MANAGERIAL ECONOMICS

UNIT – II –PRODUCTION AND COST ANALYSIS

PRODUCTION

Production in Economics refers to the creation of those goods and services which have exchange
value. It means the creation of utilities. These utilities are in the nature of form utility, time
utility and place utility. Creation of such utilities results in the overall increase in the production
and redistribution of goods and services in the economy. Utility of a commodity may increase
due to several reasons.

FACTORS OF PRODUCTION

Human activity can be broken down into two components, production and consumption. When
there is production, a process of transformation takes place. Inputs are converted into an output.
The inputs are classified and referred to as land, labour, and capital. Collectively the inputs are
called factors of production.

1. Land

Land as a factor of production refers to all those natural resources or gifts of nature which are
provided free to man. It includes within itself several things such as land surface, air, water,
minerals, forests, rivers, lakes, seas, mountains, climate and weather. Thus, ‘Land’ includes all
things that are not made by man.

Characteristics or Peculiarities of land

(i) Land is a free gift of nature

(ii) Land is fixed (inelastic) in supply.
(iii) Land is imperishable
(iv) Land is immobile
(v) Land differs in fertility and situation
(vi) Land is a passive factor of production
As a gift of nature, the initial supply price of land is zero. However, when used in production, it
becomes scarce. Therefore, it fetches a price, accordingly.

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2. Labour

Labour is the human input into the production process. Alferd Marshall defines labour as ‘the use
or exertion of body or mind, partly or wholly, with a view to secure an income apart from the
pleasure derived from the work’.

Characteristics or Peculiarities of labour

(i) Labour is perishable.

(ii) Labour is an active factor of production. Neither land nor capital can yield much without
labour.

(iii) Labour is not homogeneous. Skill and dexterity vary from person to person.

(iv) Labour cannot be separated from the labourer.

(v) Labour is mobile. Man moves from one place to another from a low paid occupation to a
high paid occupation.

(vi) Individual labour has only limited bargaining power. He cannot fight with his employer for
a rise in wages or improvement in work- place conditions. However, when workers combine
to form trade unions, the bargaining power of labour increases.

3. Capital

Capital is the man made physical goods used to produce other goods and services. In the
ordinary language, capital means money. In Economics, capital refers to that part of man-made
wealth which is used for the further production of wealth. According to Marshall, “Capital
consists of those kinds of wealth other than free gifts of nature, which yield income”.

Forms of Capital/Livelihood Capitals

A. Physical Capital or Material Resources

B. Financial Capital or Monetary Resources, and

C. Human Capital or Human Resources

D. Natural Capital

E. Social Capital

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4. Organization or Enterprise

An entrepreneur is a person who combines the different factors of production (land, labour and
capital), in the right proportion and initiates the process of production and also bears the risk
involved in it. The entrepreneur is also called ‘organiser’. Entrepreneurship is risk taking,
managerial, and organizational skills needed to produce goods and services in order to gain a
profit. In modern times, an entrepreneur is called ‘the changing agent of the society’. He is not
only responsible for producing the socially desirable output but also to increase the social
welfare.

Functions of an Entrepreneur

1. Identifying Profitable Investible Opportunities: Conceiving a new and most promising

and profitable idea or capturing a new idea available in the market is the foremost
function of an entrepreneur. This is known as identifying profitable investible
opportunities.

2. Deciding the size of unit of production: An entrepreneur has to decide the size of the unit
– whether big or small depending upon the nature of the product and the level of
competition in the market.

3. Deciding the location of the production unit: A rational entrepreneur will always locate
his unit of production nearer to both factor market and the end-use market. This is to be
done in order to bring down the delay in production and distribution of products and to
reduce the storage and transportation cost.

4. Identifying the optimum combination of factors of production: The entrepreneur, after

having decided to start a new venture, takes up the task of hiring factors of production.
Further, he decides in what combinations he should combine these factors so that
maximum output is produced at minimum cost.

5. Making innovations: According to Schumpeter, basically an entrepreneur is an innovator

of new markets and new techniques of production. A new market increases the sales
volume whereas a new cost cutting production technique will make the product cheaper.
This will in turn increase the volume of sales and the profit.

