BUSINESS ECONOMICS

(22MBACC102)

Dr. Salma Begum

 Module-2
Theory of Production, Cost & Revenue
Analysis
 Production

• Any activity which creates value is production.

• Transformation of inputs (such as capital, equipment, labour,
and land etc.) into output such as good or service.
Inputs/Factors of Production
Labour:
Land: Physical or mental effort of human
Anything which is gift of nature beings that undertakes the production
and not the result of human effort, process. Labour is supplied by the
e.g. soil, water, forests, minerals. workers.
Owner of land is called landlord - Labour can be skilled as well as
Reward of land is rent. unskilled, physical or intellectual -
Reward/price of labour is wages/ salary.
Enterprise/Entrepreneurship/Organ
Capital:
ization:
Wealth which is used for
The ability and action to take risk of
production as machine/
collecting, coordinating, and utilizing all
equipment/intermediary good
the factors of production for the purpose of
It is outcome of human efforts
uncertain economic gains
meaning capital is man-made -
Owner of enterprise is entrepreneur -
Reward of capital is interest
Reward of entrepreneurship is profit
 Production Function
• Production function express the technological relationship
between physical inputs and physical output of a firm under
given conditions
• A production function may be written as:
Q = f(Ld, L, K, E,…..)
Where,
• Q = output (total product)
• Ld = Land
• L = Labour
• K = Capital
• E = Entrepreneurship
 Production Function
• A simpler version of the concept of production function (for
better understanding) takes two input factors for producing one
output
• The two inputs to be taken are labour and capital since they are
most important variables

Thus,
Q = f (L, K)

– Different combinations of labour and capital will produce different

quantities of output
– Logically, more units of input factors will produce more quantities of
output
 Types of Production-Function
• Short Period And Long Period
• The time-period during which a firm in
order to make changes in its production
can bring about change only in its variable
factors but not in its fixed factors, is
termed as short-period
– In the short-period, a firm cannot change its
scale of plant
• The time period in which a firm can
change all the factors of production and its
scale of plant, is termed as long-period
Production Function With one Variable Input
▪ As the quantity of a variable input (labour) increases while all
other inputs are fixed, output rises.

▪ Initially, output will rise more and more rapidly, but eventually
it will slow down and perhaps even decline - This is called the
Law of Diminishing Marginal Returns.

▪ It holds that we will get less and less extra output when we add
additional doses of an input while holding other inputs fixed. It
is also known as law of Variable Proportions.
 1. Total Physical product (TP)

▪ Total product (TP) is the amount of output produced from land

with given number of labourers employed
▪ As the amount of the variable increases, the total output
increases.
▪ But the rate of increase in total output varies at different levels
of employment of the variable factor.
▪ When more are employed with a given quantity of capital, the
total output of the product increases.
 2. Average Physical Product (APP)

▪ Average product of a variable factor (labour) is the total output

(Q) divided by the amount of labour employed with a given
quantity of capital (fixed factor) used to produce a commodity.
▪ Thus,

APL = 170/2 = 85
APL = 270/3 = 90
 3. Marginal Physical Product (MPP)

▪ The law of returns are concerned with the relation between

marginal change in input and the resulting marginal change in
output.
▪ Marginal product is a product by using additional unit of
variable factor.
▪ The Concept of marginal product plays an important role in
explaining the laws of returns.
• Students can watch this 5-7 minutes video at
the end of session 1 and discussed the points
mentioned in it
• https://www.youtube.com/watch?v=TWXAzr-
Bhfc
 Law of Variable Proportions

