MANAGERIAL ECONOMICS 22MBA16

Unit 3: Cost Analysis & Production analysis (10 Hours)

Concepts, production function with one variable input - Law of Variable Proportions. Production
function with 2 variable inputs and Laws of returns to scale, Indifference Curves, ISO-Quants &
ISO-Cost line, Least cost combination factor, Economies of scale, Diseconomies of scale.
Technological progress and production function, Types of cost, Cost curves, Cost – Output
Relationship in the short run and in the long run, LAC curve. Break Even Analysis – Meaning,
Assumptions, Determination of BEA, Limitations, Uses of BEA in Managerial decisions (with
simple problems)

Theory of Production

Once business firms take decision on ‘what to produce’ the major issues that arise are ‘how to
produce’ and ‘how much to produce’. These issues arise because achieving optimum efficiency
in production and minimizing cost for a given production is one of the prime concerns of the
business managers.
Managers of business firms endeavour to minimize the production cost of a given output or, in
other words, maximize the output from a given quantity of inputs. In their effort to minimize the
cost of production, the fundamental questions that managers are faced with are:
(i) How can production be optimized with given resources?
(ii) How does output respond to change in quantity of inputs?
(iii) How does technology matter in reducing the cost of production?
(iv) How can the least-cost combination of inputs be achieved?
(v) Given the technology, what happens to the rate of return when more plants are added to the
firm?

Input & Output

An input is a good or service that goes into the process of production. In the words of Baumol,
“An input is simply anything which the firm buys for use in its production or other processes.”
An output is any good or service that comes out of production process.

Fixed and Variable Inputs

Inputs are classified as
(i) fixed inputs, and
(ii) variable inputs.

Fixed and variable inputs are defined in economic sense and also in technical sense. The two
concepts of input are explained below in economic as well as in technical sense.
Fixed Inputs: In economic sense, a fixed input is one whose supply is inelastic in the short run.
Therefore, all of its users together cannot buy more of it in the short-run. In technical sense, a
fixed factor is one that remains fixed (or constant) for a certain level of output.
Variable Input: A variable input is defined as one whose supply in the short-run is elastic, e.g.,
labour and raw material, etc. All the users of such factors can employ a larger quantity in the
short-run as well as in the long-run. Technically, a variable input is one that changes with the
change in output. In the long-run, all inputs are variable.

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Short-run and Long-run

Production of a good involves timer. The reference to time period involved in production process
is another important concept used in production analysis. The two reference periods are short-run
and long-run. The short-run refers to a period of time in which the supply of certain inputs (e.g.,
plant, building, machinery, etc.) is fixed or is inelastic and are used in a fixed quantity. In the
short-run, therefore, production of a commodity can be increased by increasing the use of only
variable inputs like labour.

On the other hand, long-run refers to a period of time in which the supply of all the inputs is
elastic, but not enough to permit a change in technology. That is, in the long-run, all the inputs
are variable. Therefore, in the long-run, production of a commodity can be increased by
employing more of both variable and fixed inputs.

PRODUCTION FUNCTION

Production function is a mathematical presentation of input-output relationship. More

specifically, a production function states the technological relationship between inputs and
output in the form of an equation, a table or a graph.

For example, suppose production of a product, say X, depends on labour (L) and capital (K),
then production function is expressed in equation form as

Qx = f (L, K)

SHORT-RUN LAWS OF PRODUCTION: PRODUCTION WITH ONE VARIABLE

INPUT

The laws of production state the relationship between output and input. In the short-run, input-
output relations are studied with one variable input (labour), other inputs (especially, capital)
held constant. The laws of production under these conditions are called the ‘Laws of Variable
Proportions’ or the ‘Laws of Returns to a Variable Input’. In this section, we explain the ‘laws of
returns to a variable input’.

The Law of Diminishing Returns to a Variable Input

The law of diminishing returns states that when more and more units of a variable input are used
with a given quantity of fixed inputs, the total output may initially increase at increasing rate and
then may be at a constant rate, but it will eventually increase at diminishing rates. That is, the
marginal increase in total output decreases eventually when additional units of a variable factor
are used, given quantity of fixed factors.

Assumptions.
The law of diminishing returns is based on the following assumptions:
(i) labour is the only variable input, capital remaining constant;
(ii) labour is homogeneous;

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(iii) the state of technology is given; and

(iv) input prices are given.

The Three Stages in Production.

Below graph gives the explanation about the law of diminishing returns. There are three usual
stages in the application of the laws of returns to variable input.

(Refer the graph which you have drawn in class…that is the better one)

In Stage I, TPL increases at increasing rate. This is indicated by the rising MPL till the
employment of the 5th and 6th workers. Given the production function, the 6th worker produces
as much as the 5th worker. The output from the 5th and the 6th workers represents an
intermediate stage of constant returns to the variable factor, labour.

In Stage II, TPL continues to increase but at diminishing rates, i.e., MPL begins to decline. This
stage in production shows the law of diminishing returns to the variable factor. Total output
reaches its maximum level at the employment of the 10th worker. Beyond this level of labour
employment, TPL begins to decline. This marks the beginning of Stage III in production.

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To conclude, the law of diminishing returns can be stated as follows. Given the employment of
the fixed factor (capital), when more and more workers are employed, the return from the
additional worker may initially increase but will eventually decrease.

