Production, Costs and Revenue

1.
2.
3.

4.
5.
6.

To give basic idea about production function.

To give basic idea about various costs and
revenue concepts.
Production Cost & Revenue
To show the behavior and shapes of short and
long run costs and revenue concepts and the rea
sons behind that.
To give basic idea about economies of scales
and scope concepts.
To give basic idea about profits maximization.
Application of these concepts to practice.

Production, Costs and Revenue

Production, costs and revenues are related with the supply theory.

Can we analyze various business organizations through one

theory or do we need many theories. One general framework with
adjustment to suit with various market structures.
Before deciding the output level, firm has to know two important
issues: How much will it cost to produce and how much
revenue will it generate
Price
Cost of production

Firm chooses
Level of output and
fixed the price

Output

Revenue

The complete theory of supply

Technology
and costs of
hiring
factors of
production

Total cost
curves,
short-run
and long
run

Marginal
cost curves,
short-run
and long
run

Average cost
curves, shortrun and long
run

Modeling

Firm
chooses
level of
output

Marginal
revenue
curve

Checks: Whether
to produce at all
in short-run:
whether to close
down in long run

Demand curve
facing the firm
(prices at
which the firm
can sell each
level of output)

Production
The term production refers to more than the physical
transformation of resources. Production involves all the
activities associated with providing goods and services.
Thus the hiring of workers (from unskilled labor to top
management), personnel training, and the organizational
structure used to maximize productivity are all part of the
production process.
Input: any good or service used to produce output.
A technique: a particular method of combining inputs to
make outputs.
Technology: is the list of all known techniques
Technical progress: production of a given output with less
inputs than before or shift in production possibility curve.

The Production Function

- A production function is a descriptive statement that relates
inputs to outputs.
- A technical relationship between physical inputs and outputs.
- It specifies the maximum possible output that can be
produced for a given amount of inputs.
- The minimum quantity of inputs necessary to produce a
given level of output.
- Production functions are determined by the technology
availability to the firm.

The Production Function

Inputs

FOPs

Outputs
Firm
Black Box

Inputs - FOPs (Factors of production)

(labour, land, materials, capital,
knowledge, etc)

The Functional Form

Q = f (costs, ...)
This can be separated into :
Q = f (K, L, La, M, ...)
Q = output, K = capital, L = labour, La = land,
M = materials

Or in its most usual form :

Q = f (K, L)

Technical efficiency and economic efficiency in

production
Technical efficiency is a method of production which
involves the minimum amount of a combination of different f
actors .
Economic efficiency is the use of resources to produce any
given output level at minimum cost .
See page no. in your second text book

Time Duration in Economics

The Short Run (Time period when at least one factor is in
fixed supply. Output can be changed by using variable
factor with the fixed factor. The length of the short run cha
nge firms to firms and industry to industry.)
Q = f (K - fixed factor, L - variable factor)
The Long Run (No fixed factors or all the factors are
variable except technology.)
The Very Long Run (The time period over which
technology might change.)
Economists analyze production, costs and revenue with
respect to these short and long run periods.

Fixed and Variable Factors

in the short run (SR), at least one of the factors

is fixed in supply (the operating period)
can split SR costs into fixed and variable
fixed costs are costs which do not vary in the
short-run with the level of output

(e.g. rent, interest payments, capital depreciation..)

variable costs are costs which do vary in the

short run with the level of output

(e.g. raw materials, heating and lighting, waged

labour...)

In studying production functions, there are two types of

relations between inputs and outputs that are of
interest for managerial decision making.
1. Returns to scale
Relation between output and the variation in all
inputs taken together.
This plays an important role in managerial decisions.
They affect the optimal scale, or size of a firm and its production
facilities.
They also affect the nature of competition in an industry and
thus are important in determining the profitability of investment
in a particular economic sector.

2. Returns to a factor
The relation between output and variation in only one of the
inputs employed.
The terms factor productivity and returns to a factor are
used to denote this relation between the quantity of an
individual input (or factor of production) employed and the
output produced.
Factor productivity provides the basis for efficient resource
employment in a production system.