• Also known as Law of Proportionality or Returns to Factor

• Economists like Alfred Marshall, Benham, Samulson contributed
to this law
Statement:
“As the proportion of the factor in a combination of factors is increased after a
point, first the marginal and then the average product of that factor will
diminish.” -Benham
“An increase in some inputs relative to other fixed inputs will in a given state of
technology cause output to increase, but after a point the extra output resulting
from the same additions of extra inputs will become less and less.” -Samuelson
“The law of variable proportion states that if the inputs of one resource is
increased by equal increment per unit of time while the inputs of other
resources are held constant, total output will increase, but beyond some point
the resulting output increases will become smaller and smaller.” -Leftwitch
 Assumptions
i. Constant Technology:
The state of technology is assumed to be given and constant. If there is an
improvement in technology the production function will move upward.
ii. Factor Proportions are Variable:
The law assumes that factor proportions are variable. If factors of
production are to be combined in a fixed proportion, the law has no
validity.
iii. Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit is identical in
quality and amount with every other unit.
iv. Short-Run:
The law operates in the short-run when it is not possible to vary all factor
inputs.
 Explanation of the Law
• The Law of Variable Proportions can be explained using the
example of agriculture.
– Suppose land and labour are the only two factors of production.
– By keeping land as a fixed factor, the production by variable factor i.e., labour can
be shown with the help of the following table:
Table 1 indicates that there are three stages of the law of
variable proportion.

•Stage-I – Stage of Increasing Returns

•Stage –II – Stage of Decreasing Returns
•Stage – III – Stage of Negative Returns

•The stages can be explained diagrammatically as follows

Graphic Presentation:
 The Stage of Operation
• A rational producer will always seek to produce in stage II
where both the marginal product and average product of the
variable factor are diminishing.

• At which particular point in this stage, the producer will decide

to produce depends upon the prices of factors.

• Stage II represents the range of rational production decisions.

Production Function With All Variable Input:
Law of Returns to Scale
• In the long run all factors of production are variable factors –
no factor is fixed or constant– all the factors are treated as
variable factors.

• Accordingly, the scale of production can be changed by

changing the quantity of all factors of production.

• If all factors of production are doubled, the total output will

also be doubled.
 Assumptions:
i. The firm is using only two factors of production that are
capital and labour.
ii. Labour and capital are combined in one fixed proportion.
iii. Prices of factors do not change.
iv. State of technology is fixed.
I. Increasing Returns to Scale II. Constant Returns to III. Diminishing Returns to
Scale Scale
• It is a situation in which • A constant • Diminishing returns to
output increase by a greater return to scale scale refers to a
proportion than increase in implies the situation in which
factor inputs. situation in output increases in
• For example, to produce a which an lesser proportion than
particular product, if the increase in increase in factor
quantity of inputs is doubled output is equal inputs.
and the increase in output is to the increase
more than double, it is said to in factor inputs. • For example, when
be an increasing returns to capital and labor are
scale. • For example in doubled, but the
• When there is an increase in the case of output generated is
the scale of production, the constant returns less than double, the
average cost per unit to scale, when returns to scale would
produced is lower. the inputs are be termed as
• This is because at this stage doubled, the diminishing returns to
an organisation enjoys high output is also scale.
economies of scale. doubled.
• Students can watch this video of 3-5 minutes at
the end of the session.
• https://www.youtube.com/watch?v=5cmZMP
pG-r4
 Isoquant
• An isoquant is a locus of points showing all the technically
efficient ways of combining factors of production to produce a
fixed level of output.

• It is also known as the equal product curve.