PRODUCTION WITH TWO VARIABLE INPUTS

In the preceding section, we have discussed the short-term laws of production, i.e., technological
relationship between inputs and output assuming labour to be the only variable input, capital held
constant. In this section, we proceed to discuss the long-term laws of production, i.e., the nature
of relationship between inputs and output under the condition that both the inputs, capital and
labour, are variable factors. In the long-run, supply of both the inputs is supposed to be elastic
and, therefore, firms can use larger quantities of both labour and capital. With larger employment
of capital labour, the scale of production increases. The nature of changing relationship between
changing scale of inputs and output is referred to the laws of returns to scale. The laws of returns
to scale are generally explained through the production function and iso-quant curve technique.
The most common and simple tool of analysis is iso-quant curve technique.

Iso-quant: The Tool of Analyses

The term ‘iso-quant’ has been derived from the Greek word iso meaning ‘equal’ and Latin word
quantus meaning ‘quantity’. The ‘iso-quant curve’ is, therefore, also known as ‘Equal Product
Curve’ or ‘Production Indifference Curve’. An iso-quant curve can be defined as the locus of
points representing various combinations of two inputs—capital and labour—yielding the same
output.

Iso-quant curves are drawn on the basis of the following assumptions:

(i) there are only two inputs, viz., labour (L) and capital (K), to produce a commodity X;
(ii) both L and K and product X are perfectly divisible;
(iii) the two inputs—L and K—can substitute each other but at a diminishing rate as they are
imperfect substitutes; and
(iv) the technology of production is given.

Iso-quant curve
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Given these assumptions, it is technically possible to produce a given quantity of

commodity X with various combinations of capital and labour. The factor combinations are so
formed that the substitution of one factor for the other leaves the output unaffected. This
technological fact is presented through an iso-quant curve (IQ1 = 100) in Fig above. The curve
IQ1 all along its length represents a fixed quantity, 100 units of product X. This quantity of
output can be produced with a number of labour-capital combinations. For example, points A, B,
C, and D on the iso-quant IQ1 show four different combinations of inputs, K and L, as given in
Table below, all yielding the same output—100 units. Note that movement from A to D indicates
decreasing quantity of K and increasing number of L. This implies substitution of labour for
capital such that all the input combinations yield the same quantity of commodity X, i.e., IQ1 =
100.

Capital – Labour Combination Table

Properties of Iso-quants

(i) Iso-quants have a negative slope.

The iso-quants have a negative slope in its economic region. An iso-quant has a negative
slope because of substitution between two inputs – Labour & Capital.

The above graph represents how the value of K is decreasing with the increase in the value of L.

(ii) Iso-quants are convex to origin.

Iso-quants are convex to origin in the sense that they tend to bend towards the point of
origin. Iso-quants are convex to origin for two reasons: (i) the two inputs – capital and labour –

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are imperfect substitutes, and (ii) the returns from inputs are subject to the law of diminishing
returns, i.e., as units of an input increase, its marginal productivity decreases.

(iii) Iso-quants are non-intersecting and non-tangential.

Another important feature of iso-quants as a tool of analysis is that they do not intersect nor are
the iso-quants tangent to one another. If iso-quants intersect or are tangent, the laws of
production get violated as it leads to two untenable facts: (i) given the technology, a combination
of two inputs, can produce two different quantities - larger and smaller, and (ii) a given quantity
of a commodity can be produced with a smaller and a larger combination of inputs.

Intersecting Iso-Quant curve

IMP: Note that two iso-quants intersect at point M—a point common to both the iso-quant
curve, Q1 = 100 and Q2 = 200. At point M the input combination is given as ML1 of capital plus
OL1 of labour, i.e., ML1(K) + OL1(L). Since this input combination is common to both the iso-
quants, it means that the same input combination can produce 100 units as well as 200 units. This
is technically not possible.

(iv) Upper iso-quants represent higher level of output.

Between any two iso-quants, the upper one represents a higher level of output than the
lower one. The reason is, an upper iso-quant represents a larger input combination, in terms of
one or both inputs and a larger input combination yields a larger output. Therefore, upper iso-
quant represents a higher level of output.

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Expansion Path: The Path of Increasing Production Scale

The firms in general tend to expand their production in the long run. A cost-minimizing firm
expands its production by ensuring the optimum combination of inputs. The root through which
firm expands in cost minimizing output is called the expansion path. The expansion path may be
defined as the locus of points indicating various cost minimizing combination of inputs at the
different levels of production.

Expansion Path

When firm’s resources increase, input prices remaining constant, its budget line shifts upward
from K1L1 to K2L2, remaining parallel to the previous budget line.
As a result, firm’s production level shifts to a higher isoquant and equilibrium point shifts from
point A to point B. When the firm invests more, its budget line shifts further upward, say, to
K3L3, and it moves an upper isoquant IQ3. Its optimum combination of inputs to maximize its
output shifts from point B to point C.
As in Fig., as firm’s resources increase, the firm’s production level goes on shifting from lower
isoquants to upper isoquants. This indicates expansion of production. By joining equilibrium
points A, B and C, one gets the expansion path.

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Budget Line or Iso-cost Line

Iso-cost line is the combination of Labour and Capital to determine the cost that the firm can
spend for the production of the desired output. It is also called as Budget Line, as it determines
the budget of the firm for production activity for a given period.

Capital

K1

0 L1 Labour
The above line represents the combination of the amount of labour and capital the firm can spend
within its budget.

Types of Iso-Quant Curves

1. Linear Iso-quants. In case two inputs— labour and capital—are perfect substitutes for one
another, then the iso-quant takes a linear form. A linear iso-quant is presented by the line AB in
Fig. A linear iso-quant implies perfect substitutability between the two inputs, K and L. The iso-
quant AB indicates that a given quantity of a product can be produced by using only capital or
only labour or by using both.