TOTAL, AVERAGE, AND MARGINAL PRODUCT

Total Product (TP): The total output that results from
employing a specific quantity of resources in a production
system. Generally this TP will rise as more units of labor are
employed with fixed volume of capital. But the trend of this curve
has different rates of increases: first it increases at an increasing
rate, then at a decreasing rate and finally it will decline. The
explanation for this behavior can be explained through the
concept of marginal product.

Marginal Product (MP): The change in output associated

with a unit change in one input factor, holding other inputs
constant.
MP = d(TP)/dQ or ATP/AQ
This curve first goes up due to workers specialization and spare
capacity in fixed factor and then goes down due to full utilization
of the fixed factor.

Average Product (AP)

Total product divided by the units of inputs employed.
AP = TP/L
This curve first goes up then goes down
Relationship between AP and MP: AP goes up then MP above it
and AP goes down then MP below it. This relationship can be
explained through principle of diminishing returns.
Principle of Diminishing Returns: More units of a variable
factor (L) are combined with a given number of fixed factors (K)
there comes a point where the returns to the variable factor
begin to decline.

Total Product, Marginal Product, and Average

Product of Factor X, Holding Y=2
Input
Quantity
(X)
1
2
3
4
5
6
7
8
9
10

Total Product
of the Input
(Q)
15
31
48
59
68
72
73
72
70
67

Marginal Prod:
of Input X
(MPx= A Q/ A X)
15
16
17
11
9
4
1
-1
-2
-3

Average Prod:
of Input X
(Apx = Q/X)
15
15.5
16
14.8
13.6
12
10.4
9
7.8
6.7

Output Q

Total, Average, and Marginal Product for

Input X: Given Y=2
80
60
40
20
0

TPx

Input x

10

20

Average and Marginal Products

Output Q

15
10

APx

5
0
-5

Input X

10

MPx

The Law of diminishing returns

As the quantity of a variable input increases,

with the quantities of all other factors being held

constant, the resulting increases in output
eventually decrease.
Holding all factors constant except one, the law
of diminishing returns says that, beyond some
level of the variable input, further increases
in the variable input lead to a steadily
decreasing marginal product of that output.

Cost Analysis
Cost Analysis plays a central role in managerial economics because
virtually every managerial decision requires a comparison between costs
and benefits.
There are number of other cost concepts.
Relevant cost and Opportunity cost
Accounting cost and economic cost
Explicit vs implicit costs
Marginal cost or Incremental Cost
Sunk cost (while leaving industry you can not recover this costs) and
fixed cost
Short and long-run costs

Short-run Costs
Short-run Total Costs
Total Cost: TC (fixed and variable costs in production)
Total Fixed Cost: TFC (Cost which does not change with
output and it is the overhead or capital costs. The curve is a hori
zontal or flatter)
Total Variable Cost: TVC (Cost which change with output: labor
and raw materials). This curve is the inverse shape of TP
curve.First it increases at decreasing rate (additional unit of labo
ur add more value to production) and then increases at increasi
ng rate (additional unit of labour add more to cost rather to prod
uction).
TC = TFC + TVC, TFC = TC - TVC, TVC = TC - TFC

Short-run Average Total Costs

TC/Q = TFC/Q + TVC/Q
ATC = AFC + AVC
AFC (falls as output increases and it is continually down-ward
slopping. It is the fixed costs per unit of output produced).
AVC (first falls and then rise and it is the inverse shape of AP
curve: AP rises then AVC falls AP falls then AVC rises due to cha
nges in labor productivity.
ATC (first falls and then rise mainly due to AVC curve)
AFC = ATC - AVC, AVC = ATC - AFC

Marginal Cost is the increase in total cost when output is

increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again rises.
The main reasons for this behaviour is production techniques
(at low level of output simple techniques then costs go up
Output increases sophisticated techniques then economies
of scales. Output further increases diseconomies of scales
such as Organizational problems cost go up).
Generally MC, AVC and ATC show some relationship.
If MC < AVC then AVC falls
If MC = AVC then AVC is at minimum
If MC > AVC then AVC rises
Same relationship holds between MC and ATC

