Mangerial Economics UNIT-2
Managerial Economics UNIT - 2
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UNIT - 1 of Managerial Economics
Okey moving on to our first topic of UNIT - 2
Production Analysis
Concept of production
"Production is an economic activity which converts inputs into outputs or services with addition of utility."
"Utility can be defined as the capability of product or service to satisfy the needs and wants of a customer."
》》Production analysis is dealing with the relationship between input factors and output of goods and services.
Production analysis studies the relationship between input factors and output to set an equilibrium point between demand and supply and to reduce the cost of production for attaining maximum profit.
Factors of production
There are broadly 4 classification of factors of production🤷♂️
1. Land
In Economics, land doesn't mean only a piece of Earth but it means all kind of materials and natural resources required for production of any particular output or service.
2. Labour
In economics, labour stands for all the physical and mental efforts made in the process of production.
3. Capital
Capital means the portion of wealth, money or investment involved in any production process.
4. Entrepreneur
Entrepreneur is the most prominent factor of production as he or she is the risk bearer, manager or organiser of the production process.
Production function
Production function is the algebraic representation of the relationship between input factors and output produced.
Assumptions of production function
•Input and output are perfectly divided. •Technology remains constant.
•Supply of fixed factors is inlastic.
Types of production function
Production function is largery divided into two categories on the basis of time period🤷♂️
1. Short run production function
2. Long run production function
1. Short run production function
Short run production function deals with a single variable input factor.
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Q = f(L,K)
Q is quantity of output produced
L is labour
_
K is constant capital here
It is of 4 different types
A) Linear production function
B) Quadratic production function
C) Cubic production function
D) Power function
2. Long run production function
Long run production function deals with all variable input factors or simply in long run, both capital and labour are considered as variable input factors.
Q = f(L,K)
Long run production function is of 5 different types:
A) Cobb-Douglas production function
This C-D production function was applicable in the entire manufacturing production rather than production of individual firms.
It also deals with analysing the relationship
between inputs and outputs.
It involves output elasticity of labour(alpha) and output elasticity of capital(beta).
Importance of Cobb-Douglas production function
● This is the most prominent long run production function as it describes the returns to scale which you will read further in the blog.
● It is convenient for international and inter industry comparison.
● It simplifies calculation by transforming functions into linear form with the help of logarithms.
Criticism of CD production function
● It includes only two factors.
● It assumes constant return to scale.
● It assumes perfect competition in factor market which is unrealistic.
● It is not fit for all the industries.
B) Constant elasticity of substitution (CES) production function
It is also called as homohighplagic production function.
C) Variable elasticity of substitution (VES) production function
This function is also same as CES production function
D) Fixed proportion(or Leontif) production function
E) Linear programming production function
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Laws of production
Laws of production are also divided into categories on the basis of time :
1. Short run laws
A) Law of variable proportions/ Return to factor/ Law of diminishing marginal productivity
●Law of increasing returns
●Law of diminishing returns
●Law of negative Returns
2. Long run laws
A) Isoquants
B) Laws of returns to scale
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Short Run laws
A) Law of variable proportion/return to factor
This law deals with the relationship between input and output, where one factor is variable in nature while others are fixed in nature.
Assumptions of law of variable proportions
•Only one variable factor
•All other factors remain constant
•Technology remains constant
•Applicable only in short run
To study law of variable proportion, we should be aware of these following terms🤷♂️
1. Total product(TP)
It is the quantity of total product produced with the use of all factors of production at any given time.
2. Average product(AP)
It is the result of total product divided by number of variable actors used.
3. Marginal product(MP)
It is the unit produced by adding an extra/ additional unit of input.
"Law of variable proportion is also known as Law of diminishing marginal productivity"
There are three stages to the law of variable proportion which are as follows 🤷♂️
Stage 1 (Law of increasing returns)
This is a stage at which the producer gets the increasing returns from the output produced.
In economics, this means that value of total product and marginal product increase at an accelerating rate and reaches its highest point (point of inflexion).
Reason behind this stage:
At lower level of production, all the resources are not fully utilised and when the total product increases, then all the resources get utilised and hence, the producer gets increasing returns from the output produced.
Stage 2 (Law of diminishing Returns)
At this stage, producer starts facing downfall in the rate of returns from the output produced.
In economics, at this stage total product keeps on increasing but at a slower rate until it reaches the maximum point which means the last point till which a firm can produce the output.
And marginal product & average product keeps on decreasing at this stage.
Reason behind this stage
On getting continuous increasing returns from the output produced, producers start to expand the production at a higher rate but such faster expansion leads to many mistakes( like inefficient resource utilisation, scarcity of resources, over utilisation of capital, etc) which gradually decreases the rate of return from the output produced.
Importance of law of diminishing Returns
●Universal
Applicable to every industry as every kind of production has a saturation point beyond which that output or product cannot be produced.
