MBA I

UNIT III Notes

Managerial Economics
Production Function: Meaning and Definitions
The business firms are actually technical or procedural units. Here in these units inputs or raw
materials are converted into output for the consumption of consumers (may be individual or other
firms). The collective and correct collaboration of land, labour, capital and organization results in the
production.
The producer of the business firm combines all the above factors in a best methodological
combination to maximize the return at the minimum cost. The conversion process of converting
inputs into output is deeply studied in the theory of production with the production function as the
basic concept. Inputs are the factors of production mentioned above and the outputs are the
quantity of a good produced with a particular grade of quality.
Definitions
According to Prof. L.R. Klein “The production function is a technical or engineering relation between
input and output. As long as the natural laws of technology remain unchanged, the production
function remains unchanged.”
“The production function is purely a technical relation which connects factor inputs and output.”
Prof. Watson says, “The relation between a firm’s physical production (output) and the material
factors

of production (inputs).”
Basically, the production function is expressed mathematically as:
Q = f (L, C, N)
Where Q, L, C and N represent the quantity of Output, Labour, Capital and Land respectively.
Here Q is a dependant variable and as shown in the expression, it depends on L, C and N.
In the simplest case, where only L and C are available, the production function can be expressed as Q
=f

(L, C).
Managerial Uses of Production Function
It is the responsibility of a manager to compute a combination of inputs having minimum cost for
their given level to obtain the maximum output. Followings are the various managerial uses of the
production function:
i) It is used by managers to compute a combination of inputs having minimum cost for their given
level to obtain the maximum output.
ii) The production function assists in determining the additional value, if needed, of any variable
input for the sustenance of maximum output.
iii) The production function helps in taking decision for the selection of a product in the long-run on
the basis of demand and supply.
iv) With the proper information available, the returns can be maximised for the given expenditure
and also any additional use of the inputs is thereby stopped.
v) The production function also helps the business unit in the field of decision making like product

planning, pricing decisions, profit planning, cost minimization, etc.

Types of Factors of production (or inputs)
i) Fixed Factors: The inputs which continue to be fixed or unchanged with the change in output in
short run and thus these are independent of output e.g. machines, computer system, premises like
buildings & offices, etc.
ii) Variable Factors: These are the inputs which change with the increase or decrease in the output
in short run. e.g. raw materials, labour, energy, etc. For a desired output, a firm can adjust the
units of labourers, raw materials and power. This implies the increase in variable factors with the
increase in production and vice-versa. It is important to note that in the long-run all factors of

production are variable.

Time period Classification
The variability of factors of production depends on the available time periods when a firm wishes to
alter its output level. A firm makes decisions on the basis of two time scales- one is the short-run and
other is the long-run.
i) The Short-Run time period: This is the period over which one or more factors of production
are fixed and others are variable. Generally, land, capital, plant and equipment are treated as
fixed factors. In short-run, the production function defines the limitations in choice of inputs with
a firm. A firm can only alter its production by making changes in variable inputs such as labour.
ii) The Long-Run time period:This is the period in which all factors of production are variable. A
firm can change the quantities of its inputs in order to get the desired production level. The longrun
also permits factor substitution.
5. Laws of Production
The production function defines the technical possibilities to increase or decrease the production.
The below two laws are working in the field of production:
Laws of production are categorised on the basis of short run production function and long run
production function as given below:
A. Law of Variable Proportions (Returns to Factor): Short Run
B. Law of Returns to Scale: Long Run
A. The Law of Variable Proportions
The law of variable proportions came into action when a firm increased its output by applying
additional variable inputs with a given quantity of fixed factors. Land, premises like offices and
machinery are the
fixed factors of production and labour, power and raw materials are the variable factors.
Now if any business firm increases the number of labourers to obtain larger output, the ratio
between
fixed and variable factors is restructured. This is where the Law of variable proportions comes into
play.
According to Prof. Leftwitch, “The law of variable proportions states that if a variable quantity of
one resource is applied to a fixed amount of other input, output per unit of variable input will
increase but beyond some point the resulting increases will be less and less, with total output
reaching a maximum before it finally begins to decline.”
It can be understood that if more and more units of a variable factor are brought in, keeping the
quantities of a fixed factor constant, a point will come beyond which marginal productwill diminish
at initial stage, average product in midway and total product finally. Thus the law of variable
proportions is also called as the law of diminishing returns.
Laws of Production
Short Run Long Run
Law of Variable Proportions
(Returns to Factor)
Law of Returns to Scale
Assumptions
i) Only one factor is variable while others are fixed.
ii) Change in the proportions is possible where the various inputs or factors are combined.
iii) All the units of the variable inputs are homogeneous.
iv) It works in short-run time period.
v) Technology is assumed to be constant.
vi) The quantity of product is measured in units like quintals, tonnes, etc.
vii) The price of the product is remains constant as it is given.
Explanation of the Law

