MANAGERIAL ECONOMICS – MIDTERMS · Cost function is divided into namely two types:

· In economics, production theory explains the Short-Run Cost

principles in which the business has to take
decisions on how much of each commodity it sells · Short run cost is an analysis in which few factors
and how much it produces and also how much of are constant which won’t change during the period
raw material, i.e., fixed capital and labor it employs of analysis. The output can be changed ie.,
and how much it will use. It defines the increased or decreased in the short run by
relationships between the prices of the changing the variable factors.
commodities and productive factors on one hand · Following are the basic three types of short run
and the quantities of these commodities and cost:
productive factors that are produced on the other » Short-run fixed cost - Fixed cost is a cost
hand. which won’t change with the changes in the
· Production is a process of combining various inputs output. For example, Building rent, Insurance
to produce an output for consumption. It is the act charges, etc.
of creating output in the form of a commodity or » Variable cost - Variable cost is the cost which
a service which contributes to the utility of changes with the change in the output. For
individuals. example, Cost of raw material, Wages,
· In other words, it is a process in which the inputs Electricity, Telephone charges, etc.
are converted into outputs. » Short-run total cost - The total actual cost
that is supposed to be incurred to produce a
Function given output is short run total cost. Total cost
· The Production function signifies a technical = Total Fixed Cost + Total Variable Cost
relationship between the physical inputs and Long-Run Cost
physical outputs of the firm, for a given state of
the technology. · Long-run cost is variable and a firm adjusts all its
· Q = f (a, b, c, z) inputs to make sure that its cost of production is
· Where a, b, c, z are various inputs such as land, as low as possible.
labor, capital etc. Q is the level of the output for · Long run cost = Long run variable cost
a firm. · In the long run, firms don’t have the liberty to
· If labor (L) and capital (K) are only the input reach equilibrium between supply and demand by
factors, the production function reduces to: altering the levels of production. They can only
· Q = f (L, K) expand or reduce the production capacity as per
· Production Function describes the technological the profits. In the long run, a firm can choose any
relationship between inputs and outputs. It is a tool amount of fixed costs it wants to make short run
that analysis the qualitative input – output decisions.
relationship and also represents the technology of Law of Variable Proportions
a firm or the economy as a whole.
1. Returns to a Factor
Production Analysis 2. Returns to a Scale
· Production analysis basically is concerned with the 3. Isoquants
analysis in which the resources such as land, labor, Returns to a Factor
and capital are employed to produce a firm’s final
product. To produce these goods the basic inputs · Increasing Returns to a Factor
are classified into two divisions: » Increasing returns to a factor refers to
» Variable Inputs - Inputs those change or are the situation in which total output tends to
variable in the short run or long run are increase at an increasing rate when more
variable inputs. of variable factor is mixed with the fixed
» Fixed Inputs - Inputs that remain constant in factor of production. In such a case,
the short term are fixed inputs. marginal product of the variable factor
must be increasing. Inversely, marginal
Cost Function price of production must be diminishing.
· Cost function is defined as the relationship · Constant Returns to a Factor
between the cost of the product and the output. » Constant returns to a factor refers to the
Following is the formula for the same: stage when increasing the application of
· C = F [Q] the variable factor does not result in
 increasing the marginal product of the · Linear Isoquant
factor – rather, marginal product of the
factor tends to stabilize. Accordingly, total This type assumes perfect substitutability of factors
output increases only at a constant rate. of production. A given commodity may be produced by
· Diminishing Returns to a Factor using only capital or only labor or by an infinite
combination of K and L.
» Diminishing returns to a factor refers to a
situation in which the total output tends to · Input-Output Isoquant
increase at a diminishing rate when more
of the variable factor is combined with the This assumes strict complementarily, that is zero
fixed factor of production. In such a substitutability of the factors of production. There is
situation, marginal product of the variable only one method of production for any one commodity.
must be diminishing. Inversely the marginal The isoquant takes the shape of a right angle. This type
cost of production must be increasing. of isoquant is called “Leontief Isoquant”.