Linear Iso-quant curve

2. L-Shaped Iso-quants: Iso-quants with Fixed Factor-Proportion. When a production

function assumes a fixed proportion between K and L, the iso-quant takes ‘L’ shape, as shown by
iso-quants Q1 and Q2 in Fig.
Such an iso-quant implies zero substitutability between K and L. Instead, it assumes perfect
complementarity between K and L. The perfect complementarity implies that a given quantity of
a commodity can be produced by one and only one combination of K and L and that the

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proportion of the inputs is fixed. It also implies that if the quantity of an input is increased and
the quantity of the other input is held constant, there will be no change in output. The output can
be increased only by increasing both the inputs proportionately. For example, if output is to be
increased to Q2, K has to be increased by K1K2 and labour by L1L2.

The L Shaped Iso-quant

3. Kinked Iso-quants or Linear Programming Iso-quants.
In real life, however, the businessmen and the production engineers find in existence
many, but not infinite, techniques of producing a given quantity of a commodity, each technique
having a different fixed proportion of inputs. In fact, there is a wide range of machinery available
to produce a commodity. Each machine requires a fixed number of to make its full utilization.
This number varies from machine to machine. For example, 40 persons can be transported from
one place to another by two methods: (i) by hiring 10 taxis and 10 drivers, or (ii) by hiring a bus
and 1 driver. Each of these methods is a different process of production and has a different fixed
proportion of capital and labour.
Let us suppose that for producing 10 units of a commodity, X, there are four different
techniques of production available. Each techniques has a different fixed factor-proportion, as
given in Table

The ray OA represents a production process having a fixed factor-proportion of 10K:2L.

Similarly, the other three production processes having fixed capital-labour ratios 6K:4L, 4K:6L
and 3K:10L have been shown by the rays OB, OC and OD respectively. Points A, B, C and D
represent four different production techniques. By joining the points, A, B, C and D, we get a
kinked iso-quant, ABCD.

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Kinked demand curve

LAWS OF RETURNS TO SCALE

The laws of returns to scale explain the nature of changed in output in response to a proportional
and simultaneous change in inputs. Increasing inputs proportionately and simultaneously is, in
fact, an expansion of the scale of production.
When a firm expands its scale of production, i.e., it increases both the inputs in a certain
proportion, then there are three technical possibilities of increase in production:
(i) Total output may increase more than proportionately;
(ii) Total output may increase proportionately; and
(iii) Total output may increase less than proportionately.

Accordingly, there are three kinds of laws of returns to scale:

(i) The law of increasing returns to scale;
(ii) The law of constant returns to scale, and
(iii) The law of diminishing returns to scale.

Law of Increasing Returns to Scale

When inputs, K and L, are increased at a certain proportion and output increases more than
proportionately, it exhibits the law of increasing returns to scale. For example, if quantities of
both the inputs, K and L, are successively doubled and the resultant output is more than doubled,
then the law of returns to scale is said to be in operation.
In Fig., lines OB and OC represent the expansion path. The movement from point a to b
on the line OB means doubling the inputs. Input combination increases from 1K + 1L to 2K +
2L. As a result of doubling the inputs, output is more than doubled: it increases from 10 to 25
units, i.e., an increase of more than double. Similarly, the movement from point b to point c

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indicates 50% increase in inputs as a result of which the output increases from 25 units to 50
units, i.e., by 100%. Clearly, output increases more than the proportionate increase in inputs.
This kind of relationship between the inputs and output exemplifies the law of increasing returns
to scale.

Increasing Returns to scale

Law of Constant Returns to Scale

When the increase in output is proportionate to the increase in inputs, it exhibits constant returns
to scale. For example, if quantities of both the inputs, K and L, are doubled and output is also
doubled, then the returns to scale are said to be constant. Constant returns to scale are illustrated
in Fig.
The lines OA and OB are ‘expansion paths’ indicating two hypothetical techniques of
production with optimum capital-labour ratio. The iso-quants marked Q = 10, Q = 20 and Q = 30
indicate the three different levels of output. In the figure, the movement from points a to b
indicates doubling both the inputs—increasing capital from 1K to 2K and labour from 1L to 2L.
When inputs are doubled, output is also doubled, i.e., output increases from 10 to 20.
Similarly, the movement from point b to c indicates a 50 per cent increase in both labour
and capital. This increase in inputs results in an increase of output from 20 to 30 units, i.e., a 50
per cent increase in output. In simple words, a 50 per cent increase in inputs leads to a 50 per
cent increase in output. This kind of relationship between inputs and output exhibits constant
returns to scale.

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Constant Returns to Scale

Law of Decreasing Returns to Scale

The firms are faced with decreasing returns to scale when a certain proportionate increase in
inputs, K and L, leads to a less than proportionate increase in output. For example, when inputs
are doubled and output is less than doubled, then decreasing returns to scale is in operation.
As the figure shows, when the inputs K and L are doubled, i.e., when capital-labour
combination is increased from 1K + 1L to 2K + 2L, the output increases from 10 to 18 units.
This means that when capital and labour are increased by 100 per cent, output increases by only
80 per cent. That is, increasing output is less that the proportionate increase in inputs. Similarly,
movement from point b to c indicates a 50 per cent increase in the inputs. But, the output
increases by only 33.3 per cent. This exhibits decreasing returns to scale.

Decreasing Returns to Scale

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OPTIMAL COMBINATION OF INPUTS: The Least-Cost Combinations of Inputs or the

balanced curve

Having introduced the iso-costs, we may now combine iso-quants and iso-costs to determine the
optimal input-combination or the least-cost combination of inputs.