●Basis for the theory of rent(you will read in UNIT-4 blog)
The difference in production from first consumption and second consumption is known as rent.
●Basis for the theory of distribution
Stage 3 (Law of negative Returns)
At this stage, the producer starts getting a downfall in all the aspects of production.
In Economical terms, at this stage total product, marginal product and average product, all of these decline.
Reason for this stage
Even after reaching the maximum point of production, producer tries to cross that point in order to estimate profits in future but constant increase in output even at decreasing rate of return leads to negative rate of Returns.
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Long run laws
A) Isoquants
Isoquants is a graphical representation of different combinations of inputs which can be used for producing the same quantity of output in order to make the production more effective and cost efficient.
Isoquants are also known as isoproduct, isoproduct curves, production indifference curve or equal product curve.
Properties of isoquants curves
●Isoquants are negatively sloped
Because to use more of one input, producer has to reduce use of another input.
●Higher isoquant represents larger output.
●Two isoquants cannot intersect or touch each other.
Because every single isoquant represents different levels of output.
● Isoquants are convex to origin.
Because of marginal rate of substitution(MRS)
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B) Law of returns to scale
In long run, all inputs are considered to be variable factors. Hence, a firm can increase or decrease its output by making proportional changes in all inputs. This concept is known as return to scale.
"Law of return to scale shows the relationship between change in level of output and proportionate change in level of input, in long run."
Types of returns to scale
● Increasing returns
This is a state in which change in level of output is more than change in factors of production. ●Constant returns
This is a state in which change in level of output is equal to change in factors of production.
●Diminishing/Decreasing returns
This is a state in which change in level of output is less than change in factors of production. It is quite similar to the law of diminishing marginal productivity.
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Economies and diseconomies of scale
Advantages arising due to large scale production are termed as economies of scale, which is basically economies of production at a larger scale.
As you have read the law of increasing returns, so this is the very similar stage which says that
"expanding production to a certain level divides the fixed cost of production among more units of output resulting in higher returns which is also known as economies of scale."
"Diseconomies of scale can be observed as decreasing returns due to continuous expansion of firm size or production activities."
As you have already read the law of diminishing returns so this is the very similar case of that law.
》》In most cases, diseconomies of scale occur due to problems in behavioural aspect of managers in managing a very large scale enterprise.
Kinds of economies and diseconomies of scale
Kinds are broadly divided into two categories:
1. Internal economics & diseconomies of scale
2. External economies & diseconomies of scale
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Economies of scope
"A situation where a firm can produce variety of products at lower production cost instead of producing few products is termed as economies of scope."
Economics of scope is attained by increasing production of variety of products at a lower production cost when compared to producing those products separately.
For example: KFC is now also providing vegetarian food items in its menu.
Reason for existence of economies of scope
●Economies of scope exist because of better utilisation of available resources and production facilities.
●Economies of scope also exist because of the by- products produced in the production of one product can be used as the raw material for producing variety of products.
For example: it is easy for a sugar mill to produce alcohol when compared to a steel mill for producing alcohol.
Features of economies of scope
●Helps in potential cost saving by encouraging joint production
●Involves production of more than two products
●It exists because of optimum resource utilisation and cost saving strategies.
●Focuses on cost reduction by increasing variety of production.
Condition for attaining economies of scope
Economies of scope can only occur if, a firm has the ability to produce two or more products at a production cost cheaper than producing those products separately.
When a firm cannot fulfill this condition then that situation is known as diseconomies of scope.
Importance of economies of scope
●It enables the firm to earn competitive advantage
●Enables diversification
●Facilitates international and regional variations
●Immediately responds to the changing needs of market.
For example: providing selfie cameras in the smartphone.
Potential problems in attaining economies of scope
●Producers have less knowledge in new products which leads to diseconomies of scope.
●Sometimes it can damage the brand name, if it becomes difficult to manage all the variety of products which again can lead to diseconomies of scale.
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Cost analysis
"Cost analysis is the study of behaviour of cost with respect to various determinants of production," such as size of output, scale of production, prices of factors of production and other variables.
The expenses incurred in the business activity of producing and supplying goods & services to the consumer are defined as cost.
Cost comprises of all factors of production (land, labour, capital, entrepreneur as well as taxation).
Types of cost
1. Opportunity cost
The loss of earning due to loss of opportunities is known as opportunity cost.
This is also known as alternative cost because it is an expected income from the second best option.
Importance of opportunity cost
●Useful in determination of relative prices of goods.
●Useful in fixation of remuneration to a factor.
●Helpful in efficient allocation of resources.
Criticism of opportunity cost
●It is not easy to calculate.
●Risk and pain beared by an entrepreneur cannot be calculated.
●It is only applied in case of perfect competition which is quite unrealistic.
Actual cost
The expenses incured actually on labour, material, plant, building, machinery, travelling, transport, etc are known as actual cost.