• In case of two variable factors, labour and capital, the curve

shows the efficient alternative techniques of production or
alternative combinations of two factors that can produce a
fixed level of output.
Isoquant
 Properties of Isoquants
1. An isoquant lying above and
to the right of another
isoquant represents a higher
level of output.
 Properties of Isoquants
2. Two isoquants cannot
cut each other
• Considering IQ1
–A=C
• From IQ2
–A=B
• That implies,
–A=B=C
• But, B > C as B is
on higher isoquant
• Thus, illogical
conclusion
 Properties of Isoquants
3. Isoquants are convex to the origin
• As the producer moves from point
A to B, from B to C and C to D
along an isoquant, the marginal rate
of technical substitution (MRTS) of
labor for capital diminishes.
• The MRTS diminishes because the
two factors are not perfect
substitutes.
• In figure, for every increase in labor
units by (ΔL) there is a
corresponding decrease in the units
of capital (ΔK).
 Properties of Isoquants
4. No isoquant can touch
either axis
 Properties of Isoquants
5. Isoquants are negatively
sloped
– The logic behind this is
the principle of
diminishing marginal
rate of technical
substitution.
– In order to maintain a
given output, a reduction
in the use of one input
must be offset by an
increase in the use of
another input.
 Properties of Isoquants
6. Isoquants need not be
parallel
The shape of an isoquant
depends upon the marginal
rate of technical
substitution. Since the rate
of substitution between two
factors need not necessarily
be the same in all the
isoquant schedules, they
need not be parallel.
 Properties of Isoquants
7. Each isoquant is oval-shaped
– An isoquant is oval shaped contains a pair of ridged lines that it
enables the firm to identify the efficient range of production
 Isocost Lines
• “An isocost line shows the
different combinations of
factors of production that can be
employed with a given total
cost.”

• The isocost line represents the

total cost C as constant for all
K-L combinations satisfying the
equation.
 COST ANALYSIS
▪ Cost Concepts
▪ Money cost and Real cost
▪ Actual cost and Opportunity cost
▪ Fixed cost and Variable cost
▪ Explicit cost and Implicit cost
▪ Historical cost and Replacement cost
▪ Short-run cost and Long-run cost
▪ Accounting cost and Economic cost
 Money cost and Real cost
• Production cost expressed in
• Real cost refers to the payment
money terms is called as
made to compensate the efforts
money cost.
and sacrifices of all factor
• Money cost includes the owners for their services in
expenditures such as cost of production.
raw materials, payment of
• Real cost includes the efforts
wages and salaries, payment of
and sacrifices of landlords in
rent, Interest on capital,
the use of land, capitalists to
expenses on fuel and power,
save and invest, and workers,
expenses on transportation and
in foregoing leisure.
other types of production
related costs. • Real costs are considered pains
and sacrifices of labor as real
• Money costs are considered as
cost of production.
out of pocket expenses.
 Actual cost and Opportunity cost
• Costs that are actually • The opportunity cost is the
incurred in acquiring or notional cost of sacrificing
producing a good or service the alternatives.
are known as actual cost. • It is the value of a resource in
• These costs are real cash its best alternative use, i.e. the
outflows and are generally value that must be foregone
recorded in the account in putting a resource to one
books, they are also called particular use.
Acquisition or accounting • Investment vs inputs of
costs. production
• E.g. rent for land and
building; wages to Labour;
interest of Capital.
 Fixed cost and Variable cost
• Costs that remain constant • Costs that vary with
with respect to the output. respect to the output.
• E.g. interest on borrowed
capital, rent of building • e.g. costs of raw material,
and factory, cost of plant wages etc.
and machinery.

• Charges for electricity and

telephone are semi-variable
costs.
 Explicit cost and Implicit cost
• Explicit cost are • There are some costs that
out-of-pocket costs for don’t involve a cash
which a cash payment is outlay. They are called as
made. implicit or book costs.
• E.g. payments for raw • E.g. depreciation and
material, utilities, wages salary for owner manager
 Historical cost and Replacement cost

• The historical cost of an • The replacement cost

asset refers to the actual stands for the cost which
cost incurred at the time must be incurred if the
the asset was acquired. asset is to be purchased
today.
 Short-run cost and Long-run cost
• It is a period during which • It is the cost that varies
one or more inputs of the with the output when all
firm are fixed. the factor inputs change.
• It is the cost that varies
with the output when plant
and equipment remains the
same.
 Accounting cost and Economic cost

