MBA: SEMESTER: 1

MANAGERIAL ECONOMICS

MODULE II

Dr. Boola Choudhary

Associate Professor, FoM
 THEORY OF PRODUCTION
• Creation of utility which has market value is called Production.
• Production should create following types of Utilities:
• 1) Form Utility: making the good available in that particular form in which
they are not generally available.
• 2) Place Utility: making the good available where they're not generally
available.
• 3) Time Utility: making the good available when they are not generally
available.
• 4) Service Utility: making the goods available which provide those services
that are not generally provided.
 PRODUCTION FUNCTION
• Hey it shows physical/technical/functional relationship between factors of
production and output.
• Q= f (L,K)
• Production function is physical relationship because we take physical quantities of
inputs and output.
• Functional because it shows cause and solution relationship.
• Technical relationship because production process should be technically possible or
feasible.
• Technically feasible or efficient production process is that production process which
gives more output with minimum capital output ratio in inputs.
• K/O in inputs minimum→ output increase.
• Long Run Production Function : All factors of production can be changed.
• Q = f( L, K, T, N)
• In this case, returns to scale works.
• Short Run Production Function: Only one input is increased keeping
others constant.
• Q = f( L, K, T, N)
• In this case, law of variable proportions works.
• →In short run production function size of plant can't be increased.
• →In long run production function size of plant can be increased. If the size
of plant is doubled then other factors should also be doubled.
 LAW OF VARIABLE PROPORTIONS
Assumptions:
• 1) It is a short run concept.
• 2) Only one factor input is increased (L) keeping others constant (K).
• 3) Level of technology is given and constant.
• This law is also known as Law of Diminishing Returns.
• Law of diminishing returns implies that when we vary one input only
keeping other inputs constant then productivity of that variable
input start declining (initially 𝑀𝑃𝐿 and then 𝐴𝑃𝐿 ). Here, L is the
variable input.
• Law of Variable Proportions:
• If we increase one input keeping others inputs constant then after a point of
time productivity of variable input starts declining, first 𝑀𝑃𝐿 and then the
𝐴𝑃𝐿 .
• It is called law of variable proportions because when one input is changed
(i.e. Labour) keeping other inputs (K) constant, then the labour capital ratio
varies. Since, labour capital ratio is variable, thus, it is called LOVP.
• LVP stresses on diminishing variable proportions. Therefore, it is a part of 3
stages of production.
• Three Stages of Production:
• Due to increase in input, output may change in same proportion, less or more
than increase in input. This will determine 3 stages of production. Three
stages of production says that there will be increasing, diminishing, and
negative returns to scale.
• TPL = Total Productivity of Labour.
• MPL = marginal productivity of labour.
• It is the change in total product when there is one unit change in labour.
• MPL = 𝑇𝑃𝑛−1 − 𝑇𝑃𝑛
∆𝑻𝑷𝑳
• 𝐌𝐏𝐋 =
∆𝑳

• It is the slope of tangent drawn at a point on TPL curve.

• APL = average productivity of labour.

𝑻𝑷𝑳
• 𝐀𝐏𝐋 =
𝑳

• It is the slope of ray drawn from origin to point of production. Ray at pt. B is
highest from origin, that is why APL is max at this pt.
• Relationship between 𝑇𝑃𝐿 and 𝑀𝑃𝐿 :
• A) when 𝑇𝑃𝐿 ↑, then 𝑀𝑃𝐿 >0
• B) when 𝑇𝑃𝐿 is max., then 𝑀𝑃𝐿 =0
• C) when 𝑇𝑃𝐿 ↓, then 𝑀𝑃𝐿 <0

• Relationship between 𝐴𝑃𝐿 and 𝑀𝑃𝐿 :