The above graph is the representation of Least cost combination curve. There are 2 Iso-quant
curves having Q1 = 100 and Q2 = 200. If the firm has the budget of K1L1 then the firm can select
the Point B. If the budget of the firm can be increased to K2L2, then there are 2 combinations, at
Point A and at Point D. The output on both these points will be Q1 = 100. Instead, if Point P is
selected then with the same budget of K2L2 we can achieve production Q2 = 200. Hence, the
point where the Iso-cost line and Iso-quant curve are tangent to each other must be selected. This
is called the least cost combination.

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COST CONCEPTS

The cost concepts that are relevant to business operations and decisions can be grouped on the
basis of their nature and purpose under two overlapping categories: (i) cost concepts used for
accounting purposes, and (ii) analytical cost concepts used in economic analysis of business
activities.

Accounting Cost Concepts

1. Opportunity Cost and Actual Cost - Actual cost is all paid out costs of the business firms to
take the advantage of the best opportunity available to them. The opportunity cost is the
opportunity lost for lack of resources. An opportunity to make income is lost because of scarcity
of resources like land, labour, capital, etc.

2. Business Costs and Full Costs

Business costs include all the expenses that are incurred to carry out a business. The
concept of business costs is similar to the actual or real costs. Business costs “include all the
payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment.”1 Business costs are used for calculating business profits
and losses and for filing returns for income tax and also for other legal purposes.
The concept of full cost, includes business costs, opportunity cost and normal profit. The
opportunity cost includes the foregone earning expected from the second best use of the
resources, or the market rate of interest on the internal money capital and also the value of an
entrepreneur’s own services that are not charged for in the current business. Normal profit is a
necessary minimum earning in addition to the opportunity cost, which a firm must receive to
remain in its present occupation.

3. Actual or Explicit Costs and Implicit or Imputed Costs

The Actual or Explicit costs are those which are actually incurred by the firm in
payment for labour, material, plant, building, machinery, equipment, travelling and transport,
advertisement, etc. The total money expenses, recorded in the books of accounts are, for all
practical purposes, the actual costs. Actual cost comes under the accounting cost concept.
In contrast to explicit costs, there are certain other costs that do not take the form of cash
outlays, nor do they appear in the accounting system. Such costs are known as implicit or
imputed costs. Opportunity cost is an important example of implicit cost.
The explicit and implicit costs together make the economic cost.

4. Out-of-Pocket and Book Costs

The items of expenditure that involve cash payments or cash transfers, both recurring and
non-recurring, are known as out-of-pocket costs. All the explicit costs (e.g., wages, rent,
interest, cost of materials and maintenance, transport expenditure, electricity and telephone
expenses, etc.) fall in this category.
There are certain actual business costs that do not involve cash payments, but a provision
is therefore made in the books of account and they are taken into account while finalizing the
profit and loss accounts. Such expenses are known as book costs. In a way, these are payments

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made by a firm to itself. Depreciation allowances and unpaid interest on the owner’s own funds
are the example of book costs.

Analytical Cost Concepts

1. Fixed and Variable Costs

Fixed costs are those that remain fixed in amount for a certain quantity of output. Fixed
cost does not vary with variation in the output between zero and a certain level of output. In
other words, costs that do not vary or remain constant for a certain level of output are treated as
fixed costs. The fixed costs include (i) depreciation of machinery, building and other fixed
assets, (ii) costs of managerial and administrative staff, (iii) maintenance of land, etc. The
concept of fixed cost is associated with the short-run.
Variable costs are those which vary with the variation in the total output. Variable costs
include cost of raw material, running cost of fixed capital, such as fuel, repairs, routine
maintenance expenditure, direct labour charges associated with the level of output, and the costs
of all other inputs that vary with output.

2. Total, Average and Marginal Costs

Total cost (TC) refers to the total outlays of money expenditure, both explicit and
implicit, on the resources used to produce a given level of output. It includes both fixed and
variable costs. The total cost for a given output is measured as

TC = Total fixed cost + Total variable cost

Average cost (AC) is of statistical nature—it is not actual cost. It is obtained by dividing the total
cost (TC) by the total output (Q), i.e.,
AC = TC
Q
Marginal cost (MC) is defined as the addition to the total cost on account of producing one
additional unit of the product. Or, marginal cost is the cost of the marginal unit produced.
Marginal cost is calculated as TCn – TCn –1 where n is the number of units produced. Using
cost function, MC is obtained as the first derivative of the cot function.

MC = δTC
δQ

3. Short-Run and Long-Run Costs

Short-run and long-run cost concepts are related to variable and fixed costs, respectively,
and often figure in economic analysis cost-output relationship.
Short-run refers to the time period during which scale of production remains unchanged.
The costs incurred in the short-run are called short-run costs. It includes both the variable and the
fixed costs. From analytical point of view, short-run costs are those that vary with the variation
in output in short-run, the size of the firm remaining the same. Therefore, short-run costs are
treated as variable costs.

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Long-run costs, on the other hand, are those that are incurred to increase the scale of
production in the long-run. The costs that are incurred on the fixed factors like plant, building,
machinery, etc., are known as long-run costs. It is important to note that the running cost and
depreciation of the capital assets are included in the short-run or variable costs.

