the
MP of one or other input must be negative. Above OA, the MP of capital is
negative. Thus output will increase if less capital is used, while the amount of
labour is held constant. Below OB, the MP of labour is negative.
148
Thus, output will increase if less labour is used, while the amount of capital is Production Function
held constant. The lines OA and OB are called ridge lines. And the region
bounded by these ridge lines is called economic region of production. This
means the region of production beyond the ridge lines is economically
inefficient.

Figure 7.6: Economic Region of Production

7.5 THE OPTIMAL COMBINATION OF INPUTS

In the above section you have learned that any desired level of output can be
produced using a number of different combinations of inputs. As said earlier
in the introduction of this unit one of the decision problems that concerns a
production process manager is, which input combination to use. That is, what
is the optimal input combination? While all the input combinations are
technically efficient, the final decision to employ a particular input
combination is purely an economic decision and rests on cost (expenditure).
Thus, the production manager can make either of the following two input
choice decisions:

1. Choose the input combination that yields the maximum level of output
with a given level of expenditure.
2. Choose the input combination that leads to the lowest cost of producing a
given level of output.
Thus, the decision is to minimize cost subject to an output constraint or
maximize the output subject to a cost constraint. We will now discuss these
two fundamental principles. Before doing this we will introduce the concept
isocost, which shows all combinations of inputs that can be used for a given
cost.

Isocost Lines

Recall that a universally accepted objective of any firm is to maximize profit.

If the firm maximizes profit, it will necessarily minimize cost for producing a 149
Production and Cost given level of output or maximize output for a given level of cost. Suppose
Analysis there are 2 inputs: capital (K) and labour (L) that are variable in the relevant
time period. What combination of (K,L) should the firm choose in order to
maximize output for a given level of cost?

If there are 2 inputs, K,L, then given the price of capital (Pk) and the price of
labour (PL), it is possible to determine the alternative combinations of (K,L)
that can be purchased for a given level of expenditure. Suppose C is total
expenditure, then

C = PL * L + PK * K

This linear function can be plotted on a graph.

Figure 7.7 : Isocost line

If only capital is purchased, then the maximum amount that can be bought is
C/Pk shown by point A in figure 7.7. If only labour is purchased, then the
maximum amount of labour that can be purchased is C/PL shown by point B
in the figure. The 2 points A and B can be joined by a straight line. This
straight line is called the isocost line or equal cost line. It shows the
alternative combinations of (K,L) that can be purchased for the given
expenditure level C. Any point to the right and above the isocost is not
attainable as it involves a level of expenditure greater than C and any point
to the left and below the isocost such as P is attainable, although it implies
the firm is spending less than C. You should verify that the slope of the
isocost is1:

− = * =

EXAMPLE

Consider the following data:

PL = 10, Pk = 20 Total Expenditure = 200

150 1
The negative sign is due to the fact that the slope of the isocost is negative.
 Let us first plot the various combinations of K and L that are possible. We Production Function
consider only the case when the firm spends the entire budget of 200. The
alternative combinations are shown in the figure (7.8).

Figure 7.8 : Shifting of Iscost

The slope of this isocost is –½. What will happen if labour becomes more
expensive say PL increases to 20? Obviously with the same budget the firm
can now purchase lesser units of labour. The isocost still meets the Y–axis at
point A (because the price of capital is unchanged), but shifts inwards in the
direction of the arrow to meet the X-axis at point C. The slope therefore
changes to –1. You should work out the effect on the isocost curve on the
following:

i) decrease in the price of labour

ii) increase in the price of capital
iii) decrease in the price of capital
iv) increase in the firms budget with no change in the price of labour and
capital
[Hint:The slope of the isocost will not change in this case]

Optimal Combination of Inputs: The Long Run

When both capital and labour are variable, determining the optimal input
rates of capital and labour requires the technical information from the
production function i.e. the isoquants be combined with market data on input
prices i.e. the isocost function. If we super impose the relevant isocost curve 151
Production and Cost on the firm’s isoquant map, we can readily determine graphically as to which
Analysis combination of inputs maximize the output for a given level of expenditure.

Consider the problem of minimizing the cost of a given rate of output.

Specifically if the firm wants to produce 50 units of output at minimum cost.
Two production isoquants have been drawn in Figure 7.9. Three possible
combinations (amongst a number of more combinations) are indicated by
points A, Z and B in Figure 7.9. Obviously, the firm should pick the point on
the lower isocost i.e point Z. In fact, Z is the minimum cost combination of
capital and labour. At Z the isocost is tangent to the 50 unit isoquant.

Alternatively, consider the problem of maximizing output subject to a given

cost amount. You should satisfy yourself that among all possible output
levels, the maximum amount will be represented by the isoquant that is
tangent to the relevant isocost line. Suppose the budget of the firm increases
to the amount shown by the higher of the two isocost lines in Figure 7.9,
point Q or 100 units of output is the maximum attainable given the new cost
constraint in Figure7.9.

Figure 7.9: Optimal combination of inputs

Regardless of the production objective, efficient production requires that the

isoquant be tangent to the isocost function. If the problem is to maximize
output, subject to a cost constraint or to minimize cost for a given level of
output, the same efficiency condition holds true in both situations. Intuitively,
if it is possible to substitute one input for another to keep output constant
while reducing total cost, the firm is not using the least cost combination of
inputs. In such a situation, the firm should substitute one input for another.

For example, if an extra rupee spent on capital generates more output than an
extra rupee spent on labour, then more capital and less labour should be
152
 employed. At point Q in Figure 7.9, the marginal product of capital per rupee Production Function
spent on capital is equal to the marginal product of labour per rupee spent on
labour. Mathematically this can be shown as
L K
= ………………………….....….11

Or equivalently,

L L
= …………………………....…...212
K K

Whenever the 2 sides of the above equation are not equal, there are
possibilities that input substitutions will reduce costs. Let us work with
numbers. Suppose PL = 10, Pk = 20, MPL = 50 and MPk = 40. Thus, we
have:

>

This cannot be an efficient input combination, because the firm is getting

more output per rupee spent on labour than on capital. If one unit of capital
is sold to obtain 2 units of labour (Pk = 20, PL = 10), net increase in output
will be 602.3 Thus the substitution of labour for capital would result in a net
increase in output at no additional cost. The inefficient combination
corresponds to a point such as A in Figure 7.9. At that point two much
capital is employed. The firm, in order to maximize profits will move down
the isocost line by substituting labour for capital until it reaches point Q.
Conversely, at a point such as B in figure7.9 the reverse is true-there is too
much labour and the in equality

< will hold

21
Recall that is the slope of the isoquant and it is also the MRTS while is the slope of
the isocost line, Since for optimum, the isocost must be tangent to the isoquant, the result
follows. Many text books denote PL which is the price of labour as w or the wage rate and
PK which is the price of capital as r or the rental. The equilibrium condition can thus also be
written as
=
2 Since the MPL = 50, 2 units of labour produce 100 units, while reducing capital by 1 unit
decreases output by 40 units (MPk = 40). Therefore, net increase is 60 units. This, of
course, assumes that MPL and MPk remain constant in the relevant range. We know that as
more labour is employed in place of capital, MPL will decline and MPK will increase (this
follows from the law of diminishing returns)and thus equation (2) will be satisfied.
153
Production and Cost This means that the firm generates more output per rupee spent on capital
Analysis
than from rupees spent on labour. Thus a profit maximizing firm should
substitute capital for labour.

Suppose the firm was operating at point B in Figure 7.9. If the problem is to
minimize cost for a given level of output (B is on the isoquant that
corresponds to 50 units of output), the firm should move from B to Z along
the 50-unit isoquant thereby reducing cost, while maintaining output at 50.
Alternatively, if the firm wants to maximize output for given cost, it should
move from B to Q, where the isocost is tangent to the 100-unit isoquant. In
this case output will increase from 50 to 100 at no additional cost. Thus both
the following decisions:

(a) the input combination that yields the maximum level of output with a
given level of expenditure, and

(b) the input combination that leads to the lowest cost of producing a
given level of output are satisfied at point Q in Figure7.9.

You should be satisfied that this is indeed the case.

The isocost-isoquant framework described above lends itself to various

applications. It demonstrates, simply and elegantly, when relative prices of
inputs change, managers will respond by substituting the input that has
become relatively less expensive for the input that has become relatively
more expensive. On average, we know that compared to developed countries
like the US, UK, Japan and Germany, labour in India is less expensive. It is
not surprising therefore to find production techniques that on average, use
more labour per unit of capital in India than in the developed world. For
example, in construction activity you see around you in your city, inexpensive
workers do the job that in developed countries are performed by machines.

L One application of the isocost-isoquant framework frequently cited is the

response of industry to the rapidly rising prices of energy products in the
1970s. (Remember the oil price shock of 1973 and again of 1979). Most
prices of petrol and petroleum products increased across the world, and as our
analysis suggests, firms responded by conserving energy by substituting other
inputs for energy.

Activity 3
1. Draw an isoquant map using the information available in the following
Table.
154
 Isoquant-I Isoquant-II Isoquant-III Production Function

L K L K L K
2 11 4 13 6 15
1 8 3 10 5 12
2 5 4 7 6 9
3 3 5 5 7 7
4 2.3 6 4.2 8 6.2
5 1.8 7 3.5 9 5.5
6 1.6 8 3.2 10 5.3
7 1.8 9 3.5 11 5.5

1a) Which one of the isoquants provides you with highest level of output
and why?

1b) Take any one of the isoquants and compute MRTSLK. What do you
observe about computed MRTS? Explain the observed trend.
Isoquant..........
L K MRTSLK

155
Production and Cost 2. The marginal product of labour in the production of computer chips
Analysis is 50 chips per hour. The marginal rate of technical substitution of
hours of labour for hours of machine-capital is ¼. What is the
marginal product of capital?
3. What would the isoquants look like if all inputs were nearly
perfect substitutes in a production process? What if there was
near-zero substitutability between inputs?

7.6 RETURNS TO SCALE

Another important attribute of production function is how output responds in
the long run to changes in the scale of the firm i.e. when all inputs are
increased in the same proportion (by say 10%), how does output change.
Clearly, there are 3 possibilities. If output increases by more than an increase
in inputs (i.e. by more than 10%), then the situation is one of increasing
returns to scale (IRS). If output increases by less than the increase in inputs,
then it is a case of decreasing returns to scale (DRS). Lastly, output may
increase by exactly the same proportion as inputs. For example a doubling of
inputs may lead to a doubling of B output. This is a case of constant returns
to scale (CRS).
Figure 7.10: Isoquants Showing Returns to Scale

156
In unit 8 we will examine returns to scale from the point of view of cost and Production Function
also advance reasons for increasing and decreasing returns to scale. For the
moment consider the following example. A box with dimensions 4*4*4 has a
capacity of 64 times a box with dimensions 1*1*1, even though the former
uses only 16 times more wood than the smaller box3.4.

Isoquants can also be used to depict returns to scale (Figure 7.10)

Panel A shows constant returns to scale. Three isoquants with output levels
50,100 and 150 are drawn. In the figure, successive isoquants are equidistant
from one another along the ray CZ. Panel B shows increasing returns to scale,
where the distance between 2 isoquants becomes less and less i.e. in order to
double output from 50 to 100, input increase is less than double. The
explanation for panel C, which exhibits decreasing returns to scale, is
analogous.

There is no universal answer to which industries will show what kind of

returns to scale. Some industries like public utilities (Telecom and Electricity
generation) show increasing returns over large ranges of output, whereas
other industries exhibit constant or even decreasing returns to scale over the
relevant output range. Therefore, whether an industry has constant, increasing
or decreasing returns to scale is largely an empirical issue.

7.7 FUNCTIONAL FORMS OF PRODUCTION

FUNCTION
The production function can be estimated by regression techniques using
historical data (either time-series data, or cross-section data, or engineering
data). For this, one of the first tasks is to select a functional form, that is, the
specific relationship among the relevant economic variables. We know that
the general form of production function is,

Q = f (K,L)

Where, Q = output, K = capital and L = labour.

Although, a variety of functional forms have been used to describe

production relationships, only the Cobb-Douglas production function is
discussed here. The general form of Cobb-Douglas function is expressed as:

Q=

3 Volume of box : 4 * 4 * 4= 64 Area of box: 4 * 4 * 6 =96

1 * 1 * 1= 1 1 * 1 * 6 =6

157
Production and Cost where A, α, and β are the constants that, when estimated, describe the
Analysis quantitative relationship between the inputs (K and L) and output (Q).

The marginal products of capital and labour and the rates of the capital and
labour inputs are functions of the constants A, α, and β and. That is,

MPK =  AK-1 L

MPL = = AK L

The sum of the constants ( + ) can be used to determine returns to scale.

That is,

( + ) > 1  increasing returns to scale,

( + ) = 1  constant returns to scale, and

( + ) < 1  decreasing returns to scale.

Having numerical estimates for the constants of the production function

provides significant information about the production system under study.
The marginal products for each input and returns to scale can all be
determined from the estimated function.