• A) when 𝐴𝑃𝐿 ↑, then 𝑀𝑃𝐿 > 𝐴𝑃𝐿
• B) when 𝐴𝑃𝐿 is max., then 𝑀𝑃𝐿 =
𝐴𝑃𝐿
• C) when 𝐴𝑃𝐿 ↓, then 𝑀𝑃𝐿 < 𝐴𝑃𝐿
• In the beginning TPL curve increases at an increasing
rate upto point A, and till here TPL curve is convex to X-
axis. Point A is the point of inflection, where curve
changes its shape. From point A, TPL increases at
decreasing rate and becomes concave to origin till point
C. At point C, TPL is maximum. From here, TPL starts
declining and at the same time MPL becomes negative.
 Three stages of production:
• First Stage of Production: (Stage of Increasing Returns)
• It starts from the point of origin and ends at a point where APL is maximum (pt. B).
• It doesn’t end at point A because all though MPL is decreasing but APL is still
increasing.
• TPL → increases initially at increasing rate and after a point (A) at decreasing rate.
• APL → increases and becomes maximum.
• MPL → increases and becomes maximum and then starts declining but remains
positive.
• In this stage, output increases at increasing rate and then at diminishing rate.
Reasons for Increasing Returns:
1) While starting production, variable input is less. As production increases variable
input will increase and other factors will be constant, which are already more in
number. Increasing variable input will lead to better utilization of fixed input .
2) There is specialization and division of Labour.
→ Output shouldn’t take place in this stage.
• Second Stage of Production: (Stage of Diminishing Returns)
• It starts from a point where APL is hey maximum (B) he ends at a point where
TPL is maximum (C).
• Here,
• TPL → increases initially at decreasing rate and becomes maximum.
• APL → decreases continuously and remains positive.
• MPL → decreases continuously and becomes zero.
Reasons for Decreasing Returns:
• 1) The inputs are imperfect substitutes.
• 2) After pt. B, the optimum combination between 2 inputs is disturbed, as
variable factors are more than required for fixed factors.
• Production should take place in this stage.
• Third Stage of Production: (Stage of Negative Returns)
• It starts at a pt. where TPL is maximum and MPL = 0.
• Here,
• TPL and APL decreases and MPL < 0
• Therefore, Production is not possible in this stage.
• In this state, variable input is utilised excessively due to rise in
it intake, this will reduce output.
 Stage of operation:
3rd stage can't be stage of production because here MPL is negative, i.e. Hey
labour is increased so much that its productivity has declined and there will be
fall in output.
Output can be increased by reducing Labour→ TPL ↑
Also, in perfect competition, factors are paid according to the marginal
productivity and since MPL is negative, there payments will also be negative,
which is not possible.
Therefore, rational producer will not produce in this stage.
Rational producer will also not produce in stage I because MPL will increase as
labor is less in quantity but MPK will be negative (as its 3rd stage for capital).
Hence, a rational producer will produce in second stage as L↑ and MPL ↑
Thus, it's beneficial to increase output.
 ISOQUANTS:

• An isoquant shows various combinations of two inputs which can produce

same level of output.
• 𝑸𝒐 = 𝒇(𝑳, 𝑲)
• Where, 𝑄 𝑜 = constant output level.
• In case of IC, utility can be measured by IC whereas, IQ can measure
output. Other properties are same.
∆𝐾 𝑀𝑃𝐿
• Slope of IQ = = − <0
∆𝐿 𝑀𝑃𝐾
• IQ is negatively sloped, because MPL and MPK > 0
• Output remains constant on a IQ.
 MARGINAL RATE OF TECHNICAL SUBSTITUTION:

• 𝑀𝑅𝑇𝑆𝐿𝐾 (labour for capital) shows rate at which quantity of capital which an
entrepreneur is willing to sacrifice to get one more unit of Labour so that total
output remains constant.
−∆𝐾 𝑀𝑃𝐿
• 𝑀𝑅𝑇𝑆𝐿𝐾 = = >0 (movement downward)
∆𝐿 𝑀𝑃𝐾
• 𝑀𝑅𝑇𝑆𝐿𝐾 is the negative of the slope of isoquant.
• Thus, the value of 𝑀𝑅𝑇𝑆𝐿𝐾 will always be positive.
−∆𝐿 𝑀𝑃𝐾
• Similarly, 𝑀𝑅𝑇𝑆𝐾𝐿 = = (movement upward)
∆𝐾 𝑀𝑃𝐿
• It shows number of labourers which an entrepreneur is willing to sacrifice while
keeping output constant.
• In real life Labour and capital can't be substituted. hey generally they are
complimentary.
• Therefore, when 𝑀𝑃𝐿 and 𝑀𝑃𝐾 > 0, then slope of isoquant is negative and MRTS
is positive.
 Iso-cost line