4. Incremental Costs and Sunk Costs

Conceptually, incremental costs are closely related to the concept of marginal cost but
with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit
(generally one unit) of output, incremental cost refers to the total additional cost associated with
the decisions to expand the output or to add a new variety of product, etc.
The sunk costs are those which are made once and for all and cannot be altered, increased
or decreased, by varying the rate of output, nor can they be recovered. For example, once it is
decided to make incremental investment expenditure and the funds are allocated and spent, all
the preceding costs are considered to be the sunk costs. The reason is, such costs are based on the
prior commitment and cannot be revised or reversed or recovered when there is a change in
market conditions or change in business decisions.

5. Historical and Replacement Costs

Historical cost refers to the cost incurred in past on the acquisition of productive assets,
e.g. land, building, machinery, etc., whereas replacement cost refers to the expenditure made for
replacing an old asset.
These concepts owe their significance to the unstable nature of input prices. Stable prices
over time, other things given, keep historical and replacement costs on par with each other.
Instability in asset prices makes the two costs differ from each other.
As regards their application, historical cost of assets is used for accounting purposes, in
the assessment of the net worth of the firm whereas replacement cost figures in business
decisions regarding the renovation of the plant.

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THEORY OF SHORT-RUN COST: SHORT-RUN COST-OUTPUT RELATIONS

Short-Run Cost-Output Relations

The basic analytical cost concepts used in the analysis of cost behaviour are Total, Average and
Marginal costs. The total cost (TC) is defined as the actual cost that are incurred to produce a
given quantity of output. The short-run TC is composed of two major elements: (i) total fixed
cost (TFC), and (ii) total variable cost (TVC). That is, in the short-run,

TC = TFC + TVC

Short-Run Cost Functions and Cost Curves

1. Linear Cost Function

When total cost increases at a constant rate with increase in production, it produces a
linear cost function. A linear cost function takes the following form.

TC = a + bQ

where TC = total cost, Q = quantity produced, a = TFC, and b = Change in TVC due to change in
Q.

Linear Cost Function

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To illustrate a linear cost function, let us suppose that an actual cost function is given as
TC = 60 + 10Q

Table above presents a series of Q and corresponding TFC, TVC, TC, MC and AC for output Q
from 1 to 10. The figures in Table, graphed in Fig., shows the relationship between total costs
(TC, TFC, and TVC) and output.

AC and MC Curves Derived from Linear Cost Function

2. Quadratic Cost Function

When TC increases at increasing rate with constant increase in output (Q), the TC data
produces a quadratic cost function expressed as

TC = a + bQ + Q2

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where a and b are constants and TC and Q are total cost and total output, respectively.
Given the cost function, AC an MC can be obtained as follows:

Let the actual (or estimated) cost function be given as TC = 50 + 5Q + Q2

The cost curves that emerge from the cost function are graphed in Fig. (a) and (b). As shown in
panel (a), while fixed cost remains constant at 50, TVC is increasing at an increasing rate. The
rising TVC sets the trend in the total cost (TC). Panel (b) shows the behaviour of AC, MC and
AVC in a quadratic cost function. Note that MC and AVC are rising at a constant rate whereas
AC declines till output 8 and then begins to increase.

3. Cubic Cost Function

When TC increases first at decreasing rate and then of increasing rate with increase in
production, the TC data produces a cubic cost function. A cubic cost function is of the form

TC = a + bQ – cQ2 + Q3
where a, b and c are the parametric constants.

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From the cost function, AC and MC can be derived as follows:

Let us suppose that the cost function is empirically estimated as

TC = 10 + 6Q – 0.9Q2 + 0.05Q3

Note that fixed cost equals 10. TVC can be obtained by subtracting 10—the fixed cost—from
TC-function
TVC = 6Q – 0.9Q2 + 0.05Q3

The TC and TVC, based on the above Eqs., have been calculated for Q = 1 to 16 and
presented in Table below. The TFC, TVC and TC have been graphically presented in Fig. As the
figure shows, TFC remains fixed for the whole range of output, and hence, takes the form of a
horizontal line—TFC. The TVC curve shows two different trends with increase in output. The
total variable cost first increases at a decreasing rate and then at an increasing rate with the
increase in the output. The rate of increase can be obtained from the slope of TVC curve. The
two patterns of change in the TVC stems directly from the law of increasing and diminishing
returns to the variable inputs. So long as the law of increasing returns is in operation, TVC
increases at decreasing rate. And, when the law of diminishing returns comes into operation
output increases at decreasing rate causing TVC to increase at increasing rate.

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THEORY OF LONG-RUN COST: LONG-RUN COST-OUTPUT RELATIONS

In the context of the production theory, long run refers to a period in which firms can use more
of both the inputs – labour and capital – to increase their production. The long-run theory of cost
deals with the long-run cost-output relationship. To understand the long-run-cost-output relations
and to derive long-run cost curves, it will be helpful to imagine that a long-run is composed of a
series of short-run production decisions.

Long-run Total Cost Curve (LTC)

In order to draw the long-run total cost curve, let us begin with a short-run situation. Suppose
that a firm having only one plant has its short-run total cost curve as given by STC1, in panel (a)
of Fig. Let us now suppose that the firm decides to add two more plants over time, one after the
other. As a result, two more short-run total cost curves are added to STC1, in the manner shown
by STC2 and STC3 in Fig.(a). The LTC can now be drawn through the minimum points of
STC1, STC2 and STC3 as shown by the LTC curve corresponding to each STC.