Returns to a Scale · Kinked Isoquant

· If all inputs are changed simultaneously or This assumes limited substitutability of K and L.
proportionately, then the concept of returns to Generally, there are few processes for producing any
scale has to be used to understand the behavior of one commodity. Substitutability of factors is possible
output. The behavior of output is studied when all only at the kinks. It is also called “activity analysis-
the factors of production are changed in the same isoquant” or “linear-programming isoquant” because it
direction and proportion. Returns to scale are is basically used in linear programming
classified as follows: Least Cost Combination of Inputs
» Increasing returns to scale: If output
increases more than proportionate to the · A given level of output can be produced using many
increase in all inputs. different combinations of two variable inputs. In
» Constant returns to scale: If all inputs are choosing between the two resources, the saving in
increased by some proportion, output will the resource replaced must be greater than the
also increase by the same proportion. cost of resource added. The principle of least cost
» Decreasing returns to scale: If increase in combination states that if two input factors are
output is less than proportionate to the considered for a given output then the least cost
increase in all inputs. combination will have inverse price ratio which is
equal to their marginal rate of substitution.
· For example: If all factors of production are
doubled and output increases by more than two Marginal Rate of Substitution
times, then the situation is of increasing returns
to scale. On the other hand, if output does not · MRS is defined as the units of one input factor that
double even after a 100 per cent increase in input can be substituted for a single unit of the other
factors, we have diminishing returns to scale. input factor. So MRS of x2 for one unit of x1 is:
· The general production function is Q = F (L, K) = Number of unit of replaced resource (x2) / Number
Isoquants of unit of added resource (x1)

· Isoquants are a geometric representation of the Price Ratio (PR) = Cost per unit of added resource /
production function. The same level of output can Cost per unit of replaced resource
be produced by various combinations of factor = Price of x1 / Price of x2
inputs. The locus of all possible combinations is
called the ‘Isoquant’. Therefore, the least cost combination of two inputs
can be obtained by equating MRS with inverse price
Characteristics of Isoquant ratio.
» An isoquant slopes downward to the right. x2 ∗ P2 = x1 ∗ P1
» An isoquant is convex to origin.
» An isoquant is smooth and continuous. Cost Concepts
» Two isoquants do not intersect · Costs play a very important role in managerial
Types of Isoquants decisions especially when a selection between
alternative courses of action is required. It helps
The production isoquant may assume various shapes in specifying various alternatives in terms of their
depending on the degree of substitutability of factors. quantitative values
Following are various types of cost concepts: If a factor of production is owned, its cost is a book
cost while if it is hired it is an out-of-pocket cost.
· Future and Past Costs
· Replacement and Historical Costs
Future costs are those costs that are likely to be
incurred in future periods. Since the future is Historical cost of an asset states the cost of plant,
uncertain, these costs have to be estimated and cannot equipment, and materials at the price paid originally for
be expected to absolute correct figures. Future costs them, while the replacement cost states the cost that
can be well planned, if the future costs are considered the firm would have to incur if it wants to replace or
too high, management can either plan to reduce them acquire the same asset now.
or find out ways to meet them.
For example: If the price of bronze at the time of
Management needs to estimate future costs for a purchase in1973 was Rs. 18 per kg and if the present
various managerial uses where future cost are relevant price is Rs. 21 per kg, the original cost Rs. 18 is the
such as appraisal, capital expenditure, introduction of historical cost while Rs. 21 is the replacement cost.
new products, estimation of future profit and loss
statement, cost control decisions, and expansion · Explicit Costs and Implicit Costs
programs. Explicit costs are those expenses which are actually
Past costs are actual costs which were incurred on the paid by the firm. These costs appear in the accounting
past and they are documented essentially for record records of the firm. On the other hand, implicit costs
keeping activity. These costs can be observed and are theoretical costs in the sense that they go
evaluated. Past costs serve as the basis for projecting unrecognized by the accounting system.
future cost but if they are regarded high, management · Actual Costs and Opportunity Costs
can indulge in checks to find out the factors responsible
without being able to do anything about reducing them. Actual costs mean the actual expenditure incurred for
producing a good or service. These costs are the costs
· Incremental and Sunk Costs that are generally recorded in account books.
Incremental costs are defined as the change in overall For example: Actual wages paid, cost of materials
costs that result from particular decision being made. purchased.
Change in product line, change in output level, change in
distribution channels are some examples of incremental The concept of opportunity cost is very important in
costs. Incremental costs may include both fixed and modern economic analysis. The opportunity costs are
variable costs. In the short period, incremental cost the return from the second best use of the firm’s
will consist of variable cost—costs of additional labor, resources, which the firm forfeits. It avails its return
additional raw materials, power, fuel etc. from the best use of the resources.
Sunk cost is the one which is not altered by a change For example, a farmer who is producing wheat can also
in the level or nature of business activity. It will remain produce potatoes with the same factors. Therefore,
the same irrespective of activity level. Sunk costs are the opportunity cost of a ton of wheat is the amount
the expenditures that have been made in the past or of the output of potatoes which he gives up.
must be paid in the future as a part of contractual
· Direct Costs and Indirect Costs:
agreement. These costs are irrelevant for decision
making as they do not vary with the changes There are some costs which can be directly attributed
contemplated for future by the management. to the production of a unit for a given product. These
costs are called direct costs.
· Out-of-Pocket and Book Costs
Costs which cannot be separated and clearly attributed
“Out-of-pocket costs are those that involve immediate to individual units of production are classified as
payments to outsiders as opposed to book costs that indirect costs.
do not require current cash expenditure”
Types of Costs
Wages and salaries paid to the employees are out-of-
pocket costs while salary of the owner manager, if not All the costs faced by companies/business
paid, is a book cost. organizations can be categorized into two main types:
The interest cost of owner’s own fund and depreciation · Fixed costs
cost are other examples of book cost. Book costs can
be converted into out-of-pocket costs by selling assets Fixed costs are expenses that have to be paid by a
and leasing them back from the buyer. company, independent of any business activity. It is one
of the two components of the total cost of goods or The long-run cost of production is the least possible
service, along with variable cost. cost of production of producing any given level of
output when all inputs are variable including the size of
Examples include rent, buildings, machinery, etc. the plant. In the long-run there is no fixed factor of
· Variable costs production and hence there is no fixed cost.