• An iso-cost line shows various combinations of labour and capital which a firm
can purchase with a given total outlay and factor prices.
• 𝑪 = 𝑳𝑷𝑳 + 𝑲𝑷𝑲
• Or, C = w L + r K
• Where, C = total cost
• L = amount of labour employed
• K = amount of capital employed
• PL = price of labour (w)
• PK = price of capital (r)
• C = LPL + KPK
• KPK = C − LPL
𝐶 𝑃𝐿
• K= − L
𝑃𝐾 𝑃𝐾

𝑃𝐿
• = ratio of factor prices.
𝑃𝐾
• Negatively sloped iso-cost line implies that as more labourers are employed capital
becomes less, i.e. total cost is given which acts as a constraint.
𝐶 𝐶
• → intercept on vertical axis implies that is the total capital invested when L=0.
𝑃𝐾 𝑃𝐾
OPTIMUM FACTOR COMBINATION: PRODUCER’S EQUILIBRIUM
• The equilibrium of a firm is determined under 2 objectives of
producer:
• 1) Minimization of cost subject to given output/ least cost
combination/ constraint cost minimization.
• 2) Maximisation of output subject to given cost.
• On the other hand, consumer has one objective, which is
maximization of utility subject to budget constraint.
 Minimization of cost subject to given output→ LCC:
• Equilibrium point →E, where IC line is tangent to IQ.
• L1 and K1 are the amount of labour and capital used.
𝑃𝐿
• Pt. A and B are not feasible because 𝑀𝑅𝑇𝑆𝐿𝐾 >
𝑃𝐾
• Equilibrium condition:
• 1) IC line should be tangent to IQ, i.e.
• Slope of IQ = Slope of IC line
𝑀𝑃𝐿 𝑃𝐿
• =
𝑀𝑃𝐾 𝑃𝐾
𝑃𝐿
• Or, 𝑀𝑅𝑇𝑆𝐿𝐾 =
𝑃𝐾
• 2) IQ should be convex to origin.
• Both the conditions are satisfied at pt. E.
• Thus, E→ least cost combination pt. and L1 and K1 are the least cost combinations.
 Maximization of output subject to given cost:
• Equilibrium condition:
• 1) IC line should be tangent to IQ, i.e.
• Slope of IQ = Slope of IC line
𝑀𝑃𝐿 𝑃𝐿
• =
𝑀𝑃𝐾 𝑃𝐾
• 2) IQ should be convex to origin.
• Both the conditions are satisfied at pt. E.
• Thus, output is maximized at pt. E rather
than pt. A and B(where output is less) under
given cost.
• Here, L1 and K1 are optimum factor
combinations.
 Law of returns to scale:
• It is a long run concept when all the inputs are increased by the same
proportion. There will be 3 stages or situations:
• 1) Increasing Returns to Scale (IRS):
• When we increase inputs by some proportions then output will be increased
proportionately more than increase in the inputs.
• Some economists have pointed certain factors for increasing returns to scale:
• A) Indivisibility of factors
• B) Greater possibilities of specialization of labour and machinery.
• C) Dimensional economies.
• 2) Constant Returns to Scale (CRS):
• When inputs are increased in some proportion, then output will be
increased by same proportion.

• 3) Decreasing Returns to Scale (DRS):

• When inputs are increased by some proportion then output will
increase proportionately less than the increase in the inputs.
 IRS:
• OR→ ray from origin which shows that equal proportion of L and K are
used. (i.e. if L is doubled then K will also be doubled).