Long-run Average Cost Curve (LAC)

Like LTC, long-run average cost curve (LAC) is derived by combining the short-run average
cost curves (SACs). Note that there is one SAC associated with each STC. The curve SAC1 in
panel (b) of Fig. corresponds to STC1 in panel (a). Similarly, SAC2 and SAC3 in panel (b)
correspond to STC2 and STC3 in panel (a), respectively. Thus, given the STC1, STC2, and
STC3 curves in panel (a) of Fig., there are three corresponding SAC curves as given by SAC1,
SAC2, and SAC3 curves in panel (b) of Fig. Thus, the firm has a series of SAC curves, each
having a bottom point showing the minimum SAC. For instance, C1Q1 is minimum AC when
the firm has only one plant. The AC decreases to C2Q2 when the second plant is added and then
rises to C3Q3 after the addition of the third plant. The LAC curve can be drawn through the
SAC1, SAC2 and SAC3 as shown in Fig. (b). The LAC curve is also known as the ‘Envelope
Curve’ or ‘Planning Curve’ as it serves as a guide to the entrepreneur in his plans to expand
production.

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The SAC curves can be derived from the data given in the STC schedule, from STC function or
straightaway from the LTC curve.6 Similarly, LAC curve can be derived from LTC-schedule,
LTC function or from LTC-curve. The relationship between LTC and output, and between LAC
and output can now be easily derived. It is obvious from the LTC that the long-run cost-output
relationship is similar to the short-run cost-output relation. With the subsequent increases in the
output, LTC first increases at a decreasing rate, and then at an increasing rate. As a result, LAC
initially decreases until the optimum utilization of the second plant and then it begins to increase.
These cost-output relations follow the ‘laws of returns to scale’. When the scale of the firm
expands, LAC, i.e., unit cost of production, initially decreases, but ultimately increases as shown
in Fig. 11.7 (b). The decrease in unit cost is attributed to the internal and external economies of
scale and the eventual increase in cost, to the internal and external diseconomies of scale. The
economies and diseconomies of scale are discussed in the following section.

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ECONOMIES AND DISECONOMIES OF SCALE AND COST OF PRODUCTION

As shown in above Fig of Long-run Total and average Cost Curves, LAC decreases with the
expansion of production scale up to OQ2 and then it begins to rise. Decrease in LAC is caused
by the economies of scale and increase in LAC is caused by diseconomies of scale. Economies
of scale result in cost saving and diseconomies lead to rise in cost. Economies and diseconomies
of scale determine also the returns to scale. Increasing returns to scale operate till economies of
scale are greater than the diseconomies of scale, and returns to scale decrease when
diseconomies are greater than the economies of scale. When economies and diseconomies are in
balance, returns to scale are constant.

ECONOMIES OF SCALE

The economies of scale are classified as

(A) Internal or Real Economies, and

(B) External or Pecuniary Economies.

A. Internal Economies

Internal economies, also called ‘real economies’, are those that arise within the firm with
addition of new production plants. This means that internal economies are available exclusively
to the expanding firm. Internal economies may be classified under the following categories.

(i) Economies in production;

(ii) Economies in purchase of Inputs;
(iii) Managerial economies, and
(iv) Economies in transport and storage.

(i) Economies in Production

Economies in production arise from two sources: (a) technological advantages, and (b)
advantages of division of labour based on specialization and skill of labour. Technological
advantages. Large-scale production provides an opportunity to the expanding firms to avail the
advantages of technological advances. Modern technology is highly specialized. The advanced
technology makes it possible to conceive the whole process of production of a commodity in one
composite unit of production. For example, production of cloth in a textile mill may comprise
such plants as (i) spinning; (ii) weaving; (iii) printing and pressing; and (iv) packing, etc.
Likewise, a composite dairy scheme may consist of plants like (i) chilling; (ii) milk processing;
and (iii) bottling. Under small-scale production, the firm may not find it economical to have all
the plants under one roof. It would, therefore, not be in a position to take the full advantage of a
composite technology. But, when scale of production expands and firms hire more capital and

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labour, their total output increases more than proportionately till the optimum size of the firm is
reached. It results in lower cost of production.

Advantages of division of labour and specialization. When a firm’s scale of production

expands, more and more workers of varying skills and qualifications are employed. With the
employment of larger number of workers, it becomes increasingly possible to divide the labour
according to their qualifications, knowledge, experience, expertise and skills and to assign them
the function to which they are best suited. This is known as division of labour. Division of labour
leads to a greater specialization of manpower. It increases productivity of labour and, thereby,
reduces cost of production. Besides, specialized workers develop more efficient tools and
techniques and gain speed of work. These advantages of division of labour improve productivity
of labour per unit of labour cost and time. Increase in labour productivity decreases to per unit
cost of production.

(ii) Economies in Purchase of Inputs

Economies in input purchases arise from the large-scale purchase of raw materials and
other material inputs and large-scale selling of the firm’s own products. As to economies in the
purchase of inputs, the large-size firms normally make bulk purchases of their inputs. The large
scale purchase entitles the firm for certain discounts in input prices and other concessions that
are not available on small purchases. As such, the growing firms gain economies on the cost of
their material inputs.

(iii) Managerial Economies

Managerial economies arise from (a) specialization in managerial activities, i.e., the use
of specialized managerial personnel, and (b) systemization of managerial functions. For a large-
size firm, it becomes possible to divide its management into specialized departments under
specialized personnel, such as production manager, sales manager, HR manager, financial
manager, etc. The management of different departments by speciallized managers increases the
efficiency of management at all the levels of management because of the decentralization of
decision-making. It increases production, given the cost. Large-scale firms have the opportunity
to use advanced techniques of communication, telephones and telex machines, computers, and
their own means of transport. All these lead to quick decision-making, help in saving valuable
time of the management and, thereby, improve the managerial efficiency. For these reasons,
managerial cost increases less than proportionately with the increase in production scale upto a
certain level, of course.