The Cobb-Douglas function does not lend itself directly to estimation by the
regression methods because it is a nonlinear relationship. Technically, an
equation must be a linear function of the parameters in order to use the
ordinary least-squares regression method of estimation. However, a linear
equation can be derived by taking the logarithm of each term. That is,

log Q = log A+ log K+ log L

A linear relationship can be seen by setting,

Y = log Q, A* =log A, X1 =log K, X2 = log L and

Re writing the function as

Y = A* + X1 + X2

This function can be estimated directly by the least-squares regression

technique and the estimated parameters used to determine all the important
production relationships. Then the antilogarithm of both sides can be taken,
which transforms the estimated function back to its conventional
multiplicative form. We will not be studying here the details of computing
production function since there are a number of computer programs available
for this purpose.

158
Types of Statistical Analyses Production Function

Once a functional form of a production function is chosen the next step is to

select the type of statistical analysis to be used in its estimation. Generally,
there are three types of statistical analyses used for estimation of a production
function. These are:(a) time series analysis,(b)cross-section analysis and(c)
engineering analysis.

a) Time series analysis: The amount of various inputs used in various

periods in the past and the amount of output produced in each period
is called time series data. For example, we may obtain data
concerning the amount of labour, the amount of capital, and the
amount of various raw materials used in the steel industry during each
year from 1970 to 2000. On the basis of such data and information
concerning the annual output of steel during 1970 to 2000, we may
estimate the relationship between the amounts of the inputs and the
resulting output, using regression techniques.

Analysis of time series data is appropriate for a single firm that has
not undergone significant changes in technology during the time span
analyzed. That is, we cannot use time series data for estimating the
production function of a firm that has gone through significant
technological changes. There are even more problems associated with
the estimation a production function for an industry using time series
data. For example, even if all firms have operated over the same time
span, changes in capacity, inputs and outputs may have proceeded at
a different pace for each firm. Thus, cross section data may be more
appropriate.

b) Cross-section analysis: The amount of inputs used and output

produced in various firms or sectors of the industry at a given time is
called cross- section data. For example, we may obtain data
concerning the amount of labour, the amount of capital, and the
amount of various raw materials used in various firms in the steel
industry in the year 2020. On the basis of such data and information
concerning the year 2020, output of each firm, we may use regression
techniques to estimate the relationship between the amounts of the
inputs and the resulting output.

c) Engineering analysis: In this analysis we use technical information

supplied by the engineer or the agricultural scientist. This analysis is
undertaken when the above two types do not suffice. The data in this
analysis is collected by experiment or from experience with day-to-
day working of the technical process. There are advantages to be
gained from approaching the measurement of the production function
from this angle. Because the range of applicability of the data is
159
Production and Cost known, and, unlike time- series and cross-section studies, we are not
Analysis
restricted to the narrow range of actual observations.

Limitations of Different Types of Statistical Analysis

Each of the methods discussed above has certain limitations.

1. Both time-series and cross-section analysis are restricted to a

relatively narrow range of observed values. Extrapolation of the
production function outside that range may be seriously misleading.
For example, in a given case, marginal productivity might decrease
rapidly above 85% capacity utilization; the production function
derived for values in the 70%-85% capacity utilization range would
not show this.

2. Another limitation of time series analysis is the assumption that all

observed values of the variables pertains to one and the same
production function. In other words, a constant technology is
assumed. In reality, most firms or industries, however, find better,
faster, and/or cheaper ways of producing their output. As their
technology changes, they are actually creating new production
functions. One way of coping with such technological changes is to
make it one of the independent variables.

3. Theoretically, the production function includes only efficient (least-

cost) combinations of inputs. If measurements were to conform to
this concept, any year in which the production was less than nominal
would have to be excluded from the data. It is very difficult to find a
time-series data, which satisfy technical efficiency criteria as a
normal case.

4. Engineering data may overcome the limitations of time series data but
mostly they concentrate on manufacturing activities. Engineering data
do not tell us anything about the firm’s marketing or financial
activities, even though these activities may directly affect production.

5. In addition, there are both conceptual and statistical problems in

measuring data on inputs and outputs.

It may be possible to measure output directly in physical units such as tons of

coal, steel etc. In case more than one product is being produced, one may
compute the weighted average of output, the weights being given by the cost
of manufacturing these products. In a highly diversified manufacturing unit,
there may be no alternative but to use the series of output values, corrected
for changes in the price of products. One has also to choose between
‘gross value’ and ‘net value’. It seems better to use “net value added”
concept instead of output concept in estimating production function,
160 particularly where raw-material intensity is high.
The data on labour is mostly available in the form of “number of workers Production Function
employed” or “hours of labour employed”. The ‘number of workers’ data
should not be used because, it may not reflect underemployment of labour,
and they may be occupied, but not productively employed. Even if we use
‘man hours’ data, it should be adjusted for efficiency factor. It is also not
advisable that labour should be measured in monetary terms as given by
expenditure on wages, bonus, etc.

The data on capital input has always posed serious problems. Net investment
i.e. a change in the value of capital stock, is considered most appropriate.
Nevertheless, there are problems of measuring depreciation in fixed capital,
changes in quality of fixed capital, changes in inventory valuation, changes in
composition and productivity of working capital, etc.

Finally, when one attempts an econometric estimate of a production function,

one has to overcome the standard problem of multi-collinearity among inputs,
autocorrelation, homoscadasticity, etc.

7.8 MANAGERIAL USES OF PRODUCTION

FUNCTION
There are several managerial uses of the production function. It can be used
to compute the least-cost combination of inputs for a given output or to
choose the input combination that yields the maximum level of output with
a given level of cost. There are several feasible combinations of input factors
and it is highly useful for decision-makers to find out the most appropriate
among them. The production function is useful in deciding on the additional
value of employing a variable input in the production process. So long as
the marginal revenue productivity of a variable factor exceeds it price, it may
be worthwhile to increase its use. The additional use of an input factor should
be stopped when its marginal revenue productivity just equals its price.
Production functions also aid long-run decision-making. If returns to scale
are increasing, it will be worthwhile to increase production through a
proportionate increase in all factors of production, provided, there is enough
demand for the product. On the other hand, if returns to scale are decreasing,
it may not be worthwhile to increase the production through a proportionate
increase in all factors of production, even if there is enough demand for the
product. However, it may in the discretion of the producer to increase or
decrease production in the presence of constant returns to scale, if there is
enough demand for the product.

Activity 2

1. Can you list some more managerial uses of production function other
than those given in section 7.8?
161
Production and Cost
Analysis
7.9 LET US SUM UP
A production function specifies the maximum output that can be produced
with a given set of inputs. In order to achieve maximum profits the
production manager has to use optimum input-output combination for a
given cost. In this unit, we have shown how a production manager
minimizes the cost for a given output in order to maximize the profit.
Also, we have shown how to maximize the output at a given level of cost.

The law of diminishing marginal returns states that as equal increments of

variable input are added to fixed input, a point will eventually be reached
where corresponding increments to output begin to decline. We have also
seen the relations between the marginal product, average product, and total
product. There are three stages of production. Stage I is characterized by
MP>0 and MP>AP. Stage II is characterized by MP>0 and MP<AP. Stage
III is characterized by MP<0. The economically meaningful range is Stage
II. The production manager maximizes the profit at a point where the
value of marginal product equals the price of the output.

A production isoquant consists of all the combinations of two inputs that

will yield the same maximum output. The marginal rate of technical
substitution is ∆K/∆L, holding output constant. The law of diminishing
marginal rate of substitution implies the rate at which one input can be
substituted for another input, if output remains constant. An isocost line
consists of all the combinations of inputs which have the same total cost.
The absolute slope of the isocost line is the input price ratio. Returns to
scale, a long run concept, involves the effect on output of changing all
inputs by same proportion and in the same direction. Although, there are
many different forms of production function we have discussed here only
Cobb-Douglas production function.

7.10 TERMINAL QUESTIONS

1. Fill in the blanks in the following Table.

Units of labour Total product Average product Marginal product

1 40
2 48
3 138
4 44
5 24
6 210
7 29
8 -27

162
2. The marginal product of labour is known to be greater than the average Production Function
product of labour at a given level of employment. Is the average
product increasing or decreasing? Explain.
3. Explain the law of diminishing marginal returns and provide an
example of the phenomenon.
4. Explain why a profit maximizing firm using only one variable input
will produce in stage-II.
5. Explain why an A P curve and the corresponding MP curve must
intersect at the maximum point on the A P curve
6. Explain why MP is greater than (less than ) AP when AP is rising
(falling).
7. Suppose a firm is currently using 500 labourers and 325 units of capital
to produce its product. The wage rate is `25,and price of capital is
`130. The last labourer adds 25 units of total output, while the last unit
of capital adds 65 units to total output. Is the manager of this firm
making the optimal input choice? Why or why not? If not, what should
the manager do?

FURTHER READINGS
Adhikary, M. (1987). Managerial Economics (3rd ed.).Khosla Publishers,
Delhi.

Maddala, G. S., & Miller, E. M. (1989). Micro Economics: Theory and

Applications. McGraw-Hill, NewYork.

Maurice, S.C., Smithson, C.W., & Thomas, C. R.(2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:

Concepts and Cases. Tata McGraw-Hill, New Delhi.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

163
Production and Cost
Analysis
UNIT 8 SHORT RUN COST ANALYSIS
Structure

8.0 Objectives
8.1 Introduction
8.2 Actual Costs and Opportunity Costs
8.3 Explicit and Implicit Costs
8.4 Accounting Costs and Economic Costs
8.5 Direct Costs and Indirect Costs
8.6 Total Cost, Average Cost and Marginal Cost
8.7 Fixed and Variable Costs
8.8 Short-Run and Long-Run Costs
8.9 Short Run Cost Function
8.10 Applications of Short Run Cost Analysis
8.11 Let Us Sum Up
8.12 Terminal Questions

8.0 OBJECTIVES
After going through this unit, you should be able to:
 understand some of the cost concepts that are frequently used in the
managerial decision-making process;
 understand short run cost function; and
 understand applications of short run cost function in managerial decision
making.

8.1 INTRODUCTION
The analysis of cost is important in the study of managerial economics
because it provides a basis for two important decisions made by managers:
(a) whether to produce or not and (b) how much to produce when a decision
is taken to produce. There are two types of cost analysis: short run cost
analysis & long run cost analysis.

In this Unit, we shall discuss some important cost concepts that are relevant
for managerial decisions. We analyze the basic differences between these cost
concepts and also, examine how accountants and economists differ on
treating different cost concepts. We shall discuss short run cost function and
its applications in managerial decision making. The short run cost estimates a
helpful to managers in arriving at the optimal mix of inputs to achieve a
164 particular output target of a firm.
 Short Run Cost
8.2 ACTUAL COSTS AND OPPORTUNITY Analysis
COSTS
Actual costs are those costs, which a firm incurs while producing or
acquiring a good or service like raw materials, labour, rent, etc. Suppose, we
pay ` 150 per day to a worker whom we employ for 10 days, then the cost of
labour is ` 1500. The economists called this cost as accounting costs because
traditionally accountants have been primarily connected with collection of
historical data (that is the costs actually incurred) in reporting a firm’s
financial position and in calculating its taxes. Sometimes the actual costs are
also called acquisition costs or outlay costs.

On the other hand, opportunity cost is defined as the value of a resource in

its next best use. For example, Mr. Ram is currently working with a firm and
earning ` 5 lakhs per year. He decides to quit his job and start his own small
business. Although, the accounting cost of Mr. Ram’s labour to his own
business is 0, the opportunity cost is ` 5 lakhs per year. Therefore, the
opportunity cost is the earnings he foregoes by working for his own firm.
One may ask you that whether this opportunity cost is really meaningful in
the decision-making process. Opportunity cost can be similarly defined for
other factors of production. For example, consider a firm that owns a building
and therefore do not pay rent for office space. If the building was rented to
others, the firm could have earned rent. The foregone rent is an opportunity
cost of utilizing the office space and should be included as part of the cost of
doing business. Sometimes these opportunity costs are called as alternative
costs.

8.3 EXPLICIT AND IMPLICIT COSTS

Explicit costs are those costs that involve an actual payment to other parties.
Therefore, an explicit cost is the monetary payment made by a firm for use of
an input owned or controlled by others. Explicit costs are also referred to as
accounting costs. For example, a firm pays ` 100 per day to a worker and
engages 15 workers for 10 days, the explicit cost will be ` 15,000 incurred by
the firm. Other types of explicit costs include purchase of raw materials,
renting a building, amount spent on advertising etc.

On the other hand, implicit costs represent the value of foregone

opportunities but do not involve an actual cash payment. Therefore, an
implicit cost is the opportunity cost of using resources that are owned or
controlled by the owners of the firm. Implicit costs are just as important as
explicit costs but are sometimes neglected because they are not as obvious.
The implicit cost is the foregone return, the owner of the firm could have
received had they used their own resources in their best alternative use rather
than using the resources for their own firm’s production. For example, a
manager who runs his own business foregoes the salary that could have been
earned working for someone else as we have seen in our earlier example. 165
Production and Cost This implicit cost generally is not reflected in accounting statements, but
Analysis rational decision-making requires that it be considered.