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 6. Deciding the reward payment: The factors used in production have to be rewarded on
the basis of their productivity. Measuring the productivity of the factors and the payment
of reward is the crucial function of an entrepreneur.

7. Taking Risks and facing uncertainties: According to Hawley, a business is nothing but a
bundle of risks. Products are produced for future demand. The future is uncertain. The
investments are made in the present. This is the serious risk in production. One who is
ready to accept the risk becomes a successful entrepreneur. A prudent entrepreneur
forecasts the future risks scientifically and take appropriate decision in the present to
overcome such risks. According to Knight one of the important functions of entrepreneur
is uncertainty bearing.

PRODUCTION FUNCTION

The functional relationship between inputs and outputs is known as production function. Inputs
refer to the factor services which are used in production i.e. land, labour, capital and enterprise.
Output refers to the volume of goods produced.

Q = f (x1, x2, x 3….xn ) in which

Q is the quantity produced during a given period of time and x1, x2, x3 ….xn are the quantities
of different factors used in production i.e. Land, Labour, Capital, raw material etc...,

RELATIONSHIP BETWEEN MARGINAL PRODUCT AND TOTAL PRODUCT

(i) When marginal product is positive, the total product increases

a. When marginal product increases, the total product will be increasing at an increasing rate
b. When marginal product remains constant, the total product will be increasing at a constant
rate
c. When marginal product decreases but is positive, the total product will be increasing at a
decreasing rate
(ii) When marginal product is zero, the total product reaches the maximum and remains constant
(iii) When marginal product is negative, the total product decreases.

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Types of Production function

Production function may be classified into two:

1. Short-run production function: It refers to production in the short-run where there are some
fixed factors and variable factors. In the short-run, production will increase when more units of
variable factors are used with the fixed factor. Law of variable proportion comes under Short-
run production.

2. Long-run production function: It refers to production in the long-run where all factors
become variable. In the long-run, production can be increased by increasing units of all the
factors simultaneously and in the same proportion. Laws of returns to scale comes under long-
run production function.

LAW OF VARIABLE PROPORTION

The law of variable proportions states that as the quantity of one factor is increased, keeping the
other factors fixed, after a point, first the marginal and then the average product of that factor
will diminish. This law is also known as the “law of non-proportional returns” or “law of the
diminishing marginal returns”.

Assumptions of the law

1. Only one factor is variable and other factors are fixed

2. The variable factor units are homogenous
3. Input prices remain unchanged
4. The technology remains the same at a given point of time.
5. The entire operation is only for short-run
Stages of Law

Stage I: Stage of increasing returns

End of Stage I where the average product reaches its maximum point. During this stage, the
total product, the average product and the marginal product are increasing. It is notable that
the marginal product in this stage increases but in a later part it starts declining. Though
marginal product starts declining, it is greater than the average product so that the average
product continues to rise.

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 Stage II: Stage of decreasing returns

Stage II ends at the point where the marginal product is zero. In the second stage, the total
product continues to increase but at a diminishing rate. The marginal product and the average
product are declining but are positive. At the end of the second stage, the total product is
maximum and the marginal product is zero.

Stage III: Stage of negative returns

In this stage the marginal product becomes negative. The total product and the average
product are declining.

Table - Stages of Law of Variable Proportion

Fixed factor Variable Total Average Marginal Stages

Machine factor labour product product in product in
in units units units
1+ 1 10 10 10
1+ 2 22 11 12
1+ 3 36 12 14 Increasing Return
1+ 4 52 13 16
1+ 5 66 13.2 14
1+ 6 76 12.6 10
1+ 7 80 11.4 4
Decreasing Return
1+ 8 82 10.2 2
1+ 9 82 9.1 0
1+ 10 78 7.8 -4 Negative Return

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 Diagram of Law of Variable Proportion

The stage of Operation

In stage I the fixed factor is too much in relation to the variable factor. Therefore in stage I,
marginal product of the fixed factor is negative. On the other hand, in stage III the marginal
product of the variable factor is negative. Therefore a rational producer will not choose to
produce in stages I and III. He will choose only the second stage to produce where the marginal
product of both the fixed factor and variable factor are positive. At this stage the total product is
maximum. The particular point at which the producer will decide to produce in this stage
depends upon the prices of factors. The stage II represents the range of rational production
decisions.

