Chapter Three (3)

Theory of the
Firm
Managerial Economic
 Introductio
n that we identified
⚫ Recall two broad groups of economic actors -
Households and Business Firms.
⚫ In our study of demand we looked at households as consumer units

effecting demand for goods and services in the product market.

⚫ On the supply side of the product market are the economic (or

business) firms.
⚫ They are the producers (and sellers) of goods and services.
 Business Firm
⚫ A business firm is an economic unit engaged in the production of one

or more economic goods or services.

⚫ Applying the technology available to it, a business firm combines

economic resources (factors of production) to produce one or more

goods for the purpose of making profits.
⚫ A business firm buys economic resources (inputs) and sells the goods

it produces (outputs).
 Questions to be asked and need to be
Answered:
⚫ How do firms decide what to produce and how much to produce?

⚫ What factors constitute a firm’s costs?

⚫ How do firms determine what price(s) to charge?

⚫ What determines a firm’s profit?

⚫ What determines the shape and the position of a (firm’s) supply curve?
 3. Production and Costs
⚫ To produce a good or a service, a firm needs economic resources or factors

of production.
⚫ In economics, the factors of production used by a firm in
the production of a good or a service are generally referred to as inputs.
⚫ What a firm produces is called output.

⚫ A firm has to pay for the inputs it needs.

⚫ Therefore, inputs, on the one hand, generate costs and, on the other hand,

generate output.
⚫ We first study the relationship between inputs and the output;

that is "production function".

⚫ Then we will proceed to the relationship between the output

and costs; that is cost function.

 3.1. Theory of Production
⚫ In economics, production theory explains the principles in which the

business has to take decisions on how much of each commodity it produces and
how much it sells and also how much of raw material i.e, fixed capital & labor
it employs & how much it will use.
⚫ It defines the relationships between the prices of the commodities and

productive factors on one hand and the quantities of these commodities and
productive factors that are produced on the other hand.
 Production - Definition
⚫ Production is a process that create/adds value or utility.
⚫ It is the act of creating output in the form of a commodity or a service which
contributes to the utility of individuals.

⚫ In other words, it is a process in which the inputs are converted into outputs.
 Production Possibility Frontier
⚫ A production possibility frontier (PPF) shows the maximum possible output

combinations of two goods or services an economy can achieve when all

resources are fully and efficiently employed.
⚫ It is used to illustrate the concepts of opportunity cost, trade-offs and also
show the effects of economic growth.
⚫ Points within the curve show when a country’s resources are not being
fully utilized.
⚫ Combinations of the output of consumer and capital goods lying inside the PPF

happen when there are unemployed resources or when resources are

used inefficiently.

⚫ We could increase total output by moving towards the PPF.

⚫ Combinations that lie beyond the PPF are unattainable at the moment.

⚫ A country would require an increase in factor resources, an increase in

the productivity or an improvement in technology to reach this combination.

⚫ Trade between countries allows nations to consume beyond their own PPF.

⚫ Producing more of both goods would represent an improvement in welfare and a

gain in what is called allocative efficiency.

Production Function
⚫Production function means the functional relationship between inputs and
outputs

in the process of production.

⚫It is a technical relation which connects factors inputs used in the

production function and the level of outputs.

Q = f (Land, Labour, Capital, Organization, Technology, etc)
 FOR EXAMPLE

⚫A computer company hires workers to use machinery, parts, and

raw materials in factories to produce personal computers.

⚫The output of a firm can either be a final commodity or an

intermediate product such as computer and semiconductor

respectively.
⚫The output can also be a service rather than a good such as

education, medicine, banking etc.

 Inputs : Fixed inputs and Variable inputs
 The factors of production that is carry out
the production is called inputs.
 Land, Labour, Capital, Organizer, Technology, are
the example of inputs

Inputs/ Factors

Variable inputs Fixed Inputs

 Inputs : Fixed inputs and Variable inputs

Fixed inputs Variable inputs

 Remain the same in the short  Inthe long run all factors of
period . production are varies
 At any level of out put,
the according to the volume of
amount is remain the same.
 outputs.
The cost of these inputs are
 The cost of variable inputs is
called Fixed Cost
 called Variable Cost
 Examples:- Building, Land etc
( In the long run fixed inputs are Example:- Raw materials,
become varies) labour, etc
 Various concept of production
 Total product (total physical product) = the total amount of
output produced, in physical units.