8.4 ACCONTING COSTS AND ECONOMIC

COSTS
For a long time, there has been a considerable disagreement among
economists and accountants on how costs should be treated. The reason for
the difference of opinion is that the two groups want to use the cost data for
dissimilar purposes. Accountants always have been concerned with firms’
financial statements. Accountants tend to take a retrospective look at firm’s
finances because they keep trace of assets and liabilities and evaluate past
performance. The accounting costs are useful for managing taxation needs as
well as to calculate profit or loss of the firm. On the other hand, economists
take forward-looking view of the firm. They are concerned with what cost
is expected to be in the future and how the firm might be able to rearrange its
resources to lower its costs and improve its profitability. They must therefore
be concerned with opportunity cost. Since the only cost that matters for
business decisions are the future costs, it is the economic costs that are used
for decision-making. Accountants and economists both include explicit costs
in their calculations. For accountants, explicit costs are important because
they involve direct payments made by a firm. These explicit costs are also
important for economists as well because the cost of wages and materials
represent money that could be useful elsewhere.

Accountants and economists use the term ‘profits’ differently. Accounting

profits are the firm’s total revenue less its explicit costs. But economists
define profits differently. Economic profits are total revenue less all costs
(explicit and implicit costs). The economist takes into account the implicit
costs (including a normal profit) in addition to explicit costs in order to retain
resources in a given line of production. Therefore, when an economist says
that a firm is just covering its costs, it is meant that all explicit and implicit
costs are being met, and that, the entrepreneur is receiving a return just large
enough to retain his/her talents in the present line of production. If a firm’s
total receipts exceed all its economic costs, the residual accruing to the
entrepreneur is called an economic profit, or pure profit.

Example of Economic Profit and Accounting Profit

Mr. Raj is a small storeowner. He has invested ` 2 lakhs as equity in the

store and inventory. His annual turnover is ` 8 lakhs, from which he must
deduct the cost of goods sold, salaries of hired staff, and depreciation of
equipment and building to arrive at annual profit of the store. He asked help
of a friend who is an accountant by profession to prepare annual income
statement. The accountant reported the profit to be ` 1.5 lakhs. Mr. Raj
could not believe this and asked the help of another friend who is an
economist by profession. The economist told him that the actual profit was
166
only ` 75,000 and not ` 1.5 lakhs. The economist found that the accountant Short Run Cost
Analysis
had underestimated the costs by not including the implicit costs of time spent
as Manager by Mr. Raj in the business and interest on owner’s equity. The
two income statements are shown below:

Income statement prepared by accountant Income statement prepared by economist

` ` ` `
Sales 8,00,000 Sales 8,00,000
Explicit costs Explicit costs
Cost of goods sold 6,00,000 Cost of goods sold 6,00,000
Salaries 40,000 Salaries 40,000
Depreciation 10,000 6,50,000 Depreciation 10,000 6,50,000
Implicit costs
Salary to owner 50,000
Manager
Interest on owners’ 25,000 75,000
equity
Accounting profit 1,50,000 Economic profit 75,000

Controllable and Non-Controllable costs

Controllable costs are those which are capable of being controlled or

regulated by executive vigilance and, therefore, can be used for assessing
executive efficiency. Non-controllable costs are those, which cannot be
subjected to administrative control and supervision. Most of the costs are
controllable, except, of course, those due to obsolescence and depreciation.
The level at which such control can be exercised, however, differs: some
costs (like, capital costs) are not controllable at factory’s shop level, but
inventory costs can be controlled at the shop level.

Out-of-pocket costs and Book costs

Out of pocket costs are those costs that improve current cash payments to
outsiders. For example, wages and salaries paid to the employees are out-of-
pocket costs. Other examples of out-of-pocket costs are payment of rent,
interest, transport charges, etc. On the other hand, book costs are those
business costs, which do not involve any cash payments but for them a
provision is made in the books of account to include them in profit and loss
accounts and take tax advantages. For example, salary of owner manager, if
not paid, is a book cost. The interest cost of owner’s own fund and
depreciation cost are other examples of book cost. The out-of-pocket costs
are also called explicit costs and correspondingly book costs are called
implicit or imputed costs.
167
Production and Cost Past and Future costs
Analysis
Past costs are actual costs incurred in the past and they are always contained
in the income statements. Their measurement is essentially a record keeping
activity. These costs can only be observed and evaluated in retrospect. If they
are regarded as excessive, management can indulge in post-mortem checks to
find out the factors responsible for the excessive costs, if any and take
corrective actions for future. Past costs serve as the basis for projecting future
costs.

Future costs are those costs that are likely to be incurred in future periods.
Since the future is uncertain, these costs have to be estimated and cannot be
expected to be absolutely correct figures. In periods of inflation and deflation,
the two cost concepts differ significantly. Managerial decisions are forward
looking and therefore they require estimates of future costs. Unlike past costs,
future costs are subject to management control and they can be planned or
avoided. Management needs to estimate future costs for a variety of reasons
such as expense control pricing, projecting future profits and capital
budgeting decisions. When historical costs are used instead of explicit
projections, the assumption is made that future costs will be the same as past
costs. In periods of significant price variations, such an assumption may lead
to wrong managerial decisions.

Historical and Replacement costs

The historical cost of an asset is the actual cost incurred at the time; the asset
was originally acquired. In contrast to this, replacement cost is the cost,
which will have to be incurred if that asset is purchased now. The difference
between the historical and replacement costs results from price changes over
time. Suppose a machine was acquired for `50,000 in the year 2015 and the
same machine can be acquired for ` 1,20,000 in the year 2021.Here ` 50,000
is the historical or original cost of the machine and ` 1,20,000 is its
replacement cost. The difference of `70,000 between the two costs has
resulted because of the price change of the machine during the period. In the
conventional financial accounts, the value of assets is shown at their
historical costs. But for decision-making, firms should try to adjust historical
costs to reflect price level changes. If the price of the asset does not change
over time, the historical cost will be the same as the replacement cost. If the
price raises the replacement cost will exceed historical cost and vice versa.
During periods of substantial price variations, historical costs are poor
indicators of actual costs.

Private Costs and Social Costs

A further distinction that is useful to make - especially in the public sector - is

between private and social costs. Private costs are those that accrue directly
to the individuals or firms engaged in relevant activity. Social costs, on the
168
other hand, are passed on to persons not involved in the activity in any direct Short Run Cost
Analysis
way (i.e., they are passed on to society at large). Consider the case of a
manufacturer located on the bank of a river who dumps the waste into water
rather than disposing it of in some other manner. While the private cost to the
firm of dumping is zero, it is definitely harmful to the society. It affects
adversely the people located down current and they have to incur higher costs
in terms of treating the water for their use, or having to travel a great deal to
fetch potable water. If these external costs were included in the production
costs of a producing firm, a true picture of real or social costs of the output
would be obtained. Ignoring external costs may lead to an inefficient and
undesirable allocation of resources in society.

Relevant Costs and Irrelevant Costs

The relevant costs for decision-making purposes are those costs, which are
incurred as a result of the decision under consideration. The relevant costs are
also referred to as the incremental costs. Costs that have been incurred
already and costs that will be incurred in the future, regardless of the present
decision are irrelevant costs as far as the current decision problem is
concerned.

There are three main categories of relevant or incremental costs. These are
the present-period explicit costs, the opportunity costs implicitly involved in
the decision, and the future cost implications that flow from the decision. For
example, direct labour and material costs, and changes in the variable
overhead costs are the natural consequences of a decision to increase the
output level.

Also, if there is any expenditure on capital equipments incurred as a result of

such a decision, it should be included in full, notwithstanding that the
equipment may have a useful life remaining after the present decision has
been carried out. Thus, the incremental costs of a decision to increase output
level will include all present-period explicit costs, which will be incurred as a
consequence of this decision. It will exclude any present-period explicit cost
that will be incurred regardless of the present decision.

The opportunity cost of a resource under use, as discussed earlier, becomes a

relevant cost while arriving at the economic profit of the firm. Many
decisions will have implications for future costs, both explicit and implicit. If
a firm expects to incur some costs in future as a consequence of the present
analysis, such future costs should be included in the present value terms if
known for certain.

Sunk Costs and Incremental Costs

Sunk costs are expenditures that have been made in the past or must be paid
in the future as part of contractual agreement or previous decision. For
example, the money already paid for machinery, equipment, inventory and
future rental payments on a warehouse that must be paid as part of long-term
lease agreement are sunk costs. In general, sunk costs are not relevant to
169
Production and Cost economic decisions. For example, the purchase of specialized equipment
Analysis designed to order for a plant. We assume that the equipment can be used to
do only what it was originally designed for and cannot be converted for
alternative use. The expenditure on this equipment is a sunk cost. Also,
because this equipment has no alternative use its opportunity cost is zero and,
hence, sunk costs are not relevant to economic decisions. Sometimes the sunk
costs are also called as non-avoidable or non-escapable costs.

On the other hand, incremental cost refers to total additional cost of

implementing a managerial decision. Change in product line, change in
output level, adding or replacing a machine, changing distribution channels
etc. are examples of incremental costs. Sometimes incremental costs are also
called as avoidable or escapable costs. Moreover, since incremental costs
may also be regarded as the difference in total costs resulting from a
contemplated change, they are also called differential costs.

As stated earlier sunk costs are irrelevant for decision making, as they do not
vary with the changes contemplated for future by the management. It is the
incremental costs, which are important for decision-making purpose.

Activity 1
1. A graduate from a business school decides to open business and devote
his full time to its management. What cost would you assign to his time?
Is this implicit or explicit?

2. Why is the historic cost of inventory or capital equipment irrelevant for

managerial decision making?

3. Comment on the nature of costs involved in depreciation from both

economic and accounting approaches.

8.5 DIRECT COSTS AND INDIRECT COSTS

There are some costs, which can be directly attributed to production of a
given product. The use of raw material, labour input, and machine time
involved in the production of each unit can usually be determined. On the
other hand, there are certain costs like stationery and other office and
administrative expenses, electricity charges, depreciation of plant and
buildings, and other such expenses that cannot easily and accurately be
separated and attributed to individual units of production, except on arbitrary
basis. When referring to the separable costs of first category accountants call
them the direct, or prime costs per unit. The accountants refer to the joint
costs of the second category as indirect or overhead costs. Direct and
indirect costs are not exactly synonymous to what economists refer to as
variable costs and fixed costs. The criterion used by the economist to divide
cost into either fixed or variable is whether or not the cost varies with the
170
level of output, whereas the accountant divides the cost on the basis of Short Run Cost
Analysis
whether or not the cost is separable with respect to the production of
individual output units. The accounting statements often divide overhead
expenses into ‘variable overhead’ and ‘fixed overhead’ categories. If the
variable overhead expenses per unit are added to the direct cost per unit, we
arrive at what economists call as average variable cost.

Separable Costs and Common Costs

Costs can also be classified on the basis of their traceability. The costs that
can be easily attributed to a product, a division, or a process are called
separable costs. On the other hand, common costs are those, which cannot
be traced to any one unit of operation. For example, in a multiple product
firm the cost of raw material may be separable (traceable) product-wise but
electricity charges may not be separable product-wise. In a University the
salary of a Vice-Chancellor is not separable department-wise but the salary of
teachers can be separable department-wise. The separable and common costs
are also referred to as direct and indirect costs respectively. The distinction
between direct and indirect costs is of particular significance in a multi-
product firm for setting up economic prices for different products.

8.6 TOTAL COST, AVERAGE COST &

MARGINAL COST
Total cost (TC) of a firm is the sum-total of all the explicit and implicit
expenditures incurred for producing a given level of output. It represents the
money value of the total resources required for production of goods and
services. For example, a shoe-maker’s total cost will include the amount s/he
spends on leather, thread, rent for her/his workshop, interest on borrowed
capital, wages and salaries of employees, etc., and the amount s/he charges
for her/his services and funds invested in the business. The total cost concept
is useful in break-even analysis and finding out whether a firm is making
profit or not.

Average cost (AC) is the cost per unit of output. That is, average cost equals
the total cost divided by the number of units produced (N).If TC =`500 and
N = 50 then AC = `10.The average cost concept is significant for calculating
the per unit profit.

Marginal cost (MC) refers to the change in total cost associated with a one-
unit change in output. Marginal cost (MC) is the extra cost of producing one
additional unit. At a given level of output, one examines the additional costs
being incurred in producing one extra unit and this yields the marginal cost.
For example, if TC of producing 100 units is `10,000 and the TC of
producing 101 units is `10,050, then MC at N = 101 equals `50.This cost
concept is significant to short-term decisions about profit maximizing rates of
171
Production and Cost output. For example, in an automobile manufacturing plant, the marginal cost
Analysis
of making one additional car per production period would be the labour,
material, and energy costs directly associated with that extra car. Marginal
cost is that sub category of incremental cost in the sense that incremental cost
may include both fixed costs and marginal costs.

However, when production is not conceived in small units, management will

be interested in incremental cost instead of marginal cost. For example, if a
firm produces 5000 units of TV sets, it may not be possible to determine the
change in cost involved in producing 5001 units of TV sets. This difficulty
can be resolved by taking units to significant size. For example, if the TV sets
produced is measured to hundreds of units and total cost (TC) of producing
the current level of three hundred TV sets is `15,00,000 and the firm decides
to increase the production to four hundred TV sets and estimates the TC as
`18, 00,000, then the incremental cost of producing one hundred TV sets
(above the present production level of three hundred units) is `3, 00,000.