The law is illustrated with the help of below given Table 1, where
the variable factor (labour) is

The column 1 exhibit the units of fixed factors and column 2 exhibit the units of variable factors of
production i.e. Land and Labour respectively. The columns 3, 4, and 5 exhibit the total product,
average product, and marginal product respectively. The addition made in TP by employing one
additional unit of variable product is called MP. The AP is determined by dividing the TP by the
labour units employed.
The table portrays that the total product, average product and marginal products rise up to a
maximum
levels and then started declining as also shown in figure 1.
i) It is clear from the table that the TP reaches its maximum value when 7 units of labour are
employed and then it diminishes.
ii) The AP continues to increase till the 4th unit of labour comes into action and then it diminishes.
iii) The MP reaches at its maximum value at the 3rd unit of labour, and then it diminishes.
iv) It is important to note that the point of diminishing output is not the same for the TP, MP and
AP. First of all, the MP begins to fall followed by the AP and then the TP.
v) The law of variable proportions is explained in the below given figure explaining the three
stages.

Figure 1
Various Stages of Production Function under the Law of Variable Proporion
i) Stage I of Increasing Returns: The stage is started from the point of origin ‘O’ to the point
‘E’.The average product (AP) reaches its maximum and equals the MP when 4 labourers are
employed with the constant units of land which is a fixed factor. Here at the point E, the AP and
MP curves encounter as well as there is rapid increase in TP curve. As the units of land is
employed too much as compare to the units of labour, there are the increasing average returns
and to cultivate land in this stage is purely uneconomical.
ii) Stage II of Diminishing Returns:This is the most important stage as it is the only stage in
which production is feasible and profitable. This stage is shown from point ‘E’ (where the AP is
at its maximum) to the point ‘F’ (where the MP is zero) & to the point ‘C’ (where TP is the
highest). During this stage, the labour units (variable factor) is increased from 4 to 7 (shown
from EB to FC) to cultivate the given fixed land (Fixed Factor) in order to increase the output.
The units of land are used intensively in this stage. During this stage, the TP increases at a
diminishing/slow rate and the AP & MP decline. The MP is below the AP throughout this stage.
iii) Stage III of Negative Marginal Returns: Here during this stage, the point where the 8th labour
is employed during a production process as shown in table, there happens a decline in the TP and
MP becomes negative. It implies that the employed labour units (variable factor) are too much in
relation to the available land (fixed factor) making it absolutely impossible to cultivate. It is clear
from here that after the point F, the variable input (labour) is used excessively and thus, the
production cannot be said to take place.
The Best Stage or The Stage of Rational Decision: The Stage II
During the stage I, the fixed factor is too much in relation to the variable and thus it is not
economical to utilize the given fixed factor (land) optimally because both the AP and TP are
increasing. So, there is a need to increase the output.
During the stage III, the variable factor is available too much in comparison to the fixed factor.
To increase the produce, employment of more units of the variable factor i.e. labour units is
uneconomical because there is negative MP and the declining TP.
The rational production will always take place in stage II where total product is increasing at a
diminishing rate and AP & MP are maximum. After that both start decreasing and the total
product (TP) is maximum. Thus, the stage II of diminishing returns is the optimum and the best
stage of production for a purely competitive firm.
 Causes of Applicability of the Law
In the following situations the law of variable proportions is applicable:
i) The fixed factors like land and machines are under-utilized in the initial stage of production and
more additional units of variable factors are required for optimum utilization of fixed factors that
increases the returns to a factor.
ii) In short run, if only one factor is variable and others are kept constant. The ratio of fixed factor
to the variable factor falls with an extra unit of a variable input employed. Here the marginal
return of variable factor starts to diminish.
iii) “The imperfect substitution of factors is the main cause for the operation of the law of
diminishing returns”, according to Mrs. Joan Robinson.
iv) As the one factor cannot be substitute the other factor of production. For the increase in the
output, the additional variable factors like labour, power, etc. are employed. Also the volume of
fixed factor could be increased. But after the optimum use of a fixed factor, it cannot be replaced
by another factor.
v) The marginal return of variable factor starts to reduce after optimum i.e. the best use of a fixed
factor because the ratio of fixed and variable factors become imperfect. Thus, TP increases a
little bit and the MP diminishes.
Long Run Production Function (Law of Returns to Scale)
This law as a long run production function explains the relation between inputs and outputs when all
the factors of production are variable. The firms can increase the level of production by varying all
the inputs in the same proportion as all the inputs are assumed to be elastic. It is also termed as law
of Returns to Scale. This law actually describes the relation between outputs and the scale of inputs
in the long-run where all the inputs or the factors of production are increased in the same
proportion.
Roger Miller says about this law as, “To the relationship between changes in output and
proportionate changes in all factors of production.”
In the words of Koutsoyiannis, “The term returns to scale refers to the changes in output as all
factors change by the same proportion.”
According to Leibhafsky, “Returns to scale relates to the behaviour of total output as all inputs are
varied and is a long run concept.”
Assumptions of the Law
i) All inputs are variable
ii) Production technology is constant
iii) A perfect competitive market is there.
iv) The labour (which is an input or factor) works with given tools and implements
Explanation
The firms can increase the level of output by increasing all the inputs in same or different
proportions.
Generally, returns to scale is the result of increase in all the inputs in the same proportion.
Suppose, originally the production function is:
P = f (L, K)
As per this law, when both the