• The basic difference • The concepts of average

between these two types of cost, marginal cost, short
costs is of being recorded run cost, long run cost,
in the books of account. opportunity cost and
• The concepts of actual replacement cost are
cost, fixed cost, variable economic costs.
cost, explicit cost, implicit
cost, etc. are accounting
costs.
 Determinants of cost

1. Level of output
2. Price of input factors
3. Productivities of factors of production
4. Size of plant
5. Output stability
6. Lot size
7. Laws of returns
8. Levels of capacity utilization
9. Time period
10. Technology
11. Experience
12. Process of range of products
 Types of Costs

▪ Total costs, Average costs and Marginal cost

▪ The sum of all the costs: fixed, variable, explicit and
implicit for the entire output is known as total cost.
▪ In the SR, TC = TFC + TVC
▪ Average cost is the cost per unit of output and is computed
by dividing the total cost by the number of units produced.
▪ In the SR, AC = TC/Q or AFC + AVC
▪ Marginal cost is the change in total cost due to the
production of one additional unit of output.
▪ MC = MCn – MCn-1
 Cost function
▪ The cost function expresses a functional relationship between
total cost and factors that determine it.

▪ Usually, the factors that determine the total cost of production

(C) of a firm are the output (Q), the level of technology (T),
the prices of factors (Pf).

▪ Symbolically, the cost function becomes

C = f (Q, T, Pf )
 Cost of Production

Short Run cost Long Run cost

function function

Fixed Cost Variable cost

 Short Run Cost Function
▪ In short run there is difference between fixed cost and variable
costs
▪ Therefore, the short-run cost function is written as
C = f (Q, T, Pf, F)
▪Here,
▪ C = cost of production
▪ F = functional relationship between output and factor prices
▪ Q = output
▪ T = technology
▪ Pf = factor prices
▪ K = fixed factors
 Y Y VC
Variable costs

Fixed costs C3

C2
C1 FC
C1
Cost

O M1 M2 M3 X O M1 M2 M3 X
Quantity
Relation between Total, Fixed & variable Cost

Output Fixed Cost Variable Cost Total Cost

0 240 0 240
1 240 120 360
2 240 160 400
3 240 180 420
4 240 212 452
5 240 280 520
6 240 420 660
 Short Run Average cost (SRAC)

▪ Average cost is the cost per unit of output.

▪ Short Run Average total cost is the sum of average fixed and
the average variable cost.

▪ As output increases and average fixed cost becomes smaller

and smaller, the vertical distance between the average total
cost curve (ATC) & average variable cost curve goes on
declining.
 Average fixed cost (AFC)

Total fixed cost per unit of output produced

Average variable cost (AVC)

Total variable cost per unit of output produced

Average total cost (ATC)

Total cost per unit of output produced
Average fixed cost, Average variable cost and Average total
cost
Output Average Fixed Average Average Total
(units) Cost TFC ÷ Q Variable Cost Cost TC ÷ Q
TVC ÷ Q
1 240 ÷ 1 = 240 120 ÷ 1 = 120 360 ÷ 1 = 360

2 240 ÷ 2 = 120 160 ÷ 2 = 80 400 ÷ 2 = 200

3 240 ÷ 3 = 80 180 ÷ 3 = 60 420 ÷ 3 = 140

4 240 ÷ 4 = 60 212 ÷ 4 = 53 452 ÷ 4 = 113

5 240 ÷ 5 = 48 280 ÷ 5 = 56 520 ÷ 5 = 104

6 240 ÷ 6 = 40 420 ÷ 6 = 70 660 ÷ 6 = 110

 Average Fixed cost = TFC/Q
Cost

AFC

Output
 Average Variable cost = TVC/Q

AT
C
AVC
Cost

Output
 MC
Total Costs = TC
Average Costs = AC
AC
Marginal costs = MC

AVC
Costs

AFC

0 q1 Q
Output
 Marginal cost

▪ The concept of marginal cost occupies an important place in

economic theory.
▪ Marginal cost is addition to the total cost caused by producing
one more unit of output.
▪ In other words, marginal cost is the addition to the total cost of
producing n units instead of n-1 units.