The marginal and incremental cost concepts are needed in deciding

whether a firm needs to expand its production or not. In fact, the relevant
costs to be considered will depend upon the situation or production problem
faced by the manager.

8.7 FIXED COSTS AND VARIABLE COSTS

Fixed costs are that part of the total cost of the firm which does not change
with output. Expenditures on depreciation, rent of land and buildings,
property taxes, and interest payment on bonds are examples of fixed costs.
Given a capacity, fixed costs remain the same irrespective of actual output.
Variable costs, on the other hand, change with changes in output. Examples
of variable costs are wages and expenses on raw material.

However, it is not very easy to classify all costs into fixed and variable. There
are some costs, which fall between these extremes. They are called semi-
variable costs. They are neither perfectly variable nor absolutely fixed in
relation to changes in output. For example, part of the depreciation charges is
fixed and part variable. However, it is very difficult to determine how much
of depreciation cost is due to the technical obsolescence of assets and hence
fixed cost, and how much is due to the use of equipments and hence variable
cost. Nevertheless, it does not mean that it is not useful to classify costs in to
fixed and variable. This distinction is of great value in break-even analysis
and pricing decisions. For decision-making purposes, in general, it is the
variable cost, which is relevant and not the fixed cost.

To an economist the fixed costs are overhead costs and to an accountant these
are indirect costs. When the output goes up, the fixed cost per unit of output
comes down, as the total fixed cost is divided between larger units of output.
172
 Short Run Cost
8.8 SHORT RUN AND LONG RUN COSTS Analysis

The short run is defined as a period in which the supply of at least one
element of the inputs cannot be changed. To illustrate, certain inputs like
machinery, buildings, etc., cannot be changed by the firm whenever it so
desires. It takes time to replace, add or dismantle them. Short-run costs are
the costs that can vary with the degree of utilization of plant and other fixed
factors. In other words, these costs relate to the variation in output, given
plant capacity. Short-run costs are, therefore, of two types: fixed costs and
variable costs. In the short-run, fixed costs remain unchanged while variable
costs fluctuate with output.

Long run, on the other hand, is defined as a period in which all inputs are
changed with changes in output. In other words, it is that time-span in which
all adjustments and changes are possible to realize. Long-run costs are costs
that can vary with the size of plant and with other facilities normally regarded
as fixed in the short-run. In fact, in the long-run there are no fixed inputs and
therefore no fixed costs, i.e., all costs are variable. Thus, in the short run,
some inputs are fixed (like installed capacity) while others are variable (like
the level of capacity utilization); but in the long run all inputs, including the
size of the plant, are variable.

Both short-run and long-run costs are useful in decision-making. Short-run

cost is relevant when a firm has to decide whether or not to produce and if a
decision is taken to produce then how much more or less to produce with a
given plant size. If the firm is considering an increase in plant size, it must
examine the long-run cost of expansion. Long-run cost analysis is useful in
investment decisions.

Activity 2

1. Classify different cost concepts into:

a. Useful for decision making

b. Not useful for decision making

2. Give specific example of:

a. Direct costs:……………………………...…………………………….
b. Indirect costs: ………………………………………………………….
c. Sunk costs: …………………………………………………………….
d. Traceable costs: ……………………………………………………….
e. Common costs : ……………………………………………………….
173
Production and Cost f. Implicit costs: …………………………………………………………
Analysis
g. Social costs: ……………..…………………………………………….
h. Non-controllable costs : ……………...………………………………..

3. Give examples to distinguish between ‘fixed overheads’ and ‘variable

overheads’.

4. Can all ‘direct costs’ be treated as ‘variable costs’? Explain?

8.9 SHORT RUN COST FUNCTIONS

In above sections, we have distinguished between the short run and the long
run. We also distinguished between fixed costs and variable costs. The
distinction between fixed and variable costs is of great significance to the
business manager. Variable costs are those costs, which the business manager
can control or alter in the short run by changing levels of production. On the
other hand, fixed costs are clearly beyond business manager’s control, such
costs are incurred in the short run and must be paid regardless of output.

Total Costs

Three concepts of total cost in the short run must be considered: total fixed
cost (TFC), total variable cost (TVC), and total cost (TC).Total fixed costs
are the total costs per period of time incurred by the firm for fixed inputs.
Since the amount of the fixed inputs is fixed, the total fixed cost will be the
same regardless of the firm’s output rate. Table 8.1 shows the costs of a firm
in the short run. According to this table, the firm’s total fixed costs are `100.
The firm’s total fixed cost function is shown graphically in Figure 8.1.

Table 8.1: A Firm’s Short Run Costs (in `)

Q TFC TVC TC MC AFC AVC ATC

0 100 0 100
1 100 50 150 50 100.0 50 150
2 100 90 190 40 50.0 45 95.0
3 100 120 220 30 33.3 40 73.3
4 100 140 240 20 25.0 35 60.0
5 100 150 250 10 20.0 30 50.0
6 100 156 256 6 16.7 26 42.7
7 100 175 275 19 14.3 25 39.3
8 100 208 308 33 12.5 26 38.5
9 100 270 370 62 11.1 30 41.1
10 100 350 450 80 10.0 35 45.0

174
 Figure 8.1: Total Cost Curves Short Run Cost
Analysis

Total variable costs are the total costs incurred by the firm for variable inputs.
To obtain total variable cost we must know the price of the variable inputs.
Suppose if we have two variable inputs viz. labour (V1) and raw material (V2)
and the corresponding prices of these inputs are P1 and P2, then the total
variable cost (TVC) = P1 × V1 + P2 × V2. They go up as the firm’s output
rises, since higher output rates require higher variable input rates, which
mean bigger variable costs. The firm’s total variable cost function
corresponding to the data given in Table 8.1 is shown graphically in Figure
8.1.

Finally, total costs are the sum of total fixed costs and total variable costs. To
derive the total cost column inTable 8.1, add total fixed cost and total variable
cost at each output. The firm’s total cost function corresponding to the data
given in Table 8.1 is shown graphically in Figure 8.1.Since total fixed costs
are constant, the total fixed cost curve is simply a horizontal line at `100.
And because total cost is the sum of total variable costs and total fixed costs,
the total cost curve has the same shape as the total variable cost curve but lies
above it by a vertical distance of `100.

Corresponding to our discussion above we can define the following for the
short run:

TC = TFC + TVC

where,

TC = total cost
TFC = total fixed costs
TVC = total variable costs
175
Production and Cost Average Fixed Costs
Analysis
While the total cost functions are of great importance, managers must be
interested as well in the average cost functions and the marginal cost function
as well. There are three average cost concepts corresponding to the three total
cost concepts. These are average fixed cost (AFC), average variable cost
(AVC), and average total cost (ATC). Figure 8.2 shows typical average fixed
cost function graphically. Average fixed cost is the total fixed cost divided by
output. Average fixed cost declines as output (Q) increases. Thus, we can
write average fixed cost as:

AFC = TFC/Q

Figure 8.2: Short Run Average and Marginal Cost Curves

Average Variable Costs

Average variable cost is the total variable cost divided by output. Figure 8.2
shows the average variable cost function graphically. At first, output
increases resulting in decrease in average variable cost, but beyond a point,
they result in higher average variable cost.

AVC =

where,

Q = Output
TVC = total variable costs
AVC = average variable costs
176
Average Total Cost Short Run Cost
Analysis
Average total cost (ATC) is the sum of the average fixed cost and average
variable cost. In other words, ATC is total cost divided by output. Thus,

ATC = AFC + AVC =

Figure 8.2 shows the average total cost function graphically. Since ATC is
sum of the AFC and AVC, ATC curve always exceeds AVC curve. Also,
since AFC falls as output increases, AVC and ATC get closer as output rises.
Note that ATC curve is nearer the AFC curve at initial levels of output, but is
nearer the AVC curve at later levels of output. This indicates that at lower
levels of output fixed costs are more important part of the total cost, while at
higher levels of output the variable element of cost becomes more important.

Marginal Cost

Marginal cost (MC) is the addition to either total cost or total variable cost
resulting from the addition of one unit of output. Thus,

∆ ∆
MC = =
∆ ∆

where,

MC = marginal cost
Δ = change in output
ΔTC = change in total cost due to change in output
ΔTVC = change in total variable cost due to change in output

The two definitions are the same because, when output increases, total cost
increases by the same amount as the increase in total variable cost (since
fixed cost remains constant). Figure 8.2 shows the marginal cost function
graphically. At low output levels, marginal cost may decrease with increase
in output, but after reaching a minimum, it goes up with further increase in
output. The reason for this behavior is found in diminishing marginal returns.

The marginal cost concept is very crucial from the manager’s point of view.
Marginal cost is a strategic concept because it designates those costs over
which the firm has the most direct control. More specifically, MC indicates
those costs which are incurred in the production of the last unit of output and
therefore, also the cost which can be “saved” by reducing total output by the
last unit. Average cost figures do not provide this information. A firm’s
decisions as to what output level to produce is largely influenced by its
marginal cost. When coupled with marginal revenue, which indicates the
change in revenue from one more or one less unit of output, marginal cost
allows a firm to determine whether it is profitable to expand or contract its
level of production.
177
Production and Cost Relationship between Marginal Cost and Average Costs
Analysis
The relationships between the various average and marginal cost curves are
illustrated in Figure 8.2. The figure shows typical AFC, AVC, ATC, and MC
curves but is not drawn to scale for the data given in Table 8.1. The MC cuts
both AVC and ATC at their minimum. When both the MC and AVC are
falling, AVC will fall at a slower rate. When both the MC and AVC are
rising, MC will rise at a faster rate. As a result, MC will attain its minimum
before the AVC. In other words, when MC is less than AVC, the AVC will
fall, and when MC exceeds AVC, AVC will rise. This means that as long as
MC lies below AVC, the latter will fall and where MC is above AVC, AVC
will rise.

Therefore, at the point of intersection where MC = AVC, AVC has just

ceased to fall and attained its minimum, but has not yet begun to rise.
Similarly, the MC curve cuts the ATC curve at the latter’s minimum point.
This is because MC can be defined as the addition either to TC or TVC
resulting from one more unit of output. However, no such relationship exists
between MC and AFC, because the two are not related; MC by definition
includes only those costs which change with output, and FC by definition is
independent of output.

Relationship between Average Product and Marginal Product, and

Average Variable Cost and Marginal Cost

There is a straightforward relationship between factor productivity and output

costs. To see this, let us consider a single variable factor L say labour. All
other inputs are fixed. AP and MP will denote the average and marginal
products of labour, respectively. If W is the wage rate and L is the quantity of
labour, then

TVC = W * L

Hence, if Q is the output,

AVC = =W

Consequently, since Q/L is the average product (AP), AVC = W/AP

Also, ΔTVC = W * ΔL (W does not change and is assumed to be given.).

Dividing by ΔQ we get

∆ ∆
MC = =W
∆ ∆

But, marginal product (MP) = Δ / Δ . Hence, MC = W/MP

Figure 8.3 shows the relationship between average product and marginal
product, and average variable cost and marginal cost. The relationship AVC
178 = W/AP shows that AVC is at a minimum when AP is at maximum.
Similarly, the relationship MC = W/MP shows that MC is at a minimum Short Run Cost
Analysis
when MP is at a maximum. Also, when AP is at a maximum, AP = MP.
Hence, when AVC is at a minimum, AVC = MC. It is clearly shown that
when MP is rising, MC is falling. And when MP is falling, MC is rising.

The relevant costs to be considered for decision-making will differ from one
situation to the other depending on the problem faced by the manager. In
general, the TC concept is quite useful in finding out the breakeven quantity
of output. The TC concept is also used to find out whether firm is making
profits or not. The AC concept is important for calculating the per unit profit
of a business firm. The MC concept is essential to decide whether a firm
should expand its production or not.

Figure 8.3: Relationship between AP and MP, AVC and MC

179
Production and Cost Activity 3
Analysis
1. Fill in the blanks in the Table below:

Q TFC TVC TC AFC AVC ATC MC

1. 50 55
2. 50 8 25
3. 50 60.5
4. 13
5. 50 65
6. 50 18 3 11.3 3
7. 50 72.5
8. 50 28
9. 86
10 50 45 5 9.5 9
11. 50 54.5 4.5 9.5 9.5
12. 50 65.2
13. 50 130
14. 50 99.1

15. 50 174.75
16. 50 162

17. 50 259.25
18. 269.5

19. 50 399
20. 50 450 2.5 22.5 25 101

Note: Output Q is measured in ’000 units

All costs are measured in ` ’000

2. Suppose that a firm is currently employing 20 workers, the only variable

input, at wage rate of ` 60. The average product of labour is 30, the last
worker added 12 units to total output, and total fixed cost is ` 3600.

a. What is the marginal cost?

b. What is the average variable cost?

c. How much output is being produced?

d. What is the average total cost?

e. Is average variable cost increasing, constant, or decreasing? What

about average total cost?