LAWS OF RETURNS TO SCALE

The term ‘returns to scale’ refers to the response of total output to changes in all inputs by the
same proportion. The laws of ‘returns to scale’ refers to the effects of scale relationship. The law
of returns to scale states that when all factors of production are increased in the same proportion,
the output will increase but the increase may be at increasing rate or constant rate or decreasing
rate. The ratio of the proportionate change in output to a proportionate change in all inputs is
called the function coefficient.

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Assumption of the law

1. All the factors of production (such as land, labour and capital) are variable but
organization is fixed

2. There is no change in technology

3. There is perfect competition in the market

4. Outputs or returns are measured in physical quantities

5. The entire operation is only for long-run

Three phases of Returns to Scale

Phase I: Increasing returns to scale:

It occurs when the increase in output is more than proportional to increase in inputs. The first
stage starts from the point of origin and continues till the average product is maximum.

For example, if all the inputs are increased by 5%, the output increases by more than 5% i.e. by
10%. In this case the marginal product will be rising.

Phase II: Constant returns to scale:

It occurs when the increase in output is proportional to increase in inputs. If we increase all the
factors (i.e. scale) in a given proportion, the output will increase in the same proportion i.e. a 5%
increase in all the factors will result in an equal proportion of 5% increase in the output. Here the
marginal product is constant.

Phase III: Decreasing returns to scale:

It occurs when the increase in output is less than proportional to the increase in inputs.

For example: if all the factors are increased by 5%, the output will increase by less than 5% i.e.
by 3%. In this phase marginal product will be decreasing.

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Three Stages of Returns to Scale

Scale of inputs Total Marginal Stages

Product Product
1 Labour + 1 Capital 4 4
2 Labour + 2 Capital 10 6
Stage I : Increasing Returns
3 Labour + 3 Capital 18 8
4 Labour + 4 Capital 28 10
5 Labour + 5 Capital 38 10
Stage II : Constant Returns
6 Labour + 6 Capital 48 10
7 Labour + 7 Capital 56 8
Stage III : Decreasing Returns
8 Labour + 8 Capital 62 6

Diagram of Law of returns to scale

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PRODUCTION FUNCTION THROUGH ISO-QUANTS

The isoquant analysis helps to understand how different combinations of two or more factors are
used to produce a given level of output. Considering two factors of production, (capital and
labour) the following table shows various combinations of capital and labour that help a firm to
produce 500 units of a product.

Assumption of Isoquant

1. It is assumed that only two factors are used to produce a commodity

2. Factors of production can be divided into small parts
3. Technique of production is constant
4. The substitution between the two factors is technically possible
5. Under the given technique, factors of production can be used with maximum efficiency
Production with two variable inputs

Combination Units of Labour Units of Capital Output in units

A 2 5 500
B 4 4 500
C 6 3 500
D 8 2 500
E 10 1 500

Diagram – isoquant Curve

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Characteristics of an isoquant

1. The isoquant is downward sloping from left to right i.e. it is negatively sloped

2. An isoquant is convex to the origin because of the diminishing marginal rate of technical
substitution.

3. Non inter-section of Iso-quant curves

4. An upper iso-quant curve represents a higher level of output.

5. Iso-quant curve does not touch either X axis or Y axis.

Isocost Line

An isocost line is defined as locus of points representing various combinations of two factors,
which the firm can buy with a given outlay. Higher isocost lines represent higher outlays (total
cost) and lower isocost lines represent lower outlays.

It is otherwise called as “iso-price line” or “iso-income line” or “iso-expenditure line” or “total

outlay curve”.

Diagram of Iso cost line

PRODUCER’S EQUILIBRIUM

Producer equilibrium implies the situation where producer maximizes his output. It is also
known as optimum combination of the factors of production.

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 Producers’ Equilibrium

In the above figure, E is the point of equilibrium, where isoquant IQ2 is tangential to isocost line
at AB. Given budget line AB, points ‘P’, ‘N’ and ‘F’ are beyond the reach of the producer and
points ‘R’ and ‘S’ on isoquant IQ1 give less output than the output at the point of equilibrium ‘E’
which is on IQ2 . The amount spent on combinations R, E, S is the same as all the three points lie
on the same isocost line. But the output produced at point E is higher as E lies on a higher
isoquant.