Short-Run Cost Relationships

Q
1
2
3
4
5
6
7
8
9
10

TC
120
138
151
162
175
190
210
234
263
300

TFC
100
100
100
100
100
100
100
100
100
100

TVC
20
38
51
62
75
90
110
134
163
163
200

ATC
120
69
50.3
40.5
35
31.7
30
29.3
29.2
30

AFC
100
50
33.3
25
20
16.7
14.3
12.5
11.1
10

AVC MC
20
20
19
18
17
13
15.5 11
15
13
15
15
15.7 20
16.8 24
18.1 29
20
37

Short Run Cost Curves

$ per time
period

Increasing
productivity
of variable
factors

Decreasing
productivity
of variable
factors

Total cost

F
Total
Variable
cost

Fixed
cost
O

Q2 Q3
Q1
Output per time period (units)
Total Costs

Fixed
cost = OF

Variable
cost

Short Run Cost Curves

Cost

MC
ATC
AVC

Q1

Q2

Q3

Profit maximising output Q1

MR

AFC
Output

Cost ()

Bringing FC and VC together

ATC
AVC
TFC

AFC
0

q1

Quantity (no. of units)

Cost ()

ATC and MC

MC
ATC

q*

Quantity (no. of units)

The Relationship between Average and

Marginal Curves
AC is falling when MC is less than AC, and rising
when MC is greater than AC (AC is declining
whenever MC is below AC, and rising whenever MC
above).
AC is at minimum at the output level at which AC and
MC cross (MC cuts the minimum point of AC).

Short-run Optimality
Full or optimum capacity = firm produces at minimum level of
short-run average cost curve and at this point all the inputs are
employed to their optimum efficiency.
If the firm faces long U shape (Saucer) cost curve, the range of
the minimum points are called load factor or normal capacity
utilization.
If firm producing a point right to this then its average costs is
rising.
If firm is producing left to this point then firm has a reserve
capacity; firm is not fully utilizing its factors of production.

Self-study Exercise 1: Identify the main

fixed and variable costs need to
operate within the following
industries...

Newspaper business
Jewellery retailing
Electronic components manufacture
Electricity generation
Software development
Cellular telecommunications
Hotel management

Long-Run Cost Curves

In the long run all the factors are variable and accordingly firm
can change its scale of the operation. However firms can not
change all the variables together. Therefore, long-run is going to
be a series of short run periods.
During this period firms will change the scale of production (the
amount firm is able to produce in relation to its size) which will
affect for productive efficiency in three ways:
1) Constant returns to scale
2) Increasing returns to scale
3) Decreasing returns to scale

LR Average Costs

in the long run, quantities of all inputs can be

varied (the planning horizon)
this means that there are no fixed costs in the
long run
and so the LRAC curve is different from the
SRAC weve considered so far. It is more
enlarge U (saucer) shaped one. It is the
envelope of the short-run cost curves.

The Long Run Average Cost Curve

LRAC

cost ()

LRMC
SRAC1

c1

SRAC5
SRAC4
SRAC2

c2

SRAC3

c*

q1

q2

q*

q4

q5

The relationships between LRAC and LRMC same units of output

like in short-run.

Economies and diseconomies of scale

There are economies of scale (increasing returns to scale)
when long-run average cost decreases as output rises or
volume of output rises more quickly than the volume of
inputs.
There are constant returns to scale when long-run average
cost are constant as output rises or volume of output
increases in the same proportion to the volume of inputs .
There are diseconomies of scale (decreasing returns to
scale) When long-run average cost increase as output rises or
volume of output rise less quickly than the volume of inputs.
These are explained by the presence of both internal and
external economies and diseconomies of scale in production.