(iv) Economies in Transport and Storage

Economies in transportation and storage costs arise from fuller utilization of transport and
storage facilities. Transportation costs are incurred both on production and sales sides. Similarly,
storage costs are incurred on both raw materials and finished products. The large-size firms may

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acquire their own means of transport and they can, thereby, reduce the unit cost of transportation,
at least to the extent of profit margin of the transport companies. Besides, own transport facility
prevents delays in transporting goods. Some large-scale firms have their own railway tracks from
the nearest railway point to the factory, and thus they reduce the cost of transporting goods in
and out. For example, Bombay Port Trust has its own railway tracks, oil companies have their
own fleet of tankers. Similarly, large-scale firms can create their own godowns in various centres
of product distribution and can save on cost of storage.

(B) External or Pecuniary Economies

External economies are those that arise outside the firm. External economies appear in the form
of money saving on inputs, called pecuniary economies. Pecuniary economies accrue to the
large-size firms in the form of discounts and concessions on (i) large scale purchase of raw
material, (ii) large scale acquisition of external finance, particularly from the commercial banks;
(iii) massive advertisement campaigns; (iv) large scale hiring of means of transport and
warehouses, etc. These benefits are available to all the firms of an industry but large scale firms
benefit more than small firms.

DISECONOMIES OF SCALE

The economics of scale have their own limits, i.e., scale economies exist only up to a certain
level of production scale. The expansion of scale of production beyond that limit creates
condition for diseconomies of scale. Diseconomies of scale are disadvantages that arise due to
the expansion of production scale beyond its optimum level and lead to rise in the cost of
production.

1. Internal Diseconomies

Internal diseconomies are those that are exclusive and internal to a firm as they arise
within the firm. Like everything else, economies of scale have a limit too. This limit is reached
when the advantages of division of labour and managerial staff have been fully exploited; excess
capacity of plant, warehouses, transport and communication systems, etc., is fully used; and
economy in advertisement cost tapers off. Although some economies may still exist,
diseconomies begin to outweigh the economies and the costs begin to rise.

Managerial Inefficiency

Diseconomies begin to appear first at the management level. Managerial inefficiencies

arise, among other things, from the expansion of scale itself. With fast expansion of the
production scale, personal contacts and communications between (i) owners and managers, (ii)
managers and labour, and (iii) between the managers of different departments or sections get
rapidly reduced. The lack of fast or quick communication causes delays in decision-making
affecting production adversely.

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Labour Inefficiency

Increasing number of labour leads to a loss of control over labour management. This
affects labour productivity adversely. Besides, increase in the number of workers encourages
labour union activities that cause loss of output per unit of time and hence, rise in the cost of
production.

2. External Diseconomies

External diseconomies are the disadvantages that arise outside the firm, especially in the
input markets, due to natural constraints, specially in agriculture and extractive industries. With
the expansion of the firm, particularly when all the firms of the industry are expanding, the
discounts and concessions that are available on bulk purchases of inputs and concessional
finance come to an end. More than that, increasing demand for inputs puts pressure on the input
markets and input prices begin to rise causing a rise in the cost of production. These are
pecuniary diseconomies.

On the production side, the law of diminishing returns to scale come into force due to
excessive use of fixed factors, more so in agriculture and extractive industries. For example,
excessive use of cultivable land turns it into barren land; pumping out water on a large scale for
irrigation causes the water table to go down resulting in rise in cost of irrigation; extraction of
minerals on a large scale exhausts the mineral deposits on upper levels and mining further deep
causes rise in cost of production; extensive fishing reduces the availability of fish and the catch,
even when fishing boats and nets are increased.

BREAK-EVEN ANALYSIS: PROFIT CONTRIBUTION ANALYSIS

Meaning of Break-even Analysis

The break-even analysis is an important analytical technique used to study the

relationship between the total costs, total revenue and total profit and loss over the whole range
of stipulated output. The break-even analysis is a technique of having a preview of profit
prospects and a tool of profit planning. It integrates the cost and revenue estimates to ascertain
the profits and losses associated with different levels of output.

The relationship between cost and output and between price and output may be linear or
non-linear in nature. We shall discuss the break-even analysis under both linear and non-linear
revenue conditions.

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

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(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Linear and Revenue Functions

To illustrate the break-even analysis under linear cost and revenue conditions, let us
assume linear cost and linear revenue functions are given as follows:

Cost function: TC = 100 + 10Q ………(1)

Revenue function: TR = 15Q …………(2)

The cost function given in Eq. (1) implies that the firm’s total fixed cost is given at Rs.
100 and its variable cost varies at a constant rate of Rs. 10 per unit in response to increase in
output. The revenue function given in Eq. (2) implies that the price for the firm’s product is
given in the market at Rs. 15 per unit of sale.

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Break-even Analysis: Linear functions

When the firm needs to carry out the break-even analysis of its business operations is to make a
chart of its total fixed cost (TFC), total variable cost (TVC), total cost (TC) and the total revenue
(TR), and graph them to find the break-even point. The process of break-even analysis is
illustrated graphically in Fig. above. The line TFC shows the total fixed cost at Rs. 100 for a
certain level of output, and the line TVC shows the variable cost rising with a slope ∆TVC/∆Q =
10/1 = 10. The line TC has been obtained by plotting the TC function. It can also be obtained by
a vertical summation of TFC and TVC at various levels of output. The line TR shows the total
revenue (TR) obtained as Q × P. The TR and TC lines intersect at point B, where output is equal
to 20 units. The point B shows that at Q = 20, firm’s total cost equals its total revenue. That is, at
Q = 20, TC breaks-even with TR. Point B is, therefore, the breakeven point and Q = 20 is the
breakeven output. Below this level of output, TC exceeds TR. The vertical difference between
TC and TR, (i.e., TC–TR) is known as operating loss. Beyond Q = 20, TR > TC, and TR–TC is
known as operating profit. It may thus be concluded that a firm producing a commodity under
cost and revenue conditions given, must produce at least 20 units to make its total cost and total
revenue break-even.