COBB-DOUGLAS PRODUCTION FUNCTION

The simplest and the most widely used production function in economics is the Cobb-Douglas
production function. It is a statistical production function given by professors C.W. Cobb and
P.H. Douglas.

The Cobb-Douglas production function can be stated as follows

Q = bL a C 1-a in which
Q = Actual output
L = Labour
C = Capital
b = number of units of Labour
a = Exponent∗ of labour
1-a = Exponent∗ of Capital

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According to this production function, if both factors of production (labour and capital) are
increased by one percent, the output (total product) will increase by the sum of the exponents of
labour and capital i.e. by (a+1-a). Since a+1-a =1, according to the equation, when the inputs are
increased by one percent, the output also increases by one percent. Thus the Cobb Douglas
production function explains only constant returns to scale. In this production function, the sum
of the exponents shows the degree of “returns to scale” in production function.

a + b >1 : Increasing returns to

scale a + b =1 : Constant returns to

scale

a + b <1 : Decreasing returns to scale

Note: * Exponent- a raised figure or symbol that shows how many times a quantity must be
multiplied by itself. For example in a4 - 4 is the exponent.

PRODUCTION POSSIBILITY CURVE

A production possibility curve measures the maximum output of two goods using a fixed amount
of input. The PPC, which assumes that production is optimally efficient, is alternatively referred
to as the "production possibility curve" or the "transformation curve."

Assumption of PPC

1. There is no change in the production technique

2. It can produce the two goods X and Y in different proportions

3. The amount of factors of productions are fixed

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 Production possibility Schedule

Production Quantity of Apples Quantity of Oranges

Possibility
Schedule
Possibilities
A 4 0
B 3 2
C 2 4
D 1 6
E 0 8

Production Possibility Curve

In the above schedule and figure, A and E are possibilities where the economy either produces
100 percent of apples or 100 percent of oranges alone. But the production possibility curve
assumes the production of two goods in different combinations. Possibilities A, B,C ,D and E are
such that the economy produces 4 units of apples and 0 units of oranges in possibility A, 3 units
of apples and 2 units of orange in possibility B, 2 units of apples and 4 units of oranges in
possibility C, 1 unit of apple and 6 units of oranges in possibility D, 0 unit of apples and 8 units
of oranges in possibility E.

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ECONOMIES OF SCALE

‘Economies’ mean advantages. Scale refers to the size of unit. ‘Economies of Scale’ refers to the
cost advantages due to the larger size of production. As the volume of production increases, the
overhead cost will come down. The bulk purchase of inputs will give a better bargaining power
to the producer which will reduce the average variable cost too. All these advantages are due to
the large scale production and these advantages are called economies of scale.

TYPES OF ECONOMIES OF SCALE

1. Internal Economies of Scale:

‘Internal economies of scale’ are the advantages enjoyed within the production unit. These
economies are enjoyed by a single firm independently of the action of the other firms. For
instance, one firm may enjoy the advantage of good management; another may have the
advantage of more up-to-date machinery.

Kinds of internal economies

1. Technical Economies: As the size of the firm is large, the availability of capital is
more. Due to this, a firm can introduce up- to-date technologies; thereby the increase in
the productivity becomes possible. It is also possible to conduct research and development
which will help to increase the quality of the product.

2. Financial Economies: It is possible for big firms to float shares in the market for
capital formation. Small firms have to borrow capital whereas large firms can buy capital.

3. Managerial Economies: Division of labour is the result of large scale production. Right
person can be employed in the right department only if there is division of labour. This
will help a manager to fix responsibility to each department and thereby the productivity
can be increased and the total production can be maximized.

4. Labour Economies: Large Scale production paves the way for division of labour. This
is also known as specialization of labour. The specialization will increase the quality and
ability of the labour. As a result, the productivity of the firm increases.

5. Marketing Economies: In production, the first buyer is the producer who buys the raw
materials. As the size is large, the quantity bought is larger. This gives the producer a

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 better bargaining power. Also he can enjoy credit facilities. All these are possible because
of large scale production. Buying is the first function in marketing.