 Average product (AP) – total output divided by total units of

input
i.e. it is the production per unit of input.
AP = TP/variable
input
 Marginal product – the extra product or output added by 1 extra
unit of that input while other inputs are held constant.
 Laws of Production function
⚫ The laws of production describe the technically possible ways of increasing the

level of production.

⚫ Output may increase in various ways.

⚫ Output can be increased by changing all factors of production.

⚫ Clearly this is possible only in the long run.

⚫ Thus the laws of returns to scale refer to the long-run analysis of production.

⚫ In the short run output may be increased by using more of the variable factor(s),

while capital (and possibly other factors as well) are kept constant.
⚫ The marginal product of the variable factors will decline eventually as

more and more quantities of this factor are combined with the other
constant factors.
⚫ The expansion of output with one factor (at least) constant is described

by the law of (eventually) diminishing returns of the variable factor,

which is often referred to as the law of variable proportions.
A. The Law of Variable Proportions: Short-Run Analysis of Production:
⚫ If one factor is variable while the other(s) is kept constant, the product line will be a

straight line parallel to the axis of the variable factor .

⚫ In general, if one of the factors of production (usually capital K) is fixed, the

marginal product of the variable factor (labour) will diminish after a certain range of
production.

⚫ We said that the traditional theory of production concentrates on the ranges of

output over which the marginal products of the factors are positive but diminishing.

⚫ The ranges of increasing returns (to a factor) and the range of negative productivity

are not equilibrium ranges of output.

 Returns to a Factor
a. Increasing Returns to a Factor

⚫ Increasing returns to a factor refers to the situation in which

total output tends to increase at an increasing ratewhen
more of variable
factor is mixed with the fixed factor of production.
⚫ Insuch a case, marginal product of the variable factor must
be increasing.
⚫ Inversely, marginal price of production must be diminishing.
b. Constant Returns to a
Factor
⚫ Constant returns to a factor refers to the stage when increasing the application of the
variable factor does not result in increasing the marginal product of the factor –
rather, marginal product of the factor tends to stabilize.
⚫ Accordingly, total output increases only at a constant rate.

c. Diminishing Returns to a Factor

⚫ Diminishing returns to a factor refers to a situation in which the total output tends to

increase at a diminishing rate when more of the variable factor is combined with the
fixed factor of production.
⚫ In such a situation, marginal product of the variable must be diminishing. Inversely

the marginal cost of production must be increasing.

B. Laws of Returns to Scale: Long-Run Analysis of Production:

⚫ In the long run expansion of output may be achieved by varying all factors.

⚫ In the long run all factors are variable.

⚫ The laws of returns to scale refer to the effects of scale relationships. In the long run output may

be increased by changing all factors by the same proportion, or by different proportions.

⚫ Traditional theory of production concentrates on the first case, that is, the study of output as all

inputs change by the same proportion.

⚫ The term ‘returns to scale’ refers to the changes in output as all factors change by the same

proportion.
⚫ Returns to scale are classified as follows:
i. Increasing returns to scale − If output increases more than proportionate to the
increase in all inputs.
ii. Constant returns to scale − If all inputs are increased by some
proportion, output will also increase by the same proportion.
iii. Decreasing returns to scale − If increase in output is less than proportionate to
the increase in all inputs.
 For example − If all factors of production are doubled and output increases by
more than two times, then the situation is of increasing returns to scale.
 On the other hand, if output does not double even after a 100 per cent increase in
input factors, we have diminishing returns to scale.
 Isoquants
⚫ ‘Iso’ refers to ‘equal’, ‘quanta’ refers to ‘quantity’.

⚫ An isoquant may be defined as a curve, which shows the

different combinations of two inputs producing the same level of output.

⚫ Isoquants are a geometric representation of the production function.

⚫ The same level of output can be produced by various combinations of

factor inputs.

⚫ The locus of all possible combinations is called the ‘Isoquant’.