• Here, the distance between consequent IQs (IQ1, IQ2, IQ3, IQ4) goes
on decreasing which means less amount of inputs can increase output.
 DRS:
• Here, the distance between consequent IQs (IQ1, IQ2, IQ3, IQ4) goes on
increasing which means to increase output, inputs must be increased
proportionately more than output.
 CRS:
• Here, the distance between consequent IQs (IQ1, IQ2, IQ3, IQ4) remains
constant, which means to output will be increased in same proportion
as increase in inputs.
• Therefore, to increase output, input should be increased in same
proportion.
ISOQUANTS

• EXPANSION PATH:
• It’s the line connecting various
tangency (equilibrium) points of
isoquants and indifference curves
line when only cost changes.
• The constraint cost minimization
and constraint output maximization
points lie on the expansion path.
• The profit maximization point will
also lie on the expansion path.
 Price- factor Curve:
• It’s the line connecting different
tangency points of Iso-quants and
Iso-cost lines when only factor
prices changes.
 Isocline:

• It’s the locus of different points of Isoquants where MRTS is constant.

 Technical Progress and Production Function:

• When there is technical progress then production function

shifts upwards and isoquant shifts downwards.
• i.e. with same resources we can produce more output
• Or
• We can produce same output with decline in inputs.
• If after technical progress the isoquant shifts downwards and if input
prices are constant then K/L ratio will be increasing. This implies technical
progress is capital deepening.
 Hicks has distinguished 3 types of technical progress:

• Capital Deepening TP: Technical progress capital deepening (or capital using)
if along a line (a ray drawn) on which the capital Labour ratio (K/L) is constant
and 𝑀𝑅𝑇𝑆𝐿𝐾 declines that is 𝑀𝑃𝐾 increases more than 𝑀𝑃𝐿 .
• From A to B→ 𝑀𝑅𝑇𝑆𝐿𝐾 has declined in the diagram.
• Slope of tangent line drawn at B is lesser than the slope at pt. A.
𝑀𝑃𝐿
• 𝑀𝑅𝑇𝑆𝐿𝐾 = ↓ and slope of Isoquants increases.
𝑀𝑃𝐾
 𝑀𝑃𝐿
• Labour Deepening TP: 𝑀𝑅𝑇𝑆𝐿𝐾 = ↑
𝑀𝑃𝐾
• 𝑀𝑃𝐿 increases more than 𝑀𝑃𝐾 .
• slope of Isoquants decreases.

𝑀𝑃𝐿
• Neutral TP: 𝑀𝑅𝑇𝑆𝐿𝐾 = (same)
𝑀𝑃𝐾
• 𝑀𝑃𝐿 = 𝑀𝑃𝐾 .
• Therefore, technical progress refers to an increase in
productivity of inputs and can be represented by shift in
isoquants towards origin referring to output level. This
implies any level of output can be produced with fewer
inputs or more output with same inputs.
 Economies and Diseconomies of Scale
When we talk about the scale of production of a firm, we often hear about the
fact that large-scale production, usually, helps in reducing the cost of
production. Economies of scale refer to these reduced costs per unit arising due
to an increase in the total output. Diseconomies of scale, on the other hand,
occur when the output increases to such a great extent that the cost per unit
starts increasing. In this article, we will look at the internal and external,
diseconomies and economies of scale.
Internal and External Economies
When a firm opts for large-scale production, the economies arising out of it are
grouped into two categories:
Internal economies – economies of production that the firm accrues when it
increases the output leading to a drop in the cost of production. These arise due to
endogenous factors like entrepreneurial efficiency, talents of the management team,
type of machinery, etc. These economies arise within the firm and help the firm only.
External economies – these are the benefits that each member firm of the industry
accrues due to the expansion of the entire industry.
Internal Diseconomies and Economies of Scale

While studying returns to scale, we observed that they increase during the initial stages, remain constant for a while, and then
start decreasing. The reason is simple – initially, the firm enjoys internal economies of scale and after a certain limit, it suffers
from internal diseconomies of scale. Let’s look at the types of economies and diseconomies:

Technical

Large-scale production is linked to technical economies. When a firm increases its scale of operations, it needs to use a more
specialized and efficient form of capital equipment and machinery. Such machinery helps to produce larger outputs at a lower
unit cost.