6. Economies of survival: A large firm can have many products. Even if one product fails
in the market, the loss incurred in that product can be managed by the profit earned from
the other products.

2. External economies of scale:

When many firms expand in a particular area – i.e., when the industry grows – they enjoy a
number of advantages which are known as external economies of scale. This is not the advantage
enjoyed by a single firm but by all the firms in the industry due to the structural growth. They are

a) Increased transport facilities

b) Banking facilities

c) Development of townships

d) Information and communication development

All these facilities are available to all firms in an industrial region.

DISECONOMIES OF SCALE

The diseconomies of the scale are a disadvantage to a firm or an industry or an organization.

This necessarily increases the cost of production of a commodity or service. Further it delays the
speed of the supply of the product to the market.

These diseconomies are of two types:

a) Internal Diseconomies of Scale: and

b) External Diseconomies of Scale

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a. Internal Diseconomies of Scale: If a firm continues to grow and expand beyond the optimum
capacity, the economies of scale disappear and diseconomies will start operating. For instance, if
the size of a firm increases, after a point the difficulty of management arises to that particular
firm which will increase the average cost of production of that firm. This is known as internal
diseconomies of scale.

b. External Diseconomies of Scale: The term “External diseconomies of scale” refers to the
threat or disturbance to a firm or an industry from factor lying outside it. For example a bus
strike prevents the easy and correct entry of the workers into a firm. Similarly the rent of a firm
increases very much if new economic units are established in the locality.

COST ANALYSIS

Cost refers to the total expenses incurred in the production of a commodity. The functional
relationship between cost and output is expressed as ‘Cost Function’.

A Cost Function may be written as

C = f (Q)

where, C=Cost and Q=Quantity of output.

The determinants of cost of production are: the size of plant, the level of production, the nature
of technology used, the quantity of inputs used, managerial and labour efficiency.

Cost Concepts and Classification

1. Money Cost

2. Real Cost

3. Explicit Cost

4. Implicit Cost

5. Economic Cost

6. Social Cost

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 7. Opportunity Cost

8. Sunk Cost

9. Floating Cost

10. Prime Cost

11. Fixed Cost

12. Variable Cost

1. Money Cost : Money cost or nominal cost is the total money expenses incurred by a firm in
producing a commodity. It includes: cost of raw materials, payment of wages and salaries,
payment of rent, interest on capital, expenses on fuel and power, expenses on transportation
and so on.

2. Real Cost : Real cost is a subjective concept. Real cost refers to the payment made to
compensate the efforts and sacrifices of all factor owners for their services in production. It
includes the efforts and sacrifices of landlords in the use of land, capitalists to save and invest,
and workers in foregoing leisure.

3. Explicit Cost : Explicit costs are the payments made by the entrepreneur to the suppliers of
various productive factors. Explicit cost includes, wages, payment for raw material, rent for
the building, interest for capital invested, expenditure on transport and advertisement, other
expenses like license fee, depreciation and insurance charges, etc. It is also called Accounting
Cost or Out of Pocket Cost or Money Cost.

4. Implicit Cost : The money rewards for the own services of the entrepreneur and the factors
owned by himself and employed in production are known as implicit costs or imputed Costs.

5. Economic Cost: It refers to all payments made to the resources owned and purchased or hired
by the firm in order to ensure their regular supply to the process of production.

Economic Cost = Implicit Cost + Explicit Cost

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6. Social Cost: It refers to the total cost borne by the society due to the production of a
commodity. Social Cost is the cost that is not borne by the firm, but incurred by others in the
society. For example, large business firms cause air pollution, water pollution and other
damages in a particular area which involve cost to the society. It is also called as External
Cost.

7. Opportunity Cost : It refers to the cost of next best alternative use. In other words, it is the
value of the next best alternative foregone. For example, a farmer can cultivate both paddy
and sugarcane in a farm land. If he cultivates paddy, the opportunity cost of paddy output is
the amount of sugarcane output given up. Opportunity Cost is also called as ‘Alternative Cost’
or ‘Transfer Cost’.