All Facets of the law of Returns to Scale:

I. Increasing Returns to Scale or diminishing cost refers to a situation in which output increases
at a more increasing rate when all factors of production are increased. For example, if we
doubled all the inputs or factors of production, then the output increases at a higher rate than the
double. Division of external economies of scale may be one of the reason for this. This stage is
illustrated in the figure 2.
Here X-axis signifies the increase in capital and labour and the Y-axis displays the returns or the
increase in output. An increase in the capital and labour from Q to Q1 along the X-axis is smaller
than the increase in output level from P to P1.
II. Constant Returns to Scale or constant cost is that stage where the output increases exactly to
the same level as that of inputs/factors of production. We can say if we doubled the factors of
production, then there is exact doubling of the output. Here the internal and external economies
of scale are closely or exactly equal to the internal and external diseconomies of scale
respectively.

That is why it is also called as homogeneous production function. This phase is illustrated in figure 3.
The increase in factors of production i.e. capital and labour are equal to the increase in output.

III. Diminishing Returns to Scale: This is the stage when all the factors or inputs are increased or
employed in a specific proportion, but the resultant output increases in a comparatively smaller
amount. In other words, if a firm doubled the inputs then, the level of output will be less than
doubled. It is an instance of shrinking/diminishing returns to scale. Here, the internal and
 external economies are less than internal and external diseconomies respectively. Figure 4
clearly depicts the situation.

Here the X-axis represents the inputs like labour and the Y-axis represents the output. The increase
from P to P1 (output) is less than the increase from Q to Q1 (input) which describes the diminishing
returns to scale.
THEORY OF COST
MEANING OF COST- Cost may be defined as the monetary value of all sacrifices made to achieve an objective i.e. to
produce goods and services. Cost are very important in business decision making. Cost of production provides the
floor to pricing. It helps manager to take correct decision, such as what price to quote, whether to place particular
order for inputs or not whether to abandon or add a product to the existing product line and so on.
Ordinarily, cost refer to the money expenses incurred by a firm in the production process. Cost also included
imputed value of the entrepreneur’s own resources and services, as well as salary of the owner-manager.

Introduction: A firm carries out business to earn maximum profits. Profits are the revenues collected by a business
firm after production and sale of their goods and services. But to gain something, the producer has to lose
something. That means, to earn revenues the producer has to incur costs.
Cost: A cost is an expenditure incurred by a firm to produce goods and services for sale in the
market. In other words, a cost is the outflow of money from the business to gain inflow of money
after sale of the commodity. A producer has to incur various costs in order to produce goods and
services. These costs are of various types.
According to Marshall, the real cost of production includes the ―real cost of efforts of various
Qualities‖ and ―real cost of waiting‖
Determinants OF COST
Factors determining the cost are:

(a) Size of plant: There is an inverse relationship between size of plant and cost. As size of plant increases, cost

falls and vice versa.