Direct cost
The cost directly related to the production of goods and services is known as direct cost.
Indirect cost
All the other expenses such as electricity, stationary, office expenses, etc are indirect cost.
Incremental cost
The expenses incurred due to change in nature or level of business activity is known as incremental cost.
Sunk cost
The cost which cannot be altered by change in nature or level of business activity are sunk cost. Simply, the cost already being incurred is Sunk cost.
Explicit and implicit cost
All expenses incurred on rent, wages, salaries, power, fuel, etc are explicit cost and the expenses incurred for the payment of self-owned resources in production is known as implicit cost.
Historical cost and replacement cost
The book value of a asset is historical cost whereas replacement cost is the present value in the market of that same asset.
Past cost and future cost
Past costs are the expenses already made for business activities whereas future costs are the expenses which are expected to incurr in future.
Shutdown cost and abandonment cost
Cost incurred in the situation of closer of a plant or factory is known as shutdown cost whereas cost incurred due to retiring of a plant from use is abandonment cost.
Real cost and Prime cost
Real cost is same as the concept of actual cost whereas prime cost = direct material + direct wages + direct expenses
Fixed cost and variable cost
The cost which does not change at a certain level of output is a fixed cost whereas the cost that changes with the change in output is variable cost.
Total, average and marginal costs
The sum total of all the costs incurred in the production is total cost whereas ratio of total cost to total output is average cost and cost incurred because of additional unit of production is marginal cost.
Short run cost and long run cost
Short run cost is same as variable cost and long run cost is similar to the cost incurred in purchase of fixed assets like plant, machinery, etc.
Private cost and social cost
The sum total of all actual costs incurred in business activity is private cost whereas the total cost incurred for the welfare of and contribution in society is social cost.
Accounting cost and economic cost
All the costs recorder in the books of account is accounting cost and the actual value taken for information and recording purposes at a larger scale is economic cost. Economic cost comprisers both of explicit and implicit cost.
Cost function
Cost function is the mathematical representation of the cost analysis.
C = f(O,S,T,P,U...)
O is level of output
S is size of plant
T is time considered
U is unknown factors
Determinants of cost
1. Operating Law of Returns
As we have already read the three stages of law of variable proportion, same goes here, at the stage of increasing returns, cost of production will be less and at the stage of decreasing returns, cost of production will be higher.
2. Size of plant
Larger the size of plant, higher will be the cost and vice versa.
3. Capacity of utilisation
Optimum the resource utilisation, lower will be the cost and vice versa.
4. Prices of factors of production
Higher the prices, higher will be the cost and vice versa.
Some other determinants are nature of output, efficiency in use of input, technology,etc.
Uses of cost analysis in managerial decision-making
●Product costing and pricing decisions
●Cost Management
●Profit planning
●Capital decisions
●Investment decisions
●Marketing decisions
Cost curves
"Cost curve is the graphical representation of cost function."
The study of cost-output relationship or cost curve is important to determine the optimum level of production.
Before heading to the types of cost curves, it is very important to understand these three terms:
●Total cost
●Average cost
●Marginal cost
Which I have already explained in types of cost.
Total cost curves
Total cost(TC) = Total fixed cost( TFC) + Total variable cost(TVC)
1. Short run total fixed first curve[SRTFC curve]
(horizontal line)
2. Short run total variable cost curve[SRTVC curve]
(increasing slope)
3. Short run total cost curve[SRTC curve]
(Inverted "S" shape)
4. Long run total cost curve[LRTC curve] (Inverted "S" shape)
Long run total cost curve is attained by joining the lowest point of many short run total cost curves.
Hence, it is also known as envelope curve because it contains many short run curve inside it.
Reason behind "U" shape of this curve is that every short run curve follows the law of variable proportion and on combining many short run curves, long run curve makes the shape of "U" alphabet.
Average cost curves
Average cost = Average fixed cost(AFC) + Average variable cost(AVC)
1. Short run average fixed cost curve[SRAFC curve]
(Rectangular hyperbola)
2. Short run average variable cost curve[SRAVC]
(U-shape)
3. Short run average cost curve[SRAC curve]
(U-shaped)
4. Long run average cost curve[LRAC curve]
(U-shaped)
Long run average cost curve is also known as envelope curve as it comprises of many short run average cost curves.
It is also known as planning curve as it is used in decision making for different production process and activities.
Reason behind "U" shape of this curve is that every short run curve follows the law of variable proportionand hence, on joining the lowest point of every short run curve, long run curve takes the shape of "U" alphabet.
Marginal cost curves
MC(n) = TC(n+1) - TC(n)
1. Short run marginal cost curve[SRMC)]
(U-shaped)
2. Long run marginal cost curve[LRMC]
(U-shaped)
Reason behind the "U" shape of marginal cost curve is same that these curves follow the law of variable proportion or law of diminishing marginal utility.
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