Further, as the scale of production increases and the amount of labor and other factors becomes larger, the firm manages to
reduce costs by introducing a degree of division of labor and specialization.

However, beyond a certain point, the firm experiences diseconomies of scale. This happens because after reaching a large
enough output, the firm utilizes almost all possibilities of the division of labor and employment of efficient machinery.

Post this, any increase in the size of the plant causes the costs to rise. When the scale of operations becomes too large, the
management finds it more difficult to control and coordinate the operations.
Managerial

As the output increases, the firm can apply the division of labor to the management as well. For example, the
production manager can look after production, the sales manager can look after sales, etc. When the scale of
production increases further, the firm divides each department into sub-departments like sales is divided into
advertising, exports, and service.

Thus helps in increasing the efficiency and productivity of the management team since a specialist manages
each sub-department. Further, the firm has the option to decentralize decision-making authority enhancing the
efficiency further. Therefore, specialized management allows the firm to reduce managerial costs.

However, as the firm increases its scale of operations beyond a certain limit, the management finds it difficult to
control and coordinate between departments. This leads to managerial diseconomies.
Commercial

As a firm increases its volume of production, it requires large amounts of raw material and
components. Hence, it places a bulk order for such material and components and enjoys
discounted pricing for them.

Economies are also achieved during sales. If the sales staff is working under-capacity, then
the firm can sell additional output at little extra cost.

Further, as the scale of production increases, the advertising cost per unit fall. Hence, the firm
benefits from economies of advertising too. After an optimum level, these economies start
becoming diseconomies though.
Financial

When a firm wants to raise finance, a large-scale firm has many benefits like:

• Better security to bankers

• Well-known

• Can raise finance at lower costs, etc.

However, after the optimum scale of production, the financial costs rise faster due to the increased dependence
on external finances.

Risk-bearing

A firm enjoys the economies of risk-bearing if it has a large-scale operation with diverse and multi-production
capabilities. However, if the diversification increases the economic disturbances rather than covering them, then
the risk increases.
External Diseconomies and Economies of Scale

External diseconomies and economies of scale are very important to a firm. These are a result of the expansion of output of
the entire industry and not limited to an individual firm. They are available to one or more firms in the following forms:

Cheaper Raw materials and Capital Equipment

At times, the expansion of an industry results in new and cheaper sources of raw material, machinery, and other capital
equipment. It also results in an increased demand for the various types of materials and equipment required by the industry.

Hence, such materials/equipment can be purchased from other industries on a large scale. This, eventually, leads to a lower
cost of production and lower price. Therefore, firms using these materials/equipment get them at lower prices.

Technological External Economies

Usually, when an entire industry expands, new technical knowledge is discovered leading to new and improved machinery
for the said industry. This changes the technological coefficient of production and enhances the productivity of the firms in
the industry. Hence, the cost of production reduces.
Development of Skilled Labor

As the industry expands, the labor gets accustomed to managing various production
processes and learns from the experience. This increases the number of skilled workers which
in turn has a favorable effect on the levels of productivity.

Growth of Ancillary Industries

When a certain industry expands, many ancillary industries start specializing in the
production of raw materials, tools, machinery, etc. These ancillary industries offer the
materials/machinery at a low price.

Similarly, some ancillary industries also start processing industrial waste and create a useful
product out of it. Overall, it leads to a lower cost of production.
Better Transportation and Marketing Facilities

An expanding industry, usually, results in better transportation and marketing networks.

These aspects help reduce the cost of production in the firms from the industry.

It is important to note that, certain disadvantages can neutralize the advantages of the
expansion of industry and cease the external economies of scale. These are external
diseconomies. When an industry expands, the demand for certain materials and skilled labor
increases.

If these factors are in short supply, then their prices can increase. Further, the geographical
concentration of firms from the industry can lead to higher transportation costs, marketing
costs, pollution control costs, etc.
THANK YOU!!