(b) Level of Output: There is a direct relationship between output level and cost. More the level of output, more
 is the cost ( i. e., total cost) and vice Versa.
(c) Price of Inputs: There is a direct relationship between price of inputs and cost. As the price of inputs rises, cost
rises and vice versa.
(d) State of technology: More modern and upgraded the technology implies
lesser cost and vice versa.
(e) Management and administrative efficiency: Efficiency and cost are inversely related. More the efficiency in
management and administration better will be the product and less will be the cost. Cost will increase in case of
inefficiencies in management and administration.
COST CONCEPT
The concept of cost is central to business decision making. To make effective business decisions, the business
manager needs to be aware of a number of cost concepts and their respective uses.
Actual cost- Actual cost means the actual expenditure incurred on producing goods and services. Value of raw
material, wages, rent, salaries paid and interest of borrowed capital etc. are some of the example of actual cost.
Actual cost is also known as absolute cost or out lay cost or money cost.
Opportunity Cost- The opportunity cost is measured in terms of the forgone benefits from the next best alternative
use of a given resource. For example the inputs which are used to manufacture a car may also be used
in the productions of military equipment. Main points of opportunity cost are:
1. The opportunity cost of any commodity is only the next best alternative forgone.
2. The next best alternative commodity that could be produced with the same value of the factors, which are
more or less the same
3. It helps in determining relative prices of factor inputs at different places.
4. It helps in determining the remuneration to services.
5. It helps the manager to decide what he should produce in the factory.
Explicit cost- An explicit cost is a cost that is directly incurred by the firm, company or organization during the
production. The explicit cost is kept on record by the accountant of the firm. Salaries, wages, rent, raw
material are few example of the explicit cost. The explicit cost is also known as outpocket cost. This cost is
handy in calculating both accounting and economic profit.
Implicit cost- The implicit cost is directly opposite to it, as it is the cost that is not directly incurred by the firm
or company. In implicit cost outflow of cash doesn’t take place. It is not in the record and is heard to be traced
back. The interest on owner’s capital or the salary of the owner are the prominent example of the implicit
cost. The implicit cost is also known as imputed cost. Through implicit cost , only the economic profit is
calculated.
Incremental cost- Incremental costs are the added costs of a change in the level of production or the nature of
activity. It may be adding a new product or changing distribution channel, or adding new machinery, etc. It
appears to be similar to marginal cost, but it is not managerial cost. Marginal cost refers to the cost on added
unit of output.
 Sunk Cost- Sunk costs are costs which cannot be altered in any way. Sunk costs are costs which have already
been occurred. For example, cost incurred in constructing a factory. When the factory building is constructed
cost have already been incurred. The building has to be used for which originally envisaged. It cannot be
altered when operation are increased or decreased . Investment of machinery is an example of sunk cost.
Shutdown cost- Shutdown cost are those cost which would incurred in the event of suspension of plant
operations and which could be saved if operation were continued. For example cost of sheltering the plant
equipment and construction of sheds for protecting the exposed property, or fixed cost and maintenance cost
etc.

Economic Costs: Economic costs are those costs that an entrepreneur incurs while conducting economic
activities. For an entrepreneur an economic activity is his business. Therefore, economic costs
include all the direct and indirect that the entrepreneur incurs while conducting business. An economic
cost is the summation of explicit cost and implicit cost. An economic cost is defined as follows:

“An economic cost is the combination of direct and indirect costs that are incurred by
the firm to produce commodities.”
Uses of economic cost:

1. It shows the expenditure incurred on production of the commodity which is considered for
pricing strategy;
2. It also helps in calculating profits;