180
3. Suppose average variable cost is constant over a range of output. What is Short Run Cost
Analysis
marginal cost over this range? What is happening to average total cost
over this range?

8.10 APPLICATION OF SHORT RUN COST

ANALYSIS

In the previous sections of this unit, we discussed total, marginal, and average
cost curves for short run. The relationships between these cost curves have a
very wide range of applications for managerial use. Here we will discuss a
few applications of these concepts.

Determining Optimum Output Level

Earlier we have seen that the optimum output level is the point where average
cost is minimum. In other words, the optimum output level is the point where
average cost equals marginal cost. Consider the following example.

TC = 128 + 6Q + 2Q2

This is a short run total cost function since there is a fixed cost (TFC = 128).

AC = (TC/Q) = + 6 + 2Q

( )
=- +2=0

2 Q2 = 128

Q2 = 64

Q=8

or
( )
MC = = 6 + 4Q = 0

Setting AC = MC

+ 6 + 2Q = 6 + 4Q

- 2Q = 0

2 Q2 = 128
Q2 = 64
Q=8

Thus Q = 8 and is the optimum level of output in the short run.

181
Production and Cost Breakeven Output Level
Analysis
An analytical tool frequently employed by managerial economists is the
breakeven chart, an important application of cost functions. The breakeven
chart illustrates at what level of output in the short run, the total revenue just
covers total costs. Generally, a breakeven chart assumes that the firm’s average
variable costs are constant in the relevant output range; hence, the firm’s total
cost function is assumed to be a straight line. Since variable cost is constant,
the marginal cost is also constant and equals to average variable cost.

Figure 8.4 shows the breakeven chart of a firm. Here, it is assumed that the
price of the product will not be affected by the quantity of sales. Therefore,
the total revenue is proportional to output. Consequently, the total revenue
curve is a straight line through the origin. The firm’s fixed cost is `500,
variable cost per unit is `4 and the unit sales price of output is `5. The break
even chart, which combines the total cost function and the total revenue
curve, shows profit or loss resulting from each sales level. For example,
Figure 8.4 shows that if the firm sells 200 units of output it will make a loss
of `300. The chart also shows the breakeven point, the output level that must
be reached if the firm is to avoid losses. It can be seen from the figure; the
breakeven point is 500 units of output. Beyond 500 units of output the firm
makes profit.

Figure 8.4 Breakeven Chart

Breakeven charts are used extensively for managerial decision process.

Under right conditions, breakeven charts can produce useful projections of
the effect of the output rate on costs, revenue and profits. For example, a firm
may use breakeven chart to determine the effect of projected decline in sales
or profits. On the other hand, the firm may use it to determine how many
units of a particular product it must sell in order to breakeven or to make a
particular level of profit. However, breakeven charts must be used with
182
caution, since the assumptions underlying them, sometimes, may not be Short Run Cost
Analysis
appropriate. If the product price is highly variable or if costs are difficult to
predict, the estimated total cost function and revenue curves may be subject
to these errors.

We can analyze the breakeven output with familiar algebraic equations.

TR = P * Q

TC = TFC + AVC ×Q AVC = so, TVC = AVC ∗ Q

At breakeven point, TR = TC

P * Q = TFC + (AVC *Q)

TFC Total Fixed cost

Q= =
P − AVC Price − Variable cost per unit

Here Q stands for breakeven volume of output. Multiplying Q with price (P)
we get the breakeven value of output. In the case of our example given in
Figure 8.4, TFC = `500, P = `5 and AVC = `4. Consequently,

500 500
Q= = = 500
5−4 1
Therefore, the breakeven output (Q) will be 500 units. Similarly, the
breakeven output value will be `2500 (P × Q = `5 × 500).

Profit Contribution Analysis

In making short run decisions, firms often find it useful to carry out profit
contribution analysis. The profit contribution is the difference between price
and average variable cost (P – AVC).That is, revenue on the sale of a unit of
output after variable costs are covered represents a contribution towards
profit. In our example since price is `5 and average variable cost is `4, the
profit contribution per unit of output will be `1 (`5 – `4).At low rates of
output the firm may be losing money because fixed costs have not yet been
covered by the profit contribution. Thus, at these low rates of output, profit
contribution is used to cover fixed costs. After fixed costs are covered, the
firm will be earning a profit.

A manager wants to know the output rate necessary to cover all fixed costs
and to earn a ‘required’ profit (πR). Assume that both price and AVC are
constant. Profit is equal to revenue less the sum of total variable costs and
fixed costs. Thus

πR = TR – TC
πR = (P * Q) – TFC + (AVC ∗ Q)

Solving this equation for Q gives a relation that can be used to determine the
rate of output necessary to generate a specified rate of profit. Thus 183
Production and Cost πR + TFC = (P * Q) - (AVC *Q)
Analysis
πR + TFC = Q (P - AVC)

Q =

To illustrate how profit contribution analysis can be used, suppose that the
firm in our example (where TFC = ` 500, P = `5 and AVC = `4) wants to
determine how many units of output it will have to produce and sell to earn a
profit of `10, 000. To generate this profit, an output rate of 10,500 units is
required; that is,

,
Q= = 10500

Operating Leverage

Managers must make comparisons among alternative systems of production.

Should one type of plant be replaced by another? Breakeven analysis can be
extended to help make such comparisons more effective. Consider the degree
of operating leverage ( ), which is defined as the percentage change in
profit resulting from a 1% change in the number of units of product sold.
Thus,
%
Eπ=
%

(∆ / )∆
= = * or ∗
∆ / ∆

If the price of output is constant regardless of the rate of output, the change in
degree of operating leverage depends on three variables: the rate of output,
the level of fixed costs, and variable cost per unit of output. This can be seen
by substituting the above equation for profit with

π = TR − (TVC + TFC)

= ∗ −( ∗ )−

and change in profit ∆ = ∗ ∆ − (AVC) ∗ ∆

Therefore, the degree of operating leverage will be

∗∆ ( )∗∆ / ∗ ( )∗
E =
∆ /

On Simplification,
( )
E = ( )

Example: Consider three firms I, II and III having the following fixed costs,
average variable costs and price of the product.
184
 Short Run Cost
Analysis
Firm Fixed Cost (`) Average variable Price of the product
Cost (`) (`)
Firm-I 1,00,000 2 5
Firm-II 60,000 3 5
Firm-III 26,650 4 5

Firm-I has more fixed cost than firm-II, and firm-III. However, Firm-I has
less average costs than firm-II, and firm-III. Essentially, firm-I has
substituted capital (fixed costs) for labour and materials (variable costs) with
the introduction of more mechanized machines. On the other hand, firm-III
has less fixed costs and more average variable costs when compared to other
two plants because firm-III has less mechanized machines. The firm-II
occupies middle position in terms of fixed costs and average variable costs.

In comparing these plants, we use the degree of operating leverage. Suppose

for all the three plants Q=40,000.

( )
For firm – I, Eπ = = 6
( )

( )
For firm – II, Eπ = = 4
( )

( )
For firm – III, Eπ = = 3
( ) ,

Thus, a 1% increase in sales volume results in a 6% increase in profit at firm-

I, a 4% profit at firm-II, and 3% profit at firm-III. This means firm-I’s profits
are more sensitive to changes in sales volume than firm-II and firm-III and
firm-II’s profits are more sensitive to changes in sales volume than firm-III.

Activity 4

1. Speed-Marine Co. builds motorboat engines. They recently estimated

their total costs and total revenue as:
2
TC = 80,000 – 600Q + 2Q2 TR = 400Q - Q

Where TC is total cost, TR is total revenue, and Q is the number of

engines produced each year.

Where TC is total cost, TR is total revenue, and Q is the number of

engines produced each year.

a. At what level of production will the company breakeven? How many

engines should be produced to maximize profit?

2. Give TC=6Q + 2Q2 – Q3, find out the optimum level of output, Q.
185
Production and Cost 3. During the last period, the sum of average profit and fixed costs for a
Analysis firm totaled ` 1, 00,000. Unit sales were 10,000. If variable cost per
unit was ` 4, what was the selling price of a unit of output? How much
would profit change if the firm produced and sold 11,000 units of
output? (Assume average variable cost remains at ` 4 per unit).

8.11 LET US SUM UP

Cost concepts are important for decision-making but neither the accounting
approach nor the economic approach is completely acceptable when decision-
making is involved. Costs must be considered in various ways, depending on
the decision at hand. Both traditional economists and traditional accountants
have tended to be fairly dogmatic in their definitions of costs. On the other
hand, managerial economists want a flexible approach. All the cost concepts
need to be considered in such a way so as to help make sound decisions. The
decision maker should try to discover the “relevant” costs by asking what
costs are relevant to a particular decision at hand, and the decision maker is
not necessarily bound by traditional concepts constructed for other purposes.

In short run, the total cost consists of fixed and variable costs. A firm’s
marginal cost is the additional variable cost associated with each additional
unit of output. The average variable cost is the total variable cost divided by
the number of units of output. When there is a single variable input, the
presence of diminishing returns determines the shape of cost curves. In
particular, there is an inverse relationship between the marginal product of
the variable input and the marginal cost of production. The average variable
cost and average total cost curves are U-shaped. The short run marginal cost
curve increases beyond a certain point, and cuts both average total cost curve
and average variable cost curve from below at their minimum points.

These cost concepts and analysis have a lot of applications in real world
decision-making process such as optimum output, break even output, profit
contribution, operating leverage, etc.

8.12 TERMINAL QUESTIONS

1. Differentiate between accounting costs and economic costs?

2. Take a firm you are working with or know its nature. Make a list of
relevant cost concepts from the standpoint of an (a) accountant and (b)
economist.

3. What is the significance of opportunity cost in managerial decision-

making?

4. What is short run cost analysis? For what type of decisions is it useful?

5. What are marginal costs and incremental costs? What is the difference
186 between these two cost concepts?
6. A pharmaceutical company has spent ₹5 crores on developing and Short Run Cost
Analysis
testing a new antibiotic drug. The head of the marketing department now
estimates that it will cost ₹3 crores in advertising to launch this new
product. Total revenue from all future sales is estimated at ₹6crores, and
therefore, total costs will exceed revenue by ₹2 crores. He recommends
that this product be dropped from the firm’s product offerings. What is
your reaction to this recommendation? The head of the accounting
department now indicates that ₹3.5 crores of corporate overhead
expenses also will be assigned to this product if it is marketed. Does this
new information affect your decision? Explain.
7. When Mr. Kapoor’s father gave him a new Truck costing ₹30 lakhs.
Recently Mr. Kapoor was boasting to some of his friends that his
revenues were typically ₹150,000 per month, while his operating costs
(fuel, maintenance, and depreciation) amounted to only ₹1,20,000 per
month. A truck identical to Mr. Kapoor’s Truck is available on a
monthly rent of ₹35000. If Mr. Kapoor was driving trucks for someone
else, he would earn ₹5000 per month.

a. How much are Mr. Kapoor’s explicit costs per month? How much
are his implicit costs per month?

b. What is the amount of the opportunity cost of the resources used by

Mr. Kapoor each month?

c. Mr. Kapoor is proud of the fact that he is generating a net cash flow
of ₹30000 (=₹1, 50,000 – ₹1, 20,000) per month, since he would
only be earning ₹5000 per month if he were working for some else.
What advice would you give Mr. Kapoor?

9. The following table pertains to Savitha Company. Fill in the blanks below:

Output Total Total Total Average Average Average Marginal

Cost Fixed Variable Total Fixed Variable Cost
Cost Cost Cost Cost Cost
100 260 60

200 0.30

300 0.50

400 1.05

500 360

600 3.00

700 1.60

800 2040

187
Production and Cost 10. Suppose that a local metal fabricator has estimated its short run total cost
Analysis function and total revenue function as

TC = 1600 +100Q + 25Q2

TR = 500Q

What is the breakeven amount of output? How might the company go

about reducing the break even rate if it does not feel that it can sell the
estimated amount in the market place?

11. A TV company sells color TV sets at ₹15,000 each. Its fixed costs are
₹ 30,000, and its average variable costs are ₹ 10,000 per unit. Draw its
breakeven graph, and then determine its breakeven rate of production.

12. The Bright Electronics is producing small electronic calculators. It wants

to determine how many calculators it must sell in order to earn a profit of
₹10,000 per month. The price of each calculator is ₹300, the fixed costs
are ₹ 5,000 per month, and the average variable cost is ₹ 100.

a. What is the required sales volume?

b. If the firm were to sell each calculator at a price of ₹350 rather than
₹ 300, what would be the required sales volume?

c. If the price is ₹ 350, and if average variable cost is ₹ 85 rather than

₹100, what would be the required sales volume?

FURTHERS READINGS
Adhikary, M. (1987). Managerial Economics (3rd ed.).Khosla Publishers,
Delhi.

Maddala, G. S., & Miller, E. M. (1989). Micro Economics: Theory and

Applications. McGraw-Hill, NewYork.

Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:

Concepts and Cases. Tata McGraw-Hill, New Delhi.

Mehta, P.L.(2016) Managerial Economics: Analysis, Problems and Cases.