Variable costs are corporate expenses that vary in If Q = f (L, K)

direct proportion to the quantity of output. Unlike fixed TC = L. PL + K. PK
costs, which remain constant regardless of output,
variable costs are a direct function of production Economies and Diseconomies of Scale
volume, rising whenever production expands and falling
Economies of Scale
whenever it contracts.
As the production increases, efficiency of production
Examples of common variable costs include raw
also increases. The advantages of large scale
materials, packaging, and labor directly involved in a
production that result in lower unit costs are the
company's manufacturing process.
reason for the economies of scale. There are two
Determinants of cost types of economies of scale:
The general determinants of cost are as follows · Internal Economies of Scale
» Output level It refers to the advantages that arise as a result of
» Prices of factors of production the growth of the firm. When a company reduces costs
» Productivities of factors of production and increases production, internal economies of scale
are achieved. Internal economies of scale relate to
» Technology
lower unit costs.
Short-Run Cost-Output Relationship
· External Economies of Scale
Once the firm has invested resources into the factors
such as capital, equipment, building, top management It refers to the advantages firms can gain as a result
personnel, and other fixed assets, their amounts cannot of the growth of the industry. It is normally associated
be changed easily. Thus in the short-run there are with a particular area. External economies of scale
certain resources whose amount cannot be changed occur outside of a firm and within an industry. Thus,
when the desired rate of output changes, those are when an industry's scope of operations expands due to
called fixed factors. the creation of a better transportation network,
resulting in a decrease in cost for a company working
There are other resources whose quantity used can be within that industry, external economies of scale are
changed almost instantly with the output change and said to have been achieved.
they are called variable factors. Since certain factors
Diseconomies of Scale
do not change with the change in output, the cost to
the firm of these resources is also fixed, hence fixed When the prediction of economic theory becomes true
cost does not vary with output. Thus, the larger the that the firm may become less efficient, when it
quantity produced, the lower will be the fixed cost per becomes too large then this theory holds true. The
unit and marginal fixed cost will always be zero. additional costs of becoming too large are called
On the other hand, those factors whose quantity can diseconomies of scale. Diseconomies of scale result in
be changed in the short-run is known as variable cost. rising long run average costs which are experienced
when a firm expands beyond its optimum scale.
Thus, the total cost of a business is the sum of its total
variable costs (TVC) and total fixed cost (TFC). For Example: Larger firms often suffer poor
TC = TFC + TVC communication because they find it difficult to maintain
an effective flow of information between departments.
Long-Run Cost-Output Relationship Time lags in the flow of information can also create
problems in terms of response time to changing market
The long-run is a period of time during which the firm condition.
can vary all its inputs. None of the factors is fixed and
all can be varied to expand output.
It is a period of time sufficiently long to permit the
changes in plant like: the capital equipment, machinery,
land etc., in order to expand or contract output.