8. Sunk Cost : A cost incurred in the past and cannot be recovered in future is called as Sunk
Cost. Sunk cost are unalterable, unrecoverable, and if once invested it should be treated as
drowned. For example, if a firm purchases a specialized equipment designed for a special
plant, the expenditure on this equipment is a sunk cost, because it has no alternative use Sunk
cost is also called as ‘Retrospective Cost’.

9. Floating Cost: It refers to all expenses that are directly associated with business activities but
not with asset creation. It does not include the purchase of raw material as it is part of current
assets. It includes payments like wages to workers, transportation charges, fee for power and
administration. Floating cost is necessary to run the day-to-day business of a firm.

10. Prime Cost: All costs that vary with output, together with the cost of administration are
known as Prime Cost. In short, Prime cost = Variable costs + Costs of Administration.

11. Fixed Cost : Fixed Cost does not change with the change in the quantity of output. In other
words, expenses on fixed factors are called as fixed cost. For example, rent of the factory,
watchman’s wages, permanent worker’s salary, payments for minimum equipments and
machines insurance premium, deposit for power, license fee, etc fixed cost is also called as
‘Supplementary Cost’ or ‘Overhead Cost’.

12. Variable Cost : These costs vary with the level of output. In other words, the costs incurred
on variable factors are called variable costs. Examples of variable costs are: wages of

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 temporary workers, cost of raw materials, fuel cost, electricity charges, etc. Variable cost is
also called as Prime Cost, Special Cost, or Direct Cost.

SHORT-RUN AND LONG-RUN COST CURVES

Short-run is defined as that period of time in which the firm can expand or contract its output
only by varying the amounts of variables factors such as labour and raw materials. In the short
period the size of the plant cannot be altered. More production is possible only by over working
the existing plant or by hiring more workers and by purchasing and using more raw materials.

Long-run is defined as that period of time in which both fixed and variable factors are variable
and both the factors can be adjusted. Over a long period of time, the firm can expand its output
by enlarging the size of the existing plant or by building a new plant of a greater productive
capacity.

TOTAL COST

Total cost is the sum of total fixed cost and total variable cost.

TC = TFC + TVC

where

TC = Total cost

TFC = Total Fixed cost

TVC = Total variable cost

The relationship between total fixed cost, total variable cost and total cost will be clear from
following the Figure;

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Average Fixed Cost (AFC)

The average fixed cost is the fixed cost per unit of output. It is obtained by dividing the total
fixed cost by the number of units of the commodity produced.

AFC = TFC / Q

Where AFC = Average fixed Cost

TFC = Total Fixed cost

Q = number of units of output produced

Example:

Suppose for a firm the total fixed cost is Rs 5000 when output is 100 units, AFC will be Rs
5000/100 = Rs 50

Average Variable cost (AVC):

Average variable cost is the variable cost per unit of output. It is the total variable cost divided
by the number of units of output produced.

AVC = TVC / Q

Where AVC = Average Variable Cost

TVC = Total Variable Cost

Q = number of units of output produced

Diagrammatially, the AVC is ‘U’ shaped. The law of variable proportions provides the
fundamental explanation for the shape of this curve. It means that the AVC curve first falls,
reaches a minimum and then begins to increase.

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Average Total Cost or Average Cost (AC)
Average total cost is simply called average cost which is the total cost divided by the number of
units of output produced.

AC = TC / Q

where

AC = Average Cost

TC = Total Cost

Q = number of units of output produced

Average cost is the sum of average fixed cost and average variable cost.

i.e. AC = AFC+AVC

Calculation of Average Fixed, Average variable and Average Total Cost

Units of TFC TVC TC AFC AVC AC

Output 2 3 2+3 2÷1 3÷1 5+6
1 4 5 6 7
0 120 0 120 0 0 0
1 120 100 220 120 100 220

2 120 160 280 60 80 140

3 120 210 330 40 70 110

4 120 240 360 30 60 90

5 120 400 520 24 80 104
6 120 540 660 20 90 110
7 120 700 820 17.14 100 117.14
8 120 880 1000 15 110 125

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The average cost is also known as the unit cost since it is the cost per unit of output produced.
The following figure shows the shape of AFC, AVC and ATC in the short period.