MC = TCn – TCn-1
MC = Marginal cost Marginal cost = ΔTC/ΔQ
TCn = total cost of ‘n’ units
TCn-1 = total cost of n – 1 units
 Computation of Marginal Cost
Output in Units Total cost in Rs. Marginal cost in
Rs.
1 250 -
2 290 40
3 320 30
4 360 40
5 412 52
6 472 60
7 546 74
8 646 100
Output, Total Cost, Average Cost & Marginal Cost

Output TFC TVC TC AFC AVC ATC MC

0 100 0
1 100 25
2 100 40
3 100 50
4 100 60
5 100 80
6 100 110
7 100 150
8 100 300
9 100 500
10 100 900
Output, Total Cost, Average Cost & Marginal Cost

Output TFC TVC TC AFC AVC ATC MC

0 100 0 100 - - - -
1 100 25 125 100 25 125 25
2 100 40 140 50 20 70 15
3 100 50 150 33.3 16.6 50 10
4 100 60 160 25 15 40 10
5 100 80 180 20 16 36 20
6 100 110 210 16.3 18.3 35 30
7 100 150 250 14.2 21.4 35.7 40
8 100 300 400 12.5 37.5 50 150
9 100 500 600 11.1 55.6 66.7 200
10 100 900 1000 10 90 100 400
 Long Run Cost Function
▪ In the long run all factors are variable.
▪ Due to the absence of fixed factors in the production function, all
costs of production are variable in the long run
▪ Therefore, there is no need to distinguish between fixed and variable
cost as in short run.
C = f (Q, T, Pf) or C = f (Q)
▪ C = cost of production
▪ F = functional relationship between output and factor prices
▪ Q = output
▪ T = technology ▪In the long run, we have -
▪ Pf = factor prices 1. Long run Total cost
2. Long run Average cost
3. Long run Marginal cost
 Long Run Total Cost
▪ Long run total cost is always less than or equal to short run total cost, but it
can never be more than short run total cost.
▪ Long run total cost curve represents the least cost of different quantities of
output.
▪ Therefore, it is tangent to any given point, on short run total cost.

Long Run Average Cost

▪ Long run average cost is the long run total cost divided by the level of
output.
▪ LAC = LTC/Q
▪ According to Robert “The long run average cost curve shows the lowest
average cost of producing output when all inputs can be varied freely”.
▪ Similarly, J.S. Bain has defined the long-run average cost as “the long run
average cost curve shows for each possible output, the lowest cost of
producing that output in the long run.
 LAC Curve
Y

LAC

SAC1

SAC2
COST

0 x
q1 q2 q3 q4 q5 q6 q7 q8 q9

Outpu
t
 Long Run Marginal Cost
▪ Long run marginal cost shows the change in total cost due to
the production of one more unit of commodity.
▪ According to Robert “long run marginal cost curve is that
which shows the extra cost incurred in producing one more
unit of output when all inputs can be changed.

▪ LMC = changes in LTC/changes in Q or

LRMC = TCn – TCn-1

LRMC = Marginal cost

TCn = total cost of ‘n’ units
TCn-1 = total cost of n – 1 units
 Long-run Average & Marginal Cost
Curves
LMC

SMC2

LAC

SAC2
SMC1 SAC1
COST

0 x
q1 q2 q3

Output
 Revenue Analysis
• Revenue, in simple words, is the amount that a firm receives
from the sale of the output.