Characteristics of Isoquant
 An isoquant slopes downward to the
right.

 An isoquant is convex to origin.

 An isoquant is smooth and continuous.

 Two isoquants do not intersect.

 Isoquants
Combination Labour Capital Output level

A 20 1 100 unit
B 18 2 100 unit
C 12 3 100 unit
D 9 4 100 unit
E 6 5 100 unit
F 4 6 100 unit
An isoquants represent all those possible combination of two inputs (labour
and capital), which is capable to produce an equal level of output .
 Least Cost Combination of
Inputs
⚫ A given level of output can be produced using many different combinations of

two variable inputs.

⚫ In choosing between the two resources, the saving in the resource replaced

must be greater than the cost of resource added.

⚫ The principle of least cost combination states that if two input factors are

considered for a given output then the least cost combination will have inverse
price ratio which is equal to their marginal rate of substitution.
 Marginal Rate of Technical Substitution
(MRTS)
⚫ It is the slope of the isoquants.

⚫ The rate at which one factor of production (input) can be substituted for

other is known as marginal rate of technical substitution (MRTS).

⚫ If we assumed two factors of production say labor and capital, then the

MRTS of capital for labor is the number of units of labors, which can be
replaced by one unit of capital, while the quantity of output remaining
the same.
⚫ MRTS is defined as the units of one input factor that can be
substituted

for a single unit of the other input factor.

⚫ MRS of x2 for one unit of x1 is equal to the number of unit of

replaced resource (x2) divided to the number of unit of

added resource (x1).

 Returns to Factors
⚫ Returns to factors are also called as factor productivities, (where

productivity, is the ratio of output to the inputs.)

⚫ The productivity of a particular factor of production may be measured by

assuming the other production factors to be constant and only that particular
factor under study is changed.
⚫ Returns to factors shows the percentage increase or decrease in the

production due to percentage increase or decrease in a particular factor such

as labors (or) capital, assuming other factors to be constant.
 3.2. Theory of Cost
⚫ In managerial economics another area which is of great importance is cost

of production.
⚫ The cost which a firm incurs in the process of production of its goods

and services is an important variable for decision making.

⚫ Total cost together with total revenue determines the profit level of a
business.
⚫ Inorder to maximizeprofits a firm endeavors to increase
itsrevenue and lower its costs.
 Cost Concepts
⚫ Costs play a very important role in managerial decisions especially when a selection

between alternative courses of action is required.

⚫ It helps in specifying various alternatives in terms of their quantitative values.

⚫ Costs are incurred as a result of production.

⚫ Costs are the sum of all expenditures incurred in producing a given volume of
output.
⚫ Costs are the amount of money spent on the production of different levels of a
good.
⚫ Following are various types of cost concepts −
 Types of
⚫ AllCosts
the costs faced by companies/business organizations can be categorized into
two main types −
1.Fixed costs
2.Variable
costs
1. Fixed costs are expenses that have to be paid by a company, independent of
any business activity.
 It is one of the two components of the total cost of goods or service, along
with variable cost.
⚫ Examples include rent, buildings, machinery, etc.
 2. Variable costs
⚫ Variable costs are corporate expenses that vary in direct proportion

to the quantity of output.

⚫ Unlike fixed costs, which remain constant regardless of output, variable

costs are a direct function of production volume, rising

whenever production expands and falling whenever it contracts.
⚫ Examples of common variable costs include raw materials, packaging,

and labor directly involved in a company's manufacturing process.

 TC, MC and
AC
⚫ Total cost (TC) describes the total economiccost of production
and is

made up of variable costs plus fixed costs.

⚫ The rate at which total cost changes as the amount produced

changes is called marginal cost.

⚫ Average cost and/or unit cost is equal to totalcost divided by

the number of goods produced (the output quantity, Q).

 Determinants of Costs

⚫ The general determinants of cost are as

follows
 Output level

 Prices of factors of production

 Productivities of factors of production

 Technology
 Cost
Analysis
⚫ Cost Analysis refers to the measure of the cost-output relationship, i.e. the economists
are concerned with determining the cost incurred in hiring the inputs and how well these

can be re-arranged to increase the productivity (output) of the firm.