Cost ()

Returns to Scale
Increasing
returns to
scale

Constant
returns to
scale

Decreasing
returns to
scale

LRMC
LRAC
LRAC

LRMC

q1

q2 Quantity (no. of units)

Minimum efficient
scale (MES)

The long- run average cost curve

Average
(i.e. per
unit) cost of
production

Increasing
returns to
scale

Decreasing
returns to
scale
Constant returns to
scale

Decreasing
cost
production

Increasing
cost
production

Constant cost
production

q1

q2

Output expansion
over the long run

Increasing returns to scale

Read the given handout part

Internal economies of scale economies internal to the firm

resulting from a more efficient utilization of resources. This can
be technical or non-technical: labour, investment indivisibilities,
large scale procurement, R &D,capital, diversification, promotion,
transport and distribution, by-products, specialization, flexible
manufacturing large scale necessary to take advantage, reserve
capacity, end of learning period.

External economies of scale economies brought about by the

growth or conentration of the industry: existence of good labour
force, existence of network of suppliers, existence of social
economic and environmental infrastructure.

Decreasing returns to scale

(Internal diseconomies of scale - management, labour, other
inputs, External diseconomies of scale geography of
concentration, range of business, time of the business).
Solution to the decreasing returns to scale
1) Relocation of operation
2) Contracting-out
3) Reorganization of management structures
4) Lay-off the workers
5) Productivity increase by new technology and HR programmes.

Minimum Efficient Scale (MES)

The point at which the long run average cost curve first
becomes horizontal (flatter) and it is the technical optimum
scale of production. It gives a firm a strong competitive
advantage in the market place over higher cost producers.
Beyond this MES, firms do not have additional economies of
scales.
Expanding scale firms can further enjoy MES status. Then
managerial problems and other diseconomies are going to
emerge.

Economies of Scope
This exist where several different outputs draw on a common
resources and it is a diversification in a same or different
production and marketing lines. This diversification leads to
cost savings. Generally economies of scale and scope reinforce
each other to minimize cost.
The Degree of Economies of Scope (DES)
DES = {[TC(An) + TC(Bn)] TC (An + Bn)}/[TC (An+Bn)]
TC(An) = Total cost of producing An units of product A separately
TC(Bn) = Total cost of producing Bn units of product B separately
TC (An+Bn) = Total cost of producing A and B jointly
DES < 0 Negative ES. It is better to produce separately
DES >0 Positive ES. More economical to produce jointly.
Generally economies of scale and economies of scope are reinforcing
each other to reduce costs.

Sources of Economies of Scale and

Scope
Economies of Scale
Pecuniary Economies

Real Economies
Production
Labour
Capital
Inventory

Selling/
Marketing

Managerial

Other

Specialisation/team-working
Decentralisation
Mechanisation
Advertising
Large-scale promotion
Exclusive dealers

Bulk buy raw materials

Lower cost of finance
Lower cost of advertising
Lower transport rates
Lower R & D costs

Transport
Storage
R & D efficiencies
By-product production
Experience curves

source : adapted from Koutsoyiannis (1979)

X-inefficiency
The situation of wastage of firms resources and its costs
higher than necessary level. This can happen due to
managerial or technological or any other factor. This firm
can not exist market in long-run. Most of the public sector
institutions have this problem. But generally in the long-ru
n in competitive markets, firms can not survive if they hav
e X-inefficiency problem: full efficient firms only survive.
We can measure it as actual cost point - MES = (q1a-q1b)
=ab
C
a

LRAC

The Learning Effect (Accumulative productive

experience)
Firm accumulate its business experience over the years which improve its
production and organizational methods which ultimately reduces the cost of
production. -learning by doing approachAt managerial level the learning effects occurs
Perfection and precision reached due to constant practice of managerial
decision making.
Finding more efficient production and business procedure.
Knowing better ways to use tools and equipments.
Familiarization with the production activities which helps to give good
instructions to subordinates.
Cost per unit
Right placement of right people.
Better co-ordination and control.
Good integration of works.
LRAC
Better TQM
Better project management and scheduling
Cumulative output

Learning Effect Rate (LER)