Sultan Chand & Sons, New Delhi.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

188
 Long Run Cost
UNIT 9 LONG RUN COST ANALYSIS Analysis

Structure

9.0 Objectives
9.1 Introduction
9.2 Long-run Cost Functions
9.3 Economies and Diseconomies of Scale
9.4 Learning Curve
9.5 Economies of Scope
9.6 Cost Function and its Determinants
9.7 Estimation of Cost Function
9.8 Empirical Estimates of Cost Function
9.9 Managerial Uses of Cost Function
9.10 Let Us Sum Up
9.11 Terminal Questions

9.0 OBJECTIVES
After studying this unit, you should be able to:

 analyze the behavior of costs i n long run;

 comprehend the different sources of economies of scale;
 explain various functional forms of production and costs;
 understand empirical determination of these theoretical functions; and
 identify managerial uses of such empirical estimates.

9.1 INTRODUCTION
In unit 8, you have learnt about different cost concepts used by managers in
decision- making process, the relationship between these concepts, and the
distinction between accounting costs and economic costs, and short run cost
analysis and its applications in managerial decision making. We will continue
the analysis of costs in this unit also, long term cost analysis will be
discussed.

In the process of decision-making, a manager should understand clearly the

relationship between the inputs and output on one hand and output and costs
on the other. Estimation of cost curves will help production manager in
understanding the nature and shape of cost curves and taking useful
decisions. Both short run cost function and the long run cost function must
be estimated, since both sets of information will be required for some vital
decisions. Knowledge of the short run cost functions allows the decision
makers to judge the optimality of present output levels and to solve decision
problems of production manager. Knowledge of long run cost functions is
important when considering the expansion or contraction of plant size, and 189
Production and Cost for confirming that the present plant size is optimal for the output level that is
Analysis being produced. In the present Unit, we will discuss different approaches to
examination of cost functions, analysis of some empirical estimates of these
functions, and managerial uses of the estimated functions.

9.2 LONG-RUN COST FUNCTIONS

In the long run, all inputs are variable, and a firm can have a number of
alternative plant sizes and levels of output that it wants. There are no fixed
cost functions (total or average) in the long run, since no inputs are fixed. A
useful way of looking at the long run is to consider it a planning horizon. The
long run cost curve is also called planning curve because it helps the firm in
future decision-making process.

Figure 9.1: Short-Run and Long Run Average Cost Curves

The long run cost output relationship can be shown with the help of a long
run cost curve. The long run average cost curve (LRAC) is derived from
short run average cost curves (SRAC). Let us illustrate this with the help of a
simple example. A firm faces a choice of production with three different
plant sizes viz. plant size-1 (small size), plant size-2 (medium size), plant
size-3 (large size), and plant size-4 (very large size). The short run average
cost functions shown in Figure 9.1 (SRAC1, SRAC2, SRAC3, and SRAC4) are
associated with each of these plants discrete scale of operation. The long run
average cost function for this firm is defined by the minimum average cost of
each level of output. For example, output rate Q1 could be produced by the
plant size-1 at an average cost of C1 or by plant size-2 at a cost of C2.

Clearly, the average cost is lower for plant size-1, and thus point a is one
point on the long run average cost curve. By repeating this process for various
rates of output, the long run average cost is determined. For output rates of
zero to Q2 plant size-1is the most efficient and that part of SRAC1 is part of
the long run cost function. For output rates of Q2 to Q3 plant size-2 is the
most efficient, and for output rates Q3 to Q4, plant size-3 is the most
190
efficient. The scallop-shaped curve shown in bold face in Figure 9.1 is the Long Run Cost
Analysis
long run average cost curve for this firm. This bold faced curve is called an
envelope curve (as it envelopes short run average cost curves). Firms plan to
be on this envelope curve in the long run. Consider a firm currently operating
plant size-2 and producing Q1 units at a cost of C2 per unit. If output is
expected to remain at Q1, the firm will plan to adjust to plant size-1, thus
reducing average cost to C1.

Most firms will have many alternative plant sizes to choose from, and there is
a short run average cost curve corresponding to each. A few of the short run
average cost curves for these plants are shown in Figure 9.2, although many
more may exist. Only one point of a very small arc of each short run cost
curve will lie on the long run average cost function. Thus, long run average
cost curve can be shown as the smooth U-shaped curve. Corresponding to
this long run average cost curve is a long run marginal cost (LRMC) curve,
which intersects LRAC at its minimum point a, which is also the minimum
point of short run average cost curve 4 (SRAC4). Thus, at a point a and only
at a point a, the following unique result occurs:

SRAC = SRMC when LRAC = LRMC

Figure 9.2 : Short – Run and Long – Run Average Cost and Marginal
Cost Curves

LRAC

The long run cost curve serves as a long run planning mechanism for the
firm. It shows the least per unit cost at any output can be produced after the
firm has had time to make all appropriate adjustments in its plant size. For
example, suppose that the firm is operating on short run average cost curve
SRAC3 as shown in Figure 9.2, and the firm is currently producing an output
of Q*. By using SRAC3, it is seen that the firm’s average cost is C2. Clearly,
if projections of future demand indicate that the firm could expect to continue
selling Q* units per period at the market price, profit could be increased 191
Production and Cost significantly by increasing the scale of plant to the size associated with short
Analysis
run average cost curve SRAC4. With this plant, average cost for an output
rate of Q* would be C2 and the firm’s profit per unit would increase by C2–
C1.Thus, total profit would increase by (C2–C1)*Q*.

The U-shape of the LRAC curve reflects the laws of returns to scale.
According to these laws, the cost per unit of production decreases as plant
size increases due to the economies of scale, which the larger plant sizes
make possible. But the economies of scale exist only up to a certain size of
plant, known as the optimum plant size where all possible economies of scale
are fully exploited. Beyond the optimum plant size, diseconomies of scale
arise due to managerial inefficiencies. As plant size increases beyond a limit,
the control, the feedback of information at different levels and decision-
making process becomes less efficient. This makes the LRAC curve turn
upwards. Given the LRAC in Figure 9.2, we can say that there are increasing
returns to scale up to Q* and decreasing returns to scale beyond Q*.
Therefore, the point Q* is the point of optimum output and the corresponding
plant size-4 is the optimum plant size. If you have long run average cost of
producing a given output, you can readily derive the long run total cost
(LRTC) of the output, since the long run total cost is simply the product of
long run average cost and output. Thus, LRTC = LRAC *Q.

Figure 9.3 shows the relationship between long run total cost and output.
Given the long run total cost function you can readily derive the long run
marginal cost function, which shows the relationship between output and the
cost resulting from the production of the last unit of output, if the firm has
time to make the optimal changes in the quantities of all inputs used.

Figure 9.3 : Long Run Total Cost Function

192
Activity 1 Long Run Cost
Analysis
1. Explain why short run marginal cost is greater than long run marginal
cost beyond the point at which they are equal?

2. Explain why short run average cost can never be less than long run
average cost?

3. Why are all costs variable in the long run?

4. Why is the long run average cost curve called an “envelope curve”?
Why cannot the long run marginal cost curve be an envelope as well?

5. What do you understand by “cost-efficiency”? Draw a long run cost

diagram and explain.

6. Economists frequently say that the firm plans in the long run and
operates in the short run. Explain.

9.3 ECONOMIES AND DISECONOMIES OF

SCALE

We have seen in the preceding section that larger plant will lead to lower
average cost in the long run. However, beyond some point, successively
larger plants will mean higher average costs. Exactly, why is the long run
average cost (LRAC) curve U-shaped? What determines the shape of LRAC
curve? This point needs further explanation.

It must be emphasized here that the law of diminishing returns is not

applicable in the long run as all inputs are variable. Also, we assume that
resource prices are constant. What then, is our explanation? The U-shaped
LRAC curve is explainable in terms of what economists call economies of
scale and diseconomies of scale.

Economies and diseconomies of scale are concerned with behaviour of

average cost curve as the plant size is increased. If LRAC declines as output
increases, then we say that the firm enjoys economies of scale. If, instead, the
LRAC increases as output increases, then we have diseconomies of scale.
Finally, if LRAC is constant as output increases, then we have constant
returns to scale implying we have neither economies of scale nor
diseconomies of scale. Economies of scale explain the down sloping part of
the LRAC curve. As the size of the plant increases, LRAC typically declines
over some range of output for a number of reasons. The most important is
that, as the scale of output is expanded, there is greater potential for
specialization of productive factors. This is most notable with regard to
193
Production and Cost labour but may apply to other factors as well. Other factors contributing to
Analysis
declining LRAC include ability to use more advanced technologies and more
efficient capital equipment; managerial specialization; opportunity to take
advantage of lower costs (discounts) for some inputs by purchasing larger
quantities; effective utilization of by products, etc.

But, after sometime, expansion of a firm’s output may give rise to

diseconomies, and therefore, higher average costs. Further expansion of
output beyond a reasonable level may lead to problems of overcrowding of
labour, managerial in efficiencies, etc., pushing up the average costs.

The economies of scale and diseconomies of scale are sometimes called as

internal economies of scale and internal diseconomies of scale
respectively. This is because the changes in long run average costs result
solely from the individual firm’s adjustment of its output. On the other hand,
there may exist external economies of scale. The external economies also
help in cutting down production costs. With the expansion of an industry,
certain specialized firms also come up for working up the by-products and
waste materials. Similarly, with the expansion of the industry, certain
specialized units may come up for supplying raw material, tools, etc., to the
firms in the industry. Moreover, they can combine together to undertake
research etc., whose benefit will accrue to all firms in the industry. Thus, a
firm benefits from expansion of the industry as a whole. These benefits are
external to the firm, in the sense that these have arisen not because of any
effort on the part of the firm but have accrued to it due to expansion of
industry as a whole. All these external economies help in reducing production
costs.

Economies of scale are often measured in terms of cost- output elasticity,

Ec.

Ec is the percentage change in the average cost of production resulting from a

one percent increase in output:

= (∆TC/TC) / (∆ / ) = (∆TC/∆ ) / (TC/Q) = MC/AC

Clearly, Ec is equal to one when marginal and average costs are equal. This
means costs increase proportionately with output, and there are neither
economies nor diseconomies of scale. When there are economies of scale MC
will be less than AC (both are declining) and Ec is less than one. Finally,
when there are diseconomies of scale, MC is greater than AC, and Ec is
greater than one.

194
ECONOMIES OF SCALE Long Run Cost
Analysis

Internal economies

Real and Pecuniary are two types of internal economies. When quantity of
inputs used decrease for a particular level of output, it gives rise to real
economies. When large quantities of input are bought and large quantities of
output are sold, there are savings in the cost of inputs and distribution costs
due to bulk buying and selling, these savings are known as pecuniary
economies.

A) REAL ECONOMIES OF SCALE

1. Production economies

Production economies arise from different factors of production such

as :-

 Labour Economies
Large scale of production leads to division of labour and
specialization, leading to reduction in costs and time. Due to
large scale production, technical personnel acquire significant
experience and this ‘cumulative volume’ has positive effect on
production and costs, leading to high productivity and lower
costs for large level of outputs.

 Technical Economies
Technical economies are related to fixed capital which includes
machinery and equipments. Specialization and indivisibility of
machines and equipments leads to reduction in per unit costs.
Machines have a property of indivisibility so, when large
production (maximum capacity of machine) is achieved, machine
cost is divided between large units.

In large size firms, there are large machines which perform

different continuous automatic processes which saves time and
cost of labour as different machines for different set-ups are not
required. And with increase in scale, general purpose machinery
is left to set up more which reduces its set up costs.

 Inventory economies
The main aim of inventories is to meet random fluctuations in
supply and demand of inputs & output respectively. When size of
firm increases, these fluctuations are eased out due to large
quantity of resources.
195
Production and Cost 2. Marketing economies
Analysis
With increase in output, advertising, R&D (such as developing new
models and designs) expenditures etc. are spread over and
expenditure per unit decreases considerably.

3. Managerial economies

Managerial economies arise due to various reasons, most important

of them are specialization, decentralization, team work experience
and modern managerial techniques. When scale of operations rises,
division of managerial tasks (production, sales, finance etc.) is done
and this leads to specialization as same task is performed again and
again. Team work experience helps in improving decision making
ability of managers and with decentralization decision making
becomes faster leading to managerial efficiency.

4. Transport and storage economies

Storage costs decrease with increase in the size of output. But

transportation costs keep falling for some extent and then they
become constant, making a L shaped curve.

B) PECUNIARY ECONOMIES OF SCALE

These economies include all the savings and discounts obtained by firm
because of its large size. Few examples of these are:

 Raw material prices become competitive when there is bulk buying.

 Banks offer lower rates of interest to large firms, ultimately it comes

down to lower cost of capital.

 Large firms have need of large-scale advertising, they are offered better
prices.

 Transportation costs turn out lower for bulk transportation.

 Labour costs can be saved by large firms, if they attain a position,

which gives them monopsony power due to large size or prestige in
market.