⚫ In other words, the cost analysis is concerned with determining money value of inputs

(labor, raw material), called as the overall cost of production which helps in deciding the
optimum level of production.

⚫ There are several cost concepts relevant to the business operations and decisions and for

the convenience of understanding these can be grouped under two overlapping categories:
 1.Cost Concepts Used for Economic Purposes:

⚫ Generally, the accountants use these cost concepts to study the financial position of the firm. They are
concerned with arranging the finances of the firm and therefore keep a track of the assets and liabilities of
the firm.
⚫ The accounting costs are used for taxation purposes and calculating the profit and loss of the firm.
These
are:
 Opportunity Cost
 Business Cost
 Full Cost
 Explicit Cost
 Implicit Cost
 Out-of-Pocket Cost
 Book Cost
 2. Analytical Cost Concepts Used for Accounting Analysis of Business
Activities:
⚫ These cost concepts are used by the economists to analyze the likely cost of production in the future.

⚫ They are concerned with how the cost of production can be managed or how the input and output can be re-arranged
such that the overall profitability of the firm gets improved. These costs are:
 Fixed Cost
 Variable Cost
 Total Cost
 Average Cost
 Marginal Cost
 Short-run Cost
 Long-Run Cost
 Incremental Cost
 Sunk Cost
 Historical Cost
 Replacement Cost
 Private Cost
 Social Cost
⚫ In business, the manager must have a clear understanding of the cost-output
relationship as it helps in cost control, marketing, pricing, profit, production, etc. The
cost-output relation can be expressed as:
C = f (S, O, P, T)
Where,
 C =cost,

 S = Size of the firm,

 O = output,

 P = Price, and

 T = Technology.
⚫ With the increase in the size of the firm, the economies of scale also increase and as a

result the cost of per unit production comes down.

⚫ There is a positive relation between the cost and the output, as the output increases the

cost also increases and vice-versa.

⚫ Likewise, the price of inputs is directly related to the price, as the input price increases the

cost of production also increases.

⚫ But however, the technology is inversely related to the cost, i.e. with an improved

technology the cost of production decreases.

⚫ Thus, the cost analysis is pivotal in business decision-making as the cost incurred in the

input and output is to be carefully understood before planning the production capacity of
the firm.
 Breakeven Analysis & Contribution
Margin
⚫ Break-even point analysis is a measurement system that calculates the margin of

safety by comparing the amount of revenues or units that must be sold to cover
fixed and variable costs associated with making the sales.
⚫ In other words, it’s a way to calculate when a project will be profitable by

equating its total revenues with its total expenses.

⚫ There are several different uses for the equation, but all of them deal with

managerial accounting and cost management.

⚫ The increase in profit would be by the amount of unit contribution
margin.
⚫ Unit contribution Margin = Sales Price - Variable Costs
⚫ The unit contribution margin is the remainder after all variable
costs associated with a unit of sale are subtracted from the associated
revenues.
⚫ It is useful for establishing the minimum price at
which to sella unit (which is the variable cost).
⚫ This margin analysis can apply to the sale of either goods or services.
 BEP…..Formula…..
⚫ The purpose of the break-evenanalysis formula is to calculate
the

amount of sales that equates revenues to expenses and the amount of

excess revenues, also known as profits, after the fixed and variable

costs are met.

Formula…
⚫ Inother words, the breakeven point is equal to
the total fixed costs
divided by the difference between the unit price and variable costs.

⚫ Note that in this formula, fixed costs are stated as a total of all

overhead for the firm, whereas Price and Variable Costs are stated as

per unit costs — the price for each product unit sold.
 Breakeven Chart
⚫ The Break-even analysis chart is a graphical representation of

costs at various levels of activity.

⚫ With this, business managers are able to ascertain the period when

there is neither profit nor loss made for the organization.

⚫ This is commonly known as "Break-even Point".
⚫ In the graph above, the line OA represents the variation of income at

various levels of production activity.

