Unit IV

Analysis of Costs Production, and

Revenues.
Objectives

► Aim of the firm as an organization.

► Production Decision
► Production Function (Short-run and Long Run)
► Law of diminishing return (Variable return)
► Return to Scale
► Cost of Production and Cost curves
► Isocost curve
► Long run and short run cost curve
► Revenue Analysis
► Profit Maximization
Organization of Production

► Production: Transformation of Inputs into Output. Output can be final

commodity or intermediate product. It can be service or a good.
► It includes all activities borrowing, expanding facilities, hiring, purchasing
raw materials, quality control, cost accounting etc.

► Inputs: resources used in production ( K, L, land, natural resources)

► Ffxed Inputs: it cannot be changed easily during the time-period under
consideration.
► Variable inputs: it can be changed easily during the time-period under
consideration.

► Time Period
► Short-Run: the time period during which at least one input is fixed
► Long run : all the inputs are variable
Assumptions of Production Function

► Fixed Technology
► Efficient Use of Inputs
► Homogeneity of Inputs
► Short-Run vs. Long-Run Analysis
► Divisibility of Inputs
► Perfect Knowledge
The Production Function
Production function with one variable
Input (Short-Run)
►

6
Total Average and Marginal Product

K is fixed as 3 units, Labour is variable

No of Total Marginal Average Output

Labour Output Output Output Elasticity
1 10 - 10
2 23 13 11.5
3 33 10 11
4 36 3 9
5 36 0 7.2
6 33 -3 5.5
Total, Marginal and Average Product of
Labour
When the MP declines, the
production function becomes
flatter.
As long as MP of a worker is
positive, you can add to your
output by hiring more
workers.
MP = 0, an extra worker adds
to no extra output. That
means at that point when MP
= 0, you have maximized your
output.
Diminishing marginal product
is the property whereby the
MP of an input declines as the
quantity of the input such as
labor increases.
 Diminishing Marginal Product
▪ In a short run production function, MPL declines as more and more
workers are hired at a firm,
▪ if each additional worker contributes less and less to production
because the firm has a limited amount of equipment, then we have
diminishing MP in the production process.
▪ If a firm has only 2 computers but hires 4 people, then 2 workers
have to share a computer and thus the productivity of a worker
declines.
▪ If there are only two workers, in that case productivity of each
worker will be higher.
 Production Function

Total product in short run:

sl. land labour TP
no. (acres) (worker) tonnes APL MPL
1 1 0 0 0 0
2 1 1 3 3 3
3 1 2 8 4 5
4 1 3 12 4 4
5 1 4 15 3.75 3
6 1 5 17 3.4 2
7 1 6 17 2.83 0
8 1 7 16 2.28 -1
9 1 8 13 1.62 -3
Average and Marginal product

If we increase the quantity of a

variable input (Labour) and keep
the fixed input (K) constant then
MPL, APL will decline.

APL curve rises at first, reaches a

maximum and then falls, but it
remains positive as long as TP is
positive.

MPL is the slope of TP. It rises first

And reaches the peak before APL
and then Declines. It is zero when
TP is at its peak and then becomes
negative. Fallen portion of this
indicated law of diminishing returns
Relation between MPL & APL
sl. land labour TP
no. (acres) (worker) tonnes APL MPL
1 1 0 0 0 0
2 1 1 3 3 3
3 1 2 8 4 5
4 1 3 12 4 4
5 1 4 15 3.75 3
6 1 5 17 3.4 2
7 1 6 17 2.83 0
8 1 7 16 2.28 -1
9 1 8 13 1.62 -3

Stage-1: From origin till APL is maximum.