From the above figure, it can be understood that the behavior of the average total cost curve
depends on the behaviour of AFC and AVC curves. In the beginning, both AFC and AVC fall.
So ATC curve falls. When AVC curve begins rising, AFC curve falls steeply i.e, fall in AFC is
more than the rise in AVC. So ATC curve continues to fall. But as output increases further, there
is a sharp increase in AVC, which is more than the fall in AFC. Hence ATC curve rises after a
point. The ATC curve like AVC curve falls first, reaches the minimum value and then rises.
Hence it has taken a U shape.

Marginal cost (MC)

It is the cost of the last single unit produced. It is defined as the change in total costs resulting
from producing one extra unit of output. In other words, it is the addition made to the total cost
by producing one extra unit of output. Marginal cost is important for deciding whether any
additional output can be produced or not.

MC = ΔTC / ΔQ

where

MC = Marginal Cost,

ΔTC = change in total cost and

ΔQ = change in total quantity.

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For example, a firm produces 4 units of output and the Total cost is Rs. 1600. When the firm
produces one more unit (4 +1 = 5 units) of output at the total cost of Rs. 1900, the marginal cost
is Rs.300.

MC = 1900 – 1600 = Rs. 300.

The other method of estimating MC is :

MC=TCn –TCn-1 or TCn+1 –TCn

where,

MC = Marginal Cost,

TCn = Total cost of ‘n’th item,

TCn-1 = Total Cost of ‘n-1’ th

item, TCn+1 = Total Cost of n+1

th item. For example,

when TC4 = Rs.1600, TC(4-1)=Rs.1400 and then MC= Rs.200, (MC=1600-1400) when TC4 =
Rs.1600, TC(4+1)=1900 and then MC= 300. It is to be noted that;

a) MC falls at first due to more efficient use of variable factors.

b) MC curve increases after the lowest point and it slopes upward.

c) MC cure is a U-shaped curve.

d) The slope of TC is MC.

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RELATIONSHIP BETWEEN AVERAGE AND MARGINAL COST CURVES

1) When marginal cost is less than average cost, average cost is falling

2) When marginal cost is greater than the average cost, average cost is rising

3) The marginal cost curve must cut the average cost curve at AC’s minimum point from below.
Thus at the minimum point of AC, MC is equal to AC.

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LONG RUN COST CURVE

In the long run all factors of production become variable. The existing size of the firm can be
increased in the case of long run. There are neither fixed inputs nor fixed costs in the long run.

Long run average cost (LAC) is equal to long run total costs divided by the level of output.

LAC = LTC/Q

where,

LAC = Long-Run Average Cost,

LTC= Long-run Total Cost and

Q = the quantity of output.

The LAC curve is derived from short-run average cost curves. It is the locus of points denoting
the least cost curve of producing the corresponding output. The LAC curve is called as ‘Plant
Curve’ or ‘Boat shape Curve’ or ‘Planning Curve’ or ‘Envelop Curve’.

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BREAK EVEN POINT (BEP) ANALYSIS

 Break-even analysis is a technique widely used by production management and

management accountants. It is based on categorizing production costs between those
which are "variable“ and those that are "fixed" costs.

 Break-even is a situation where you are neither making money nor losing money, but all
your costs have been covered. A business’s break-even point is the stage at which
revenues equal costs.

 Generally, a company with low fixed costs will have a low break-even point of sale. For
an example, a company has a fixed cost of Rs.0 (zero) will automatically have broken
even upon the first sale of its product.

 It is a function of three factors, i.e. sales volume, cost and profit. Hence it is also known
as “cost-volume-profit analysis”.

Break-Even Point (Units) = Total Fixed Costs ÷ (Selling Price – Average Variable Cost)

Example:

Suppose the fixed cost of a factory in Rs. 10,000, the selling price is Rs. 4 and the average
variable cost is Rs. 2, so the break-even point would be

ВЕР = 10,000/(4-2) = 5,000 units.

BEP Diagram

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In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis.
Total revenue (TR) curve is shown as linear, as it is assumed that the price is constant,
irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Linearity of the total cost (TC) curve results from the
assumption of constant variable cost.

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