⚫ OB represents the total fixed costs in the business. As output increases,

variable costs are incurred, which means fixed + variable cost also
increase. At low levels of output, costs are greater than income.
⚫ At the point of intersection “P” (Break even Point) , costs are

exactly equal to income, and hence neither profit nor loss is made.
 Economies of Scale:
⚫ Economies of scale are the cost advantages that enterprises obtain due to their
scale of operation (typically measured by amount of output produced), with cost per
unit of output decreasing with increasing scale.
⚫ As long as the output is increased in the long run, the cost of production will be at
minimum level, this is known as economies of scale.
⚫ Economies of scale is divided into two parts.

1. Internal Economies scale

2. External Economies scale

⚫ Internal Economies:

⚫ Internal economies are those benefits or advantages enjoyed by an

individual firm if it increases its size and the output.
⚫ Internal economies result from the sheer size of the company, no matter
what industry it's in or market it sells to.
⚫ For example, large companies have the ability to buy in bulk.

⚫ This lowers the cost per unit of the materials they need to make
their products.
⚫ They can use the savings to increase profits.
 There are five main types of internal economies of scale.

1. Technical economies of scale result from efficiencies in the production process itself.

2. Monopsony power is when a company buys so much of a product that it can negotiate a
lower price than its smaller competitors.
3. Managerial economies of scale arise when firms can hire specialists to manage specific
areas of the company.
4. Financial economies of scale means the company has cheaper access to capital. A
larger company can get funded from the stock market with an initial public offering.
5. Network economies of scale- It costs almost nothing to support each additional customer
with existing infrastructure.
External Economies of
Scale
⚫ A company has external economies of scale if it receives
preferential treatment from the government or other external
sources simply because of its size.
⚫ For example, most states will lower taxes to attract large companies

since they will provide jobs for their residents.

Economies of scope
⚫ Economies of scope describe situations in which the long-run average
and marginal cost of a company, organization, or economy decreases, due to the
production of some complementary goods and services.
⚫ An economy of scope means that the production of one good reduces the cost of
producing another related good.
⚫ While economies of scope are characterized by efficiencies formed by
variety, economies of scale are characterized by volume.
⚫ The latter involves the reduction of the average cost, or the cost per unit, that stems
from increasing production for one single type of product.
⚫ Economies of scale helped drive corporate growth in the 20th century, for example
through assembly line production.
 LEARNING and Experience Effects
⚫ In any environment; if a person is assigned to do the same task, then

after a period of time, there is an improvement in his/her

performance.
⚫ If data points are collected over a period of time, the curve constructed

on the graph will show a decrease in effort per unit for repetitive
operations.
⚫ This curve is called the learning curve.

⚫ This curve is very important in cost analysis, cost estimation and

⚫ The learning curve shows that if a task is performed over
and

over, then less time will be required at each iteration.

⚫ Historically, it has been reported that whenever there has been instanced

of double production, the required labor time has decreased by 10

or 15 percent or more.
⚫ For many manufacturing processes, average costs decline substantially
as

cumulative total output increases.

⚫ Improvements in the use of production equipment and procedures are

important in this process, as are reduced waste from defects and

decreased labor requirements as workers become more proficient in

their jobs.
⚫ Learning curve is relevant in taking following
decision:

 Pricing decision based on estimation of future costs.

 Workforce schedule based on future requirements.

 Capital requirement projections

 Set-up of incentive structure

 The experience curve
⚫ “The more experience a firm has in producing a particular product,
the lower its costs.”
⚫ Working with a leading manufacturer of semiconductors, the
consultants noticed that the company's unit cost of manufacturing fell
by about 25% for each doubling of the volume that it produced.
⚫ This relationship they called the experience curve: the more experience

a firm has in producing a particular product, the lower are its costs.
 Key Takeaways from Unit
⚫ 3
Production (what is it, its concepts, its theory)
⚫ Input (what is it, its types)
⚫ Output (How to measure)
⚫ Production function (What is it, how is it in Short and Long
Runs)
⚫ Laws of Production (What is it, in Short run? In Long Runs?
⚫ MRTS and Isoquant (what are they, for what purpose?)
⚫ Cost (Concept, types, nature, measurement, determinants,
analysis)
⚫ Break-even analysis (what is it, how to estimate)
⚫ Economies of scale (what is it, its types and sources)
⚫ Learning and experience curves (what are they, for what?)
End of Chapter
3