EXTERNAL ECONOMIES

External economies are those which are not particular to one particular firm
rather these are shared by all firms operating in a particular industry. These
are external to the firm as they do not arise due to efforts of any one
particular firm, they arise when whole industry expands. These can be
economies of information, economies of concentration, economies of
disintegration etc. These external economies also help in reduction of
production costs just like internal economies.
196
DISECONOMIES OF SCALE Long Run Cost
Analysis

Diseconomies of scale occur, at a level of output where one unit increase in

output leads to increase in marginal costs. At this level, diminishing returns
are there and economies of scale are ruled out by diseconomies of scale.
Diseconomies of scale generally arise due to human and behavioural
problems instead of technical factors.

There are several reasons for diseconomies of scale, some of them have been
listed below:

Morale and motivation problems

When the size of firm increases more and more employees join the
organization which reduces personal connection with owners and
management which leads to reduction in motivation among employees.
Reduction in motivation leads to reduction in productivity as well.

Communication problems

Effective and properly defined communication channels are very important in

any business organization. When a firm increases its size, there are increased
layers of command, it may create problems in communication and a message
can be distorted or lost. So, the formal communication of objectives and
goals will also suffer in this scenario which will lead to reduction in
productivity.

In short, it can be concluded that diseconomies of scale will come into picture
when with increase in size, management faces tough challenges in regards to
communication, motivation & morale of employees etc. and they are not able
to overcome those challenges.

197
Production and Cost
Analysis

198
Activity 2 Long Run Cost
Analysis
1. Distinguish between internal and external economies of scale. Give
examples.

2. Distinguish between real and pecuniary economies of scale.

3. Explain the reasons of diseconomies of scale with examples.

9.4 LEARNING CURVE

Learning curve denotes the relationship between labour cost and additional units of
output. It basically revolves around the concept that, with practice workers improve
and ultimately, cost per unit of producing one more units of output decreases.
Learning curve effect is this reduction in cost due to learning process of employees
over a period of time.

9.5 ECONOMIES OF SCOPE

According to the concept of economies of scale, cost advantages follow the
increase in volume of production or what is called the scale of output. On the
other hand, according to the concept of economies of scope, such cost
advantages may follow from a variety of output. For example, many firms
produce more than one product and the products are closely related to one
another — an automobile company produces scooters and cars, and a
university produces teaching and research. A firm is likely to enjoy
production or cost advantages when it produces two or more products. These
advantages could result from the joint use of inputs or production facilities,
joint marketing programs, or possibly the cost savings of a common
administration. Examples of joint products are mutton and wool, eggs and
chicken, fertilizer, etc.

Therefore, economies of scope exist when the cost of producing two (or
more) products jointly is less than the cost of producing a single product. To
measure the degree to which there are economies of scope, we should know
what percentage of the cost of production is saved when two (or more)
products are produced jointly rather than individually. The following
equation gives the degree of economies of scope (SC) that measures the
savings in cost:

( )+ ( )− ( + )
=
( + )

Here, C (Q1) represents the cost of producing output Q1, C (Q2) the cost of
producing output Q2, and C (Q1, Q2) the joint cost of producing both outputs
(Q1 +Q2).
199
Production and Cost For example, a firm produces 10000 TV sets and 5000 Radio sets per year at
Analysis a cost of Rs.8.40 crores, and another firm produces 10000 TV sets only, then
the cost would be Rs.10.00 crores, and if it produced 5000 Radio sets only,
then the cost would be Rs. 0.50 crores. In this case, the cost of producing
both the TV and Radio sets is less than the total cost of producing each
separately. Thus, there are economies of scope. Thus,

10.00 + 0.50 − 8.40

= = 0.25
8.40
Which means that there is a 25% saving of cost by going for joint
production.

With economies of scope, the joint cost is less than the sum of the individual
costs, so that SC is greater than 0. With diseconomies of scope, SC is
negative. In general, the larger the value of SC, the greater is the economies
of scope.

Activity 3

1. Distinguish between economies of scale and economies of scope using

examples.

9.6 COST FUNCTION AND ITS DETERMINANTS

Cost function expresses the relationship between cost and its determinants
such as the size of plant, level of output, input prices, technology, managerial
efficiency, etc. In a mathematical form, it can be expressed as,

C = f (S, O, P, T, E….)

Where, C = cost (it can be unit cost or total cost)

S = plant size

O = output level

P = prices of inputs used in production

T = nature of technology

E = managerial efficiency

Determinants of Cost Function

The cost of production depends on many factors and these factors vary from
one firm to another firm in the same industry or from one industry to another
industry. The main determinants of a cost function are:

a) plant size
b) output level
200 c) prices of inputs used in production,
d) nature of technology Long Run Cost
Analysis
e) managerial efficiency

We will discuss briefly the influence of each of these factors on cost.

a) Plant size: Plant size is an important variable in determining cost.

The scale of operations or plant size and the unit cost are inversely
related in the sense that as the former increases, unit cost decreases,
and vice versa. Such a relationship gives downward slope of cost
function depending upon the different sizes of plants taken into
account. Such a cost function gives primarily engineering estimates of
cost.

b) Output level: Output level and total cost are positively related, as the
total cost increases with increase in output and total cost decreases
with decrease in output. This is because increased production requires
increased use of raw materials, labour, etc., and if the increase is
substantial, even fixed inputs like plant and equipment, and
managerial staff may have to be increased.

c) Price of inputs: Changes in input prices also influence cost,

depending on the relative usage of the inputs and relative changes in
their prices. This is because more money will have to be paid to those
inputs whose prices have increased and there will be no simultaneous
reduction in the costs from any other source. Therefore, the cost of
production varies directly with the prices of production.

d) Technology: Technology is a significant factor in determining cost.

By definition, improvement in technology increases production
leading to increase in productivity and decrease in production cost.
Therefore, cost varies inversely with technological progress.
Technology is often quantified as capital-output ratio. Improved
technology is generally found to have higher capital-output ratio.

e) Managerial efficiency: This is another factor influencing the cost of

production. More the managerial efficiency less the cost of
production. It is difficult to measure managerial efficiency
quantitatively. However, a change in cost at two points of time may
explain how organizational or managerial changes within the firm
have brought about cost efficiency, provided it is possible to exclude
the effect of other factors

9.7 ESTIMATION OF COST FUNCTION

Several methods exist for the measurement of the actual cost-output relation
for a particular firm or a group of firms, but the three broad approaches -
accounting, engineering and econometric – are the most important and
commonly used. 201
Production and Cost Accounting Method
Analysis
This method is used by the cost accountants. In this method, the cost-output
relationship is estimated by classifying the total cost into fixed, variable and
semi-variable costs. These components are then estimated separately. The
average variable cost, the semi-variable cost which is fixed over a certain
range of output, and fixed costs are determined on the basis of inspection and
experience. The total cost, the average cost and the marginal cost for each
level of output can then be obtained through a simple arithmetic procedure.

Although, the accounting method appears to be quite simple, it is a bit

cumbersome as one has to maintain a detailed breakdown of costs over a
period to arrive at good estimates of actual cost-output relationship. One must
have experience with a wide range of fluctuations in output rate to come up
with accurate estimates.

Engineering Method

The engineering method of cost estimation is based directly on the physical

relationship of inputs to output, and uses the price of inputs to determine
costs. This method of estimating real world cost function rests clearly on the
knowledge that the shape of any cost function is dependent on: (a) the
production function and (b) the price of inputs.

We have seen earlier in Unit – 7 while discussing the estimation of

production function that for a given the production function and input prices,
the optimum input combination for a given output level can be determined.
The resultant cost curve can then be formulated by multiplying each input in
the least cost combination by its price, to develop the cost function. This
method is called engineering method as the estimates of least cost
combinations are provided by engineers.

The assumption made while using this method is that both the technology and
factor prices are constant. This method may not always give the correct
estimate of costs as the technology and factor prices do change substantially
over a period of time. Therefore, this method is more relevant for the short
run. Also, this method may be useful if good historical data is difficult to
obtain. But this method requires a sound understanding of engineering and a
detailed sampling of the different processes under controlled conditions,
which may not always be possible.

Econometric Method

This method is also sometimes called statistical method and is widely used
for estimating cost functions. Under this method, the historical data on cost
and output are used to estimate the cost-output relationship. The basic
technique of regression is used for this purpose. The data could be a time
series data of a firm in the industry or of all firms in the industry or a cross-
section data for a particular year from various firms in the industry.
202
Depending on the kind of data used, we can estimate short run or long run Long Run Cost
cost functions. For instance, if time series data of a firm whose output Analysis

capacity has not changed much during the sample period is used, the cost
function will be short run. On the other hand, if cross-section data of many
firms with varying sizes, or the time series data of the industry as a whole is
used, the estimated cost function will be the long run one.

The procedure for estimation of cost function involves three steps. First, the
determinants of cost are identified. Second, the functional form of the cost
function is specified. Third, the functional form is chosen and then the basic
technique of regression is applied to estimate the chosen functional form.

Functional Forms of Cost Function

The following are the three common functional forms of cost function in
terms of total cost function (TC).

Linear cost function: TC = a1 +b1Q

Quadratic cost function: TC = a2 + b2Q + c2Q2

Cubic cost function: TC = a3 + b3Q + c3Q2 +d3Q3

where, a1, a2, a3, b1, b2, b3, c2, c3, d3 are constants.

When all the determinants of cost are chosen and the data collection is
complete, the alternative functional forms can be estimated by using
regression software package on a computer. The most appropriate form of the
cost function for decision-making is then chosen on the basis of the principles
of economic theory and statistical inference.

Once the constants in the total cost function are estimated using regression
technique, the average cost (AC) and marginal cost (MC) functions for
chosen forms of cost function will be calculated. The TC, AC and MC cost
functions for different functional forms of total cost function and their typical
graphical presentation and interpretation are explained below:

A. Linear cost function

TC = a1 + b1Q
AC=(TC)/Q= (a1/Q) +b1
( )
MC = = b1

The typical TC, AC, and MC curves that are based on a linear cost function
are shown in Figure 9.5. These cost functions have the following properties:
TC is a linear function, where AC declines initially and then becomes quite
flat approaching the value of MC as output increases and MC is constant at b1.

B. Quadratic cost function

TC = a2 + b2Q + c2Q2
203
Production and Cost AC = (TC/Q) = (a2/Q)+ b2 + c2Q
Analysis
( )
MC = = b2+ 2c2Q

The typical TC, AC, and MC curves that are based on a quadratic cost
function are shown in Figure 9.6. These cost functions have the following
properties: TC increases at an increasing rate; MC is a linearly increasing
function of output; and AC is a U-shaped curve.

C. Cubic cost function

TC = a3 + b3Q + c3Q2 +d3Q3
AC = (TC/Q) = (a3/Q) +b3+c3 Q+d3Q2
( )
MC = = = b3+ 2c3Q + 3d3 Q2

The typical TC, AC, and MC curves that are based on a cubic cost function
are shown in Figure 9.7. These cost functions have the following properties:
TC first increases at a decreasing rate up to output rate Q1 in the Figure 9.7
and then increases at an increasing rate; and both AC and MC cost functions
are U shaped functions.

The linear total cost function would give a constant marginal cost and a
monotonically falling average cost curve. The quadratic function could yield
a U-shaped average cost curve but it would imply a monotonically rising
marginal cost curve. The cubic cost function is consistent both with a U-
shaped average cost curve and a U-shaped marginal cost curve. Thus, to
check the validity of the theoretical cost-output relationship, one should
hypothesize a cubic cost function.

Figure 9.5: Cost Curves Based on Linear Cost Function

TC = a1+ b1 Q
TC

204 Output (Q)

 Long Run Cost
Analysis

AC = (a1/Q) + b1

MC = b1

Figure 9.6: Cost Curves Based on Quadratic Cost Function

Output (Q)

Output (Q) 205

Production and Cost Figure 9.7 : Cost curves Based on Cubic Cost Function
Analysis

TC = a3 + b3 Q+C3 Q2+d3Q3

Q1 Output (Q)

An example of using estimated cost function:

Using the output-cost data of a chemical firm, the following total cost
function was estimated using quadratic function:

TC = 1016 – 3.36Q + 0.021Q2

a) Determine average and marginal cost functions.

b) Determine the output rate that will minimize average cost and the per unit
cost at that rate of output.

c) The firm proposed a new plant to produce nitrogen. The current market
price of this fertilizer is Rs 5.50 per unit of output and is expected to
remain at that level for the foreseeable future. Should the plant be built?
206
Solution: Long Run Cost
Analysis

a) The average cost function is:

AC = (TC/Q) = (a2/Q) + b2 + c2Q = (1016/Q) – 3.36 + 0.021Q

and the marginal cost function is:

( )
MC = = b2 + 2c2Q = –3.36 + 2(0.021) Q = –3.36 + 0.042Q

b) The output rate that results in minimum per unit cost is found by taking
the first derivative of the average cost function, setting it equal to zero,
and solving for Q.

( ) 1016
= + =− + 0.021 = 0

1016
= 0.021; 0.021 = 1016; = 48381; = 220

To find the cost at this rate of output, substitute 220 for Q in AC equation and
solve it.

AC = (1016/Q) – 3.36 + 0.021Q = (1016/220) – 3.36 + (0.021 * 220)

Rs. 5.88 per unit of output.

c) Because the lowest possible cost is Rs. 5.88 per unit, which is Rs. 0.38
above the market price (Rs.5.50), the plant should not be constructed.