Limitations

The theory of break-even analysis, as presented above, is applicable only if cost and revenue
functions are linear. Under the condition of linear cost and revenue functions, TC and TR are
straight lines and they intersect at only one point dividing the whole range of output into two
parts—profitable and non-profitable.

Non-linear Cost and Revenue Functions

The non-linear functions are presented in Fig. below. TFC line shows the fixed cost at OF
and the vertical distance between TC and TFC measures the total variable cost (TVC). The curve
TR shows the total sale proceeds or the total revenue (TR) at different levels of output and price.
The vertical distance between the TR and TC measures the profit or loss for various levels of
output.

As shown in Fig. below, TR and TC curves intersect at two points, B1 and B2, where TR
= TC. These are the lower and upper break-even points. For the whole range of output between
OQ1 and OQ2, total revenue (TR) is greater than total cost (TC). This is profit-making range of
output. It implies that a firm producing an output more than OQ1 and less than OQ2 will make
profits. In other words, the profitable range of output lies between OQ1 and OQ2 units of output.
Producing less or more than these limits will result in losses.

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Contribution Analysis

Contribution analysis is the analysis of incremental revenue and incremental cost of a business
decision or business activity. Break-even charts can also be used for measuring the contribution
made by the business activity towards covering the fixed costs. For this purpose, variable costs
are plotted below the fixed costs as shown in Fig. below. Fixed costs are a constant addition to
the variable costs. In that case, the total cost line will run parallel to the variable cost line.

Profit-Volume Ratio

The profit volume (PV) ratio is another handy tool used to find the BEP for sales, specially for
the multi-product firms. The formula for PV ratio is given below:

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Where S = Selling Cost and V = Variable Cost

For example, if selling price (S) = Rs. 5 and Variable Costs (V) = Rs. 4 per unit, then

The break-even point (BEP) of sales value is calculate by dividing the fixed expenses by PV
ratio as follows:

For example, given the selling price at Rs. 5 per unit, average variable expenses at Rs. 3 per unit
and fixed expenses (F) of Rs. 4.00 per month, BEP (sale value) is calculated as follows:

The break-even sale volume can also be calculated by using the contribution per unit of sale by
the following formula:

The PV ratio is not only helpful in finding the break-even point but it can also be used for
making a choice of the product.

Margin of Safety

The margin of safety is given by the difference between the sales at break-even point and the
total actual sales. Three measures of the margin of safety are given below:

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where Sa = actual sales and Sb = Sales at BEP.

A firm calculates the margin of safety in order to be at a safer end and not to make loss if it
misses the target of achieving the breakeven point.

Use of Break-Even Analysis in Managerial Decision Making

(i) Sales volume can be determined to earn a given amount of return on capital.

(ii) Profit can be forecast if estimates of revenue and cost are available.

(iii) Effect of change in the volume of sales, sale price, cost of production, can be appraised.

(iv) Choice of products can be made from the available alternatives. Product-mix can also be
determined.

(v) Impact of increase or decrease in fixed and variable costs can be highlighted.

(vi) Effect of high fixed costs and low variable costs to the total cost can be studied.

(vii) Valid inter-firm comparisons of profitability can be made.

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(viii) Cash break-even chart helps proper planning of cash requirements.

(ix) Break-even analysis emphasizes the importance of capacity utilization for achieving
economies.

(x) Further help is provided by margin of safety and angle of incidence.

Limitations of Break-even Analysis

We have discussed above that the break-even analysis is based on linear assumptions. The
linearity assumption can be removed by pre-testing the cost and revenue functions and by using,
if necessary, the non-linearity conditions. Nevertheless, the break-even analysis as such has
certain other limitations.

First, the break-even analysis can be applied only to a single product system. Under the
condition of multiple products and joint operations, the break-even analysis can be applied only
if product-wise cost can be ascertained which is, of course, extremely difficult.

Second, break-even analysis cannot be applied usefully where cost and price data cannot be
ascertained beforehand and where historical data are not relevant for estimating future costs and
prices. Despite these limitations, the break-even analysis may serve a useful purpose in
production planning if relevant data can be easily obtained.

Important Questions

1. What are returns to scale?

2. What are different types of cost?
3. What is Iso-Quant curve?
4. Explain the laws of diminishing returns to one variable input using the 3 stages in
production. OR Explain the law of Variable proportion.
5. Give a detail on 4 properties of Iso-Quant curve.
6. Explain the Short run Cost-output relations. [Explain the liner, quadratic & Cubic curves
– depending upon the marks]
7. Explain the long run Cost-output relationship. [Explain the LAC & LTC]
8. What is Economics & Dis-economies of scale?
9. Explain the least cost combination of Inputs.
10. What are the laws of returns to scale? [Explain the notes given on Page 14 & 15]
11. What are short and long term profits?
12. What are the assumptions and uses of Break-even analysis?
13. Explain the determination of BEA (Break-even analysis) using graph.
14. Explain the concept the BEA with neat graph.
15. Practice the problems solved in the class.

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