LER = [ 1- (ACt1/ACt0)] *100
ACt1 = Average cost in initial period (t0) increment
ACt0 = Average cost in next period (t1) increment
ACt1/ACt0 = Experience factor
This measures percentage decrease in additional cost with
respect to a 100 per cent increase in output at each time.
For working examples see Mithani.D.M (2000),
Managerial Economics, Theory and Applications,
Himalaya Publishing House, Page 280-1

Self-study Exercise 2: What are the

potential sources of economies of scale
and scope in the following industries/Or
in your firm/organization?
1) Consumer finance
2) Pharmaceuticals
3) Printing
4) Road construction
5) Recorded music industry
6) Shoe manufacture & retail
7) Training and education provision

Profits Maximization
Total Revenue - Total Costs = Profits
TR - TC = Profits
d(TR)/dQ - d(TC)/dQ = Marginal profits
MR = MC, Profits maximizing condition or rule
Marginal revenue = Marginal cost
Profits maximising output decision:
MR > MC Q should goes up
MR = MC Q profit maximising output
MR < MC Q should goes down
Profits maximising output and revenue maximising output are
two different concepts (see next table).

Profit maximization & the Revenue maximization

PQd
(TR)
0

TC
(TFC+ TVC)
10

(TR-TC)
-10

21

21

25

-4

20

40

36

19

57

44

13

18

72

51

21

17

85

59

26

16

96

69

27

15

105

81

24

14

112

95

17

13

117

111

12

10

120

129

-9

P
(per unit)
-

Qd

Marginal Cost is the increase in total cost when output is

increased by 1 unit:
MC = d(TC)/dQ
Its behaviour starts at high then falls then again rises.
MC

MC

Marginal revenue is the increase in total revenue when output

is increased by 1 unit. Its behaviour depends on the firms
demand curve . Generally it is a downward for most market
structures except perfect competition (horizontal).
P

Perfect Competition

Other Markets

MR/D/P
0

MR

AR =DQ

Profits Maximization in Short

Run

MC
ATC
AVC

AFC
O

MR > MCQ1

Profits maximising output Q1

Q2

Q3

MC <
MRMR

Comparative Static Analysis

MC

MC 1
MC

MR

MC 2

MR
0

Q
Q1

Q2

Comparative Static Analysis

MC
MC

MR

MR1
0

Q1

Q2

MR2
MR
Q

See figure a (TR, TC and profits curves)

1) Break even points Q1 and Q4 (TR = TC).
2) Loss making area below Q1 and above Q4 (TC>TR).
3) Profits making area between Q1 - Q4 (TR>TC).
4) Maximum profits in Q2 (highest difference between TC and
TR).
See figure b (MC, AC, AR and MR curves)
These two figures are interrelated:
1) Break even points Q1 and Q4 (AC=AR).
2) In loss making area below Q1 and above Q4 (AC > AR).
3) Profits making area between Q1 and Q4 (AR > AC).
4) Maximum profits in Q2 (MR =MC, Moving to right from Q1
MR>MC. Moving to left from Q4 MR>MC, Moving right to Q2 MR
<MC. Therefore the best point is Q2).

Figure a

Figure b

Normal Profits
At a breakeven point firm makes zero profits. But economists
name it as a normal profits based on the opportunity cost conce
pt.
Abnormal Profits (Super normal profits)
Surplus above the normal profits. Between Q1 and Q4
Shut-Down Price
Below the normal profits firm does not get full cost recovery.
Therefore, they will decide to shut-down the business.

The Shut-down Position in Shortrun

Price and Cost

SRM
C

Abnormal profits
P5
Normal profits

D5 = MR5
D4 = MR4

P4
P3

D3 = MR3

Shut-down price P2

D2 =MR2

P1

SRAC
SRAV
C

D1 =MR1

Q1

Q2

Q3

Q4 Q5

Output

Exercise
Usage of profits maximizing model to loss making firm - Baldwins
fashion Ltd
This firm make profits till very recent but now in loss and
considering closing down. Your advice to regain the profits and to
remain in the industry.
Solutions:
1) Decreasing variable costs
2) Decreasing fixed costs
3) Increasing the level of demand
4) Combinations of all these