• According to Prof. Dooley, ” The Revenue of a firm is its sales

receipts or income.‘

• In a firm, revenue is of three types:

– Total Revenue
– Average Revenue
– Marginal Revenue
 Total Revenue Average Revenue Marginal Revenue
• The Total Revenue of a firm • Average Revenue, as the • Marginal Revenue is the
is the amount received from name suggests, is the revenue amount of money that a firm
the sale of the output. that a firm earns per unit of receives from the sale of an
Therefore, the total revenue output sold. Therefore, you additional unit. In other
depends on the price per unit can get the average revenue words, it is the additional
of output and the number of when you divide the total revenue that a firm receives
units sold. Hence, we have revenue with the total units when an additional unit is
• TR = Q x P sold. Hence, we have, sold. Hence, we have
• Where,
• TR – Total Revenue • AR=TR/Q • MR = TRn – TRn-1
• Q – Quantity of sale • Or
(units sold) • Where, • MR= ΔTR/ ΔQ
• P – Price per unit of • AR – Average Revenue
output • TR – Total Revenue • Where,
• Q – Total units sold • MR – Marginal Revenue
• ΔTR – Change in the
Total revenue
• ΔQ – Change in the
units sold
• TRn – Total Revenue of
n units
• TRn-1 – Total Revenue
of n-1 units
 Break Even Analysis (BEA)
▪ IN BEA, the break-even point is located at that level of output
or sales at which the net income or profit is zero.
▪ At this point, total cost is equal to total revenue. Hence, the break-even
point is the no-profit-no loss zone.
▪ Break even analysis is an algebraic or graphic model which
relates costs and revenues for different volumes of production.
▪ It clearly demarcates the line between profit and loss.
▪ Break even analysis, the relationship among cost, volume of
sales and profit are put together graphically.
▪ The break-even point may be defined as that level of sales in
which total revenues equal total costs and net income is equal
to zero.
▪ This is also known as no-profit no loss point.
 The Break-even Chart (BEC)

• In recent years, the break-even charts have been widely used by

business economists, company executives, investment analysts,
govt agencies and even trade unions.

▪ A break-even chart (BEC) is a group of the short-run relation of

total cost and of total revenue to the rate of output and sales.

▪ The BEC graphically shows cost and revenue relation to the

volume of output. It thus depicts profit-output relationship. Hence,
the BEC is also called profit group.
 Assumption

1. The cost function and the revenue function are linear.

2. The total cost is divided into fixed and variable costs (TC =
FC + VC)
3. Selling price is constant
4. The average and marginal productivity of factors are constant
5. The product-mix is stable in the case of a multi-product firm
6. Factor price is constant
 Break Even Point

▪ The break even point (BEP) of a firm can be found out in two
ways. It may be determined in terms of physical units and in
terms of money value
▪ Physical terms – volume of output
▪ Money terms – sales values
Break-even point – to arrive at the make or buy decision break
even point is used

FC
____________________________
QBEP =
(Selling price – Variable cost)

FC
=
Total sales revenue – Total Variable
cost
 Contribution

▪ It is the difference between total sales revenue and total

variable cost. For maximum profit contribution should be
always higher than fixed cost

Contribution = Total sales revenue – Total variable cost

= TSR - TVC
Exercise:

You are required to calculate the BEP for a business considering following
information:
A Businessman has started a new business with Rs. 20,00,000 bank loan of
12% interest paid. He has fixed cost as given below. If he charges Rs. 150 for his
product and raw material cost would be Rs. 100, find out BEP for his business.

Particulars Amount
Bank Loan 12% interest of Rs. 20,00,000
Shop rent Rs. 25,000 per month
Employee Salary (2 persons) Rs. 30,000 per month
Maintenance and others Rs. 12,000 per year
Exercise:

Ans.
BEP = Fixed Costs
Selling Price per unit – Variable Costs per unit

Fixed Costs = interest on bank loan + shop rent + employee salary + maintenance
= 240000 + 300000 + 360000 + 12000
= Rs. 912000
Selling Price per unit = Rs. 150
Variable costs per unit = Rs. 100

Thus,
BEP = 912000
150-100
= 18240 units.