Stage-2: From maximum APL till MPL is zero. Producer will try to remain in
this stage.
Stage-3: Till MPL is negative. The producer will not operate even if labour is
free.
Three Stages of Production in Short
Run
AP,MP
Stage I Stage II Stage III

APX

•TPL Increases at MPX X

•TPL Increases at
Diminshing rate. • TPL begins to
increasing rate.
•MPL Begins to decline. decline
•MP Increases at
decreasing rate. •TP reaches maximum •MP becomes
level at the end of negative
•AP is increasing stage II, MP = 0.
and reaches its •APL declines •AP continues
13
to
maximum at the decline
end of stage I
Optimal Use of the Variable Input

►
 Economies of Scale

Cost advantages business enjoys as it increases

production. When the scale of production
expands, the average cost per unit falls.
These are the cost savings that arise when the
business grows in its production or operations
 Types of Economies of Scale

1. Internal economies
2. External economies
 Types of Economies of Scale

Internal Economies
Technical economies of scale: Use of specialized equipment
or production techniques that become more efficient as
output increases.

Purchasing economies of scale: Ability to negotiate better

prices for raw materials, components, or finished products
as the volume of purchases increases.
 Types of Economies of Scale

Financial economies of scale: Ability to borrow money at

lower interest rates due to the bigger size of the
organization.

Economies in Marketing and Distribution: Companies

distribute their marketing and distribution costs over more
units when they produce in larger volumes.

Managerial Economies
 Types of Economies of Scale

External Economies

Economies of concentration
Economies of Information
Tax benefits
Shared R & D facilities
 Diseconomies of Scale

Diseconomies of Scale:
The negative effects that an organization
experiences as a result of expansion, which leads
to inefficiencies.

Diseconomies of scale occur when an additional

production unit of output increases marginal costs,
which results in reduced profitability.
Reasons for Diseconomies of Scale

Lack of coordination
Lack of motivation
Communication Breakdown
Increased Transportation and Distribution
Economies of Scope

Decrease in the total cost of production when

products are produced together rather than
separately.
Importance

Shared Resources
Marketing Synergies
Distribution Efficiency
Importance

► Reduces the cost

► Diversification of product line
► Competitive advantage
► Firms can enter into related markets
 Perfect competition

A Perfect Competition market is that type of market

in which the number of buyers and sellers are very
large, all are engaged in buying and selling a
homogeneous product without any artificial
restrictions and possessing perfect knowledge of the
market at a time.
 Features of Perfect competition

1. Large number of buyers and sellers

2. Homogenous product is produced by every firm
[Link] entry and exit of firms
4. Absence of Selling Costs
5. Consumers have perfect knowledge about the
market and are well aware of any changes in the
market
6. All the factors of production, viz. labour, capital,
etc, have perfect mobility in the market
 Features of Perfect competition

7. No government intervention
8. Each firm earns normal profits and no firms can
earn super-normal profits
9. Every firm is a price taker
Short Run equilibrium in Perfect competition
 Short Run equilibrium in Perfect competition

The firm is earning supernormal gain or profit in this case at

point E1,the equilibrium condition is satisfied. At this
equilibrium point, the output will be OA1 and the total
revenue earns is OA1E1P1 and total cost is [Link] profit
is HP1E1G.
 Short Run equilibrium in Perfect competition

In the second graph, firm is earning only normal profits, The equilibrium
price and output is at OP2and [Link] the cost of production and the
revenue are the same the firm enjoys the normal profit instead of extra
profit or loss.
E2 is called the breakeven point.
 Short Run equilibrium in Perfect competition

In the third graph, firm attains the equilibrium and suffers

from loss, the firm incurs loss in the short run because the
average cost of producing the output is more than the ruling
price.
Exit or shut down
 Short Run equilibrium in Perfect competition

If the prevailing price in the market is more than the Average

Variable cost of production, the firm would continue the
production.
If AVC exceeds AR, the firm would shut down.
long Run equilibrium in Perfect competition
 long Run equilibrium in Perfect competition

In the long run perfectly, competitive firms can earn only

normal profits.
Reason is unrestricted entry and exit of the fir.
These encourages the firms to enter the market. supply will
increase price will decrease affects the profit and the firms
which are incurring loss may leave the market, supply will
decrease and Price will increase.