3. It helps in decision – making;

4. It helps in decision making

5. It helps to ascertain opportunity costs

6. They directly impact profitability of the firm

Abandonment cost- Abandonment cost are those cost which are incurred for the complete removal of the
fixed asset from use. These may occur due to obsolesce or due to improvisation of the firm. Abandonment
costs thus involve problem of disposal of the asset.
Book cost – Book cost are those business cost which don’t involve any cash payment is made but a provision is
made in the books of accounts in order to include them in the profit and loss account and take tax advantages.
Out of pocket cost- Out of pocket cost are those costs or expenses which are current payments to the
outsiders of the firm. All the explicit costs fall into the category of out of pocket costs.
Past cost- Past costs are actual costs incurred in the past. These costs are mentioned in the financial
accounts. , since the past costs have already been incurred, and there is no scope for managerial decision.
If the management finds out that the past costs are excessive, it cannot do anything to rectify it now.
 Future cost- Future costs are those costs which are to be incurred in the near future. This is only a forecast.
Future costs matter for managerial decisions because, the management can evaluate the desirability of
that expenditure. In the case of future costs, if the management considers them very high , it can either
reduce them or postpone the use of them.
Direct cost-Direct costs are related to a specific process or product. They are also called traceable costs as
we can directly trace them to a particular activity, product or process. They can vary with changes in the
activity or product. Examples of direct costs include manufacturing costs relating to production, customer
acquisition costs pertaining to sales, etc.
Indirect costs- Indirect costs, or untraceable costs, are those which do not directly relate to a specific
activity or component of the business. For example, an increase in charges of electricity or taxes payable
on income. Although we cannot trace indirect costs, they are important because they affect overall
profitability.
Fixed Cost- Fixed cost are the amount spent by the firm on fixed inputs in the short run. Fixed cost are
thus, those costs which remain constant, irrespective of the level of output. These costs remain unchanged
even if the output of the firm is nil. Fixed costs therefore, are known as Supplementary costs or Overhead
costs.
Variable Costs- Variable costs are those cost that change directly as the volume of output changes. As the
production increases variable cost also increases, and as the product decreases variable costs also
decreases, and when the production stops variable cost is zero.
Semi Variable increase in charges of electricity or taxes payable on income. Although we cannot trace
indirect costs, they are important because they affect overall profitability.
Fixed Cost- Fixed cost are the amount spent by the firm on fixed inputs in the short run. Fixed cost are
thus, those costs which remain constant, irrespective of the level of output. These costs remain unchanged
even if the output of the firm is nil. Fixed costs therefore, are known as Supplementary costs or Overhead
costs.

Variable Costs- Variable costs are those cost that change directly as the volume of output changes. As the
production increases variable cost also increases, and as the product decreases variable costs also decreases, and
when the production stops variable cost is zero.
 Total cost-Total cost is the total expenditure incurred in the production of goods
and services.
TC= TFC+TVC

Marginal cost- The cost incurred on producing one additional unit of commodity is known as marginal
cost. Thus it shown a change in total cost when one more or less unit is produced.
MC= TCn – TC(n-1 )
Marginal Cost Formula

The formula to calculate the marginal cost of production is given as ΔC/ΔQ, where Δ means change.
Here, ΔC represents the change in the total cost of production and ΔQ represents the change in
quantity.

When the quantity is increased by 1 unit, then the marginal cost of the nth unit of production can
also be calculated using the following formula: MCn = TCn - TCn-1, where MC represents marginal cost
and TC represents the total cost. Here, it is important to note that the marginal cost is different from
the average cost of production, as average cost means the average cost of producing 1 output, while
the marginal cost means the change in the cost by producing an additional unit of output. When the
marginal cost formula is ΔC/ΔQ, the formula for average cost is TC/TQ, where TC = total cost of
production and TQ = total quantity.
Marginal cost Curve-