Short Run and Long Run Cost Function Estimation

The same sorts of regression techniques can be used to estimate short run cost
functions and long run cost functions. However, it is very difficult to find
cases where the scale of a firm has changed but technology and other relevant
factors have remained constant. Thus, it is hard to use time series data to
estimate long run cost functions. Generally, regression analysis based on
cross section data has been used instead. Specially, a sample of firms of
various sizes is chosen, and a firm’s TC is regressed on its output, as well as
other independent variables, such as regional differences in wage rates or
other input prices.

207
Production and Cost Figure 9.8: Typical Long Run Average Cost Curve
Analysis

Many studies of long run cost functions that have been carried out found that
there are very significant economies of scale at low output levels, but that
these economies of scale tend to diminish as output increases, and that the
long run average cost function eventually becomes close to horizontal axis at
high output levels. Therefore, in contrast to the U-shaped curve in Figure 9.1,
which is often postulated in micro economic theory, the long run average
cost curve tends to be L-shaped, as shown in Figure 9.8.

Problems in Estimation of Cost Function

We confront certain problems while attempting to derive empirical cost

functions from economic data. Some of these problems are briefly discussed
below.

1. In collecting cost and output data we must be certain that they are
properly paired. That is, the cost data is applicable to the
corresponding data on output.

2. We must also try to obtain data on cost and output during a time
period when the output has been produced at relatively even rate.
If for example, a month is chosen as the relevant time period over
which the variables are measured, it would not be desirable to have
wide weekly fluctuations in the rate of output. The monthly data in
such a case would represent an average output rate that could
disguise the true cost- output relationship. Not only should the
output rate be uniform, but it also should be a rate to which the firm
is fully adjusted. Furthermore, there should be no disruptions in the
208 output due to external factors such as power failures, delays in
 receiving necessary supplies, etc. To generate the data necessary for Long Run Cost
Analysis
a meaningful statistical analysis, the observations must include a wide
range of rates of output. Observing cost-output data for the last 24
months, when the rate of output was the same each month, would
provide little information concerning the appropriate cost function.

3. The cost data is normally collected and recorded by accountants for

their own purposes and in a manner that it makes the information less
than perfect from the perspective of economic analysis. While
collecting historical data on cost, care must be taken to ensure that all
explicit as well as implicit costs have been properly taken into
account, and that all the costs are properly identified by time period in
which they were incurred.

4. For situations in which more than one product is being produced with
given productive factors, it may not be possible to separate costs
according to output in a meaningful way. One simple approach of
allocating costs among various products is based on the relative
proportion of each product in the total output. However, this may not
always accurately reflect the cost appropriate to each output.

5. Since prices change over time, any money value cost would therefore
relate partly to output changes and partly to price changes. In order to
estimate the cost-output relationship, the impact of price change on
cost needs to be eliminated by deflating the cost data by price indices.
Wages and equipment price indices are readily available and
frequently used to ‘deflate’ the money cost.

6. Finally, there is a problem of choosing the functional form of equation

or curve that would fit the data best. The usefulness of any cost
function for practical application depends, to a large extent, on
appropriateness of the functional form chosen. There are three
functional forms of cost functions, which are popular, viz., linear,
quadratic and cubic. The choice of a particular function depends upon
the correspondence of the economic properties of the data to the
mathematical properties of the alternative hypotheses of total cost
function.

The accounting and engineering methods are more appropriate than the
econometric method for estimating the cost function at the firm level, while
the econometric method is more suitable for estimating the cost function at
the industry or national level. There has been a growing application of the
econometric method at the macro level and there are good prospects for its
use even at the micro level. However, it must be understood that the three
approaches discussed above are not competitive, but are rather
complementary to each other. They supplement each other. The choice of a
209
Production and Cost method therefore depends upon the purpose of study, time and expense
Analysis considerations.

9.8 EMPIRICAL ESTIMATES OF COST

FUNCTION
A number of studies using time series and cross-section data have been
conducted to estimate short run and long run cost behavior of various
industries. Table 9.1 lists a number of well-known studies estimating short
run average and marginal cost curves. These and many other studies point
one conclusion: in the short run a linear total variable cost function with
constant marginal cost is the relationship that appears to describe best the
actual cost conditions over the “normal” range of production. U-shaped
average cost (AC) and marginal cost (MC) curves have been found, but are
less prevalent than one might expect.

Table 9.1: Number of well-known studies estimating short run average

and marginal cost curves

Name Type of Industry Findings

Dean (1936) Furniture Constant MC which failed to rise

Dean (1941) Leather belts No significant increases in MC

Dean (1941) Hosiery Constant MC which failed to rise

Dean (1942) Department store Declining or constant MC, depending on

the department within the store

Ezekiel and Wylie (1941) Steel Declining MC but large variation

Hall and Hitch (1939) Manufacturing Majority have decreasing MC

Johnston (1960) Electricity, multi “Direct” cost is a linear function of output,

product function and MC is constant
food processing

Johnston (1960) Electricity Average total cost falls, then flattens,

tending toward constant MC up to
capacity

Mansfield and Wein (1958) Railways Constant MC

Yntema (1940) Steel Constant MC

Source: A.A. Walters, “Production and Cost Functions: An Econometric Survey”, Econometrica, January-
February 1963, PP.49-54
210
Table 9.2 lists a number of well known, long run average cost studies. In Long Run Cost
some industries, such as light manufacturing (of baking products), economies Analysis

of size are relatively unimportant and diseconomies set in rather quickly,

implying that a small plant has cost advantages over a large plant. In other
industries, such as meat packing or the production of household appliances,
the long run average cost curve is found to be flat over an extended range of
output, there by indicating that a variety of different plant sizes are all more
or less equally efficient. In some other industries such as electricity or metal
(aluminum and steel) production, substantial economies of size are found,
thereby implying that a large plant is most efficient. Rarely are substantial
diseconomies of size found in empirical studies, perhaps because of firms
recognizing that production beyond a certain range leads to sharply rising
costs. Therefore, they avoid such situations if all possible by building
additional plants.

Table 9.2: Number of well known, long run average cost studies

Name Type of Industry Findings

Alpert (1959) Metal Economies of scale up to some level of
output per month; constant returns to
scale and horizontal LRAC thereafter
Bain (1956) Manufacturing Small economies of scale for multi-plant
firms
Gribbin (1953) Gas (Great Britain) LRAC of production declines as output
rises
Holton (1956) Retailing LRAC L-shaped
Johnston (1960) Life Assurance LRAC declines
Johnston (1960) Road passenger transport LRAC either falling or constant
(Great Britain)
Johnston (1960) Electricity (Great Britain) LRAC of production declines as output
rises
Lomax (1951) Gas (Great Britain) LRAC of production declines as output
rises
Lomax (1952) Electricity (Great Britain) LRAC of production declines as output
rises
Moore (1959) Manufacturing Economies of scale prevail quite
generally
Nerlove (1961) Electricity (U.S.) LRAC (excluding transmission costs)
declines and then shows signs of
increasing
Gupta (1968) * Manufacturing (India) L-shaped in 18 industries,
U-shaped in 5 industries, and linear in 6
industries
Source: A.A. Walters, “Production and Cost Functions: An Econometric Survey”, Econometrica,
January-February 1963, PP.49-54.

*Vinod K. Gupta, "Cost Functions Concentration and Barriers to entry in twenty-nine Manufacturing
Industries of India." Journal of Industrial Economics, November 1, 1968, 59-60
211
Production and Cost Activity 4
Analysis
1. Pradeep Company’s total variable function is as follows: TVC = 50Q –
10Q2 +Q3

Where Q is the number of units of output produced:

a) What is the output level where marginal cost is a minimum?

b) What is the output level where average variable cost is a minimum?

c) What is the value of average variable cost and marginal cost at the
output specified in the answer to part (b)?

2. How would you reconcile the findings of Yntena with those of Ezekiel and
Wylie?

3. How would you explain the findings of Johnston (Electricity) in short run
and long run?

4. Production is related to costs. In fact, cost function can be derived from

estimated production function. In view of empirical determination of
production function, can you think of some limitations of statistical
analysis relating to cost function?

5. Despite the above limitations listed by you, an estimated cost function is

useful to a manager. Can you think of some points to support this
contention?

6. Some empirical studies have suggested that the marginal cost function is
approximately horizontal, but conventional cost theory suggests that the
marginal cost curve is U-shaped. Provide an explanation for this apparent
inconsistency.

7. The ABC Manufacturing Company’s short-run average cost function in

the year 2000 is AC=3+4Q

Where AC is the firm’s average cost (in Rs. per unit of the product), and Q is
the output rate.

a) Obtain the firm's short-run total cost function.

b) Does the firm have any fixed costs? Explain.

c) If the price of the firm’s product is Rs. 3 per unit, is the firm making
profits or losses? Explain.

d) Derive the firm's marginal cost function.

212
 Long Run Cost
9.9 MANAGERIAL USES OF COST FUNCTION Analysis

The estimated cost function can help managers to take meaningful decisions
with regard to:

1. determination of optimum plant size,

2. determination of optimum output for a given plant, and

3. determination of a firm’s supply curve.

The optimum plant size, as discussed earlier, is defined in terms of minimum

costs per unit of output. In other words, an optimum plant is given by that
value of K (plant size) for which the average cost is minimum. If the long
run total cost curve is a cubic function, the resultant long run average cost
curve will be a conventional U-shaped curve. The plant level at which the
long run average cost is minimum will be of optimum size.

For a given plant, the optimum output level will be achieved at a point where
the average cost is the least. This condition can be easily verified from the
short run total cost function.

The level of output that a firm would like to supply to the market will depend
on the price that it can charge for its product. In other words, a firm’s supply
is a positive function of the product price. To get the firm’s supply schedule,
one needs to know the firm's cost function and its objectives.

Activity 5

1. Can you list some more managerial uses of cost function other than given
in section 9.9?

9.10 LET US SUM UP

In the long run, all inputs to the production process are variable. Thus, in the
long run, total costs are identical to variable costs. The long run average cost
function shows the minimum cost for each output level when a desired scale
of plant can be built. The long run average cost curve is important to
managers because it shows the extent to which larger plants have cost
advantages over smaller ones. Economies or diseconomies of scale arise
either due to the internal factors pertaining to the expansion of output by a
firm, or due to the external factors such as industry expansion. In contrast,
economies of scope result from product diversification. Thus, the scale-
economies have reference to an increase in volume of production, whereas
the scope-economies have reference to an improvement in the variety of
products from the existing plant and equipment.

We have also discussed three forms of cost functions viz. linear cost function,
quadratic cost function, and cubic cost function and their empirical estimates.
Though, empirical estimates of both production functions and cost functions 213
Production and Cost have a lot of use for managerial decision making. There are conceptual and
Analysis statistical problems in estimating such functions. But we understand that it
will be sufficient for the manager if he knows how to interpret the estimates
based on empirical research in her/his decision-making process.

9.11 TERMINAL QUESTIONS

1. Explain the various economies of scale?
2. Explain the determinants of cost function?
3. Explain the econometric method of estimating cost function? Why is this
method more popular than the other two methods (accounting and
engineering) of costs estimation?
4. What are the common problems you encounter while attempting to derive
empirical cost functions from economic data?
5. The total cost function for a manufacturing firm is estimated as :
C=128+6Q+2Q2
Determine the optimum level of output Q to be produced.
6. Suppose that for a XYZ corporation’s total cost function is as follows :

TC=300+3Q+0.02Q2
Where TC is the total cost, Q is the output.
a. What is the corresponding fixed cost function, average fixed cost
function, and variable cost function, average variable cost function?
b. Calculate the average total cost function and marginal cost function.
7. Based on a consulting economist’s report, the total and marginal cost
functions for an ABC company are
TC = 200 + 5Q – 0.04Q2 + 0.001Q3
MC = 5 – 0.08Q + 0.003Q2
The president of the company decides that knowing only these equations
is inadequate for decision making. You have been directed to do the
following.
a. Determine the level of fixed cost (if any) and equations for average
total cost, average variable cost, and average fixed cost.
b. Determine the rate of output that results in minimum average variable
cost.
c. If fixed costs increase to ` 500, what output rate will result in
minimum average variable cost?
8. Given the total cost function for Laxmi Enterprises Co.
TC = 100Q – 3Q2 + 0.1Q3
214
 a. Determine the average cost function and the rate of output that will Long Run Cost
Analysis
minimize average cost.
b. Determine the marginal cost function and the rate of output that will
minimize marginal cost.

FURTHER READINGS
Adhikary, M. (1987). Managerial Economics (3rd ed.).Khosla Publishers,
Delhi.

Maddala, G. S., & Miller, E. M. (1989). Micro Economics: Theory and

Applications. McGraw-Hill, NewYork.

Maurice, S. C., Smithson, C. W., & Thomas, C. R.(2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw- Hill
Publishing.

Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:

Concepts and Cases. Tata McGraw-Hill, New Delhi.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

Lewis, W.C., Jain, S. K., & Peterson, H. C. (2005). Managerial Economics

(4th ed.). Pearson.

215
Production and Cost
Analysis

216