Cost function-
The cost output relationship plays an important role in determining the optimum level of
production.
TC=F(Q)
Where,
 TC= Total cost
Q= Quantity produced
F= Function
The cost function can be classified as:
Short run cost- Short run is a period where the time is too short to expand the size of industry and the increased
demand has to be met within the existing size of industry because there are certain factors which cannot be changed
in short run. So short run costs are those which vary with output when fixed plant a capital equipments remain
unchanged.
Long run costs- In the long run the size of an industry can be expanded to meet the increased demand for products
such as in long run all the factors of production can be increased according to need. Hence long run costs are those
which vary with output when all input factors including plants equipment vary.
Cost output relationship in short run-
In the short-run a change in output is possible only by making
changes in the variable inputs like raw materials, labour etc. Inputs
like land and buildings, plant and machinery etc. are fixed in the
short-run. It means that short-run is a period not sufficient enough
to expand the quantity of fixed inputs. Thus Total Cost (TC) in the
short-run is composed of two elements – Total Fixed Cost (TFC) and
Total Variable Cost (TVC).
TFC remains the same throughout the period and is not influenced by the level of activity. The firm will continue to
Incur these costs even if the firm is temporarily shut down. Even though TFC remains the same fixed cost per unit
varies with changes in the level of output.
On the other hand TVC increases with increase in the level of activity, and decreases with decrease in the level of
activity. If the firm is shut down, there are no variable costs. Even though TVC is variable, variable cost per unit is
constant.
So in the short-run an increase in TC implies an increase in
TVC only. Thus:
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.
In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line parallel to X-axis, because TFC
does not change with increase in output.
TVC curve is upward rising from the origin because TVC is zero when there is no production and increases as
production increases. The shape of TVC curve depends upon the productivity of
the variable factors. The TVC curve above assumes the Law of Variable Proportions, which operates in the short-
run.
TC curve is also upward rising not from the origin but from the TFC line. This is because even if there is no
production the TC is equal to TFC.
It should be noted that the vertical distance between the TVC curve and TC curve is constant throughout because
the distance represents the amount of fixed cost which remains constant. Hence TC curve has the same pattern of
behavior as TVC curve.

Short-run Average Cost and Marginal Cost

The concept of cost becomes more meaningful when they are expressed in terms of per unit cost.
Cost per unit can be computed with reference to fixed cost, variable cost, total cost and marginal
cost.
The following Table and diagram illustrates cost output relationship
in the short-run, with reference to different concepts of cost.
 Average Fixed Cost (AFC): Average fixed cost is obtained by
dividing the TFC by the number of units produced. Thus:
AFC = TFC/Q where, ‘Q’ refers
quantity of production.
Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as output goes
on increasing. The AFC curve is downward sloping towards the right throughout its length,
with a steep fall at the beginning.
Average Variable Cost (AVC): Average Variable Cost is obtained by dividing the TVC by the number
of units produced. Therefore: Due to the operation of the Law of Variable Proportions AVC curve
slopes downwards till it reaches a certain level of output and then begins to rise upwards.
Average Total Cost (ATC): Average Total Cost or simply Average Cost is obtained by dividing the TC
by the number of units produced. Thus:
AVC = TVC / Q
Average Total Cost (ATC): Average Total Cost or simply Average Cost is obtained by dividing the TC
by the number of units produced. Thus:
ATC = TC / Q
Cost-Output Relationship - cost-output relationship plays an important role in determining the
optimum level of production. Knowledge of the cost-output relation helps the manager in cost
control, profit prediction, pricing, promotion etc. The relation between cost and its determinants is
technically described as the cost function.

C= f (S, O, P, T ….)

Where;

 C= Cost (Unit or total cost)

 S= Size of plant/scale of production
 O= Output level
 P= Prices of inputs
 T= Technology

Considering the period the cost function can be classified as (1) short-run cost function and (2) long-
run cost function. In economics theory, the short-run is defined as that period during which the
physical capacity of the firm is fixed and the output can be increased only by using the existing
capacity allows to bring changes in output by physical capacity of the firm.

1. Cost-Output Relationship in the Short-Run

The cost concepts made use of in the cost behavior are Total cost, Average cost, and Marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the
summation of Fixed Costs and Variable Costs.

TC=TFC+TVC

Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc,
remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the
variation in output. Average cost is the total cost per unit. It can be found out as follows.

AC=TC/Q

The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased and
Average Variable Cost (TVC/Q) will remain constant at any level of output.

Marginal Cost is the addition to the total cost due to the production of an additional unit of product.
It can be arrived at by dividing the change in total cost by the change in total output.

In the short-run there will not be any change in Total Fixed C0st. Hence change in total cost implies
change in Total Variable Cost only.

The short-run cost-output relationship can be shown graphically as follows.

 In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over
more and more units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due
to the operation of the law of variable proportions.

The behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’ curve. In the initial
stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after a certain
point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC will still
continue to decline otherwise AC begins to rise.

Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-
shaped. The lowest point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the
total average cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the
maximum output level rather it is the point where per unit cost of production will be at its lowest.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows-

1. If both ‘AFC’ and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
3. ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
4. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
5. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’

2. Cost-output Relationship in the Long-Run

Long run is a period, during which all inputs are variable including the one, which are fixes in the
short-run. In the long run a firm can change its output according to its demand. Over a long period,
the size of the plant can be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their operation by bringing or
purchasing larger quantities of all the inputs. Thus in the long run all factors become variable.

In the long run the size of an industry can be expanded to meet the increased demand for products
as such in the long run all the factors of production can be varied according to the need. Hence long
run costs are those which vary with output when all the input factors including plant and equipment
vary.
Shapes of Long-Run Average Cost Curves-
While in the short run firms are limited to operating on a single average cost curve (corresponding to
the level of fixed costs they have chosen), in the long run when all costs are variable, they can
choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is
actually based on a group of short-run average cost (SRAC) curves, each of which represents one
specific level of fixed costs. The long-run average cost curve will be the least expensive average cost
curve for any level of output. 

Figure shows how the long-run average cost curve is built from a group of short-run average cost
curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a
different level of fixed costs.

This family of short-run average cost curves can be thought of as representing different choices for a
firm that is planning its level of investment in fixed cost physical capital—knowing that different
choices about capital investment in the present will cause it to end up with different short-run
average cost curves in the future.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the
firm can choose its level of fixed costs and thus choose which short-run average costs it desires At
SRAC2 the level of fixed costs is too low for producing Q 3 at lowest possible cost, and producing
q3 would require adding a very high level of variable costs and make the average cost very high. At
SRAC4, the level of fixed costs is too high for producing q 3 at lowest possible cost, and again average
costs would be very high as a result.

The shape of the long-run cost curve is fairly common for many industries.

The left-hand portion of the long-run average cost curve, where it is downward- sloping from output
levels Q1 to Q2 to Q3, illustrates the case of economies of scale.

In this portion of the long-run average cost curve, larger scale leads to lower average costs.

In the middle portion of the long-run average cost curve, the flat portion of the curve around Q 3,
economies of scale have been exhausted. In this situation, allowing all inputs to expand does not
much change the average cost of production, and it is called constant returns to scale.

In this range of the LRAC curve, the average cost of production does not change much as scale rises
or falls.

Finally, the right-hand portion of the long-run average cost curve, running from output level Q 4to Q5,
shows a situation where, as the level of output and the scale rises, average costs rise as well. This
situation is called diseconomies of scale.

Economies of scale- AND DISECONOMIES OF SCALE

The term economies of scale denotes saving in cost of production with an increase in the scale of
output or the size of the plant. It should be noted that the existence of economies does not mean a
reduction in total cost in absolute terms. It only means a reduction in relative terms and manifests
itself in a reduction in average cost of output.
Factors Causing Economies of Scale:
There are various factors influencing the economies of scale of an organization. They are generally
classified in to two categories as Internal factors and External factors.
Internal Factors:
1. Labour economies: if the labour force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labour productivity.
2. Technical economies: with the use of advanced technology they can produce large quantities with
quality which reduces their cost of production.
 3. Managerial economies: the managerial skills of an organization will be advantageous to achieve economies of
scale in various business activities.
4. Marketing economies: use of various marketing strategies will help in achieving economies of scale.
5. Vertical integration: if there is vertical integration then there will be efficient use of raw material due to internal
factor flow.
6. Financial economies: the firm’s financial soundness and past record of financial transactions will help them to
get financial facilities easily.
7. Economies of risk spreading: having variety of products and diversification will help them to spread their risk and
reduce losses.
8. Economies of scale in purchase: when the organization purchases raw material in bulk reduces the
transportation cost and maintains uniform quality.
External Factors:

1. Better repair and maintenance facilities: When the machinery and equipments are repaired and maintained, then

the production process never gets affected.

2. Research and Development: research facilities will provide opportunities to introduce new products and process
methods.
3. Training and Development: continuous training and development of skills in the managerial, production level will
achieve economies of scale.
4. Economies of location: the plant location plays a major role in cutting down the cost of materials, transport and
other expenses.
5. Economies of Information Technology: advanced Information technology provides timely accurate information for
better decision making and for better services.
6. Economies of by-products: Organizations can increase the economies of scale by minimizing waste and can be
environmental responsible by using the by- products of the organization

Concept of Cost Control

Cost control is prime function of cost accounting. Under cost control, cost
accountant measures actual costs, compare it with the standards and find the
deviations. Then redial actions are taken to reduce the variances. It involves
various actions taken to keep the cost within budgeted standards and not
rising beyond the limit. Cost Control focuses on decreasing the total cost of
production.
Features of Cost Control
Cost control has following features:
i) It is an attempt to keep the expenses within the control.
ii) It is a continuous process which includes formulating standards and
preparing budgets to set a target and then continuously comparing the
actual with these standards.
iii) It requires a continuous cost control report to identify the variances to
be resolved.
iv) It works as motivational and encouragement to the employees to
achieve the budgetary goals and keep the cost, controlled.
v) It is not only focused on reducing the cost, it also focus on the
effective utilization of the resources to get better results with the same
available resources.
Revenue
Revenue is the amount generated from sale of goods or services, or any other use of capital or
assets, associated with the main operations of firm before any costs or expenses are deducted. In
economics, we have three types of revenues-total revenue, average revenue and marginal revenue-
which are discussed in subsequent subsections.
Total Revenue (TR) Total revenue is the total money received from the sale of any given quantity of
output. The total revenue is calculated by taking the price of the sale times the quantity sold
i.e. TR = Price × Quantity
Example: If price is 10 and quantity sold is 100, then total revenue would be 1000. Figure depicts a
total revenue curve.
Average Revenue (AR)-
Average revenue is the revenue received for selling a good per unit of output sold. It is calculated by
dividing total revenue by the quantity of output,
i.e. AR= TR/Quantity
Average revenue often goes by a simpler and more widely used term- price.
Using the longer term average revenue rather than price provides a connection to other related
terms, especially total revenue and marginal revenue. When compared with average cost, average
revenue shows the amount of profit generated per unit of output produced. Average revenue is
often shown by an average revenue curve
Marginal revenue
Marginal revenue is one of several ways of looking at how revenue provides different insights helpful
to investors and businesses. For example, the margin revenue financial ratio helps calculate the
change in overall income due to the sale of an additional unit or product.
Marginal Revenue (MR) is the addition to total revenue when the quantity sold is increased by one
unit. Marginal revenue is addition to total revenue on account of an additional unit of output sold. It
is ratio of change in total revenue to change in total units sold.
MR= TRn - TRn-1
For the first unit sold, TR = AR= MR

MR pertains to change in TR only on account of the last unit sold, while AR is based upon all the units
sold by the firm. Therefore, any change in AR results in a much bigger change in MR. Reduction in
MR is far bigger than that in AR; and similarly, an increase in MR is also much bigger than the
corresponding increase in AR. The two are equal only when AR is constant.

The firm will not sell any quantity if TR or AR becomes zero or negative. However, MR can become
negative if the fall in price is big enough.

Since TR, AR and MR equal for the first unit sold, therefore, the three curves start from the same
point. TR curve slopes upwards so long as MR is positive. If MR is falling with an increase in the
quantity of sale, then TR curve will gain height at a decreasing rate. It reaches its maximum height
when MR curve touches X-axis. TR curve slopes downwards when MR curve goes below X-axis to
become a negative figure.

A change in AR causes a much bigger change in MR. Therefore, when AR curve has a negative slope;
MR curve lies below it and has a greater slope. Similarly, when AR curve has a positive slope, MR
curve lies above it and has a greater slope. When AR curve is parallel to X-axis, MR curve coincides
with it.
In case AR is a straight line, MR curve will bisect each perpendicular distance of it from Y-axis.
However, if AR curve is parallel to X-axis, then MR curve coincides with it.

The above graphical relationships between AR and MR are shown in Fig. 3.6 . In Fig. 3.6, AR has a
constant value DD’. Therefore, AR curve starts from point D and runs parallel to X-axis. Since AR is a
constant,
MR is always equal to AR and the two curves coincide with each other.

In Fig. 3.7, AR curve starts from point D on Y-axis and is a straight line with a negative slope. It
indicates that as quantity of good sold increases, it’s per unit price falls at a given rate. Accordingly,
MR curve also starts from point D and is a straight line. However, it is a locus of all those points
which bisect the perpendicular distances between AR curve and Y-axis. For example, FM= MA.